Solar Service Experts, LLC (SPRU) Earnings Call Transcript & Summary

Good morning, and welcome to the XL Fleet acquisition of Spruce Power Conference Call. [Operator Instructions] For opening remarks and introductions, I would now like to turn the call over to Stacey Constas, General Counsel for XL Fleet. Please go ahead.

Good morning, ladies and gentlemen. Welcome to the XL Fleet conference call. We appreciate everyone joining us today. The information discussed today is qualified in its entirety by the information contained in the press release and investor presentation, which have been made publicly available this morning. You are encouraged to follow along and carefully review the disclaimers included therein. Before we begin, I would like to note that this call may contain forward-looking statements including our expectations of future financial and business performance and conditions. Forward-looking statements are inherently subject to risks, uncertainties and assumptions, and they are not guarantees of performance. You are encouraged to read the press release and investor presentation as well as our other filings with the SEC for a discussion of the risks that can affect the company. In addition, during our call, we will refer to certain non-GAAP financial information, which is further described in the press release and investor presentation. Non-GAAP financial measures are subject to material limitations as they are not in accordance with or a substitute for measurements prepared in accordance with GAAP. Please see the press release and presentation for further explanation of these non-GAAP financial measures, including reconciliations to GAAP measures. Hosting today's call is Eric Tech, Chief Executive Officer of XL Fleet; Christian Fong, CEO of Spruce Power and the new President of XL Fleet; and Don Klein, Chief Financial Officer of XL Fleet.

Thank you, Stacey. I'm very excited about the new direction that XL Fleet is taking. Our team has worked very hard over the past several months to develop a new strategy for the company, that I believe has the potential to create tremendous value for our shareholders in the coming months and years. We have four goals for today's call. First, explain how we are changing our strategy, provide you with an overview of Spruce Power, outline our plan to grow the combined company and describe how that all comes together to shape our financials going forward. I'll start with a brief summary of the 6 initiatives that we announced today. First, we are acquiring Spruce Power. Spruce is the largest privately held solar as a service company in the U.S. Second, we are changing our focus from building hybrid conversion kits for trucks to providing solar, storage and EV charging to homeowners and small businesses on a subscription base. Spruce is the cornerstone of our new strategy. Third, as part of our change in strategy, we have initiated a review of the strategic alternatives for our Drivetrain segment. The goal of this review is to identify the best ways to maximize the value of the investments we have made in that business for our shareholders. Fourth, we will be transitioning the leadership of XL Fleet to align with our new strategy. The Board intends to appoint Christian Fong, the current CEO of Spruce Power and the new President of XL Fleet as CEO of XL Fleet on or prior to February 15, 2023. I will remain CEO until his name and continue to serve on Board of Directors. Fifth, we are making continued growth priority and have structured the Spruce Power acquisition to maintain our financial flexibility. Following the close of the transaction, we had more than $240 million in cash on hand, and the debt we assumed as part of the transaction is non-recourse to our parent entity. Finally, we will be changing the name of the company to match our new direction. We are currently anticipating announcing our new name and branding early next year. Now I'll turn to an overview of Spruce Power, how it becomes the cornerstone of our new strategy and why we feel the acquisition will be so transformative for our company. Spruce is the largest privately held third-party owner of residential rooftop solar systems in the U.S. The company owns a portfolio of more than 52,000 solar systems that are deployed on homeowners roofs across the country. Those homeowners subscribed for solar services typically for 20-year terms and pay the company monthly for the electricity that the systems generate. We believe that it's a very attractive business model because our customers get the benefits of solar without the upfront cost or maintenance requirements and Spruce receives a stream of recurring payments over 20-year term, that end up being a multiple of what the system cost. To put that in context, the discounted value of the remaining payments Spruce's do from its customers less Spruce cost to provide their services is $810 million. And importantly, that is just what the subscribers have today. It doesn't assume any growth. Obviously, that's an impressive number, but is really exciting to Spruce's capacity for future growth. The company is one of a very small handful of platforms with the experience and the infrastructure to provide solar as well as other home energy products on a subscription basis. There are 3 things we think the Spruce acquisition creates for XL Fleet. First, it