Description

Introduction

Element Financial (ticker: EFN CN) is the market leader in outsourced fleet management.  The Company is based in Canada but 70% of assets/revenue/pre-tax are generated in the US.  The company recently completed a large acquisition of GE’s fleet management business, which has made Element the largest fleet management company in North America.  The deal also furthered Element’s transformation from its legacy as a diverse asset financing company into a “pure play” fleet management business, with fleet management now comprising 70% of the revenue and pretax mix.  The deal also changed the revenue mix in fleet to nearly 50% fee based (the remainder being spread income and operating leases).  As a scale player, EFN enjoys several advantages vs peers (funding, purchasing, technology).  In addition, roughly 80% of the target market for fleet management is still done “in house”.  Element estimates its services are 20% cheaper than the “in house” proposition; by taking share in an underpenetrated market and capitalizing on the trend toward outsourcing, Element will likely demonstrate high single digit fee based revenue growth for many years.  As evidence of its value proposition/service offering, the Company generates a 4% pretax ROAA (best in class in financials) and a companywide ROTE of 20%+.  As Element continues to win deals organically and continues its acquisition of smaller fleet operators, earnings power will continue to expand.

The company currently trades at only 7.5x 2017 EPS (and 5.5x excluding the Company’s $4 tax asset…Element is not expected to pay cash taxes for the next 12 years).  This valuation is too low in light of estimated 60% earnings growth in 16 and 20% growth in 2017, double digit organic revenue growth and best in class 4% ROAs.  In addition, Element is unique among financials in that it has de minimis credit risk (losses were 0.0% in 2009).  We believe that over the next year the Company will trade to $26+ at ~12x fully taxed 2017 EPS of ~$2.00, offering ~70% upside.  There are several catalysts which will rerate the stock, including new organic growth wins, execution of synergies in the GE deal, reaching targeted leverage ratios, executing additional M&A, and selling the Company’s Canadian C&V business in 1q2016.

Deal overview/history

Since its IPO in June 2011, EFN has rapidly expanded its asset financing business and balance sheet through organic growth and acquisitions.  The company grew assets from $1.5b in 2013 to nearly $9b in 2014, largely driven by acquiring the US fleet management business from PHH.  More recently, the Company again doubled its most valuable division, fleet management, by acquiring GE Capital’s US fleet management business.  The deal closed on August 31 and was a transformative acquisition that increased EFN’s balance sheet by 70% and will drive 20%+ EPS accretion.  The assets were sold by GE as part of its unwinding of its GE Capital business to become a pure play industrial company.  Element’s business mix has now transformed from a diverse asset financing company, composed of 37% commercial and vendor finance (“C&V”), 24% fleet, 20% aviation and 19% rail as of Q2 2014, to 70% fleet, 13% C&V, 9% rail and 8% aviation as of Q3 2015.

Key to the GE deal’s success are substantial expected synergies.  Synergies are expected to be $90-95m ($USD), composed of $42-44m in procurement, $18m in interest savings (due to higher credit ratings post deal), and $30-35m of integration savings.  EFN has already achieved $60m in savings, with the $30-$35 infrastructure savings still in process.  The GE integration is to be fully completed by Q42016.  EFN exceeded its costs save estimate in its 2014 PHH fleet management acquisition, achieving $25m of cost savings versus the $20m initially targeted.

Summary Capitalization

Fleet Management Segment - 70% of assets, 70% of earnings

Element’s fleet management business provides a fully outsourced solution that helps corporate clients finance and manage their fleets of company cars and trucks.  In addition to providing lease financing for vehicles, Element helps its clients to both minimize the cost of vehicle ownership and to maximize their productivity via data and analytics.  Fleet costs are often one the top five “spends” for an organization (think BUD, Sysco, Comcast); the vehicle fleet is a mission critical tool for enabling company employees to perform their jobs.

