Earnings Call Transcript - HASI Q1 2021

Operator, Operator

Good afternoon, and welcome to Hannon Armstrong's conference call on its first quarter 2021 financial results. Leadership will be utilizing a slide presentation for this call, which is available now for download on the company's Investor Relations page at investors.hannonarmstrong.com. Today's call is being recorded and we have allocated 30 minutes for prepared remarks and Q&A. At this time, I would like to turn the conference call over to Chad Reed, Vice President, Investor Relations and ESG for the company.

Chad Reed, VP, Investor Relations and ESG

Thank you, Operator. Good afternoon, everyone, and welcome. Earlier this afternoon Hannon Armstrong distributed a press release detailing our first quarter 2021 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 would like to remind you that some of the comments made in the course of this call are forward-looking statements and within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934 as amended. The company claims the protections of the safe harbor for forward-looking statements contained in such sections. The forward-looking statements made in this call are subject to the 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. Please note that certain non-GAAP financial measures will be discussed on this conference call. 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, who will begin on Slide 3.

Jeffrey Eckel, Chairman and CEO

Thank you, Chad, and good afternoon, everyone. Today we are reporting GAAP earnings of $0.61 per share and distributable earnings of $0.43 per share. 38% portfolio growth year-over-year to $2.9 billion and 19% growth in our managed assets to $7.4 billion. The establishment of a $400 million unsecured revolving credit facility, a 10 basis point increase in our portfolio yield to 7.7% from the Q4 levels. And the declaration of a dividend of $0.35 per share. We continue our leadership on ESG reporting with our carbon count disclosures and our 2020 impact reports. Turning to Slide 4. We remain confident in our ability to achieve the 3-year guidance target we established last quarter due to expected portfolio growth, stable or improving margins and improvements in our operating leverage. These 3 factors will be the drivers for growth in distributable earnings per share of 7% to 10% through 2023 and the dividend growth at a rate of 3% to 5% annually, also through 2023. With distributable earnings growing faster than our dividend, we can continue to retain capital for accretive investments and believe the combination of earnings growth and dividend yield remains attractive on a total return basis.

Jeffrey Lipson, CFO and COO

Thanks, Jeff. Turning to Slide 7. We note our high-quality assets continue to perform within our expectations in the first quarter. This performance is driven in part by the structural seniority of our investments and the credit quality of our obligors. In nearly all of our investments, we are in a preferred senior or super senior position. In addition, our obligors are typically investment-grade government or corporate entities or creditworthy consumers. The structure of our investments, most notably our structural seniority, has a very meaningful impact in reducing our exposure to both operating and commodity price risk. As we discussed last quarter, this structural seniority was a significant factor in limiting the impact of the Texas weather events on our results. Moving to Slide 8. We detail our balance sheet as of the end of the quarter. In the first quarter, we funded $168 million of investments many of which are ongoing fundings of previously closed transactions. We also executed several securitization transactions, including a low yielding, highly leveraged government transaction, consistent with our past practice of taking transactions with this profile off balance sheet. The net result was a portfolio balance of $2.9 billion, similar to year-end 2020. Our funding expectation of previously announced transactions is shown on the lower left. We expect these incremental fundings, along with the strong pipeline that Jeff referenced earlier, will generate further growth in net investment income. As of the end of the quarter, we have over $200 million of cash on our balance sheet. And subsequent to the quarter, we added substantial incremental liquidity with our revolver, which I will discuss in a moment. Summarizing our results on Slide 9. We recorded distributable earnings per share of $0.43 in the first quarter, roughly flat with the same period last year. Higher revenue from gain on sale was offset by higher interest expense due to the volume of debt that we've issued since the first quarter of 2020 and higher compensation. I will also note that distributable net investment income increased to $30 million as higher income from equity method investments was partially offset by the aforementioned higher interest expense. To conclude, we enjoyed another strong quarter as our dual revenue model continued to perform. On Slide 10, we highlight our establishment of a $400 million sustainably linked unsecured revolving credit facility with 10 relationship banks. Given significant interest among other lenders, we replaced a similar $50 million facility we had established in the first quarter with JPMorgan as a sole lender. The support we received from the top-tier banks should be viewed as an affirmation of our strategy and strong confirmation of the credit profile of our portfolio. Having a revolver in place will facilitate a more efficient balance sheet as we will no longer be required to raise all of the capital prior to the funding of an investment, and we'll have the flexibility to reduce the earnings drag of outsized cash balances. The facility provides for interest rate reductions if we achieve certain levels of our carbon count metric on a quarterly basis. Therefore, in addition to further enhancing our liquidity and funding flexibility, the facility provides market validation of our carbon count scoring tool.

