Element Fleet Management Corp
TSX:EFN
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Element Fleet Management Corp
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Thank you for standing by. This is the conference operator. Welcome to the Element Fleet Management Second Quarter 2021 Financial and Operating Results Conference Call. [Operator Instructions] And the conference is being recorded. [Operator Instructions] Element wishes to remind listeners that some of the information in today's call includes forward-looking statements. These statements are based on assumptions that are subject to significant risks and uncertainties, and the company refers you to the cautionary statements and risk factors in its year-end and most recent MD&A as well as its most recent AIF for a description of these risks, uncertainties and assumptions. Although management believes that the expectations reflected in the statements are reasonable, it can give no assurance that the expectations reflected in any forward-looking statements will prove to be correct. Element's earnings press release, financial statements, MD&A, supplementary information document, quarterly investor presentation and today's call include references to non-IFRS measures, which management believes are helpful to present the company and its operations in ways that are useful to investors. A reconciliation of these non-IFRS measures to IFRS measures can be found in the MD&A. I would now like to turn the call over to Jay Forbes, President and Chief Executive Officer of Element. Please go ahead.
Thank you, operator, and thanks to all of you joining us this evening. And I will be sharing today's call with Jim Halliday, our Chief Operating Officer, who has a front-row seat with our OEM partners and will provide an update tonight on new vehicle production delays and how we're managing through the situation. We'd like to use our time with you to discuss Element's results for the second quarter and the first half of the year, the progress that we've made advancing our strategic growth objectives and the headwinds we're experiencing as a consequence of those OEM production delays, which are driven by the shortage of microchip supply to many OEMs, including the big 3 domestic manufacturers. Let me start by looking backwards for a moment at the pandemic-impacted period that made up the majority of 2020. With COVID-19 taking hold in our operating geographies early last year, we faced 2 significant tests. Was our business model as resilient as we believed it to be? And was our ongoing work transforming Element's business and balance sheet ready to withstand the challenge? Element passed those tests with flying colors. Our revenue and cash flow streams remained strong and steady. Our book of business was solid with delinquent and impaired receivable positions dramatically improving over the course of 2020. We've maintained ready access to ample, cost-efficient capital for our clients, including unimpeded access to the syndication market. Our liquidity actually improved under the circumstances. And we accelerated transformation and, in doing so, overachieved our year-end goal. Not only was Element able to successfully navigate the challenges of the pandemic last year, we benefited from the experience. We learned much about the cash flow rhythm of the business, allowing us to rightsize our funding facilities and contribute substantial interest savings and make a very positive impact on our net financing revenue. We forged even stronger ties to our colleagues across the globe as we learned to deliver a consistent and superior client experience in a very different operating environment and quickly shared these learnings to benefit our clients in all 3 regions. And this rapid sharing of best practices, coupled with our ability to proactively help clients conserve resources by lowering their total cost of fleet operations and eliminating their administrative burden, deepened our client relationships, as evidenced by our record high Net Promoter Scores. While Element's transformed business model proved strong and resilient throughout 2020, the pandemic's impact is still being felt on our financial performance. And this, in our minds, is masking the true value-creation capability of the organization. Take service revenue. We had anticipated that the widespread availability and acceptance of vaccines would usher in the return of a more normal way of life in each of our operating geographies and with it, a return to historical activity and consumption patterns for many services we provide our clients. As it turns out, this hasn't happened as quickly as we would have expected. We continue to ascend from a precipitous decline in service usage volumes in March and April of 2020. The ascent has been steady, and there have been no signs whatsoever of any systemic declines in fleet sizing. However, this return to normal has been slower than anticipated. We are only now, at the end of July, starting to see preventative maintenance, fuel consumption and other activities that generate service revenues on par with pre-pandemic levels. And of course, having built a scalable operating platform to handle the planned growth and volumes we're pursuing, the absence of these transactions has deprived us of revenue-generating activities with no attendant decline in operating expenses. And this has resulted in a continuing, albeit lessening, drag on first half operating income. Fortunately, everyone we see points to a full and solid recovery in service revenues through the balance of this year. A second impact arising from the pandemic has been the unexpected delays in OEM production arising from the global microchip shortages. In talking with colleagues like Jim, we've been in this industry for decades and have seen everything, no one has ever witnessed this type of abrupt disruption in the supply chain. These unforeseen production delays have had a knock-on effect for our business, postponing the delivery of vehicles and deferring the highly profitable origination cycle. Given the unprecedented nature of this occurrence, let me provide a few additional insights this evening. First, the decline in originations is being driven by supply, not demand. The OEMs are unable to produce vehicles on normal time lines to fulfill the strong order book that we have built. Our U.S./Canadian vehicle orders in the first half of 2021 were 56% higher than in the first half of last year and were ahead of the first half of 2017 order volumes and on par with 2018 first half volumes domestically. Only 2019 had higher first half order volumes, and those reflect a year's worth of our model orders received in that period. ANZ orders also returned to pre-pandemic levels in the first half, growing 46% from the first half of last year. And Mexico vehicle orders are up 42% year-over-year in the first half. So clearly, our clients' demand for new vehicles remains robust. However, the supply side of the equation is materially constrained. Historically, it has taken an average of 60 days for a vehicle order to be placed with an OEM in the United States to result in an origination on our balance sheet. The historical average in Canada is 90 days. As of mid-July, the current average was over 125 days in each country. While OEMs were less impacted by the chip shortage in ANZ, dealer inventories remain low, and more vehicles are being sold into the higher-margin retail channel. That reduces the supply of vehicles to fleet management companies like Element. Mexico has been the least impacted by