The Company targets fleets of over 100 vehicles in the US and of over 10 vehicles in Canada, and currently deals with approximately 3,855 different fleet customers and manages 1.3m units. Its customer base represents a diversified mix of industries (33% manufacturing, 11% wholesale trade, 10% communication and utilities, 8% natural resources, 7% construction) and is comprised of generally high-quality commercial customers.  The customer base includes around one-third of Fortune 500 companies.  Element has a customer retention rate around 98%, and more than 500 customers have been a client for 20 years or more.  The managed fleet is comprised primarily of light-duty trucks and cars (61% light duty, 15% cars, 9% medium duty), with small exposure to asset classes such as forklifts (2%) and trailers (2%).

There are 11m vehicles in the addressable fleet and commercial vehicle market.  The market has generally been stable over time and fluctuates within a 2-4% variance.  The market is segmented by financed and managed vehicles (Element’s niche), owned vehicles (where companies use their own money to purchase vehicles and manage services in-house), reimbursed vehicles (where companies pay their employees an allowance or mileage rate for their personal vehicle), and government vehicles.  EFN focuses mostly on the owned vehicle market due to the longer sales cycles in the government channel, although the government channel may be a greater source of opportunity in the future due to growing budgetary and fiscal pressures.  The company believes that only around 20% of its target market is currently outsourced.

Element is a dominant player and has 37% share of the US fleet market and 44% of the Canadian fleet market.  Privately held ARI is the second largest competitor (23% US share and 31% Canadian share).  The third largest competitor in the US is Leaseplan (11% US share).  New entrants are rare, with many key players tracing their roots back 60+ years.  In fact, the industry has been consolidating since the mid-1990s, with names like CSC, USFL, Leasing Associates, and AMI acquired by current competitors.

Cyclically, there has been a modest rebound in the fleet lease market over the past several years.  Frost & Sullivan reported that the fleet lease market has increased just enough to recover units lost in 2008-2009 recession, and projects 3.7% growth in new lease origination revenue CAGR 2012-2020.  The market should still be robust as the average age of fleet equipment is still relatively high as customers have deferred capex in the aftermath of the financial crisis.  Most of the growth opportunity here, however, is based on an increased outsourcing trend, separate from cyclical factors.

The Company makes money in two primary ways.  One is traditional spread based leasing.  Leasing (~50% of fleet revenues) is the customer attachment point that leverages the company’s other services.  The second are value add services that form the crux of Element’s value proposition.  The company’s strategy is to deliver end-to-end solutions that maximize the productivity of clients’ employees and assets at the lowest possible cost.  Fee revenue is earned for ancillary services through both recurring monthly charges and transactional activity.

Some specific examples of the Company’s fee based services that help minimize vehicle costs/improve productivity are –

·         Vehicle acquisition.  Element uses in house engineering and specification experts to minimize customer vehicle acquisition costs and maximize ultimate resale prices.

·         Accident management.  This includes 24/365 coverage for accident reporting, repair management, and claims recovery.    

·         Fuel services – Includes point of sale processing, security and authorization controls, and fuel cards to facilitate payments and monitoring.  Goal is to minimize fuel costs (which are large and represent ~40% of vehicle expenses). 

·         Managed maintenance – This includes repair negotiation and screening for duplication, overselling and warranty.  EFN charges a fixed monthly fee for access to its supplier network and service discounts.  The goal is to minimize driver downtime (a substantial cost of operating a fleet).  Element has huge preferential pricing in the maintenance market due to its scale.

·         Remarketing - Conservative lease terms coupled with strong remarketing efforts lead to consistent gains-on-sale for clients upon vehicle disposal.  Element uses an extensive, multi-channel network including auctions, dealers, retail consignment and online.  Personal representation at auctions maximizes returns, consistently exceeding market average.

·         Telematics – This is essentially a driver monitoring system.  It helps clients reduce risk, costs, and fraud and includes equipment solutions/installation, exception reporting and consulting/trend analysis. The telematics system typically results in reduced fuel use and improved driver and asset productivity, safety, and compliance with fleet policies. Other benefits from closer tracking of vehicle inventory and activity include greater route productivity and service and completion ratios. Element believes this service is only around 30% penetrated, but has the potential to get to 100% penetration.

