Lyrical Partners is a traditional value investing firm whose portfolio trades at only 11x forward earnings and their comparative benchmark the MSCI EAFE is trading at 15x. They are focused on the cheapest segment of the market since it has delivered the most enduring alpha of more than 400 bp per year since 1975 when looking at developed markets outside the US.
The most obvious problem with the cheap part of the market is that most of the companies from it are low-valued for a reason. While that segment of the market did outperform despite its fundamentals, its earnings growth is slower than the rest of the market.
The fund's aim is to find gems in the mud, which is not easy when knowing that MSCI EAFE hasn't grown since 2007. The fund is trading at the same P/E, but its holdings have grown EPS by more than 7% annually in the same time frame.
Investors have a strong belief that growth stocks are expensive, but from Lyrical comes the idea of identifying and hunting for compounders in the cheap segment of the market. That way value and growth are combined in the same stock.
Lyrical Partners employed a bottom-up approach and it several times yielded with finding cheap companies in the sectors of the market which is usually reserved for growth investors.
Nintendo is just one of the examples that was traded at 9x without cash and investments. Main competitions including EA and Take-Two were valued at above 20x. While Nintendo is traded at a solid discount it still has amongst the best IPs in the industry, and the fund gets a 30% return on capital business.
In the Q4 2021 issue of Hidden Value Stocks, Hedge Fund Alpha interviewed Dan Kaskawits and John Mullins from Lyrical Partners, and discussed their investment process, and an interesting pitch for Element Fleet Management Corp (TSE:EFN).
Investment Process
Lyrical is looking at the cheapest quintiles of the market which are based on five-year forward earning power. They tried looking at a shorter, one-year period which resulted in identifying many cyclical and slow-growing companies.
The next step is filtering out the potential quality amongst the cheapest. The fund is looking for companies with the highest discount because those can provide a certain margin of safety in case the investment goes awry.
From their experience, the cheapest quintile is the best for fishing great stocks, because that segment of the market has significantly outperformed the market. However, finding the right companies amongst the cheapest of the cheap demands a lot of experience, and knowledge.
Another important parameter that a company needs to have is a 10% to 15% ROIC. The company should be able to sustain at least a 10% return on investment capital, while they prefer it to be in the range of 15%.
By opting for that ROIC range the firm is not looking to identify great performers, but avoiding the bad ones. Companies with a ROIC in that range have a durable and sustainable competitive moat. With it, companies can sustain hits from sector-wise downturns and can grow much faster.
Specific classic value industries that are avoided by Lyrical Partners are airlines, pure commodities, and deep cyclicals. Their focus is on more predictable businesses that allow them to implement their analyzability approach.
It is strongly pointed towards simplicity and in the center is the present value of companies future cash flows. If Lyrical cannot estimate the future cash flows they also cannot estimate the value of the company and it is in fact cheap or expensive.
Relying on the margin of safety gives some breathing room in case of a miss, but managers from Lyrical point out that they need to be in the right ballpark for the investment to pay off.
Their approach to analyzability automatically removes some industries from their viewpoint, including banks, pharma, biotech, legacy media, or traditional brick-and-mortar retailers. Also, anything that is in the category of disrupted is out of the question, because it is difficult to analyze it.
Value is the crucial element of every investment decision and fuel for their performance. It allows them to generate long-term high returns, and with the larger discount, the larger the gain. The tipping point is knowing which cheap companies are badly valued for a reason, and which have the potential for more.
Elemental Fleet Management Investment Thesis
Elemental Fleet Management is one of the leaders in the commercial fleet management sector providing comprehensive servicing and financing. The company offers services like vehicle acquisition and disposition, maintenance, licensing, registration, and driver support.
All in all, they provide an all-around vehicle fleet service, annulling the need for companies to keep these operations in-house. The company provides its service to a fragmented market keeping its exposure to a single industry up to 3.5%. The firm's core customer focus is on large fleets varying between 300 and 1000+ vehicles.
In total, they service about 5,500 customers including the giant - Amazon, from 700 industries. Some of them are telecom services, electric utilities, pest control, and pharmaceuticals. They are a market leader in North America, where about 80% of their operations are located.
How Are They Making Money
The company is earning money in two ways: by servicing and financing revenue. These two provide similar input with about 50% of the take.
Servicing revenue is created on a per-vehicle or a fleet basis. This process is fueled by the need for regular maintenance of the fleet, collision management, fleet telematics, and fuel plans. The revenue that comes from it is highly attractive because it is recurring and usually aligned against variable costs. On top of that they are capital-light.
Financing revenue comes from leasing vehicles from the company. After the Element pays OEM for the vehicle and it is delivered a lease is activated. From there on the client is billed for the servicing and financing. Element is looking at a net earning asset through the entire length of the lease.
Larger clients, like Amazon, choose to finance their vehicles, paying only servicing fees to Element. Smaller clients are looking at an upside if they use the whole package, due to Element’s lower cost of capital. They are bringing capital from both servicing and financing ends.
How Element Fits Into Lyrical Philosophy
Lyrical found Elements operations easy to understand and analyze for two main factors. The first is that the company’s outsourced services are easy to understand and are recurring. Very low turnover comes as a result of the client-company relationship maintaining a historical average retention rate of 98%.
The second factor is the low credit risk of Elements operations. This encompasses both residual value exposure and customer default risk. Elemental on its operations in North America takes no residual value risk on assets that it manages. Operations also have a predictable and stable earnings stream by passing any asset gains or losses to the client.
During the worst years during the GFC Elemental realized just 10 points of annual credit loss.
