Earnings Call Transcript - HASI Q3 2022

Neha Gaddam, Senior Director, Investor Relations and Corporate Finance

Thank you, operator. Good afternoon, everyone, and welcome. Earlier this afternoon, Hannon Armstrong distributed a press release detailing our third quarter 2022 results, a copy of which is available on our website. This conference call is being webcast live on the Investor Relations page of our website, where a replay will be available later today. Before the call begins, I'd like to remind you that some of the comments made in the course of this call are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended. The company claims the protection of Safe Harbor for forward-looking statements contained in such sections. The forward-looking statements made in this call are subject to risks and uncertainties described in the Risk Factors section of the company's Form 10-K and other filings with the SEC. Actual results may differ materially from those described during the call. In addition, all forward-looking statements are made as of today, and the company does not undertake any responsibility to update any forward-looking statements based on new circumstances or revised expectations. During this call, we will primarily discuss non-GAAP financial measures, which we believe help investors gain a meaningful understanding of our core financial results and guidance. A presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. A reconciliation of GAAP to non-GAAP financial measures is available on our posted earnings release and slide presentation. Joining me on today's call are Jeff Eckel, the company's Chairman and CEO; and Jeff Lipson, our CFO and COO. With that, I'd like to turn the call over to Jeff Eckel, who will begin on slide 3.

Jeff Eckel, Chairman and CEO

Thanks, Neha, and good afternoon, everyone. I'd like to begin on slide 3 with a few key business highlights. We demonstrated continued strong performance in the third quarter with distributable earnings of $0.49 per share, a 20% increase over last year. We're pleased to affirm our prior guidance for annual growth in distributable EPS of 10% to 13% through 2024 and 5% to 8% annual growth in our dividend for the same period. Our Board has declared a quarterly dividend of $0.375 per share. As anticipated, yields on new investments are starting to improve. Higher energy prices are continuing to drive new PPA prices up, and the clean energy industry is adapting to a higher cost of capital, beginning to reprice with their clients. While the yield on our $3.9 billion portfolio remains unchanged in the quarter, we expect it to increase proportionately as we fund new investments. Our 12-month pipeline increased to more than $4.5 billion, up from more than $4 billion last quarter. The increase represents new opportunities with existing clients as well as several new clients. Notably, this increase has little to do with the IRA, with that upside still to come in the 2024-2025 time period and beyond as we will discuss later. Today, we're pleased to announce the successful debt raise of $383 million, contributing to our strong liquidity position, including cash from operations of over $1.2 billion, which gives us ample runway for funding new deals. Moving to slide 4. We provide more details on our updated 12-month pipeline, which, as I said, we've increased to greater than $4.5 billion with growth in each of the individual markets. The behind-the-meter pipeline remains strong in residential and community solar, along with increases in governmental efficiency opportunities. The grid-connected pipeline remains predominantly solar, with a significant portion expected to close in the next several quarters. We will address the sustainable infrastructure market more fully on the next page. Turning to that page, slide 5. We've always believed the Climate Solutions market was larger than the electric power sector, which represents only 25% of US greenhouse gas emissions. The rest of the GHG emissions come from industry, transport, agriculture, and the built environment. We have been building a team to commercialize these opportunities and are pleased with their early successes with two investments I will highlight now. First, we've entered the renewable natural gas market with a $125 million senior investment in a set of operating projects developed and operated by Ameresco, a long-term programmatic client. As they have been in many other markets, Ameresco has been a successful pioneer in RNG, and we're pleased to expand our investing relationship with them. Second, we also completed a $72 million transaction to support school bus modernization through software and eventually electrification with Zoom. Zoom has a significant and growing client base among investment-grade rated school systems around the country. Our investment permits the modernization of standard proven technology, in this case, school buses, into a more nimble, efficient fleet. These are both shorter tenor transactions and because tax equity is not involved, they have a superior near-term cash profile than many renewable projects. Our flexibility to reach across industry sectors is evidence that our overarching strategy to invest in assets that decarbonize is extensive. Turning to slide 6. We lay out a timeline of when and how we expect IRA policy support to have a meaningful impact on HASI’s business. This year and next, we expect improved economics on current projects in the pipeline with the anticipated extension and step-up in tax credits and election of certain solar projects from ITC to PTC. While our clients are seeing these benefits in grid-connected projects, this is happening faster in the behind-the-meter projects because they're quicker to build, leading to faster utilization of these benefits. RNG and transport benefit from the clean fuel credit and the ITC, respectively. Speaking with our clients about their pipeline in the 2024 to 2026 period, we're hearing a significant increase in ambition and resulting volumes in both grid connected and behind-the-meter developments, stemming from the clarity and certainty of the IRA provisions, including the ITC adders. We think the transferability provision could be a significant opportunity for us along with stand-alone storage. The 2024 to 2026 period looks to be pivotal when our clients scale up project development, which will then reflect volume growth in our pipeline. To clarify, our pipeline is a 12-month pipeline and does not reflect these increases. By 2026 and beyond, we expect significant new markets to develop in green hydrogen, transmission, and grid modernization. Bottom line, the energy transition is starting to accelerate, but it will take time for that acceleration to appear in our pipeline.

