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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good afternoon, and welcome to Hannon Armstrong's Conference Call on its Q2 2019 Financial Results. Management will be utilizing a slide presentation for this call, which is available now for download on their Investor Relations page at investors.hannonarmstrong.com. Today's call is being recorded, and we have allocated 30 minutes for prepared remarks and question-and-answer session. All participants will be in a listen-only mode. [Operator Instructions]
At this time, I'd like to turn the conference call over to Kate McGregor Dent, Vice President and Deputy General Counsel for the Company.
Thank you, operator. Good afternoon, everyone, and welcome. Earlier this afternoon, Hannon Armstrong distributed a press release detailing its second quarter 2019 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 Jeffrey Eckel, the Company's President and CEO; Jeffrey Lipson, our CFO.
With that, I'd like to turn the call over to Jeff, who will begin on Slide 3. Jeff?
Thanks, Kate, and good afternoon, everyone. Today, we're announcing GAAP earnings of $0.19 per share and core earnings of $0.30 per share. For the quarter, we grew our interest income and rental income by 15% over the prior year's quarter and we positioned the business for further revenue growth due to closing $204 million in transactions, 90% of which is intended for the balance sheet.
Lower gain on sale income in the quarter serves as a reminder that our quarterly results can be affected by our quarterly investment mix. Year-to-date, investment volume is over $500 million well above where we were this time last year at $300 million and we remain on track for more than a $1 billion in investments in 2019. We significantly improved our access to capital with our inaugural corporate unsecured green bond offering, which Jeff Lipson will talk more about later in this call.
We also reiterate our previously provided three-year guidance through 2020 of 2% to 6% growth in core earnings from the 2017 base. As we do every quarter and for every investment we make, we calculate the carbon reductions from our investments. The carbon count for our Q2 investments is 0.24 offsetting 48,000 metric tons of annual carbon emissions.
Turning to Slide 4. We want to review our pipeline and how the pipeline mix drives revenue. As a reminder, we source our pipeline from the premiere companies on a programmatic basis in each of the grid-connected sustainable infrastructure and behind-the-meter markets. Across those markets, those two markets are approximately 10 asset classes that provide a diversified flow of investment opportunities over a year. This gives us comfort that we will be able to invest our targeted $1 billion or more a year.
These asset classes are fairly uncorrelated, so if one falls off in a quarter, others will generally take up the slack. The pipeline may remain strong at more than $2.5 billion with behind-the-meter opportunities totaling almost 80% of the pipeline. We see good strength in virtually all of the BTM asset classes – C&I solar, community solar and residential solar as well as pace markets are all growing well. Federal efficiency and resiliency markets are also strong.
One benefit of behind-the-meter assets is the economics of a transaction are relatively unaffected by persistently low natural gas prices we're seeing. In short, our belief that the future of energy will be decentralized, digitalized and decarbonized is reflected in this pipeline mix. Grid-connected opportunities are 12% of the total pipeline and are primarily land for utility scale solar plant, a market that has continued to be strong.
We like the solar land business because of its senior position and cash flows as the landlord, which largely inoculates us from low natural gas prices in credit events like the PG&E bankruptcy. There are some wind transactions in the pipeline, but a relatively small amount.
Sustainable infrastructure is 9% of the pipeline and we continued to see interesting investment opportunities as communities grapple with adapting to climate change impacts from severe weather events. Again, defining our investment horizon to climate change solutions provides us a broad platform to find the best risk adjusted returns.
Let me turn to the revenue implications from each of these asset classes. The overall business model we've discussed since the IPO is to put 70% of our investments on the balance sheet to generate recurring portfolio income and to securitize 30% for current period gain on sale income.
As the yield curve flattened and rates fell, the bid for long-term fixed rate assets improved and we migrated to securitizing a higher percentage of our assets. However, it's important to note that a much larger driver of the quarterly result is the mix of – the business mix of the investments.
Typically, government energy efficiency transactions are securitized and other asset classes typically remain on the balance sheet. The first two quarters of 2019 are good examples of this. In the first quarter, we securitized over 90% of the transactions and in the second quarter, we securitized less than 10%.
When there's higher gain on sale, current period revenue increases in a quarter like this one where we added more to the balance sheet. Current period revenue is lower, but recurring portfolio revenue increases. As the balance sheet grows, this variability should be reduced and the quarterly differences will even out.
