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 Third Quarter 2021 Financial and Operating Results Conference Call. [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 and 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 statement, 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 conference over to Jay Forbes, President and Chief Executive Officer of Element. Please go ahead, sir.
Thank you, operator, and thanks to all of you for joining me and Frank on the call this evening. We'd like to use our time with you to discuss Element's results for the third quarter and our year-end forecast as well as the progress that we've made in advancing our strategic priorities and provide a bit of an outlook for the coming new year as well as 2023. Let me start by reflecting for a moment on the last 3 years as Element navigated the complexities of transformation and the unknowns of the pandemic. It has been this organization's ability to stay open and responsive to changing business dynamics that has served Element so well throughout this period. And it will serve us equally well as we plot our way through the unexpected challenges arising from the current industry-first vehicle supply shortage.The ability of our organization to embrace an action, new opportunities, together with our ability to identify and mitigate new risks, have allowed Element to move the needle maturely over the last 3 years in every dimension of our business. Allow me to provide you with -- about a few examples. We've grown Element's global Net Promoter Score from negative 9 to a positive 26. We've achieved record high levels of client retention, including nearly 100% retention in Australia New Zealand and Mexico. We've improved employee engagement to 86%. We have expanded our operating margin from 44% to 53%. We've eliminated nearly $5 billion of debt from our balance sheet, and we've improved pretax return on equity from 11.9% to 15.7%. By these and many other measures, our business has never performed better nor have we been better positioned in our markets. Element's progress in becoming a great company is evident in our third quarter, year-to-date and full year forecast results for 2021. Frank will take you deeper into the numbers, but at a high level, this has and continues to be another year that showcases both the resiliency of Element's business model as well as the commitment of our people in forging ahead to deliver a consistent, superior client experience despite abnormal market conditions and often challenging practical circumstances, in particular, as a consequence of COVID-19. While client demand for new vehicles and Element services is robust across our footprint, OEM production delays driven by the global microchip shortage have reduced vehicle deliveries and consequently constrained origination volumes throughout 2021, particularly in the U.S., Canada and Australia New Zealand. Nonetheless, our financial and operating results remains solid. Our particularly strong service revenue growth across the business is a reflection of 3 fundamentals: a strengthened and reinvigorated commercial function, a deliberate focus on services as an important source of revenue growth and the return to more normalized service consumption as client activities return to pre-pandemic levels. Growing service revenue is one of the key thrusts of Element's capital-lighter business model. Compared to net financing revenues, services revenues have much lower funding requirements, only the net working capital position in respect of the services being procured. This makes service revenue, like syndication revenue, highly accretive to Element's return on equity. Service offerings are even more important to our business from a client perspective. You've heard us talk about fleet management as a sticky business. While our ready access to cost-efficient capital allows us to be competitive on financing, services are the glue that creates 98% historical average client retention rates, a metric that we have improved on considerably across all 3 regions. Services, in the manner in which they are experienced by our clients, are also our greatest point of competitive differentiation. We have, by far, the largest and broadest network of automotive service supply partners across North America. We have the deepest data sets in the automotive industry in areas of specialty like remarketing and accident management, earnest clients that initially use Element for nothing else. It's these service capabilities that underpin our compelling value proposition of materially reducing our clients' total cost of fleet operations and eliminating the related administrative burden. Indeed, our trademark consistent superior client experience is, at its heart, a service experience. Let me turn it over to Frank for a deep dive into our Q3 and forecast full year 2021 results as well as an outlook on 2022 and 2023.
Thank you, Jay, and good evening, everyone. I'm happy to be with you tonight to talk through our resilient third quarter and year-to-date results as well as our forecast for this year-end and our expectations for 2022 and 2023. Let me start with a brief discussion of the quarter and year-to-date periods. All of the comparative results I'm going to reference are on a constant currency basis. Our outlooks on year-end 2022 and 2023 and are also all constant currency as we don't factor any future FX hypotheses into our forecasting. Net revenue for Q3 was 4.4% higher than Q3 of last year and 7% higher year-to-date versus 2020 at Q3. We continue to demonstrate the scalability of our transformed operating platform, which magnifies net revenue growth into higher rates of adjusted operating income or AOI growth, steadily expanding operating margins in the process. Year-to-date AOI has grown 13.9% from the same measure last year, and operating margin has expanded 200 basis points from 51.5% to 53.5% for the first 9 months of the year. After-tax AOI per share or adjusted EPS of $0.21 for Q3 was flat year-over-year despite a materially higher effective tax rate this year. Q3 adjusted EPS was up $0.01 per share quarter-over-quarter. By comparison, Q3 free cash flow per share grew 17.4% or $0.04 per share year-over-year and was flat at $0.27 per share quarter-over-quarter. Remember that the real cash tax amounts we pay are materially less than the reported tax line item on our income statement, which is one of the reasons why we view free cash flow per share as the most important measure of Element's performance. We continue to derive benefits from advancing our capital-lighter business model, which enhanced pretax ROE in Q3 by 180 basis points