production delays, with the major OEMs in that country having been best prepared for the market realities that we're facing. The combination of robust demand in the form of orders and significant delays in OEM production levels has created the largest order backlogs on record in each of our 3 regions. Now I'm excluding Armada from historical record here given the lumpy distribution of their orders over the last 10 quarters. And we haven't talked much about orders or, for that matter, order backlogs in past discussions given the consistently short, elapsed time between an order and an origination. However, with the material elongation of this time frame arising from the OEM production delays, the topic does warrant further elaboration. So here's how orders relate to originations. We place orders with OEMs on behalf of our clients. Upon acceptance, Element is liable to purchase that vehicle from the OEM. And simultaneously, our client becomes legally bound to lease that vehicle from Element under the terms and conditions of our agreements. So in other words, an accepted order is the equivalent of an origination. We have a record backlog of orders, which means we have a record backlog of originations in waiting, all of which are effectively guaranteed to occur as OEM production volumes normalize. In addition, we see a growing need for our clients to order more vehicles than are represented in the current backlogs because clients' fleets continue to age. This suggests even more pent-up demand being released as the pandemic wanes and new vehicles do become available. So to reiterate, the fundamentals of the business remains strong and intact. The decline in originations is a supply, not a demand, issue. We've seen orders return to pre-pandemic levels as clients return to historical patterns of regular fleet renewals, and our inability to fulfill these orders on account of OEM production delays will not result in lost revenue, just revenue deferred until production volumes normalize. Now with the time value of money being what it is, we would obviously like to have these originations sooner than later. That said, that same factor giving rise to these deferred originations is creating incremental revenue opportunities such as much higher gains on sale in Australia and New Zealand that we would not otherwise be able to avail ourselves of. Let me turn the call over to our COO, Jim Halliday, who can provide some additional color on the importance of originations to our net revenue streams across the organization as well as the onetime or limited time net revenue that we earned in the first half and that we continue to earn today as a direct consequence of the delay in originations. Jim?
Thank you, Jay, and good evening, everyone. Originations are a crucial component of Element's business. Every origination is a new vehicle for one of our clients, and new vehicles for our clients are core drivers of net revenue for Element. I want to clarify that we don't just lease new vehicles to our clients. In some cases, we order and acquire vehicles on behalf of our clients and then turn around and resell the vehicles directly to the clients. We call those A&R or acquisition and resale transactions, and they're valuable to us, too, even though they don't show up in origination volumes. I think A&R is an important dimension of our business to acknowledge, so I wanted to mention it upfront, and I'll come back to it in a bit. Originations are the precursor to leases as well as a number of pre-lease and related services, all of which are revenue events for Element. For example, before a client takes delivery of their vehicle, we typically have titled, licensed and registered that vehicle for them. Those are highly administrative tasks that vary in nature by jurisdiction as well as by type of vehicle. We make that complexity simple for our clients by taking care of it on their behalf, in exchange for which we charge a small fee. Another example of post-origination, pre-lease activity we engage with -- for our clients is upfit. Approximately 55% of our clients' vehicles are upfitted in some way, shape or form. And in many cases, Element is helping design and engineer that upfit package. Upfit can be anything from a custom paint color to vehicle details to custom racking, hydraulic suspension or aftermarket lifting -- lighting systems. It even gets as complicated as pieces of machinery that are sometimes worth more than the vehicle itself being integrated with the chassis for specialized use cases. Vehicle upfit is a lot of work, from design and planning to managing delivery and execution. And the shops that provide these specialized services are often small- and medium-sized businesses without the infrastructure to digitize or automate the administrative parts of their operation. We take care of this complexity for our clients, keeping their lives simple. They order the vehicles they need from Element, and we make sure the vehicles get delivered to them in a perfect condition for whatever their business use case is. The cost of upfit is typically added to the capital cost of the vehicle lease. So it would increase the reported origination value over and above the price we pay the OEM for the vehicle. This also increases our net financing revenue from that lease, and it increases the gross interest income that our syndication partners purchase if we syndicate that lease. Another source of revenue for Element between origination and activation of a vehicle lease is accommodation income. We often make accommodations for our clients to begin driving their new vehicles technically before the lease is activated, and we invariably advance working capital on a client's behalf to pay the OEM and upfitter for their vehicle weeks or even months before we start collecting lease payments. So we charge small fees for these kinds of accommodations to cover the cost of our capital and activities during that pre-lease period. Last for now, but certainly not least, is our vehicle remarketing revenue. In the U.S. and Canada, our clients bear the residual value risk of the vehicles we lease to them. When it comes time to replace a vehicle, in order to optimize the total cost of fleet operations, that vehicle may not be at the end of its lease contract term. Rather, the client buying -- rather than the client buying out the remainder of the lease, more often than not, they will retain Element to remarket the vehicle on their behalf. We have incredible remarketing partners like Manheim, ADESA and retail dealers who ensure that our clients get the best price for their used vehicle. And out of the proceeds from that remarketing a vehicle, Element pays off the remainder of the related lease, earns a fixed fee service for coordinating the remarketing transaction and remits any leftover proceeds of sale to the client. The reason remarketing service revenue is impacted by OEM production delays is that the clients aren't giving us their existing vehicles to our market, and that's because we can't originate a new vehicle to replace their used vehicle with. Those are just a few examples of the net financing and service revenues generated in relation to a new vehicle origination. You'll recall earlier, I told you about A&R vehicles, which don't get counted in the origination volume. However, all of the revenue associated with ordering, upfitting, titling, licensing, registering and delivering new vehicles is still captured on A&R vehicles. It won't get capitalized as part of the lease principal and earned interest income into net financing