Description

Summary: Element Fleet Management (Bloomberg: EFN CN) is an increasingly capital-light, 99% gross retention business services company masquerading as a balance sheet financial. It’s a $6.5Bn USD market cap listed in Canada (for now) covered by Canadian financials-focused sell-side analysts. Capital light Services are responsible for the slight majority of sales and grew 15.5% organically in constant currency in 2023. We expect similar (likely 1-2% lower) Services growth annually for the next 3-5 years. Non-Services revenue has been and should continue enjoying mid-single digit organic topline growth. Adjusted operating margin is 55%, and incremental margins have averaged 75% over the past 5 years. The balance sheet is conservatively financed. The stock trades at 14.7x our 2024 Adj EPS and 11.8x our 2024 FCF/sh estimates, respectively. We expect a) mid-teens EPS growth for the foreseeable future and b) the company to eventually receive a consolidated NTM P/E multiple of ~18x. As a result, our spot estimate is a low-20s 5-year IRR (EPS growth x modest dividend yield x modest annual multiple expansion).

More Detail:

Element Fleet Management is a fleet management company (FMC), meaning it serves as an outsourced manager of fleet vehicles for large enterprises. FMCs act as aggregators for any kind of service a fleet would need, including procurement, management, maintenance, and selling vehicles at the end of their useful life. FMCs handle all transactions, allowing customers to consolidate their operations and contracts into a single point of contact. Because of the FMC’s scale, customers tend to get materially better pricing than if they were to contract for all these services independently. Additionally, the FMC provides analytics and best practices consultations. In exchange, customers pay the FMCs recurring management fees and volume-based service fees. In addition, FMCs commonly provide a financing function, whereby the FMCs own the vehicles and lease them to customers. Financing vehicles was core to Element’s historical model, but the company began moving to a more capital light model in recent years where it reduces its financed vehicle mix and increasingly syndicates out financed assets (but keeps the related recurring management fees). Element generates a Net Interest Margin on the financing business and matches assets and liabilities to mitigate rate/duration risk. While difficult to parse out via the company’s current financial disclosure, we estimate 35-40% (and shrinking) of profit is derived directly from its balance sheet with the remainder generated by high margin, very capital light service and management fees.

Element is responsible for 1.5m vehicles, of which ~850k are “service only” (i.e., vehicles are owned by the customers) and ~600k are “service and finance.” Roughly 70% of the company’s business is in U.S. (62%) and Canada (5%) with the remainder from Mexico (15%), Australia (13%) and New Zealand (5%). Element primarily caters to large (1,000+) service fleets with a focus on lightly upfitted vehicles. The North American market is roughly half penetrated by FMCs, and Element is the largest player with ~33% market share. The industrial logic behind the FMC value proposition is straightforward – scaled outsourced management has an insurmountable scale advantage that enables lower pricing from suppliers and best-practice insights. Amazon is Element’s largest customer but is <5% of sales. Amazon is referred to as “Armada” in Element’s filings. Our work strongly supported Element’s claim that it reduces total cost of fleet ownership by 10-20% while delivering higher vehicle uptime and streamlining the management process compared to self-management. Once embedded, switching costs are high and pricing isn’t a top customer priority.  As a result, Element’s gross customer retention is just shy of 99%.

We have been following Element closely for the past year. The puzzle piece on which we’ve spent the most time is the company’s growth runway – we’ve used several research pathways to triangulate (a) the size of the white space opportunity (i.e., large self-managed fleets) and (b) the odds and pace of self-management conversion. Element has ~1m vehicles under management in the U.S. and estimates they control roughly 1/6^th of the market (33% of the ~50% that is outsourced) – our work suggests the company’s framing is on the conservative side of reasonable and that half of its TAM remains unpenetrated. Working with a former industry executive, we used OEM-reported U.S. fleet vehicle sales data to build-up an installed base of vehicles in Element’s target market. We concluded the U.S. TAM is at least 6mm vehicles. By comparison, the industry executive who helped us with the analysis stated that he’s “90% confident the U.S. TAM is 10m+.” Separately, we worked with a third-party data provider to pull vehicle registration data for all commercial vehicles in the U.S. and this exercise suggested a U.S. vehicle TAM of 6-10m. This 6-10m is just a subset of the 30m+ commercial vehicles in the U.S. Most of the vehicles beyond our 6-10m sit in smaller fleets that we believe Element can potentially address over time as they automate their service offering and reduce their cost to serve.

Further to our constructive outlook on Element’s growth potential, we believe two recent developments should accelerate the transition from self-managed to FMC-managed in the coming years. First, the nascent transition to electric vehicles complicates fleet management and alters the resources & relationships required to effectively manage one’s fleet. Second, fleet operational challenges have spiked in recent years enhancing the FMC value proposition. Large customers – and Element is typically the largest customer – have been prioritized by OEMs and maintenance and repair service providers (i.e., EFN can provide its customers with preferred scheduling within its 60K strong supplier network).