year-over-year and 40 basis points quarter-over-quarter to 15.7%, testing last quarter's record high. We syndicated $520 million of assets for the quarter and generated $13.9 million in revenue. Year-to-date, we are almost flat to 2020 at Q3 in terms of syndicated volume with approximately $2.1 billion, and we are technically ahead of syndication revenue, but single-digit basis points behind on syndication revenue yield, which is indicative of how consistent the results are. I attended the ELFA syndication conference in San Antonio with our team a couple of weeks ago. And I have to say that the experience confirmed my beliefs which were that our syndication capability at Element are among the most sophisticated in the vehicle leasing marketplace. We've invested heavily and wisely in this resilient source of high-quality earnings and cash flow, and I'm looking forward to our expansion of the practice into Canada and Mexico in the new year. As Jay noted, growing services revenue is the other thrust advancing our capital-lighter business model. Compared to net financing revenue, service revenues has a relatively low funding requirement, that being only the net working capital position of procured services. Services revenue performance stands out in our Q3 and year-to-date results, particularly when you control for the $8.3 million of onetime services revenue recorded in Q3 of last year. Absent that amount, services revenue grew 9.4% year-over-year for the third quarter and 3.8% year-to-date versus same period last year. We dedicate a fair amount of space in our disclosures this quarter to discussing the importance of services revenue to our business. I would highlight that we see a path to high single-digit annual services revenue growth in 2022, as our clients return to pre-pandemic vehicle activity levels and we continue to focus on share of wallet wins across our footprint. You can read about our early success on this front in the Achievements and Initiatives section of our MD&A this quarter, on the first page under Our Clients. Last but not least of our revenue streams, net financing revenue grew $8.7 million or 8.7% year-over-year for Q3, despite average net earning assets decreasing 15.5% on the same basis. Net financing revenue grew $41.5 million or 14.4% for the year-to-date period compared to 2020 at Q3. This strong performance was driven by gains on the sale of used vehicles in Australia New Zealand and Mexico, lower cost of funding with the significant maturation of our treasury function and smaller balance sheet, some of the benefits of a capital-lighter model and the reduction of our balance sheet allowance for credit losses. As we signaled last quarter, adjusted operating expenses were 7.8% higher this quarter than Q3 of last year and are up 2.5% year-to-date versus 2020 at Q3. Due to various accruals that occur over the course of the year and the timing of same, our last 12 months' metric is much more indicative of trend and progress on operating margins. You can see 130 basis points of expansion comparing our last 12 months operating margin to that of the prior 12 months. We recorded a onetime adjustment to the short-term incentive accrual on salaries and related expenses in the quarter to reflect the outstanding performance of the business in 2021. In the face of a first-ever OEM supply shortage, our people are still delivering on Element's 4% to 6% net revenue growth target, and we are returning a significant amount of cash to shareholders. The modest OpEx increase on a year-to-date basis is mostly attributable to Q3 depreciation and amortization as several significant work-in-process projects came online. We anticipate D&A increasing over the next several years as we continue to bring IT investments online that allow us to deliver a consistent, superior client experience, while increasing efficiencies in our operations. Before I change gears to our outlook, I want to reiterate the free cash flow per share growth that I noted earlier and speak to our return of capital strategy. Year-to-date, we have grown free cash flow per share of 4.1% or $0.03 per share from $0.73 in Q3 2020 to $0.76 per share this year. The combination of free cash flow growth and our ability to manage tangible leverage through syndication enable us to return excess equity to common shareholders by way of growing dividends and share repurchases for cancellation. The latter, of course, enhancing Element's per share performance metrics. As of October 31 this year, we have returned approximately $568 million in cash to common shareholders, $111 million in dividends and $457 million of buybacks under our NCIB. We announced a 19% increase to Element's common dividend today from $0.26 to $0.31 per share annually, which is effective immediately and therefore, will be reflected in the dividend to be paid in respect of Q4 2021 on January 14, 2022.With this increase, our common dividend represents approximately 30% of Element's last 12 months free cash flow per share, which is the midpoint of the 25% to 35% payout range we plan to maintain going forward. We also announced the TSX approval of our Notice of Intent to renew the NCIB, allowing us to continue returning cash to shareholders by way of buybacks well into 2022, which we intend to keep doing as we feel our common shares are undervalued as a result of the OEM production shortages and the significant net revenue, operating income and free cash flow growth deferred in our order book. And finally, on return of capital, we intend to fully redeem Element's Series I preferred shares class when the opportunity presents itself in June of next year. Moving along to our outlook on the end of 2021 and performance in '22 and '23. Our clients' demand for vehicles has surpassed pre-pandemic levels. The month of October this year was the single largest month of U.S. and Canadian vehicle orders in Element's history, excluding Armada. The OEM's inability to fill these orders has resulted in a massive backlog and created a significant deferral of revenue, operating income and cash flow. At year-end 2021, we anticipate our order backlog to be an all-time high of between $2.5 billion and $2.8 billion, which is approximately $1.5 billion to $1.8 billion higher than our average year-end backlog of approximately $1 billion. We expect that excess backlog to represent approximately $50 million of net revenue deferred by OEM production shortages in 2021. Fortunately, and to some extent as a result of OEM production shortages, we are trending to offset this estimated $50 million deferred net revenue growth and still achieve between 4% and 5% annual net revenue growth for 