Spruce Power Holding Corp Q1 FY2023 Earnings Call

Thank you. Good afternoon, and welcome to Spruce Power's conference call to discuss results for the first quarter of 2023. With me today are Christian Fong, our Chief Executive Officer; Donald Klein, our outgoing Chief Financial Officer; and Sarah Wells, our incoming Chief Financial Officer. Our call this afternoon will include statements that speak to the company's expectations, outlook or predictions of the future, which are considered forward-looking statements within the meaning of federal securities laws. These forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, which may cause our actual results to differ materially from those expressed in or implied by these statements. Similarly, out of our control is the timing of some of the processes we will discuss today, which could impact the expectation-related statements you will hear shortly. We are not obliged to revise or update any forward-looking statements except as may be required by law. Please refer to our disclosures regarding risk factors and forward-looking statements in today's earnings release, our annual report on Form 10-K and other Securities and Exchange Commission filings. A copy of our press release has been posted to the Investor Relations page of our website for reference. The non-GAAP financial measures discussed in this call are reconciled to the U.S. GAAP equivalent and can be found in the press release that we issued this afternoon. With that, I will turn the call over to our CEO, Christian Fong. Christian, go ahead.

Thank you, Bronson, and thanks to everyone for joining us on the call today. Spruce is in its strongest position ever with a focus on maintaining strong customer service, owning a large portfolio of zero-carbon, clean electricity rooftop power systems and operating the long-term, high-margin contracts that generate a steady stream of cash. During the quarter, we essentially completed the transformation of Spruce Power to a pure-play residential rooftop solar company with just a few final changes left. One of those is a long-planned management transition as Sarah Wells becomes our new CFO. More on that later. Another is the runoff of expenses tied to the wind down of XL Fleet, some of which impacted the Q1 bottom line. Those expenses are mostly incurred so our numbers going forward will really showcase the attractiveness of our business model. So looking ahead, we have a substantial cash balance to drive incremental growth and value creation for shareholders, and we can put cash to work to grow through acquisitions as we've demonstrated at the end of March in buying the portfolio we renamed Spruce Power 4. That deal increased our overall portfolio by 44%, a full year's customers' growth target in one swing. Today, I'll be presenting our operating results for the quarter and talking about some recent events in the context of the three core pillars of our strategy. The first pillar is to build the industry-leading customer experience. Our first quarter customer satisfaction score was 71%, beating our 70% target and up substantially year-on-year from 54% in Q1 of 2022. We are also on track with this year's technology roadmap to ensure month-in, month-out reliability and system visibility to a customer base that now numbers over 72,000. For IT upgrades, we successfully implemented a customized new billing software based on the Zuora ecosystem and rolled out a single log-in customer portal. Cultivating a great customer experience not only benefits individual customers, it provides an opportunity to create incremental value for Spruce as people upgrade toward full home power systems with battery storage and eventually newer technologies such as EV charging. We haven't broken out our battery leasing numbers yet as retrofit batteries are still a niche market and very regional with over 80% of our leasing in California. Our second pillar is delivering operational excellence, both in our core business of producing carbon-free electricity and in generating cash from our portfolio. At Spruce, our Q1 performance ratio, which is the production compared to the theoretical maximum of the installed solar panels, was 92%, that's down from 95% for Q4, largely because of the historically rainy January on the West Coast. We obviously can't manage winter storms; that's definitely over my pay grade. So we also look at the weather-adjusted performance ratio, where Spruce booked a strong 102%, demonstrating the efficiency and reliability of our portfolio. The financial measure of our operations is our ability to generate cash. Our portfolio's robust performance is the bulk of Spruce's current run rate of $110 million to $130 million of annual cash inflows, which we'll discuss later. Moving on, we paired growth and capital together as our third pillar because our growth is primarily through M&A. And so we stay disciplined in our use of capital. Historically, the cost of growth has been low enough to generate consistently strong investment returns. That continued in Q1 when we hit a home run in acquiring the Spruce Power 4 portfolio. This transformative acquisition grew our portfolio by 44% overnight, adding contracted cash flows from over 22,500 customers. During Q2, we've been integrating this acquisition. It immediately improved our run rate cash flow, so we expect to see a clean view of