Description

Investment Thesis

This is a chance to buy a great business that services Amazon’s fleet of delivery vehicles, along with thousands of other customers, at an incredible price. The opportunity exists because Element has a near-term problem – it can’t get enough product to meet demand. But, this is a short-term issue only and Element’s record backlog will soon translate into solid earnings growth that will likely capture a higher valuation multiple. Free cash flow per share is expected to decline 3% in 2021, but then increase 37% by 2023, resulting in the stock trading at an 11% free cash flow yield for a company that should grow its top-line at 4-6% organically and its free cash flow per share by double-digits.   

Business Overview

Element is a leading commercial vehicle fleet management business that provides comprehensive servicing and financing. Element’s offerings include vehicle acquisition and disposition, maintenance, licensing, registration, and driver support activities. In short, Element handles all aspects of managing a vehicle fleet and eliminates an in-house administrative burden, so customers can focus on their core competencies.

The company provides a critical service to a fragmented customer base, with no more than 3.5% exposure to any one industry. In total, Element serves over 5,500 clients, including Amazon, in over 700 industries, such as telecom services, electric utilities, pest control, and pharmaceutical preparations and delivery. Element’s core customer focus is on larger fleets of at least 300 vehicles with a strong leaning towards fleets of 1,000+. 80% of its sales are from North America, where it is the market leader.

Business Model

Element makes money in two ways: through servicing revenue and financing revenue. Each bucket contributes about 50% to total sales.

Servicing revenue is generated on a per vehicle, or fleet, basis. It’s driven by a client’s vehicle usage and includes routine maintenance, collision management, fleet telematics, and fuel plans. These fees are attractive because they are recurring, are mostly aligned against variable costs, and are capital-light.   

Financing revenue is generated from customers who choose to lease vehicles from Element. In this relationship, Element pays the OEM for the order and, upon delivery of the vehicle, a lease is activated and the client is billed for both servicing and financing. For the duration of the lease, that vehicle is a net earning asset on Element’s balance sheet.

Larger clients, like Amazon, that have access to attractive financing often choose to fund the vehicles themselves. These clients generate servicing revenue, but no financing revenue. For smaller clients, it makes sense to leverage Element’s lower cost of capital. These clients generate both servicing revenue and financing revenue.  

High-Quality Business

Element is a high-quality and resilient business that generated a 15.7% pre-tax return-on-equity for the year ended 3Q21. Element’s competitive advantage is tied to its scale and broad servicing network, which results in purchasing power, driving down the total cost of ownership for its clients.

Element’s outsourced services are sticky, recurring, and easy to understand. The nature of the company’s relationships with clients translates into high switching costs and very low turnover. Element’s historical average retention rate is 98%.

Element also has low credit risk – both from residual value exposure and customer default risk. In North America, it takes no residual value risk on the assets it manages, including those on its balance sheet. Any asset gains or losses are contractually passed through to the client, creating a predictable and stable earnings stream. With respect to customer default risk, even in the company’s worst years, during the Global Financial Crisis, Element realized just 10bps of annual credit losses (as a percent of finance receivables).

The business model was durable through the pandemic. The company manages mission-critical assets for a diverse set of customers, whose businesses are heavily dependent on their fleets. In this environment, fleets of delivery vans, utility services trucks, and vehicles transporting samples for lab testing, to name a few, are as important as ever. This allowed Element to increase its ROE from around 14.5% in late 2019 to near 16% today.

In addition to being a good business, Element generates healthy free cash flow, which routinely exceeds reported earnings. The main reason for this is that cash tax requirements are lower than accounting tax treatment. This is a benefit because it allows Element to grow while also throwing off excess free cash flow that can be used for share repurchases.

And, as mentioned in response to the previous question, the company has historically realized low default rates and takes no residual value risk in its main market, North America. These attributes allow Element to perform well through the economic cycle.

Competition

Most of Element’s addressable market is still controlled by entities that self-manage their fleets. This is an opportunity, as 55-65% of the addressable market is still insourced and I expect Element to continue to convert these organizations to outsourced fleet management.

