UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

Commission file number 1-6732

 

Covanta Holding Corporation

(Exact name of registrant as specified in its charter)

 

 

 

(973) 882-9000
(Registrant’s telephone number including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer þ   Accelerated filer o  Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

The number of shares of the registrant’s Common Stock outstanding as of the last practicable date.

 

 

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

FORM 10-Q QUARTERLY REPORT
For the Quarter Ended June 30, 2006

 

 

Certain statements in this Quarterly Report on Form 10-Q may constitute “forward-looking” statements as defined in Section 27A of the Securities Act of 1933 (the “Securities Act”), Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), the Private Securities Litigation Reform Act of 1995 (the “PSLRA”) or in releases made by the Securities and Exchange Commission (“SEC”), all as may be amended from time to time. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of Covanta Holding Corporation and its subsidiaries (“Covanta”) or industry results, to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Statements that are not historical fact are forward-looking statements. Forward-looking statements can be identified by, among other things, the use of forward-looking language, such as the words “plan”, “believe”, “expect”, “anticipate”, “intend”, “estimate”, “project”, “may”, “will”, “would”, “could”, “should”, “seeks”, or “scheduled to”, or other similar words, or the negative of these terms or other variations of these terms or comparable language, or by discussion of strategy or intentions. These cautionary statements are being made pursuant to the Securities Act, the Exchange Act and the PSLRA with the intention of obtaining the benefits of the “safe harbor” provisions of such laws. Covanta cautions investors that any forward-looking statements made by Covanta are not guarantees or indicative of future performance. Important assumptions and other important factors that could cause actual results to differ materially from those forward-looking statements with respect to Covanta, include, but are not limited to, the risks and uncertainties affecting their businesses described in Item 1A of Covanta’s Annual Report on Form 10-K for the year ended December 31, 2005 and in other securities filings by Covanta.

 

Although Covanta believes that its plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, actual results could differ materially from a projection or assumption in any of its forward-looking statements. Covanta’s future financial condition and results of operations, as well as any forward-looking statements, are subject to change and inherent risks and uncertainties. The forward-looking statements contained in this Quarterly Report on Form 10-Q are made only as of the date hereof and Covanta does not have or undertake any obligation to update or revise any forward-looking statements whether as a result of new information, subsequent events or otherwise, unless otherwise required by law.

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Organization

 

Covanta Holding Corporation (“Covanta”) is a holding company that owns subsidiaries engaged in the businesses of waste and energy services, and insurance services. The predominant business is the waste and energy business which is comprised of Covanta Energy Corporation and its subsidiaries (“Covanta Energy”), which subsidiaries include Covanta ARC Holdings, Inc., formerly known as American Ref-Fuel Holdings Corp., and its subsidiaries (“ARC Holdings”), which Covanta Energy acquired on June 24, 2005 (the “Acquisition Date”). See Note 3. Acquisition of the Notes to Condensed Consolidated Financial Statements (“Notes”).

 

Covanta Energy and its domestic subsidiaries develop, construct, own and operate for themselves and others infrastructure for the conversion of waste-to-energy, waste disposal, and independent power production businesses in the United States. Covanta Energy’s subsidiary, Covanta Power International Holdings, Inc. and its subsidiaries (“CPIH”), engage primarily in the independent power production business outside the United States. Covanta’s business segments are comprised of Waste and Energy Services, which is comprised of Covanta Energy’s domestic and international operations, and Other Services, which is comprised of the holding company and insurance subsidiaries’ operations.

 

Covanta also has investments in subsidiaries engaged in insurance operations in California. Covanta holds all of the voting stock of Danielson Indemnity Company (“DIND”). DIND owns 100% of the common stock of National American Insurance Company of California, Covanta’s principal operating insurance subsidiary. National American Insurance Company of California and its subsidiaries are collectively referred to herein as “NAICC.” The operations of NAICC are in property and casualty insurance. NAICC writes non-standard private automobile insurance policies in California.

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of Covanta have been prepared in accordance with the instructions to Form 10-Q. As permitted by the rules and regulations of the Securities and Exchange Commission (“SEC”), the financial statements contain certain condensed financial information and exclude certain footnote disclosures normally included in audited consolidated financial statements prepared in accordance with United States generally accepted accounting principles (“GAAP”). In presenting the unaudited condensed consolidated financial statements, management makes estimates and assumptions that affect the amounts reported and related disclosures. Estimates, by their nature, are based on judgments and available information. Accordingly, actual results could differ from those estimates. In the opinion of management, the accompanying financial statements contain all adjustments, including normal recurring accruals, necessary to fairly present the accompanying financial statements. Operating results for the interim period are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in Covanta’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