revenue because there is no lease. However, we would still ensure we cover our costs, including the cost of our working capital as part of our A&R service, and we are earning fees over and above that cost reimbursement. Those fees are being captured in the service income line on our P&L. As Jay noted, even though all of this guaranteed revenue related to new vehicles is held up for now as a result of the OEM production delays, there are some onetime and limited-time opportunities for Element to generate healthy net revenue from other sources while we wait for production volumes to normalize. The obvious example is gain on sale income in Australia, New Zealand and Mexico, where the used vehicle markets are incredibly strong right now as a result of the same forces that have created record order backlogs, namely new vehicle supply constraints. Unprecedented gain on sale premiums won't last forever for Element, but we are anticipating that it will continue into the second half of the year. And if we're wrong, it is likely because new vehicle availability has increased, normalizing used vehicle market prices. New vehicle availability means we can be originating for our clients and fulfilling demand. The gain on sale premiums that may diminish will be replaced by revenue related to new vehicles, and we will continue to earn gain on sale on the resale of our end-of-life leases in Australia, New Zealand and Mexico. It is just unlikely to be at the outsized amounts that we're enjoying today. All else being equal, revenue related to new vehicles is better for Element. In the U.S. and Canada, constraints on origination volumes are causing many of our clients who have placed orders for new vehicles to continue driving their existing vehicles by necessity until supply matches demand. In some cases, those vehicles are being driven beyond their optimal point of cost efficiency. In other words, they're getting into the mileage bands and level of vehicle wear and tear that are likely to result in expensive maintenance and repairs having to be done. We take care of coordinating that maintenance and those repairs on our clients' behalf, and we ensure their drivers have adequate alternative vehicles to use in the meantime in order to minimize downtime. All of our work to these ends, making the complex simple for our clients and delivering consistent, superior service experience, is revenue-generating work. And it is in revenue we'd be earning if these vehicles have been replaced in the normal course with timely originations. We've also seen an uptick in service revenue from long-term rentals, which we coordinate for our clients who needs standard vehicles to continue to operate their business until the new vehicle they have ordered are -- is ready for use. So I want to be clear that we are eager to return to the balance of new vehicle supply fulfilling the strong demand from our clients. We'd rather be meeting their regularly scheduled needs. We are advocating for Element's client needs in all of our discussions with our OEM partners, and I thought I'd give you a little bit of insight into this dynamic. First and foremost, we're approaching this challenge the same way we approach everything in Element: make the complex simple and do the right thing for our clients. That's our client centricity in a nutshell. On a day-to-day basis, our teams are communicating with our counterparts at the OEMs and pushing our clients' orders to get allocated production slots. We're also communicating with our clients daily, educating them about what we know and what we believe to be true. As I know Jay and Frank have told investors before, we don't have insider access to OEM production, volume or timing decisions at large. We're always receiving information pertaining to specific client orders directly from our OEM partners and working with OEMs to interpret the impacts they advise us of. We also carefully monitor OEMs' public announcements and interpret how those -- that information in those announcements will impact our existing client orders with that OEM. Then we think through how that announcement might impact near-term orders our clients intend to place, and we are keeping our clients in the loop at all times. Part of the reason we're able to leverage OEM intel to help our clients stay better informed and make better decisions than the average OEM customer is because we have a sizable team of experts on this and a deep data set to triangulate with. For example, data received from one OEM last week allowed us to determine that, that manufacturer produced over 4x as many vehicles for Element in each of June and July to date as they did in April and May. And they expect to more than double their production in August based on the existing production schedule. We know every inch of our order book with that OEM, so we can now advocate for production slots and make sense within those volumes. We're not just calling up the OEMs and saying, "Hey, produce more vehicles for our clients." We can say, it looks like factory A is going to have additional production slots. Could you allocate those to our clients' orders, which have been backlogged since May? That's the type of dialogue that we're having. Our teams are communicating with OEMs day in, day out. We do this even when production volumes and timing are normal. We have deep relationships with our contacts at OEMs, and I can tell you that these relations are especially valuable at times like this. The relationship value is in the fact that our contacts will listen to us. We get the time of day because we are constantly ordering and purchasing vehicles 365 days a year. Our clients are huge companies and brands that OEMs want to serve and maintain strong relationships with, and the OEMs know those relationships go through Element. As a result, we're not shy about advocating for our clients. We are providing almost as much value to the OEMs as we are to our clients with our advocacy. OEMs want to know about future order volumes, client preferences and competitive offerings. We would obviously never breach a client's confidence, but the OEMs still learn a lot in the aggregate from their relationship with Element. The dynamic I'm describing here is a huge competitive advantage for Element. Our clients, our order volumes and our size get us to the front of line amongst FMCs. That's a benefit we derive from market leadership and being approximately twice the size of the next largest FMC in North America. Another dimension in which our size and scale matters is strategic consulting. Our strategic consulting team is the largest in the industry, and we bring their data-driven analytical skills to bear in this context to help clients make ordering decisions and pivot quickly from one OEM to another, if necessary. We are treating this as an opportunity to shine for our clients and to showcase what we can do for them. Our philosophy of making the complex simple for our clients really applies to these strange times. Just as with the pandemic, we believe there's an opportunity here to emerge from this with even deeper client relationships. In terms of when we will emerge from this, that timing is outside of Element's control. But as Jay noted, the lower present value of deferred originations and related revenue is at least partly offset by the onetime and limited-time revenues we are generating right now as a result of the production delays. And the revenue related to deferred originations remains guaranteed. It's only a matter of time. With that, I'll hand it back to you, Jay.