The industry is rational with an oligopolistic structure. Within outsourced commercial fleet operators, there are only two primary competitors. Both companies are much smaller than Element, which controls about 40% of the outsourced North American commercial fleet. The largest competitor is ARI, which is privately owned, and is about half the size of Element. The second largest competitor is an Apollo-owned entity, Wheels/Donlen, that is slightly smaller than ARI.

Over the past two years Element has picked up some market share as its competitors chose to cut costs during the pandemic, which negatively impacted customer service. Those market share gains have been small at less than 1%. Yet, that speaks to the stickiness of the business as contracts typically last 3-5 years and switching costs are high, especially for large fleets that have expiring leases on a revolving basis.

Valuation

On a five-year forward basis, I believe that Element can generate C$2.15 per share. Historically, the Canadian market has traded at about 9x five-year forward earnings and using that multiple, I think the stock is worth approximately C$20 per share, which results in ~60% upside to intrinsic value. 

Element’s near-term earnings growth is being stifled simply because it cannot source enough vehicles. Orders have been strong, which has driven Element’s backlog to a record C$2 billion, above the average backlog of around C$800 million from 2018-2020. Thus, I expect Element to deliver significant growth in 2023, as deferred revenue, operating income and cash flow are recovered from backlogs.

In the current year, free cash flow per share is expected to decline 3% because of these supply chain issues. But, as vehicles are procured over the next two years, I expect 11% growth in 2022 and 23% growth in 2023.

Growth

Longer-term, I expect Element to grow its top line by 4-6% and its bottom line per share by 10%+. Sales growth is driven by three primary sources: 1) converting self-managed fleets to outsourced fleets, 2) increasing service penetration - or share of wallet - with existing clients, and 3) taking market share from other fleet management companies. On top of this growth, Element should be able to modestly expand operating margins over time, as it continues to increase scale, and then use capital allocation to achieve double-digit profit growth.

Element’s balance sheet is healthy, so it can use excess cash flow to make share repurchases. Over the past year, Element has bought back 5% of its market cap and I expect buybacks to continue.   

While I expect healthy long-term growth, as mentioned in the previous response, Element is facing supply chain issues that are hampering growth in the short-term. Because of this, Element’s top-line is only expected to grow low-single-digits in 2022, before accelerating to near 10% growth in 2023.

Management

Management’s track record has been exceptional. In May 2018, Jay Forbes was appointed CEO. After a detailed assessment of the business, he announced a Transformation Plan in October 2018. As part of this plan, the company achieved C$200 million of cost reductions/efficiencies, strengthened the balance sheet, and divested its lower-quality truck-financing business.

The company is now in a great position to grow, and management is focused on aggressively pursuing organic revenue growth, advancing its capital-lighter business model that will enhance ROE, and growing free cash flow per share. 

The CEO is an excellent leader and communicator. Each quarter, he writes a shareholder letter that clearly outlines the company’s strategic vision, while being honest and transparent about both the current challenges and opportunities. It’s an easy-to-understand update that, frankly, I don’t see from many companies, but wish I did.

Challenges / Opportunities

I am keeping a close eye on the transition to electric vehicles. I see the gradual electrification of automotive fleets as both a threat and an opportunity. Today, electric vehicle penetration in Element’s US/Canada business is just 0.09%, but it is expected to grow over time.

Certain parts of Element’s business, like fuel programs and engine repairs, will be disrupted, but in general I think the value proposition of fleet management increases over time with more logistics support around installing and managing charging stations, telematics, and more. This is likely to shift more of Element’s customers to total fleet management. 

While electric vehicles require less maintenance in general, the major areas of work for Element—brakes, tires, and glass—will be unchanged. EV’s, equipped with advanced driver assist or autonomous vehicle capabilities, may result in lower collisions, but 80% of accidents occur when a vehicle is parked, which should persist. I think these negatives are minor when compared to the opportunity for Element to provide more total fleet management to its customer base.

Catalyst

FCF per share growth