·         Violations /E*Toll Compliance - Suite of services to reduce costs associated with traffic, parking, red light, speeding tickets and electronic tolls.

·         Licensing & Regulatory Compliance - Manages and inventories correct titles for every vehicle, including processing for sold vehicles.

·         Risk & Safety - Identifies high-risk drivers via Motor Vehicle Record Checks, High Risk program, Driver Profile program. Trains drivers to reduce accidents.

As a result of these fee based revenue drivers, Element is seeing a positive mix shift in its business whereby fee based revenues are growing at a much greater rate than spread income.  The mix is currently near 50/50, but fee as a % of total will likely grow closer to 60/40 over the next several years.

The barriers to entry in EFN’s fleets business are high, leading to Element’s 98% customer retention rates and outsized profitability (4% pretax ROAs).  Some of the barriers and EFN’s advantages and value proposition include the following:

For one, Element simply has much greater scale than its competitors (Element is 50% greater than its nearest competitor ARI and EFN’s fleet size dwarfs the size of in-house competitors).  This manifests itself in several ways.  The primary way is the that the Company is one of the largest single purchasers from the OEMs, tire companies, parts manufacturers, maintenance repair shops, resellers etc.  Element has procurement relationships with all of them and buys in bulk.  Element is therefore able to get pricing concessions that no one else (particularly an in-house managed fleet) is able to get.  These savings are meaningful (perhaps 20%+ better than what an in-house solution would pay), and Element passes these savings onto the customer.

Secondly, Element has made a significant investment in a deep data set and analytics package.  EFN has data on thousands of its customers’ fleets over decades, it’s almost infeasible that an in house solution would be able to run as effectively.  Using data from BUD as an example, Element can demonstrate specific savings it can bring to Pepsi.  In addition, the asset management, transaction processing and data sets that Element captures are tightly integrated into clients, suppliers, and OEM’s (making them difficult to replace).  The company just announced it is investing another $75m into its new technology platform.

In addition, the business is very capital intensive and EFN has access to capital and a funding advantage versus peers (particularly in house).  Given its size and scope, Element obtains 90-100% advance rates on its vehicles in the bank market, and with its diverse package of clients and vehicle types, Element also finances vehicles in the ABS market at an interest cost of only ~ 100 bps.  It’s unlikely that even a large corporate client could finance its fleet this cheaply, which in addition to EFN’s purchasing scale with OEM’s etc, drives a meaningfully higher cost advantage versus the in-house solution.  Element estimates that it can offer a 20% total lower cost of ownership versus an in house solution (purchasing, reduced down time, higher fleet efficiency via analytics, driver monitoring, etc).

Lastly, via its partnership with Arval (the dominant European fleet management company), EFN CN is one of the only fleet companies that can service fleets of large multinational clients.

Another attractive aspect is the recurring revenue nature of the business.  For one, fleet is a mission critical element for most of its clients (Comcast will need to run its vehicles no matter where we are in the economic cycle).  A typical vehicle replacement cycle may be 3 years, therefore when the customer enters into a lease, EFN has contracted revenue for the next three years.  There is also excellent visibility from new customer wins.  Typically deals are boarded on a “staggered” basis, such that the customer would transfer its business at 20% per year over five years.  Some of these are larger deals, such that if EFN were to say win a $1.5b fleet deal, that would be a meaningful 3% annual top line contracted tailwind for five years.  If a client wanted to switch vendors, the existing leases would also roll off on a staggered basis.    Therefore, a full transition would take several years, and during this time the client would be running two different service providers on separate service networks (for fuel, maintenance, telematics, etc.) and reporting using different systems.  This would obviously be costly, cumbersome, and disruptive. In addition, a change of providers would require a retraining of vehicle operators on with whom and how to deal with refueling, maintenance and accident situations.

The Company’s growth algorithm is as follows –

·         Only 20% of the market is outsourced.  EFN will win market share via conversion of historically self-managed fleets.

·         A relatively low percentage of customers are using the full suite of Elements technology and add-on fee based services (perhaps 30%).  EFN will cross sell these higher margin applications to its existing customers.