Jim, thanks for the additional insights on this topic. If those on the call only take 2 things away from our discussion of the OEM production delays this evening, I hope they are the following: Firstly, it's a supply problem. The demand from our clients has returned to pre-pandemic levels. And secondly, it's a temporary problem, one that's going to be short-lived. Based on our understanding of the latest OEM production plans, we expect to return to normal production volumes later in this half. We expect this will clear our order backlogs and generate increased levels of originations and their associated impacts on revenue and cash flow in early 2022. These would be higher than historical run rate originations, although my use of the term run rate here continues to exclude Armada originations in 2019 to 2020. I do hope that we've provided you with a deeper understanding of the primary challenge our business faced in the first half of this year. I'm now going to turn the call over to Frank to discuss our financial and operating results for the period.
Thank you, Jay, and good evening, everyone. I'm happy to be here with you tonight to talk through our solid second quarter and first half results and how they demonstrate our progress on Element's strategic growth priorities. With a few exceptions, I'm going to focus my comments on first half results and their comparison to the first half of last year on a constant currency basis because the second quarter of last year was heavily impacted by COVID, and the first quarter of last year was one of the Element's strongest and not materially impacted by COVID. By using the first half results, we get a better picture of last year's Q1 and Q2 balance each other out a bit for comparison purposes. In addition, our stated target growth rates are annual. So comparing year-to-date this year to year-to-date last year is more indicative of our progress against these goals. I will also focus many of my comments on constant currency, which is a truer measure of our progress given the translation noise in restating our U.S. revenues, earnings and cash flows, our largest geographic contributor, into Canadian dollars. To put the magnitude of this translation noise into perspective, the Canadian dollar appreciated by nearly 10% from USD 0.73 last year to USD 0.80 this year, creating a noneconomic drag on our financial performance. Starting briefly with Q2 results. Our adjusted operating income for the quarter was $126.5 million or $0.20 per common share on an after-tax basis, which is in line with consensus. The provision for taxes applicable to Element's adjusted operating income is based on 25.8% effective rate for the second quarter, up from 23.4% last quarter. As I mentioned on our last call, we recommend modeling Element's adjusted EPS based on a 23% to 25% effective tax rate for 2021. I would suggest erring towards the higher end of that range. Remember that the real cash tax amounts that Element pays are a lot less than the reported tax line item on our income statement. For that reason, we continue to believe free cash flow is a better metric than the after-tax AOI on a per share basis when it comes to evaluating the underlying performance of our business. In the first half of 2021, Element generated $484 million of net revenue, which is $38 million or 8.4% growth from first half of 2020 net revenue of $446 million on a constant currency basis. This growth was primarily driven by net financing revenue improvements of $32.9 million or 17.6%, helped along by $2.3 million and $2.4 million improvements of first half-over-first half servicing income and syndication revenue growth, respectively, again, all on a constant currency basis. Adjusted operating expenses in constant currency were flat in the first half of this year compared to last year with salaries and wages up modestly, offset by lower G&A expenses. Growing net revenue while keeping OpEx flat is the hallmark of a scalable operating platform. Our first half operating margin expanded by 390 basis points in year-over-year and still 360 basis points after the impact of changes in foreign exchange. As we indicated in our disclosures today, we expect operating margins to moderate slightly in the second half because first half adjusted operating expense benefited somewhat from a collection of discrete nonrecurring items, and net revenue also benefited from approximately $5 million of provision for credit loss releases in the first half, which are likely to be the largest releases from our allowance for credit losses this year. Nevertheless, we will continue to enjoy strong operating leverage throughout 2021. That 8.4% first half net revenue growth was magnified by our scalable platform almost twofold into 16.7% adjusted operating income growth year-over-year before the impact of FX. Adjusted EPS for the half year-over-half year grew 10.9% in constant currency, despite a 730 basis point increase in the applicable effective tax rate. Changing gears now to our strategic priority of advancing a capital-lighter business model. I want to offer my perspective on the role of syndication in Element's growth strategy. Syndication advances all 3 of our current strategic priorities. We are not relying on syndication to grow net revenue 4% to 6% annually. However, with low related operating expenses, syndication revenue contributes materially to our operating margins by landing heavily on the adjusted operating income line. Syndication leads our charge to a capital-lighter business model by reducing liabilities on our balance sheet, freeing up equity while maintaining our target tangible leverage ratio. Additionally, syndication provides the means to generate capital that can be returned to shareholders via repurchase of common shares for cancellation under our NCIB or also driving return on equity and accelerating growth on a per share basis. Through strong performance in reducing the equity capital invested in the business, we grew our pretax return on common equity 100 basis points alone in Q2 on a quarter-over-quarter basis. It is important to remember that each lease is entered into under terms we are willing to keep on our balance sheet. We only syndicate leases when the totality of the transaction is economically superior to holding the lease on our balance sheet. So syndication is always a net win for Element. In the first half of this year, we syndicated $1.6 billion in assets or $36 million of net revenue, largely on par with the roughly $1.5 billion syndicated in the first half last year that generated $33.3 million of revenue on a constant currency basis. The other driver of our capital-lighter business model that enhances return on equity is servicing income, which grew 1.3% in the first half over last year and 1.4% as measured quarter-over-quarter in both cases before foreign