The Quality Of The Company
At the time of the interview, the last report from Q3 2021 showed that Element generated a 15.7% pre-tax return on equity in 2021. These indicators show that Element is a high-quality and resilient business. It has a strong competitive advantage that is reflected in the scale of its business and a broad servicing network. As an end result, the purchasing power is rising, lowering the total cost of ownership for their clients.
The business showed its robustness during the pandemic rising its ROE from 14.5% in late 2019 to 16% at the time of the interview.
Besides being a good business, Elemental is also creating significant free cash flow from its operations. One of the reasons behind this is that cash tax requirements are lower than accounting tax treatment. This factor comes with two benefits - it allows Element to grow, and excess free cash flow can be used for share repurchasing.
Competitive Environment
Most of the market in which Elemental operates has players that manage their own fleets. At the moment about 60% of the market does not outsource these operations. This represents a huge potential for Elemental to grow its business and offer solutions to those companies.
The industry itself is an oligopoly, with two main competitors being ARI, and Wheels/Donlen. ARI is privately owned and is half the size of Elemental, while W/D is a bit smaller than ARI and is owned by Apollo.
During the pandemic, the main competitors decided to cut costs, which gave more space for Elemental to grow. While the market share increase was small, within the range of 1%, it shows the stickiness of the business, because contracts are signed for periods between 3 and five years, with high switching costs.
Valuation Of The Business
Lyrics value their investments on the five-year window using forward earnings, or free cash flow as a proxy. When looking at Elemental shares from these angles, Lyrics estimates potential return generation to reach 2.15 CAD.
When looking at historical figures, the Canadian market has been traded at 9x five-year forward earnings. In this case, when these data are used the result is about 60% upside from the intrinsic value of the share.
Lyrical sees a big potential in the long-term because, in the short-term horizon, Elemental cannot provide enough supply for the demand. Orders for new vehicles reached 2 billion CAD, which is a significant upside from 800 million CAD between 2018 and 2020.
In 2021 the expected decline in free cash flow per share is about 3% due to supply issues, but they expected a growth of 11% and 23% in 2022 and 2023 respectively.
Lyrical expects a growth of stock between 4% and 6% when looking at the top line, and more than 10% at the bottom line. Three proponents of sales growth include moving from self-managed fleets to outsourced fleets, increased service penetration, and taking market share from the competition.
During 2020 Element bought back about 5% of their shares, and with the excess free cash flow it is expected to continue doing the same. Problems with supply will hamper short-term growth, but once that issue is settled, the annual growth should reach double digits.
Another selling point for this company is inspirational management with a strong track record. At the time of this report, the CEO was Jay Forbes, who with his team was pushing for organic revenue growth. In February 2023 Forbes retired, with Laura Dottori-Attanasio filling the CEO position.
Her extensive experience includes a vice president position in the risk department at the National Bank of Canada and Head of Personal & Business Banking at CIBS.
Potential Risks
The widespread implementation of electric vehicles could prove to be a challenge, due to a complex and new approach to maintaining these vehicles. Also, engine repairs and fuel programs will be disrupted, but a chance of installing and maintaining charging stations could fill the revenue gaps.
How The Investment Played Out
At the time of the interview, the Element stock price was at 12.88 CAD, while today it is 28.32 CAD, resulting in an almost 75% increase.
From the 2023 annual report Element Fleet Management showed an increase in both service income ($673 million from $472 million in 2021) and net financing revenue ($554 million from $436 million in 2021). Total net revenue has increased to $1.294 billion from $973 million in 2021.
Earnings per share also saw a rise from $0.76 in 2021 to $1.13 in 2023. Adjusted free cash flow per share jumped from $1.05 in 2021 to $1.67 in 2023.
Element is managing 1,485 million vehicles which is a decrease from 2022 when the figure was 1,523 million.
What fueled the strong performance in the last year was a massive 35.8% increase in new originations, continued success in converting self-managing fleets, taking market share from the competitors, and increasing the shared wallet of existing clients.
From Element's latest report one of the important takes is the complete electrification of internal fleets in Australia and New Zealand. They also made plans to completely electrify the internal fleet on a global scale by the end of 2025.
Recently CIBS raised Element's target price for the company stock from 26 CAD to 30 CAD based on the positive outlook for the company’s second-quarter performance. The driver of this upward trend is a strong demand for fleet management services, combined with strong efficiency on the operational level.
Other positive triggers include optimizing fleet performances and reducing the total cost of ownership for the clients. Implementation of advanced technologies like telematics and data analytics allowed Elemental to enhance its service offerings and deliver higher value to its customers.
It is expected that Element Fleet Management will revise its 2024 guidance upwards. Factors that can contribute to this decision are an expected increase in investment in fleet management services, expanding service offerings, entering new markets, and aiming for new strategic acquisitions.
What is also indicative is that Simply Wall Street did research, and based on it, if you invested in Elements Fleet Management five years ago, you would earn 187% gain.
When analyzing all these indicators from the last three years, it is not hard to see that Lyrical Partners made a bold bet on a struggling company that managed to be a very good long-term investment.
They saw beyond short-term struggles, perfectly understood the potential that the company had in the prolonged time frame, and made a long-term profit in line with their investment approach.
The firm exited from this position in Q1 2023 after selling the last batch of 6,880 stocks at a price of ~18 CAD per share. This is a solid return on investment, reaching a roughly 33% gain, since the price at the initial trade was 12.88 CAD.
Lyrical Partners maybe could have planned a better exit strategy, because the stock is still on the rise. Nonetheless, this is an overall success story for the fund and for the investors.