gives us the exposure to rooftop solar market, which is experiencing tremendous growth. Growth in residential solar directly benefits Spruce, and we believe that the rooftop solar market is going to have significant tailwinds for the foreseeable future. We believe that rising energy prices, cheaper batteries that allow homeowners to store solar energy and the recently passed Inflation Reduction Act are all accelerants. Second, it gives us an established business with predictable recurring cash flows. Most businesses start each year at 0 and have to find customers for their products. Spruce starts each year with more than 52,000 customers that have 20-year-plus contracts with the company where they pay every month. Over the 12-month period, ending June 30, 2022, Spruce generated about $15 million of net income, $51 million of adjusted EBITDA and $30 million of free cash flow from their current subscriber base. Spruce has also shown that it can add subscribers at lower cost than its peer spend. I'll talk more about how they are able to do that later. But Spruce is generating what we believe are industry-leading margins, revenue per employee and customer acquisition costs. That gives us confidence that we will not only be able to grow the business significantly, but also profitably, which is something that we think sets us apart from our solar peers. Third, it creates an opportunity to use our capital to accelerate the growth in what is already a good business. Spruce has already has the infrastructure in place to double the size of this business. We bring the capital they require to create step change growth in their subscriber base. And together, we think we can create a great public company. The ultimate goal of this transformation is to create value for our shareholders. We think we achieved that in 3 ways. First, the price we pay for Spruce represents about a 50% discount on an enterprise value to gross earning assets basis relative to where the company's 2 primary comps, Sunrun and Sunnova currently trade. The math behind that is an enterprise value of $590 million relative to the company's gross earning assets of $810 million. That equates to a multiple of 0.7x, which compares to 1.6x and 1.4x for Sunrun and Sunnova, respectively. Second, we have structured this as an all-cash transaction. We did not issue any shares to sellers, so our shareholders will get 100% of the value we create. And third, Spruce's existing debt will carry over with the company. That was extremely attractive because Spruce's debt is low cost, approximately 5.5% on a weighted average basis without the typical underwriting fees to raise new financing for the deal. We also kept the debt nonrecourse to our parent company, so our cash remains unencumbered. For those of you who are less familiar with the rooftop solar market, I thought it would be helpful to provide some more context or how Spruce fits into the industry. Today, there are 2 ownership models for solar: homeowner and third-party ownership or TPO. Under the homeowner model, the customer owns the system and is responsible for its upkeep. Under the TPO model, a third party like Spruce, owns the system and is responsible for its upkeep. The homeowner pays the third-party a monthly fee in return for energy produced by the system. Sunrun, Sunnova and Spruce are TPO companies. Sunrun and Sunnova are largely the Spruce, but they've also raised a lot more capital than Spruce has. Tesla to SolarCity was historically a large player in TPO, but the business is not a focused for them today and SunStrong is essentially a financial JV between SunPower and Hannon Armstrong. We believe that Spruce has potential to get to the size of Sunrun over time. When I get to Spruce's customer acquisition models, I think you will see why we believe the company has an opportunity to get there quicker and a lower cost than its peers. Well, both the homeowner and TPO model have been successful in the market. We think the TPO model offers a compelling set of benefits. For homeowners, it offers a low-risk way for customers to start using solar energy. They don't have to make an upfront investment to reduce their energy costs and decrease their carbon footprint, and the TPO company takes the possibility for maintaining the system. Investors in TPO companies like Spruce get the benefit of contracted recurring revenues with very low volatility as well as long-term customer relationships that can be expanded to include other products and services as technology becomes available. Finally, society gets the benefit of reduced greenhouse gas emissions, a more resilient power grid and jobs for workers that install and maintain the systems, which, by their nature, cannot be offshored. We think TPO companies like Spruce have a very high ESG impact for investors that prioritize those aspects of their investment. Spruce has more than 52,000 subscribers who pay an average of $143 each month for solar service. The company's customers are exceptionally creditworthy with an average FICO score of 756 at inception. All Spruce customers have entered into long-term contracts with the company. As of June 30, 2022, the weighted average remaining life of contracts Spruce has with its customers was approximately 13 years. Over the 12-month period ending June 30, 2022, Spruce has generated about $15 million in net