Fitch Rates Covanta's New Tax-Exempt Bonds 'BB+', Upgrades CEC's Secured Debt to 'BBB-'
Fitch Ratings has assigned its 'BB+' rating to the proposed issuance of Covanta Holdings Corporation's (Covanta) $335 million unsecured tax-exempt bonds with maturities ranging from 12-30 years. These bonds are guaranteed by Covanta's wholly owned subsidiary, Covanta Energy Corporation (CEC). In addition, Fitch has upgraded its rating for the $1.2 billion senior secured facilities at CEC to 'BBB-' from 'BB+'. A complete list of rating actions is provided at the end of this release.
Fitch has affirmed the Issuer Default Ratings (IDR) of 'BB' for Covanta and CEC. The IDRs of Covanta and CEC are linked due to a high degree of business, legal and financial linkages. The Rating Outlook is Stable for both the entities. Fitch has also affirmed its 'BB' rating for Covanta's existing 6.375% $400 million senior unsecured notes due 2022, 7.25% $400 million senior unsecured notes due 2020 and 3.25% $460 million cash convertible senior notes due 2014.
The net proceeds from the new $335 million issuance of tax-exempt bonds by Covanta will be used to refinance Haverhill, Niagara and SEMASS project bonds, which all together have a face value of $328 million. In addition, the transaction will raise $20 million in new proceeds to fund qualifying capital expenditures in Massachusetts. In Fitch's view, the proposed transaction enhances Covanta's consolidated debt maturity profile and is modestly positive for liquidity given the release of project restricted funds that result in approximately $52 million of net cash proceeds to the company. However, the transaction results in modestly higher leverage in 2013 and beyond compared to Fitch's prior forecasts given that amortizing project debt is being replaced with bonds with long-term bullet maturities.
Fitch views the proposed transaction as favorable for CEC's secured debt since its relative position in the overall capital structure is improved due to a reduction in the amount of project-level debt outstanding that was structurally superior. Pro forma for the transaction, the project debt at CEC's various domestic project subsidiaries will be $275 million as compared to $603 million preceding the transaction. The release of liens due to the prepayment of project debt enhances the collateral package for CEC's secured debt. As a result, Fitch has upgraded the ratings of CEC's secured debt by one-notch. The proposed new tax-exempt bonds are notched one-level higher than Covanta's existing unsecured debt due to the upstream guarantee from CEC.
The 'BB' IDR reflects Covanta's reliance on distributions from its wholly owned subsidiary, CEC, which, in turn, derives cash flow from upstream distributions by its numerous project subsidiaries. Covanta's ratings reflect its visible and sustainable cash flow generation from highly contracted waste disposal and energy revenue with credit-worthy counterparties and a small, but increasing proportion of recycled metal sales. Covanta enjoys a strong liquidity position including a stable free cash flow profile, manageable debt maturities and consistently demonstrated capital markets access. The ratings also reflect a highly leveraged capital structure and structural subordination of corporate debt to the debt at various project subsidiaries.
Fitch has modestly reduced its revenue and EBITDA expectations for Covanta for the near term as challenging economic conditions persist. Fitch expects waste volumes to be slightly lower than its prior forecast. Fitch expects Covanta's waste and service fee revenue to benefit from contractual escalations in tip and service fees, which are usually indexed to inflation and an increase in higher priced, special waste volume in the overall mix. Covanta's service and waste disposal agreements expire at various times and the company has been successful in extending a majority of its existing contracts. However, Fitch expects that the average contract length for waste and energy revenues if going to become shorter as historical contracts roll-off. There are several service-fee owned contracts that face contract expiration over 2014-2016 and will likely get extended or transition to tip-fee structure, in Fitch's opinion.
Continued weakness in natural gas prices has negatively affected power prices leading to a lower energy revenue expectation than Fitch's prior estimates. Fitch recently lowered its natural gas price outlook to $2.75/3.50/4.00 per MMBtu for 2012/2013/2014, respectively. Approximately, 80% of Covanta's retained electricity production in under contract and/or hedged for 2013. However, with the roll-off of historical contracts, a greater proportion of energy revenues will get exposed to market-driven rates.
