DBRS Morningstar Revises Element Fleet Management Corp’s Ratings Trend to Positive; Confirms LT Issuer Rating at BBB (high)

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Element Fleet Management Corp. (EFN or the Company), including the Company’s Long-Term Issuer Rating of BBB (high), Short-Term Issuer Rating of R-2 (high), and Perpetual Preferred Shares rating of Pfd – 3 (high). At the same time, DBRS Morningstar revised all trends to Positive from 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 CREDIT RATING CONSIDERATIONS
The change in trend to Positive reflects EFN’s improved earnings generation capacity supported by sound revenue diversification and strengthening return metrics, which have benefited from the Company’s actioning of $208 million of sustained pre-tax annual run-rate profit improvements achieved via its wide-ranging transformation initiatives (Transformation). The Positive trend also considers the Company’s progress in diversifying funding, including the introduction of a greater component of unsecured funding. The Positive trend also reflects our view that EFN’s credit fundamentals will remain sound over the near-term, despite the uncertain economic outlook and lingering OEM production constraints. Although OEM production has improved, should the United Auto Workers (UAW) strike broaden to additional production facilities or last for an extended period of time, OEM production could become further constrained, somewhat dampening the Company’s origination volumes.

The ratings confirmation considers the Company’s leading commercial fleet management franchise including leading market shares in North America and Australia - New Zealand, as well as the Company’s sound risk profile with very limited credit losses through cycles and a modest degree of residual value exposure. The ratings also consider weaker leverage relative to higher rated peers, albeit improving from previously higher levels.

CREDIT RATING DRIVERS
Continuation of similar solid performance metrics, as well as sound credit and asset performance despite any potential negative effects from a prolonged UAW work stoppage, while maintaining appropriate balance sheet fundamentals would result in a ratings upgrade. Weaker than expected operating performance or a material increase in tangible leverage would result in a return of the ratings to a Stable trend. While unlikely given the Positive trend, the ratings would be downgraded if the Company were to sustain a material loss that would result in substantially higher tangible leverage.

CREDIT RATING RATIONALE
Franchise Strength Assessment: Good
With a legacy dating back to 2007, EFN maintains a top-tier commercial fleet management franchise in its chosen geographical markets. Headquartered in Toronto, the Company offers its diverse customer base a broad set of products and services, and utilizes its substantial scale to obtain preferred pricing on vehicles from OEMs and discounts from various other vendors and suppliers which it passes onto its fleet customers. EFN’s high customer retention rates evidence the value fleet customers see in these product and services, including the pricing discounts that lower customers’ overall fleet costs.

Earnings Power Assessment: Good
The rating actions reflect EFN's improved earnings generation capacity and return metrics, underpinned by its three sources of revenues including net financing revenue, net servicing revenues, and net syndication revenue. EFN’s earnings generation proved to be resilient during the pandemic reflecting the Company’s strong business model and the essential nature of the vehicles that it manages and finances. Supporting this resiliency, EFN’s revenue mix is well balanced with net financing revenue comprising 43.2% of total revenues in 2022 while net servicing revenue comprised 51.3%, compared to 42.1% and 50.0% in 2020, respectively.

In 1H23, earnings totaled $226.5 million representing an ROAA of 3.12% as compared to $204.7 million, or 3.07% in 1H22. Improved year-on-year (YoY) 1H23 earnings primarily reflected increased levels of net servicing income and net financing revenues, partially offset by lower syndication fees and higher operating expense. Higher net servicing income in 1H23 was driven by a significant increase in originations which drove associated services utilization including titling and registration, telematics setup and the remarketing of older vehicles being replaced. Improved net financing revenue was driven by higher gains on vehicle sales in Mexico, along with higher average net earning assets spurred by increased origination volumes. These results follow improved full-year 2022 earnings of $409.6 million, or an ROAA of 3.00%, up from $356.0 million, or 2.55% in 2021.

Although the Company’s significant vehicle order backlog could increase if the UAW strike at specific plants of General Motors Company, Ford Motor Company, and Stellantis N.V. were to broaden, or continue over an elongated period of time, we expect that vehicle order backlogs will eventually be converted into deliveries/originations over time, benefiting future revenue generation. We note that vehicle order backlogs totaled $2.6 billion in 2Q23, down from $2.8 billion in 2Q22, and up from $1.1 billion in 2Q20.

Risk Profile Assessment: Strong / Good
The Company’s sound risk profile, is underpinned by comprehensive and well managed credit risk and residual value risk policies. Net charge-offs (NCOs) remain very low, reflecting EFN’s significant level of investment grade clients, conservative underwriting, and the mission critical nature of the leased vehicles to the customer. Specifically, NCOs totaled a very modest $0.4 million in 1H23, up from $0.1 million in 1H22. For full-year 2022, NCOs totaled just $0.4 million in 2022, down from $1.6 million in 2021. Meanwhile, the majority of the Company’s clients’ leases in the U.S. and Canada are open-ended, limiting its residual value risk. For open-ended leases, it is the client, not the Company, that is exposed to declines in used vehicle values upon disposition. Lastly, we view operational risk as a relevant risk with the significant amount of client data that EFN holds across its operating platform. We view operational risk to be well-managed.

Funding and Liquidity Assessment: Good / Moderate
EFN continues to be reliant on secured forms of funding but has made good progress in diversifying funding, including the introduction of a larger component of unsecured funding. At June 30, 2023, 43.0% of the Company’s funding was unsecured compared to 22.1% in 4Q20 (Transformation completed). Importantly, EFN’s funding mix is also diverse by lender and investor base. EFN also has an established syndication platform that supports liquidity as well as potential customer concentration limits while providing an additional predictable revenue stream. Overall, we view the Company’s funding as well-aligned with the asset base. Meanwhile, liquidity is sound. The Company has $3.2 billion of committed liquidity, including $1.8 billion of availability under its revolving unsecured credit facilities, and $1.4 billion under its vehicle management asset-backed facilities (if collateral is available), at June 30, 2023.

Capitalization Assessment: Moderate
The Company’s capital position is acceptable. EFN has demonstrated good capital discipline since the introduction of the Transformation initiative with EFN’s tangible leverage ratio improving to 5.61x at June 30, 2023, down from 5.86x at December 31, 2022, and down from 6.18x at June 30, 2022. Despite the improvement, we note that the Company targets tangible leverage in the 6.00x to 6.75x range. Importantly, the Company continues to simplify its capital base by retiring costly preferred shares, which now constitute just 9.3% of total capital compared to 13.5% in 4Q20.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
General Considerations
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at[July 4, 2023] https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings .

Notes:

Morningstar DBRS notes that this Press Release was amended on March 15th, 2024 to update the methodology dates and links below.

All figures are in Canadian dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 1, 2023), at https://dbrs.morningstar.com/research/420144/global-methodology-for-rating-non-bank-financial-institutions. In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (July 4, 2023), https://dbrs.morningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings-archived, in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The primary sources of information used for this credit rating include Morningstar Inc. and Company Documents. DBRS Morningstar considers the information available to it for the purposes of providing this credit rating was of satisfactory quality.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

DBRS Morningstar had access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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