Turning to Slide 5. Our portfolio stands at $1.8 billion at the end of Q2, down from $1.9 billion last quarter, largely due to portfolio optimization. There was a slight shift to behind-the-meter assets, 47% up to 50%, but BTM is still relatively balanced with grid-connected assets.
The portfolio yield is 7.4%, up from 6.9% last quarter, a 50 basis point change, largely due to the sale of lower yielding behind-the-meter assets, which caused the behind-the-meter asset yield to improve from 6.7% to 7.4% quarter-over-quarter.
The rest of the yield improvement came from higher yielding additions to the portfolio. The yields for both grid-connected and other sustainable infrastructure assets both increased 20 basis points to 7.5% and 5.8% respectively.
In total, we have over 190 investments with a $9 million average investment size, which makes the portfolio quite diverse. As we pointed out last quarter, we count some portfolios of assets as a single investment, so the total number of physical assets in obligor is substantially larger and thus diversity is even greater than reported here. The portfolio has a long average life of approximately 14 years with minimal refinance or call risk.
Finally, if anyone asks that class becomes too large as a percentage of the portfolio, we may look to are decades long experience in syndications and securitizations to selectively reduce our exposure.
I'll now turn it over to Jeffrey Lipson to detail our financial performance.
Thanks, Jeff, and good afternoon. Turning to Slide 6. This slide provides a summary of certain financing highlights since the 2013 IPO, as we have grown our equity base from $167 million to $885 million over the past six years.
We have constructed a very flexible and diverse funding platform, including secured, unsecured and convertible debt as well as equity. We recently achieved a very significant financing milestone.
In July, we closed our initial senior unsecured debt offering – we often refer to it our debt IPO. This five-year transaction was very well received with over 60 investors participating. It was ultimately executed at a 5.25% coupon and was upsize to $350 million after being launched at $300 million.
The transaction itself and Hannon Armstrong each received ratings of BB+ by both Standard & Poor's and Fitch ratings which represented our first corporate ratings from the large rating agencies. We also obtained a green bond designation of this security in line with our broader ESG strategy. As with equity markets, we are hopeful the debt markets provide a benefits of green issuers over time.
Following this transaction, we now have access to an extremely deep and stable market whereby we can consistently and flexibly fund our assets with unsecured debt. In addition, although we don't want to unduly emphasize day-to-day trading levels of our bonds, it is noteworthy that these securities have already traded at a yield below 4.5%.
Turning to Slide 7, year-to-date, total GAAP revenue was up slightly, as the increase in investment revenue was almost entirely offset by the decrease in gain on sale revenue. As Jeff noted, the gain on sale revenue can be inconsistent over short periods. The increase in investment revenue was primarily the result of higher yields on the portfolio. Interest expense decreased by approximately $7.4 million year-to-date to $30.3 million as a result of lower leverage and lower debt costs.
Year-to-date income from equity method investments increased to $12.1 million from $8.3 million last year due primarily to the realization of investment tax credits in one of our renewable energy projects. In total, we have $12.7 million or $0.19 per diluted share of GAAP income for the quarter compared to $17.3 million and $0.32 per diluted share in the second quarter of 2018.
Year-to-date GAAP earnings are $26.4 million or $0.41 per diluted share versus $16 million and $0.29 per diluted share last year. As a reminder, GAAP earnings did not include the full effect of the cash we received from our equity method investments. Year-to-date we've collected $54 million in cash from our equity method investments, which include both an earnings component and return of investment.
Year-to-date we've made a core adjustment of approximately $7 million, which when added to our $12 billion of GAAP earnings results in core earnings on this portfolio of $19 million and thus the other $35 million of cash collected represents a return of investment. In total core earnings were $19.8 million for the quarter or $0.30 per share and $0.63 year-to-date. The comparable figures for 2018 were $20.8 million for the quarter or $0.39 and $0.65 year-to-date.
Turning to Slide 9. Our portfolio credit quality is largely consistent with our previous presentations and we continue to have less than 1% of the portfolio on non-accrual status. Balance sheet activities for the quarter have included the portfolio decreased by over $100 million, primarily due to sales of approximately $200 million of low yielding highly leveraged assets.
As Jeff mentioned, we had a very successful quarter closing new transactions and attractive yields. Some of which funded this quarter, but most of which we'll fund on balance sheet in future quarters. We repaid one of our secured debt transactions scheduled to mature this year and extended the other facility that was scheduled to mature.