Element discloses its vehicles under management, the key unit driver for its service revenues. On a headline basis, the most recently reported quarter suggests 0% vehicle growth y/y.  This is misleading and fails to highlight the underlying strength in Element’s service business. In 2023, Element exited a white-label agreement with a competitor that resulted in them shedding roughly 175k vehicles, carrying negligible revenue and profitability. Once adjusted for these vehicles, Element’s services business grew vehicle count by 13%. We estimate there’s another 20-25k negligible revenue generating vehicles to be shed in early 2024, after which the steady and healthy VUM growth will be more easily observable.

We believe Element’s Canadian listing, relatively short public market history, sub-optimal financial disclosure, and a deeply troubled asset integration from 2017 to 2019 that required a distressed fund raise and management upgrade are all reasons why the investment opportunity exists. [Note: our work suggests the company grew organically through the above-cited troubled integration despite NPS going meaningfully negative. NPS in 2023 was +41, and the company’s public target for 2024 is 50.] Further, Element is treated as a mostly balance-sheet heavy lender by the sell-side community. Nearly all analyst coverage is lumped together with Canadian banks. In reality, the majority of Element profits are derived from capital light service and management fees that require near-zero capital. A large portion of the company’s reported “interest income” is not directly tied to lending, but instead to management and origination fees, which are still earned on syndicated vehicles (i.e., vehicles moved off Element’s books). While the investment is mostly about the services business, importantly, we believe that the financing side of the business is much higher quality than a typical spread income stream because Element takes minimal credit risk as well as minimal duration and currency risk.

Credit Risk:

• Of its U.S. net earning finance receivables (i.e., vehicles on lease), 60% are tied to investment grade counterparties and 37% are B- through BB+.
• The receivables are collateralized by vehicles that are mission critical to the customer base.
• Element has limited residual asset value risk. ~75% of Element’s “hard assets” (i.e., financing receivables plus operating assets) come with zero residual risk upon disposal because gains or losses on asset sales accrue to the underlying customers per the “open-end lease” contracts. The remaining 25% relates to leases outside the U.S. and does bear residual risk. However, assets in these markets are typically close to fully depreciated by the time of disposal.
• Charge offs have been running at 1-3bps of the portfolio in recent years and were negligible during the GFC for the portion of Element’s business that we can cleanly observe during that period.

Duration & Currency Risk:

• As a policy, and by virtue of its ABS funding, Element matches currency, duration, and floating/fixed asset profiles with its funding.
• While there can be short term mismatches in rate resets, Element makes explicitly clear that they will match funding to lock in fixed spreads, and hedge when necessary to do so.

Finally, Element’s lease assets fully cover its outstanding debt – debt was 90% of interest earning assets at YE’23 – so arguably the high-quality services business that supports the vast majority of Element’s intrinsic value is unlevered.

As of March 12, 2024, we estimate that we own a business with high visibility and durable growth at 14.7x 2024 EPS and 11.8x 2024 FCF/share, respectively. On our 2025 numbers, Element is trading at 12.3x EPS and 9.8x FCF/share, respectively. We expect operating leverage and share repurchases to turn 9-10% annual organic topline growth into low double digit operating profit growth and mid-teens EPS and FCF/share growth for each of the next several years.

Important Disclosures: Certain funds and accounts managed by us and our affiliates are currently long EFN CN.  This document should not be the basis of an investment decision.  We may buy and/or sell shares of EFN CN in the future for the funds and accounts managed by us without notice, and we are under no obligation or agreement to take, or not take, any action or restrict our actions in any manner.  This is not a recommendation to buy or sell shares.  Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this investment thesis.  The information above is from public sources.  We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information.  We undertake no obligation to update any information below. Statements made in this document include forward-looking statements which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or believe,” or the negatives thereof or other variations thereon or comparable terminology.  These statements, including those relating to future financial expectations, involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.

Catalyst

• We aren’t playing for any particular catalysts, but we list three below. We expect shares to grind higher over time as EBIT a) mix shifts towards high multiple services income and b) predictably compounds at a low double digit annual rate for many years.
• Q1 Earnings Call: Like last year, we expect the company’s beat and raise pattern to begin with the first quarter earnings call. CFO on the Q423 call, “One is we have not revised our guidance. We've got one month of results under our belt here, and so we'll look at that when we get to our Q1 earnings.”
• Reporting: The company is converting to USD reporting starting Q124, which should clean up the financials a bit since the majority of the business transacts in USD. We also believe the company could take steps to make it easier for investors to understand the extent to which the company’s profits are derived from recurring, capital light services.
• US Listing: To be clear, the company has not made any statements stating it intends to list in the U.S. However, the recent USD reporting change combined with the company’s step to centralize various core functions in Ireland suggest to us the company is moving in that direction. They're also currently pursuing SOX compliance, which they expect to receive in 2H25.