Jeff Lipson, CFO and COO

Thanks, Jeff. On slide 7, we detail our $3.9 billion balance sheet portfolio as of the third quarter of 2022, which has grown 22% over the last year. We added over 100 new investments in the past year, contributing to our recurring net investment income. Our portfolio now includes over 365 investments across eight asset classes, as the diversity of the business remains an ongoing positive attribute. The projects underlying these investments represent over 12 gigawatts of clean energy and improve economic value in times of higher commodity prices and provide cost-effective critical energy to end users. Therefore, these investments are non-cyclical, with 99% of investments currently performing within our financial expectations, and we do not expect a recession to negatively impact performance. Further, we detail our Q3 portfolio reconciliation on the right side of the slide. The portfolio balance was flat for the quarter as we funded $91 million of investments, offset by collections and securitizations on existing assets. Funding expectations of previously closed transactions is over $625 million expected to fund through 2023. On slide 8, we have summarized our third quarter results with a year-over-year comparison on the top left and year-to-date comparisons on the remainder of the slide. We recorded distributable earnings per share of $0.49 in the third quarter, which is up 20% year-over-year. We also had a strong quarter of distributable net investment income of approximately $43 million, which is up 36% year-over-year, and recorded a gain on sale of $19 million. In the upper right, we note year-to-date distributable EPS growth was 13% year-over-year, primarily due to higher revenue from a larger portfolio. Additionally, as shown on the lower right, we are on track for another strong year of gain on sale and fees, with $64 million of this revenue source through three quarters, similar to last year despite the higher rate environment, reflecting that our securitization profitability is unaffected by rates, a topic I will discuss in more detail in a few minutes. On the lower left, distributable net investment income was approximately $134 million year-to-date, reflecting year-over-year growth of 40%, driven by a larger portfolio and continued strong margins. In summary, despite higher rates and capital market disruptions, we were able to achieve our targeted level of profitability and again affirm our guidance. The next two slides both address interest rate risk in our business, a topic frequently asked about. Page 9 addresses this risk related to our balance sheet and page 10 addresses our off-balance sheet investments. As the top left graph on page 9 indicates, we have maintained strong margins and are now entering a phase where we expect our cost of debt to increase. However, most of that increase will be offset with higher yields on new investments, as Jeff described earlier. It is also important to note that our current portfolio yield and cost of debt include a substantial amount of existing assets and liabilities. So neither figure will move up quickly, as incremental investments in debt at higher rates will initially comprise a modest percentage of the balance sheet. The primary conclusion of this chart is that in this illustrative scenario, we believe higher yields and higher debt costs would result in margins large enough to support a run rate of approximately 10% to 12% ROE, consistent with our historic levels of profitability. On the upper right of the slide, we detail other factors which we expect will allow us to maintain strong margins, including utilizing lower leverage and pivoting to bank and private debt while public debt markets are volatile. We also continue to manage our leverage in a consistent range, and our debt-to-equity ratio was 1.7 times at year-end. Please note we have an updated cash sources and uses slide on Page 15 in the appendix, reflecting that net cash collections remain well above the dividend. $158 million of year-to-date excess cash collections can be utilized to fund new higher-yielding investments, further reducing our reliance on external funding. In summary, it was another quarter of strong growth in earnings and net investment income. The portfolio is performing as expected, and our liquidity profile remains excellent. With that, I'll turn the call back over to Jeff.

Jeff Eckel, Chairman and CEO

Great job. Thanks, Jeff. Turning to Slide 12, an update on our ESG activity includes finalizing an improved carbon count methodology and kicking off our business partner ESG engagement program. We're very pleased to have Beth Ardisana join our Board and Audit Committee. Beth brings significant experience in the renewable fuel and transport sectors to our Board. We'll wrap up on Slide 13. Good businesses get tested in rough markets, and we're pleased with how we performed this quarter and this year. We believe this is due to our resilient dual revenue business model of net investment income and securitization gains on sale. Our pipeline is growing, and yields are adjusting to the higher cost of capital. Pipeline growth is driven by partnering with the best clients in the best market, Climate Solutions investing. Despite higher interest rates, we're able to affirm our guidance for earnings and dividend growth through 2024. With that, we'll conclude our remarks and open up the line for questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. We'll take our first question from Noah Kaye with Oppenheimer. Please go ahead.