The condensed consolidated financial statements include the accounts of Covanta and its wholly-owned subsidiaries. Companies in which Covanta owns between 20-50% are typically accounted for using the equity method. Those companies in which Covanta owns less than 20% are accounted for using the cost method. Certain prior period amounts, including various revenues and expenses, have been reclassified in the condensed consolidated financial statements to conform to the current period presentation. All intercompany transactions and balances have been eliminated.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

On March 31, 2006, the Financial Accounting Standards Board (“FASB”) issued an exposure draft that would require recognition of the overfunded or underfunded positions of defined benefit pension and other postretirement benefit plans on the balance sheet. For an underfunded plan, the incremental liability to be recorded would be equal to the difference between the projected benefit obligation and the fair value of plan assets. Statement of Financial Accounting Standards (“SFAS”) No. 87, “Employers’ Accounting for Pensions” (“SFAS 87”) and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” (“SFAS 106”) allow for deferred recognition of this liability through amortization of this difference over time. Under this exposure draft, actuarial gains and losses and prior service costs and credits that arise during the period but, pursuant to SFAS 87 and SFAS 106 are not yet recognized as components of net periodic benefit cost, would be recognized as a component of accumulated other comprehensive income, net of tax. The exposure draft also requires an adjustment to the beginning balance of accumulated earnings, net of tax, for any transition obligation remaining from the initial application of SFAS 87 and SFAS 106. Such amounts would then not subsequently be amortized as a component of net periodic benefit cost. When a final pronouncement is released, Covanta will evaluate the impact on its consolidated financial statements.

 

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). This interpretation increases the relevancy and comparability of financial reporting by clarifying the way companies account for uncertainty in income taxes. FIN 48 prescribes a consistent recognition threshold and measurement attribute, as well as clear criteria for subsequently recognizing, derecognizing and measuring such tax positions for financial statement purposes. The interpretation also requires expanded disclosure with respect to the uncertainty in income taxes. FIN 48 is effective for fiscal years beginning after December 15, 2006. Covanta is evaluating the potential impact of this interpretation on its consolidated financial statements.

 

ARC Holdings

 

On June 24, 2005, Covanta, through its wholly-owned subsidiary Covanta Energy, purchased 100% of the issued and outstanding shares of ARC Holdings’ capital stock. Under the terms of the stock purchase agreement, Covanta paid approximately $747 million in cash and transaction costs for the stock of ARC Holdings and assumed the consolidated net debt of ARC Holdings of $1.3 billion at June 24, 2005 ($1.5 billion of consolidated indebtedness and $0.2 billion of cash and restricted cash). The acquisition of ARC Holdings was financed by a combination of debt and equity described below. Immediately after the transaction was completed, ARC Holdings became a wholly-owned subsidiary of Covanta Energy.

 

As part of the ARC Holdings acquisition, Covanta Energy entered into credit arrangements which totaled approximately $1.1 billion and are guaranteed by Covanta and certain domestic subsidiaries of Covanta Energy. For details related to these financing arrangements, see Note 12. Changes in Capitalization. The proceeds from these credit arrangements were used to fund the acquisition of ARC Holdings, to refinance approximately $479 million of Covanta Energy’s existing recourse debt and letters of credit, and to pay related fees and expenses. The revolving credit and letter of credit facilities are further available for ongoing permitted expenditures and for general corporate purposes.

 

The equity component of the financing consisted of a $400 million offering of warrants to purchase Covanta’s common stock (the “ARC Holdings Rights Offering”). Such warrants entitled Covanta’s existing stockholders to purchase Covanta’s stock on a pro rata basis, with each holder entitled to purchase 0.9 shares of Covanta’s common stock at an exercise price of $6.00 for each share of Covanta’s common stock held as of May 27, 2005, the record date. Covanta received net proceeds of approximately $395.8 million ($400 million gross proceeds, net of $4.2 million of expenses) and issued 66,673,004 shares of common stock.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Three of Covanta’s largest stockholders, SZ Investments L.L.C. (together with its affiliate EGI-Fund (05-07) Investors, L.L.C. to which it transferred a portion of its shares, “SZ Investments”), Third Avenue Business Trust, on behalf of Third Avenue Value Fund Series (“Third Avenue”), and D. E. Shaw Laminar Portfolios, L.L.C. (“Laminar”), representing an aggregate ownership, at the time of the ARC Holdings Rights Offering, of approximately 40.4% of Covanta’s outstanding common stock, committed to participate in the ARC Holdings Rights Offering and acquired at least their pro rata portion of the shares. As consideration for their commitments, Covanta paid each of these stockholders an amount equal to 1.75% of their respective equity commitments, which in the aggregate was $2.8 million and was accounted for as a reduction of the ARC Holdings Rights Offering proceeds. See Note 17. Related-Party Transactions.