2021, so within our target 4% to 6% constant currency range. Certain compensating revenue drove this growth achievement. The reduction in our allowance for credit losses, given the outstanding quality and performance of our asset portfolio will have contributed approximately $9 million to net revenue in 2021. The elimination of fees and costs because we recalibrated the size of our credit facilities to better meet the needs of our clients, as we advance our capital-lighter business model, will have contributed approximately $15 million to net revenues in 2021. An increased gain on sale or GOS earned in ANZ and Mexico due to favorable used vehicle pricing, driven by OEM production shortages in those markets, will have contributed approximately $30 million to our net revenue in 2021. We believe this elevated GOS performance will continue until OEM production shortages subside. These opportunities and offsets are testaments to our resilient business model through myriad market conditions. We forecast 2021 adjusted operating income of $500 million to $510 million, equivalent to between $0.80 and $0.82 adjusted earnings per share. We forecast free cash flow per share in the $1 to $1.02 range for 2021, representing 3% to 4% growth in free cash flow per share over 2020. Operating margin will have expanded year-over-year in '21 to between 52% and 53%. And pretax return on equity will almost invariably be a record in the mid-15% range for '21 as a whole. Moving to 2022 outlook. Looking out to 2022 and 2023, I want to flag the reality that we do not have perfect information on the timeline or trajectory of OEM production volumes normalizing. We've triangulated from multiple sources of information, including in-person meetings with our OEM partners to establish our expectations for the next 2 years. We deliberately expressed these expectations in ranges of key financial and operating metric outcomes. We will continue to report these metrics on a quarterly basis, but we won't be updating the related content in this quarter supplementary or repeating it quarterly going forward, unless there's a material change to our knowledge or assumptions. In 2022, we see a good year that will nevertheless continue to experience headwinds from OEM production shortages. We believe the year will get stronger sequentially by quarter as vehicle availability improves. We expect demand in 2022 to be sufficient to produce 5% to 6% net revenue growth. However, OEM production shortages will likely see approximately $30 million to $35 million of this revenue deferred as order backlog, reducing the effective growth rate between 1% and 3%. We provide detailed walks and commentary on our supplementary disclosure this quarter, showing how we expect each of our revenue streams, service, net financing revenue and syndications to change from '21 to '22. Taking a moment to drill down on syndication revenue, we expect it to moderate somewhat next year as OEM production shortages continue to delay originations and vehicle deliveries. Only following delivery can a lease be activated, which creates fleet assets for potential syndication. As noted in the supplementary, we will be syndicating certain operating leases in 2022, and the revenue from those transactions will actually benefit the net financing revenue line because accounting requires us to treat the proceeds of these operating lease syndications as gain on sale. Also, as previously disclosed, we intend to expand our syndication capabilities into Canada and Mexico in 2022, and we expect both geographies to contribute modestly to syndication revenue. More importantly, these are further steps being taken to advance our capital-lighter business model, which enhances pretax return on equity and accelerates the velocity of cash flow, allowing for reinvestment in our business and return of capital to shareholders. Returning to our P&L at a high level. I mentioned approximately $30 million to $35 million of demand-driven revenue likely being deferred as order backlog. The remaining approximately $20 million of growth revenue next year will be partially offset by approximately $10 million of adjusted operating expense growth, resulting in year-over-year adjusted operating income growth of between 1% and 3%. We expect to hold operating margins relatively flat next year by maintaining tight OpEx controls in this supply-constrained environment, so only depreciation and amortization is expected to grow materially, as our transformation investments in infrastructure and technology continue to come online. We see some of the fruits of our capital return strategy in 2022 when we look at the AOI growth rate compared to that of the adjusted earnings per share. We expect EPS to grow between 6% and 11% next year as a function of our continued return of capital to shareholders by way of buybacks. And our free cash flow per share growth is even strong. We anticipate free cash flow growth of 2% to 6% in 2022, but free cash flow per share growth of 8% to 13%. This is what's so compelling about our evolving capital-lighter business model. It gives us the ability to return cash to shareholders through buybacks, which in turn, magnifies free cash flow growth on a per share basis. Looking at 2023 outlook, with expectations of OEM production capacity back to 100% by the end of the first half of 2023, we can reasonably expect vehicle manufacturers to start clearing our excess order backlog in the U.S. and Canada shortly thereafter. For 2023 as a whole, we expect originations, combined with services and syndication, sufficient to grow our net revenue by 5% to 6% organically. We also expect to recover an incremental $25 million to $35 million of net revenue from our order backlog, resulting in a full year net revenue growth of 8% to 10%, with significant additional deferred net revenue to be recovered from remaining excess order backlog in 2024. We anticipate achieving 10% to 16% AOI growth for '23 as the 8% to 10% net revenue growth is magnified into 53% to 55% operating margins atop our scalable operating platform. This AOI growth, combined with our capital lighter and capital return strategies, has us expecting approximately 13% to 19% adjusted EPS growth for 2023, and we expect even stronger free cash flow per share growth, driven by approximately $60 million to $70 million of organic free cash flow growth in 2023 combined with the initial and only partial recovery of an additional approximately $30 million to $40 million of free cash flow from our order backlog. The result is 20% to 27% free cash flow growth on a per share basis with significant additional deferred free cash flow to be