Element Fleet Management: A Smooth And Quality Ride For The COVID Era

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Tulpenmanie
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Summary

  • Element Fleet Management is a market leader in the fleet management space, which is a $20B industry in the U.S. and Canada alone.
  • Element is in the business of managing corporate fleets on behalf of small and large businesses; in doing so Element saves its customers money and helps simplify their day-to-day operations.
  • Element competitive advantage comes from its massive scale, which allows it to save its customers 15-20% from a total cost of ownership perspective.
  • Biz model is highly resilient to economic cycle: 80% of Element's vehicles are service vehicles (think vans and trucks) with a good percentage being deployed to provide essential services.
  • With a market cap of ~$5B the business is currently selling for 10x LTM free cash flow (10% yield); significant upside remains from earnings growth and multiple appreciation.

*Note all figures mentioned in this article are in Canadian Dollars unless otherwise noted

Element (OTC:ELEEF) is a high-quality business, led by a strong management team with a long runway for growth. The company has exhibited strong resilience to the impacts of COVID-19 thanks largely to its high-quality customer base and the "essential" nature of the fleets it manages. Element has an attractive financial profile and trades at a very reasonable multiple of cash flow (10x). At its current share price, investors would be able to compound their capital at 10-15% on an annual basis for the next 5-10 years.

Business Model Explained

Element is in the business of leasing vehicles primarily to small, medium, and large businesses. These vehicles are the trucks, vans, and cars used by businesses to conduct their everyday business.

For example, the vehicle used by your local cable company to transport the company representative to your location is likely to be leased by Element. Another example would be the Mercedes-Benz Sprinter Crew Van used by Amazon (AMZN) as part of their distribution network.

Element makes money from its customers across two revenue streams being leasing/syndication and servicing income. As of the most recent quarter, these revenue streams were split roughly 50% / 50%.

The leasing/syndication piece is more straight forward and relates to the leasing income earned by Element for leasing the fleets to its customers. As of the most recent quarter, across its fleet, Element generated a leasing yield of ~6.5%, which was offset by interest expense of 3.2% equivalent to a net interest margin of 3.3%. In effect, Element is leveraging its low cost of capital, which is due to its massive scale, investment-grade balance sheet, and high-quality diversified customer base.

The servicing income revenue stream relates to re-marketing the vehicles (e.g., selling them in an auction), maintenance, fuel, telematics, etc. Due to Element's massive scale, it is in a position to negotiate much better prices across the various costs that go into owning a vehicle. Element in turn passes on these cost savings to its customers creating a "win-win" value proposition. In effect, Element has created a network of servicing partners that view Element as a key customer. A few facts to highlight include: (1) Element is Ford (F) and GM's (GM) biggest customer. This allows Element to get some of the lowest prices on new vehicles in the industry, low prices which its customers would not be able to obtain on their own and (2) Element has guaranteed slots at auction houses and "preferential status" allowing it to get the best prices when auctioning its customers used vehicles. It is important to note that for the vast majority of Element's customer contracts, Element earns a "flat" re-marketing fee that is unrelated to the price achieved at auction. In other words, the residual value risk remains with the customer and is not borne by Element. Re-marketing has been noted by management as the biggest component of servicing income.

Source: Element Fleet company filings

Brief Note on Company History

Prior to the appointment of Jay Forbes as CEO on June 1, 2018, the previous Element management team had made a string of poor acquisitions that led to a significant decline in the earnings power of the business. Jay Forbes was brought in due to his extensive experience as a turnaround artist. Since his arrival, he has meaningfully streamlined the business, sold-off non-core assets, driven accountability throughout the organization, and is in the process of successfully executing on a transformation plan that is expected to deliver ~$180M of cost savings and revenue enhancements creating significant value for shareholders in the process.

Customer Profile

Element's focus is to convert the fleets of blue-chip companies utilizing fleets in their everyday business. Other competitors focus on lower-quality companies, but Element has an extensive underwriting/review process to understand the credit quality of its customers. Approximately 65% of Element's portfolio is considered investment grade based on the credit quality of the customers. Customers are diversified across 700 sub-industry classifications and 5 geographies (the U.S. representing the majority of assets); additional detail on customer industry classification below:

Source: Element Fleet investor presentation

Competitive Landscape

Element's key competitors include companies such as ARI, Wheels, Enterprise, Donlen, and LeasePlan; the industry is highly consolidated consisting of only a handful of players with the majority of the market share.

Element is the only publicly traded competitor in the group

As per the chart below, Element is one of the largest players in the industry with a fleet size dwarfing several of its competitors:

Source: AF research department

Management Team (CEO)

As mentioned, Jay Forbes joined the company on June 1, 2018, as CEO. Forbes was previously with Manitoba Telecom Services, where he created $1.1B of shareholder value before selling the business to BCE (BCE). Based on listening to several quarterly earnings calls, it is clear to me that he is a thoughtful and meticulous operator and capital allocator and his positive impact on the business can be clearly shown. The company has set out a clear business plan and has executed and often exceeded its financial targets. Forbes is also a significant shareholder having recently purchased 100K shares in the open market.