 

The purchase price was comprised of the following (in millions of dollars):

 

 

The purchase price included acquisition related restructuring charges of $9.1 million which were recorded as a liability and assumed in the ARC Holdings acquisition, and consisted primarily of severance and related benefits, and the costs of vacating duplicate facilities. As of June 30, 2006, the remaining restructuring liability was $4.8 million.

 

The following table summarizes the purchase price allocation of the assets acquired and liabilities assumed at the Acquisition Date in conformity with the SFAS No. 141 “Business Combinations” (“SFAS 141”) and SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”) (in thousands of dollars).

 

 

The acquired intangible assets of $287.4 million relate to favorable energy and waste contracts, landfill rights, other nonamortizing intangibles and a favorable leasehold interest with an approximate 10 year average useful life. As of June 30, 2006, goodwill was $217.5 million. As part of Covanta’s purchase price allocation during the quarter

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

ended June 30, 2006 for the ARC Holdings acquisition, goodwill was adjusted to reflect a $28.6 million reversal of a deferred tax asset valuation allowance as discussed in Note 11. Income Taxes of the Notes. Goodwill also reflects an increase to the carrying value of property, plant and equipment of $9.5 million; an increase to the deferred tax liability of $6.9 million; a reduction to the liability of $27.4 million owed to one of the prior owners of ARC Holdings (See Note 10. Other Noncurrent Liabilities); an increase in an unfavorable waste contract of $12.1 million; and various other asset and liability adjustments of $8.1 million.

 

Pro Forma Results of Operations

 

The results of operations from ARC Holdings are included in Covanta’s consolidated results of operations from June 25, 2005. The following table sets forth certain pro forma unaudited consolidated operating results for 2005, as if the acquisition of ARC Holdings was consummated on the same terms at January 1, 2005 (in thousands of dollars, except per share amounts):

 

 

Restructuring and Acquisition-Related Charges

 

In connection with the acquisition of ARC Holdings, Covanta Energy incurred integration costs of $1.8 million and $2.0 million for the three and six months ended June 30, 2005, primarily related to professional fees and employee incentive costs. These charges were included as part of the operating costs of the Waste and Energy Services segment.

 

Covanta Energy also incurred restructuring costs in 2005 of $2.7 million. The restructuring costs resulted from $2.1 million of severance payments to CPIH executives in connection with overhead reductions made possible by the elimination of CPIH’s separate capital structure during the second quarter of 2005. An additional $0.6 million was paid to remaining CPIH executives as incentive payments from existing contractual obligations relating to CPIH debt repayment in connection with the ARC Holdings acquisition.

 

Effective January 1, 2006, Covanta adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payments” (“SFAS 123R”) using the modified prospective transition method and therefore has not restated results for prior periods. Under this transition method, stock-based compensation expense for the three and six months ended June 30, 2006 included compensation expense for stock-based compensation awards granted prior to, but not yet vested as of, December 31, 2005, based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Stock-based compensation expense for all stock-based compensation awards granted after December 31, 2005 is based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.

 

Covanta recognized compensation expense based upon the number of stock options and restricted stock awards expected to vest, which was determined based on historical turnover experience of Covanta Energy

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

employees’ populations from the Covanta Energy pension plan. Covanta will review its forfeiture rate annually and revise its compensation expense, if necessary. Covanta recognizes these compensation costs using the graded vesting attribution method over the requisite service period of the award, which is generally the vesting term of three years.

 

Prior to the adoption of SFAS 123R, Covanta recognized stock-based compensation expense in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS 123R and the valuation of share-based payments for public companies. Covanta has applied the provisions of SAB 107 in its adoption of SFAS 123R.

 

The impact to the condensed consolidated financial statements, as a result of Covanta’s adoption of SFAS 123R compared to continued recognition of stock-based compensation under APB 25, was not material to income before income taxes and net income for the six months ended June 30, 2006. The impact on both basic and diluted earnings per share was less than $0.01 per share for each of the three and six months ended June 30, 2006. The reductions that resulted from the adoption of SFAS 123R reflected the stock-based compensation expense associated with the unvested stock option awards. Stock-based compensation expense previously recognized in accordance with APB 25 for restricted stock awards, remained essentially unchanged under the provisions of SFAS 123R.

 

Covanta received $0.3 million and $0.6 million from the exercise of non-qualified stock options in the three and six months ended June 30, 2006, respectively. The tax benefits related to the exercise of the non-qualified stock options and the vesting of the restricted stock award were not recognized in the first six months of 2006 due to Covanta’s net operating loss carryforwards (“NOLs”). When the NOLs have been fully utilized by Covanta, Covanta will recognize a tax benefit and an increase in additional paid-in capital for the excess tax deductions received on the non-qualified stock options and vested restricted stock. Future realization of the tax benefit will be presented in cash flows from financing activities in the condensed consolidated statements of cash flows in the period the tax benefit is recognized.

