Element Fleet Management Corp
TSX:EFN
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Element Fleet Management Corp
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Ladies and gentlemen, welcome to Element Fleet Management Corp. Fourth Quarter Results Conference Call. I would now like to turn the meeting over to Mr. Zev Korman, Senior Vice President, Investor Relations. Please go ahead, Mr. Korman.
Thank you, operator. Good morning, everybody. Thanks for joining us on our conference call today to discuss our fourth quarter results for the 3 months and year ended December 31. Joining us today to discuss the results are Dan Jauernig, acting Chief Executive Officer; and Samir Zabaneh, Chief Financial Officer. News release summarizing our results was issued earlier this morning, and the financial statements and MD&A have been filed on SEDAR. The information is also available on our website at www.elementfleet.com, and a presentation has been posted to the Presentation section as well, you're invited to open that now. Before we begin, I want to remind our listeners that some of the information we're sharing with you today includes forward-looking statements. These statements are based on assumptions that are subject to risks and uncertainties. And I'll refer you to the cautionary statement and risk factors of the most recent MD&A and annual information form for a description of these risks, uncertainties and assumptions. Although management believes that the expectations reflected in these statements are reasonable, we can obviously give no assurance of the expectations of any forward-looking statements will prove to be correct.Our earnings release, financial statements, MD&A and today's call include references to a number of non-IFRS measures, which we believe will help 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 our MD&A. We'll begin with some formal remarks from management followed by questions. Please limit yourself initially to one question and one follow-up, after which time, we invite you to requeue.Now I'll turn the call over to Dan Jauernig.
Thank you, and good morning. And thank you for joining us today. Since our last corporate update on February 5, we've moved quickly to focus on customer retention while streamlining our operations to reduce operating expenses. We've focused on optimizing the customer experience, executing on our pipeline and positioning the company for a return to earnings growth in 2019.As noted last month, the implementation of the industry's most advanced technology platform took longer than expected, and it involves some integration challenges. Most of those challenges started after the migration of the GE portfolio on the Element Fleet Management system in late Q1 2017 and continued throughout the most of the second quarter last year. This period was the height of our post-integration challenges. And since then, we've be making steady progress in improving our customer experience and satisfaction scores. Although progress is never a straight line, we are clearly moving in the right direction. It's only been about 40 days since our last update. However, we are seeing encouraging signs across the organization, the leading indicators of customer retention are improving. The majority of these leading indicators on customer satisfaction levels have been improving steadily since the end of Q2 2017. As a result, we are very optimistic that the higher-than-normal attrition rates that we experienced in Q4 2017 won't repeat themselves in 2018.On February 5, we talked about the need to streamline our operations, rightsize the organization and align our expense base to our revenue growth. Turning to Slide 5, I wanted to outline some of those initiatives implemented in this regard. They include very targeted, but limited headcount reductions, select office closures and consolidation, new business processes where applicable and a curtailing of all discretionary expenses, among many others. We expect each of these to contribute to improving our operating expenses over the course of 2018. We will take an approximate $40 million restructuring reserves in Q1 in connection with these cost-cutting initiatives, and we expect that these initiatives will save Element nearly $20 million in annual SG&A from our fourth quarter 2017 run rate by the end of 2018 once all of these initiatives take full effect.Notwithstanding the challenges that we had last year, the business also had its fair share of successes in 2017. We continued to generate strong operating income and cash flows, including $0.72 of adjusted earnings per share and the return of $194 million in capital to our common shareholders in 2017 to increase dividends and share buybacks. Samir will go through our financial results in greater detail shortly.On the growth side, we generated strong originations of $6.2 billion last year, up 3.3% from 2016. This growth was driven by a combination of new customer wins and from our existing customer renewals throughout 2017. This included new business with world-class companies such as Shell Global, Johnson Controls, Home Depot and many others. We also continued to make significant advances providing fleet management services to the rapidly growing ride sharing and car sharing segments of the transportation sector. Our newest customers in these markets, as highlighted last quarter, include Splend, an Australian-based company that provides vehicles for on-demand ride share and delivery services; as well as Maven, the car sharing platform of General Motors. Each of these relationships is off to a great start in 2018.From a funding point of view, we completed more than $3 billion of securitizations in our Chesapeake II facilities in 2017, the most in a year from any Fleet ABS issuer. Our performance in the ABS market has been very strong. We continued to get strong interest in our asset-backed security as recently as 2 weeks ago from participants in Las Vegas at the largest capital markets conference in the world. Because of the high quality