The AA: AA+ or junk?

11th Feb '19 by mojomogoz

17 comments 3475 reads

Hello

Over 12 months ago I kicked off this conversation on AA (LON:AA.)

https://www.stockopedia.com/content/aa-who-rescues-the-4th-emergency-service-307988/

For anyone interested I want to kick of the conversation again. I hold and interested in counter opinion and detail...save me from myself ;)

I started looking at AA simply as I was trawling through Woodford's portfolio looking for stocks that may have been overly beaten up due to his holding in them and his deteriorating reputation. AA intrigued me and I was curious to gauge sentiment. Its obvious that its got more debt than is healthy....but look beyond that and what you have is a super brand that is almost unchallengeable in its position in the UK.

The discussion lead me to believe that the AA was probably massively undervalued. Its an unstable proposition though as depends on a bunch of moving factors and how new CEO Simon Breakwell's changes work out.

There's so much debt placed on intangible brand that there is no other option than the debt guys need to back the business and support equity

Okay, okay! I know you cynics are sniggering at me now. What a ridiculous point of view...right?

There is a chance that equity in AA could be worthless as debt pressures weigh. I believe this is very unlikely even if the company struggles to repay debt as the debt holders have close to zero incentive to initiate demise of AA given that ultimately there is no asset value and just an intangible brand that generates revenue. Tarnish it and there's nothing left to pay the debts.

Are the debt holders going to take over the running of the company? That's quite unlikely as whilst they can safeguard short term coupon repayments they need a decent business to keep the coupon repayments coming long term and some of the debt to be repaid.

What about a hugely dilutive equity issuance? Its possible. Its not obvious its needed today but perhaps deterioration in revenues and margins could see it come in future? I think the odds are stacked against this course. The equity is already too little relative to debt to make it worthwhile.

A private equity takeover for close to zero is the only plausible risk IMO. That would create quite a mess and the process of getting there…

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JohnWigg

12th Feb '19

My first impression is that you are gaming the various possible scenarios, on the basis of which you've decided the AA is probably undervalued. You do mention the outlook for the underlying business a couple of times, but that's the aspect which I'd be considering first.

My main impression is that this is a business in decline: breakdowns are becoming less frequent because cars are becoming more reliable. This shows some evidence -
https://www.gov.uk/government/publications/statistics-of-vehicle-breakdowns-on-uk-motorways-and-a-roads-foi

A second point is that there's a competing business model, seen in such as Green Flag, where a local garage handles your emergency. I've been a member of this in the past and found it pretty reliable and cheaper than AA/RAC.

A third point is that I think some unsavoury practices soured reputations a few years ago. Call-out drivers were allegedly incentivised to suggest your battery needed replacing. This may have been RAC, I forget.

Anyway, sorry for the ramble, and best of luck!

mojomogoz

John

I suppose you could say I'm gaming it. I think the only way to think of AA is as a probability distribution. I accept some chance of zero but think its much less than implied by market price. Current low multiple is on reduced earnings due to Breakwell investment plans.

I disagree that their business is in decline. The core is well established and so faces cost pressures. The fact that they have needed more vans and use of external garages in recent years suggests that punters call on their services more. Reliability is not the whole issue...convenience and competence of the motoring public is. My unscientific sampling of friends who have AA membership is that they like it. Assurance.

Green Flag and RAC can't compete with AA national coverage. Of 13m customers, 10m comes from their tie up with car manufacturers and corporates. This is as only they can be a truly national repair garage on the road.

There's so much to talk about and so many moving parts that in my above (longer than should be ramble but written quickly last night) analysis I tried to focus on the key areas which is really debt and provided a crude spreadsheet for interested punters to play around with.

Best wishes
Paul

Incidentally, you wrote your piece before today's trading statement, which I've just noticed:

https://www.investegate.co.uk/aa-plc--aa--/rns/pre-close-trading-update/201902120700056935P/

So maybe your timing was good!

Yes, was trying to get comment out ahead of news. News is quite meh...nothing exciting going on....Breakwell’s plans not creating growth yet (he didn’t claim it would yet)...but retaining key customers and looking like they may be placed to gather more of the corporate relationships like VW and Lloyd’s (there’s been comment they could get BMW from RAC who are looking a bit distressed). I will go to ‘innovation day’ if I can to see what they having going on. Obvs a bit of playing to the gallery from Breakwell but with his Expedia (founder) and Uber (launched them in Europe) background he might actually pull out some interesting whiz bang

All to be proven but I reckon the share price will drift up into results now as news not bad enough to hold down.

brucepackard

13th Feb '19

I haven't been following it, so don't know what caused the revenue and profit decline in 2016?
Related question, why do you think that the "odds are stacked against a highly dilutive debt for equity swap"?

I have spent very little time looking at it, but with that debt burden seems dilution is quite likely / and that is what the share price is factoring in?

First off, obviously its a guess by me that could be very wrong. If I am wrong then the downside odds on my position go up a lot and stub equity is say 5p rather than, say, 40p (made up touchy feely numbers just to give risk picture). 5p is as good as zero to me and a howler whereas 40p is painful but I escape with some dignity.