He has also developed a strong management team around him putting the right people in the right roles to drive the best possible client experience. I believe the client-centric obsession across the management team is serving to create the right corporate culture, positioning Element for success in the marketplace.

Finally, we like that Forbes has highlighted his focus on organic growth opportunities as opposed to pursuing risky M&A transactions.

Quality of Business

In my view, Element is a high-quality business due to the following characteristics:

Highly Recurring & Predictable Revenue Streams: The leasing portion of the business is recurring and predictable. In most cases, customers have contracts for several years with Element and Element has maintained a 95%+ retention rate among its customers.

Sticky Customer Relationships / Switching Costs: Based on management commentary, once customers decide to outsource their fleets to Element, they typically don't ever go back to being insourced. The nature of the asset and relationship translate into high switching costs and thus low turnover. Element has a near 95% retention rate.

Limited Threat of Disruption: It would very difficult to disrupt Element's business model. The only threat of disruption would be the advent of autonomous vehicles that would limit the number of vehicle accidents and hence the revenue Element earns in its servicing business line. However, this doesn't represent a sizable portion of Element's revenues and would likely take many decades to fully materialize.

High Barriers to Entry: As the image below shows, Element's business model has significant barriers to entry due to the sheer number of partnerships and scale that the business model requires. There hasn't been a new fleet management business startup in the last 40 years.

Source: Element Fleet investor presentation

Highly Cash Generative Financial Profile: Element's business generates strong returns on equity and requires limited capital expenditures. The stability of the business model allows the company to utilize credit facilities to finance its leasing assets. These factors coupled with the company's attractive operating margins (50%+) make the business highly cash generative.

Financial Profile

Cash Flow

Element is a highly cash-generative business due to its attractive margins and limited capital expenditure requirements.

($ in millions of CAD) 2017 2018 2019
Before-Tax Adj. Operating Income $467 $387 $514
Add / (Less) Cash / Non-Cash Adjustments (34) 25 74
Cash Flow from Operations $432 $413 $588
Sustaining Capital Investments $61 $40 $41
Preferred Share Dividends 41 44 44
Cash Taxes Paid 41 41 46
Free Cash Flow $290 $287 $456
Weighted Average Shares Outstanding 385.400 391.659 434.805
Free Cash Flow / Share $0.75 $0.73 $1.05
Growth (%) (2.4%) 43.0%

Income Statement

The business experienced a 14% growth in revenue and 26% growth in adjusted operating income per share in 2019. Prior periods have been excluded due to the lack of comparability to the business today.

(in millions of CAD) 2018 2019
Originations $6,492 $7,852
Growth (%) 21.0%
End-of-Period AUM $15,699 $16,710
Growth (%) 6.4%
Net Revenue
Net Interest Income & Rental Revenue $802 $851
Growth (%) 6.0%
Interest Expense $405 $445
Growth (%) 10.1%
Net Financing Revenue $398 $405
Growth (%) 1.9%
Servicing Income, Net $455 $493
Growth (%) 8.3%
Syndication Revenue, Net $12 $90
Growth (%) 652.9%
Total Net Revenue $865 $988
Growth (%) 14.2%
Operating Expenses
Salaries, Wages & Benefits $327 $314
% of Revenue 37.8% 31.8%
General & Administrative Expenses $127 $113
% of Revenue 14.7% 11.5%
Depreciation & Amortization $24 $40
% of Revenue 2.8% 4.0%
Adjusted Operating Expenses $478 $467
% of Revenue 55.3% 47.3%
Adjusted Operating Income $387 $521
% of Revenue 44.7% 52.7%
Provision for Taxes Applicable $70 $95
After-Tax Adjusted Operating Income $317 $426
Cumulative Preferred Share Dividends $44 $44
After-Tax Adj. Operating Income (Common) $273 $381
Weighted Average Shares Outstanding 391.659 434.805
After-Tax Adj. Operating Income per Share $ 0.70 $ 0.88
Growth (%) 25.8%

Source: Created by the author based on publicly available filings

Balance Sheet

You may notice that the business has a high amount of leverage, but given Element's business model involves leasing vehicles, it is important to distinguish the debt tied to the assets being generated and the actual "corporate debt".

As of March 31, 2020, Element has $12.4B in "borrowings" but of that $12.4B figure, only $1.7B consists of corporate debt and $740M in convertible debentures.

By adding back the interest expense on the corporate debt and convertible debentures, Element LTM leverage ratio is approximately 3.8x EBITDA.

The remaining debt is borrowings tied to the vehicles that are being leased. This debt is non-recourse to Element and is secured by the vehicle itself.

Management has made a commitment to continue to delever the balance sheet and is targeting a leverage ratio of 6.0x by year-end. This will be achieved by paying down the corporate debt and convertible debentures (beginning with the debentures).

