DBRS Upgrades Element Fleet Management Corporation to BBB (high), Stable Trend Following Separation

DBRS, Inc. (DBRS) has today upgraded the ratings of Element Fleet Management Corporation (Element or the Company), including its Issuer Rating to BBB (high) from BBB. The trend on all ratings is Stable. Concurrently, DBRS has changed the name of Element Financial Corporation to Element Fleet Management Corporation on its website, reflecting the change in the Company’s legal name effective today following the legal separation of Element from its former commercial businesses which are now housed within ECN Capital Corporation. Today’s rating action concludes the Under Review with Positive Implications, where the ratings were placed on February 17, 2016.

The rating action reflects Element’s strong franchise underpinned by its leading position in the North American commercial fleet management market, as well as top-tier positions in Mexico, Australia and New Zealand. Moreover, DBRS views the Company’s strong franchise position and strengthening earnings profile as unaffected by the separation. Strong and predictable revenues underpin the earnings profile of the Company, which along with well-managed liquidity and appropriate levels of capital for the risk profile are foundations to the rating. The rating action also considers the positive impact on the Company’s risk profile, as the separation from the legacy commercial business removes the largest source of credit risk, as well as a key source of asset residual exposure from the Company’s balance sheet. DBRS views the positives for the risk profile as more than outweighing the loss of revenue diversification by business line. The Company’s reliance on secured forms of wholesale funding, historical appetite for growth through acquisitions constrain the ratings.

The Stable trend reflects DBRS’s anticipation that the Company’s earnings profile will continue to strengthen, as earnings assets grow, and the Company improves its penetration rate within its fleet customers, while maintaining credit costs within historical levels. Further, the Stable trend considers DBRS’s expectations that overall industry fundamentals will continue to be favorable and that Element will maintain good access to the capital markets at reasonable costs.

DBRS sees certain execution risks associated with the separation of the businesses, but overall DBRS views the separation risks as manageable. Element’s operating strategy will remain unchanged and the executive management team is well-established with deep experience in the fleet management industry. Moreover, there is minimal IT separation required as the fleet business had a dedicated operating platforms owed to the uniqueness of the assets. As a result, while there will be a degree of back-office systems to be separated, DBRS sees IT separation costs and risks as lower in this transaction than in many other separations or spin-outs. Importantly, Element’s funding strategy has been to have permanent funding in place for each vertical, which in DBRS’s view should also aid in a smooth separation. Finally, DBRS notes that the integration of the GE Fleet business into Element is on target with IT integration expected to be completed in 4Q16.

DBRS considers Element’s franchise as strong, anchored by its broad range of products and robust IT capabilities that enable the Company to provide industry leading fleet analytics to its clients. With more than 1 million vehicles under management, Element is the North American leader in commercial fleet management. 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. 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. While DBRS would expect any near-term acquisitions to be of the smaller, strategic bolt-on variety, DBRS considers the establishment by management of a track record operating the current entity as an important factor for any potential future positive rating movement.

Element’s strengthening earnings profile is a key factor in the ratings. The continuing expansion of earning assets and early progress in improving the penetration rate of fee-related products and services with customers have been key contributors to the improving profitability. For 1H16, on a pro-forma basis, Element generated C$255.4 million of adjusted operating pre-tax income, which excludes transaction and integration related costs, amortization of debt related discounts and share-based compensation, compared to C$80.6 million in the year ago period. Nevertheless, the slow growth of the U.S. economy does pose a potential headwind to earnings, as companies could potentially defer fleet expansion or fleet refresh plans and contract pricing could tighten due heightened competition.

From DBRS’s perspective, Element’s below-average risk profile is a positive and a key factor in the ratings. The Company’s risk profile is supported by its conservative credit risk appetite and its well-designed risk management framework. Credit risk, which is derived from the Company’s corporate client base, is Element’s primary risk exposure. However, with more than 60% of the client base investment grade corporates, historical credit losses in Element’s fleet management business have been very low, averaging approximately 0.03% of book value annually. Moreover, Element’s overall risk profile benefits from minimal exposure to asset risk, given the lease structure of the majority of the leasing portfolio.

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. Liquidity is largely comprised of unrestricted cash and capacity under its bank facilities, supported by solid cash flow from operations, which as of June 30, 2016, on a pro-forma basis, was more than sufficient to fund expected originations over the next year. DBRS views capitalization as solid given the credit risk profile, limited residual value exposure and strengthening ability to generate organic capital. On a pro-forma basis, tangible leverage is in line with industry peers at 7.5x, at June 30, 2016, and within maximum covenant limits.

RATING DRIVERS
Ratings could be positively impacted by continuing expansion of earnings and returns supported by improving margins and operating efficiency, while maintaining credit costs within historical levels. Reduced asset encumbrance while sustaining leverage at or below industry peers would be viewed favorably. Conversely, ratings could come under pressure should there be indications of miss-steps in the legal separation of the businesses evidenced by the loss of key customers or operational-related charges. Further, leverage outside of fleet management peers would be viewed negatively. Sustained credit losses that are above the historically well-controlled levels that indicate that the Company is sacrificing its conservative risk appetite for growth could have negative implications for the ratings.

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

The applicable methodologies are Global Methodology for Rating Finance Companies (October 2015) and DBRS Criteria: Preferred Shares and Hybrid Security Criteria for Corporate Issuers (January 2016), which can be found on our website under 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.

Lead Analyst: David Laterza
Rating Committee Chair: Roger Lister
Initial Rating Date: September 24, 2015
Most Recent Rating Update: February 17, 2016

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.