Description

Quick Thesis: Element Fleet Management is a Canadian-listed vehicle fleet management company (#1 market share in N. America) that has >50% upside in roughly 12 months based on a 13x forward P/E ratio. This is a high quality business with strong organic growth because of a sticky product, long-term outsourcing trends, and growing demand for asset-light data-based services, with massive scale benefits vs. competitors and in-house solutions. This opportunity exists because of an overhang caused by a non-core business that great new management is exiting and merger integration failures. The new CEO has recently completed a strategic review, announcing a large cost cut program along with an equity offering necessitated by the implosion of that non-core asset. Pro forma for the offering, the stock is trading for 7.9x – 8.3x 2020 target run-rate Adj. EPS, vs. 9.8x for its closest comp, ALD. Unlike EFN, ALD carries residual value risk in its business and has historically high risk now due to European diesel exposure caused by the emissions scandals that have plagued European OEMs. EFN should trade for 13x+ 2020 target run-rate Adj. EPS by end of 2019 given it is a superior business with great new management and HSD long-term EPS growth.

Company Overview:

• EFN is the #1 player in the North American outsourced fleet management business. The company buys corporate vehicle fleets, financed by ABS with cost of debt <3%, and then rents those fleets to corporate customers at a ~270bps spread. EFN takes no end-of-lease residual value risk in the bulk of its core business.
• Customer base is primarily Fortune 500 U.S. companies – the top 25 customers represent ~37% of earning assets and customers are diversified across industries. North America generates 90% of core business revenue with the bulk of the remainder in Australia & New Zealand (note that EFN is based in Toronto and reports in CAD). Use cases include cable technician trucks, pest control technician trucks, HVAC distributor trucks, etc.
• The company is the product of a roll-up that culminated in the acquisition of GE’s U.S. fleet management business in 2015 – most of the non-fleet assets were spun-off in 2016. For additional information, there are two historical VIC write-ups on the pre-spun entity.
• Prior management botched the integration of the PHH and GE fleet assets, which led to numerous large customer losses in 2016 and 2017 despite structural industry tailwinds. Customer growth resumed in 2018 as a result of best-in-class efforts initiated by new management. As these customer losses were occurring, EFN largely abandoned efforts to achieve merger cost synergies, which were originally given a C$90-100M expected range.
• EFN has #1 market share in a fairly consolidated industry where the two largest players are ~60% of the outsourced market and multiple players including the #2 player are family-owned:
  • 

How does EFN CN make money?

• ~40% of net revenue is from corporate fleet leasing (a spread business)
  • In the core business, the customer bears 100% of residual value risk, so credit losses are ~0% and will be ~0% through cycles (EFN sells the vehicle at the end of the lease and then credits or debits the customer on the next regular invoice for the full amount of the residual value gain or loss). This excludes Australia & NZ. Customer bankruptcies are rare (over half of EFN’s customers have investment-grade ratings), but when they do occur, these obligations are among the quickest to be paid if the bankrupt business is to be a going concern. Even in Chapter 7 liquidations, losses will still be minimal as many of the vehicles in a fleet have positive equity associated with them. Credit losses were 0.00% in 2009 and 0.08% in 2011, the year of the Circuit City liquidation, which had been a large customer.
  • The business is sticky with a ~97% normal customer retention rate (customers typically sign multi-year contracts and largely renew without going to market).
  • There are clear scale advantages: financing costs (EFN is a large and regular auto ABS issuer with AAA-rated senior tranches) and bulk discounts from manufacturers (EFN is among the largest customers of Ford, GM, and many auto parts companies in the United States).
  • This business benefits from inflation, i.e., customers lease more expensive vehicles, generating more interest income and depreciation mark-up, while active contracts are indexed to EFN’s funding costs, although there can be short term negative impacts as prices reset monthly or quarterly.
  • For EFN and the industry, corporate fleet leasing should grow GDP + 1-2% (driven by continued outsourcing tailwinds).

• ~60% of net revenue is from services sold to primarily the same customer set as above – this includes administrative services as well as maintenance, fuel, etc., and a quickly growing telematics / data analytics service line
  •  Services are growing HSD - LDD in the industry at large given tailwinds around data collection and analysis, and continued outsourcing tailwinds (e.g., we spoke to a customer that still does their safety program in-house but will add that to their contract scope).
  • Roughly 3/4 of EFN’s current net services revenue has a nearly 100% attachment rate, while the other 1/4 is more discretionary (e.g., outsourced safety programs, telematics, etc) and is growing faster than corporate fleet leasing due to increasing attachment rates and increasing average spend per attached customer.
  • For EFN, in the near term, services should grow ~100bps faster than corporate fleet leasing growth as management prioritizes cost cuts and excellence in its core activities but concurrently benefits from structural tailwinds. Longer term, services has the potential to grow even faster. 

New CEO:

• Jay Forbes was announced as CEO of EFN in May 2018 (started June 1). Forbes is a highly respected CEO with a strong track record and the share price was up 23% on the news (and is higher since).
• Forbes’ track record includes a 22% IRR as CEO at Manitoba Telecom Services (56% TSR from 1/1/15 to 3/21/17 acquisition) – Forbes slashed costs at an underperforming subsidiary (Allstream) and sold it, cut costs at the core business, cleaned up the balance sheet including quickly cutting an unsustainable but cherished dividend, and sold the business to a larger competitor (BCE).
• After joining EFN, Forbes quickly replaced the CFO and COO, effectively ending the legacy (“Element Financial Corporation”) management culture at EFN.
• Forbes is highly aligned with shareholders. He currently owns C$8.5M of stock exposure (including buying ~C$1M with his own money) and is eligible to earn >C$11M more if the price increases 50% from here excluding further equity grants and cash compensation. That is in all likelihood a material part of his net worth, although it’s worth nothing that he did earn at least C$5 million at MTS.
  • 

• Our reference checks on Forbes have been very positive. Jay Forbes is an admired, ethical, extremely data-driven, and decisive CEO who builds performance-oriented organizations.