·         The GE assets were more “financing” oriented while the PHH assets were more technology heavy.  EFN will retrain/refocus the GE salesforce to focus more on its technology component. 

·         Element will focus its efforts on the market for vehicles with a higher proportions of work trucks/service vehicles over executive/sales cars.  These vehicles tend to have higher acquisition costs, more complex upfitted equipment, longer service lives, and greater need for regulatory compliance.

·         Inorganic - the Company has already acquired 4+ fleet management companies and will continue to roll up other operators.

The Company has spoken to a target of 8-10% y/y fleet revenue growth driven by 2-5% y/y growth in existing fleets (GDP driven plus the upselling of fee based services), 1.5% y/y inflation in vehicle prices, and 3-4% growth from onboarding of new clients (market share wins).

EFN’s efforts appear to be bearing fruit as they have been on road talking about a large organic fleet account win for Q116.  Because some organic fleet wins can be big ($1-$2b account sizes), that would be very meaningful on a $13b fleet earning asset base (consider the that GE deal brought assets of $7b).  A $1-2b USD win would provide ~2-4% of embedded topline growth per year for 5 years.  With 20+ large accounts in the sales pipeline, the company believes this can bridge them to their 8-10% multi-year organic growth targets.  Importantly, new fleet wins are generating ~ 4% ROAs.

Credit

Element also differs from most spread based financial companies in that the company does not take material credit risk.  One of the unique aspects of EFN’s model is that company does not bear residual risk on its leased fleet assets.  Its contracts are structured such that the customer/counterparty assumes residual risk on the fleet assets, i.e. the lessee is responsible for the mark to market value after the lease expires.  Upon maturity EFN will sell the vehicle into secondary market and the client either receives a credit or pays the difference between the sale price and book value.

In a scenario where an Element customer were to default, Element will seize its collateral and sell the assets in the secondary market.  If the lease is early in its term, Element is worse off as the asset will have relatively less depreciation then later in the lease term.  In a scenario where the assets have been leased for a few years, it’s more likely EFN’s realized price will more likely approximate book value on the asset less the accumulated depreciation (resulting in no loss).  The most likely scenario of a defaulted customer is that they continue to operate the assets in bankruptcy anyway, as these assets are mission critical.  Consider Comcast (needs to run its vans to customers for installations) or Budweiser (needs to deliver beer to its vendors or it has no business).  So for Element to have to take back the collateral in the first place its likely only in a more rare Chapter 7 situation.

The proof is in the reported results.  In the financial crisis in 2008/2009, losses were 0.00% (not a misprint).  In 2011 when the Circuit City bankruptcy went to liquidation, charge offs were only 0.08%.

Funding

Element’s funding plan uses committed secured bank lending and supplements this by accessing the ABS market.  The Company’s bank syndicate has 24 lenders (mostly US based). As of September 30^th, EFN had $21b in committed lending facilities and $4.3b in availability to fund new originations.

Separate from its bank facilities, Element routinely funds in the ABS market.  The advantage of ABS funding is that it is typically cheaper then bank financing.  As of September 30^th, Element’s ABS funding cost was ~100 bps versus ~240 bps on its bank facility.

Element’s ABS funding vehicle (“Chesapeake”) has been funding in the ABS markets since 1999, completing 17 separate deals amounting to nearly $7.7b of issuance.  This facility remained open during 2008 and 2009.   In fact Element did $2.2b in four deals during 2009 and issued the paper at an average spread of L+175 bps.  In December 2015, Element announced new $4.8b ABS funding conduit (“Chesapeake II”) and issued $3.3b in notes, leaving $1.3b in capacity.  The Company will pay down its bank facility with the proceeds.  The deal was reportedly very well received and oversubscribed at 2:1. Pricing was in line with recent deals (my guess is libor + 50-70 bps).  This deal was completed just three weeks ago, despite the fact that credit markets have been rather weak of late (lower deal volumes, high yield spread widening, general risk off in the financing markets).

