Earnings Call Transcript - HASI Q1 2022

Operator, Operator

Greetings, and welcome to Hannon Armstrong First Quarter 2022 Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Neha Gaddam, Senior Director, Investor Relations & Capital Market. Thank you, and over to you.

Neha Gaddam, Senior Director, Investor Relations & Capital Market

This conference call is being webcast live on the Investor Relations page of our website, where a replay will be available later today. Before we begin, I want to remind you that some comments made during this call are forward-looking statements under the Securities Act and the Securities Exchange Act. The company seeks the protections of the Safe Harbor for these statements. The forward-looking statements discussed are subject to risks and uncertainties outlined in the Risk Factors section of the company's Form 10-K and other SEC filings. Actual results may significantly differ from those mentioned. Furthermore, all forward-looking statements are made as of today, and the company does not take any responsibility to update them based on new circumstances or revised expectations. During this call, we will focus on non-GAAP financial measures, which we believe provide investors with a meaningful understanding of our core financial results and guidance. This information is not intended to be viewed in isolation or as a substitute for GAAP financial information. A reconciliation from GAAP to non-GAAP financial measures can be found in our earnings release and slide presentation. Joining me today are Jeff Eckel, the company’s Chairman and CEO, and Jeff Lipson, our CFO and COO. With that, I’ll turn the call over to Jeff Eckel, who will start on slide three. Jeff?

Jeff Eckel, Chairman and CEO

Thank you, Neha, and welcome to the Investor Relations role, and good afternoon, everyone. Today, we're pleased to report continued strong performance in the first quarter, with distributable earnings of $0.52 per share, a 21% increase over last year, continued growth in net investment income, up 41% from last year and up 10% from Q4 2021, also a dividend of $0.375 per share. Strong NII growth contributed to this strong quarter and sets us up for a strong year. With our gain on sale revenue added to NII, we demonstrate again that the HASI dual revenue business model, built on a diverse set of clients, technologies and assets, continues to work well, despite macroeconomic and industry challenges. As such, we're pleased to reaffirm 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. As we do every quarter, this quarter, we highlight a carbon count of some projects, in this case, two California-based solar investments, one grid connected at a 0.8 carbon count and one behind-the-meter at 0.2. With the same grid emissions profile, the difference in the carbon count is the relative cost per KW, with the grid-connected solar cost three to four times lower than the behind-the-meter transaction. Now, of course, there are other advantages to behind-the-meter solar plus storage assets such as reliability, but we believe measuring and reporting with this level of rigor on carbon count is where the market needs to go. Turning to Slide 4. We'd like to discuss some of the headline challenges that are top of mind of our investors. First, as we mentioned last quarter, the clean energy industry is continuing to adapt to inflation by raising PPA prices. Our clients in both grid connected and behind-the-meter segments are increasing PPA pricing to end customers to manage higher capital costs and inflation. And while renewable PPAs are pricing higher, the alternatives in gas-fired or utility supply power have generally increased as well due to a near tripling of natural gas prices. As for the impact of HASI, higher inflation has minimal impact on our portfolio due to the largely fixed-price O&M contracts. And because we price our new investments at current pricing and once the impact of inflation on a project is understood, we can generally increase pricing with market rates. Additionally, our portfolio benefits from higher commodity prices and retail rates to the extent there are sales into the wholesale markets. For behind-the-meter generation, including residential solar, the customer value proposition is improving due to utility rising rates. In fact, the long-term prospects for elevated natural gas prices are causing us to look more favorably on common equity investments to capture some of that upside. Next, as most of you are aware, the anti-circumvention investigation initiated by the Department of Commerce is creating disruption in the solar supply chain with a threat of retroactive tariffs on panels imported from Southeast Asian suppliers. This is primarily affecting grid-connected solar projects due to their tighter PPA pricing and the sheer volume of panels those projects require. On our grid connected pipeline, we are fortunate to have large companies as clients who've generally been able to source panels from unaffected supply chains. Will there be softness in the solar pipeline six to nine months out? I think that is inevitable, yet manageable, given the diversity of our origination platform across the clean energy landscape. The success of the grid-connected wind and solar industries over the last few years has not been matched by investment in transmission systems to move the power to the load. This congestion and basis risk causes pricing mismatches under some PPAs leading to revenue shortfalls from the project plan. We have experienced some of this with our portfolio and have adjusted our expected yield accordingly. The preferred nature of many of our grid-connected assets is a significant mitigant but not a perfect mitigant for an industry-wide problem that is getting the attention it deserves from the industry. Finally, the brutal war in Ukraine by Russia is a reminder that energy security is national security. This should be a clear message that notwithstanding the near-term challenges of the clean energy industry I've just been discussing, we should not lose sight that the clean energy industry is the only viable path to both energy independence and climate change mitigation, further reinforcing our investment strategy. Moving to Slide 5. We provide an update on our 12-month pipeline, which we continue to report as greater than $4 billion. Consistent with last quarter, the bulk of our pipeline remains behind the meter and is weighted towards energy efficiency. The grid connected portion is weighted towards solar projects that are either operating, in construction, or in late-stage development that have mitigated the antidumping issues we just discussed. Lastly, our sustainable infrastructure pipeline continues to provide opportunities in environmental restoration, transportation, stand-alone storage, and renewable natural gas. Now I'll turn it over to Jeff L to detail our portfolio performance and financial results.