Jeffrey Eckel, Chairman and CEO

Thanks. Turning to Slide 13. We highlight the publication of our 2020 impact report, which we're proud of, and I really urge you to read it. It's a terrific piece of work. The report features enhanced disclosures and advocates for a common ESG reporting framework that includes standardized reporting on avoided emissions, particularly for financial institutions. We would certainly love for them to embrace the carbon count metric. In addition, yesterday, we announced the Hannon Armstrong Foundation's first grant to establish the Climate Solutions Scholarship Program. The program provides financial assistance for high-achieving, sustainability-focused undergraduate students from underrepresented communities. At launch, the participating schools include Morgan State University, Maryland's largest historically black college and university, and Miami University in Oxford, Ohio. The needs-based scholarships will cover the cost for up to 5 students interested in pursuing careers related to climate change and sustainability. We believe this grant serves as an important step forward in our journey to drive meaningful and sustainable impact as well as a potential pipeline of new professionals in the industry. We'll conclude on Slide 14. Our 4 key strengths are the strong programmatic investment platform with the firms who are driving the energy transition to a low-carbon future. We are grateful for the opportunity to support these companies in this effort. Second, our well-diversified funding platform allows us to satisfy our clients' capital requirements, whether the assets are a good fit for our balance sheet or not. This flexibility allows us to solve our customers' financing problem with a full range of behind-the-meter and grid-connected assets these programmatic clients generate. Third, it is terrific to have a policy tailwind for the first time in 4 years. We expect recent and anticipated executive orders on proposed federal legislation to contribute to continued growth in our existing markets and asset classes. As we've shown over the last 4 years, we don't need the tailwind, but if the country is going to meaningfully address climate change, public policy will be a key piece of the solution. As Jeff L showed, we have a proven track record in a variety of interest rate environments over our 8 years as a public company, with consistent growth in distributable earnings, independent of the level of interest rate or the shape of the yield curve. This track record should give investors comfort in how we will manage the business into the future. To sum up, the opportunity for growth has never looked more promising, and we are confident in our ability to execute in the months and years ahead.

Operator, Operator

The first question comes from Noah Kaye with Oppenheimer.

Noah Kaye, Analyst

A lot of positive commentary and actual reported results from some of the leading performance contracting companies. It seems like just a having moved past some of the logistics difficulties during the pandemic of doing contracting, we're starting to see improved contracting flow. I just wanted to get your color on whether you're seeing that as well and how you look at the flow in the energy efficiency business over the balance of the year? I know you addressed that; it's a large part of the 12-month pipeline. But just curious for any incremental color you can provide.

Jeffrey Eckel, Chairman and CEO

Yes, Noah, I believe that our behind-the-meter pipeline, which is primarily focused on energy efficiency, reflects the strong position of the ESCO market that you mentioned. It's a solid business, and they are performing well. We are beginning to see progress at the federal, state, and local levels after some delays due to COVID last year, but things are starting to pick up again.

Noah Kaye, Analyst

You've mentioned that the timing of originations can be inconsistent. Based on that, do you have confidence in an increasing pace of originations for the rest of the year?

Jeffrey Eckel, Chairman and CEO

I think we're quite confident, Noah. What we did in Q1 was about what we did in Q1 last year. And if you look at last year, it ended rather well with high volumes. I don't think anybody should be surprised if the same thing happens this year.