(in millions of CAD) 2018 2019 Q1 2020
Assets
Cash $22 $24 $91
Restricted Funds 504 434 542
Finance Receivables 13,204 11,987 12,451
Equipment under Operating Leases 2,162 2,101 2,017
Accounts Receivable & Other Assets 409 220 228
Derivative Financial Instruments 35 41 94
Property, Equipment & Leasehold Improvements 61 142 146
Intangible Assets 854 793 847
Deferred Tax Assets 411 441 463
Goodwill 1,302 1,246 1,341
Total Assets $18,964 $17,430 $18,220
Liabilities
Accounts Payable & Accrued Liabilities $707 $925 $992
Derivative Financial Instruments 68 39 119
Borrowings 13,271 11,893 12,399
Convertible Debentures 897 712 716
Deferred Tax Liabilities 45 48 46
Total Liabilities $14,989 $13,617 $14,272
Equity
Total Shareholders' Equity $3,975 $3,813 $3,948
Weighted Average Shares Outstanding 391.659 434.805 437.291
Book Value:
Book Value / Share $ 10.15 $ 8.77 $ 9.03
Tangible Book Value / Share $ 4.64 $ 4.08 $ 4.02
Credit Quality:
Finance Receivables Past Due (%) 0.14% 0.16% 0.16%
Allowance for Credit Losses as a % of Receivables 0.07% 0.07% 0.16%
Tangible Leverage Ratio 7.8x 7.1x 7.5x

Source: Created by the author based on publicly available filings

Return on Capital

Element generates attractive returns on equity (~11.8% as of Q1 2020) and the efforts were undertaken by management to improve the cost structure should continue to drive ROE expansion going forward.

Element ROE Source: Element Fleet investor presentation

Growth Runway

  • Over the last 2 years, the business has been primarily focused on driving cost savings as opposed to origination/revenue growth
  • Beginning in 2021 and notwithstanding the impacts of COVID-19, the Element management team believes they can grow revenue at 4-6% annually, which should translate to ~10% of earnings and cash flow growth.
  • There is a clear path for Element to grow its revenues as there is $2B of revenue opportunity simply by converting in-house fleets to managed fleets. This compares to Element's revenue of $988M.
  • Other areas of growth include the growth of existing fleets. For example, the growth in e-commerce is driving the growth of delivery fleets, which Element is also benefitting from.

Source: Element Fleet Investor Presentation

Valuation & Return Profile

At its current share price of $11.24, Element is trading at 10.4x its LTM levered free cash per share of $1.08. Adding the run-rate impact of the $180M in cost savings ($130M of which have already been reflected), would add an additional $0.11 in free cash flow per share.

Source: Created by the author based on publicly available filings

Based on the quality of the business, I believe a 15x free cash flow multiple is more appropriate than the current multiple of 9.2x.

Taking a 3-year view on the business, assuming no growth in cash flow in 2021 and two years of 10% cash flow growth, by applying a free cash multiple of 15x, I arrive at a target price of $22.60, which represents 127% upside from the current share price.

Stock Price $11.20
Date 8/1/2020
Basic Shares Outstanding 436.5
Dilutive Shares 5.5
Diluted Shares Outstanding 442.0
Market Capitalization $4,950
(-) Cash & Equivalents $64
(-) Value of Tax Assets ($412)
(+) Net Debt $1,774
(+) Convertible Debentures $152
(+) Preferred Shares $699
Enterprise Value $7,227
Free Cash Flow per Share:
LTM $1.08
Free Cash Flow Yield (%):
LTM 9.7%

COVID-19 / Investment Risks

It goes without saying that like many businesses Element's earnings power will be impacted by COVID-19, but is important to remember the following facts that in my view, play to Element's favor:

  • For the vast majority of Element's customers, the fleets utilized are core to their everyday operations. Even if business owners are seeing a deterioration in their own business due to lower business activity, that won't necessarily translate into a reduction in the size and utilization of fleets.
  • Even in the event of bankruptcy among Element's customers, many of the fleets are essential to the business operations and will continue to be utilized
  • In the worst-case scenario, Element can recoup its principal by selling off the vehicles; in many cases, the value of the vehicles is in excess of the principal
  • During the GFC, Element experienced less than 10 bps of credit loss (as a % of financial receivables) and has provisioned 20 bps in Q1 2020

In summary, Element takes on very little "financial risk" on behalf of its customers.

Final Thoughts

In summary, Element is a high-quality business led by a strong management team with a long runway for growth. In my view, it is exactly the kind of business one can own comfortably for several years on auto-pilot. The shares remain attractively valued since at its core Element is an unexciting business that is also not straight forward to understand. Only investors who take the time and effort to appreciate the characteristics of Element's business model and the tailwinds that exist in the industry can fully appreciate the investment opportunity and become excited about owning a stake in the business.

This article was written by

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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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