of our commercial fleet portfolio, we anticipate that we will continue to have strong demand for our asset-backed securities when we access the capital markets next month.As you know in 2017, we also segmented the noncore assets from our core fleet operations and assets to put more focus on our fleet business. We've reduced noncore assets last year through the strategic sales of our Rail Notes and approximately 60% of the heavy-duty truck portfolio. As you know, the largest portion of our noncore portfolio is 19th Capital, and I'll come back to that shortly to give an update on it.From a technology point of view, we have developed and launched what we believe is the most advanced fleet management and analytics platform in the industry, having invested over $70 million to date, with another $35 million earmarked for product enhancements and new product innovation throughout 2018. In doing so, we are ensuring that our customers benefit by giving them actionable insights into their fleets and making their fleets smarter, safer and more productive.Turning to Slide 7, you can see a summary of our core fleet portfolio. It's a very high quality and diversified portfolio of $14 billion of finance receivables, representing a diversified customer base of over 2,000 customers in 5 countries around the world. It's because of the stable and high-quality portfolio of customer lease receivables that we have unmatched access to the capital markets to fund our growing book of business. From a growth perspective, we originated $1.46 billion of new vehicle purchases during the quarter, up 2.2% from Q4 2016. We continued to execute on a strong pipeline. And in that regard, I'm pleased to share with you a few new wins that are indicative of the new contracts we're signing.The first is a recap, as I mentioned on the last call, Advantage Rent A Car and its fleet of 27,000 vehicles for our industry-leading accident services program. We have successfully launched in 4 locations and anticipate full deployment by the end of Q2 or early Q3.I'm also pleased to highlight another 2 of our newest customer wins. Universal Hospital's Services is a leader in hospital management, including equipment supply and delivery services. Element will provide UHS with leasing, fuel, maintenance, accident services and telematics, all of which will contribute to improved safety, less downtime and a lower total cost of ownership for their fleet of 1,000 vehicles. We will also be providing a range of services, including fuel, maintenance, telematics, accident services and forklift management to Pool Corporation's fleet of 2,500 vehicles. It's worth noting that both customers, with a combined potential fleet of over 5,000 vehicles, are new to Element and have been previously used a competitor's fleet management services. These wins demonstrate the value add of our service offerings and are representative of the kind of signings that we anticipate throughout 2018, as we demonstrate the value of our platform, technology road map and investments that we have made to date and will continue to make in our fleet management system.I also wanted to take this opportunity to highlight Element's recognition as supplier of the year by Axalta, a customer in paint and coating manufacturing. This award recognizes Element's ability to meet criteria for quality, service, technology and value while meeting Axalta's compliance and sustainability requirements. It's a good example of the service and value we strive to provide all of our fleet customers globally. Our focus in 2018 remains on improving the customer experience, one customer at a time, and returning to growth by executing on our pipeline and continuing to add services that make our customers' fleet safer, more efficient and less costly to operate.As I mentioned previously, I wanted to provide an update on 19th Capital before I turn it over to Samir. Under the leadership of its new CEO, Rob Watters, 19th Capital is implementing a strategic plan to improve the utilization rates of its fleet and return the JV to profitability. As you've probably noted, overall trends in the trucking market have been improving, providing favorable tailwinds for the JV and its portfolio of heavy-duty trucks. As a result, there remains a large and receptive market for 19th Capital services. But in the interim, the JV had to do 2 things: one, rightsize their portfolio by disposing of older trucks; and two, optimizing their feet by focusing on corporate fleet customers versus traditional owner-operators.On Slide 12, you can see more details of the strategies underway at 19th Capital. The results and underlying trends of management's multifaceted transformation strategy have been encouraging. However, as noted previously, to execute on its strategy, the JV had to take some short-term pain by cleaning up its portfolio and selling its older trucks. In connection with its operating plan and year-end audit, they have taken a write-down of all remaining trucks in the portfolio of 2013 vintage or earlier and a reclass of all remaining MaxxForce trucks to held for sale regardless of their current leasing status. As a result, the combination of our share of operating losses from the joint venture from the quarter, the previously mentioned write-downs and a $29 million reserve we established against our investment in the joint venture resulted in a total charge of $60.9 million in the quarter. This is a significant charge against our investment in the JV, but it was the right thing to do. And the actions taken by the JV in the quarter will put it in a much better position going forward, with a newer, more leasable portfolio of trucks. We expect to see improvement in the operating attributes of 19th Capital over the next several quarters, and their mid- to long-term plan is unchanged to restore profitability and eventually return capital to its shareholders while paying down Element's debt to the JV.So with that, I'll turn it over to Samir, who'll provide an update on our financial results for the quarter.