Fitch expects a strong growth in recycled metal revenues driven by higher metal recoveries. Covanta has been channeling a portion of its surplus cash toward smaller projects that can drive organic growth. These include modest capital investments to enhance metal recovery during waste-to-energy conversion. Fitch also expects a shift in mix to non-ferrous metals, which would further boost the metal revenue. The pricing environment for both ferrous and non-ferrous metals, however, has turned soft during 2012 with the slowdown of major global economies.
Fitch expects consolidated EBITDA to be under pressure over 2012-2014 driven by weaker energy revenues, partially offset by an increase in metal revenue and a shift in mix toward higher priced special waste. Toward the latter part of the forecast period, Fitch expects EBITDA growth to rebound from improved power prices, higher retained share of electricity production and sustained growth in metal revenues. Fitch expects the free cash flow generation to remain more or less stable over 2012-2014 and then be negatively impacted from higher cash tax payout due to the expiration of net operating losses, offset by EBITDA growth.
Fitch expects the company to generate surplus cash flow of approximately $100 million annually over the next five years after netting dividend, maintenance and growth capex. In absence of significant development projects and after meeting the declining scheduled project debt payments, Fitch considers it likely that management will use the surplus cash to return to shareholders. Covanta will be de-leveraging its capital structure due to the scheduled pay down of project debt, which will minimize structural subordination of cash flows and is positive for the credit profile. It is quite likely that management may raise debt at the corporate level in order to utilize the freed up capacity and use the proceeds to further return capital to shareholders. Any significant re-levering of the balance sheet would be negative for Covanta's credit profile and could warrant a downward revision in ratings.
Covanta's financial flexibility is quite robust given a healthy cash flow generation profile, adequate liquidity and sufficient flexibility to allocate surplus capital within the limitations of the existing and proposed debt instruments. As of Sept. 30, 2012, Covanta had unrestricted cash and cash equivalents of $262 million and availability under its revolver of $597 million.
Fitch estimates Covanta's consolidated gross leverage to be approximately 4.0 times and funds flow from operations (FFO) to total debt to approach 15% toward the end of Fitch's forecast period (2015). These metrics are in line with Fitch's guideline ratios for a medium-risk 'BB' rated issuer.
The Stable Outlook for Covanta incorporates Fitch's expectation that its cash flow generation remains solid and credit metrics remain stable over the forecast period supported by a strong liquidity profile that should enable the company to withstand any worsening of the commodity downturn.
Fitch's rating concerns include increasing business risk as historical, long tenured waste, service and energy contracts expire and the proportion of commodity-driven organic initiatives, which include metal sales and special waste, rise. Covanta has pursued an aggressive capital allocation policy that is directed toward returning capital to shareholders over the last two years.
Positive: Any positive rating actions in the near term will likely be driven by any material change in the company's capital allocation decisions.
Negative: Fitch could take negative rating actions if management were to seek additional leverage to return capital to shareholders or to materially increase capital spending.
Fitch has assigned the following ratings with a Stable Outlook:
Covanta Holding Corporation
--$335 million unsecured tax-exempt bonds 'BB+'.
Fitch has upgraded the following ratings with a Stable Outlook:
Covanta Energy Corporation
--$900 million senior secured revolver due 2017 to 'BBB-' from 'BB+';
--$300 million senior secured term loan due 2019 to 'BBB-' from 'BB+'.
Fitch has affirmed the following ratings with a Stable Outlook:
Covanta Holding Corporation
--Long-term IDR at 'BB';
--$$400 million 7.25% senior unsecured notes due 2020 at 'BB';
--$$400 million new senior unsecured notes due 2022 at 'BB';
--$406 million 3.25% cash convertible senior notes due 2014 at 'BB'.
Covanta Energy Corporation
--Long-term IDR at 'BB'.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', Aug. 8, 2012;
--'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers', Aug. 12, 2012;
--'Rating North American Utilities, Power, Gas and Water Companies', May 16, 2011;
--'Parent and Subsidiary Rating Linkage', Aug. 8, 2012.
Applicable Criteria and Related Research:
Corporate Rating Methodology
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers
Rating North American Utilities, Power, Gas, and Water Companies
Parent and Subsidiary Rating Linkage
Shalini Mahajan, CFA
One State Street Plaza
New York, NY 10004
Joseph Rohlena, CFA
Brian Bertsch, +1-212-908-0549 (New York)