DBRS Confirms Element Fleet’s LT Rating at BBB (high) Following Strategic Plan Announcement

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) and Short-Term Issuer Rating of R-2 (high). The trend on all ratings is Stable. The Intrinsic Assessment (IA) for the Company is BBB (high), while its Support Assessment is SA3. As a result, EFN’s final ratings are equalized with its IA.

KEY RATING CONSIDERATIONS
The ratings consider Element’s action plan following an in-depth and broad review of three distinct workstreams completed by the new executive management team and the Board of Directors that should contribute to better operating performance going forward. Nonetheless, the plan does have execution risks, including the realization of synergies and efficiencies, as well as the successful wind down of 19th Capital without additional losses or costs to Element. The Company’s position as the market leader in North American commercial fleet as well as leading positions in Australia and New Zealand, its low risk balance sheet and well-aligned funding profile support the ratings. The ratings also consider 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 elevated leverage.

The Stable trend reflects DBRS’s expectation that the Company will continue to produce solid earnings from its core fleet business as it executes the strategic plan, while maintaining strong asset performance. The Company’s ample available liquidity and good access to the capital markets are considered in the trend. The Stable trend also considers DBRS’s view 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.

RATING DRIVERS
While upward movement in the ratings is not expected in the intermediate term, the successful execution of the strategic action plan resulting in the targeted improvement in earnings, including improving operating efficiency and synergies would be considered a positive for the ratings. Additional diversification of funding that results in lower asset encumbrance, or a sustained reduction in tangible leverage below 7.0x, could also result in upward rating pressure. Conversely, failure to successfully execute the strategic plan evidenced by additional costs associated with exiting non-strategic assets, or not achieving financial targets, could result in the ratings coming under negative pressure. A sustained decline in volumes and/or service related revenues evidencing that the Company’s franchise position has fundamentally deteriorated, or a prolonged weakening of credit performance above historically well-controlled levels could have negative implications for the ratings. A prolonged increase in tangible leverage over 8.0x could result in the ratings coming under pressure.

RATING RATIONALE
On October 1, 2018, the Company announced an action plan following an in-depth and broad review of the three workstreams at Element, including the core fleet business, the 19th Capital JV, and the Company’s capital structure and balance sheet. The strategic plan includes a Reset Plan for the core fleet business utilizing eight levers identified that will drive C$150 million of improvement in annual pre-tax operating income by the end of 2020. The eight levers include both cost and revenue improvement levers and will require an upfront investment of C$150 million, primarily in restructuring charges over the next 15 months. While there are execution risks in this transformation program, DBRS sees the new executive management team’s strong track record in change management at other large Canadian firms as partially mitigating these risks. Further, the identified initiatives are numerous but small aggregating to a good overall improvement in earnings. This granularity in projects minimizes execution risks as no one project is expected to be a key driver of the earnings improvement.

As part of the strategic action plan, Element will acquire the remaining share of the19th Capital JV that it does not currently own for a nominal amount and run off the assets. Specifically, Element will manage the existing lease portfolio of 19th Capital and accelerate the disposition of the idle assets. These actions will result in an after-tax write-down of approximately C$360 million. While this charge is material, DBRS considers this as a non-recurring charge that is necessary to de-risk 19th Capital and allow Element to focus on its core fleet business.

Strengthening the Company’s balance sheet is the third and final component of the strategic action plan and necessary following the charge associated with the actions related to 19th Capital. Element announced a C$300 million fully-bought common share offering that will bolster capital and largely offset the impact to leverage of the 19th Capital actions. In addition, the Company will introduce a dividend reinvestment plan (DRIP), as well as a 40% reduction in the common share dividend. Element expects the dividend reduction to generate C$100 million of capital over the next two years to support the investments in the Reset plan. DBRS considers the participation assumptions in the DRIP program as conservative and in line with market averages in Canada for similar programs.

DBRS views Element’s franchise as strong, anchored by its leading market positions in North American and certain international markets, as well as its broad range of products and services offered to clients. While Element experienced an elevated level of customer attrition in 2H17, the Company has indicated that customer retention levels are returning to their historical levels in the mid-to-high 90% range. Importantly, Element’s fee-based business model is able to generate a high level of predictable and recurring revenues, if customer retention rates are maintained. As of 1H18, 65.5% 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.

Element’s balance sheet fundamentals continue to be sound. EFN’s credit risk exposure in its core fleet business remains low supported by a largely investment grade client base (68% of net finance receivables and leases). Since 2013, Element’s credit losses from the core fleet business have been just 0.01% reflecting sound credit underwriting, the mission critical nature of the vehicles, and a solid depreciation policy. Meanwhile, residual value risk exposure is very modest at just 15.7% of net finance receivables and leases. DBRS notes that the Company’s residual value exposure stems from its operations in Australia, New Zealand, and Mexico where closed-end leases are the market standard.

Element continues to manage its funding and liquidity to limit any potential capital calls over the forward 24-month period. While Element match funds its assets by duration, currency and interest rate, 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, 2018, totaled approximately C$6.0 billion. DBRS views capitalization as acceptable given the low risk profile of the balance sheet. However, tangible leverage is at the high-end of the Company’s targeted range at 7.82x, at June 30, 2018.

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

The applicable methodologies are Global Methodology for Rating Finance Companies (November 2017) and DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (December 2017), 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, Senior Vice President, Head of U.S. Non-Bank Financials
Rating Committee Chair: Michael Driscoll, Managing Director, Head of North American FIG, Global FIG
Initial Rating Date: September 24, 2015
Last Rating Date: September 25, 2017

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

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