If I used "debt for equity swap" as a phrase then it was an error by me. Debt for equity would likely give me decent upside from 85p as profit for shareholders would rise c.150% on 2019 estimate giving p/e of sub 2.5x for a company with net margins of c.35% (once current heavier than normal investment subsides). Obviously there would be dilution of eps of approx 5:1 so adjusting p/e up gives me 15x. If its not growing 15x for a 35% net margin business with very visible and repeatable profits isn't challenging. If growth and innovation plans take shape and AA (LON:AA.) produces 5-10% eps growth potential then the multiple will head up to mid 20s I guess (supported by either high dividend or significant share repurchase).

In the above scenario the path of share price might go below my 85p purchase as there will be an overhang of bond investors holding equity.

As things stand, if things don't recede AA can support the debt and tread water post the current high investment phase with slow payback (meaning it takes 30+ years to payback sort of thing). Unless there's an imminent belief that the AA model is outdated and will descend rapidly so creating debt payment crisis then I think I'll get upside on my 85p purchase but a relatively modest double being the top end (as earning should go up after FY2020 as investment slows down so a bit of crude adjustments say high single digit p/e on c.15-18p earnings).

The exciting upside comes from a belief in the Breakwell plan and earnings growth 2020 onwards that sees market believe that debt can paid back on a, say, sub 15 years horizon. If they convince market then only need to give the belief that they can reduce debt by say £1bn in next 8 years and the combination of brand belief, steady high margins, growth in eps from top line and interest cost reduction sees equity dominate EV with higher eps coming in and the multiple heading to mid teens a year or two out from here. I'm only going to rough paint it as there's a lot going on but over next few years I think that gives me a 3-4x on my 85p....and I should hold looking for bigger bagging over 7-8 years (hoping >10x but that's not a forecast as a lot of suck it and see).

The danger to the above other than business/brand obsolescence (which the old clowns could have "achieved" but I think Breakwell is really different gravy) is yields shooting up. As I mentioned in original piece I have a macro view on that saying it doesn't happen....but if it does then AA wont be the only large loser with more robust businesses not going under but their valuations taking a heavy hit.

Even if yields do go up I believe that the AA debt holders are in such a bind (of the sort whereby if you owe a little money to the bank the bank owns you but if you owe a lot you own the bank) that they will need to find ways to be kind as their only hope is that the business functions decently and keeps paying the coupons even at a sub market level. In this scenario debt for equity swap might take place.

DYOR! Its a high risk situation. Its got to be if I think I can bag at such high level from an established high margin business like this. I believe that fears of dreadful outcomes are too weighted in the price.

Good luck

I should have added to finish off above....

A rights issue to raise cash to pay down debt debt makes no sense for equity holders or debt holders given the current imbalance between equity and debt (as they undermine the long term case that their loans can be repaid)

AnonymousUser226237

16th Mar '19

AA (LON:AA.) are about to launch one of their innovative breakdown packages based on telematics, called AA Smart Breakdown. They have based their entire model on it going forward, so that they prevent breakdowns before they happen and digitize the whole experience for their users: you can track your car immediately, know any faults before they become a problem and fix them, driving tips, fuel consumption tips, journey history, in case of crash authorities are called while you haven't even regained consciousness etc

Trakm8 Holdings (LON:TRAK) is supplying all the tracking and data which is potentially huge for them but AA (LON:AA.) stands to benefit massively by reducing call outs on a large scale (33% of faults were predicted mostly battery issues which is AA's main hurdle). They also stand to benefit from the data themselves, there are thousands of ways they can use the tracking data to provide traffic reports, congestion patterns, get notified for life threatening incidents etc

Holding Trakm8 Holdings (LON:TRAK) and watching AA (LON:AA.) as well. They are about to announce the new breakdown package very soon, the trial has just ended.

ambrosia

What I cant get past when looking at the AA.L is their market cap to enterpise value, its scary I've never seen anything else like it, that company is more debt than anything else

17th Mar '19

ambrosia,

I agree. And that's why there is such huge potential for upside...if the equity can fight back and gain room relative to debt.

I've got a half position in AA (LON:AA.) as whilst I believe my hype and analysis above, there is undoubtedly a chance of significant (total even) loss. It's a portfolio position rather than a bet the future on it thing. No need for me to go all in as the upside if right is at least a treble and perhaps much more if it become respectable....just imagine it can start paying back debt, showing growth, holds on a phenomenally high margin and can tease with the vision of growing cash flows to start taking the debt down....equity gets parity with debt and the capital structure is no longer ludicrous...that's the bedtime story I cuddle up with anyway ;)

They've got the right CEO for it as he's founded and grown Tripadvisor and rolled out Uber in Europe. The online and connected future that AA want to get to with products and customers.

