TD Periodic TablingElement Financial Corp. (EFN-T) C$19.80
Q2/15 Outlook
Event
Element will report Q2/15 results on August 12 after market close.
Impact: NEUTRAL
Our adjusted EPS estimate is in line with consensus. TD Investment Conclusion Our target price and long-term outlook on profitability are leveraged to the following: 1) strong growth in finance receivables, which is highly dependent on management’s capacity to leverage its relationships in Element’s four verticals, particularly in Fleet and Rail; 2) reliable and increasingly diverse sources of funding, including the potential for an investment-grade credit rating from a major rating agency; 3) management’s demonstrated and stated intention to limit liquidity, interest rate mismatch, and credit risk; and 4) its highly scalable infrastructure, which should drive much lower operating expense ratios over time.
Details
We are forecasting adjusted operating EPS (f.d.) of $0.23, up 118% y/y. On a cash basis (pretax earnings), our adjusted operating EPS (f.d.) is $0.30, up 118% y/y. The strong y/y growth in earnings is driven by a near tripling of net finance receivables and higher margins, partially offset by a higher share count. Originations are expected to approach $1.8 billion, driven by very strong originations in Fleet, Commercial/Vendor, and Rail. Beyond earnings and originations, the key issues we expect to be addressed on the call include:
Closing of GE deal: The deal is still expected to close in Q3. The company announced that it has received early termination of anti-trust waiting period regarding the GE deal. Early termination supports management’s view that EFN is not approaching anti-trust limitations because regulators look at the size of the market as including companies and governments that do not use third parties to provide fleet management services or leasing. Accordingly, although EFN did not participate in the LeasePlan deal, we do not see this as an indication that EFN’s capacity to grow in Fleet is limited. In fact, we believe that from the perspective of: a) opportunities in the U.S. Fleet market; and b) leverage capacity, Element could increase its post-GE earnings assets by $5 billion–$6 billion or 28%. The addition of $6 billion in leverage would take the leverage ratio from 4.3x pro forma the GE deal to 5.8x, which is below the 6.0x management referred to on the most recent call and well below the 7x-plus appropriate for a Fleet business.
Valuation
Element is currently trading at 12.0x our 2016E adjusted operating EPS. Diversified leasing companies in the U.S. are trading at approximately 12.5x 2016E EPS and a long-term forward P/E of 14.5x. Element is currently trading at 1.9x current book value per share (a range of 1.1x–2.6x) versus the average of 1.1x (a range of 1.1x– 1.6x over the last three years) for the diversified leasing companies.
Justification of Target Price
Our $24.00 target price is based on a 15x multiple (unchanged) applied against our 2016E adjusted EPS of $1.65. The target price is consistent with a 1.7x P/B applied against Q3/16E book value per share.
We set our target price based on a 15.0x target P/E applied to 2016E EPS. We continue to believe that EFN warrants a material premium to other financial services companies in Canada. We currently value the banks and insurers at 12.0x–12.5x. We believe that the premium is supported by the following:
Approximately two-thirds of EFN’s business is in the U.S., where growth should exceed the growth of financial services companies in Canada.
GE’s Fleet and fees should grow at an accelerated pace in the near term as EFN modifies the business model to emphasize fees.
We believe that EFN’s conservative balance sheet could support further tuck-in and even large acquisitions. Acquisitions are likely to be in Fleet, with asset deals (rather than businesses) in Rail.
Key Risks to Target Price
We have identified the following key risks that could prevent Element shares from attaining our target price: 1) inaccuracies or misstatements in the reports, presentations, and statements provided by the company and management upon which we materially rely; 2) changes in key personnel and management and/or actions by key personnel and management that are detrimental to the company’s operating performance or strategic positioning; 3) larger-than-expected declines in the demand for commercial financing in North America; 4) disruptions that reduce the availability, or increase the cost, of funding; 5) deterioration in the credit performance of commercial credit in North America; 6) unfavourable changes in the competitive landscape; 7) challenges associated with acquiring, funding, and integrating any future acquisitions; 8) limited history as a public entity; 9) lower degree of regulatory oversight; 10) limited financial disclosures relative to other regulated financial services companies; 11) rail safety and the costs associated with retrofitting; and 12) foreign exchange fluctuations.