income and $51 million of EBITDA. And the present value of the remaining payments the company is due from the subscribers, less the company's cost to serve is $810 million. There are 3 parts to the Spruce business, the rooftop solar portfolio, the servicing platform and the M&A function. The company's rooftop solar portfolio provides Spruce with recurring cash flows from the monthly fees that subscribers pay and it is our goal to continue to grow that portfolio. The servicing platform is the machine behind the portfolio. It has the infrastructure for billing and collecting payments from subscribers as well as maintaining the company's rooftop solar systems. Building a servicing platform that is capable of managing large numbers of customers efficiently is challenging. And Spruce has proven that as one of the few players who is able to do it well. That's underscored by the fact that other third-party owners of rooftop systems pays Spruce to manage their systems. Today, the company manages over 28,000 systems for other companies. The M&A function is the growth mentioned for Spruce and what makes it different from companies like Sunrun and Sunnova. Rather than selling one subscription at a time to homeowners through a paid sales force and then installing them with their own technician, Spruce acquires portfolios of already operating systems from other companies. The company has a dedicated team that tracks the assets in the marketplace, cultivates relationships with potential sellers and performs due diligence in-house when a portfolio becomes available. The Spruce M&A team has a long track record of successful acquisitions, having acquired 10 portfolios in just the past 3 years, more than doubling the number of systems owned by the company. Now I'll spend a few minutes diving into some of the more detail on each of the 3 parts of the Spruce business. Drilling down on the company's portfolio, you will see that it has several attractive characteristics. I'll touch on three of them. First, there is a lot of remaining life in the company's contracts. More than 2/3 of the portfolio have between 12 and 15 years remaining on their subscriber agreements. Second, the assets are young. Almost 90% of the systems have more than 20 years of remaining life. That's important because we expect most of those company's customers will want to recontract this Spruce at the end of their term. Because the company's assets are young, Spruce will have an opportunity to continue to generate revenues from them well beyond the initial contract term. Third, the company has high-quality customers that pay their bills. About 85% of the subscribers have over 700 FICO scores, and nearly 60% have over 750 FICO scores at inception. Homeowners in these FICO bands have extremely low delinquency rates and even lower default rates through all type of macroeconomic environments. One of the big things that attracted us to Spruce was the strength of the servicing platform and the significant experience of the leadership team had in managing a wide range of assets. That was very important to us because we wanted to grow not only the number of rooftop solar systems in Spruce's portfolio but also to expand the types of subscriptions that the company offers beyond the solar. Spruce either currently services or has serviced in the past a wide range of assets in a variety of formats. So we are comfortable that the company has the capability to grow its portfolio rapidly, while continuing to effectively manage assets and provide good customer service. Spruce's M&A capability is what really differentiates this company from other rooftop solar TPOs. Most of the company's peers grow by using a sales force to sign up new subscribers one at a time. That model has enabled companies like Sunrun and Sunnova to grow very rapidly. But it's extremely expensive and requires big investments in people, infrastructure and vehicles. It also forces you to fight your competitors or subscribers and sometimes offer a better deal than you might want to because you need to keep all the sales installation of people you have on your payroll working. Spruce has a very different approach. The company does not have a sales force or old installation crews, instead Spruce acquired systems that are already in operation from other owners. The advantage of this approach is that you don't have the costs associated with having a large sales force and installation crews. There is more history with the customer when he buy, so you know what you're getting. And you can afford to wait for the right price because you don't have to keep the salesforce busy. You see these advantages reflected in Spruce's financial metrics. The company spends less than half of what its peers do on acquiring a customer. The company generates far more revenue per employee than its peers because it doesn't have to have a sales force or installers on payroll. The result of those 2 is much higher EBITDA margins than its peers. Now I'd like to introduce Christian Fong, the CEO of Spruce Power, to talk about our growth and strategy going forward. Christian has led Spruce for the past 5 years and has a long history of helping to build successful renewable energy businesses, most recently as the lead independent director at TerraForm Power, prior to the company's acquisition by Brookfield Renewable Energy Partners.