Great. Thank you, Dan. And good morning, everyone. Turning to Slide 14, adjusted earnings per share for the core fleet management operations was $0.18 for the quarter, closing the year at $0.72 per share, which was in line with our expectation and the guidance we provided during the year.Noncore assets contributed $0.01 for a total of $0.19 in adjusted basic EPS for the quarter. On Page 15, you could see average earning assets on the core fleet business were $12.3 billion, up from the $12.1 billion in Q3 2017. The sequential increase in average earning asset was driven partly by the $350 million decline in interim funding during the quarter as we continued to clear integration-related backlogs. We expect the interim funding to further return to its normalized run rate in the range of $450 million to $500 million over the next couple of quarters. Consistent with prior quarters, core fleet management made up over 93% of earning assets, net revenue and after-tax adjusted operating income.Moving on to the next page. Total revenue for the quarter was $221 million, up 1% sequentially and 12% year-over-year. This was driven by stronger service and other revenues, which increased 15% from the prior year and 5% relative to Q3 2017.Services and other revenue benefited from a combination of higher remarketing fees, acceleration of accident services in Mexico, higher maintenance fees in Canada and telematics revenue in the U.S. We are pleased that services revenue continued the strong momentum throughout this year. Over the course of 2017, services revenue increased by 19% from the level in Q4 of 2016 on a constant currency basis, partly due to the acquisition of CEI at the end of 2016 and also due to solid organic service revenue growth in the U.S.Net interest and rental revenue was $8 million (sic) [ $80 million ] for the quarter, an increase of 11% compared to last year on a constant currency and a decrease of 4% sequentially. The increase over Q4 2016 reflected better spreads on the Chesapeake terminals in the current year compared to those in 2016. In addition, combining Chesapeake I and II earlier this year enabled us to reduce excess capacity that were carried in the prior year, which reduced FX cost related to such capacity. The sequential decrease compared to Q3 2017 reflected the prior quarter benefiting from revenue catch-up related to Q2 2017 and which was built as interim funding declined.On Page 17, net interest margin for the quarter was 2.61%, in line with expectations. This was up from 2.3% compared to the prior year, reflecting higher portfolio net yield and lower than the 2.77% reported in Q3 2017, which was temporarily elevated due to the clearing of previous integration-related backlogs as indicated earlier. On an annual basis, however, which takes into account the fluctuation of interim funding during the year, mean percentage has increased by 2 basis points, again reflecting the funding efficiency of our platform that, in this case, more than offset the pricing pressure experienced during the year.Turning our attention to the operating expenses on Page 18. Adjusted operating expenses were $127 million for the quarter, an increase of approximately 6% sequentially and 11% compared to the prior year. Salaries and related expenses increased sequentially, partly due to a true up of -- on actual results against the plan for the year, which affected compensation. In addition, as we had indicated previously, our focus late in 2017 was on maintaining customer service levels and accelerating the completion of various automation processes in the post-integration phase, which necessitated maintaining sufficient headcount support throughout the period. The increase in general and administration expenses was mainly related to other onetime items such as write-off of unrecoverable value-added taxes in Mexico and marketing costs related to Element Fleet roundtable and professional fees in connection with various projects related to integration, compliance and taxation.As indicated previously, and as Dan has mentioned, we anticipate that Q4 will be the high watermark for expenses and that we will begin to see this decline gradually in 2018. Overall, we expect 2018 expenses to be approximately $15 million below those of the run rate of the fourth quarter.Excluded from the adjusted operating expenses shown are approximately $12 million of onetime costs related to the company's strategic review process.Turning our attention to the noncore operations on Page 19. Net interest and rental revenue for Q4 2017 was $7.9 million, a decrease of approximately $3 million compared to Q3 of 2017. This reflected the sale of noncore assets in the previous quarter as well as depleting equipment finance portfolio in New Zealand. Service and other revenue within this segment was primarily related to fees delivered in connection with various services provided to nonfleet customers. By nature of the various commercial arrangements, these fees will fluctuate from time to time.Next slide. As shown on the page, total noncore assets as of December 31, 2017, was $984 million, a reduction of 8% compared to the level at the end of the previous quarter. As Dan mentioned earlier, the current value of the equity ownership at 19th Capital declined by nearly $59 million, which can be summarized as follows: Element's pro rata share of operating losses in the joint venture was $14 million, which increased compared to the $9 million incurred in Q3 2017. The majority of such increase, however, was due to the acceleration of depreciation as a result of changes in estimate. The joint venture recorded losses and write-downs on equipment sale of $42 million, of which $24 million was recorded against the reserve Element provided for in the second quarter of 2017. And finally, the third item was a further write-down of $29 million that Element took against the carrying value of its equity in the joint venture.The New Zealand equipment finance and the heavy-duty truck portfolios are amortizing, as expected, and hence the reduction was in line with the plan.It is important to highlight that Element will adopt IFRS 9 beginning Q1 2018 and which adoption will likely have an impact on the carrying values of each of ECAF as well as the senior term loans and the equipment revolver for 19th Capital. We are in the process of quantifying the impact on each asset and which will be recorded in the opening balance of returned earnings.On the next slide. From a treasury perspective, at year-end, Element had $4.6 billion (sic) [ $4.7 billion ] in available financing to fund ongoing origination. Our current plan is to issue nearly $3 billion over 3 to 4 term issuances. Recent issuances of fleet term ABS have been consistent with those of the prior year for the terms that we issue. This will continue to support efficiency in our debt cost structure. Our cash flow from -- adjusted cash flow from operation was $480 million. We believe that this cash flow and the liquidity available on our balance sheet will be sufficient to fund future business growth.Before handing the call back to Dan, let me give you my perspective on the quarter. The financial results for the core business in the quarter indicates strong performance. Services revenue increased sequentially and compared to the prior year. The decline in the net interest margin sequentially was due to a catch-up of revenue in Q3 as I indicated earlier, though NIM percentage came in as expected. Our expenses were elevated. However, 50% of the increase was due to onetime or unusual items. Overall, I'm pleased that we were able to deliver on guidance, and I'm optimistic that we will manage well through the tail end of the post-IT migration and return Element to the growth trajectory we all expect from us.With that, I will turn the call back to Dan.