Noah Kaye, Analyst

And just one last question. You may have seen that on Earth Day, we had a lot of announcements, but the European Commission announced that as part of the new climate law package in June, they are going to add buildings to the emissions trading system for carbon. In other words, building decarbonization is going to be properly incentivized. There's always been a U.S.-focused business. I'm just curious for perspective on that, whether there's potential for similar legislation in the U.S. to benefit, and whether your ambition might start to stretch overseas as you consider the potential for building carbon pricing to actually impact the bottom line.

Jeffrey Eckel, Chairman and CEO

Great question, Noah. As you know, we've been big fans of carbon pricing in whatever form it might take and applaud the EU for adding buildings, which is, I think, 40% of greenhouse gas emissions or something like that. So if we're actually going to get at it, you should be incentivizing it. I'm not familiar with any comparable legislation in the U.S., but it certainly is a good idea and would provide yet another revenue stream and benefit to the energy services industry.

Operator, Operator

The next question comes from Ben Kallo with Baird.

Benjamin Kallo, Analyst

Congrats. Maybe, Jeff Lipson, can you just talk a little bit more about interest rates because all of our sector stocks have gotten crushed partly because of interest rates, I think. And maybe just refine or remind, I guess remind us how they impact you and how we think about the yield curve. I know you have this slide here. I know you guys talked about it. But any color you can give there.

Jeffrey Lipson, CFO and COO

Sure, Ben. The key point to consider is that we have fixed rate assets supported by long-term fixed rate liabilities, and we've been extending the duration of our liabilities, especially with a 10-year debt offering we completed in 2020. This means we have secured margins on a significant portion of our portfolio. As we continue to make new investments, our funding costs will be determined at the time of closing, allowing us to maintain our margins. Therefore, fluctuations in interest rates don't have an immediate impact on the existing portfolio; the margins there are already set. For new investments, we can secure our margins at the time we close as well. Additionally, we have an off-balance sheet distribution network that we can rely on more heavily if necessary to manage any disconnect between funding costs and our investment markets, but we certainly do not anticipate that happening.

Jeffrey Eckel, Chairman and CEO

Ben, I want to emphasize that what we truly focus on is the economic return of these assets. I'm confused as to why a shift of 50 or 100 basis points in interest rates would endanger the stability of these assets. They are not so weak that such a movement would be detrimental to them.

Benjamin Kallo, Analyst

Well, that was going to be my question. So sorry to interrupt. But what is that kind of threshold that you think about across the different asset classes? I have a bigger picture question for you guys too after that.

Jeffrey Eckel, Chairman and CEO

The renewable energy and energy efficiency sectors have successfully navigated higher interest rate environments in the past by consistently reducing costs within their operations. While it's challenging work, I am confident that they will continue to find ways to improve efficiency. It baffles me that a modest increase in market rates, which hasn't yet occurred, could threaten the entire industry's viability. I don't have an exact figure to answer your question, but we are not pessimistic about this industry. We believe it has a strong potential to thrive even in a fluctuating and elevated interest rate landscape.

Benjamin Kallo, Analyst

Yes. No, it's good context to remember just the history of that. So thank you. A question that you've gotten forever, maybe on competition, but you're not small anymore. And you raised a lot of capital and you're doing bigger deals. And used to be that you were a player and people didn't want to do small deals like this. But now where do you stand with that competition front? Because every headline is if you want to pour money into the sector here. And so how do you guys stay that same nimble as well as have the growth?

Jeffrey Eckel, Chairman and CEO

Good question. I mean, we have competition in every market in every asset class. But I still haven't seen anybody who's put their financial services offering together the way we have that can nimbly go with the same team from a grid-connected transaction to a behind-the-meter transaction. And our clients are doing both. You have some companies that are just doing wind and solar, and I'm sure we'll have more competition over time. We need a lot more capital in this industry to make a meaningful difference on climate change. That said, I'm hard-pressed to see where somebody is coming in with a better offering than we have right now. Our cost of capital has come down, our price of capital has come down. I think we're extremely competitive. And then at the end of the day, service does matter, knowledge of the industry matters, and our portfolio management business continues to be a very sticky aspect of client management.