Since the GE deal announcement the Company has achieved its targeted funded synergies as they received a credit upgrade and completed this ABS facility.  To the extent Element continues its mix shift towards ABS and achieves further credit rating upgrades post full GE integration, there could be further interest savings opportunities in the future.

The Company uses a match funding strategy for both duration and rates.  In other words, debt maturities are structured to mirror the expected asset duration of its leases.   Similarly, its mix of floating versus fixed rate debt is targeted to be the same as its lease proceeds (the leases have escalators should rates rise, as an example).

Putting it all together, it’s rare to find a financial generating high single digit organic growth, with a 50%+ fee based component, 4% ROAs and de minimis credit risk.  Pro forma for the GE deal, Element will be 70% fleet management. While Element is traditionally grouped with other equipment financing companies, in reality Element’s business mix (financing but also a lot of high margin and low capital intensive services) is superior.

Rail/Aviation/Commercial & Vendor finance - 30% of assets, 30% of earnings (pro forma for Canadian C&V sale)

Rail/Aviation/Commercial & Vendor finance Summary financials -

This segment represents EFN’s legacy businesses.  In this segment, EFN finances rail cars, corporate aircraft, helicopters, capital equipment and smaller asset based corporate loans.

The Company is actually generating strong originations growth in these verticals, although they are not the primary focus of the company versus allocating capital towards the higher fee, higher ROE, higher growth fleet segment.  The primary benefit of the rail assets ($2b or 10% of total company assets) is that the accelerated depreciation in this business aids Element’s substantial deferred tax shield.  In conjunction with amortization from the PHH purchase (in the fleet segment), rail allows Element to defer cash tax payments for 12 years currently.  By growing rail originations at the current pace of 25% per year, Element may be able to defer cash taxes by up to 20 years ultimately (increasing the value of this tax asset).

EFN’s rail fleet has a young average life (2.5 years).  The average lease term is relatively long at 5 years.  EFN is reasonably well diversified by car type, lessee, industry and term.  In December 2013, EFN renewed a significant relationship with Trinity Industries, a leading manufacturer of railcars.  EFN has the preferred access to originate lease financings for Trinity's railcars.  This agreement resulted in ~$2 billion of lease originations in 2014/2015.  Recently, EFN resigned with Trinity through 2019 and is guiding to 25% asset growth in the rail segment in 2016 and 20-30% growth thereafter.

Tankcars are 18-20% of EFN’s rail assets.  Some investors have expressed concern about a slowdown in the business due to the decline in energy prices and therefore lower demand and collateral prices for these railcars.  In the financial crisis, commodity prices snapped back relatively more quickly and therefore industry rail car losses/pricing was not that draconian the last time around.  This time (it seems) is likely different (lower for longer energy prices).  I take some comfort in the relative young life of EFN’s fleet age and the 5 year lease life.  The assets are mission critical for the lessor and so you’d need a chapter 7 liquidation and pricing in the secondary market would have to be destroyed to take losses. Obviously the assets are secured as well.  Nonetheless, for the sake of analysis if I (across the whole rail portfolio) take a cycle high unsecured loss rate (say as witnessed in unsecured consumer credit) of 10%, that would imply a $200m credit loss versus $85m of rail pre-tax income.  This loss rate would also map to a 20% frequency of default and 50% severity given default (also seemingly draconian).  So this implies a net loss of $115m pretax, $89m after tax or a 23c hit to book value.  Given that EFN is doing 40c/quarter in EPS, under this dire scenario book value would not be impaired and capital ratios would not be effected.

Recently, as part of its continued focus on allocating capital to the Fleet segment, Element has announced the sale of its Canadian Commercial and vendor “C&V” business.  These assets are ~$1b or roughly 1/3 of the C&V segment.  This sale is important because it will simplify the EFN story and drive more business mix towards fleet, which should improve the Company’s valuation.  C&V is a fine business with decent growth but has lower available leverage (5.5x) versus Fleet at closer to 7.5x.  The Company has spoken to a purchase price at > 1.5x BV.  Given the fact that EFN is under-levered, on a stand-alone basis this will de-lever EFN even more.  As such, I think this implies management is bullish that strong fleet asset growth will re-lever the business.

