EVA - Enviva: Near Term Should Be Solid But Long-Term Worries Persist

Summary

• Wood pellet demand is strong in Europe and Asia.
• EVA has a price advantage versus competitors in other countries.
• However, biomass is heavily subsidized and questions remain about whether wood pellets actually reduce carbon emissions.

While I have some worries about biomass being a viable business over the long haul, long-term take-or-pay contracts, strong demand powered by generous subsidies, and a recent EU ruling confirming wood pellets as a viable renewable energy source should bode well for Enviva ( EVA ) in the near to medium term. However, the current issues surrounding the stock keep me on the sidelines.

Company Profile

EVA is a producer of wood pellets that are used as a replacement for coal and other fossils fuels. The company acquires low-grade wood fiber that it processes into utility-grade wood pellets that it then ships overseas to Europe and Asia. EVA says that the wood it procures is largely considered waste or byproducts, such as limbs and tree tops, that would otherwise be left on the forest floor or burned.

The company owns 10 production plants located throughout the Gulf Coast and Mid-Atlantic regions. The plants have a combined production capacity of 6.2 million tons per year. In addition to production facilities, EVA also owns two port locations in Virginia and Mississippi, as well as leases 4 others on the east coast and Gulf Coast. The six ports have 10.9 million tons of throughput capacity and 352,000MT of storage capacity.

EVA sells its wood pellets under long-term take-of-pay off-take contracts. The contracts typically provide for fixed-price deliveries and include price escalators.

EVA is structured as a master limited partnership or MLP.

Opportunities

EVA has greatly benefited from European Union or EU environmental mandates to reduce carbon emissions by 55% by 2030. Wood pellet biomass, the type EVA produces, meanwhile, is an easy replacement for coal. Coal-to-biomass plant conversions are comparatively easy, and allow coal plants to operate using their existing supply, generation, and grid infrastructure.

The EU also subsidizes wood pellet biomass as part of its Renewable Energy Directive (RED). In 2020, they handed out $13 billion in biomass subsidies. Late last year, the EU voted to continue to keep biomass classified as a renewable energy source.

Subsidies and easy coal-to-biomass retrofits for power plants has greatly increased wood pellet demand in Europe. In 2021, the EU produced 19.7 million tons of wood pellets, while another 3.7 million tons were imported from the U.S. Since the Russia-Ukraine war, wood pellet imports from the U.S. have soared according to the Clean Air Committee in The Netherland .

For its part, EVA benefits from a strong price arbitrage between timberland prices in the Southern U.S. versus prices in the EU and eastern Europe, as well as in Asia and even South America. Southeast wood chip prices were about $63 a dry ton in Q2 versus $126 in Germany, $133 in Latvia, $156 in Brazil, and $129 in Japan. This cost advantage greatly benefits EVA, as shipping costs are about $20MT to Europe and $45MT to Japan, with bunker fuel cost increases passed on to customers.

Strong wood pellet demand, a structural pricing advantage, and attractive long-term take or pay contract have set up EVA to continue to increase its production capacity moving forward. The company expects to more than double its production capacity from 6.2 million tonne per year to 13.0 million tons per year by 2026. This includes both plant expansions, as well as new plants in Alabama and Mississippi. The company is also looking at future sites in Georgia and South Carolina. EVA has said new plants are built at a 5x EBITDA multiple.

While Europe has been EVA’s biggest growth driver, Japan and South Korea are expected to take on a lot of the new capacity. The company sees a nearly 50/50% revenue mix between Europe and Asia by 2025. In 2021, Japan and South Korea imported a combined 6 million metric tons of wood pellets, and that number is expected to continue to explode higher, also on the back of generous subsidies.

Risks

The biggest risk that EVA faces is that many scientists don’t believe that burning wood pellets is actually environmentally friendly. When taking into account deforesting and shipping, many scientists believe that biomass actually creates more carbon emissions than burning coal.

In late 2021, 500 scientists signed a letter urging the U.S., EU, Japan, and South Korea to curb the use of wood pellets in energy production.