recovered from remaining excess order backlog in 2024. In terms of valuing the excess order backlog heading into 2024, we expect it to be sufficiently significant to bolster 2024 net revenue growth beyond our 4% to 6% annual range in normal market conditions with a growth outlook for 2024 closer to the 8% to 10% we expect in 2023. Before I turn it back to Jay, a couple of housekeeping items. First, as we have matured our business and, in particular, our balance sheet and cost of funds, we have the opportunity to modestly increase our leverage levels from a target of 6x tangible leverage to one of 6.5x, thereby further optimizing our cost of capital while staying safely within our credit rating parameters. We look at this on an FX-normalized basis, and as a result, we would remain below the 6.5x level with the current strength of the Canadian dollar. Second, I want to acknowledge the significant volume of proposed tax legislation being floated right now. You will note that we assumed a modestly higher effective tax rate on our adjusted operating income in 2022 and 2023 in our supplementary table on forward-looking adjusted EPS as part of our outlook. Given it is early going, we do not know if proposed legislation will be enacted or if the ultimate impact on our ETR will be [ small ].Recall that real cash taxes amounts Element pays are materially less than the reported tax line item on our income statement. For that reason, we continue to believe that free cash flow per share is a better metric than after-tax AOI per share when it comes to evaluating the underlying performance of our business. With that, I'll turn it back to Jay.
Thanks, Frank. Having had the benefit of studying those 2022 and 2023 outlooks for the last several weeks as we pressure-tested our forecast and challenged and debated the assumptions underlying the same, I come to think of our business having a good year ahead in 2022 and a great year in store for 2023. Unquestionably, we have the right strategic priorities in place and these priorities are well understood and warmly embraced by our 2,500 employees such that everyone is driving on the same track, in the same direction. Our momentum in growing the business is accelerating. You will see ample evidence of that throughout our disclosures this quarter. While OEM production shortages will defer the financial impacts of much of that growth until 2023, the key word here is defer. None of the benefits of our growth efforts are lost. What's more, as you will have read in my letter to our shareholders today, there are silver linings to the current circumstances, which continue to evidence the remarkable resilience of this business model and its capacity to generate free cash flow through a myriad of market conditions. And while we will continue to strategically reinvest a small amount of that free cash flow back into the development and maturation of our operations and capabilities, we will be returning the lion's share of that free cash flow to our shareholders by way of growing common dividends and ongoing share buybacks. I'm now well into my fourth year with Element and never have I been more confident regarding the future success of this company. Our commercial teams are hitting their full stride in all 3 regions for the very first time. Operations has never been more efficient nor more effective in their service of our clients. Finance has given us unbridled access to cost-effective capital that allows us to compete with anyone in our markets. And our people, more experienced and capable from -- on overcoming the challenges of the last few years, are engaged, they're collaborative, quickly disseminating best practices across our global footprint to deliver a consistent, superior client experience every single day. We provided you with a great deal to chew on this quarter, so we're going to keep our prepared remarks to this and allow more time to hear from you and to take and answer your questions. So let's open the floor to those now. Operator?
[Operator Instructions] Our first question is from Geoff Kwan with RBC Capital Markets.
My first question was on the OEM kind of normalization guidance you've given, like is there a specific data point or points that changed in the past couple of months to have the meaningful change in the expected time for the production to normalize? And how would you describe the level of your comfort with this new timeline?
Yes. As we talked through in the second quarter, there was a dearth of information, both sources and quantity of information that was available to us, and we were, much like the larger investor public, trying to aggregate the publicly disclosed information and refine it based on our own knowledge of the industry just to come up with some type of informed view going forward. That was proven to be very unsatisfactory. And over the course of the summary, we undertook a series of actions to go far deeper in terms of our understanding of the root causes and the cascading effects to the OEMs and into our industry. So firstly, we took the conversation, if you will, from the trenches to the executive suites of the OEMs and engage with their executive teams to better understand their views as to what was unfolding and in turn, share our needs in terms of having a greater visibility in terms of their production schedule. Secondly, we took the input from those meetings and very clear guidance in terms of production timelines and volumes as it related to the models of greatest interest to ourselves and our clients. And we undertook our own analysis based on best estimates of productive capacity coming back online to full capacity over the ensuing months, match that up against our understanding of our portfolio and the maturation of that portfolio to develop a very concise and more precise indication as to how this might all unfold by way of origination volumes in the next 6 to 8 quarters. And then lastly, we undertook independent research and again, went to the root cause of the semiconductor chip shortage, why we ended up in this situation in terms of the cascading effects to the OEMs, and achieved a better understanding in terms of both the enablers and blockades that the OEMs were likely to encounter as they position themselves to be a bigger taker of semiconductor chips over the next year or 2. And so if you will, those -- that 3-pronged deep dive that we undertook allowed us to have a more informed view as to the root causes, their effects on the OEMs and in turn, the most likely effects it would have on our originations. And the output has been shared with the investors as part of our disclosures here this evening.