Benjamin Kallo, Analyst

Let me ask this way. Who would buy you if they were going to buy you?

Jeffrey Eckel, Chairman and CEO

No, Ben, I'm not going to answer that.

Benjamin Kallo, Analyst

All right. I had to try, I mean.

Operator, Operator

The next question comes from Philip Shen with ROTH Capital Partners.

Philip Shen, Analyst

In your prepared remarks, you talked about how the shortages that people are seeing out there, whether they be chip shortages, or what have you, are not impacting your business yet. I was wondering if you might be able to elaborate on that more. As you mentioned, you're getting a lot of inbounds on this. So there is the interest to hear and get more color on this. Specifically, when I've been in touch with EPCs recently, they're saying capacity through the whole kind of system is very tight, whether it be EPC capacity or even truckers in the U.S. that drive blades and get materials from one point to another. So are you getting any sense that some of your investments and the timing that you might have expected earlier might be getting pushed out a little bit into 2022? Any color on this would be very helpful.

Jeffrey Eckel, Chairman and CEO

Phil, I recently checked with a number of our clients on this very question. And I think one of the themes is prices are going up a little bit, and it's some of the risk of development that they've got, and we don't wear. But they're basically getting the material they need. I won't say it's absolute, and everybody's got everything just in time. But generally, that's not the thing that our clients seem to be worrying about. And maybe what they're worrying about are next year's projects, looking at the supply chain for next year's transaction. That may be. But we're not seeing it in the business we think we're going to do in 2021.

Philip Shen, Analyst

Okay. And that was my follow-up on that topic. What are they worrying about? Anything else you have in mind on that topic?

Jeffrey Eckel, Chairman and CEO

No. I think those are normal concerns for developers of these assets to consider. They are focused on the price and whether there is a margin. Overall, they are managing well, but it is clear that prices are increasing in various areas, such as labor, steel, copper, and chips.

Philip Shen, Analyst

Yes, Aluminum, et cetera.

Jeffrey Eckel, Chairman and CEO

Yes.

Philip Shen, Analyst

Okay. Great. Last quarter, you guys talked about it was too early to get a full understanding of the impact of the Texas events on your portfolio. So I was wondering if you could give us an update on the situation, what's the risk, you may have a write-down at some point or pay any kind of settlement for power that wasn't supplied from your facilities. You highlight that 99% of your assets are performing, but wanted to see if you could share some more there.

Jeffrey Lipson, CFO and COO

So there's not too much update from what we said last quarter, Phil, in terms of the overall impact on the portfolio is going to be minor. There's no sort of contingent items still hanging out there. There's various force majeure resolutions going on and payments in cash for power when the power couldn't be provided. But as we said last quarter, the punchline of all that for us is some very minor reductions in the expected lifetime IRR of some of our investments, very, very minor. So that's the impact for us. It really hasn't changed from last quarter.

Philip Shen, Analyst

Okay. So as we look across Texas and ERCOT, how many megawatts of projects are actually behind on payments to you guys? How much is actually late? And if there were late payments, are they already caught up? Or is there any continuation of that potential threat?

Jeffrey Lipson, CFO and COO

There's no late payments to us. Again, we're supplying power. And as we talked about last quarter and some of the developers have talked about, we did have to make certain payments for the days we could not provide power, but nobody is late in a payment to us.

Philip Shen, Analyst

Great. Okay. That's really helpful. And then one last housekeeping question on compensation and benefits. I think it looks like it increased $5 million quarter-over-quarter. What drove this? Is it a one-time thing? Should we be modeling this level going forward?

Jeffrey Lipson, CFO and COO

It was driven by higher headcount. It was driven by a higher percentage of our compensation being paid in cash, which runs through distributable, whereas equity does not. And then there's also a bit of onetime in there as well, which will not recur in the subsequent quarters.

Philip Shen, Analyst

So we should have an increased net line item, but maybe not as much as $5 million. Is that a fair way of putting it?