Our interest rate risk remains very well managed. The fixed rate debt ratio end the quarter at 76%, well within our targeted range and floating rates at comprises only 14% of our debt and equity. Leverage ended the quarter at $1.2 as a result of the previously discussed sales of highly leveraged assets coupled with the quarterly equity raise via the ATM program of $50 million. We may see leverage move upward in the third quarter as we used a portion of the proceeds of the unsecured offering to repay debt and expect to use a portion to fund new assets.
Turning to Page 9, as we began to include last quarter, we display our chart reflecting the growth in net investment income to reinforce the success and importance of continuing to increase our portfolio revenue. As reflected on Page 9, core net investment income remains on track in 2019 for significant growth versus 2018. This growth in portfolio revenue facilitated by both improvements in yield and debt costs remains a critical metric.
We have constructed a powerful earnings engine fueled by interest in rental revenue and earnings from equity investments funded by a flexible debt and equity platform that will allow us to continue to grow our net investment revenue.
I will turn the call back over to Jeff.
Thanks Jeff. Turning to Slide 10. In closing, we believe our Q2 results are consistent with our investment thesis. We will earn superior risk adjusted returns investing on the right side of the climate change line and we do that by supporting the top tier clients were engineering the decentralized, digitalize, and decarbonized future of energy.
These investments allow us to deliver an attractive ROE, providing investors and attractive dividend yield above the average dividend yield of utilities, our peers and REIT. This yield plus our 2% to 6% growth from a diversified portfolio provides investors an attractive total return investment.
Finally, we have set a high bar for ourselves on investment choice and ESG disclosures that we hope other capital providers will someday integrate into their financial reporting.
I want to close by thanking Mark Cirilli and Becky Blalock for their contributions to the Board and welcome Simone Lagomarsino and Michael Eckhart to our Board. We are very pleased with where our business stands today and excited for our refreshed Board to help us develop the business further.
Thank you for joining us today. Now we'll take a few calls.
[Operator Instructions] We'll take our first question from Julien Dumoulin-Smith from BoA. Please go ahead.
Hey. This is Anya filling in for Julien.
Hey, Anya.
Hey, how are you? So first off, I'm just wondering, how are you thinking about the overall portfolio credit quality? Because it looks like an investment grade portion is down slightly to 55% of the overall portfolio from 61% last quarter. So how do you look at that? And then do you have a long time target for a mix that you'd find reasonable?
What we've said is we're looking for the best risk adjusted yields, while we would prefer a all investment grade portfolio in this market with a global search for yield. That's just not an attractive portfolio to own. So I think the real question is, are we getting paid for taking a non-investment grade risk and are we able to manage the risks that we're buying? In both cases we feel we're in a good position and now we don't have an explicit or even implicit target for credit quality.
Okay, thanks. And then what about the fixed versus floating rate mix there? Any updates on your targeted range there, especially following the recent rate cut?
I think we've talked about the fixed rate debt being 65% to 80% of the debt and we're comfortable with that range. I don't think we think the rate cut is material to our business and certainly not material to the existing portfolio of assets and liabilities we have on the books now. So we've not changed our thinking there.
Okay. Thanks. And one more for me just on the green bond. It seems like there's a lot of demands amongst those generally. So could you maybe talk a little bit more about that? What kind of demand you're seeing? And then any interest in pursuing other deals like that in the future?
So this is Jeff Eckel. The strategy we've had in place since going public had in mind that at some point in the future green bonds and an equity that has every investment with a carbon count on it would someday appeal to investors. Certainly early on in our public life that didn't occur. It does feel very much like sticking to our principles of neutral to negative on incremental carbon, tracking those investments and then applying the several green bond standards is now being rewarded by the market.
I'm not sure we can say how many basis points of improvement we get, but it just feels like, there is indeed more demand for that product and the fact that we've somewhat set the bar fairly high for our assets and our liabilities in the case of bonds, is I think going to work in our favor. Jeff, would you add anything on that?
I would agree with that. And Anya we will tell you that in the – what's typically referred to as the high yield market, there's not been a lot of green bonds. So our designation and our offering was somewhat unique in that regard.
And as Jeff said, it's hard to quantify that, but there were clearly some investors in our transaction that were attracted because of the green bond designation and because of the ESG strategy. And then it's also hard to quantify the impacts of what's happened in the secondary market with the bonds. But we do think anecdotally there's some other ESG money out there that's been attracted to the bonds as well. So I think that's something that will, as Jeff indicated, manifest itself even further over time.