Great. Thank you, Samir. Looking ahead, the board and management are confident that the business is taking the right steps and making the right investments to deliver better results and return to growth going forward. We are 100% focused on customer retention. At the same time, we are streamlining and rightsizing our cost structure to our revenue growth. And finally, we're executing on our customer pipeline of potential new business, which includes some very large and attractive opportunities. As I noted last month, it takes time for new customer signings to ramp up over the course of 2018 to offset the impact from the higher customer attrition we experienced in Q4 of last year.The good news is, from a macro perspective, commercial fleet sales were up nearly 12% in the first 2 months of 2018, with the asset mix continuing to move from passenger cars to our area of focus, commercial trucks, vans and SUVs. This provides a healthy backdrop for our ability to add new -- both new finance units and service units during the course of the year.As indicated in early February, core fleet adjusted operating income for 2018 is still expected to be down approximately 3% to 5% from our results in 2017 on a currency-neutral basis. We -- as I noted previously, we expect our financial results to build throughout the course of the year as we execute on our solid pipeline and return to growth in 2019.And with that, operator, I'll pass the call back to you to open up the lines for questions.
[Operator Instructions] The first question is from Nick Stogdill from Crédit Suisse.
If I could just start with the leverage for Samir, 7.7x tangible this quarter. I know you target 7x to 7.5x. Maybe you could just give us some thoughts on how much flexibility you have going above that range in the shorter term and where you're comfortable taking it. Also, if you could just give us an update on where the bank covenant ratio was? I believe the last time we had that number was -- it was 5.8 against the cap of 6.5. And finally, how should we think about the IFRS 9 -- the allowance bill under IFRS 9 for 19th Capital? There's 0 allowance today. And should we look at the operating losses for that business of $30 million to $40 million and assume that might be a reasonable number to benchmark it against?
Sure. Okay. So the first question of the tangible leverage ratio, that is -- as we mentioned before, that is an increase. We always said it would be between 7x to 7.5x. And we always set in our mind the high mark being the 8x, so we still have room. And obviously, we will continue to work through that to bring it back in line, but we do have flexibility, and that level does not concern me today. In terms of the second question...
The bank covenant leverage as well, maybe where...
Yes. So the bank covenant is still in line with the way it was and the way it has been. And again, we have a plenty of room as part of that covenant. So that particular one does not concern me. And then on IFRS 9, we are in the process of going through the process. Obviously, it's a totally different methodology of estimating expected losses rather than historical losses. You have to look at it over -- throughout the life of the loan. So that actually changes metrics, and you have to do it on a probability weighted. I cannot give you guidance today of what that number is going to be, but I do expect there will be a number. But in terms of materiality, I cannot given any guidance on that one yet. We're still working through it.
But there is 0 allowance today against 19th Capital, the loans?
That is correct.
Our next question is from Geoff Kwan from RBC Capital Markets.
My first question was with respect to the time from when you had the call till now. Has there been any additional developments of any customer losses and/or anything that you might have had to do from a financial perspective on customer retention, whether or not it's discounts on services or NIM yield discussions?
Yes. Jeff, it's Dan. As you know, it's only been 40 days since our last call. Clearly, when we had our last call, we provided you a pretty well an up-to-the-minute update in terms of where we were. You have to put this in perspective, and I tried to lay this out in my opening comments. The vast majority of the challenges that we had ended -- were in late Q1 and all of Q2. We've been making steady progress all throughout Q3 and Q4. The attrition that we experienced in Q4 of 2017 was a lag effect of the challenges that those customers experienced in late Q1 and Q2, not because they had problems in Q4. So we've been seeing steady progress since the end of Q2 in terms of how we're working with our customer, our customer satisfaction scores. And clearly, I've seen nothing new in the last 40 days that would indicate that we will have higher-than-normal attrition like we had in the fourth quarter. All of our trends have been improving steadily, and there've been nothing that -- in terms of new customer attrition that I would announce over the last 40 days, that's for sure.
Okay. And then just my other question was in and of the financial statements, there is the discussion about the term loan at 19th Capital on the repayment modifications, so I just want to make sure I understand this. So you're making or -- it makes a comment that there is expected to be full repayment of the principal and interest. There's been some remodifications right now that there may be some remodifications over the next little bit. And is it fair to characterize, I guess, it's -- I mean, it obviously can be driven by the underlying economics of what's going on in the business. I'm just trying to understand, I mean, if to the extent that things don't recover as quickly as what the business plan entails, there may be further remodification even beyond that on the repayment schedule. Is that correct?
Yes. So the way to look at it is when we set up the joint venture, we always viewed it as a portfolio that will provide cash flows and that we would use those cash flows from the joint venture first to make interest payments and then we make principal repayments on the deck. And we viewed it as like a waterfall from a pool of assets. So when you look at the notes -- the financial statements, you can see that the business is generating plenty of cash flows after interest expense and after its operating expenses to pay down principal. When we set up the joint venture, we put in a very aggressive term pay-down schedule for the joint venture that was mostly put in place so that we could have tight control over their cash flows. But our view is, we've always viewed it as a waterfall like you described it, and the cash flows coming off of the portfolio will be used to pay down the debt over time.
Our next question is from Vincent Caintic from Stephens Inc.
Maybe taking a step back, Dan, I appreciate the comments on the accounts, but maybe if you could just describe Element's interactions with the accounts. What are the accounts talking about right now in terms of the opportunities and the challenges? And then for particularly the existing accounts, are they growing their portfolios again with Element? And are we starting to see maybe a pipeline of growth throughout?