Thanks, Eric. I'd like to start off by saying how excited the entire Spruce Power team is about joining XL Fleet. The combination of our platform with XL Fleet's financial resources at a time when we're seeing growing tailwinds for solar has any more optimistic about the growth we can achieve in our business than at any other time during my tenure as CEO. This page sets the stage for what our opportunity is. These maps show you just how ubiquitous rooftop solar is becoming. What started off largely as a West Coast phenomenon, has become a national mega trend. When I became Spruce's CEO in 2018, there were only 12 states where more than 7,500 residential systems were being installed each year. That was in part driven by the combination of incentives and high power prices, making solar economically attractive in those states. Whereas everywhere else, it was more marginal. Since then, system prices have fallen significantly. While energy costs have increased, and we've seen residential solar become something that makes economic sense almost everywhere. That's reflected in the state-by-state installation numbers, which now shows 16 states installing over 7,500 systems a year, totaling over 500,000 new homes going solar every year. What that means for Spruce is that our addressable market, which we define as available systems that we can purchase is growing very rapidly. To put that market size in perspective, if we had an opportunity to acquire just 10% of the systems installed in a single year in the U.S., we would double our subscriber base. Importantly, I see the market growing even faster now because of 3 things: first, power prices are increasing dramatically, which makes going solar more attractive. I'll put some perspective on that. Electricity prices in the 5 most popular states in the U.S., California, Florida, Texas, New York and Pennsylvania, all increased by nearly double-digit percentages over the past 12 months. Second, the adoption of electric vehicles is accelerating. That's important because having an EV increases your electricity consumption by about 30%. Higher electricity prices, coupled with more electricity usage makes solar especially attractive to those consumers. We see that in the correlation between EV ownership and rooftop solar. Now 30% to 40% of EV owners also have solar power. Third, battery costs are continuing to fall, which allows homeowners to pair storage with solar. Storing excess power generated by the solar system during the day and using it at night can significantly increase the savings a homeowner can realize as well as make them much more resilient to grid outages. The takeaway from all that is we think solar is going to become like other major systems, things like air conditioning, furnaces or a hot water heater that consumers will want to have in their homes. That would be good news for Spruce because it would create a target-rich environment to grow the business. So how do we take advantage of that growth in the market? Our strategy is to grow both the number of subscribers we have and the number of services each subscriber purchases from us. We're planning to do that in 4 ways. First, our strategy is to grow the number of subscribers we have by continuing to execute on our strategy of acquiring existing portfolios of systems. One of the questions that Eric asked me when we first started talking was how much more M&A can you do? We believe that the answer is a lot. We're working diligently on a number of opportunities that we're excited about. Typical sellers we see are companies that change strategy for one reason or another. And I don't want to manage decade-plus relationships with homeowners, financial institutions that purchase systems and want to recycle capital and even the TPO leaders when they need to raise capital. There's no shortage of opportunities and many sellers see us as the preferred buyer because of our knowledge of the assets and ability to move quickly. Secondly, we'll also seek to grow by selling our existing subscriber base new services. Today, nearly all of our subscribers buy only one service from us, solar on their rooftops. We're piloting a battery storage program now, and we're in the early stages of developing an offering for EV charging. Our cost to add another service for the same homeowner is relatively small. So the incremental margin for us from selling a second and third service is very significant. Third, we're going to look at originating new subscriptions through channel partners and our online portal at sprucepower.com. Our focus today is to acquire existing systems rather than to do new build. But if in the future we can install new systems with reasonable customer acquisition costs, it's something we would consider. Importantly, the one thing we don't currently plan to do is the retail direct-to-consumer model that some of our peers have, keeping customer acquisition costs low has been a key to producing good returns in TPO. This next slide shows you the various paths we have to monetize a customer relationship and how powerful adding subscriptions for new services can be for us. As I mentioned earlier, nearly all of our customers buy only solar power from us today. We see a clear opportunity to offer them storage and emerging opportunity to offer them EV charging. High-power residential EV chargers can cost over $5,000, and we think there's an opportunity for a subscription-based product to be successful. Selling subscriptions for those products can be game changers for us. Because if an existing customer has both the could substantially increase our revenues without adding as much cost for us. Mathematically, it would be great margin expansion. Grid services is another area where we see an incremental opportunity. Once a subscriber adds storage, there's an opportunity to receive grid services revenues by participating in demand response programs. I'll wrap up by reiterating how excited I am about becoming part of the XL Fleet team. We see a lot of growth ahead for our business. And we have structured this transaction in a way that we have the resources we need to grow. Now I'll turn it over to Don Klein, XL's Chief Financial Officer, to talk about financials.