 

The following table illustrates the effect on net income and earnings per share as if Covanta had applied the fair value recognition provisions of SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” (in thousands of dollars, except per share amounts).

 

 

On March 17, 2006, the Compensation Committee of the Board of Directors, under the equity award plan for employees, awarded certain employees 480,055 shares of restricted stock. The restricted stock awards will be expensed over the requisite service period, and assumes a five percent forfeiture rate. The terms of the restricted stock awards include vesting provisions based on two financial performance factors (applicable to 66% of the award) and continued service over the passage of time (applicable to 34% of the award). If all performance and service criteria are satisfied, the awards vest over 3 years, with 160,002 shares (33.33%) vesting on March 17, 2007,

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

160,002 shares (33.33%) vesting on March 17, 2008 and the remaining 160,051 shares (33.34%) vesting on March 17, 2009.

 

On May 31, 2006, in accordance with its existing program for annual director compensation, Covanta granted 36,000 shares of restricted stock under the Covanta Holding Corporation Equity Award Plan for Directors (the “Directors Plan”). The awards have a requisite service based vesting period as follows: 12,000 shares (33.33%) vested on May 31, 2006; 12,000 shares (33.33%) vesting on May 31, 2007; and 12,000 shares (33.34%) vesting on May 31, 2008. Covanta determined that the service vesting condition of the restricted stock awards granted to the directors on May 31, 2006 to be non-substantive and, in accordance with SFAS 123R, recorded the entire fair value of the award as compensation expense in the three months ended June 30, 2006. See Restricted Stock Awards below for further information.

 

Stock-Based Awards

 

Covanta adopted the Covanta Holding Corporation Equity Award Plan for Employees and Officers (the “Employees Plan”) and the Directors Plan (collectively, the “Award Plans”), effective with stockholder approval on October 5, 2004. On July 25, 2005, the Covanta Board of Directors approved and on September 19, 2005, Covanta’s stockholders approved the amendment to the Employees Plan to authorize the issuance of an additional 2,000,000 shares. The 1995 Stock and Incentive Plan (the “1995 Plan”) was terminated with respect to any future awards under such plan on October 5, 2004 upon stockholder approval of the Award Plans. The 1995 Plan will remain in effect until all awards have been satisfied or expired.

 

Restricted Stock Awards

 

Restricted stock awards that have been issued to employees and directors typically vest over a three year period. Restricted stock awards are stock-based awards for which the employee or director does not have a vested right to the stock (“nonvested”) until the requisite service period has been rendered and the required financial performance factor has been reached for each pre-determined vesting date. A percentage of each employee restricted stock awards granted have financial performance factors. Stock-based compensation expense for each financial performance factor is recognized beginning in the period when management has determined it is probable the financial performance factor will be achieved for the respective vesting period.

 

Restricted stock awards to employees are generally subject to forfeiture if the employee is not employed on the vesting date. Restricted stock awards issued to directors prior to 2006 were subject to the same forfeiture restrictions as are applicable to employees. Restricted stock awards issued to directors in 2006 are not subject to forfeiture in the event a director ceases to be a member of the Board of Directors, except in limited circumstances. Prior to vesting, restricted stock awards have all of the rights of common stock (other than the right to sell or otherwise transfer). The fair value of restricted stock awards is based on the market price of Covanta’s common stock on the grant date of the award.

 

Changes in nonvested restricted stock awards during the six months ended June 30, 2006 were as follows:

 

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As of June 30, 2006, there was $10.2 million unrecognized stock-based compensation expense related to nonvested restricted stock awards. This expense is expected to be recognized over a period of up to three years. The total fair value of restricted stock awards expensed was $2.3 million and $2.8 million for the three and six months ended June 30, 2006, respectively.

 

Stock Options

 

Covanta has also awarded stock options to certain employees and directors. Stock options awarded to directors vested immediately. Stock options awarded to employees typically vested annually over three years. Covanta had one nonvested stock option award outstanding as of December 31, 2005 which was granted in October 2004. The fair value of the options was based on the Black-Scholes option pricing model with the following assumptions: fair value option price — $5.68; risk-free interest rate — 4.25%; dividend yield — 0%; expected volatility (based on historical volatility) — 76%; and expected life — 8 years.

 

Option activity for all outstanding options, vested and nonvested, from January 1, 2006 through June 30, 2006 was as follows:

 

 

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the closing stock price on the last trading day of the second quarter of 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2006. The intrinsic value changes based on the fair market value of Covanta’s common stock. Total intrinsic value of options exercised for the six months ended June 30, 2006 was $1.1 million. The total fair value of options expensed was $0.3 million and $0.6 million for the three and six months ended June 30, 2006, respectively.

