Description

Element Financial will spin its lower multiple commercial finance business ECN Capital on October 3rd, leaving a pure-play, market-leading Fleet Management business that’s growing the top line 8-10% organically, and is trading at an implied 8-9x P/E multiple. Post separation, I expect the pure-play Element Fleet business to see multiple expansion to ~14x. Applying a 0.75x P/BV multiple to the spinco’s $3.95 in BV, I get a price target of $20, for 44% upside from the current price of $13.83.

Element stock was most recently written up on VIC by compass868 in an excellent and very thorough report in January 2016, so this write-up is going to be very short, focusing only on what has changed and the value that can be unlocked by the upcoming spin.

The primary catalysts for the multiple expansion at Fleet will likely be (i) the separation from the commercial finance business,  which significantly cleans up the story, and (ii) a credit rating upgrade, which should be known as of the separation date. Fleet’s credit rating is expected to be increased to a single-A rating, allowing them to use an extra 1.5 turns of leverage, which should lift the ROTE ~4-5% to 20-25% (1.5x the 4.0% ROA less tax).

In summary, Element is cheap, very unloved, and has upcoming catalysts that should unlock value. The primary risks are the USD-CAD currency exposure and a management team that has been perceived to be deal junkies.

Events from the last year:

1. Closed on the GE Fleet acquisition- Element closed on the GE Fleet transaction on 9/30/15. They’ve been focused on integrating that acquisition, and they have increased their original cost synergy target of $90m to $100m. Sources of those cost synergies were: (i) a cost  of funds reduction with a second investment grade rating on the BS; (ii) cost synergies from procurement savings from OEMs and part suppliers, and additional and incremental rebates from the OEMs ($55-60m from cost savings); and (iii) operational savings from rolling two offices and senior management teams into one.

2. Tried to get a single A credit rating- Element started down the path of trying to secure a further level of ratings increases on the basis of ratings that other fleet companies had achieved in the past (they have a BBB+/BBB rating with a stable outlook but they want a single A rating). The ratings agencies reportedly indicated to Element that getting a single A credit rating would be difficult without Fleet being a stand-alone company.

3. Did a strategic review- They did a strategic review and looked at selling the Canadian commercial finance business, but the initial offers weren’t compelling. They then reached out to their key partners (life insurance companies and other institutions), who discouraged them from selling. Element management says their funding partners like having exposure to these finance assets because they provide diversification from other asset classes, and they also get attractive capital relief under these funding structures.

4. Decided on a separation- They concluded that they should do a separation of the Fleet business and the rest of the business. Originally, they planned to include the Rail assets with the Fleet business because the rail assets have the tax shield, and they thought that Fleet would need that to shield their fee income. However, they set up an Irish tax shelter, and now Fleet will only have a tax rate of 22-25%.

5. Decided to make Fleet a pure play- Because of the low tax rate provided by the Irish tax shelter, Element decided to keep the Rail assets with the ECN Capital business, as they’re a better fit there. Also, with Element Fleet as a pure play, credit rating agencies are more likely increase Fleet’s credit ratings.

6. Infor Acquisition announcement- Management unexpectedly announced in late July that post separation, ECN Capital would be acquiring all of the outstanding shares of Canadian SPAC Infor Acquisition Corp, in a 100% share exchange deal. Infor shares are to be valued at net cash per share, and ECN Capital shares are to be issued at fair market value. This transaction is essentially a capital raise for ECN Capital that is supposed to put a marker on the stock at the $3.95 in BV per share. The closing is conditional on the fair market value of ECN Capital shares that Infor holders are receiving “being in the range of approximately equity net book value”. My base case is that this deal does not get done, as I’m assuming only a 0.75x P/BV ratio in my valuation. However, given that the majority of the value here is in the Fleet business, changes in the P/BV multiple are not very impactful to the valuation.

Valuation:

Taking the ECN Capital BV out of the current stock price ($13.71-$4=$9.71), and applying the $1.20 in EPS that Fleet should earn in 2017, the market is implying an 8x P/E for Fleet (or a 9x implied P/E if you assume a P/BV multiple of 0.75x for ECN Capital).

Element Fleet Management is the market leader in a sticky industry, the business is experiencing 8-10% top line growth, and it’s trading at an implied P/E of 8-9x. For perspective, this is ½ of the 17x forward P/E multiple of the S&P 500, for a company that is growing revenue at 1.5x the rate of the index (Fleet at ~9% vs ~6% for the S&P 500). The 8-10% top line growth at Fleet is comprised of leasing revenue organic growth of 5-7%, and service fee revenue organic growth of ~12%. This seems way too cheap.

Applying an 11x P/E for the leasing business, my 14x target P/E implies a 16x P/E for the service fee component of Fleet’s income stream, which doesn’t seem overly demanding for a recurring revenue stream with double digit top line growth. Given that Element Fleet should get (i) a credit rating upgrade, (ii) be able to use more leverage, and (iii) see ROTE expansion, that multiple should re-rate higher post separation.

My quick valuation assumes a 0.75x P/BV multiple for ECN Capital ($4 x 0.75x = $3), and a 14x P/E for the Fleet management business (market leader, growing EPS 10% / yr and has a 22-24% ROE). So that’s 14x EPS of $1.20, or $16.80 for Fleet. Adding the $3 in value for ECN Capital, I get ~$20 in total value, for 43% upside.

Risks:

Currency risk as Element gets the majority of its earnings from the US (~70%) and reports in CAD.

Management risk as Element management has historically been perceived by the buyside as deal junkies.

EPS risk at ECN Capital as they execute their transition to an asset management model.

Catalyst

The separation from the commercial finance business,  which significantly cleans up and de-risks the story.

A credit rating upgrade for Element Fleet, which should be known as of the separation date of October 3rd 2016. Fleet’s credit rating is expected to be increased to a single-A rating, allowing them to use an extra 1.5 turns of leverage, which should lift the ROTE ~4-5% to 20-25% (1.5x the 4.0% ROA less tax).