how its cash flow impacts the company's financials starting in Q2. To refresh you on the efficiency of our M&A model versus our peers, since 2019, we have acquired in a dozen separate transactions about 55,000 residential solar systems and contracts. Our average cost of acquiring customers is about $375 per customer. This compares favorably to last September when we reported an average cost of $421 per customer. We expect stair-step growth as we aim for 90,000 customers and contracts by the end of 2024. As a reminder, we don't disclose or discuss the number or nature of deals that are currently under negotiation, and so we can't give guidance on timing. Before I get to the capital strategy, I want to emphasize a financial headline. Except for the legacy XL items that are still being wrapped up, Spruce Power has positive cash flow. In fact, Spruce finished the last quarter once again with over $200 million of cash on hand, including $173 million in totally unrestricted cash and once again, with no corporate-level debt. With that much cash, we want to discuss how much to keep in reserve and how we intend to deploy any excess. First, having cash liquidity is a great safety net. So we expect to keep at least $75 million of cash on hand through 2024. Just to be clear, we're not saying that from our quarter-end balance of $205 million, we actually plan to spend down to $75 million. Rather, we're identifying a prudent level that still earmarks adequate investment cash to reach our 90,000 customer target. In the financial section, we'll walk through our cash run rate, yet I'd just say that given the amount of cash we're generating in our core business, added to the cash we already have, our capital allocation can be an all-of-the-above strategy. That means buying more assets, paying down debt, completing CapEx projects, investing in our team and returning some cash to shareholders. I'll expand on that last item. A few days ago, our Board approved a two-year common stock repurchase program of up to $50 million of our common shares. First, we believe that repurchasing shares is an efficient way to return cash to shareholders. The program doesn't require us to repurchase any specific number of shares, but it is our preferred tool to get money back to our investors. The second reason is more immediate. We look at our current stock price and see a way for us to add value on a per-share basis. The market is offering to sell us or really anybody shares at a dramatic discount to what we believe is a fundamental value. With lots of cash on hand, with positive cash flow from our core businesses, with a great management team and a differentiated business model in a rapidly growing industry, we want this share buyback program to send a strong signal that this is a high-priority use of our capital at the current stock price. I'll now make some comments about the residential solar macro environment and our positioning. Long-term demand for residential solar should be strong, but upstream installers and consumers face challenges. Notably, this includes a higher cost of capital. In contrast, Spruce is largely insulated from near-term volatility in the debt capital markets. We have attractively priced nonrecourse project loans with several years until the nearest maturity, and we have no corporate debt at all. We can be disciplined in adjusting the price of future acquisitions to maintain our target return on equity investment of an IRR in the mid-teens, even as debt costs change. Furthermore, we're seeing a notable shift in the consumers' financing decision when they choose to go with rooftop solar, towards lease and PPA products and away from loans. We know this through our relationships with installers across the United States. Naturally, this benefits us as third-party-owned systems are our addressable market for acquisitions. We expect tailwinds for further lease and PPA market penetration as clarity emerges on the ability of the TPO market to capture additional ITC adders as described in last year's IRA legislation. This should ultimately boost the competitiveness of leases and PPAs. Simply put, we believe Spruce stands out favorably in the current capital and tax environments. We're excited about our progress as a public, pure-play investment in residential solar and especially pleased with the substantial growth from the Spruce Power 4 portfolio acquired last quarter. Before handing the call over to Don to discuss financials, I want to acknowledge that this will be his final earnings call with us as we take the next step in our post-merger management transition. We announced last week that Sarah Wells will become CFO on May 19. Having just brought Deloitte on as our independent auditor, this is the right time for this long-planned transition. Sarah has been Spruce's Head of Sustainability and by my side leading finance and accounting for Spruce Power and its affiliates since 2018. She is a smart, experienced and driven member of the Spruce team who has played a leading role in Spruce's strong growth over the past years. And Don, I want to acknowledge you for your vision and dedication over the past year serving as Spruce's CFO. You were instrumental in the business combination last fall and in helping Spruce Power transition to a place of greater strength as a public company. On behalf of the whole company, we thank you.

