Description

Element Fleet Management Corporation (TSX: EFN)

Element Fleet Management Corporation (TSX: EFN) was written up by HTC2012 nearly two months ago and we agree the Company has considerable upside potential over the next 12 months. Since HTC2012’s write-up, Element’s valuation has become even more compelling as the stock is down ~20% from its November highs.  

Executive Summary:

Element is a Canadian listed global fleet management company with upside potential of ~60%-75% from our base case valuation, and ~90%-100% from our upside case valuation.  Over the past six months, Element completed an overhaul of the Company resulting in a new senior leadership team, a refreshed strategic operating plan ($150 million profit improvement program), and an improved balance sheet (equity raise, JV restructuring) which should pave the way for margin improvement, earnings growth, and multiple expansion in 2019.

The Company is currently trading at ~7.5x Element’s 2020 adjusted operating earnings per share forecast of $0.90-$0.95.  We believe with continued execution and restored investor confidence, Element’s multiple should re-rate to 12x-13x earnings and trade at a premium to its peers based on the following attributes:

• Global market share leader in a counter cyclical industry

• Long tenured, highly integrated customer base creates “Sticky” customer relationships – 95% customer retention rate

• Element’s leasing structure results in the Company not bearing residual risk on its North American leased fleet assets (90% of portfolio).

• Company takes virtually no credit risk - Investment-grade credit rating reflects superior asset quality (A-, BBB+). Element is much less sensitive to economic fluctuations as evidenced by the 0.0% of credit losses from 2008/2009

• Large greenfield opportunity to grow revenue organically- estimated that ~80% of the fleet management industry is ran in-house representing opportunity for Element to take share by providing productive/reliable service at significantly lower costs than in-house managers

• Element’s services business has high recurring revenue components which should be valued at a much higher multiple than a leasing-only company

• Improved balance sheet with better capital position after equity raise (includes the prefunding of most of the 2019 convertible maturity)

• Large deferred tax balance enabling Company to pay limited cash taxes for years

• New senior leadership team with renewed focus on operational improvements and ROIC focused investment in the business with a strong track record of executing turnarounds

• Potential for other strategic alternatives: we believe the sale or spin of the Australian / New Zealand business could happen; additionally, the possibility of separating the Company into lease co / service co (multiple arbitrage opportunity)

• Potential for high-profile customer wins / announcements;  we know that Element landed Amazon as a customer earlier this year (which the Company will not comment on but the industry has confirmed Amazon Sprinter Order).  Details beyond the initial 19,000-20,000 vehicles would be just guesses, but considering the customer, the potential for this becoming a significant, mega-sized account is very possible

As Element continues to execute on its profit improvement plan we believe the Company should trade between 12x-13x 2020 adjusted EPS, representing a price range of $11.40 - $12.35 as a base case. We assessed our upside case using a SOTP valuation and arrive at a price range of $13.55 - $14.25 by assigning a higher multiple to the services side of the business (due to our belief that a standalone services business should trade at a premium to a financial (leasing) company).

Company Description:

Element is the largest publicly traded fleet management company in the world boasting market leadership in North America and industry leading positions in Australia and New Zealand. The company helps corporate clients finance and manage their fleet of company cars and trucks by offering a variety of services including, but not limited to, vehicle acquisition, title, registration and delivery, fuel management, maintenance services, and telematics. In addition to providing the lease financing and service offerings, a fleet management company’s goal is to both minimize the cost of vehicle ownership and maximize the productivity of this critical asset for clients.

Element’s core business is split between the services and financing segments. The financing segment is the corporate leasing business in which Element taps the ABS market, purchases vehicles, and then leases them to their customers, earning a spread on the transaction. The Company’s ability to assess the ABS market provides Element with extremely attractive financing rates.  Element then offers an assortment of services to their customers that cover a variety of issues that may arise during the term of the lease. The service revenue is a combination of recurring monthly fee income that is billed on a per vehicle basis along with ongoing transactional fees that are frequent in nature (i.e. fuel card revenue). Generally, the term of the lease contracts are 3-5 years, while the services contracts are most likely renewed on an annual basis.  Another beneficial aspect of the business model is that if a leasing customer decides to leave Element for a competitor that customer will remain an Element client until the vehicles under management reach the end of their lease contract. The lengthy, cumbersome process of switching fleet managers makes the industry (as a whole) quite sticky in terms of customer retention.