And then my second question was, in your 2022 and 2023 guidance, what sort of assumption is there around new revenue units, wins or additions?
We are very bullish, as you can see by the continued success that we're having in terms of stealing share, share of wallet in self-managed fleets in all 3 regions. Again, we're very bullish in terms of the underlying fundamentals of the business. Our issue is not making a sale, it's not converting that sale into an order. It's having that order being fulfilled with the delivery of the vehicle and origination, which we have described for many years has been the most lucrative part of the cycle in terms of our business. So we continue to remain very bullish in terms of our outlook for sales, very bullish in terms of orders. As Frank spoke to in his remarks, October was just absolutely outstanding month in terms of record order taking and November is off to an equally bullish start. Again, for us, this is translating into an order backlog for which we have very good, very high level of confidence in terms of line of sight around the amount of deferred net revenue, deferred operating income and free cash flow, but it is deferred to subsequent periods.
Our next question is from John Aiken with Barclays.
First of all, guys, thank you very much for the detail in the outlook. That's fantastic, and I really appreciate it. Jay, I'm not going to argue with your outlook for what the OEM production is going to be. Your line of sight is obviously way better than what mine is going to be. But my question for you is just if there is risk of additional push out, I know you've gone to great pains to explain to us that the orders right now are locked in their contracts. But is there at some point there -- where that actually does break down? Like does the contract ever break down if you, through the OEM, cannot actually produce a vehicle? Is there some timeframe where this actually dissipates? And secondarily, is there any risk on the vehicle purchase in terms of inflation? So if the vehicle delivery is 12, 18 months out now and presumably, the cost of cars are going to be a lot higher at that stage, is there any risk on your income statement?
Yes. So firstly, when we think about the chain of obligation here, when a client places an order with Element and Element in turn places that order with an OEM, upon acceptance of that order by the OEM, we've effectively traded a chain of obligation. We are legally obligated to execute that order, pay for the vehicle upon its delivery to us. And in turn, coincident to that, the client is obligated -- legally obligated to pay for that vehicle upon receipt. So we have, again, a legal obligation that takes effect upon acceptance of these orders by the OEMs. Secondly, we have a very practical consideration. The OEMs want the sale, they want to produce this vehicle, fulfill the order, deliver that vehicle and record the sale. At the same time, the client needs that vehicle. It's either replacing a vehicle that is long in the tooth, well beyond the best before date or is in need to facilitate the growth objectives.So for instance, one of the clients I was talking to in the last 2 weeks, needs 500 new Malibus for an expansion of their sales force and those are additive vehicles. The orders will be placed and they will be anxiously awaiting their arrival. So legally, there is an obligation that sees this fulfilled regardless of the timeline it takes to fulfill it. And practically, the longer this goes, the more eager the client is to have that vehicle because either they are paying much higher operating costs to utilize their existing vehicle or they're paying even higher costs in the form of a long-term rental from us to provide their workforce that they're able to visit the clients as salespeople or service their clients as service personnel. So that is the legal and practical ties that bind this chain of obligations together, if you will. And it looks through the timeline. And remember, while this is not exactly first in, first out, there is a precedent. So the earlier your orders are getting fulfilled, generally speaking, earlier than the later orders.And so even though we're looking out to 2023 before the backlog is -- begins to be cleared, Q1's backlog is being cleared as we speak, and Q2's will be clearing as we speak and into the next quarter, et cetera. So the timeline for this isn't 18 or 24 months from date of order to date of receipt of a vehicle. And then lastly, in terms of the inflationary piece of this, again, we are protected from that. The client understands the pricing, understands the ability for that price to shift and assumes obligation in terms of that price. And we are seeing increases in model year pricing. So the '22 model year in general has gone up 2% with select models in the high single-digit levels of inflation. And for us, as we've talked before, inflation is a friend. It's additive in terms of net finance revenue, it's additive in terms of syndication revenue. And over time, it's quite additive from a service revenue point of view as well.
Our next question is from Paul Holden with CIBC.
So First question for you is related to your 2021 guidance. And again, I'd echo appreciation for all the additional details you've given us on the guidance. But the 2021 guidance of $0.80 to $0.82 in EPS compares to $0.63 year-to-date and so implies $0.17 to $0.19 for Q4. I'm just wondering what's kind of driving the expectation for a sequential decline in Q4 earnings?
Sure. This is Frank. So when we look at it, think back to the summer and the summer when most of the OEMs had production -- the weakest production that they've seen in a long time with many, many of the facilities closed for the chip shortages and the like. Those vehicles that would have been manufactured in the summer would likely be the vehicles that would be originated in Q4. And so as a result, Q4 originations will likely be lighter than we've seen in the first 3 quarters. And hence, the flow-through of those lighter originations will impact the quarter. Service revenues, other revenues should be in line, but the origination component of that is likely to drive a weaker quarter than the -- on a sequential basis.