Peg Putt, coordinator of the Forest Biomass Working Group of the Environmental Paper Network, recently said:

“Europe continues to make 60% of its so-called ‘renewable’ energy from biomass and biofuels, which are not low-emission energies at all,” Putt said. “Alleged benefits of burning forest biomass are illusory and actually exacerbate climate change, which has been amply demonstrated by many scientists but roundly ignored by the European Parliament.”

Meanwhile, a short seller report from Blue Orca accused EVA of greenwashing its wood procurement. European subsidies are only supposed to be for wood pellets that come from lumber waste, and are not allowed for whole trees taken directly from a forest. While EVA has long claimed it only procures tree waste to make its wood pellets, Blue Orca claims that this is not the case.

In its report , the firm says:

“Hidden Metadata Reveals that Enviva Procures Wood from Clear-Cutting Forests. Enviva publicly denies clear-cutting forests, the controversial practice of removing full swaths of forest which is widely condemned by ESG investors and climate change advocates. Although Enviva refuses to disclose to watchdogs or investors the exact location of its harvests, when we analyzed the metadata from its Track and Trace database, we found embedded GPS coordinates. We think that there is a reason Enviva tried to conceal this data. When we geolocate Enviva’s harvests using these GPS coordinates, satellite imagery reveals hundreds of images of clear-cut forests, suggesting that the practice is widespread and that Enviva is misleading investors. We corroborated this with interviews of two former senior Enviva executives, who unequivocally stated that Enviva sources wood from clear-cutting. A former senior Enviva sustainability executive lamented that the practice was routine because clear-cutting was cheaper than other more sustainable methods of harvesting. Ultimately, multiple strands of independent evidence, from the statements of former senior executives to satellite imagery, indicate that Enviva is procuring wood from clear-cutting, a practice roundly rejected by ESG investors and expressly discouraged by EU sustainability guidelines.”

In addition to its long-term risk over whether its products are indeed a renewable energy source worthy of subsidies, EVA is also currently generating negative cash flow from operations. Through the first nine months of 2022, the company has had an outflow of -$51.5 million. In addition, it's paid over $158 million in distributions over that same time period and spent over $162 million on CapEx.

On its Q3 call, CFO Shai Even said it will see very strong cash flow from operating activities in 2023. However, when discussing OCF with RBC Analyst Elvira Scotto, he didn’t use a traditional method of how it is typically calculated, talking more about distributable cash flow, which is a common MLP metric.

Valuation

EVA trades at about 15x the 2023 EBITDA consensus of $310.2 million, and 12.5x the 2024 consensus of $384.1 million.

For 2022, it doesn’t appear the company will generate much if any free cash flow.

The company claims it will have a 1.1x distribution coverage ratio in 2023. However, even using its distributable cash flow or DCF, its coverage ratio was only 0.5x through the first 9 months of the year and 0.7x last quarter.

Conclusion

Heading into earnings, I don’t expect any bombshells from EVA given the nature of its contracts and the recent reaffirmation by the EU that biomass will continue to be viewed as a renewable energy source worthy to be subsidized. The company should have a pretty clear view of what 2023 holds in store and given its commentary on 2023 last quarter, there shouldn’t be too many surprises. In fact, the continued war in the Ukraine should only bolster demand for alternative energy sources in Europe.

That said, I think there are longer-term worries when looking at EVA. The biggest is the growing concern about biomass and its impact on the environment. Demand for wood pellets from the EU, Japan, and South Korea is exploding due to generous subsidies, as these nations look to aggressively cut carbon emissions. However, the impact of biomass appears to be more about show to reach these targets than actually having an impact.

If these generous subsidies go away, I don’t see biomass as a viable business going forward. While EVA has long-term contracts in place, this could lead to a pretty messy situation all around.

EVA trades at hefty valuation versus other MLPs, largely due to its strong growth. However, given its lack of cash flow and its reliance on subsidies, I don’t think this is necessarily deserved. That said, I’d view the stock more as “Hold” at the moment, as I don’t see an immediate catalyst that would push the stock down.

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