Okay, I think we're ready to start our next presentation. My pleasure to introduce Heath Valkenburg, CFO of Element Fleet. Heath, welcome, and thanks for joining us.
Absolutely, Paul. Thanks for having me.
Yeah. How I want to start off is looking at year-to-date financial performance, right? These are the metrics. Revenue growth 13%, adjusted EPS 18%, free cash flow up 11% year-over-year, and free cash flow conversion of 123%. ROE of 19.9%, up 200 basis points year-over-year. I read all those financial metrics, I'm like, "This is great," right? You look at the stock and you're like, "Wait a second. There's a disconnect here." That's kind of what I want to drill down on, right? Because I think there's an interesting opportunity now in the market, given these types of sets of financial performance, which are strong versus what's happened in the stock market. Where I guess I want to start is talking about the top-line growth, right? Multiple levers to support a 6%-8% medium-term revenue growth objective and double-digit EPS growth. Anything changed in that outlook?
Yeah. What I might do is start with what hasn't changed. What hasn't changed is we still have a tremendous opportunity for growth. Upwards of 50% of the market is still self-managed fleets. We have a really big opportunity to continue to grow our client base, our vehicles under management, our service penetration, and drive that into the business. The other thing that hasn't changed is the business is still very, very robust. So investment grade balance sheet, our client retention is in the 98% mark. We got strong recurring revenues. And we generate, as you said at the top, a lot of free cash flow, and we've got an increasingly capital- light business model. And then I'd also say that we've got a strong moat in the company. So our funding, our service network, our scale, and our data gives us a good moat.
Nothing has changed structurally. I guess what has changed is our conversion of that opportunity into growth. What we've seen really is probably two things is, one on the commercial execution. We haven't seen that in recent times really be where we want it to be in terms of winning new business, and driving VUM growth and service penetration. The other thing that we're seeing is there is a bit more caution in the market. So clients are experiencing higher fuel prices, higher interest rates, trade wars, higher capital cost of vehicles. Excuse me. There's just a bit more caution from clients in terms of replacement cycles or also increasing their fleets. That second one is temporal. Our focus really is on driving the commercial execution. We've made some management changes there to address that one.
But really our focus will be on commercial execution to drive vehicles under management, to drive services per vehicle and to ultimately drive revenue per vehicle higher. And that's our focus and the opportunity is still there. The only thing I would say is it will take some time for that to play through the system. So we've made some changes in the commercial organization. Those changes will take some time to embed themselves, and then there is a longer sales cycle time with fleet. And then once you win a client, it does take some time for the fleet to ramp up. So I think to summarize that opportunity is still very strong. The business model is still very, very robust. We want to increase our execution from a commercial perspective to keep the growth rates that we expect over time.
Okay. It doesn't sound like structurally nothing has changed in that growth algorithm we've talked about. You kind of alluded to some of the or you've talked about some of the management changes, some of the challenges that I would relate back to originations, of originations have been softer for the first half of the year. Talk to us about the outlook for the second half of the year. And in particular with some of the headwinds you mentioned, but also some of the management changes, which should see an improvement in originations, but maybe with a little bit longer duration to get there.
Yeah. There are probably three things that are impacting the originations. The first is we made a deliberate decision to right size the exposure to an originate to syndicate client. That has had some impact on our year-over-year originations number. If you exclude that, we are up 4%. The second thing is similar to what I discussed before. We are in an environment where clients are more cautious. With all of the impacts that I said, they are looking at their fleet to replace from four or five years ago when it was a lower cap cost, a lower interest rate, those sorts of things. There has been some delay in replacement cycles and expanding fleet sizes. The third one is again, on the commercial side of things.
Driving new business wins is important for us to also grow those originations as you onboard those units over time. Pleasingly, we have started to see some of that delayed ordering in Q3 come through and the originations have started, or the orders, sorry, have started to pick up in Q3. There is obviously a delay between orders to origination. Again, our key focus is on the commercial execution to drive that incremental new business wins.
Okay. You also made references to the growth in vehicles under management, the VUM. It has been growing on sort of that 2%-4% target range despite weaker originations. What is driving that VUM growth despite originations being down year over year? When originations start to show growth again, how should we think about the VUM growth? Should it be accelerating from the current run rate?