exchange. Service revenue requires only working capital to support its growth and, therefore, represents high-quality, high-return revenue. Service revenue is being led by maintenance volume uptick in the U.S. and Canada as well as accident services revenue. We are also seeing the organic growth of service revenue streams from Australia, New Zealand and Mexico, where we continue to increase our share of wallet with existing clients in addition to new client wins. As you heard Jay say, and we have communicated in our written disclosures this quarter, we believe that servicing income has now turned a corner. And we anticipate continued growth in the second half of this year on a constant currency basis, with clients' vehicle usage returning towards pre-pandemic levels this month. Each Q3 and Q4 servicing income should be successfully better than Q2 this year, even without adjusting for potential FX headwinds. Our third strategic priority, alongside profitable revenue growth and advancing a capital-lighter business model, is annual free cash flow growth before FX in 2021 and the return of excess equity to common shareholders. Free cash flow per share for the first half was essentially flat year-over-year, with Q1 of last year being the free cash flow high point for the last 3 years and thus, making for a tough comparison. Year-over-year for the second quarter, free cash flow was up 13.8% and 16.3% on a per share basis, each before FX. Quarter-over-quarter, Q2 free cash flow grew 16.3% and 18.2% on a per share basis, again, before foreign exchange. The per share metrics were aided by our NCIB activity. Element repurchased over 13.5 million common shares in the second quarter and has repurchased over 22 million common shares or 5% of our float for cancellation since the inception of our program last November. Combined with common dividends, we returned $189.4 million in cash to shareholders in Q2 and have returned $360 million since the NCIB began. Before I hand things back to Jay, I'd like to walk you through the impacts of OEM production delays and deferred originations on our net revenue and cash flow. The key message here regarding the OEM production delays is that the financial benefits of affected originations are not lost but simply deferred. Our clients need these vehicles to operate their businesses and fulfill the needs of their customers. As Jay explained, an order placed with an OEM creates a binding obligation on our client to lease when the ordered vehicle is produced by the OEM, thereby turning it into an origination. When that origination occurs, we begin to obtain both the P&L and cash flow benefits associated with that new vehicle. At the end of Q2, we had just under $1.5 billion of would-be originations in the form of backlogged orders. To put that into perspective, it's a record backlog when you exclude backlogged Armada order volumes from prior periods. It's over $170 million larger than the order backlog at the end of last quarter, meaning the end of Q1 2021. It's over $425 million larger than the order backlog at the end of Q2 of last year. And it's over $500 million larger than the order backlog at the end of Q2 2019, again, excluding Armada. These deltas are all based on global volumes in constant currency, but the Q2 2021 global record Backlog is comprised of record backlogs in each of our geographies. So how do OEM production delays impact net revenue? OEM production delays negatively impact net finance revenue in the near term because the deferred originations keep the financial benefits from hitting the books in the current period. However, the orders are firm, and the financial benefits do come on the books when the OEM is ultimately able to deliver the vehicle and trigger an origination. The net financing revenue from originating and leasing that vehicle is not lost but simply deferred to subsequent quarters. And it would be incremental net financing revenue on top of the net financing revenue linked to normal originations, which occur in that subsequent quarter. Additionally, the OEM production delays impact the number of vehicles to which Element provides services shortly after origination, such as titling, registration and the other services that Jim talked us through, including the remarketing of the vehicle being replaced. Again, the related service revenues would be absent from the period affected by the deferral but be additive to a future period in which the origination occurs. The deferral of originations also leaves us with a lower number of new leases we can syndicate. Depending on the proportion of originations we plan to syndicate in any period, lower originations could lead to lower syndication revenue. Like net financing revenue and servicing income, these syndication revenues are not lost but rather only deferred until origination occurs and we have the asset on book to syndicate. We will realize the related deferred syndication revenues 4 to 6 months -- generally 4 to 6 months after the origination. This revenue would be incremental to normal syndication revenues being generated in the period. Remember, our business is proven solid, and that includes its financial performance. We believe we will offset much, but not all, of the revenue and cash flow headwinds from OEM production delays through countervailing revenue streams inherent in our business model such as gain on sale as well as other opportunities we identified, some of which Jim spoke to earlier. We remain on target to achieve between 4% and 6% net revenue growth for full year 2021 over last year on a constant currency basis. Right now, the OEM production delays have us trending towards the lower end of that 4% to 6% range. But the situation is very fluid, as you've heard. To give you a directional sense of the size of the positive impact that deferred originations can have on our business when OEM production capacity normalizes, I offer the following hypothetical. If Element has effectively accumulated $1 billion of deferred originations, by the time OEM production capacity normalizes, we would expect the ensuing 12 to 18 months to benefit from those originations occurring. We would expect the net revenue growth rate during that 12- to 18-month period to increase by 100 to 300 basis points. Meaning that, if we were otherwise going to grow 5% annually over that period, we would expect the growth rate to increase to between 6% and 8%. And we would expect free cash flow from the same 12 to 18 months to benefit incrementally by approximately $40 million to $50 million in total. Finally, I would add that the incremental growth will ultimately be driven by the timing of how quickly OEMs can meet our backlog and new orders, which are likely to be spread out as they ramp up to meet not only our pent-up demand but the market's in general. With that, I'll hand it back to Jay.
