Element Fleet Management: A Menu Of Great Preferred Shares
Summary
- Element Fleet preferred shares is a very safe way to achieve 7-8% yield plus some upside.
- Element's business model and customer credit profile mean that it can sustain the dividend even in a draconian scenario.
- The CEO wants to "institutionalize" its capital structure so over time I expect the preferred shares will be redeemed at par.
Element Fleet Management (OTC:ELEEF) is a dual-listed (Canada & US). All figures in the article are in CAD unless noted otherwise.
Business Model Overview
After a series of transformational acquisitions by the previous management team, Element is now the largest fleet management company in North America and Australia/New Zealand. Element provides a suite of services that spans the entire fleet lifecycle, starting from the acquisition of the fleet, the financing of the acquisition of the fleet, management of the fleet while in use, and divesting the fleet. Element's value-add is to lower the total cost of vehicle ownership (i.e. it's cheaper to let the expert do it vs. managing the fleet in house). Simply put, Element makes money in two ways:
Net Interest Margin - It earns a net interest margin on the financing of the acquisition of the fleet, similar to any other lenders. On the interest income side, Element collects lease payments from clients who acquired vehicles with the money borrowed from Element. On the interest cost side, Element initially uses its senior credit facilities as a temporary funding source, and subsequently taps the ABS market to free up the senior credit facilities. This lending business model requires that customers stay current on their lease payments and the funding remains adequate and low-cost. Given that the two-thirds of Element's lending book is with investment-grade clients and the long-term yield as low as it is, I believe these two conditions will remain true.
Service Revenue - Element provides essential services to its clients including vehicle acquisition, fuel management, telematics, maintenance & repair and finally vehicle remarketing. Most of these services are essential to Element's customers. For example, a cable company needs the vehicles for their technicians to drive around. However, the acquisition and remarketing activities are slowing down given COVID-19 as customers delay their capital expenditures. The offsetting factor is that as the vehicle lifecycle is prolonged, Element is able to charge maintenance revenue for a longer period of time.
Source: Q1-2020 Presentation
Overall, I feel very confident about Element's survivability due to its business model and client credit profile. Below I attempt to show that even in a draconian scenario, the preferred share dividends have ample coverage.
Preferred Dividend Coverage
I'm using a simplified cash earnings model to forecast Element's levered free cash flow for the next few quarters. I used overly pessimistic assumptions on purpose to stress test Element's ability to sustain the preferred dividends.
Net Interest Income - I assume the lending portfolio goes into run-off model for the remaining 2020 and shrinks by 5% each quarter until the end of 2021. I assume the net interest margin to drop to 2.75% and remains there. The net interest margin drop is to indirectly reflect credit losses.
Service Revenue - I assume 10% drop in service revenue quarter-on-quarter for 2020 and 5% drop for 2021 to model a drastic drop in vehicle recycling (i.e. replacing old fleet with new fleet).
Syndication Revenue - Element fleet syndicates part of its origination to third-party lenders and charges a fee for this work (you can think of it like the fee when a mortgage broker completes a mortgage origination). Since the portfolio is run-off model, I just completely eliminated this revenue source.
Opex & Tax - I just flat-lined all the Q1-2020 reported expenses. In reality though, if the portfolio is drastically shrinking, the management team will scale down the cost base. I assumed a 10% cash tax rate.
Cash Net Income - cash income before tax, subtract tax, and add back the deprecation and amortization expense (D&A) as it's a non-cash expense.
Capital Return / (Equity Capital Call) - This requires a little explanation. Basically whenever Element is making a loan it's creating a financial asset. To match this (and to balance the balance sheet), incremental debt and equity are required to fund this asset. You can't fund the asset with 100% debt because that will eventually push the Debt/Equity leverage ratio to an unsustainable level, so you need to allocate some equity capital over. When the lending portfolio is growing, there is an equity capital call (cash outflow) and when the portfolio is in run-off, there is a return of capital (cash inflow). The assumed debt advance rate of 90% means that each $100 loan was funded by 10% equity, which also means for each $100 loan repayment, $10 equity capital is returned to Element.
Leverage Free Cash Flow - cash net income subtracting capex, and then taking into account the capital return / equity capital call aspect of the lending portfolio.
As you can see, even in this draconian scenario, Element's preferred share dividends are comfortably covered close to ~3.4x by the end of 2021. Once again, if the economic reality becomes as bad as I'm assuming here, the management can do a lot on the cost side to maintain cash flow generation.
Below is what I think a reasonable base-case scenario will be - portfolio run-off stops by the end of 2020, but remains stable in 2021 (i.e. assuming no quick bounce back). In this (still somewhat bearish) scenario, coverage remains above 5.1x.
Source: Q1-2020 FS, Author's estimation
Institutionalize The Capital Structure
One downside of investing in preferred shares is that there is no terminal date so investors are stuck with an illiquid security that could be trading below par forever, in theory. While I don't assign a high probability to this, I believe Element will eventually redeem these preferred shares and replace them with more institutional-like securities like straight investment-grade bonds.
These series of preferred shares were issued under the previous management team when they were making large acquisition. Selling preferred shares to retail investors were a quick way of raising permanent capital without diluting the common shareholder base.
Source: Company FY2019 FS, TMX Money
Recently Element issued its US$400 million inaugural bond at 3.85%, with proceeds used to retire the $567 million 4.25% convertible debenture, another retail-oriented security in Canada that was issued to fund acquisitions under the previous management team.
To be clear, the CEO never said that he intends to redeem the preferred shares on record and the 6.0x debt/equity leverage target will prevent the company from redeeming the preferred shares (because preferred equity is counted as equity, redeeming them will increase the leverage by definition). However, it feels like the CEO will continue to "mature" the Element's capital structure when the situation allows, providing the patient investors with some capital gain.
This article was written by
Analyst’s Disclosure: I am/we are long ELEEF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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