Yeah, I think it is important to separate vehicles under management from originations. The bulk of your originations in any one year is just pure replacement cycle of your existing clients. That drives originations but does not necessarily drive your VUM growth. VUM growth is really the size of your portfolio, and for us, that is the more key metric of the growth of the business. That is again, what we are targeting to drive that continued VUM growth over time. That will also help originations, and winning new business will drive your VUM growth and then also drive the originations as those orders flow through over time.
Okay. Let's talk about the servicing income that comes out of that VUM growth. Servicing income re-accelerated last quarter to 8% after a couple quarters of softer results. What changed, and how should we think about the sustainability of high single digit or higher servicing income growth?
Yeah. Service revenue growth is driven by a number of factors. Eric, thank you. You've got your vehicles under management is a key attribute to driving service revenue growth. So too is the penetration of your products into those vehicles. You then have utilization of those services, and utilization does increase and decrease in certain quarters. We did have a stronger quarter in Q2. All of those aspects impact that. But again, for us, it's really continuing to grow the size of our portfolio, continuing to grow the amount of product that is utilized by our client base, and then making sure that we're driving the right price to drive the revenue per unit to continually increase that service revenue over time.
Okay. A couple follow-up questions on that, I guess. First off, where are the opportunities specifically to drive higher service penetration, whether that's by product, by geography? Drilling a little bit more into where those opportunities are. Or maybe it's really from some of the acquisitions or partnerships you've done as well.
Yeah. I would say that we actually have opportunity across the board. Whether it's the U.S., Canada market, the Mexico market, the ANZ market, there's still plenty of opportunity and white space to drive product penetration across all markets. Then there's also opportunity across all products. Even our more mature products, if you take maintenance, for example, the penetration rate is in the 50% range there. So still plenty of white space to drive increased utilization and penetration of the products. Then you've got some newer products, which are generally more the technology type products, whether it's telematics or route optimization, those sorts of things. Their penetration rates are more in the low single digits to the 20% penetration range. So they've got lots of upside. For us, that's why we're confident with the opportunity.
Plenty of white space to sell more products, and it's more around the commercial execution.
Okay. One of the things you mentioned two or three times, if not more, in your answer is kind of the size of the portfolio. I find it interesting that even though originations you've pointed out are more clients replacing vehicles, right? But you're being able to grow the total size of portfolio. I think that's interesting. Talk more about how you've been able to grow the size of your book of business.
Yeah. Well, it's important to note that about 60% of our portfolio is services only. So those clients don't drive originations funding. They purely drive services. That's why for us, you should decouple VUM from originations. We can grow the VUM by growing our existing client base, by bringing new clients in that are services only or in some cases have services and financing. So that's why we sort of look at VUM as more the size of the portfolio, the opportunity set that we have to drive more products across that portfolio. Then obviously selling financing into that portfolio will drive originations, but a lot of the originations is just the churn of the existing book.
Okay. But with that growth in VUM, let's just say exclude the servicing only component, still growing, yes?
Yeah.
Including the leasing component?
Yeah.
Which suggests over time, as the replacement cycle normalizes, it does suggest higher originations over time. Is that the right way to think about it?
Yeah. If we exclude that one originate to syndicate client we spoke of, our originations have grown 4%.
Okay.
Absolutely. As I said, the opportunity to grow originations is there for us, and we would expect it to grow over time.
Okay. One of the most powerful drivers of revenue and earnings growth for Element for the last two, three years has been expansion in the net financial revenue yield or margin. Talk about, remind us what have been the primary drivers of that in the past, and also what are the opportunities still going forward?
Yeah. The yields that we've been able to generate on the financing have been really strong. Part of the drivers of that has been the introduction of the leasing business that we rolled out a few years ago to really focus in on leasing and make sure we're optimizing risk-adjusted returns from a leasing standpoint. The other side of the equation is on the funding. We've been able to mature the business, continually improve the balance sheet, roll out new funding structures, and ultimately reduce our funding costs, which has driven really strong yield from a financing perspective. As we look going forward, there's still opportunities for us to continue to optimize our funding, but I wouldn't expect that the rate of yield increase we've seen in the past will continue into the future.