 

As of June 30, 2006, there was $1.6 million of total unrecognized compensation expense related to stock options which is expected to be recognized over a weighted-average period of 1.7 years.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Per share data is based on the weighted average outstanding number of shares of Covanta’s common stock, par value $0.10 per share, during the relevant period. Basic earnings per share are calculated using only the weighted average number of outstanding shares of common stock. Diluted earnings per share computations, as calculated under the treasury stock method, include the weighted average number of shares of additional outstanding common stock issuable for stock options, restricted stock, and rights whether or not currently exercisable. Diluted earnings per share for all the periods presented do not include shares related to stock options and rights if their effect was anti-dilutive (in thousands of dollars, except per share amounts).

 

 

Basic and diluted earnings per share and the weighted average shares outstanding have been retroactively adjusted in 2005 to reflect the bonus element contained in the ARC Holdings Rights Offering that was consummated in June 2005. See Note 3. Acquisition of the Notes for information related to the ARC Holdings Rights Offering.

 

Pass through costs are costs for which Covanta Energy receives a direct contractually committed reimbursement from the municipal client which sponsors a waste-to-energy project. These costs generally include utility charges, insurance premiums, ash residue transportation and disposal and certain chemical costs. These costs are recorded net of municipal client reimbursements in Covanta’s condensed consolidated financial statements. Total pass through costs were $13.7 million and $12.9 million for three months ended June 30, 2006 and 2005, respectively, and $28.4 million and $30.0 million for the six months ended June 30, 2006 and 2005, respectively.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table summarizes the components of waste and service revenues for the periods presented below (in thousands of dollars):

 

 

Unbilled service receivables include fees related to the principal portion of debt service earned to service project debt principal where such fees are expressly included as a component of the service fee paid by the municipality pursuant to applicable waste-to-energy service agreements. Regardless of the timing of amounts paid by municipalities relating to project debt principal, Covanta Energy records service revenue with respect to this principal component on a levelized basis over the term of the service agreement. Long-term unbilled service receivables related to waste-to-energy operations are recorded at their discounted amounts.

 

Electricity and steam sales included lease income from the international business of $33.6 million and $25.8 million for the three months ended June 30, 2006 and 2005, respectively, and $61.3 million and $50.7 million for the six months ended June 30, 2006 and 2005, respectively.

 

Equity in net income from unconsolidated investments was $14.7 million and $4.1 million for the three months ended June 30, 2006 and 2005, respectively, and $21.5 million and $10.6 million for the six months ended June 30, 2006 and 2005, respectively.

 

The equity in net income for the three months and six months ended June 30, 2006 includes approximately $7 million of cumulative deferred income tax benefits related to unrealized foreign exchange losses that are expected to be tax deductible for Philippine tax purposes in future years. Quezon Power, Inc. (“Quezon”) recorded this cumulative deferred income tax benefit in the period ended June 30, 2006 on the basis of rulings which were issued by the Philippine tax authorities in June 2006 clarifying the tax deductibility of such losses upon realization. The realization of this deferred tax benefit is subject to fluctuations in the value of the Philippine peso versus the US dollar.

 

Equity in net income from unconsolidated investments primarily relates to Covanta Energy’s 26% investment in Quezon. The unaudited results of operations from Quezon were as follows (in thousands of dollars):

 

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Intangible Assets

 

Intangible assets consisted of the following (in thousands of dollars):

 

 

Amortization expense related to waste and energy contracts and other intangible assets was $11.0 million and $5.6 million for the three months ended June 30, 2006 and 2005, respectively, and $24.1 million and $10.3 million for the six months ended June 30, 2006 and 2005, respectively. The lease interest asset is amortized to rent expense in plant operating expenses and was $0.7 million for the three months ended June 30, 2006 and $1.5 million for the six months ended June 30, 2006. The following table details the amount of the actual/estimated amortization expense associated with intangible assets as of June 30, 2006 included or expected to be included in Covanta’s statement of operations for each of the years indicated (in thousands of dollars):

 

 

Goodwill

 

In connection with the ARC Holdings acquisition, Covanta Energy recorded $217.5 million of goodwill in its purchase price allocation as of June 30, 2006. Goodwill represents the total consideration paid in excess of the fair value of the net tangible and identifiable intangible assets acquired and the liabilities assumed in the ARC Holdings acquisition in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”
(“SFAS 142”). Goodwill has an indefinite life and is not amortized but will be reviewed under the provisions of SFAS 142 for impairment. Covanta will perform an annual fair value test of its recorded goodwill for its reporting units using a discounted cash flow approach as of October 1, 2006. Goodwill is not deductible for federal income tax purposes.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Other noncurrent liabilities consisted of the following (in thousands of dollars):

 

 

As of June 25, 2005, ARC Holdings’ waste and service contracts were recorded at their fair market values, in accordance with SFAS 141, based upon discounted cash flows attributable to the “below market” portion of the waste and service contracts using currently available information.