Strategic review & cost cutting program:

• The company announced a C$300M equity offering at a 1.5% discount to Oct. 1 closing price that will close on Oct. 11 (with a C$45M greenshoe) concurrent with the conclusion of the new CEO's strategic review, the key outcomes of which are as follows:
  • 2020 Adj. EPS will be C$0.90 – C$0.95, inclusive of pre-tax profit improvements below plus very modest organic growth
  • C$120M cost cutting program (on a LTM 6/30/18 base) that has already been partly delivered and will be at full run-rate by EOY 2020
  • C$30M revenue assurance program also through EOY 2020 on a LTM 6/30/18 base (i.e., billing systems not matching current customer contracts)
  • $360M after-tax impairment of 19^th Capital Group asset and planned divestment/run-off of all non-core assets
  • 40% dividend cut and implementation of a DRIP at a 2% discount
  • Affirmation from key ratings agencies of investment grade issuer status (important to maintain low cost of ABS funding)

19^th Capital:

•  To summarize the historical context of 19^th Capital, prior management made the mistake of venturing into a bad business with a bad partner, and we are pleased to see new management exit it. We are especially pleased to see Jay Forbes, a self-described “fixer”, resist the urge to throw good money after bad, going a long way in earning our trust in his capital allocation abilities.
• Forbes has taken the required step of aggressively writing down the carrying value of EFN’s economic interest in 19^th Capital Group, its non-core Class 8 truck leasing JV with Celadon Group. In conjunction with this, EFN is acquiring Celadon’s stake in the business for a nominal consideration.
• The C$480M pre-tax writedown impairs EFN’s tangible equity as calculated by its lenders and ratings agencies by C$360M (C$120M DTA creation).
• To put this writedown into context, EFN invested C$1.0B into this venture at the end of 2016, so has written down ~75% of its investment within two years.
• EFN will consolidate this now wholly-owned asset with an equity value of C$260M, and run off the leased truck portfolio over the course of 36 months.
• The pro forma capitalization of 19^th Capital includes roughly C$250M of third party debt, which appears to be secured by specific trucks (vs. senior security on the whole truck portfolio, thereby greatly reducing risk of EFN needing to take any further impairments). Assuming that there are only ~8,000 trucks remaining in the portfolio and modest NWC, this leads to a carrying value of ~US$45,000 per truck, which roughly approximates the current wholesale liquidation value of the portfolio based on truck age disclosures and public auction data. A well-executed run-off should generate higher net proceeds.
• To execute the run-off, Forbes has hired key lieutenant(s) from the team that turned around MTS Allstream, which was largely a cost cutting story.
• In summary, we expect EFN to successfully pull out its C$260M equity in this asset over the course of a 36-month run off, effectively reducing 19^th Capital to negligible consideration. That equity will be reallocated to higher ROIC opportunities in the core business. Furthermore, we conservatively expect cumulative run-off net income over 36 months to approximate a paltry, but positive C$15M.

Valuation Discount & Catalyst:

• Management has issued guidance of C$0.90 – C$0.95 of Adj. EPS in 2020, which includes only run-rate achievement of its C$150M cost cutting and revenue assurance programs by the end of 2020, offering another ~5 cents of EPS in 2021 in addition to HSD organic growth. The stock is therefore trading for 7.9x – 8.3x 2020 target run-rate Adj. EPS. EFN should trade for 13x+ 2020 target run-rate Adj. EPS within 12 months, offering >50% upside.
• The best comp (ALD) trades for 9.8x 2020 P/E (Bloomberg consensus). However, ALD takes residual risk on all of the vehicles that it leases, something EFN does not do. ALD has historically high residual value risk now due to European diesel exposure caused by the emissions scandals that have plagued European OEMs. EFN is a more defensive business with higher EPS growth opportunities going forward: EFN should grow EPS at least HSD long-term (MSD net revenue growth + LSD operating leverage + ~1% contribution from preferred equity leverage). For further context, the S&P 500 Financials Sector Index trades for 12.3x NTM P/E, and EFN should re-rate at least to that level given its relative profile of organic growth, credit risk, and return on tangible common equity.
• This discount to fair value today is due to uncertainty around 19th Capital Group and related equity dilution risk (now resolved) and hangover effects from aforementioned self-inflicted execution errors in late 2016 through early 2018.
• There is >50% near-term upside as management executes on its core business initiatives (cost cuts and revenue growth), the stock re-rates to a sector-premium multiple, where it traded prior to self-inflicted wounds, and shareholders continue to collect dividends (in form of cash or stock).
• There is further upside if, upon completion of a majority of the cost cuts and with no signs of revenue deterioration, a natural buyer with low cost of capital acquires the business well above 13x P/E (e.g., Canadian pension plan or Japanese bank). 

Key Risks:

• Recession causes fleets to shrink and customers to cut back on the discretionary portion of services spend
• Renewed customer attrition in core leasing business
• Failure to keep up with technology improvements in services side of the industry, leading to market share losses to non-traditional competitors and low revenue growth within services
• Price war leads to spread compression within fleet leasing
• Failure to execute on cost cuts
• FX (bulk of revenue in USD but reports in CAD)

Catalyst

• Management executes on its core business initiatives (cost cuts and revenue growth)