Jeff Lipson, CFO and COO

Thanks, Jeff. Summarizing our first quarter results on slide 6. We recorded distributable earnings per share of $0.52 and had a strong quarter of distributable net investment income of over $42 million and recorded a gain on sale of approximately $22 million. On a year-over-year basis, we continue to demonstrate substantial growth in our distributable net investment income and steady realization of gain on sale fees as our dual revenue model continues to bolster our distributable EPS. In the upper right, we note distributable EPS year-over-year growth was 21%, resulting from growth in both equity method investment income and interest revenue. In addition, as shown on the lower right, our gain on sale from securitized assets for the first quarter was $22 million, representing an 8% increase year-over-year. Lastly, distributable net investment income was over $42 million in the first quarter, reflecting year-over-year growth of 41%, driven by a larger portfolio and ongoing strong margins. Our net investment income is expected to grow each quarter as we add assets to the balance sheet, providing ongoing stability and visibility into our future earnings growth. Therefore, we are affirming our guidance of 10% to 13% compound annual growth in distributable EPS through 2024. Turning to slide 7. We detail our $3.7 billion balance sheet portfolio as of the first quarter of 2022, which has grown 28% from $2.9 billion over the last year. Our portfolio now includes over 320 investments across eight asset classes with a weighted average life of 18 years. With no asset class comprising more than 30% of the portfolio, the diversity of our business remains a strength, particularly in a period in which certain asset classes are more impacted by the aforementioned macroeconomic trends. Our forward-looking portfolio yield at quarter end was 7.3%, down from 7.5% at year-end. This reduction was primarily the result of a change in distributable earnings accrual rates for two grid connected projects due primarily to congestion in the Southwest Power Pool, which resulted in a modest reduction of our long-term IRR expectations for these investments. These investments continue to perform within our expectations and the grid connected portfolio will likely benefit long-term from higher natural gas prices. Consistent with the past several quarters, our overall portfolio continues to perform very well, with 99% of our investments performing within our expectations. Turning to slide 8. We detail our Q1 portfolio reconciliation. We funded over $160 million of investments, resulting in portfolio growth of 5% from year-end. Funding expectations of previously closed transactions, as shown on the right, with over $675 million expected to fund through the end of 2023. To be clear, the amounts in this table reflect closed but unfunded transactions and are entirely incremental to the portfolio growth we expect from our greater than $4 billion pipeline. On slide 9, we highlight our successful offering in April of $200 million of carbon count exchangeable notes. These notes carry a coupon of 0% and mature in 2025. The investors have the option to either exchange the notes for stock at a 32.5% premium subject to dividend adjustments, which at closing was $56.54, or receive accretive principal at 3.25% per annum at redemption. Given the volatile capital markets backdrop, we are pleased with the terms of this financing. We also issued $50 million of equity in the quarter at an average price of slightly above $48 per share. With cash proceeds from the notes and the shares, combined with availability in our credit facilities and CP program, our total available sources of liquidity increased to greater than $930 million. We have no material debt maturities until 2025, as we continue to manage our market risk by utilizing modest leverage, lighter debt maturities, and diverse funding sources. Turning to slide 10, we reiterate our management of interest rate risk, which is not unique to our business, and we take this risk very seriously in our enterprise risk management processes. Our investment portfolio of over $3.7 billion is comprised of fixed rate loans and equity method investments with yields that are largely unaffected by changes in interest rates. Combined with our debt, which is 96% fixed rate, our existing balance sheet is largely insulated from near-term changes in interest rates. The chart on the left demonstrates our historical ability to actively manage our interest rate risk and grow distributable earnings. Since 2014, our first full year as a public company, neither the level of rates nor the shape of the yield curve has meaningfully diminished our ability to grow earnings. This is in part because we actively manage our balance sheet and securitization program to maximize our ROE, which was 11.5% in Q1. The graph on the right shows our margins have been maintained as our yields have been steady, despite a competitive investing environment, while our cost of funds has decreased. As noted earlier, our yield is a bit lower this quarter, but our margins continue to be strong, as our interest expense as a percent of our average debt balance continued its downward trend in the quarter. Given current market conditions, we expect incremental term debt issued in 2022 would likely be above our current cost of debt. However, we expect our aggregate margins to remain relatively consistent and sufficient to achieve our guidance. We also expect these margins will facilitate continued strong growth in net investment income. Finally, I'd note our securitization strategy has functioned well during our 40-year history, including in much higher interest rate environments. So we remain confident that we can continue to utilize this source of capital as part of our funding and market risk strategies. In conclusion, earnings growth remains robust. Our guidance is affirmed, and our market risk and capital market strategies remain sound. With that, I'll turn the call back over to Jeff.