Valuation

There are no specific fleet comps, but given the recurring revenue, high growth, and high ROA it seems reasonable that EFN should trade in a year at ~12x forward earnings or to $28 (including the PV of the Company’s tax asset).   Comps in the equipment financing vertical (CHW CN, CIT, MRLN, NEWS) currently trade ~ 10x forward earnings.

As a sanity check to a 12x multiple, using 12-14x for fleet management and 9-10x for equipment financing implies ~12x on a blended basis. (see below).

As a further sanity check, year end 2016 TBV will be ~$9 and 2017 ROTE will be ~20%, as such it seems reasonable EFN should trade near 2.2-2.4x TBV plus the value of its tax asset.

Due to accelerated depreciation from the company’s rail business and PHH acquisition benefits, Element will not pay cash taxes for 12 years.  Using the current GAAP tax bill over the next 12 years, at a 6.5% discount rate, management calculates the PV of the deferral at $4.65 per share.  I use a more conservative 10% discount rate which calculates the value of this asset at ~$4.00 per EFN share.

If the market ascribes no value to this asset and values just off of reported financials, there is still good upside in the stock.  12x 2017 EPS and $0 for tax value implies a $24 stock or 60% upside from here.

The Company reports in Canadian currency, but 70% of its assets/revenue/pretax income is generated in the US.  The Company’s guidance of $1.61 in after tax EPS in 2016 was predicated on the CAD/USD exchange rate as of June 2015, which has since depreciated by 12%.  As such, there may be an uplift to numbers via currency alone (which is not explicitly included in my model above).  I am explicitly modeling around $1.93 in EPS in 2017 but I use $2.00 in the above tables to account for this likely uplift from currency (which I think may be conservative).

There is further upside in that Element is only currently levered at 4.7x per its tangible leverage ratio.  The Company believes the business can operate at closer to 6.0x.  This will be achieved with some combination of organic growth, M&A, or capital return.  As you can see, as the Company achieves its target 6.0x over time, it is highly accretive to EPS and value. (see below).

Catalysts

·         new organic growth wins

·         execution of synergies in the GE deal

·         reaching targeted leverage ratios, either via organic growth, M&A, or capital return

·         executing additional M&A

·         sale of C&V Canada (1q 2016)

·         potential increase in 2016 guidance (due to customer wins, currency, recent ABS deal)

·         continued funding of ABS deals at attractive rates

Risks

·         Historical track record at Newcourt.   In the mid-1980s, Element's management team founded Newcourt Credit Group, an equipment finance company that grew to be a leading industry player with $36 billion in assets before its distressed sale to CIT in 1999.  Newcourt was sold for a distressed price, as the company was not match funded (it was borrowing short and lending long) and disruptions in the capital markets at the time negatively impacted its ability to fund.  The funding profile here at Element is entirely different (better), so it appears to me this time around management has learned their lesson. 

·         Funding.  Element has traded particularly poorly along with other non-deposit funded financials of late, due to a seizing up of the levered loan and high yield markets and general spread widening in funding markets.  I think I addressed this in the funding section well enough, but just to reiterate EFN just did a super cheap ABS deal that was 2x oversubscribed (smack in the middle of the weak funding markets), but most importantly this is a company that was routinely funding ABS during the financial crisis.

·         Canadian listed company in a bad Canadian tape. The mitigant here is the despite the Canadian listing, this is a 70% US company, and offers Canadian investors one of the few ways to invest in a Canadian listed company that has mostly US exposure (and also therefore implicitly short $CAD). 

·         Rail slowdown/rail credit.  Addressed in rail section.

Catalyst

new organic growth wins, execution of synergies in the GE deal, reaching targeted leverage ratios (either via organic growth, M&A, or capital return), executing additional M&A, sale of C&V Canada (1q 2016), potential increase in 2016 guidance (due to customer wins, currency, recent ABS deal), continued funding of ABS deals at attractive rates