Understood. Okay. Not a completely surprising answer, but I had to ask. Another question, I guess, is with respect to the quarter and also how it incorporates into forward guidance, is this increase in the short-term incentive payments.So just wondering specifically what performance metrics drove the incentive payments this quarter? And what is the risk that similar incentive payments result in lower -- maybe lower EPS guidance than what you've embedded in your forward outlook?
Sure. So in regards to the incentives, given the lack of visibility on the OEM production shortages through the first half of the year, we were accruing our bonus incentives at target for that. As we continue to focus on both the financial metrics and the other meaningful components in our balanced scorecard, which drives our short-term incentive plans, we are seeing outperformance. And as we got through Q3, it was clear to us that, that outperformance was going to manifest itself in more than a higher than target payout in regards to that short-term incentive payments from that perspective. And think about the lack of clarity around the market as the OEM production shortfalls were playing out.And the fact that in the face of that, from a financial perspective, we are generating 4% to 6% net revenue growth. We are scaling the platform. And many of the things that we talk about as strategic priorities, client satisfaction, Net Promoter Scores and the like, all of those have been performing well for the year and that's what caused that increase. In Q4, I would not anticipate another material change to that, up or down. So I think that, that would not be something that concerns me in regards to volatility around the earnings profile for the fourth quarter.
Our next question is from Jaeme Gloyn with National Bank Financial.
Yes. My question is looking at the compensating AOI and nonrecurring items in 2021, clearly beneficial for this year. I would think that as we go through a normalization process, this reverses in future years, but I don't see that in the walk-throughs on any of the guidance. So I'm just wondering if that is embedded somewhere else that we can't see? And how you're thinking about those revenue drivers in those future years?
Yes. So think about the gain on sale component, which is the largest component of those drivers, right? And if we continue to see OEM production shortfalls through the first half of 2023 and then still not eating through the full backlog in 2023, we remain bullish on the outlook for gain on sale and used vehicle prices as that moves forward through the remainder of both 2021 and the forecast period. So you don't see it because it's in the base. Similar to many of the financing benefits that we got as far as the reduction in the balance sheet and the optimization of our capital structure, again, stays in the base. So because it's in the base, and we're not looking at a material change, those numbers just kind of carry forward as that base piece through that forecast period.
Our next question is from Tom MacKinnon with BMO Capital.
Just with respect to your detailed investigation in terms of OEM delays. From what I understand, when you order a -- specifically the time between ordering a vehicle and getting the vehicle produced by the OEM, that's the biggest delay that you're seeing right now, correct? And that's caused most of this pushout in terms of earnings. What have you seen in terms of the time it takes really before you pay, between when you pay an OEM and then you actually get the lease activated? So that can take some time. There's vehicle delivery time, there's a vehicle upfitting time. What are you seeing with respect to that trend? And has that -- has any change in that trend been reflected in your pushout of your guidance?
Yes. This is essentially all attributable to the delay in order to origination cycle time with the OEMs. We're not seeing any material elongation of the cycle times in terms of delivery upfitting and ultimately lease activation. There's all kinds of capacity in the pipeline given the inability for the OEMs to produce that volume. But now this is all attributable to the elongation in the cycle time between order and origination with OEMs.
So no issues in terms of labor for upfitting or any kind of parts needed for upfitting or...
Not related to any issues. No. No issues in terms of labor or materials in terms of upfitting. Inflationary pressures, it is costing more than the price points 6, 12 months ago. But no, there's no bottlenecking in terms of constraints on either labor or materials.
Okay. And just as a quick follow-up, can you talk about the backlog? Now how does the backlog look versus what you may have traditionally been getting in terms of orders? Is it more -- is there anything in terms of the self-managed market that's in this backlog? Are the -- is the backlog have any kind of additional services that customers might be taking that they weren't taking in the past?
Yes. So this order backlog, Tom, would be just as I mentioned it for you, at $2 billion, growing to anticipated $2.5 billion to $2.8 billion by year-end. We would anticipate that this would be $1.5 billion, $1.8 billion above our normal backlog at year-end. So we always have orders that we have taken, placed on behalf of our clients with the OEMs that are waiting production and delivery. We always have some backlog, but we are running at multiples of historic backlog. And again, at year-end, we anticipate that to be roughly $1.5 billion, $1.8 billion of order backlog. That backlog would be for vehicles in Canada and the U.S., to a lesser extent, ANZ and Mexico, and it would be across the full continuum of our client base. So we're not seeing any particular concentration in one industry but instead across the entirety of our client base. And further, obviously, with the viewpoint that we have into each and every client's fleet, we're not seeing any order stuffing in the channel, if you will. The orders that are being placed are for vehicles that are needed to either replace, a vehicle that is coming off lease replaced, a vehicle that has been damaged and taken off road by virtue of an accident or a vehicle that is in need to fulfill the growth mandate of our clients. So these are bona-fide orders, orders that are anxiously being anticipated by our clients and well distributed across the full continuum of our client set.
And are there any of those orders associated with the self-managed market or earn more than you would have seen in the past? Or is it just the makeup of that is just generally the same as what you've seen in the past [Technical Difficulty] client?