Jeff Eckel, Chairman and CEO

Thanks, Jeff. Great job. Turning to slide 11. We continued efforts to improve the carbon count methodology, and we're pleased to be recognized by Fast Company for our innovations in Climate Solutions investing. On the social front, our foundation advanced several Climate Justice Initiatives, including efficiency upgrades for nonprofits, advancing our Climate Corps fellow program, funding of resilient hubs in Baltimore and supporting an online climate education library. Finally, we encourage you to take a deep dive into our 2021 impact report, which includes many new disclosures and details on the progress of our various ESG initiatives, is now posted on our website along with our new and improved proxy. We'll conclude on slide 12. There are three reasons we think this is a fantastic business. First, over our nine years as a public company, we've demonstrated that our dual revenue business model continues to grow earnings in a variety of macro environments, and we're well positioned to continue that growth in the future. Second, our commitment and credibility in ESG attracts and retains the best talent committed to making a positive impact, leading to high employee retention, which in turn, improves our operating leverage and our ability to solve client problems, a direct benefit to shareholders. Finally, our pipeline of Climate Solutions investment opportunities is large and growing. The growth is driven by the twin priorities of addressing climate change while improving our national energy security, an enormous addressable market for years to come. With that, I'll ask the operator to open the line for questions.

Operator, Operator

Thank you. At this time, we will be conducting a question-and-answer session. The first question comes from the line of Mark Strouse with JPMorgan.

Mark Strouse, Analyst

Yes, good afternoon. Thank you very much for taking our questions. Just wanted to go back to your comments about the yield coming down a little bit. Kind of what drives that? How do we reconcile that with just kind of generally increasing PPA rates across the space? And then how should we think about that over the near future?

Jeff Eckel, Chairman and CEO

Take it, Jeff.