Great. Thank you.
We'll take our next question from Noah Kaye from Oppenheimer. Please go ahead.
Thanks. And just following up on that green bond discussion, I think one way to quantify it is that the trading yield on that bond has come down greater than the BBBA yield have come down over the same period. So to your point that would suggest some fundamental demand here, but that aside, just want to dig in a bit more on the portfolio management in the quarter. The rotation of $200 million of low yield assets of the balance sheet, it looks like a large part of that was in that federal state and local bucket. Is that correct?
That's correct. And again, we refer to them as highly leveraged assets. So most of them were from that bucket.
Right. So I mean, I guess should we expect to see kind of further rotation out in coming quarters? I mean in the current environment it just makes more sense to securitize that business right?
The energy efficiency transactions as Jeff indicated are typically securitized and to extent we hold a certain ones on balance sheet, you are directionally correct that we will opportunistically look at opportunities to perhaps syndicate them even once we've held them for awhile. So I don't think we have anything specific to report there other than that continued optimization is, is part of our strategy.
Right. And I think even if you rotate out at the same clip you did this quarter, not saying that you will, but then you're funding, and putting on balance sheet was 90% of $500 million or something like that. I would seem like the current portfolio can actually grow in size or at least stay the same size. So I guess the question is, would you expect to roughly maintain or grow the current portfolio from the $1.8 billion that is now exiting the year?
We expect to grow the portfolio.
Okay. And then I guess the last point in, I think I knew I was trying to get to this as well. Just as we sort of see this rotation, clearly you're very familiar with a lot of these assets even if they are non-investment grade. And just I trying to understand what kind of margin of comfort, we should have around increasing the non-investment grade and still being able to maintain the corporate credit rating and whatever other metrics that you're managing too?
Well, I think, the portfolio continues to be diverse. Some of the portions of the portfolio that that get referred to as non-investment grade are still a very high credit quality, and we're very comfortable with the credit risk we've taken and the shifts that we understand it very well.
Asset quality was certainly a strength in the ratings process and I don't expect that to change as our track record regarding, credit losses is impeccable and so I don't view any – I'll refer to as marginal rotation in the portfolio as likely to impact our ratings.
Great. Thank you very much.
Thank you. We'll take our next question from Mark Strouse from JPMorgan. Please go ahead.
Yes. Good evening. Thanks for taking our questions. I wanted to start with the unlevered yield on the behind-the-meter portfolio, pretty good improvement quarter-over-quarter and really good year-over-year. You attributed some of that selling off the lower yielding or highly levered assets.
Are you able to quantify, how much of that improvement was simply from that sell off? And maybe an add-on to that is can you talk even at a high level about some of the unlevered yields that you're seeing on some of the opportunities that you're looking at over the near-term?
The majority of the shift in the behind-the-meter yield improvement was due to assets disposition sell off. And in terms of the kinds of yields we're getting, we typically don't disclose those. I think some of the resi-solar transactions have been disclosed. But we're really not that comfortable talking about individual transaction yields.
Okay. That's fair enough. That's it for us. Thank you very much.
Thanks, Mark.
We'll take our next question from Philip Shen from ROTH Capital Partners. Please go ahead.
Hi, everyone. Thanks for the questions. First one is, related to the portfolio growth, just as a follow-up. Can you talk about how much the portfolio could end up growing, by the end of the year? So what could we exit the year with? We saw year-over-year, last year, it was mostly flats. With the yield curve where it is and so forth, and given the securitizations, I know this quarter was less. Could we see a modest amount of growth called [1,500 million] or do you see potential for something more meaningful than that? Thanks.
Phil, I think what we said on the last call was – wouldn't be surprising to have us be at 50% on balance sheet and 50% off balance sheet. So if you take $1 billion, that's $0.5 billion going on the balance sheet. We're obviously taking some off. So I would say something less than a $500 million, but certainly we expect more than your $50 million number.
Great. Thanks, Jeff. And in terms of the corporate credit rating, congrats on that. You're at BB+ currently, what is the path to get to investment grade, and over what time could that happen? What milestones would you guys need a hit to get that to a higher level and then how do you expect that to translate into benefits for you going forward?