Jeffrey Lipson, CFO and COO

That's exactly right.

Operator, Operator

The next question comes from Stephen Byrd with Morgan Stanley.

Stephen Byrd, Analyst

Congrats on the scholarship announcement as well. That's fantastic. So a lot's been addressed. I wanted to maybe just focus on energy efficiency a little bit further. Obviously, you're bullish on the outlook. I was just curious, given the bid administration's focus on a variety of things, but certainly energy efficiency is on the list. Is that bullishness reflective of sort of what you expect there? Or is it possible we could see a further step change upward in terms of government demand beyond what you're seeing already in your sort of bullish overview of where you see energy efficiency going?

Jeffrey Eckel, Chairman and CEO

Good question, Stephen. I think we reflect on our pipeline that we're reporting as of 3/31. We didn't factor in a lot of new stuff. The way we build our pipeline, there's got to be a lot of granularity. So it's very doubtful that with a inauguration in January, we would have seen deals happen and go to our pipeline. So I think what we're talking about is just sort of normal course business. We're certainly very encouraged by the type of appointments the administration has made in the appropriate agencies and the experience these people have. They actually know how to turn the dials and push the levers of energy efficiency. So you haven't seen anything go up. But I would also caution again, people always talk about energy efficiency as that low-hanging fruit, and that just means they've never picked grapes on a vine because low-hanging fruit takes a long time to engineer these solutions. I think the one thing I would point to is, in our comments, was the industrial sector, which has always been a real challenge for the energy services business to be effective in. But we're starting to see signs that the service providers are offering a really interesting value-add service to industrial customers and corporate customers that hit a lot of their sustainability goals inclusive of on-premise energy efficiency.

Stephen Byrd, Analyst

That's helpful. It does seem clear that while these projects are difficult to complete, the trend appears favorable. I tend to ask about legislation each quarter, but I wanted to approach it differently this time. I believe there is a positive outlook for clean energy support. One aspect I haven't addressed much is the potential impact of a higher corporate tax rate. Could you remind us how we should consider the effects on Hannon Armstrong if a higher corporate tax rate were implemented?

Jeffrey Lipson, CFO and COO

Well, I guess there's two answers to that. The impact on Hannon Armstrong as an entity and the impact on our outlook for additional projects and investments. So for us, of course, we're a REIT, so we're not a taxpayer. It doesn't affect us. We do have taxable REIT subsidiaries. But we have enough in the way of tax planning strategies. We don't expect our taxable REIT subsidiaries to be taxpayers for the foreseeable future. So virtually no impact on us. On our investment outlook, it would potentially create more tax equity capacity, which would be certainly positive for the volume of transactions that could get done.

Operator, Operator

The next question comes from Julien Dumoulin-Smith with Bank of America.

Julien Dumoulin-Smith, Analyst

Let's go back for a moment to clarify. It seems that your impact during the quarter is quite minimal. From what I gather from your previous response, you appear to have a greater credit exposure rather than equity exposure. How do you view this as a continuing risk? It seems that matters related to counterparties on projects also carry some significance, especially since not everything has been resolved yet. Am I interpreting your earlier comments correctly?

Jeffrey Eckel, Chairman and CEO

Talking about taxes?

Jeffrey Lipson, CFO and COO

Yes. Julien, you are breaking up a little bit, but I think we got most of that. So on Texas, again, to reiterate, the ongoing exposure is very limited. Most of these situations have now been settled up. And for us, with very limited impact on our portfolio. There's still, as I mentioned, a few loose ends being tied up on various, to the hedges and arrangements, but it's mostly behind us at this point.

Julien Dumoulin-Smith, Analyst

Excellent. I just wanted to make sure I heard that right. And the real question I had for you guys is, how do you think about the scaling and the cadence of the balance sheet through the course of this year? Specifically, obviously, quarter-on-quarter here, not too much of a change in the balance sheet. How do you think about what this balance sheet looks like in size and composition by the end of this year, if you can speak to that a little bit more? Obviously, I'm seeing community solar to be a little bit of a step-up here. What is that pie going to look like, if you will?