Through our diligence efforts we learned that there is an extremely low percentage of lease-only customers (less than 3%), and in fact 93% of Element’s customers are both leasing and services customers.  Customers currently use on average about 3-4 services and Element’s goal is to further cross-sell their service offerings to drive higher margin business from existing customers. The chart below illustrates the economics of adding one additional service per customer.

One of the unique aspects of Element’s business model (and North American fleet leasing in general) is that the Company does not bear residual risk on its North American fleet assets (roughly 90% of the entire portfolio). These lease agreements are structured as open-ended leases meaning the customer bears the residual risk and is responsible for the ultimate remarketing of the vehicles at the end of the lease term (although Element usually does remarketing for its customers for a fee). This gives Element a much lower risk profile compared to foreign competitors and other leasing companies who bear the residual risk at the end of the lease term. Additionally, Element has a diversified customer base with more than two thousand clients in five countries. Their customer profile is spread across a variety of industries including cable and telecom, electrical/energy services, and agriculture to name a few.

Over the past few years Element has invested a great deal in its telematics platform in order to develop connected vehicle capabilities. The telematics platform coupled with their multi-decade customer relationships has resulted in Element owning massive amounts of fleet data. Part of the Company’s strategy is to leverage the data related to their portfolio of fleet assets to provide greater benchmarking data, to create innovative data driven services, and provide actionable insights to reduce costs for their customers. It is our understanding that Element has yet to monetize this data.

In North America, Element’s competitors include ARI Global Fleet Management (2nd largest NA operator and private family owned business), Wheels Inc. (private), Enterprise, Donlen Corporation (part of Hertz), and LeasePlan (private). In Australia and New Zealand, Element competes with LeasePlan, SG Fleet, ORIX, Fleet Partners, Eclipx, and Toyota Fleet Management. As you can see by the chart below, Element is the largest global fleet manager with more than 1.7 million vehicles (ARI is not included in the chart since they are a private company and vehicle data is difficult to come by, HTC2012 estimated ARI has ~870k vehicles in NA).

The market for fleet management services is competitive however Element’s largest competitors are the “in-house” fleet managers. We estimate ~80% of the fleet management industry is ran in-house, representing a large greenfield opportunity for Element to grow revenue organically and take market share.  We believe most customer wins are in-house conversions rather than taking share away from a director competitor.

Attractive Industry Characteristics:

The fleet management industry itself is an inherently attractive industry. In general fleet vehicles are critical tools for enabling a corporation’s revenue generating activities and as a result are typically a “Top Five Spend” for an organization. Since these vehicles are mission critical assets (cars, trucks) for a corporation’s sales, service, and management personnel, organizations will continue to run (and stay current on payments) their fleet vehicles even in a Chapter 11 situation.

Furthermore, the industry is expected to grow over the next few years, has high barriers to entry (particularly related to the balance sheet requirements), very low cost of funding, high customer retention rates (Element’s 95% retention rate vs. industry average 97%-98%), and limited cyclicality. The mission critical nature of a customer’s fleet vehicles also result in extremely low levels of charge-offs.

Why this Opportunity Exists:

Element began an aggressive expansion strategy in 2012 to grow its business and build scale in the fleet management industry. The Company was effectively a roll-up strategy led by Steve Hudson (who has a controversial track record including his previous roll-up Newcourt).  Element spent more than $10 billion on acquisitions (including assumed debt) between 2012 and 2016 to expand its presence in North America and expand into the Australian and New Zealand fleet management markets. The acquisition spree consisted of purchasing four fleet operators, most notably PHH’s fleet management business and the North American and Australian/New Zealand fleet business of GE. In early 2016 Element announced they would be separating the fleet management business and the legacy commercial and vendor finance business into two separately traded entities (EFN & ECN).

The roll-up strategy gave Element commanding market share but came at a considerable cost due to management’s inability to effectively integrate the acquired companies leading to some notable customer departures throughout 2017. At this time the Company also began experiencing issues with its 19th Capital joint venture which caused management to write down and take impairment charges to the underlying portfolio of class 8 trucks. These issues coupled together, resulted in the Company missing its Q2 20017 earnings guidance. As Element’s stock performance languished in late 2017 rumors began to swirl that activist investors Marcato and Sachem Head were pressuring Element to sell the company (whose activist efforts likely started much earlier in the year). The activist pressure resulted in management announcing a strategic review process (we believe the strategic review process was legitimate however highly flawed as the customer attrition issues, 19th Capital JV disclosures, and earnings misses during the process made it extremely difficult to execute a transaction).

