DBRS Assigns Issuer Rating of BBB to Element Financial Corporation, Trend Stable

DBRS, Inc. (DBRS) has today assigned an Issuer Rating of BBB to Element Financial Corporation (Element or the Company). Concurrently, DBRS has assigned a Short-Term Instruments rating of R-2 (middle) and a rating of Pfd-3 to the Company’s Perpetual Preferred Shares. The trend on all ratings is Stable.

The ratings reflect the Company’s strengthening franchise, which is anchored by Element’s leading position in North American fleet management and a growing presence in railcar leasing. The Company’s better than average credit risk profile, and developing and strengthening earnings profile are also considered in the ratings. These factors are offset by the Company’s reliance on secured funding sources, its appetite for growth through acquisitions, and the integration and execution risks present in the recent acquisition of GE Capital’s fleet management business (GE Fleet).

The Stable trend reflects DBRS’s expectations that Element will successfully integrate the GE Fleet business, while strengthening its earnings profile as earnings assets grow and the Company improves its penetration rate within its fleet customers. While near-term upward ratings migration is unlikely, over the medium-term, ratings could be positively impacted by further earnings expansion while credit costs remain within historical levels and operating efficiency improves. A more balanced funding profile and leverage maintained at or below industry peers would be viewed favorably. Conversely, a noteworthy increase in leverage, sustained deterioration in operating performance, or indications of mis-steps in the GE Fleet integration evidenced by loss of key customers or operational-related charges could result in negative ratings pressure. Ratings could also be pressured by a material acquisition that DBRS views as outside of Element’s core verticals and capabilities.

Element’s growing franchise is a key factor underpinning the ratings. Since its founding in 2007, Element has grown both organically and through acquisitions. In 2014, Element acquired the fleet operations of PHH Corporation, which was subsequently followed by the acquisition of GE Fleet on August 31, 2015. As a result, Element is now the North American leader in fleet management with an estimated 40% market share (by vehicles under management). Moreover, through its relationship with Trinity Industries, Inc., Element has a growing presence in railcar leasing and is expected to become a top 10 player in the market by year-end 2015. DBRS considers this strategy of growth through acquisition as a constraint on the ratings as DBRS views integration and execution risks as becoming elevated with the layering of multiple corporate cultures and IT platforms. Nonetheless, in regards to the integration of the GE Fleet business, DBRS takes comfort in Element’s track record of successfully integrating prior fleet acquisitions, including the sizeable PHH fleet operations, as well as GE’s Canadian fleet operations, which Element acquired in 2013.

Element’s earnings continue to develop and strengthen as the franchise grows. Also important to the ratings, revenues are well-balanced with 42% fee related with the balance being spread-based and are expected to migrate towards a 50-50 split over the medium-term, supporting the quality of earnings. With approximately 82% of earnings assets (pro-forma to the GE Fleet acquisition) related to fleet management and rail car leasing, which are businesses with stable, long-term earnings generating characteristics, DBRS considers visibility into medium-term earnings as good, which is also a key factor in the ratings. For 1H15, Element generated C$147.7 million of adjusted pre-tax income, excluding transaction and integration related costs, compared to C$49.8 million in the year ago period. DBRS sees this expansion in earnings as demonstrating the positive impact to both the franchise and earnings from the transformational PHH fleet acquisition. DBRS expects a similar step-change in earnings power from the recently acquired GE Fleet business.

The ratings also consider Element’s risk profile, which DBRS views as well-managed supported by low credit risk and manageable asset risk. Traditionally, the fleet management and railcar leasing businesses, have generated low levels of credit losses. Indeed, historical credit losses in both Element’s fleet management business as well as the GE Fleet business have averaged less than 0.10% of book value annually. Within Element’s CAD$1.7 billion railcar portfolio, losses have been minimal, benefiting from the young age, well-diversified by type and high-quality customer base. DBRS notes that Element has minimal exposure to tank car retrofitting resulting from the recently introduced U.S. DOT regulations related to tank cars carrying flammable liquids. DBRS considers asset risk as manageable with no residual exposure to the fleet management vehicles. Indeed, asset risk exposure is primarily derived from the Aviation Finance vertical, which will comprise just 7% of net earning assets, pro-forma to the GE Fleet acquisition, and includes helicopter assets which traditionally have much more stable values than fixed wing civilian aircraft.

DBRS considers Element’s funding and liquidity profile as appropriately managed and aligned with the asset base. However, DBRS views the reliance on secured forms of wholesale funding as limiting financial flexibility and a constraint on the ratings. While Element has made some progress in diversifying funding by issuing convertible corporate debt and preferred shares, 91% of total funding is from secured forms funding. As a result, at June 30, 2015, 73% of Element’s adjusted assets (total assets excluding cash held in escrow for acquisition, investment funds, intangible assets and goodwill) were encumbered. Over the longer-term, DBRS expects that Element will look to improve its financial flexibility by introducing senior unsecured corporate debt into its funding mix. Liquidity is largely comprised of unrestricted cash and capacity under its bank facilities. At June 30, 2015, available liquidity totaled $3.2 billion, which DBRS believes is more than sufficient to fund expected originations over the next year.

From DBRS’s perspective, Element’s balance sheet management is acceptable given the risk profile inherent in the balance sheet. Tangible leverage is in line with industry peers at 5.3x, pro-forma to the GE Fleet acquisition, and within maximum covenant limits of 6.0x.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Finance Companies (October 2014). Other applicable methodologies include the DBRS Criteria – Rating Holding Companies and Their Subsidiaries (January 2015) and DBRS Criteria: Preferred Share and Hybrid Criteria for Corporate Issuers (January 2015). These can be found at: http://www.dbrs.com/about/methodologies.

The primary sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: David Laterza
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 24 September 2015
Most Recent Rating Update: 24 September 2015

For additional information on this rating, please refer to the linking document under Related Research.