Thanks, Frank. Just a few more thoughts from me before we open the floor to your questions. First, when I think about the challenge our business is facing in the form of the OEM production delays, our Q2 and first half results are all the more impressive. We remain on track to grow net revenue 4% to 6% year-over-year before FX as we said we would in spite of a linchpin product supply shortage. We're materially enhancing our return on equity despite a tepid service revenue recovery and unplanned syndication activity, and we're growing free cash flow year-over-year and returning excess equity to shareholders exactly as we said we would. This is once again showcasing the resilience of Element's business model, which we proved last year through the depths of the pandemic. Yet again, we're growing Element's business in spite of unforeseen and unprecedented circumstances. My second line of thinking is inspired by being back on the East Coast of Canada right now, a place where I grew up. Element's market-leading, growing, resilient fleet management business is like a stunning coastal vista, which has often been shrouded in fog, thereby obscuring the view. Back in 2018, we had the heavy fog cover of 19th Capital, an overleveraged balance sheet and a struggling core fleet business. Transformation started cutting through that fog, with early 2020 offering the first visibility of what this company could really look like. We were in the fog when the pandemic rolled in. And no sooner did that fog start to dissipate, then we became shrouded in yet another bank of fog caused by these OEM production delays. However, like coastal weather systems, the current fog won't last long. We can tell that from the weather report showing the strength of our order book, the recovery of our service revenue and our healthy financing and syndication positions. You can imagine Element's looking like, in the clear light of day, as a highly scalable operating platform, one that ensures net revenue growth falls almost straight through to operating income; a view where our transformed processes, systems and procedures, which we continue to automate and improve, mean that we can handle high transaction and interaction volumes without a commensurate increase in operating costs. And more importantly, we can do that without risk of degradation in the consistent, superior experience that our people deliver to our client. And our world-class and uninterrupted funding and syndication capabilities continue to show their value, advancing our capital-lighter business model that has already materially enhanced ROE and provides the opportunity to return capital to shareholders. Imagine what our results will look like when the new client share wallet wins and accompanying revenue units secured by our commercial teams in the first half have been onboarded, implemented, generating net revenue, operating income and cash flow. And imagine the service revenue potential in a post-COVID, V-shaped economic recovery with our client fleets now back at pre-pandemic levels of activity. Jim, Frank and I have the privilege of seeing Element up close every day, unobscured by any fog. And we can tell you, it looks even better from here than it does from afar. The best is still yet to reveal itself. With that, let's open the floor to your questions. Operator?
[Operator Instructions] The first question comes from Geoff Kwan with RBC Capital Markets.
My first question was just on sort of the new client wins and existing clients doing more business with you. I mean, the Q2 results showed you had another good quarter of new client wins and, again, existing clients doing more business. You talked about shortening the sales cycle and improving the pipeline quality. I know it's hard to generalize. But are there additional insights that you can share just about what you're doing and then why clients are switching that's causing your hit rate to increase? And then any additional insights on trying to get self-managed as well as U.S. mega fleet targets.
Geoff, Jay here. We continue to ramp up the win rates across all 3 regions. And I think it's a combination of a number of factors. Firstly, sales force effectiveness. So we have invested heavily in a much more disciplined approach to our commercial efforts than what has been the case in the past, leveraging some of the IP that we have developed in the Mexican market, refined in the ANZ market and brought into the U.S./Canadian market in final form, if you will. And then with that team, embracing it, putting it into use -- in productive use here in Canada and in the U.S. They have expanded on that IP and, in turn, have shared their learnings with their colleagues in both Mexico and ANZ to the betterment of their sales force effectiveness. So a concerted effort in developing a go-to-market process, complete with marketing capabilities, complete with better sales funnel management wherein the quality of the prospects in that funnel, the speed by which we're able to move from prospect to proposal to contract to signed agreement, that has all helped accelerate the pace of growth that you're seeing. So I think that's one key factor. Second factor is indeed that best practice sharing across 3 regions, where there's active sharing of learnings in terms of what's working and what isn't. And I would also point to the reputation and the return of the reputation that we enjoyed prior to the amalgamation of these organizations into the entities that became known as Element. They operated as market leaders, had a great reputation in the marketplace for the consistent client experience that they offered and the return to that stature wherein we are seen to be the market leader not only in size, but indeed, the consistency and superiority of that client experience has opened up more doors for us, both with our existing client base as we look to increase the share of wallet and the services that we provide our existing clients who have a deeper level of trust and respect for us. But it has also opened the door to prospects. And in particular -- and this was a surprise to us, in particular, the clients of our competitors who aren't as satisfied with the offerings and the experience that they're having with our competitors. And they have come forward knocking on our door, asking us to entertain doing business with them. And you can see that in the numbers. We've skewed heavily towards share wallet and market share in terms of adds in the first half, largely as a result of, again, going within our existing client base and selling into the white space of opportunities there. But secondly, being more responsive to the RFPs that have come forward as prospective clients have looked into the market, thus seeing a viable alternative to their incumbent. And they pushed us to consider doing business with them.
And sorry, just on self-managed and U.S. mega fleet targets?
Yes. In self-managed, I would say to you the -- for any available -- of highly qualified targets in the -- stealing market share and share of wallet space has elbowed out some of our effort that we would have put into self-managed, to be honest with you. It does not, in any way, shape or form, reflect any diminished perspective or diminished interests. Quite the contrary, what we're seeing in our early forays into the self-managed fleet have been encouraging. They constitute a goodly amount of the pipeline in terms of prospects. And we have been modifying our go-to-market approach for self-managed fleets based on those early forays into the U.S. and Canadian market, in particular, and to some extent, ANZ, again, leveraging a lot of the knowledge that we cultivated as we built a very successful self-managed strategy for Mexico.And then in mega, nothing probably of substance to report there. Again, long sales cycles and complex client needs, very bespoke offerings. And so we continue to have a number of opportunities that we're pursuing with interest. And again, I would say that the credentials that come with supplying Armada with like service solutions has served us very well in terms of providing us an entree for discussions with these larger potential mega fleet opportunities.
Okay. And just my second question was on Armada. Q1 and Q2 were a very subdued amount there. I think last quarter, you still suggested that a "normal" year, that I think we may see that still in 2021. But given we haven't had much so far in Q1 and Q2, do you still kind of think that's achievable? Or are we going to see something less than typical for them in terms of originations this year?
