DBRS: Element’s 3Q Underlying Results Higher on Organic Growth and GE Fleet Acquisition

Summary:
• For 3Q15, Element reported a net loss of C$4.7 million, but excluding transaction and integration costs and other items, after-tax adjusted operating income attributable to common shareholders was 28% higher sequentially at C$87.2 million.
• Origination volumes totaled C$1.9 billion with quarter-on-quarter (QoQ) growth across all verticals, with the exception of Aviation Finance.
• DBRS rates Element Financial Corporation Issuer Rating at BBB, Stable trend.

DBRS, Inc. (DBRS) views Element Financial Corporation’s (Element or the Company) 3Q15 underlying results as sound reflecting solid organic volume growth, and the benefit of one month of GE North American Fleet activity. For 3Q15, Element generated an IFRS net loss of C$4.7 million, compared to net income of C$25.2 million in the prior quarter. Results were impacted by acquisition and integration costs associated with the closing of the GE North American fleet business on August 31, 2015, and subsequently, the GE Fleet Mexico, Australia, and New Zealand businesses on September 30, 2015. Excluding acquisition and integration costs, share-based compensation, amortization of intangible assets from acquisitions and certain debt costs, Element reported after-tax adjusted operating income attributable to common shareholders of C$87.2 million, up 29% on a linked quarter. Further, balance sheet fundamentals remain solid with stable credit performance, sufficient liquidity, and modestly higher leverage, which was expected by DBRS.

Importantly, Element reported good organic growth in origination volumes illustrating the strength of the franchise, especially in its two largest verticals: Fleet Management and Rail Finance. Origination volumes grew 4.9% QoQ with record volumes in Commercial and Vendor Finance (C&V). Including GE Fleet, organic volume growth in Fleet Management was strong across the U.S. and Canada with volumes totaling C$867.8 million, or 6% higher QoQ. Meanwhile, Rail Finance had strong sequential expansion in origination volumes of 30% with good order flow from Trinity Industries. Aviation Finance was the only vertical to report lower QoQ originations, but DBRS notes that volumes in this business tend to be lumpy given the nature of the assets.

Revenues benefited from the expansion of the balance sheet as a result of the origination performance, as well as the acquisition of the GE North American Fleet business. In the quarter, Element reported total revenue of C$189.7 million, a 24% increase sequentially. Net financial revenue benefited from the growth in earning assets, which offset a 30 basis point (bp) reduction QoQ in net financial margin to 5.69%. Margin was impacted by a 36 bp decline in asset yields reflecting lower advisory fees from Aviation Finance, and reduced syndication and remarketing fees in Fleet Management, partially offset by a 6 bp improvement in funding costs. Underlying results also benefited from the Company’s increasing scale and completion of the PHH fleet integration with operating expense as a percentage of average earning assets declining 5 bps QoQ to 2.39%.

Element’s balance sheet remains solid with low levels of non-current and impaired loans, and C$4.3 billion of available financing providing sufficient liquidity to fund ongoing originations over the coming quarters. As expected, financial leverage, which includes the convertible debentures as debt but not equity, was modestly higher QoQ at 3.24x, reflecting the GE Fleet acquisition. DBRS anticipates that financial leverage will continue to increase as the franchise matures, but will remain within industry peer levels.

During the quarter, Element announced strategic actions that the Company was undertaking to further its evolution to a North American fleet management company with complementary commercial finance operations. Element announced that it was reviewing options related to its Canadian C&V business, including a potential sale. However, the Company will retain the U.S. C&V business, which focuses on leasing Class 8 trucks, which the Company views as an adjacent business to fleet management. Further, the focus of the Aviation Finance vertical will be reoriented to fee-based activities including executing on fund structuring mandates and will no longer originate new aviation lease assets past those already committed. Finally, Element reached a new four-year agreement with Trinity Industries under which Element will purchase up to USD$1.0 billion of leased railcars, which meet Element’s underwriting specifications. While the potential divestiture of the Canadian C&V business and refocusing of the Aviation Finance business will have a modest impact on revenue diversity, from DBRS’s perspective, this is more than outweighed by the removal of a primary contributor of credit risk on the Company’s balance sheet (Canadian C&V), and as the existing aviation lease portfolio runs-down, the removal of a key source of asset risk. Further, the new agreement with Trinity is viewed favorably as it will provide Element with a source of good leased railcar assets, while allowing Element to diversify the railcar portfolio by manufacturer.

DBRS rates Element Financial Corporation’s Issuer Rating at BBB, Stable trend.

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