Jeff Lipson, CFO and COO

Sure. So thanks for the question, Mark. We tried to highlight it was a little bit different dynamic this quarter. It wasn't a function of new assets coming on the balance sheet. It was strictly a function of the congestion in SPP causing us to lower the IRRs on a couple of investments, and that served to reduce the overall portfolio yield. But I think the trend long-term should be that these higher PPA prices and higher interest rate environments should gradually result in a higher yield over time. It was a unique dynamic this quarter that we wanted to highlight.

Mark Strouse, Analyst

Can you provide more details about participating in the common equity investments? Is this happening across your entire portfolio or focused on a specific sub-segment? Will this require changes to your existing partnership models that have been in place for many years?

Jeff Lipson, CFO and COO

So Mark, over the years, we – when we went public, we explicitly said that we would invest in the common equity in these assets. Over the years, we've not exactly found those returns to be all that compelling. Thus, we structured things more as a preferred. If you can't get the return, don't take the risk. And that's been our philosophy. But now we see the potential with $5 and $6 gas persisting in our view for quite a while as presenting some opportunities. But the fundamental principle is we don't want to make any investment where we don't get paid for the risk, but we're not unwilling to take risk if we feel we're going to get paid for it.

Mark Strouse, Analyst

Okay.

Jeff Lipson, CFO and COO

And we don't have to make any other changes in our business model or anything. We actually have equity and pure equity and some things relatively small, but it's not any kind of a change to the business.

Mark Strouse, Analyst

Yes, okay. Very helpful. Thank you.

Jeff Eckel, Chairman and CEO

Thank you.

Operator, Operator

Thank you. The next question comes from the line of Chris Souther with B. Riley. Please go ahead.

Chris Souther, Analyst

Hi guys. Thanks for taking my question here. I just wanted to talk a little bit about transactions in the quarter and then movements within the pipeline. Could you talk about the end markets for this quarter based on the balance sheet growth and capital issues mostly behind the meter stuff that you'd be securitizing? I wanted to see if there were any other segments that weren't captured there. And then it's kind of a shift in the pipeline, reflecting any challenges you're seeing on the utility grid side at all?

Jeff Eckel, Chairman and CEO

We mentioned two solar projects in the carbon count section, one behind the meter and one grid-connected. Those were the only solar projects we highlighted this quarter. As for the shift in the pipeline, I don't really see a significant change. We did discuss that the impact on solar may be noticeable in six to nine months, but we believe it will be manageable. Deals always move around in timing every quarter, but there's no substantial shift in the pipeline. Jeff, do you have anything to add?

Jeff Lipson, CFO and COO

No, I think you’ve covered it.

Chris Souther, Analyst

Okay. And then looking at, I guess, the elevated receivables held-for-sale that kind of indication that securitization is something that we should be expecting a larger number in the next quarter. I don't think I've seen you guys break out a number that since you started breaking that out. So I'm just kind of curious if you could talk about that at all?

Jeff Eckel, Chairman and CEO

Sure. So Chris, I wouldn't read anything in particular into that. It just means we had some assets on the balance sheet at quarter end that we intend to securitize; sometimes the timing is such where we close in one quarter and securitize in the next. And in those instances, we do have the held-for-sale bucket a little higher. And in other quarters, we essentially securitize everything we intend to and held-for-sale is virtually zero. So as sort of a business model or a trend issue, I would not read anything into that.

Chris Souther, Analyst

Okay. Appreciate. Thanks guys.

Jeff Eckel, Chairman and CEO

Thank you.

Operator, Operator

Thank you. The next question comes from the line of Ben Kallo with Baird. Please go ahead.

Ben Kallo, Analyst

Hi, good evening. Could you discuss electricity prices and power purchase agreements? How quickly do they impact both the utility side and the residential side? Also, do higher electricity prices present opportunities in other asset classes that you typically haven't explored? I'll stop there. Thank you.