I probably would have to fall back to our blanket statement around OEM production volumes and the resumption of the same later in the second half. It really is quite dependent on how quickly the OEMs are going to be able to rebuild the production capability as the microchip shortage starts to wane and that becomes less of a constraint. So yes, we have to fall back on that just as the catch-all, unfortunately. And so it will totally depend on the rate of ascent the OEMs see in terms of return to normal production levels.
The next question comes from Paul Holden with CIBC.
First question is with respect to servicing income. So you provided some helpful context around where you're at in utilization at end of July, like back to pre-pandemic. I think to better understand that, it would be helpful to understand where you were in Q2 relative to sort of pre-pandemic run rates.
Yes. Nearing normal. It has been just a very constant ascent back to normal in terms of transaction levels and where transaction levels could be anywhere from the occurrence of routine preventative maintenance, the consumption of fuel, the rate of incidents around accidents and collisions. We never really saw anything but kind of a straight-line ascent in terms of return to normal. It just planed out a little lower than what we had anticipated, took a little longer than what we had planned for. And again, I think it is as much a function of the general environment and the issues that we have seen around vaccination and the return to normal in terms of societal interaction. So delighted to -- as we saw the continued ascent through the second quarter, delighted to, subsequent to Q2, to see us actually hit normal pre-pandemic levels of consumption, especially around fuel consumption and managed maintenance. So it feels like we're there. And obviously, based on the growth that you're seeing in terms of the new client wins, the share of wallet and new prospects that we've converted to clients, then we're encouraged by the profile for service revenue growth going forward.
Okay. Second question is really to help me better understand the risks, either upside or downside, to sort of your origination outlook for the next few quarters, right, stretching into 2022. And I guess the question is, what changed between the Q1 update with respect to the expected delay of roughly $200 million from Q2 to Q3? And what actually occurred? And does that -- again, does that mean anything in terms of potential risks, either negative or positive, in terms of your forward outlook today?
Yes. And maybe given Jim's at the coalface here, I'll ask him to speak to that, Paul.
Yes. Paul, thanks for the question. I think the main -- the driver of that obviously is the OEM production cycles continued to rise in Q2. As Jay sort of alluded at the beginning of the call, they're normally 60 days in the U.S. and 90 in Canada, and they're now up to 130. And they're still moving north. So that's really the driver of kind of the fluidity in the OEMs' forecast as much as ours is changing as that dynamic happens.
So sorry, I don't -- I guess I don't fully understand the answer. Just in terms of -- again, I think the original expectation is roughly $200 million of -- worth of originations being delayed due to supply in the quarter.
Yes. So the reason that the originations moved out in quarter 2 was because the OEMs' ability to deliver those vehicles to us moved out.
So in the U.S., Paul, we actually ended up at twice the normal time to convert an order to an originated unit. And that increase in 2 months on average just pushed those originations into a future period. And again, as Jim has indicated, right now, the cycle time continues to increase. And so we -- as we look to the second half, very difficult to have any type of line of sight with any degree of exactitude as to when that cycle time will start to compress and will get back to the normal 60-day cycle time from order to origination. So it's -- that was the big factor. It was just the elongation of the cycle time from order to origination far beyond what anyone would have anticipated.
And if I read through the answer correctly, and based on my understanding of light vehicle sales in the U.S., then that's kind of suggesting that the OEMs are prioritizing the restocking of dealer inventories over fleet sales. Is that a correct interpretation?
No. No.
No. I would -- no. I mean, I can take that one, Jay, if you want.
Yes.
Yes. So Paul, in the U.S., the way that the OEMs work, and Canada is the same, is there's an allocation that's for the fleet customers. And so they're not deprioritizing our business. It's just -- and the retail is facing the same challenges. If you drive by a dealer lot today, you'll see just incredible lack of vehicle inventory, particularly from our core 3 OEMs. And that's both on the retail and fleet. It's not different. But we're -- we get updates from them every day. And certainly, their perspective is that they're making progress towards securing more chips and that they expect to return to normal production volumes late in -- kind of the second half of the year.
Paul, I think it's important just to step back again. As you think about this, recognize that as we think about the business globally, we're absolutely, in the U.S. and Canada, missing out on net financing revenue, syndication revenue and service revenue. And more importantly to us, we're missing out on significant amounts of cash flow by virtue of having these originations deferred, okay? They will take place, but they are being deferred right now. But globally, the same factor that has given rise to these OEM production shortages has given rise to a ridiculous used vehicle markets in ANZ and, to a lesser extent, in Mexico, which in turn has given rise to significant increments in gain on sale. And so when we look at the business globally, there's almost a hedging here that is taking place at the NFR level. So what we're actually seeing deferred in the U.S. and Canada, they will be realized as revenue in the subsequent period. We're actually in receipt of onetime revenue that significantly offsets that NFR. And so the real exposure for us is more along the service revenue and, as Jim has pointed out, remarketing. So if we're not replacing a vehicle, we can't sell the end-of-life vehicle off and earn the associated fees associated with doing so, which, again, is a very lucrative part of our business, nor are we able to, through the origination, generate the upfront cash flows that usually come as part of an origination transaction. That -- those are the 2 parts of the business that are still exposed by virtue of this OEM production delay. And that exposure, again, is temporary in nature, short term in nature and a mere deferral of the revenue that will be earned in the subsequent period, that subsequent period being totally conditional upon the ability of the OEMs to quickly ramp up given the influx of chips that are becoming available to them now.
The next question comes from Mario Mendonca with TD Securities.
Jay, sort of along the same lines, you've offered that the cycle time in the U.S. is up by 2 months and 1 month in Canada. That would imply then that with the orders being as strong as they are, that we should see a real spike in originations next quarter. I mean, if we're really just talking about 1 month or 2 of delay, what's causing you to think 2022? Is it simply that the cycle time is not a constant, it continues to expand? Or is there something else going on?