Yes. No, very good question. And actually, that's one of the encouraging signs that we're seeing from our current customer base is that, in fact, I was just speaking to Kristi Webb, our head of our North American operations. She's been on the road for the last 3 weeks meeting our largest customers throughout the United States. And many of them were part of the GE data migration. They were former GE Fleet customers. And they've clearly been saying that a lot of the integration pain that they've felt throughout Q2 have been steadily improving, and they're ramping up doing more vehicle orders with us and subscribing to new services. So we feel very good that a good portion of our growth is going to come from our current customer base. It's going to order more vehicles, but more importantly, subscribe for more services like Telematics going forward. So we're actually seeing good indication from our current core customer base.
Okay. That's great. That's very helpful. And then on the restructuring plan you have on the cost-cuttings, is there any more detail you can provide? And I'm just also thinking about that from the perspective of the accounts, if there's any impact on the customer interfacing side of the business.
Vincent, this is Samir. So when you look at the charts that we have, when we look at the headcount reduction that we have, I can describe it to you in the following way. We ensured, as we embarked on this, that we will not do anything that will impact customers. So on the operations side, on the IT side, for the most part, they have not been impacted. Most of the savings that you would see on the headcount were streamlining the organization. And in some ways, a big part of it was already -- or could have already been done in a plan. When a company goes through a massive migration and you combine companies of this size and you go through this -- I mean, there was -- there ultimately has to be some duplicative work and duplicative roles. So we took this opportunity to actually eliminate that. So it's not just cost saving, I actually believe that will make us into a better company, much more efficient. So that's a big part of the saving, just eliminating duplicate roles. In terms of other areas, companies go from time to time and evaluate performance of every employee, and that is a healthy process. And we also took the time to evaluate that, and we actually moved on then. People ask us sometimes about the merit increases. This is normal. Many organizations do not have annual merit increases. In fact, they would pay competitively based on market and, I believe, we do. So having just an annual merit increase every year is not necessary. So this is a view that we have on this. In terms of the office closure, that should not have an impact on us. In fact, I think that will be -- that will make us probably closer together as a company. We'll make the people in Toronto spend more time in the U.S., more time in Mississauga, and that's always healthy and actually helpful. So it's not just cost savings, I think that it overall makes us a better company.
Okay. Great. And just, sorry, one quick one. Any timing on the when the permanency overall will be finalized?
So Vincent, I'm going to turn that over to David Colman, our General Counsel, since I may be consumer conflicted in that answer.
Yes. Thanks a lot, Vincent. This is David Colman, General Counsel for the Corporation. I just wanted to pass along a message from the Chair of the board. The CEO and the Director search are both progressing well and are well under way. And with respect to the Director search, the Chair will report further in the days ahead. So thanks a lot for the question.
Our next question is from Paul Holden from CIBC.
So first question. In the context of current 2018 guidance, maybe you can just give us a little bit more around expected free cash flow. And if you would use that free cash flow in excess of dividends to repurchase stock, given where the share price currently is.
Yes. So we have -- when I talked about the adjusted free cash flow from operations of $481 million, that was for 2017. And I don't view that number to change materially. Obviously, it will be a reflection of the overall operating results. So when we talk about the decline of 3% to 5% in 2018, I would expect that, that cash flow would actually be impacted. But still, at that level, it's a really healthy level. That cash flow will be used to fund the -- a growth in the business. We have CapEx to continue to invest in the technology. And we do pay a fair amount of dividends on the fresh shares as well as on the common shares. The cash that comes after that, that will be used to fund debt, potentially buy back shares. But these are all decisions that we will make prudently as we embark on the year and have really good handle of the usage of cash that we need to have. So I can't give you a metric of how much shares we will buy, but we will talk about this as we move through the year.
Okay. And then second question, maybe you can talk a little bit more about what you're seeing in the ABS Market in terms of availability, i.e. liquidity spreads, appetite just because there's been a number of questions related to your ABS funding model and how that may or may not be impacted by the customer losses.
Paul, we were in Las Vegas in sort of ABS conference that Dan mentioned earlier, and we had, in total, over 40 meetings, and I could tell you all of the meetings were positive. For the most part, people are focusing on the health of the portfolio that we have inside Chesapeake, the credit-rating that we have. I mean, from time to time, we had questions related to the governance, the CEO search, but for the most part, our ABS investors are focused on the Chesapeake platform and the credit quality it actually provides. So as I mentioned earlier, we will be on the road in a couple of weeks, and we feel confident that we'll be able to do the size of the term deals at the prices that we expect to have similar to what we did last year.
And Paul, the only thing I'll add is that secondary trading in our asset-backed securities continue to remain very strong and at spreads that are at or tighter than our last offering.
Our next question is from Brenna Phelan from Raymond James.
I just wanted to walk through the losses and write-downs recorded in the joint venture. So the total $42 million, which includes the $24 million that was part of the $30 million booked in Q2, that all relates to vehicles that were sold in the quarter?
That would all be related to vehicles sold in the quarter or actual write-down that the joint venture has taken. So it would all be relating to write-down of assets. Whether they're fully sold or not yet, I don't have the breakdown for you, but that would be related to assets.
And then the further $29 million, can you speak to what proportion of the remaining vehicles in that portfolio best relates to or relative decline in net realizable value? And does any of that relate to vehicles that are now held for sale?