Noah Kaye, Analyst

Thanks for taking the questions, and I appreciate some of these incremental slides. First, just to clarify on the securitization platform slide discussion. So there's a bilateral transaction you're buying and selling at pretty much the same time. In a higher rate environment, where the discount rate is higher, is the assumption that the spread between X and Y should expand to keep the NPV constant? Is that the right way to think about it? And is that what you're effectively seeing in getting acceptance for in the market?

Jeff Eckel, Chairman and CEO

The base rates will go up on both sides. The spread may or may not go up. Typically, I’ve seen over the years, in the last two decades we've been doing this, that spreads are proportional to the base rate. So as base rates go up, spreads go up. But that's not a law of physics. I do want to highlight that in 2008 and 2009 when markets were even more perturbed than they are now, that was still open. The life insurance companies still have liabilities from their life insurance policies, and they still need to offset that with high-quality assets that are long dated and have a premium to the US Treasury. And that's what we've been able to supply over the last two decades.

Noah Kaye, Analyst

Very helpful. And then you mentioned in the prepared remarks that the potential value of the one-time transferability of the tax credits. Can you maybe expand on that a little bit on how that might be useful to you and how you might position yourself in terms of utilizing the transferability?

Jeff Eckel, Chairman and CEO

Good question. We're all waiting for treasury to finalize regulations to see what it actually is. If it's what we think it could be, it's just another way for us to solve our client problems by using our broker dealer to arrange the tax equity. We have lots of corporate relationships with tax liability. So it's an opportunity. But again, it's a couple of years out and a whole lot of details and regulations before we really know what's there.

Noah Kaye, Analyst

Great. Maybe if I could sneak one more in. You highlighted some of the new sustainable infrastructure investments. They do have a sort of shorter tenor versus the portfolio average, and maybe you can talk a little bit about the expected trends there. With some of these newer asset classes, it makes sense to have relatively shorter tenors early on. But are some of these asset classes in your view maturing where we get long-term off-takes and you can kind of pair the tenor of your investment to match those long-term PPAs?

Jeff Eckel, Chairman and CEO

Let me answer the tenor question with the cash flow. The cash flow is more front-end loaded. When I talk about tenor, I'm discussing the weighted average life, which shortens the weighted average life. But these are not like 36-month transactions. These are approximately 10 years or even longer, but with a front-end loaded cash flow.

Chris Souther, Analyst

Hi guys. Thanks for taking my question here. Maybe just on the pipeline increase to $4.5 billion, any color on how we should expect the weighting of that timeline over the next 12 months? I'm curious if you're seeing stuff slip into next year, given some of the incentives come around and also the volatility we’ve had within rates. So I'm just kind of curious how your customers are thinking about timelines with the interest rate uncertainty that might bump up the returns you would be looking to get on different projects.

Jeff Eckel, Chairman and CEO

I think we talked about grid-connected solar being dominant, but the American Clean Power Association reported yesterday or today that the panel shortage is still plaguing the industry, and that's true. We believe our pipeline factors in the delays with the best information available to us. Unfortunately, Chris, our ability to predict that mix of our pipeline is pretty limited. It's hard for us to detect the pattern of which transactions will mature on any reliable timeline. That's why we like to have a pipeline that is multiples of what we're trying to invest annually.

Chris Souther, Analyst

Okay. No, that all makes sense. And just historically, if you go back and see how you guys matched up versus the 12-month pipeline on like a go-forward basis, it's almost always above 50% if you go back to at least 2019 or so. Is that a good way to think about the success rate now that the pipeline has gotten a lot bigger, or do you think it’s just a larger size but maybe not the same kind of success rate moving forward?

Jeff Eckel, Chairman and CEO

I think there are two answers to that question. One is a larger pipeline allows us to be a bit more selective on where we invest. Not every client adjusts to higher capital costs in precisely the same way and timing. There's no question the market is working through higher costs throughout all supply chains, including capital. The flip side is we generally have programmatic clients who we expect to get our fair share of the business. 50% is not a bad estimate. We expect to grow, but it's a lot of moving parts in this industry right now.

Chris Souther, Analyst

Okay. That all makes sense. Just last one. You mentioned the transferability opportunities potentially helping you out specifically. I was curious if that was just overall market or something specifically that you think you'd be able to benefit from?

Jeff Eckel, Chairman and CEO

First of all, I think the overall provision will be healthy for the industry. It shouldn’t, if structured correctly, introduce more competition in tax equity, which everybody should rejoice in. I think the transferability provision might be more useful to smaller clients with smaller projects, who have typically had more challenging times getting the big tax equity suppliers to pay attention to them. To that extent, we can provide another solution, and we’ll be glad to step in there and be competitive.