Yes, we've had some success with our self-managed fleets in terms of sale leaseback. So to the extent that we have purchased those assets and brought them on book, obviously, there has been a cycle of replacement for those. But indeed, there are -- the population of clients constituting that order backlog, that indeed include new recent self-managed fleet wins in all 3 regions.
Our next question is from Mario Mendonca with TD Securities.
Can we just start with the originations outlook for 2023? It's a big improvement, and I understand the underlying assumptions that would drive, looks like about a 40% increase in 2023 relative to 2022. What surprised me a little bit is with the origination growth assumed to be that high, that we wouldn't see a little bit more on the revenue side, your revenue outlook, while certainly better, seems a bit light relative to the origination growth you're assuming. Are you sort of building in a little conservatism into your revenue outlook, particularly in the context of this origination growth you're speaking of?
Yes, Mario, what I'd say is that when you think about 2023, remember, we said that it doesn't start to recover the order backlog until the second half of the year. So you've got a much heavier weighting in the second half of the year. So you're not getting the full run rate on that normalized production cost plus the backlog eating through. And so that's probably why you're seeing -- when you look at it, it doesn't look as big as it should be because it's not annual -- it's neither annualized nor beginning at the beginning of the year, that recovery is much heavier in the second half.
Okay. I think that does go a long way toward explaining to me. One other quick question here. On the origination outlook, could you help us think through what activations could be like relative to the originations? I don't want to pin you down too much on this, but would it be appropriate to assume that on a quarterly basis, activations might run a couple of hundred million dollars light of where originations are?
Yes, there would definitely be a time delay. So again, if we step back for a second and just level set everyone in terms of fleet. So of our portfolio, 80/20 service-sales vehicles. Of the 80% service, rough, rough, rough, 60% of those are upfitted.And so to the extent that you are taking a origination-delivered vehicle from the OEM and then getting it upfitted before it's delivered to the client, yes, there will be a delay between the origination and the activation of the lease and terms of that fully upfitted vehicle. And in terms of quantification, think about it more -- as opposed to maybe on a monetary basis, think about it on a timeline basis, 30 to 60 days.
Okay. Now wouldn't there also be a difference in originations and activations related specifically to Armada orders, is that still a dynamic you would highlight for?
Yes.
Okay. And then finally, you may have addressed this when Paul asked the question, but you'll recall that last year, Q4 '20, there was a fairly meaningful amount of share-based comp. Should we assume that a similar true-up could happen this quarter or was that more specific to last year?
We're not expecting that to happen. That was more specific to a significant outperformance of the 2019 plan. And right now, we don't expect that type of outperformance in any of the other plans.
Okay. And just sort of one final one while I've got you there. Jay, the company went through an important transformation in the last -- the first few years in your tenure. Do you see any need going into 2022 with these OEM delays for maybe another maybe rightsizing of the organization or a restructuring? Or do you really see this as still fleeting, part of the fun, but still fleeting that really it would be too drastic to make any changes, transformational or already kind of restructuring of the organization?
Well, one of the great legacies of the transformation has just been a mindset and the capability that we introduced into the organization of continuous improvement and constantly challenging why we do things, why we do it that way and in turn, how we might be able to improve the effectiveness and/or efficiency of the different business processes that support the client experience.And suffice it to say that we have this kind of competing set of priorities. We want to stay the course strategically. So when we think about the organic growth, the top of scalable platform and the ability to convert operating income gains into free cash flow for distribution to our shareholders, that strategy is proving out on every dimension of our balanced scorecard. So we want to hold to that strategy and stay true to it through 2022, even though we are going to be constrained by vehicle deliveries from the OEMs.At the same time, you want to deliver a fair rate of return to the shareholders, you want to continue to test the model and the resiliency of the model. And that is the bit of stress, if you will, that we've introduced into our 3-year planning process and particularly in respect to 2022. We want to strategically stay the course. But short term, we want to continue to evolve our means of doing business to ensure that they are the most efficient, the most effective. And you see that in our commitment to hold to in 2022 an operating margin of mid -- 53% even against a modest top line growth and the attendant benefits that flow through to both EPS and free cash flow growth.So that's the tension that we introduced into the business as we embarked upon our 3-year planning. How do we stay true to what we know and proving is the right strategy for the organization long term, while we continue to deliver an acceptable level of performance short term for our investors.
So Jay, does that mean it's not likely there would be another restructuring or transformation?
No, no. Instead, this will be yet another year of continuous improvement. We're -- again, we examine the underlying processes and systems that support the business and look for additional areas for efficiency. So we have transformed the business, again, be it Net Promoter Score, employee engagement, operational effectiveness. The team is just shooting the lights out operationally. It really is quite incredible to see all of the time and investment of the last 3 years take hold in terms of concrete improvements in the operational performance of the business. So we know we have something very special here. And so it's about continuing to evolve it and refine it to ensure that, again, it yields the necessary efficiencies that allow us to meet the objectives that we've set in terms of the financial guidance for 2022.
Our next question is from Geoff Kwan with RBC Capital Markets.