The $29 million was our own provision as we look at the value of equity at this present time. As you know, Brenna, the valuation is always done at a certain period of time. While Dan -- as Dan had mentioned, there are some improvements on the operations. Rob and his team are embarking on a strategy that seems to be working, but it does take time. And when we look at the valuation at this present time, we felt it was prudent and important that we take the value today. So the $29 million I would call it as a general write-down of the equity today. So it's not -- we didn't allocate it to certain assets inside the JV, it's just overall -- call it, overall impairment as of the end of the year.
And is there still further progress to be done on selling vehicles in the joint venture? Or is the 2,000 sold deemed to be sufficient for now?
There is definitely going to be a progress. As you know, in this business, when trucks age beyond 5 or 6 years, then you would have to look at the residual value, and you need to time the sale in a way that you can capture most of the residual value that you have on the books. So we do have a number of trucks that are 2013 and 2012, so those will be -- will -- management of 19th Capital will be looking at divesting those prudently. The good news is that there is a demand for trucks and some of the results that we've seen recently at auction houses prove that like-for-like trucks that we sold 3 months ago -- I mean, even the MaxxForce trucks were getting more money for them right now than we did 3 months ago. So there is a plan to sell, and there is always a plan to refresh the fleet.
Okay. And then following up a little bit on next question. I appreciate you can't give guidance on the IFRS 9 allowance. But is that potentially order of magnitude big enough to cause concern for your leverage ratios? And is this a factor in your guidance for not really being sure on share buybacks?
I cannot give you any guidance on this. Until we finish the numbers, it's hard for me to give you any magnitude.
Okay. And then last one for me. Can you give an update on progress on establishing a stand-alone funding structure for the Australia and New Zealand business?
Yes. So actually, we have Karen Martin, our treasury, here, so I am going pass that question over to her.
We're actually well underway on the launching of the program, and we expect to have it done by the end of Q2, and we're targeting Q2 to have it completed. So that's well underway.
Our next question is from Tom MacKinnon from BMO Capital Markets.
Samir, a question for you on the leverage calculations. We have a tangible leverage at 7.7x and a bank leverage calculation as well. Which, in your opinion here, is the more important one? And as a follow-on, do any of these leverage ratios impact -- do customers care about these leverage ratios, I mean, your core fleet customers? Does your ABS funding -- is it -- does it matter or do you need to have -- how does the leverage impact that? Is that the largest source of your liquidity? So share your thoughts on these.
Okay, sure. So yes, there is -- there are leverage ratios for the banks and for the rating agencies. I would personally put a lot of emphasis. Actually, I care about both. But certainly, the banking covenant is really important one for us because that is something we just have to always watch. And as I mentioned earlier, we do have space there, so it's not at a level that concerns me. In terms of the 7.7x that you mentioned, that is from the rating perspective and, obviously, that kind of process will take discussions with the rating agencies. But as I mentioned, I do not envision any issue that we would have there. In terms of the customer side, and I'll let Dan provide comments, but I'll give you my perspective. Our customers, they care about our stability, they want to make sure that we are funding their assets and that we are providing them with the most efficient funding platform so we can remain competitive in the marketplace. In terms of the actual rating, I would imagine that would be important for them. But for them, it's a translation of what is the finding cost for them going to be.
Yes. So I just wanted to add, Tom, just to highlight on what Samir was saying. One thing you note, our banking covenants treat 1/2 of the sub-debt as equity. So there's a big difference between the way the banking group looks at our debt-to-equity ratio versus the rating agencies that treat 100% of the sub-debt as debt. So there's a lot more room in the banking covenants than there is in terms of how we stand back and look at the business where we treat 100% of the sub-debt as debt. And even with that, at 7.7x, we're well within -- in a portfolio of our asset quality, we have plenty of room in that regard. I agree with Samir. Our customers, they really focus on our access to the ABS markets and overall funding structure. Clearly, the rating agencies are important to them because it talks about our health overall as an organization. But what really drives our cost to funds and, ultimately, our lease rates to our customers is the ABS market in the U.S.
And as you embark on going into the ABS market, these leverage -- to what extent do these leverage ratios matter?
Sorry, can you repeat the question? I missed it, sorry.
Our next question is from Mario Mendonca from TD Securities.
Just a follow-up on Tom's question. He asked to what extent does the leverage ratio impact anything due to the ABS funding. Just wanted to follow up on Tom's question first.
None whatsoever. I mean, at the end of the day, the ABS is a stand-alone structure, very much focused on the portfolio. Obviously, as servicer to the structure, they look at our corporate ratings. But our corporate ratings were well investment grade, A- from Kroll and BBB+ from both DBRS and Fitch. So our leverage rating is not an issue whatsoever when it comes to the ABS.
Okay. Then a quick question on the $40 million charge you expect in Q1. Is that a pretax number or after-tax number?
That's a pretax number.
And then on the 19th Capital. So it sounds like you sold some trucks. I think the number you used was 2,000 of trucks sold. And I imagine a number of -- there were a number of truck Smart sales in Q4. You've also said that truck values are good, including the ones that caused you some trouble. When you sold these trucks, presumably you realized some cash. And where I'm going with this is, why is that cash not used to pay down some of that loan -- the loan to the JV?
It was. So any cash generated by the JV in excess of what they need for operating expenses or interest expense is used to pay down the principal.
And why is it that the value of that loan disclosed never seems to go down? And it didn't go down this quarter.
No. It has gone down. I think if you look at it for FX-adjusted basis, it's gone down.