Jeff Eckel, Chairman and CEO

Thanks, Ben. There are two types of developments to consider. One involves revenue contracts that are fixed and may result in minimal or even negative development fees for the sponsors. These situations can be challenging, but they serve as strong reminders to sponsors that future deals must be better priced. It's almost immediate; once you realize there's a negative development fee, you quickly understand that it's not favorable and you need to ensure your next deal improves. We're witnessing this trend with distributed solar and grid-connected solar, where some contracts are being renegotiated and adjusted. I believe this won't take a long time to resolve, as the industry has to adapt. Regarding higher utility prices, that's an excellent question. We're definitely noticing an increase in interest in energy efficiency. The economics were already favorable, and they have only improved. Additionally, there's a sort of safety in energy efficiency since it stabilizes electricity costs. People are now aware that natural gas prices are rising, along with demand charges, making conservation a much better option. While this may not push us into completely new technologies, continuing with our current initiatives would be beneficial.

Ben Kallo, Analyst

Thank you.

Jeff Eckel, Chairman and CEO

It won't take us to exotic technologies, I can guarantee that.

Operator, Operator

Thank you. The next question comes from the line of Julien Smith with Bank of America. Please go ahead.

Anya Shelekhin, Analyst

Hi, guys. This is Anya stepping in for Julien. So first off, I just wanted to ask on the portfolio, just following up on that. Portfolio increased from $3.6 billion to $3.7 billion this quarter. And I know you mentioned that the yield declined largely due to that transmission congestion and basis risk. But are there any other moving pieces there? Just curious on those new additions to the portfolio, what kind of impact did those have on the yield? And are you seeing yields relatively flat as you just discussed based on PPA prices going up? Maybe could you just talk a little bit about that? Thanks.

Jeff Eckel, Chairman and CEO

Sure, we added $160 million to the portfolio in the quarter, bringing the total to $3.7 billion. The new additions had almost no effect on the overall portfolio yield due to the calculations involved. Generally speaking, as we mentioned earlier, with rising inflation and interest rates affecting our power purchase agreements, we are aiming for a higher yield on the portfolio than we have previously achieved, and we are optimistic about this trend.

Anya Shelekhin, Analyst

Okay. Great. And as a follow-up, could you maybe discuss the progress on the Clearway co-investments. What are the risks of development delays on that investment at this point? Any color you could provide on procurement efforts on their side will be helpful. And what do you kind of look like on the high...

Jeff Eckel, Chairman and CEO

I'm not sure we can provide any color. They're working hard at it, and it's a great group that will get those projects developed. I'm sure they've got one million headaches that we frankly don't know about and that they're managing. But every bit is incentivized as anybody in the transaction to get it done. So no real color Anya.

Anya Shelekhin, Analyst

Okay. Thanks. Could you also actually provide more information on the energy efficiency opportunity, you just mentioned right now. Have you seen a pickup in interest already at this point? And just how are you looking at that right now, just given the dynamics in the market today?

Jeff Eckel, Chairman and CEO

Maybe I'm being a bit optimistic, but I can't believe that the rise in utility rates and gas prices won't lead to an increase in efficiency. I might have expressed my optimism a bit too strongly. It certainly should affect you, and we will see.

Anya Shelekhin, Analyst

Great. Thank you. I'll jump back in the queue.

Jeff Eckel, Chairman and CEO

Thank you.

Operator, Operator

Thank you. The next question comes from the line of Noah Kaye with Oppenheimer. Please, go ahead.

Noah Kaye, Analyst

Good afternoon. Thanks for taking the questions. First one, around transmission bottlenecks and potential opportunity. When we look at the report that Lawrence Berkeley put out at the end of 2021, I think it showed over a terawatt of solar storage, et cetera, in the interconnection queue. And even if we assume only 15%, 20% of those products get built, it seems like the transmission issues will get worse, and that may be a solvable problem and something that you can participate in. So, can you talk a little bit about opportunities that you may have on the transmission side or in supporting sustainable infrastructure, or generally, how you think about these congestion issues affecting your opportunity set?