 

Agreements between an ARC Holdings’ subsidiary and one of the prior owners of ARC Holdings have been terminated as of June 14, 2006. The liability related to these agreements has been adjusted to recognize the termination of the liability. See Note 3. Acquisition of the Notes for ARC Holdings purchase price allocation adjustment related to the termination of these agreements.

 

The following table details the amount of the actual/estimated amortization contra-expense associated with the below market waste and service contracts liability as of June 30, 2006 included or expected to be included in Covanta’s statements of operations for each of the years indicated (in thousands of dollars):

 

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Covanta records its interim tax provision based upon its estimated annual effective tax rate and accounts for the tax effects of discrete events in the period in which they occur. Covanta currently estimates its annual effective tax rate for December 31, 2006 to be approximately 29.8%. Covanta reviews the annual effective tax rate on a quarterly basis as projections are revised.

 

The current quarter tax rate includes the impact of the cumulative adjustment due to the adoption of the permanent reinvestment exception under APB Opinion No. 23, “Accounting for Income Taxes — Special Areas” (“APB 23”) as discussed below. The actual effective tax rate was 44.7% for December 31, 2005. The difference between the actual prior year rate and the current year estimate is primarily due to Covanta’s intention to reinvest foreign earnings in international investments and the impact of the cumulative adjustment due to the adoption of APB 23.

 

The effective income tax rate was 19.9% and 37.3% for the six months ended June 30, 2006 and 2005, respectively. Excluding the cumulative adjustment of $10 million due to APB 23, the effective income tax rate was 38.2% for the six months ended June 30, 2006.

 

Beginning in the second quarter of 2006, Covanta adopted the permanent reinvestment exception under APB 23 whereby Covanta will no longer provide deferred taxes on the undistributed earnings of its international subsidiaries. Covanta intends to permanently reinvest its international earnings outside of the United States in its existing international operations and in any new international business it may develop or acquire. As a result of the adoption of APB 23, Covanta recognized a one-time benefit of $10 million during the three months ended June 30, 2006 associated with the reversal of deferred taxes accrued on unremitted earnings of international affiliates in prior periods.

 

Covanta files a federal consolidated income tax return with its eligible subsidiaries in the United States. Covanta’s federal consolidated tax return includes the results of ARC Holdings after June 24, 2005. Effective July 31, 2005, CPIH and its eligible United States and foreign subsidiaries were included in Covanta’s federal consolidated income tax return. Covanta’s subsidiary associated with its Lake County, Florida waste-to-energy project (“Covanta Lake”) is not a member of any consolidated return group.

 

Covanta’s federal consolidated income tax return also includes the taxable results of certain grantor trusts which were established by state insurance regulators in California and Missouri as part of the 1990 reorganization of certain of Covanta’s predecessor insurance entities (the “Mission Insurance Entities”) and their emergence from federal bankruptcy and various state insolvency court proceedings. These trusts were created for the purpose of assuming various liabilities associated with certain of the Mission Insurance Entities. This allowed the state regulators to administer the continuing run-off of the insolvent insurance business, while Covanta (then named Mission Insurance Group, Inc.) and the remaining Mission Insurance Entities were released, discharged and dismissed from the proceedings free of any claims and liabilities of any kind, including any obligation to provide further funding to the trusts. The Insurance Commissioner of the State of California (the “California Commissioner”) and the Director of the Division of Insurance of the State of Missouri (the “Missouri Director”), as the trustees, have sole management authority over the trusts. Neither Covanta nor any of its subsidiaries has any power to control or otherwise influence the management of the trusts nor do they have any rights with respect to the selection or replacement of the trustees. At the present time, it is not likely that Covanta or any of its subsidiaries will receive any distribution with regard to their residual interests in the existing trusts. Since Covanta does not have a controlling financial interest in these trusts and is not the primary beneficiary, the trusts are not consolidated with Covanta for financial statement purposes.

 

