DBRS Confirms Element Fleet Management’s Long-Term Issuer Rating at BBB (high), Trend Stable

DBRS, Inc. (DBRS) has confirmed the ratings for Element Fleet Management Corp. (EFN or the Company), including the Company’s Long-Term Issuer Rating of BBB (high). The trend on all ratings is Stable. Concurrently, DBRS has assigned a Support Assessment of SA3 to EFN. As a result, EFN’s Intrinsic Assessment (IA) is BBB (high), which is equal to the final rating.

The ratings consider EFN’s strong franchise supported by its leading North American commercial fleet management business, as well as top-tier positions in Australia and New Zealand. These strong market positions and the diverse suite of products and services that EFN offers its clients generate a high level of predictable and recurring revenues, which anchor the Company’s sound earnings generation ability. The ratings also consider the Company’s sound balance sheet underpinned by historically strong credit performance, appropriately managed liquidity and solid funding profile. These factors are offset by the Company’s reliance on secured forms of wholesale funding, returns that are solid, but lag the peer group at the next rating level and the Company’s historical appetite for growth through acquisitions.

The Stable trend reflects DBRS’s expectation that the Company will continue to produce sound earnings supported by ongoing service revenue growth, as well as portfolio growth, while asset performance will remain strong. The Stable trend also considers DBRS’s views that the long-term fundamentals for the commercial fleet industry will remain favorable supported by the continuing trend of large corporates outsourcing the management of their commercial fleets to save costs. Moreover, the increasing volume of data produced by vehicles that may be analyzed to increase driver productivity and the operating efficiency of the fleets requires scalable IT platforms, such as that offered by EFN, further underpinning demand for commercial fleet services.

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 in its chosen geographic markets. By number of vehicles under management and revenues, Element is the North American leader in commercial fleet management. Further, through its alliance with Arval (a subsidiary of BNP Paribas), EFN provides client support in over 50 countries. Importantly, the pace of acquisitions by EFN has slowed, and over the near-term, DBRS would expect any acquisitions to be of the smaller, strategic bolt-on variety. With the integration of the two large acquisitions, PHH Fleet (June 2014) and GE Fleet (September 2015) completed, as well as the completion of the separation from ECN Capital, management can now focus on improving the financial performance of EFN to be more in line with higher rated entities, which is a key driver for any potential upward ratings movement.

In August 2017, EFN separated approximately C$1.3 billion of assets (7.1% of total assets) into a Non-Core segment. The Non-Core assets reflect those that are not aligned with the Company’s commercial fleet focus, but were acquired as part of larger acquisitions, or remained with EFN following the separation from ECN Capital in the fall of 2016. Positively, as of September 19, 2017, the Company has agreed to two transactions to sell portfolios of Non-Core assets that reduces the Non-Core to 6% of total assets, pro-forma. Importantly, each sale has occurred at a price that exceeds book value. DBRS expects over time that the Company will gradually exit these assets through run-off or sales with a modest impact to earnings as these assets were typically high-yielding assets.

The Non-Core segment includes the Company’s investment in 19th Capital Group, LLC (19th Capital or the JV), a joint venture with Celadon. In 2Q17, EFN recognized a share of loss and provision charge related to 19th Capital of C$40.9 million. The majority of the loss was related to a C$30.0 million provision recorded against certain assets in the JV, reflecting the reduced likelihood that the current value of those assets will be realized as the JV takes actions to improve the efficiency of the fleet, as well as to optimize the fleet’s overall size and mix.

EFN’s earnings generation ability remains sound underpinned by strong and predicable revenues. As of 1H17, 62% of the Company’s total revenues, net of interest expense, were derived from service related fee revenues, which require less capital to generate and contain very modest credit risk. EFN continues to generate substantial pre-provision earnings that are more than sufficient to absorb the low cost of credit, as well as any potential unexpected losses. Operating efficiency is expected to improve as integration and separation costs are materially reduced in 2H17 and into 2018. DBRS sees improving operating efficiency, as well as restoring expansion to net interest and rental revenue margin as important drivers for improving the Company’s earnings, as well as returns on capital and assets.

From DBRS’s perspective, EFN’s balance sheet fundamentals continue to be sound. EFN’s credit risk exposure remains low supported by a largely investment grade client base (68% of net finance receivables and leases) and sound credit underwriting, which focuses on the client’s ability to repay EFN and not recovery from the collateral. Reflecting this sound credit underwriting, the mission critical nature of the vehicles, and a solid depreciation policy, historical credit losses for EFN have been very low, averaging approximately 0.03% of book value annually. Moreover, residual value risk exposure is very modest at just 11.7% of net finance receivables and leases. DBRS notes that the Company’s residual value exposure stems from its operations in Australia and New Zealand where closed-end leases are the market standard.

EFN maintains a match funding strategy by duration, interest rate and currency. Moreover, EFN manages its funding and liquidity to limit any potential capital calls over the forward 24 month period. However, DBRS considers 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, which as of June 30, 2017, totaled C$3.4 billion, which is more than sufficient to fund expected originations over the next 12 months. Liquidity is further supported by cash flow from operations. DBRS views capitalization as solid given the lower risk profile of the balance sheet and solid earnings generation. Tangible leverage is in line with industry peers at 7.36x, at June 30, 2017, and within maximum covenant limits.

RATING DRIVERS
Ratings could be positively impacted by improving earnings and returns supported by margin expansion and strengthening operating efficiency. Further diversification of funding, which results in lower asset encumbrance would be viewed favorably. Ratings could also be positively impacted by reduced levels of tangible leverage. Conversely, ratings could come under pressure should there be a sustained material reduction in volumes and/or service related revenues evidencing that the Company’s franchise is weakening, or should EFN recognize an additional significant charge related to the Non-Core Asset segment. A persistent deterioration in credit performance that is above the historically well-controlled levels indicating that the Company’s risk appetite has increased could also have negative implications for the ratings. Further, a prolonged increase in tangible leverage above 8.0x could result in ratings pressure.

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

The applicable methodologies are Global Methodology for Rating Finance Companies (October 2016), Global Methodology for Rating Banks and Banking Organisations (May 2017) and DBRS Criteria: Preferred Shares and Hybrid Security Criteria for Corporate Issuers (December 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.

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

Lead Analyst: David Laterza, Senior Vice President, Head of U.S. Non-Bank Financials, Global FIG
Rating Committee Chair: Mike Driscoll, Head of North American FIG, Global FIG
Initial Rating Date: September 24, 2015
Last Rating Date: October 3, 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.