Jeff Eckel, Chairman and CEO

I would say that our clients are making significant efforts to develop transmission solutions, but this is not a short-term business or a quick fix. We are observing them incorporating storage or adding solar to wind to help mitigate some of the impacts. It’s not a rapid solution. Some utilities are addressing it, although their incentives might not fully align with ours, but it absolutely needs to be resolved.

Noah Kaye, Analyst

Okay. I believe that our clients are working very hard to produce transmission solutions, but that's never been a short-term business, never a short-term fix. We are seeing them add storage or add solar to wind to try to offset some of the impacts. It's not a quick fix. Some of the utilities are working on it. Their incentives may be a little out of alignment with ours, but it absolutely has to be addressed.

Jeff Eckel, Chairman and CEO

I don’t know if you’re asking the real fix for it, though.

Noah Kaye, Analyst

All right. Well, to be continued. But I think a couple of folks have been asking this question in a couple of different ways, but I just want to see if we can take a shot at it, where in the markets do you see the higher energy prices most clearly accelerating the sales cycle. And I wonder if you could touch specifically on the types of projects that historically have had long development cycles like the P3 investments.

Jeff Eckel, Chairman and CEO

I'm not sure that we would be able to speak to sales cycles by asset class. But anybody who's opened up their electric bill has said, "Dang, this is higher than I thought it was." And particularly with the additions of the rate base that have been added by most utilities and it's not an easy number to take in a monthly bill. So what we see primarily, Noah, are the economics are even better for residential solar, for C&I solar with storage for energy efficiency. And that, typically, we're all economic animals, and that should provoke more business. But we really couldn't say which asset class might be moving the fastest.

Noah Kaye, Analyst

Appreciate it. Thank you.

Jeff Eckel, Chairman and CEO

Thank you.

Jeff Lipson, CFO and COO

Thanks.

Operator, Operator

Thank you. The next question comes from the line of Nate Crossett with Berenberg. Please, go ahead.

Nate Crossett, Analyst

Hey. Good evening. Couple of questions. First one, just on competition, just with rates rising, have you seen any change in the players that you normally compete against in terms of just their ability to compete for deals with higher funding costs? And then maybe you can just, kind of, go through your funding needs for the rest of the year? It sounds like the pipeline continues to be pretty strong. So how should we think about funding that? And it looks like you just recently did that green exchange senior note deals, should we expect to see similar things like that?

Jeff Eckel, Chairman and CEO

So on competition, I don't think we've seen too much change, most of the new entrants really are not investing at the asset level, they're actually investing at the sponsor level and new sponsors, particularly to create development platforms. That's not an area where we want to be. We like to fund our clients and not create competitors to our clients. But there's always a new entrant every quarter we've not seen before, and then somebody exits, but it's not a significant change in the competitive profile.

Jeff Lipson, CFO and COO

And on the funding platform, we'll continue to use the diverse sources of capital in our arsenal that we've developed. As we've noted, we have substantial dry powder on the credit facility. We'll probably lean on that a little bit. If we're successful converting on a significant amount of the pipeline, you should expect us to do a term debt deal at some point this year and will be a relatively consistent issuer on our ATM as well, and we'll also continue to actively securitize certain assets. So the core diverse funding strategy that we've used historically, probably all those sources will get tapped this year.

Nate Crossett, Analyst

Okay. And just maybe one on the portfolio yield of 7.3, like are you guys articulating that, that's the lowest we would see this year, or I guess, how do you see that trending? I know you had some longer-term comments, but is this like a bottom tick quarter in that sense?

Jeff Eckel, Chairman and CEO

We're not saying that specifically. What we really wanted to highlight is that it was not new investments that caused the portfolio yield to decrease this quarter, and we just wanted to make that point. It is not necessarily a low point for the year. There are many dynamics at play, such as securitization activity and taking items off the balance sheet. Clearly, this influences portfolio yield, and the timing of when certain investments pay off can also affect it. There are many factors influencing that figure, so we are not ready to state that this is specifically the lowest point of the year.

Nate Crossett, Analyst

Okay. I’ll leave it there. Thank you.

Operator, Operator

Thank you. As there are no further questions, this concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.