Element Fleet Management: A Menu of Interesting Preferred Stocks (OTCMKTS: ELEEF)

Element fleet management (OTC:ELEEF) is a dual listed company (Canada and United States). All item figures are in CAD unless otherwise stated.

Presentation of the business model

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 spanning the entire fleet lifecycle, from fleet acquisition, fleet acquisition financing, fleet management while in use and disposal of the fleet. The added value of Element is to reduce the total cost of ownership of a vehicle (i.e. it is cheaper to let the expert do it than to manage the fleet in-house). Simply put, Element makes money in two ways:

Net interest margin – It earns a net interest margin on financing the acquisition of the fleet, similar to all other lenders. On the interest income side, Element collects lease payments from customers who have acquired vehicles with money borrowed from Element. On the interest expense side, Element initially uses its senior credit facilities as a source of temporary funding and then taps the ABS market to release the senior credit facilities. This lending business model requires that customers stay current on their lease payments and that financing remains adequate and inexpensive. Given that two-thirds of Element’s loan book is in high-quality clients and the long-term yield is so low, I think both of those conditions will hold true.

Service revenue – Element provides essential services to its customers, including vehicle acquisition, fuel management, telematics, maintenance and repair and finally vehicle remarketing. Most of these services are essential for Element customers. For example, a cable company needs vehicles for its technicians to travel. However, acquisition and remarketing activity is slowing in light of COVID-19 as customers delay capital expenditures. The compensating factor is that as the life cycle of the vehicle is extended, Element is able to charge maintenance revenue for a longer period.

Source: Q1-2020 Presentation

Overall, I’m very confident in Element’s survivability due to its business model and customer credit profile. Below, I attempt to show that even in a drastic scenario, preferred stock dividends have broad coverage.

Preferred dividend coverage

I use a simplified cash profit model to forecast Element’s free cash flow for the next few quarters. I deliberately used overly pessimistic assumptions to test Element’s ability to maintain preferred dividends.

Net interest income – I assume the loan portfolio goes into liquidation model for the rest of 2020 and decreases by 5% each quarter until the end of 2021. I assume the net interest margin drops to 2.75% and there rest. The decline in net interest margin should indirectly reflect credit losses.

Service revenue – I assume a 10% drop in service revenue quarter over quarter for 2020 and a 5% drop for 2021 to model a drastic drop in vehicle recycling (i.e. replacement of the old fleet by a new fleet).

Syndication revenue – Element Fleet syndicates some of its origination to third-party lenders and charges a fee for this work (you can think of it as the fee when a mortgage broker completes a mortgage origination). Since the wallet is a run-off model, I just eliminated this source of income altogether.

Opex & Taxation – I have just flattened all the declared expenses of Q1-2020. In reality however, if the portfolio shrinks significantly, the management team will reduce the cost base. I assumed a cash tax rate of 10%.

Net cash income – pre-tax cash income, subtract the tax and add back the amortization and depreciation (D&A) expense as this is a non-cash expense.

Return on capital / (call for equity) – This requires a little explanation. Basically, every time Element makes a loan, it creates a financial asset. To match this (and balance the balance sheet), additional debt and equity is needed to fund this asset. You cannot finance the asset with 100% debt, as this will eventually push the debt-to-equity leverage ratio to an unsustainable level, so you must allocate equity. When the loan portfolio is growing, there is a call for equity (cash out) and when the portfolio is in run-off, there is a return of capital (cash in). The assumed debt advance rate of 90% means that each loan of $100 was funded by 10% equity, which also means that for every loan repayment of $100, $10 of equity is returned to Element.

Take advantage of free cash flow – the net cash result subtracting the capex, then taking into account the return on capital / equity call aspect of the loan portfolio.

As you can see, even in this draconian scenario, Element’s preferred stock dividends are comfortably hedged at nearly ~3.4x by the end of 2021. Again, if economic reality gets as bad as I’m guessing here, management can do a lot cost-wise to keep cash flow generation going.

Below is what I think is a reasonable base-case scenario – the portfolio run-off stops by the end of 2020, but remains stable in 2021 (i.e. assuming that there is no quick rebound). In this (still somewhat bearish) scenario, coverage remains above 5.1x.

Source: Q1-2020 FS, author’s estimate

Institutionalize the capital structure

One of the disadvantages of investing in preferred stocks is that there is no expiry date, so investors are stuck with an illiquid security that could trade below par forever, in theory. While I don’t assign a high probability to this, I believe Element will eventually redeem these preferred stocks and replace them with more institutional securities like investment grade bonds.

These series of preferred shares were issued under the previous management team in a major acquisition. Selling preferred stock to retail investors was a quick way to raise permanent capital without diluting the common shareholding.

Source: Company FY 2019, TMX Money

Recently, Element issued its inaugural US$400 million 3.85% bond, the proceeds of which were used to retire the US$567 million 4.25% convertible debenture, another sell-focused security. retail in Canada that was issued to fund acquisitions under the previous management team.

To be clear, the CEO never said he intended to redeem the registered preferred shares and the 6.0x debt/equity leverage target will prevent the company from redeeming the preferred shares (because the Preferred shares are counted as equity, redeeming them will increase the leverage by definition). However, it looks like the CEO will continue to “mature” Element’s capital structure when conditions allow, offering patient investors a capital gain.

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