A couple of factors to think about. So one, yes, absolutely, we're at 125, 130 days of cycle time right now, and it's rising. And so when do we crest? And when do we actually start to see a reduction in that cycle time and an expansion of capacity and the ability to draw down the order book? And so what we're seeing is the pipeline, for all intents and purposes, has been constrained. And yes, we will have originations in Q3 and Q4, absolutely. But they are going to be longer in arriving to us than they would normally be, which means that the orders that we might have placed in Q1, Q2 get produced in Q3. And so it wouldn't be unrealistic to see the order book continue to build, order backlog continue to build, depending on how quickly the OEMs were ready to ramp back up production to normal levels and reduce that cycle time. So it is just constrictive supply that is preventing us from originating these vehicles. And it will clear -- but it will be cleared at a pace that resembles the OEMs' ability to produce at volume.
A related question then. I think you told us -- and correct me if I'm wrong, but I think you told us that the backlog is about $1.5 billion. Is that right?
Yes. Yes.
So maybe -- you've also been good enough to explain that Armada hasn't made a meaningful contribution to originations in Q1 and in Q2. Has Armada made a meaningful contribution to that order of backlog in 2021?
The comparisons that we have offered have tried to bring Armada out of this, just so we could have like-for-like and, if you will, everyone but Armada or the core business. And the reason why Armada had so few originations in Q1 and Q2 was a function of better matching of supply to their needs. Vehicles arriving in Q1 are not as valuable to them as vehicles that are arriving in Q3.
So have they given orders to EFN? Has Armada given orders to EFN in 2021?
Yes, they have.
The next question comes from Tom MacKinnon with BMO Capital.
We certainly have been -- you've certainly made it clear that demand is robust, and it seems to be just an issue here in terms of OEMs being able to fulfill what has been a very strong order book. But I was curious by the comments you put in the press release where you said Element believes that there is additional near-term client demand for vehicles in the U.S. and Canada that is not reflected in the first half '21 order volumes, as some clients have remained cautious in the first half of the year to the lingering uncertainty regarding the pandemic and economic recovery. So maybe you can tell us what made you -- you've talked about demand being robust. But at the same time, you're saying that clients have remained cautious. And maybe you can talk about what you were seeing there and why you were saying that, and how that cautiousness with respect to clients has trended through the first half of the year.
Yes. And maybe I'll start and ask Jim to add a little bit more color. So if you will, Tom, segment the population of clients into the bulls and the bears. So those whose business model has been less impacted, less affected by the pandemic and have a very bullish outlook for the future prospects of their organization have their orders in, and they are aggressively moving towards a continued revitalization that we're seeing -- keeping with the past practices. At the same time, we would have some clients who wouldn't be taking a more cautious view of how the pandemic might unfold and the impacts it may have on their organizations and the organizational needs. And then you stir into that. And gosh, even if I put an order in, given the chip shortages and the resulting OEM production delays, am I even going to be able to get a vehicle? Why bother?So if you stratify the client base into those 2 groups, what you see in terms of record order backlogs in each of the 3 regions reflects that conviction of those clients with a bullish attitude. What it doesn't reflect is those that are sitting on the sideline [indiscernible] either a cautious view as to however the economy might unfold and with it, how the business may be impacted and/or a bit of reluctance to place an order knowing that it's just going to be queued up for a considerable period of time awaiting OEM production. And Jim's conversations, David's conversations, Chris', other leaders' conversations with those clients would suggest that, yes, what -- we've been cautious for a while, and we can no longer -- either we have become more bullish in terms of the economic sentiments or just more pragmatic in terms of our approach. Our fleet is aging. It's becoming more expensive to run. We're incurring greater down time than what we should be, and it's just time to place those orders. And so that would represent that second group and what we're hearing in terms of additional pent-up demand. So that, in our mindset, is how the 2 segments can coexist, those that have placed the orders and contributed to record order backlogs, coupled with those that, to this point, have been a bit more cautious, a bit more wait-and-see in attitude. But the clock is running against them in terms of managing an efficient fleet. And they need to make some decisions.
Okay. And the second question is with respect to the buyback. The 5.6 leverage -- you bought back a lot in the quarter. The 5.6 leverage kind of stayed the same quarter-over-quarter. You're like halfway through, and it's at 10% NCIB, and there's maybe a little over 4 months left on it. So related to that, like is your intention to just sort of continue on this pace and utilize the entire NCIB, especially given that you're at an attractive 5.6 leverage? And does this increase in OEM cycle time have any impact on that?
Yes. With regards to the latter point, no, the OEM cycle time wouldn't have any material weighting in terms of our consideration around the NCIB or capital allocation process. So no, that wouldn't be a factor per se. And we're pleased with the pace of the program, where we've set up to buy as much as 10% of the shares -- outstanding shares of the organization. And as we've stated before, one of the governing factors for us -- one of the more important governing factors for us is tangible leverage and trying to keep our tangible leverage in that sweet spot of plus or minus 6x tangible leverage, recognizing that's where we want to be on the efficient front here. So that will continue to be a bit of a beacon, a bit of a guiding light for us in terms of the pace and sizing of the share buyback program as we go forward.
[Operator Instructions] There are currently no more questions from the phone lines, and this concludes the question-and-answer session. I would like to turn the call back over to Mr. Forbes for any closing remarks.
Thank you, operator. And more importantly, thanks to all of you for joining us this evening for a discussion of our Q2 results. Much appreciate your time and your continued support. Thanks all, and stay well.
This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant evening.