Our next question is from Jaeme Gloyn from National Bank Financial.
Yes. I just want to dive into Geoff's question a little bit more around the loan modifications on 19th Capital. So I understand that maybe your -- I guess, you're not applying as much of the cash flows to principal repayments. But how did you arrive at these modifications? And it looks like $23.5 million in Q4 and then expectations for $60 million over the course of 5 years in terms of lower principal payments. I guess, how does that impact the financial figures for the 19th Cap? And then how does that translate through to Element? Just a little bit more color.
Yes. So again, we took all of that into consideration when we looked at whether or not we needed to put a reserve against the loan balance at the end of the fourth quarter of this year. Again, I focused more on when we set up the joint venture, we really looked at this as a portfolio that generates cash flow. First, the cash flow was applied against interest payments and the rest against principal. We put in place so that we can monitor their cash flow very tightly, a very aggressive debt repayment schedule. But at the end of the day, what we really knew that the principal payments would come from the portfolio. And it's fair to say that the operating losses in 19th Capital has been slightly -- well, has been higher than we expected throughout the course of 2017. And the disposition of the trucks that we took, especially earlier in the year, resulted in losses higher than we expected. However, since then, the trucking market has been improved. We're seeing better results. We have disposed of more than 2,000 trucks in the joint venture, many of the older trucks, and that's making the rest of the portfolio much better. We've -- well, I shouldn't say we, I should say the management team in 19th Capital has put out over a 1,000 new trucks to small corporate fleets, and that's their focus going forward. They had a lot of trucks with O&O operators that had partial utilization rates. And by that, I mean, O&O drivers simply weren't driving enough to make their full monthly lease payments. So we were aggressive in taking back trucks from owner-operators and redeploying them into small corporate fleets. And that's the focus of the management team going forward, now that they have a much tighter, smaller portfolio of newer leasable trucks. So we feel pretty good about their business plan. Of course, they're going to have some operating losses in the first 2 to 3 quarters of next year. But as they execute their business plan, we should see them return the profitability in late Q3, early Q4.
Okay, okay. So if we can just summarize this real quickly then, the modifications really reflects the fact that you're not expecting any principal pay down on the debt through, I'll say, at least 2018. And I guess, is the interest even being paid? Or is this just accrual and you're just adding that to the debt?
Jaeme, let me provide some clarification on this. The $60 million that we mentioned in the statements is the maximum number that we believe we will have to modify from a principal payment. But that doesn't mean we will not be getting principal payments. We will be receiving a principal payment, and that is the expectation we have. From time to time, based on their business plan, we noted that there may be a cash shortfall if we do not modify the principal repayment. And therefore, the agreement was actually made that we would give them the flexibility to keep the business going and ensure that we provide them with the support that they need until the joint venture is entirely on its feet and does not need this kind of support. So the $60 million is what we believe to be the maximum number. It will go up and down, but we don't envision it to go higher based on the business plan today. But again, that doesn't mean we will not be receiving principal payments. We fully expect we will be receiving a principal payment. And of course, we fully expect that the interest payments will be -- on the loan will be coming.
Okay. And why was it $23.5 million in Q4? I mean, the $60 million feels like it's quite a bit smaller on a relative basis in this Q4 number. How did you arrive at $24 million for Q4?
That is the actual total modification that was made during the quarter. So that's including that truck sales that we had.
Sorry, I just wanted to jump in. Actually, if you turn to Page 22 of the financial statements, it gives you the cash flows that 19th Capital is generating, and you can see that after interest expense, they generated $77.6 million of free cash flow, all of which is being used to pay down principal.
Our next question is from Nigel D'Souza from Veritas Investment.
So I had a question on your capital structure and just the plans going forward over the longer term. So your common dividend to start with, it's relatively high in terms of the yield to peers. Is the plan to maintain that with your expectations? And then for your pref shares, is the plan to replace that with a lower cost of funding? And then the last point on your convertible, the tranche that's coming due in 2019, I just want to confirm that your current expectation is to repay the principal there with cash from your operations -- from your core operations.
Sure. So in terms of changes to the actual dividends that we have both on the common and the prefs, that is not expected. So there is no plan to make any changes right now. The pref shares will not come due until they actually -- they would renew in December of this year. That's the first tranche that would be renewed, and the expectation is that they will continue to be rolled over. I think your last question, I didn't catch it, was related to the convertible debt?
Yes. That's right. You have convertible debts maturing next year, so just the plan there.
Sure. So as part of that securitization program that we're doing with ANZ, that will make capacity for us to have -- to use the balance sheet and take on -- taking out these converts. We certainly produce free cash flow that we need to also keep in mind that we need to build a cushion for taking them out. So we fully expect that we will take those convertibles out when they come due through flexibility that we will create on the balance sheet between now and then and taking -- and putting cash aside from the free cash flow that we have.
Got it. And just a follow-up. That access to the capital markets that you spoke on earlier next month, I just wanted to confirm that's the ABS market, right?
That is correct.
Our next question is from Tom MacKinnon from BMO Capital Markets.
My question was asked and answered.
Our next question is from Paul Holden from CIBC.
One follow-up. So I guess, back in the follow-on maybe 2018, you contemplated number of strategic options, some of which were rolled out possibly because the share price at that time was $9 to $10. Now the share price is somewhat below $5. Does that make you circle back and recontemplate any of those strategic options? And if not, maybe you can just kind of explain why not.