Thanks, Christian. I'll provide an overview of Spruce's revenues and expenses and then talk about what the combined company's balance sheet will look like. Today, Spruce has 2 primary revenue streams, monthly payments from homeowners for solar service and monthly payments from other TPOs who use Spruce to manage their systems. Contracted payments represent about 90% of revenues. Other revenues the company generates include the sale of SRECs, which are an environmental credit generated by the company's systems that it sells to utilities, which they use to meet certain regulatory obligations. Revenue from subscriber payments is very predictable. Roughly half are fixed and the other half vary based on the amount of energy produced by the system. Because of the price that the customers pay for the energy is fixed and the amount of energy that the systems will produce doesn't vary much year-to-year, we know it's a lot of precision what revenues will be in any period. It's also important to note that more than half of the company's contracts have price escalators. So there's some built-in growth even if we don't add any subscribers. Spruce's expenses are the cost of its employees and servicing infrastructure as well as payments for company makes the contractors who maintain the company's systems when needed. Most of the company's expenses are fixed or semi-fixed, which means that the contribution margin on incremental revenues is very high. As Eric and Christian talked about, the primary way Spruce grow subscribers is by acquiring existing portfolios with many subscribers, whereas its peers grow subscribers one at a time by selling direct to customers. The result is that we have the ability to achieve step change growth when we make an acquisition rather than small but continuous growth. The takeaway is the consecutive quarterly subscriber growth may not be comparable between Spruce and its direct-to-consumer peers. Like our peers, Sunrun and Sunnova, XL will begin reporting the present value of the remaining payments due to Spruce from its customers quarterly. We believe this information will help investors to understand the value of our business, particularly as we add subscribers. As of June 30, 2022, Spruce had gross total subscriber value of $810 million, which represents the net present value of the remaining net cash flows from customer contracts plus expected renewals discounted at 5%. One of the things that was very important to us when we structured the traction was that we preserved our cash on balance sheet. So we have the resources to continue to grow. Following the closing of the Spruce transaction last Friday, we had more than $270 million in cash, of which $240 million was unrestricted and available to execute on the growth strategies that Christian described. Additionally, the debt we will be assuming in the transaction is very attractively priced with a weighted average interest cost of only approximately 5.5%. It's also worth noting that our first maturity is not until April 2026 and the debt is nonrecourse to XL Fleet Corp. So our cash remains unencumbered. Now back to Eric for closing remarks.

Thanks, Don. I believe that now is an exciting time for XL Fleet investors. Our new strategy gives us exposure to rooftop solar, which I believe is one of the most significant megatrends of our lifetime. Our new business of providing subscription-based solutions for solar, battery storage and EV charging is very attractive. And we have a strategy to grow it that is differentiated from other companies in this space. I'd like to close by thanking our customers for their commitment to XL Fleet, our employees for their contribution to the company's success and our shareholders for their continued support. And with that, thank you, everybody. I appreciate your time today.

Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.