The transaction integration issues culminated on February 5, 2018, when Element hosted a corporate update call revealing that CEO Brad Nullmeyer would be retiring, the Company anticipated adjusted operating earnings would be down 3%-5% in 2018, a large customer would be ending their relationship with the Company, and that Element had concluded the strategic review process and determined the best course of action was to remain independent. This announcement led to an immediate 30% drop in the stock price as a result of the combination of “bad news” and event driven investors pouring out of the stock. When the Company announced its full-year 2017 numbers in March the stock took another 25% hit as a result of ongoing issues with problematic their non-core JV assets and concerns that liquidity could become a concern if the balance sheet continued to be impacted by write-downs. In summary, Element’s stock price dropped a combined 51% between the beginning of February and the end of March because of the issues outlined above.

As a result of the collapse in share price, Element was targeted by a group of activist investors after the Q4 earnings call.  On May 14, 2018, Element announced the Company had reached a settlement agreement with investors which allowed EdgePoint Wealth Management, Lion Point Capital, and Ancora Advisers to each nominate a director to Element’s board and replace two legacy directors (including Steve Hudson). Along with the settlement announcement, Element named a highly experienced and successful turnaround executive, Jay Forbes, as the Company’s CEO effective June 1, 2018.

Element since June 1, 2018:

Jay Forbes was chosen to lead Element based on his experience leading restructuring and turnaround efforts at previous companies. These roles included:

• President and CEO of Manitoba Telecom Services, where he designed and executed a customer-centric strategy that created $1.1 billion in shareholder value

• President and CEO of Teranet Inc., a world-leading developer where he developed an information services growth strategy to yield billions in high-margin revenues

• President at Ingram Micro Inc., where he successfully restructured the business to improve profitability at the onset of an economic recession

• President and CEO / CFO at Aliant Inc., where he repositioned the business to become the second largest regional telecom services provider in North America, delivering $2 billion in shareholder value

Jay has been tasked with cleaning up the “self-inflicted” blunders of the legacy management team including the problematic 19th Capital JV, customer attrition issues, and the failure to properly integrate previous acquisitions. Since becoming CEO, Jay has made significant changes to senior management, seemingly stabilized customer attrition, brought on BCG and Barclays to complete an end-to-end strategic assessment of the business, and announced the results of that assessment in early October.

The strategic assessment focused on meaningfully improving financial performance, strengthening and de-risking the Company’s balance sheet, and positioning the business for future growth. The highlights of the Company’s strategic plan are listed below:

• Element strengthened its investment-grade balance sheet through a $300 million equity offering via a bought deal transaction that was oversubscribed 2-3x

• The Company agreed to purchase the remaining interests in the 19th Capital JV with plans to undertake an orderly run off / liquidation of the JV’s assets over the next 36 months

• In conjunction with this initiative, Element recognized an after-tax charge of approximately $360 million in the third quarter reflecting a write down of the carrying value of its remaining investment in 19th Capital

• Post write-down 19th Capital will have a book value of $260 million. The Company expects to recoup the remaining book value (including $100 million expected to be recovered by the end of 2019)

• Element will undertake a series of concrete actions to “improve the customer experience” and generate an estimated $150 million in run-rate pre-tax operating income improvements by the end of 2020

• The $150 million plan further breaks down to $120 million of cost, procurement, and operational improvements, as well as $30 million of revenue enhancements. The Company stated that half of the $120 million portion will be in the form of cost cuts. However, we believe most of the $120 million will be either cost cuts or cost of goods reductions.  A significant portion of the $120 million will be in the OpEx line with a portion showing in Services related COGS

• The profit improvement plan is expected to be realized as follows: $40 million in 2018 ($30 million has already occurred); $100 million by the end of 2019; and the full $150 million in 2020

• The Company will initiate a clear accountability plan, including a transformation management office run by a leading global consulting firm that will bring focus, support and accountability for the duration of the program, as well as regular reporting to track performance

• Additionally, Element provided initial after-tax adjusted operating income per share guidance in the range of $0.90 to $0.95 for fiscal year 2020, which is a full year number, not a run-rate

Valuation:

• Legacy valuation overhang has been addressed (19th Capital resolution removes a critical impediment to market multiple)

• EFN should trade at a premium to peers based on the reasons outlined at the start of this report

• We believe Element’s “real” peer group should be a combination of its fleet management peers along with other high margin services-only businesses; ultimately, we expect Element’s multiple to re-rate to 12x-13x earnings