I expect a choppy ride as there's a lot of perception and reality to re-channel

blondemon

I bought Trakm8 Holdings (LON:TRAK) at 60p after attending the last investor presentation after the AGM. I only bought 1/10th of a full position as the accounts were a mess stretching every sinew to try and show earnings thro massaging the numbers and the CEO shifty (sorry but he was...a professional life interviewing people around large amounts of money lets me see someone playing the crowd).

Then they warned after that and got hammered down (rightly). I haven't done work on the new strategic partnership (forgotten name of partner that now has sizeable stake) and the chance of future growth but my guess remains that they a little bit extra revenue will first be used to try and right the ship....there's got to be a chance that the partner is going to buyout cheap at point the ship starts to right itself but the accounts haven't yet turned around?

18th Mar '19

its on my watch list but i never invested, i'm uncomfortable that despite all that debt they still have a reasonable PE ratio, I'd feel happier investing if more of that divident was being used to pay down debt.

my idea was wait till they suspend or reduce the dividends, thatll cause the share price to dip as the income investors sell and i'll buy on that dip
whether that idea will ever play out for me or not

john652

Having just tried to cancel and membership with 6 months left and be told the customer service email response is 7 days & when I finally got through there is 'no refund sorry sir'. What for 6 months left, no, if we did people would ask for refunds all the time! I've always thought a value trap, and with this experience they are very focused on getting the cash and not on the customer, imo, so double no for me.

john562

I don't think I would expect a refund from this sort of product as its a form of insurance. Does that seem right?

As they have very high operating margin I don't see as a value trap....just a dodgy capital structure that they may not be able to escape...my gamble is that they can over time, or at least show that its doesn't suffocate their future. Undoubtedly, its a mad amount of debt but that's why there is an interesting opportunity.

10th Jun '19

AA (LON:AA.) is a story of wow (in a bad way) since the results. Probably double whammy of sudden CFO departure and then Woodford entanglement rather than a real belief of imminent destruction through too much debt. Maybe throw in a bit of rate rise cycle and yields up macro perspective from earlier in year too getting the ball rolling downhill.

I’ve dug in more on accounts and spoken to CEO and temp CFO at AGM last week and got some detailed questions asked re accounts. They’re complex and a bit messy - probably the work of the PE background old CFO and IMO definitely a bit book cooking or obfuscation going on. That will help drive some of the shorting action as it makes them screen bad on quality of earnings. I believe I can see the foundations through the smoke.

CEO is adamant they will produce £80-100m free cash flow this year (post interest and still hefty investment). So 4x FCF or less If achieved. Talking up new marketing campaign from July emphasising ‘fresh’ inc tech AA.

It’s got a stupid amount of debt and the CEO is happy to say that now. There’s always a chance that this sinks it but that does need stuff to start going bad from here (just saying debt’s high doesn’t work).

That no zero chance of zero aside (and I don’t think that’s higher than 10% at the moment) I believe AA has super compound ability over the years as there’s a double leverage effect into eps/cash earning from some top line growth at 30% op margin and slow deleveraging. Obvs when next refinance comes in 2022 if they need to refinance higher that will bite into earnings. A triple bag is the low hanging fruit. Upper reaches? Well if revenue grows to £1.5bn over, say, 7 years, debt reduces by £1bn to £1.7bn, op margin trends up towards 35% due to operating leverage thro growth and much better tech platform and revenue profile is resolutely asynchronous with economic cycles then would you begrudge a £5bn EV....at least that right? That’s 10 bags from here...

That’s not a forecast. It’s a scenario. I wouldn’t even try weight it. But I do want to buy a great value option for a shot at that.

Next 6 mths price can move in huge range - easily 35-100p as so much to work out about the stock and proof comes slowly. I’ll try to put up some fundamental analysis in new post to deal with perceived negatives if I can find time/will

PS at a bit over £300m the small cap report guys could cover this one

uktim32

11th Jun '19

I wouldn't invest in AA. More and more companies such as AutoAid are doing exactly the same thing but cheaper. Over time these such companies will become the most popular until the old established companies can come up with similar cheap deals.

uktim32

This is a real threat. No doubt this makes growing subscribers harder. But there are many never be AA customers (or slow to get there through bad experience with others). I believe AA will remain the premium service and is doing all needed to achieve that with new CEO. Green Flag and RAC perhaps more at risk from these services initially as they seek to compete on price more. AA has a dominant relationship with car manufacturers (approx 10m customers through this route) and no one else can really compete with that. This provides platform to retain and innovate with customers. AA moving towards being an impressively tech/data enabled service too that others will struggle to compete against.

Note, I realise that the AA has had some service problems in the past too. Its a function of PE under-investment and being addressed right now.

AutoAid looks like a rehash of the old AutoNational business (a new website that is smartphone compatible). Autonational has been around for 10+ years. Won some prizes in 2010-3 period and then quiet. Doesn't look like a business they can grow. I'd be curious what the service level is like as they obviously use ad hoc garaging services...the very thing AA is investing in to avoid using as lower quality and creates expense for them that damages earnings. They've tended to use when extreme weather in past

The AA: AA+ or junk?

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Mojomogoz

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