So the rating agencies tend not to lay out a specific plan of any kind of upgrade. They generally shy away from a few accomplish A, B and C, we will upgrade you. That's really not their model of how they operate. And they both issued reports, which are public, and they talk about some items that you would expect them to talk about, like leverage in terms of how they think about our rating and asset quality and scale and some other things like that.
But we were not able to layout a plan of upgrade, nor would we be able to layout a timetable of upgrade. But we continue to dialogue actively with the rating agencies and over time there's certainly perhaps an opportunity for some kind of upgrade.
Okay. Thanks. I'll pass it on.
We'll take our next question from Jeffrey Osborne from Cowen and Company. Please go ahead.
Hey, good afternoon, guys. A couple of questions on my end. One is on a – is there a way you could discuss at a high level what the yields in the pipeline are for the different – similar to how you discussed the yields for the portfolio? Is there any material difference and any of the segments or pipeline?
Jeff, we anticipated getting that question given the way we set the slides up and we're comfortable talking about transactions we've done and what the yield because they're facts. We don't really feel comfortable talking about things that haven't happened yet.
As a general matter though, while markets are competitive, they're pretty stable right now. So I don't - I wouldn't - I think you should be thinking there's a lot of difference between what's in the pipeline and what's in the portfolio. Some yields are just aren't going to a lot lower. And probably there hopefully as low as they can go. But it should be pretty similar.
Got it. And then about the pipeline just as more and more of it’s behind-the-meter? Is there which has been a growing area for several quarters now for you folks? But is there any noticeable difference in the competitive environment or slower close rates in any kind of different variable that maybe you hadn't anticipated?
I'm pausing to think about that. No, I think it's been - it's our historic legacy market. I think the big addition is resi-solar, but that's - to us - a subset of that behind-the-meter market. I think they close when they close. We don't control that. Our hit rate is relatively stable. And again, it's made up of a series of asset classes. So if one isn't working then and the others tend to balance that out.
I guess I was thinking more along the lines of like micro grids and more complex solutions with batteries, efficiency and solar all at one.
So we've talked about I understand the question better now. We've talked about the Parris Island transaction, which is a micro grid. And it's a true it takes more time to put those transactions – to develop those transactions from our client's standpoint. That doesn't necessarily translate into a slowdown in us to finance it.
So by the time we see transactions in our pipeline, the cadence to go from qualified lead to a closing really hasn't changed much. The ESCO might've spent an extra six months working in storage or micro grid technologies, but that's on their side, not on ours.
Got it. That's helpful. Two other quick ones here. You mentioned 10, sort of uncorrelated areas of investment? Is there any of those 10 areas that maybe aren't working as well? Our sense is that sort of all of the areas that you're focused on our historically have done, seem to be moving in the right direction, but maybe you're seeing something different on your side of the table.
Well, I mentioned in the script that wind is relatively small portion. The wind industry is going gangbusters to get as much built with the PTC is remained. The last thing they want to do right now is working on a new capital provider and a new capital structure. When the PTC goes away. I suspect that works a whole lot better. But that would be the one area that we do have some wind opportunities, but it's not one that we're counting on in the near-term.
Got it. And then my last question is just on the government receivables. I think they peaked at the end of 2017 at a little North of $500 million are on $520 or so. And I think in this quarter you were around $340. Is there – was there something as part of the ratings agency process that you know needed to drive that that number lower?
It's just a bit unique that that you would unload roughly 10% of your portfolio in a quarter. And seem to be focused on that segment in particular. Trying to get a sense of – are they just uncorrelated variables that the rating agency was at the same time as you're moving these assets?
So good description there uncorrelated variable, the decision to sell some of these government receivable transactions did not have anything to do with the ratings process. These were opportunistic situations where given rate movements and some other dynamics created some opportunity for us. And it certainly cleared some space on the balance sheet for some higher yielding assets. As we've talked about and have used the word rotation, but that had absolutely nothing to do with the ratings process.
Got it. That's helpful. That's all I had. Thank you.
Thanks you.
Thanks Jeff.
Thank you. That concludes today's question-and-answer session. Mr. Jeffrey Eckel, at this time, I would like to turn the conference back to you for any additional or closing remarks.
Thanks. You ask good questions. I think we're going to hit the road here in a next couple of weeks. So we look forward to meeting the analysts and the investors and talking about Q2 and the prospects of the business going forward. Thanks again.
This concludes today's call. Thank you for your participation. You may now disconnect.