Peer Group:

The lack of a “true” peer group does hurt Element in our opinion.  At times it seems to track the fates of rental / leasing companies like Hertz, Ryder, and Avis.  Yet we would argue that it shouldn’t trade with that group due to Element’s superior business model and better risk profile.  We also acknowledge that Element’s business shouldn’t be valued liked pure-play technology/payments processors. ALD is probably the closest “real” publicly traded comp, however their business is primarily in Europe and includes a significant component of vehicle sales (as unlike Element, ALD bears the risk of remarketing its fleet leases).  It was unfortunate that LeasePlan cancelled its scheduled IPO (in October) as that would have created a 2nd major global player in the fleet management space (and LeasePlan’s initial valuation appeared quite attractive).

Sum of the Parts (SOTP):

• We used a SOTP valuation method to value the leasing and services business separately

• The services business carries higher margins and is recurring in nature and therefore we believe should be valued at a higher multiple than the leasing business

• Our upside case indicates Element’s fair value could be in the $13.55-$14.25 price range, and is primarily based on valuing each business (service and lease) separately

• We used a simple split of earnings based on the revenue mix between the two offerings.  This could be conservative as the Services business is higher margin and more than likely represents more of the overall earnings mix than the proportional revenue split

• For the Services business we used the services peer group detailed above (which includes a mix of services / payments businesses). For the leasing multiple of 11x-12x, we looked at a range of bank multiples with market caps between $1-$3 billion

Additional Valuation Considerations:

• We estimate the Australian / New Zealand business (Custom Fleet) could be valued between $600 - $700 million (CAD$) if the Company were to consider selling or spinning it

• It is our understanding that the Custom Fleet business generates ~$60 million of adjusted operating earnings; with the valuation of Australian fleet managers decreasing over the past 6 months, the overall valuation opportunity is less than it was a few months ago, which may be giving pause to Element transacting the asset today

• Although $60 million of adjusted annual earnings is certainly material to Element, the business has different risks than Element’s North American operations as Custom Fleet does bear the liability of remarketing its leased vehicles.  Additionally, the Australian economy in general appears to be far more at risk than that of US/Canada at this point

• Having only recently concluded an unsuccessful strategic process makes the likelihood of a near term sale of the Company unlikely; however, there are several items that should be considered:

• Jay Forbes track record is to turnaround and sell companies.  He has not been one to stick around for the long-term, and although he has never said anything that we are aware of that would indicate he plans to try to sell Element as well, his career pattern and age (as well as that of his CFO Vito Culmone) leads to a strong likelihood of an eventual sale here as well

• As mentioned earlier, the failure of the previous strategic process was probably far more likely an outcome than a successful ending based on the numerous issues that plagued the Company during the process itself.  The 19th Capital revelation alone at the start of the process was beyond damaging.  Our point is that once management executes its strategic plan and proves that the Company is not only stable but actually growing again, attempting another process should result in a dramatically different outcome

Conclusion:

• Element’s balance sheet has been de-risked with the additional capital from the $300 million equity raise

• The problematic 19th Capital JV has been brought in house and will be ran-off/liquidated over the next 36 months. The value of that asset has been written down so much that it will not affect Element going forward

• Element has shown progress on the customer retention front by adding new customers in each of the last two quarters

• Element provided initial 2020 adjusted EPS guidance in the range of $0.90 to $0.95 reflecting margin improvement and confidence they can achieve the $150 million of costs by FY 2020

• With a clear strategic plan laid out, coupled with a strengthened balance sheet and credible operational improvement plan in place, we expect investor focus to turn to execution over the next 12 to 24 months

• We believe the new senior leadership team, a refreshed strategic operating plan (equity raise and cost cutting program), and a de-risked balance sheet should pave the way for margin improvement, earnings growth, and multiple expansion in 2019

Risks:

• Further customer attrition issues

• Full $150 million of profit improvement plan not realized resulting in the Company not being able to achieve its 2020 adjusted EPS guidance

• Meltdown of the Australian economy

• Although we believe the Company will be able to withstand a recession far better than most companies (industries), during recessions the ABS market tightens significantly creating risk for Element should it not be able to use other means of financing to conduct its business

Catalyst

Catalyst:

• Demonstrated progress on cost cutting program leading to multiple re-rating based on 2020 adjusted EPS of $0.90 to $0.95

• Potential sale of Australian business

• Separation of Lease Co. and Services Co.

• Sale of the entire Company (long-term catalyst)