During or at the conclusion of the administration of these grantor trusts, taxable income could result which could utilize a portion of Covanta’s NOLs which in turn could accelerate the date on which Covanta may be otherwise obligated to pay cash taxes.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In January 2006, Covanta executed agreements with the California Commissioner, who administers the majority of the grantor trusts, regarding the final administration and conclusion of such trusts. The agreements, which were approved by the California state court overseeing the Mission insolvency proceedings (the “Mission Court”), settle matters that had been in dispute regarding the historic rights and obligations relating to the conclusion of the grantor trusts. As part of the settlement, on April 28, 2006, the Mission Court determined the aggregate amount of certain claims against the grantor trusts which are entitled to distributions of Covanta’s common stock previously issued to the California Commissioner. The Mission Court also approved procedures by which Covanta will determine, in cooperation with the California Commissioner, a complete list of such claimants entitled to receive such shares, and thereafter the number of shares to be distributed to such claimants by the California Commissioner. In connection with these agreements and in order to facilitate the orderly conclusion of the grantor trust estates, the distribution of such stock and the settlement of the related disputes, Covanta paid an aggregate amount equal to approximately $9.14 million to the California Commissioner for distribution to the grantor trusts on May 2, 2006. While Covanta cannot predict with certainty what amounts, if any, may be includable in Covanta’s taxable income as a result of the final administration of the trusts, Covanta believes that these arrangements with the California Commissioner will result in no material reduction in available NOLs.

 

Covanta is in preliminary discussions with the Missouri Director regarding similar arrangements for distribution of Covanta common stock held by the Missouri Director to claimants of the Missouri grantor trusts. Because Covanta’s discussions with the Missouri Director are currently at a preliminary stage, Covanta is unable to determine at this time whether all claimants contemplated by the 1989 and 1990 agreement as eligible to receive such stock will receive a distribution from the Missouri Director. As a result of this uncertainty, Covanta has reduced the aggregate amount of its available NOLs by $46 million and reduced the valuation allowance accordingly. Covanta cannot provide any assurance that it will enter into similar arrangements with the Missouri Director or that the NOL reduction will ultimately be reversed. However, in connection with the administration or conclusion of the grantor trusts, Covanta does not expect either further reductions to its available NOLs or additional material amounts of taxable income to be recognized as a result of the administration or conclusion of the grantor trusts.

 

SFAS 109 requires the establishment of a valuation allowance when it is not “more likely than not” that an entity will realize its deferred tax assets. Pursuant to SFAS 109, Covanta makes periodic determinations of whether it is “more likely than not” that all or a portion of Covanta’s deferred tax assets will be realized. In making these determinations, Covanta considers all of the relevant factors, both positive and negative, which may impact its future taxable income including the size and operating results of its subsidiaries, the competitive environment in which these subsidiaries operate and the impact of the grantor trusts. The remainder of the valuation allowance associated with the NOLs was released during the quarter ended June 30, 2006, primarily due to Covanta’s determination that it is “more likely than not” that all remaining deferred tax assets associated with the NOLs will be realized.

 

If Covanta’s existing insurance business were to require capital infusions in order to meet certain regulatory capital requirements, and were Covanta to fail to provide such capital, some or all of its subsidiaries comprising the insurance business could enter insurance insolvency or bankruptcy proceedings. In such event, such subsidiaries may no longer be included in Covanta’s consolidated tax return and potentially, a significant portion of Covanta’s remaining NOLs would no longer be available to it. Such an event may also result in a significant inclusion of taxable income in Covanta’s federal consolidated tax return.

 

Covanta had NOLs estimated to be approximately $489 million for federal income tax purposes as of the end of 2005. The NOLs will expire in various amounts from December 31, 2006 through December 31, 2023, if not used.

 

If Covanta were to undergo an “ownership change,” as such term is used in Section 382 of the Internal Revenue Code, the use of its NOLs in any given year could be limited. The impacts, if any, to Covanta of any such limitation would depend upon factors such as the amount of Covanta’s taxable income in a given tax year, the date on which an “ownership change” were to occur, and Covanta’s market capitalization at the time of an “ownership change”.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Generally, Covanta will be treated as having had an “ownership change” if there is a more than 50% increase in stock ownership during a 3-year “testing period” by a “5% stockholder”. Covanta’s Certificate of Incorporation contains stock transfer restrictions that were designed to help preserve Covanta’s NOLs by avoiding an ownership change. Covanta cannot be certain, however, that these restrictions will prevent an ownership change. The transfer restrictions were implemented in 1990, and Covanta expects that they will remain in-force as long as the NOLs are material to Covanta or until the limitations on Covanta’s use of the NOLs that would otherwise result from such a change in control would not create material adverse consequences to Covanta.

 

Covanta’s provision for income taxes in the condensed consolidated statements of operations also includes certain state and other taxes. Tax filings for these jurisdictions do not consolidate the activity of the grantor trusts referred to above and in certain states reflect preparation on a separate-company basis. For further information, reference is made to Note 22 of the Notes to the Consolidated Financial Statements included in Covanta’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Financing Arrangements

 

As part of the ARC Holdings acquisition on June 24, 2005, Covanta Energy entered into credit arrangements which totaled approximately $1.1 billion and are guaranteed by Covanta and certain domestic subsidiaries of Covanta Energy. These credit arrangements consisted of a first priority senior secured credit facility and a second priority senior secured credit facility. The first priority senior secured credit facility was initially comprised of a $275 million first lien term loan, a $100 million revolving credit facility, and a $340 million letter of credit facility. The second priority senior secured credit facility was initially a $400 million second lien term loan facility.

