Hannon Armstrong Sustainable Infrastructure Stock: Unsustainable premium to book value

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Hannon Armstrong (NYSE:HASI) is a mortgage REIT that provides financing for various types of green projects. They were one of the first to go into space and they are very good at it. I like the business and think there are many opportunities in green finance. Unfortunately, the valuation of HASI is excessively high, so it is actually a dangerous investment.

The Sell thesis

The nature of the mREIT business is such that the market price must always be anchored approximately around book value. The market seems to have gotten caught up in the excitement of HASI’s environmental talk and has forgotten the basics of mREIT valuation. HASI is trading at 3.13 times its book value. In this article, I intend to show that even though their investments perform extremely well, there is no reasonable outcome in which they are worth HASI’s market capitalization.

It’s not about whether they are good investments. Even with extremely optimistic forecasts, they simply cannot be worth 3.13 times the book. It is a matter of the structure being such that their value is capped.

Book value and REITs

Book value is a tricky concept with REITs. For equity REITs, this is an almost meaningless metric because properties are depreciated to 0 on the balance sheet, making the book value in no way reflective of the true value of the asset. .

Mortgage REITs are different. Loans are usually carried at face value or some measure of fair value, with companies often reporting both. Face value and fair value are useful measures for mREITs and provide an excellent guide for valuation.

mREIT anchored near book value

There are different types of mREITs such as agency mREITs, CRE mREITs, and private equity style mREITs, but they all have one thing in common: a valuation peg at approximately book value.

In fact, mREITs used to be part of the financial industry until they were phased out along with equity REITs in the 11e GICS sector.

These non-bank lenders all tend to trade around book value as shown below

Company (symbol)

To preserve

AGNC Investment (AGNC)

0.90

Annaly Capital (NLY)

0.98

New Residential Investment Company (NRZ)

0.99

Two ports (TWO)

0.92

Chimera (CIM)

0.94

Blackstone Mortgage Trust (BXMT)

1.16

KKR Real Estate Financing (NYSE: KREF)

1.11

Capital Loan (RC)

1.12

Data from SNL Financial

The list above includes both large and small companies as well as those with excellent reputations and those that have made mistakes.

Why such uniformity of valuation despite great differences between companies?

Well, there is an underlying mechanism that anchors a lender’s value to book value and it’s quite simple.

Loans tend to recoup the capital invested plus interest. The interest is proportional to the risk level of the loan. So, by lending $1,000, you recover a risk of $1,000 plus interest which has a risk-adjusted present value of about $1,000. Loans can go horribly wrong so you get $0 back, but there is no mechanism by which a loan can be a home run.

If the loan goes perfectly, you only get back the capital plus interest.

Given this capped return, it would be pretty silly to pay $3,000 for the receivables stream of a $1,000 loan and yet that’s what happens with HASI.

Unrealistic HASI valuation

Here is the Vital Statistics form on which I am basing this argument

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Statistics

SNL Financial

Thus, the enterprise value shown above of $6.5 billion offsets the cash and cash equivalents of the $2.467 billion in liabilities plus $4.561 billion in market capitalization. This means that to justify the current valuation, the assets, including cash, must be worth just over $7 billion.

Now let’s take a look at the strengths of the business.

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Balance sheet

10-Q

Assets of $3.9 billion are quite a far cry from the $7 billion. Let’s dig into the major line items to see if any of them might be worth much more than they carry on the balance sheet.

  • $413 million of cash and cash equivalents is worth $413 million.

The other significant items are receivables and equity investments using the equity method.

To estimate the real value of these, we need to know how HASI accounts for them. Here is their description of the 10-Q

“Investments are debt securities that meet the criteria of ASC 320, Investments – Debt and equity securities. We have designated our debt securities as available for sale and carry these securities at fair value on our balance sheet.

HASI also provided the following table:

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HASI Investments

HASI

Source: 10-Q

If the loans perform perfectly, they would functionally recover that $39 million loss provision. Even still, that brings it to just over $1.4 billion.

We should also attribute some value to embedded interest payments. A HASI bull might argue that since many of these loans are functionally super senior within the debtor’s capital stack, the level of risk is very low compared to the 5%+ interest rates on these loans. .

As such, HASI got a better deal than the market and so there would be a positive risk-adjusted present value on the interest payments.

I think there is some validity to this argument, but there is also risk on the other side with long-term, fixed-rate interest payments in a rising rate environment.

The 10-year Treasury yield just hit 1.668% and is expected to rise with the Fed’s tapering and hikes coming later this year.

Overall I think HASI is getting a better than average deal on their loan book so one could spot the fair value a bit higher than the balance sheet but the difference would be in the tens of millions, not in the hundreds of millions.

As such, the loan portion of HASI fits the mREIT profile perfectly in that it must be firmly anchored to book value.

A little more leeway in investments using the equity method

Equity investments, as opposed to loan investments, may fluctuate somewhat more in value with the performance of the underlying asset. As such, if there is a bucket in which HASI’s book value underestimates the actual value, this would be it.

As of 9/30/21, HASI held $1.468 billion in investments under the equity method. Here is how HASI counts them:

“Our investments in renewable energy or energy efficiency projects are accounted for using the equity method. Under the equity method, the carrying value of these equity-accounted investments is determined based on the amounts we have invested, adjusted for equity in the profit or loss of the investee allocated based on the LLC agreement, less distributions received.

In short, they are recorded at cost with cash flow type adjustments. Thus, the delta between the real value and the book value of this item would be the change in the fair value of the instrument beyond the cash flows it generated.

So, let’s look at investments using the equity method.

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Investments under the equity method

HASI

The largest is Jupiter Equity Holdings, a company that owns nine operating wind farms producing about 2.3 gigawatts. HASI contributed $540 million to the project in July 2020.

It was a good time to build renewables because the performance metrics look solid. This deal is made more secure with power supply deals already under long-term contract, so I suspect it will cash in well. That said, there are two factors that I believe limit how much this could have appreciated beyond book value:

  1. July 2020 is not that far away.
  2. HASI has a preferred interest in the project rather than a common tranche. Thus, its cash flow is more secure, but the upside is also reduced.

Lighthouse Partnerships is a similar investment in that HASI holds a preferred tranche in a large solar and wind project. HASI’s total investment is expected to be $663 million, but as of 9/30/21, only $219 million has been invested.

This too looks like a lucrative investment, but it is still in its infancy. Given recency and prime tier, I suspect fair value is only slightly north of invested capital.

HASI does everything right and every investment it makes seems to be relevant. I particularly like how they structure their trades so that they are so high in the capital stack that their returns are near AA caliber.

Even their equity investments are structured with a preferential yield which greatly increases HASI’s chances of profitability in the companies.

It’s a conservative company with the expertise in green financing to get the right deals with the right partners. I strongly believe that they will consistently generate strong IRR at relatively low risk. If the company was trading at around book value, I’d be happy to stock up on stocks.

A simple case of overvaluation

The challenge with HASI’s current valuation at 3.13X Pound is that given the conservative nature of their investments, it is absurd to value them so highly. A conservative lender simply cannot triple their money in just a few years.

On each of the HASI investments that I have reviewed, I believe they got a good deal, making the present value of these investments perhaps 10% or even 20% greater than their invested capital.

As such, the $7 billion valuation is absurd. Given that the capital has been so well invested, I think the $3.2 billion invested by HASI as of 9/30/21 is probably worth around $3.6 billion. Adding the $413 million in cash and cash equivalents, I would see the asset value at $4.13 billion.

Don’t pay $7 billion for $4.13 billion

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