For us, it's more around stabilizing or maintaining that yield and driving growth across the portfolio. The only other aspect to that is you do have your gain on sale income goes into the net financing revenue, which we saw increase over the COVID period with supply chain increasing the value of vehicles in the secondary market. And we're seeing continued normalization of that over the last couple of years. And we expect a little bit more of that to come through in the back half of this year.
Okay. But those gains on sale are still significantly higher than they were pre-COVID.
Yep.
And the expectation is they will remain higher than pre-COVID, even if they normalize to some degree?
Yeah. They remain higher for two reasons. One is price, and the other one is number of units. As we grow our portfolio, we grow the number of units that we have been able to sell. We expect the price will continue to normalize, but there will be a partial offset in terms of the number of units.
Okay. Element announced a new financing structure in June. It is, I think, designed to improve relative economics versus a straight syndication deal. I guess, help us walk through what the financial benefits are from that new structure. How does it change the earnings you realize from the leases? It is designed probably to free up some capital versus a securitization. What is the benefit there? Help us walk through why did you introduce this structure and what is the benefit? Make it—
Yeah.
—tangible for us.
Absolutely. We have our traditional syndications, and then we have the new structure, which we refer to as the equity residual structure. Importantly, both structures enable us to take assets off the balance sheet and delever the balance sheet while maintaining the client relationship and the service revenue. Both structures do that. From a syndication perspective, you typically receive an upfront fee, and you give away your rights to the future cash flows and the future tax benefits of the leases and the tax depreciation. Under the new structure, we receive a smaller upfront fee, but we retain 49% of the future cash flows on the financing and 49% of the future tax benefits. It enables us to share in a greater portion of the economics over time. It also enables us to have more optionality and flexibility in terms of off-balance sheet funding.
Syndications are typically more larger clients that investors will buy. This is a pool of assets, so it enables us to put smaller clients into the pool, which therefore increases the optionality that we have from an off-balance sheet perspective. What it does though, importantly, is it does have a, initially as we transition some volume into this structure, it does have a timing impact on the P&L because you have less revenue on day one and more revenue over time, which obviously plays through the P&L over the coming years.
Okay. Since you brought up the tax benefit, I did want to ask you a more micro type question. With the recent announcement from Government of Canada, bonus depreciation they call it in the U.S., but same concept. That was a big financial benefit. Obviously, Canadian business is smaller than U.S. Is there any way we can start thinking about what the potential tax benefit would be for Element Fleet in terms of that bonus depreciation in Canada?
Yeah. The bonus depreciation in Canada will work similar, I guess, to the U.S. in that you can claim 100% depreciation on the vehicles upfront. From an immediate tax profile landscape, it doesn't change anything materially in the near future. We have enough tax shield in Canada to be able to. That doesn't make an impact in the immediate term. Where it potentially brings some optionality is syndications in Canada and driving higher syndication yield in Canada, which is something we are working through.
Okay, good. Let's talk about expenses and margins. You announced some actions to reduce headcount and target CAD 20 million of annual savings. What's driving the restructuring? What's the nature of it, and why now? Why is this the right amount, and is there potentially more to come over time?
Yeah. The first thing I would say is the focus here is actually on digitizing the client experience and making sure that we've got a modern-day, high impactful client experience. That's actually been the focus of our digitization. It does have an added benefit that it can create scale in the business, and really with this CAD 20 million cost out, that's what we're seeing. If I bring that to life for you, one of the key things that we've done is digitized, with our data and AI, our maintenance process. The ability to approve, reject, and do the compliance part of the maintenance transactions. That gives the clients a faster, more accurate experience, but also has the benefit of being able to do more with less in our maintenance team as just one example. Yeah. We'll continue to digitize the client experience.
It's important that we do that in a controlled process to make sure we enhance the client experience as we go along, and we test these things adequately before we roll them out. But certainly the added benefit that it also has is the scale that it brings from a margin perspective.
Okay. If I go back to that growth algorithm we talked about before and the 68% annualized revenue growth target, how do I think about potential margin expansion or operating leverage at that kind of growth rate and with some of these expense initiatives or opportunities you have?