Ben Kallo, Analyst

Hey guys. Good evening. Thank you. So, just with the pipeline, how should we think about the yield of the portfolio or expected? Jeff, you kind of talked about how the greater pipeline gives you more opportunities. But will there be any kind of big change in that? Then I have a follow-up.

Jeff Eckel, Chairman and CEO

I mean, if it's a $4 billion pipeline and let's say we add $1 billion in a year at higher rates, but we're not doubling our yield. That's for sure. As Jeff mentioned, this will be a slow-moving uptick, so don't expect anything big overnight. The Ameresco transaction was in Q4. We talked about it on this call because of Ameresco's press release which came out, so it's not in the Q3 number.

Ben Kallo, Analyst

So my question was, are we doing bigger truck year deals or are we still trying to focus on mid-teen deal sizes?

Jeff Eckel, Chairman and CEO

Yes. I mean, nothing has fundamentally changed in the way we're investing. We'll have some larger investments. There are three assets in the Ameresco portfolio, so we would consider those three separate projects. But no, nothing has changed that says we're going to be writing single project checks in the multi-hundred dollar range.

Jeff Lipson, CFO and COO

Sure. Okay. This is in a category of sustainably linked debt. Many banks now provide incentives to address climate change by lowering the rate based on thresholds they establish for each client. In our case, we already have a metric for carbon count. If we maintain our carbon count at a certain level, we do get a reduction in the interest rate on the loan. The first part of the question comes out of ongoing dialogue we have with our bank partners. We have a great relationship with a number of banks as evidenced by our revolver and this transaction and by discussing various funding alternatives, we mutually arrived at the notion of syndicating a term loan in this particular capital markets environment being an optimal solution for us right now. So it was a joint effort, not necessarily one party coming to the other.

Jeff Osborne, Analyst

Good evening, guys. A couple of questions on my end. I was curious, with the changes in the IRA and given how typically, particularly in grid-scale, you folks come late to the equation. Are you seeing any projects being delayed as people await guidance from treasury or possibly moving from ITC to PTC?

Jeff Eckel, Chairman and CEO

I would say every one of our lead projects on our lead list gets delayed at some point in its lifecycle. The honest answer is yes, everything gets delayed. I wouldn't say that there’s a specific pattern in the delays right now that would be related to the IRA. There was a lot of uncertainty about whether there would be an IRA, and many analysts had to do infinite runs on ITC versus PTC. The clarity that the IRA provides has broken that logjam. Now we’re seeing some projects go forward with clarity of tax policy. Any delays are likely going to relate to transferability and things like that, where there are no treasury regulations to implement.

Jeff Osborne, Analyst

Got it. That's helpful. And then, I think I want to make sure I understand what's going on here. You mentioned $620 million of previously closed transactions are locked and loaded in the pipeline, and that's one of the rationales for the funding. Is all of that in calendar 2023? If we assume you're to do roughly $1.25 million to $1.5 billion, are you about halfway through, maybe at the low end of that range if you're in that typical funded volume commitment range? Just trying to think about visibility into 2023 at this point?

Jeff Lipson, CFO and COO

So just as a reminder, closed transactions and the unfunded amounts related to them from a reporting perspective: when we say transactions closed, like this quarter, we said 273, that doesn't mean that's what’s funded. The remaining amounts will not all be in 2023; probably some of it will be in 2022. We don’t know definitively how much will be in 2023, as that is always subject to change. It’s hard to identify when things will close, but some of it may indeed be from 2022.

Jeff Osborne, Analyst

Got it. If I could ask one more question about the newer areas, it's great to see your entry into the RNG market, something we've been anticipating from your team. Regarding the cash flow dynamics, I wanted to understand two things: first, what is the yield of those initiatives? And second, is there any increased risk compared to typical PPA structures? For instance, in the bus sector, several companies are effectively leveraging energy with vehicle-to-grid arrangements during summer months and when school buses are not in operation. Are you perhaps more susceptible to fluctuations in merchant electricity prices or reliant on a software platform to manage those activities? I'm not very familiar with Zoom, the company you've invested in.

Jeff Eckel, Chairman and CEO

As you know, we haven't been the first movers in RNG or fleet modernization, and that's intentional. We like to go slow. And when we do get in, we like to be senior while we learn how the assets perform. We’re investing in the 7-8% return area, and we’re not going to disclose specific pricing details, but we like the outcomes, and we’re optimistic.

Operator, Operator

There are no further questions at this time. Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may now disconnect your lines, and have a wonderful day.