I just had a follow-up from one of Tom's questions earlier. In the discussions you've had with the OEMs that when you pass forward to 2023, is there a plan on production going back to full production as it would kind of on a normal economic conditions? Are they looking to do higher levels of production, for example, adding extra shift? Because I'm just wondering if there's implications for any sort of capacity issues from the transportation logistics network as well as the upfitters?
Yes. Very much the latter, Geoff. As I step back, and again, you can appreciate the FMC marketplace is near and dear to their heart. When you think about the volumes that we transact with them, when you think about the predictability of the order volumes, the fact that in the U.S., the vast majority of the vehicles we originate are ordered with the factory. And so they can plan the production well in advance. We're a very attractive segment for them and the vehicles that our clients use are very attractive vehicles in terms of both price point and profitability. And so they will be -- they will have a strong bias to ramp up production of these types of vehicles for these types of clients fast and where possible, add additional capacity so that they can be producing well beyond the 100% and start chewing through this backlog, recognizing the repeat nature of it for their own revenue and profitability. And then as you kind of then look at how that might in turn translate into pressures along the transportation and upfitting. I'll just point you back to Armada. So in 2019, we took Armada on this new client that placed the single largest vehicle order in the history of FMC industry and we worked with our supply chain to ensure that each and every one of those vehicles was properly upfitted and delivered on time to that client. So no, the -- again, 55,000 service dealers, 7,000 auto body shops, countless transportation facilities, hundreds of upfitters. We have a very, very extensive network that will allow us indeed to move that pig-through-the-python with a relative degree of ease.
[Operator Instructions] Our next question is from Jaeme Gloyn with National Bank Financial.
Just wanted to follow up on the services revenue walk for '21 to 2022. Looking at maintenance, registration, tolls and violations, fuel and other services being the largest step up. First, how much of the current fuel price environment is baked into that forecast? And then the second piece is the ANZ Mexico market, which is the second largest part of that walk. How much of that is driven by return-to-normal activity versus clients that have been added at the end of 2021 and through 2022?
Jaeme, happy to step through it. I'm looking at Page 12 of the supplementary information document, where we do indeed provide the walk from 2021 forecast to 2022 expected. As Frank has highlighted in his comments, as we think about year-over-year, we delivered 9.4% on a kind of normalized constant currency basis in terms of service revenue. So you're already beginning to see a lot of the drivers that are represented here in this walk in the results in Q3. As we look at this remarketing, with an expectation that we're going to see somewhere in the neighborhood of 14% to 18% growth in originations, that will, in turn, give rise to remarketing opportunities, the opportunity to take that vehicle that is being replaced and sell it on behalf of the client generating the associated fees. So that will be the kind of our first meaningful step-up in terms of year-over-year service revenue. We are seeing a lot of demand for accidents, long-term rental and telematics and in part because of these shortages, our clients can ill-afford to have a vehicle written off and taken out of service because there is no vehicle to replace it. In the event that, that happens or a client needs to add personnel, then they work with us, for us to turn secure long-term rentals for them. Where short-term rental think days to weeks, long-term rentals think weeks to months. And these are vehicles that we procure on their behalf with rental agencies at kind of front of the line discounted pricing to provide them with short-term capacity. And again, given the vehicle shortages that we're seeing and continue to see, that will be a source of revenue growth. And lastly, telematics. And again, better understanding the deployment of the fleet, given the limitations of adding to that fleet by virtue of the shortages. The maintenance, registration, tolls, violations, fuel and other services, yes, inherent in that is an inflationary component for sure. The bigger driver is the full year's return to normal consumption levels, pre-pandemic consumption levels. That what's really, if you will, fueling that aspect of the revenue walk. And then lastly, on ANZ and Mexico. Remember, both of those operations were effectively carve outs of GE Financial. And as a consequence, both of those business units had a very financial orientation. As we have reinvigorated the commercial function, as we have shared best practices, both of those entities have just done a fantastic job of introducing more and more services, maintenance, fuel, registration, et cetera, into their respective marketplaces and are growing services at double, if not triple, percentage rates year-over-year.And so we would expect increased share of wallet growth in both Australia New Zealand as well as Mexico as the other contributor to the walk that we're seeing here. So we're very bullish on service revenue and in turn, service and syndication are the big drivers behind that capital-light business model. And so with the success that we would anticipate with service revenue growth in turn comes a progression in terms of our return on equity or progression in terms of our free cash flow per share.
Okay. Got it. Good color. And then just like with a super quick answer, as part of the '21 to '23 outlook, I presume that leverage will remain at 6x or under, yes?
As Frank has indicated, we've made a great progress in reducing the operational, the financial and credit risk of the business through the transformation program. And as such, we've actually been able to move the organization in terms of the efficient frontier and our target leverage in terms of maximizing our WACC. So where 6x was appropriate for the profile of the organization when we started that journey back in late 2018, again, the maturation of our risk management programs, the decrease in leverage, the operational sophistication, et cetera, has -- and, I should say, the performance of the portfolio through a very stressful period, has allowed us to take that tangible leverage target to 6.5x. And again, that's on the basis of a 1.31 FX rate.
As there are no further questions registered, this concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.