Yeah. Absolutely, we expect to grow over time. The opportunity to grow, as I said from the top, is definitely there. We've got some short-term areas of focus on the commercial execution. But we also expect that we'll be able to grow our revenues far greater than our expenses, and continue to drive operating improvements. We do have some areas of the business that we will invest in though. Something like a Waymo as an example, and investing into that to support what is an exciting new initiative for us. Yeah, we expect revenue will outpace expenses over time.
Okay. Maybe we can talk a little bit about the recent FleetPartners bid. I guess importantly, what drove the decision for Element to make an offer for FleetPartners? Then obviously you've decided not to increase your bid. Maybe a little bit of a recap what happened there.
Yeah. In terms of why we put in a bid, we saw it as an opportunity for us that made a lot of strategic sense. It would give us greater scale in the ANZ business. ANZ, especially Australia, is a fragmented market. You've got upwards of 10 different players. It's one of the markets where we're not the market leader, so it would give us scale in that market. It also had a business that had invested in some areas such as novated leasing that haven't been a core focus for us. There was some strategic benefit from that. That was why we entered into it. At the initial bid that we put in at CAD 3.80, it was a value-accretive transaction on day one and made a lot of sense.
However, strategic benefit is one side of things and the returns have to also stack up, and as we went through the process, for us, the risk-adjusted returns just weren't what we thought was the best use of our capital, especially we've got other opportunities for our capital. As you would've seen, the bid prices increased significantly well north of our CAD 3.80. For us, we were disciplined and walked away from the transaction, because it didn't meet our return thresholds. Then, importantly, we've got a really strong business in Australia. We can grow that business regardless of doing the transaction. We think there's lots of opportunities for us to keep growing in that market regardless of the acquisition.
Considering the original strategic rationale still applicable, would you consider other acquisition opportunities in Australia?
Not at this stage. From a capabilities perspective, we did the Autofleet acquisition and the Car IQ acquisition. We believe now we have the capabilities that we need, so we do not need to do any acquisitions from that perspective. We can keep growing our ANZ business regardless of doing acquisitions. This one had a strategic fit in that we knew the business well, we knew the environment very well. It had that novated leasing capability. Some of the other players have other areas of business like salary packaging, laptops, and that sort of stuff that we would not want to get into. For us, our focus is organic growth.
Okay. Another question on capital deployment, given you did not go ahead obviously with the acquisition, how attractive are share buybacks right now?
From a capital deployment perspective, what is important for us is maintaining our investment-grade credit rating. We always target our 73%-77% debt to capital range that we are focused on. Maintaining that investment-grade balance sheet is critical. We also pay back 25%-35% of our free cash flow in dividends each year. We do reinvest back into the business, and we spend about CAD 80 million a year in technology and product and all of those sorts of things to reinvest into the business. In terms of share buybacks, we normally target 1%-2% of buying back our stock each year. When the price goes what we believe well below the intrinsic value of the company, we do increase the amount of buybacks we do.
We were over 2% at the halfway point of the year relative to our 1%-2% range. We went into a blackout during the FleetPartners acquisition. As soon as that turned off, we have gone back into the share buybacks and we think there is a lot of value at these prices and this sort of multiple. Therefore, we will remain active from a share buybacks perspective.
Okay. We have covered a lot of things here. Maybe you can give us sort of the three to four sort of KPIs or items that we should be focusing on for the next 12 months. What do you really want to execute on?
Yeah. I think to recap, opportunity is still very strong. We have got a really robust business, and our focus is driving organic growth and improving our commercial execution. In terms of focus areas, number one, it is VUM growth, that is the size of our portfolio, and making sure that we increase the size of our portfolio is a key focus for us. Number two would be driving service penetration and revenue per unit. So making sure that we are not only growing the units that we have, but growing the amount of services, and the value that we are providing to our clients through our services. Then the third thing I would say is continuing to drive margin expansion.
As I said, the digitization initiative is really more a client experience and enhancing the client experience focus, but it does have added benefit in terms of driving scale across the business. I think we do all those things. We increase our portfolio, we increase our products per unit and our revenue per unit, and we increase our operating margin. They are the key things we are focused on.
Okay. Perfect. Thanks, Heath.
Excellent.
Good to talk to you. Thanks, everyone. Thank you.