Thanks, Christian. Before we discuss our first quarter results, I'd like to walk through a few items that impacted our financial reporting. As discussed in our last quarterly update, the old Drivetrain and XL Grid businesses were classified as discontinued operations. The final legacy businesses were disposed of in the first quarter, and though there will be some cleanup items in future quarters, we do not expect material expenses going forward as it relates to discontinued operations. However, our continuing operating results will reflect certain expenses related to XL Fleet, namely legal expenses tied to the previously disclosed SEC inquiry and related shareholder lawsuits. We're unable to comment on the timing or outcome of this matter, but we do expect to incur additional moderate legal expenses. And as a note on our 10-Q, we filed an extension as we finished the technical accounting for the Spruce Power 4 purchase in March, but we don't expect it to impact anything we're talking about today. With that, let's move on to results. First quarter revenue, which consisted exclusively of Spruce-related revenue, was $18.1 million compared to $18.1 million in the fourth quarter of '22. As Christian mentioned, revenue was moderately impacted in the quarter by the outsized impact of weather on our West Coast assets. This was partially offset by higher-than-expected proceeds from the renewable energy credit sales. Recall that the fourth and first quarters typically generate lower revenue due to weather-related impacts on electrical production. First quarter OpEx, which includes both SG&A and portfolio O&M, was $17.6 million compared to $30.6 million last quarter. The sequential decline largely reflects much lower integration costs tied to our acquisition by XL Fleet. Also of note, SG&A expense during the quarter includes approximately $8 million of expenses attributable to legacy XL Fleet business, namely legal expenses associated with the previously disclosed SEC inquiry and shareholder lawsuits and compensation expenses for exiting XL Fleet personnel. Excluding these expenses, the core OpEx will be closer to $9.6 million, which is a clearer view of OpEx for a stand-alone Spruce Power. On a GAAP basis, the net loss from continuing operations was $15 million as compared to $27.7 million in the fourth quarter of '22. Adjusted for certain items, including legal charges and the change in fair value of interest rate swaps, adjusted net loss was $7.7 million. Adjusted EBITDA totaled $4.7 million compared to $3.5 million in the fourth quarter of '22. As of March 31, '23, we had cash, cash equivalents and restricted cash of approximately $205 million. This compares to $240 million at the end of the fourth quarter of '22. The sequential change in cash includes approximately $10 million for principal and interest payments and approximately $23 million of net cash paid for the acquisition of Spruce Power 4. The total principal balance of long-term debt as of March 31 was $652 million. As a reminder, all of our debt is nonrecourse and backed by our long-term contracts with customers. Our debt is very attractively priced in the current environment with a weighted average cost of approximately 5.6%, including the current facility assumed alongside our acquisition of the Spruce Power 4 portfolio. We believe it's important to underscore that all our variable rate debt is 97% hedged through interest rate swaps. In fact, most of the swaps have long-term maturities, mostly into the 2030s, to extend our portfolio's interest hedges well beyond the senior loan. Finally, in measuring the value of our long-term solar contracts with customers, we've provided metrics on gross to net portfolio values, which represent the present value of the remaining net cash flows of our rooftop systems and contracts discounted at 6%. As of March 31, gross portfolio balance was $938 million. Adjusting for total loan balances, the net portfolio value was $286 million or $313 million with the value of the swaps included. With the cash we have on hand, that adds up to $518 million of net value.

Thank you, Don. And I will just add that I'm excited to begin my next chapter at Spruce as CFO. Before opening the call to Q&A, I'd like to further address the transformative impact of the Spruce Power 4 acquisition. The acquisition immediately enhances our cash flow generation. The acquired assets sit outside of our mezzanine facility, which was put in place years ago and currently claims excess cash after senior debt service of our legacy portfolios. Spruce Power 4 is a cash generator, underwritten to stand-alone portfolio customer billings of $21 million and portfolio EBITDA of $18 million. With the acquisition closing late in March, second quarter results will reflect the first full quarter contribution from Spruce Power 4. I'd like to note some accounting technicalities surrounding this transaction. The portfolio consists of the pass-through leasehold interest of about 22,500 residential solar contracts. In other words, while we are entitled to 100% of the customer payment streams through their contractual period, Spruce does not own the underlying rooftop solar systems. GAAP accounting for these leasehold interests will place the majority of the customer payment streams through the cash flows from investing section of our consolidated statement of cash flows. Regardless of where accounting rules put the cash in the financial statements, we believe the critical takeaway is the strong cash inflows that Spruce Power 4 contributes to our core residential solar business. To that end, this is how the Spruce team internally evaluates our business, with a focus on cash inflows from our long-term contracts with customers or what we refer to as business cash inflows. Because of the nuance of accounting for Spruce Power 4, we think it is beneficial to investors for Spruce to provide this framework to clarify the impact to the underlying business performance of our core business of both residential solar systems and the contracts tied to those systems. When thinking about business cash inflows for Spruce over the next 12 months, we look for a range of between $110 million to $130 million. In the middle of the funnel are cash flows remaining after OpEx and debt interest, where we expect an annual range of $35 million to $45 million. After scheduled principal payments, we look for a range of between $5 million and $15 million. Finally, with moderate levels of discretionary CapEx tied to improving customer experience and investing in employee tools and training, we still have cash left over. In line with Christian's early comments regarding capital allocation, we have three good choices in how to allocate this excess cash flow. First, it can go back to our general cash position in support of our M&A growth strategy. Secondly, we can deploy it to the newly authorized share buyback or finally, we can pay down our debt. In conclusion, achieving positive cash flow in the core business even after CapEx is a proud moment for any growth company. We look forward to executing our growth strategy and bolstering the cash-generating power of our portfolio. With that, I'd like to turn the call back to the operator for Q&A.

