The market is all in when it comes to renewable power stocks, pushing the names in the space notably higher. That's great news for investors, but there's a similar trend taking shape within the renewable power market. North American energy giant Enbridge (NYSE: ENB) has been warning about the underlying trends, but the truth is that Hannon Armstrong Sustainable Infrastructure Capital's (NYSE: HASI) business could actually benefit from what's going on.
In a recent auction, integrated energy company BP (NYSE: BP) bid 80% more for offshore wind projects than the average of its competitors. The oil company has recently shifted its business model to focus around growing its renewable power business, so in some ways, this makes sense. But such a large difference hints that, perhaps, BP isn't bidding rationally.
However, according to one notable energy company, BP isn't the only company making questionable investments. During Enbridge's fourth-quarter 2020 earnings conference call, CEO Al Monaco explained: "Renewable valuations these days are frothy to say the least, so that's good for the value of the business. But it also means that returns are being crunched down on new opportunities." In fact, Enbridge has chosen to work off its backlog of renewable power projects instead of competing in a less-than-rational market.
And this isn't the only company that has highlighted such concerns, with U.S. utility giant The Southern Company (NYSE: SO) making a similar statement not too long ago. Southern is a particularly conservative company, so it might have been a bit early with its concerns. But Enbridge's recent statements suggest things have only gotten more stretched in the renewable power space. That's not a particularly great backdrop for investment, which should leave more conservative investors concerned about the space.
A unique approach
This brings the story to Hannon Armstrong. The real estate investment trust (REIT) has seen a dramatic increase in its stock price, along with other players in the sector. To put a number on that, the stock is up nearly 375% over the past decade compared to a gain of roughly 162% for the S&P 500 Index. That said, the stock is off over 20% from its early 2020 highs, suggesting that investors are questioning the valuation here. But what about the underlying business?
While project developers may be increasingly stretching their investment criteria, Hannon Armstrong is a slightly different beast. It is, technically, a mortgage REIT, with only around 14% of its top line derived from rental income. The rest is tied to interest payments (the largest component at 50%) and fees, among other things.
The math is really very different when it looks at investments because it's providing a loan, or similar investment (such as preferred stock), to a project based on the long-term contracts for the power that the project generates. It isn't actually buying or building a physical asset.
Hannon Armstrong doesn't have to figure out if construction costs will allow it to turn a profit. It sees the long-term contract and can assess whether its loan will get paid back. While that's not a guarantee that an investment will work out, it's a far more certain outcome than getting into a bidding war with a company like BP and hoping for the best. And since the real question when it comes to a REIT is whether it can keep paying, and hopefully growing, its dividend, Hannon Armstrong's basic business model looks like it has some material advantages in the renewable power space -- doubly so when things get "frothy."
This isn't meant to suggest that Hannon Armstrong is the best investment since sliced bread. The stock price has clearly gotten caught up in the renewable power rush on Wall Street, even taking into consideration the recent price pullback. But with a differentiated business model compared to those directly building new projects, it looks like it has a chance to keep growing its business in a profitable way. That will likely remain true despite the building industry excesses Enbridge is warning about.
For dividend investors looking at the renewable power space, that might make this REIT an appealing option today. Investors with a value bent, meanwhile, might want to put Hannon Armstrong on their wish list, just in case a short-term pullback comes along, noting that the roughly 2.6% yield is on the low side for a REIT.