 

On March 21, 2006, Covanta Energy voluntarily reduced the letter of credit facility from $340 million to $320 million. On May 26, 2006, Covanta Energy entered into agreements which amended its credit arrangements. All material terms of Covanta Energy’s first priority senior secured credit facility and second priority senior secured credit facility remain unchanged except for the following:

 

 

On June 30, 2006, Covanta Energy utilized the new term loan commitment of $140 million on its first lien term loan facility to prepay $140 million under the second lien term loan facility. Covanta Energy recognized a loss on extinguishment of debt of $2.3 million which is classified as other expense on the condensed consolidated statement of operations and a write-off to interest expense of a portion of the second lien term loan facility deferred financing costs of $4.5 million in the three months ended June 30, 2006 related to the $140 million prepayment under the second lien term loan facility.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Covanta Energy Long-Term Debt

 

Long-term debt is comprised of credit facilities and intermediate debt as follows (in thousands of dollars):

 

 

Amortization Terms

 

The amended first lien term loan facility includes mandatory annual amortization to be paid in quarterly installments beginning September 30, 2006, through the date of maturity as follows (in thousands of dollars):

 

 

The second lien term loan facility has no mandatory amortization requirements and is required to be repaid in full on its maturity date in 2013.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Covanta Energy Short-Term Liquidity

 

Covanta Energy had available credit for liquidity as follows (in thousands of dollars):

 

 

 

 

As of June 30, 2006, Covanta Energy had neither drawn on the revolving credit facility nor caused to be issued any letters of credit under the revolving credit facility. On March 21, 2006, Covanta’s availability under the funded letter of credit facility was voluntarily reduced to $320 million from $340 million. As of June 30, 2006, Covanta Energy had $289.5 million outstanding letters of credit under the funded letter of credit facility.

 

Debt Covenants and Defaults

 

The loan documentation under the credit facilities, as amended, contains customary affirmative and negative covenants and financial covenants. During the term of the credit facilities, Covanta expects that the negative covenants will restrict the ability of Covanta Energy and its subsidiaries to take specified actions, subject to exceptions. As of June 30, 2006, Covanta Energy was in compliance with covenants under the credit facilities.

 

Interest and Fee Terms

 

Under the amended credit facilities, the borrowing margins for first lien term loan facility and the funded letter of credit facility are 2.25% for Eurodollar rate loans and 1.25% for base rate loans. The borrowing margins under the second lien term loan facility are 5.50% for Eurodollar rate loans and 4.50% for base rate loans. The borrowing margins for the revolving credit facility remain unchanged from the existing agreements.

 

Stockholders’ Equity

 

Covanta agreed as part of the Covanta Energy acquisition to conduct a rights offering for up to 3.0 million shares of its common stock to certain holders of 9.25% debentures issued by Covanta Energy prior to its bankruptcy at a purchase price of $1.53 per share (the “9.25% Offering”). Because of the possibility that the 9.25% Offering could not be completed prior to the completion of the ARC Holdings acquisition, and the related ARC Holdings Rights Offering, Covanta restructured the 9.25% Offering so that the holders that participated in the 9.25% Offering were offered the right to purchase an additional 2.7 million shares of Covanta’s common stock at the same purchase price ($6.00 per share) as in the ARC Holdings Rights Offering. This represented an equivalent number of shares of common stock that such holders would have been entitled to purchase in the ARC Holdings Rights Offering if the 9.25% Offering was consummated on or prior to the record date for the ARC Holdings Rights Offering. On February 24, 2006, Covanta completed the 9.25% Offering in which 5,696,911 shares were issued in consideration for $20.8 million in net proceeds.

 

Effective as of March 17, 2006, the Compensation Committee of the Board of Directors authorized the award of 480,055 shares of restricted stock to certain employees under the Employee Plan. On May 31, 2006, Covanta granted 36,000 shares of restricted stock under the Directors Plan. See Note 4. Stock-Based Compensation of the Notes.

 

COVANTA HOLDING CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Covanta has two reportable business segments — Waste and Energy Services and Other Services. Certain prior period amounts, such as parent investment income, have been reclassified in the condensed consolidated financial statements to conform to the current period presentation.

 

Within the Waste and Energy Services segment, Covanta develops, constructs, owns and operates for others key infrastructure for the disposal of waste (primarily waste-to-energy) and independent power production facilities in the United States and abroad. Covanta also has one water treatment facility in this segment. The Other Services segment is comprised of Covanta’s insurance business, which writes property and casualty insurance in California, and the parent company of Covanta which primarily receives income from its investments.

 

Segment results are shown below (in thousands of dollars):