Just with all the growth we're seeing, third-party owned and commentary from installers, just curious about other avenues of growth for Spruce. I mean is a potential avenue to partner with an installer down the road and be that source of flow-forward arrangement? Or maybe just curious about the trends you're seeing in third-party owned growth and how that could lead to other growth avenues for Spruce.

Sure. Tristan, it's Christian. The percentage of installations that are going towards Power Purchase Agreements and leases is increasing, which you can see from our peers who have reported this quarter. Long term, around 28% has been reported by some third-party researchers, moving into the 30s and possibly even 40%. There’s a lot in the pipeline, so your question is valid. Remember that Spruce started as a channel partner, which involves teaming up with installers to provide PPA and lease documents along with the necessary capital. It's actually a solid business model, and companies like Sonovus and Sunrun operate that way, as we once did. Approximately 22,000 out of our 72,000 customers came from that type of partnership. Could we pursue this path again? Absolutely. This is sometimes referred to as a real option. We have the experience and the documentation to support it. However, we have been able to grow quickly through mergers and acquisitions. Could we activate that approach again? Yes. Should we? This leads us to consider the cost of acquiring a customer. Back in September, we reported it was about $421 per customer, and it has since decreased to approximately $375 per customer. When we engaged in channel partnerships, that cost was significantly higher due to the need for sales teams and relationship management with various installers. I don't want to say we would never revisit it. Just because something is notably high margin doesn't mean we shouldn't explore other channels. For now, we are successfully meeting our growth goals at a competitive customer acquisition cost, and we will continue on this path for the time being. Simply put, yes, we could.

And then just in your script, you talked about maintaining a minimum level of cash. I mean could you talk about a scenario that might trigger or create an instance where you spend down to that level? Would it just be a large opportunity? Or how do you think about the current level of cash versus spending down to that minimum?

Sure. We are currently considering multiple factors. If we detail how we arrived at the $75 million figure, it comes from maximizing the share repurchase program we recently announced. We also accounted for approximately $5 million in annual discretionary CapEx, primarily for enhancing customer experience. When evaluating the remaining growth capital, the amount reduces from $155 million to around $75 million or $80 million, factoring in two years' worth of discretionary CapEx. To put this in perspective, with the Spruce Power 4 acquisition, we invested a net cash amount of $23 million to acquire 22,500 customers, which will contribute to future cash inflows. This means we are acquiring customers at a very efficient rate of $1,000 each. Ideally, I would like to replicate this efficiency every quarter. This strategy leaves us with ample resources to pursue customer acquisition that exceeds our target of 90,000 customers for 2024. We are confident in stating that $75 million will serve as our minimum liquidity threshold amidst current economic conditions while still allowing for significant growth opportunities should they arise.

Sarah, congratulations on becoming CFO. You may have mentioned earlier an expectation for positive cash flow, which we anticipate later this year or in the coming quarters. It seems that the Spruce Power 4 acquisition is significantly contributing to that. Could you elaborate on what aspects of that acquisition make the outlook for positive free cash flow more attainable?

Jordan, thank you so much. We have very strong cash flows coming off of Spruce Power 4. And it's unique because it sits outside of our mezz facility, unlike our legacy assets. The cash flows are unencumbered and then after our OpEx and debt interest, everything else comes to Spruce.

Yes. We derive most of our deals from three main sources. First, we have utilities that are sometimes operating out of their own regions, which face familiar return on capital requirements and inflation pressures. Second, there are financial investors who accumulate these deals, and third, we engage with installers. This industry is quite fragmented, with many players spread across the country working in local markets. While I won’t provide specifics on the number of bids or bilateral negotiations we have, I can confirm we are actively involved in both. These are real-time negotiations, and I don’t want to disclose anything that could impact our position. We remain committed to achieving a mid-teens internal rate of return, which we believe is attainable, especially since we can adjust the pricing of the equity we issue. We are not overly concerned about fluctuations in the debt markets. If debt costs decrease by 50 basis points, sellers will likely adjust their pricing accordingly, necessitating a balanced approach in negotiations. We are noticing activity and anticipate seeing more developments soon. I’d like to emphasize that many of the deals we encounter are seasoned, meaning we could collaborate with installers and secure portfolios as they complete projects. By acquiring seasoned portfolios, we reduce some initial challenges, allowing these investments to perform strongly. This is reflected in our weather-adjusted portfolio ratio, which can exceed 100%. The current trend toward power purchase agreements and leases is a response to rising interest rates, making solar loans slightly less appealing. This will create opportunities in the pipeline for the next four to five years as various owners determine their exit strategies.

Thank you, operator, and thank you again for joining us today and for your continued support. If you have any questions, please contact me or our Investor Relations team. This concludes our call today. You may all disconnect.