So, Paul, this is Dan. The mandate from the board has been very clear to management that we're done with this strategic review. Our 100% focus is on customer retention, focused on cutting costs where it makes sense based upon our revenue growth and, obviously, executing on our pipeline. Whether or not some of those discussions will revisit themselves. If they do, that will be a decision that the board will make.
Our next question is from Mario Mendonca from TD Securities.
The loan modifications, I'm curious as to why that did not result in any charge against the value of the loans. Because presumably, on the loan modification, you're giving some benefit to the borrower. Is it because there's some back-end payment to Element that compensates you for the benefit you're giving the company?
Yes. That is correct, Mario. So we will -- I mean, that -- when we do the modifications of the loan, and we don't collect the full principal that we expect to collect, we do charge interest on that one. Based on the business plan that we have today, we still fully expect that the full principal will be repaid, albeit I know what -- where you're coming from that when you defer a principal, that means there's a risk on the loan itself. But when you look at the business plan of 19th Capital and provided we believe that there is still a significant market for corporate fleet, this company needs a little bit of support and needs time and some flexibility to be able to stand on its own feet and be a business that actually could be quite valuable. So as we sit there and watch this business plan and understand the market, we feel that it is the prudent thing to do right now to give them the support that they need to be able, eventually, to go to a third-party lender. And if you recall, Mario, we said all along, we're probably not the right owners for this joint venture. In fact, I could tell you we're not. We do have an exposure there, but that exposure is actually managed. And eventually, 19th Capital will be able to get third-party financing. But to get there and without us losing value in the interim period, we need to give them the flexibility they need.
And finally, how much principal was repaid in 2017? And how much do you anticipate in 2018 to be repaid on that loan?
Why don't we take the next question while we search that number for you?
Our next question is from Jaeme Gloyn from National Bank Financial.
Follow-up, actually, on some of the changes following the February 5 update around employee compensation restructuring, I guess, and hiring and bonus freezes. What's been the impact on your employee base at this point? Do you anticipate any, I guess, attrition in the employee base because of this? And can you maybe give us a sense as to the morale given these changes and, I guess, curtailment on compensation?
Yes. No, very good question. We spent a lot of time, in particular, Kristi Webb with the North American leadership team, communicating to employees where we are as an organization. There was good news. I mean, you're absolutely right, we didn't do merit increases this year, but we did pay out bonuses last year. They weren't 100% to target, but they were still good bonuses that were paid out in early this year for performance throughout the course of 2017. The employees recognized where we are as an organization, and they're 100% committed to helping us get to where we need to go. So of course, it's never easy when you have to do some limited targeted headcount reductions. But for the vast majority of that, we have that done and completed. And as long as we focus on continuing to execute, we have plenty of opportunity to grow the business. And once we return the growth mode, we'll be able to return to merit increases and rewarding employees as the performance of the business grows. And that's what we very much focus employees on is, they have an opportunity to still grow their earnings year-over-year based upon every employee has a bonus component to their compensation plan and have an ability to pay out greater than 100% if performance is there and, actually, increase their year-over-year compensation.
Okay. And just around -- last question, I mean, around the customer relationships, and you speak about the 2 or 3 large customers that left in Q4 as a result of issues that were in Q1 and Q2. I'm just wondering like what was it that you couldn't do in Q3 and Q4 to retain those customers in -- at the end of the year? Like what was their decision-making process? What did they explain to you to sort of the reasons why they were leaving after you demonstrating in Q3 and Q4 that you had improved all of your operational issues or had made significant improvements in operational issues. I'm just wondering why they would still continue to make a decision to leave.
Yes. I mean, sometimes when customers make the decision to leave you as an organization, they don't give you full disclosure in terms of the fact that they started probably an RFP process already in Q2 because you can't just switch your business in one week's notice. It's a long drawn out process. They probably started that process when we were at the height of our integration challenges in Q2 and probably got to a point where they felt that they couldn't turn back and they've already made their decision to move on. Obviously, we tried our best to retain any customer that had those challenges. And in fact, one that said that they were leaving, in fact, came back to us and actually stayed with us because they saw the improvements that we were making, but, more importantly, our commitment to product improvement and product enhancements going forward. So did we try? Absolutely. Can you save them all? No. And we lost more than we had expected in Q4. But I feel good about where we are as a business today and where we're headed going into 2018.
There are no further questions registered at this time. So I'd like to turn the meeting back over to you, Mr. Korman.
Okay. So I just wanted to do a few closing remarks before we go. So Paul, I think we'll have to get back to you on your question with respect to 19th Capital when we have more time. But before we go, operator, I just wanted to thank all of our employees for all of their hard work and efforts throughout 2017. Certainly, we've had our share of challenges, but we've also accomplished quite a bit in 2017. We've built one of the world's leading fleet management analytics and reporting systems, we've transitioned all of our customers onto a new and enhanced system, and we executed on many exciting and new customer and business opportunities throughout the year. And finally, we continue to make the necessary investments for product enhancements and new product innovation to position the company for future growth. And with that, I'd like to thank everybody for joining us today and conclude the call. Thank you.
Thank you. The conference call has now ended. Please disconnect your lines at this time. And we thank you for your participation.