CA - Element Fleet Management: Defensive Force For A Portfolio

Summary

• Element Fleet Management offers an end-to-end fleet management service that lowers the total cost of fleet operations for clients.
• Clients' mission-critical fleet vehicles are constantly in use and regularly replaced, driving robust recurring service revenue for EFN.
• These characteristics make EFN a solid defensive stock in this uncertain economic environment.
• EFN's preferred shares are interesting opportunities, given the management wants to retire them at their next redemption dates.

Situation Overview

Element Fleet Management ( EFN:CA ) is the largest pure-play fleet management company in the world with dominant market positions in the US, Canada, Mexico, and Australia & New Zealand. The value-add of a fleet management company is mainly twofold. First, for the clients who don't want to invest the initial capital to own the vehicles outright, EFN acts as the middle person and leases the vehicles to the clients. In this capacity, EFN earns a net interest margin between the interest it pays on its funding source (typically the ABS market and its credit facilities) and the lease payments from its clients. This service is somewhat of a commodity service as the lowest funding cost wins, but EFN's competitive advantage is the scale and the diverse, high-quality client base, which creates a virtual cycle. Second, from the client's perspective, the lease payment is the least of their concerns - operating and maintaining a fleet of mission-critical vehicles is the bigger headache, and this is where EFN comes in. EFN offers end-to-end fleet management services so that not only its clients can focus on their core expertise, the total cost of fleet operation is lower.

What Makes EFN Defensive

At a high level, what makes EFN defensive is the fact that EFN's base business is embedded in its clients' day-to-day core operations. For example, telecom technicians are driving around all day to perform installations or troubleshooting, so the vehicle would be considered mission-critical. Therefore, while the growth prospective partially depends on the capital cycle, EFN's base business shouldn't be cut back significantly in a recession. Additionally, in a recession companies will look to cut costs. Companies that are currently self-managing their fleet could save money by outsourcing to firms like EFN. Companies that don't benefit from their own fleet scale, they might be better off cutting back on the headcount in this area and giving EFN to handle the fleet management operation. Lastly, EFN effectively manages its risk rate and credit risk in its leasing operation (evident during the COVID period) and the base business has not been affected by the volatile interest rate movements and credit events experienced by its clients.

Growth Opportunities

The outgoing CEO has done a wonderful job refocusing EFN on operational excellence. This has resulted in EFN's ongoing stealing of market share from its competitors. In addition, converting the self-managed segment of the market is a long-term tailwind for growth. We could see this play out meaningfully going through a recession as companies look for ways to reduce expenses. Finally, the ongoing electrification of fleets could provide another growth avenue as companies look for guidance on best practices.

Valuation

EFN is guiding 2023 free cash flow of $1.45-1.50/share, this puts EFN at ~7.6% FCF yield. This is very subjective but I think the yield is too high. EFN operates a capital-lit model with a +50% operating margin, in a defensive industry with multiple growth avenues (the management is guiding 6-8% net revenue growth and double-digital annual free cash flow per share growth). Moreover, EFN shareholders get the best of both worlds - I have no doubt that EFN will come out of a recession as a better company. However, coming out of a recession, I think EFN's free cash flow could accelerate from a pickup in lease origination, so shareholders won't be left behind in an economic recovery. As the business throws off a lot of excess free cash flow, shareholders will be rewarded with continued dividend growth and share buyback.

Preferred Shares Are Still Interesting

I've highlighted these preferred shares before . In short, these preferred shares were put in place by the previous management team when they were making large acquisitions and needed a quick way to fund. These relatively very expensive preferreds no longer make sense as part of EFN's capital structure (especially given the investment grade status), and EFN has been redeeming them (two out of the five series so far). The series A, C and E are redeemable at $25/share on December 31, 2023, June 30, 2024, and September 30, 2024, respectively. Investors can generate 6.5-8% unlevered returns with very high certainty of redemption. To give a sense of how expensive these preferreds are, the spreads are all north of 450 basis points while EFN can tap the investment grade market at ~150 spread. Also, the combined face value of the preferreds is merely ~CA$370 million.

Conclusion

EFN is a solid defensive force for a portfolio - it offers mission-critical service that saves clients' money and the steady execution of its strategies will ensure EFN is a better business in the future than today. The stock is offering, in my opinion, excess free cash flow yield for the defensive characteristics and growth potential. The preferred shares are a good place to hide given the high certainty of redemption and acceptable rate of return.

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