Jeffrey Eckel, Chairman and CEO

Well, Julian, based on the remarks, you would expect to see more grid-connected solar, which is a small slice of the pie. But that's, as I said, one of the largest elements in our grid-connected pipeline. Solar land is next, and wind. So I would expect to see more grid-connected solar and perhaps less wind added to the portfolio. The behind-the-meter assets, a lot of those are securitized, probably not added to the portfolio. Some will of course, in the government sector and in the federal and state and local government as well as the solar. In terms of the level, I did say on the last call, just by our growth in the portfolio, over the full year, not the quarter. And I would reiterate that. I think we will have a significantly larger portfolio, and that will be one of the key drivers of our earnings to hit our guidance.

Julien Dumoulin-Smith, Analyst

Yes, regarding the question about quarter-over-quarter performance, do you have any insight on the percentages related to securitization, since that impacts how growth translates into the portfolio?

Jeffrey Eckel, Chairman and CEO

Yes. It remains as unpredictable to you as it is to us. It is when the transactions happen.

Operator, Operator

The next question comes from Greg Lewis with BTIG.

Gregory Lewis, Analyst

I wanted to discuss the trend regarding the ability to recycle cash. Considering your potential to monetize parts of your portfolio, is that influenced at all by interest rates from your customers?

Jeffrey Lipson, CFO and COO

That all is sort of a tough threshold. I would say it's not particularly sensitive to interest rates. Most of the folks who are the buyers of our off-balance sheet transactions, I wouldn't say they're completely immune from interest rates, but less sensitive than, for instance, capital markets.

Gregory Lewis, Analyst

And so as we think about where we are today, would you say the appetite is as strong as it was, I don't know, pre-COVID, in terms of those opportunities to lay off existing assets to buyers?

Jeffrey Lipson, CFO and COO

It's extremely strong, as strong as pre-COVID, if not stronger.

Jeffrey Eckel, Chairman and CEO

Yes, it's been proven.

Jeffrey Lipson, CFO and COO

We are off balance sheet and aim to maintain a healthy and growing balance sheet, although if we wanted, we could take even more off balance sheet. The appetite for this is quite large.

Operator, Operator

The next question comes from Christopher Souther with B. Riley.

Christopher Souther, Analyst

Could you provide some insight on the timeline for the grid-connected projects you are considering for funding? Some deals you closed last year were funded through 2022. If you manage to close some grid-connected deals this year, should we expect a similar timeframe of one to two years before they are reflected on the balance sheet? I’d like to understand how these opportunities are currently shaping up.

Jeffrey Eckel, Chairman and CEO

That's a great question, Chris, and we might not have all the details yet. However, there is definitely a forward flow aspect to many of the grid-connected transactions we handle. Generally, there will be initial funding for some projects that are commercially developed, followed by a pipeline of future projects. It’s challenging for us to predict how this will unfold over the upcoming quarters. What we appreciate is the increasing number of programmatic platforms we are establishing, which is starting to bring good diversity across the quarters. Not every company will pursue the same set of projects in any given quarter. So, we anticipate that we may start to witness smoother quarter-to-quarter additions to our portfolio.

Christopher Souther, Analyst

Got it. That's very helpful. I wanted to ask about the various solar components in your portfolio and pipeline, specifically how storage is beginning to integrate. I assume some portion of residential solar now includes storage, but could you explain how storage fits within your overall portfolio? Also, please break down the different solar sectors you are exploring, such as residential, utility, and community.

Jeffrey Eckel, Chairman and CEO

I think they all have storage. I think community solar is much more site-specific as to whether solar or storage is valued. I know Massachusetts is one market for community solar that puts a price on capacity. And so there's value to add storage. Other markets are less interesting for community solar storage. Residential and C&I generally, we can echo what the sun powers of the world say, but the uptake is pretty strong.

Operator, Operator

This concludes our question-and-answer session, which also concludes today's conference call. Thank you for attending today's presentation. You may now disconnect.