The AA: AA+ or junk?

Monday, Feb 11 2019 by


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

For anyone interested I want to kick of the conversation again. I hold and interested in counter opinion and 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 would likely see considerable damage done to the company so reducing it ability to carry and pay back the debt holders have an incentive to be somewhat preemptive and offer relief to the company before this stage.

A bit of a game theory sort of view but I think bondholders will do all they can and swallow what they need to keep the show in the road. Of course, a zombie company wont get much valuation rating from investors. 

My arguments above are perverse...maybe I'm just wrongheaded but my view is that there is so much debt supported by the equity that the only game in town to not impair your debt holding is to keep the company healthy. Debt holders are probably keener on the Breakwell turnaround than equity punters :)

EVs, AVs and Google highways is not a threat

Many critics suggest that it could also be undermined by move to autonomous and electric vehicles. I think this is unlikely plus its too early to assume risk for that too. My opinion is such concerns are more blue sky or faddish than reality. There's plenty reason they can benefit too...who better to keep high use shared AVs on the road...anyone for a policy that means you don't have to fx tyres or recharge?

Debt modelling

This is probably the key bit to get round if you are going to invest in AA.

Obviously, debt cannot be ignored so I knocked up this very (very!) simplified spreadsheet to get a view on some debt dynamics over coming years:

There are some numbers to play around with in the spreadsheet with regard to growth rates and whether interest costs rise when bonds are rolled over. 

 Its the stuff near the bottom of the spreadsheet that is most interesting as that is where I have a go at looking how the debt dynamics play out (that was really my sole intent with this spreadsheet and some of the general numbers near the top were just me collecting some data prior to getting stuck into some debt analysis).

My assumptions will be flawed and I have not attempted to be precise and fully model everything as that would be more complex and I'd get into trouble with needing to make more precise assumptions. So it's KISS debt analysis....fag packet plus. For example, I have not fed back reductions in interest payments from debt pay down into free cash generation so in effect being more conservative on revenue to cash conversion. Again, my aim is not precision but a sense of whether they can cope with the debt over time.

My aim is to get a feel for how profit and debt dynamics could play out assuming varying degrees of success with the new CEO's plans. I have used revenue growth as the base and then taken a very crude proxy at how that turns into free cash flow (used to pay the debt!). Implicitly it captures some operating leverage as revenues increase.  I decided it was better to go from this top line with a simple assumption rather than seek more complex modelling.  I have assumed 3% revenue growth (they are targeting 3-5% so taking the bottom) and EBITDA of 5% (target is 5-8%).

Put in pessimistic or optimistic as suits your view. I think I have been quite conservative but assuming some success with Breakwell plan. Have a look and play around but assuming only 40% of revenue growth turns into free cash flow and that growth is at lower end of Breakwell's targets see £800m of debt repayment potential over next 8 years with fairly conservative success. Change the growth rates a bit and there is not game changing swings in cash generation which is a reflection of the already high margin and cash generation of the business. Its changing the extent to which any revenue growth converts to free cash flow that has biggest impact which perhaps tells you partly why old management were so focused on costs...but not achieving any growth so facing inflation costs eating margins.  If Breakwell can generate growth ahead of cost inflation and then implicitly he improves debt repayment. His is the better approach and worth making a bit more investment today to find a bit more growth...which IMO should be possible given strength of brand and position of AA.

Assume that margins can head back up to mid 30s percent and be very stable and £2bn debt doesn't look that bad on a highly profitable prime brand company. The multiple of earnings can be above 20x with earnings growth added in over that time. My 5x return on investment is a modest expectation under such circumstances.  Assume a more impressive growth trajectory and debt repayment and earnings growth accumulates the return on 85p purchase is looking astronomical.

My conclusion is that, absent a catastrophic decline in the brand, the debt should be managed down. The leverage into earnings that come from this will be impressive. I confess that there is an element of macro risk taking to my view in that I do not expect interest rates to rise very much for a long period of time. I wont go into detail other than very simplified...the world is grossly over indebted from developed to developing economies - governments, corporates and consumers. This means that a fast debt crisis a la 2008 cannot be allowed to happen and all will be done to prevent it. Did you see gigantic QE coming in 2009? Well, QE will be rerun if necessary (including "for the people") and aided by the new economic fashion of Modern Monetary Theory. If you haven't heard about it then you might want read up a bit on it. Simply it means that governments create money rather than leaving it to banks as is currently the rather misunderstood case. This removes the uncertainty and occasionally extreme volatility of private money creation (its all about the eurodollar markets where banks magic up money by exchanging balance sheet liabilities with each other when they feel confident, which is a long, opaque and complex story).

I view it as near certain that MMT plus adaptations of QE will be with us for coming couple of decades as we seek to fight our financial ills and reboot economies and, as importantly, polities. I am not saying this is right or wrong, just that it is the direction of travel. In that environment a company like AA is okay if its brand and business model remains good. Its probably even helped out by inflation in prices.

Short term view

I bought a 2/3rd position in AA about 12 months ago at 85p. Since then the price has gone up and down quite a lot and ended up in the same place! Its now a half position for me as I have increased my full commitment size since I bought into AA. Effectively that means I have cut the position a little. I've passively let this happen. 

Until the CEO Breakwell has 100% traction with his turnaround plans it is possible to experience negative updates as plans splutter, take a bit more time or get changed. I have no idea whether the update tomorrow morning is going to signal delays and jam a bit further tomorrow or be a relatively nice clean traction story.

My hunch is that they are going to report some stickiness. Partly I think that as with the share price low and not experiencing momentum might as well from PR perspective let out an update saying some teething troubles on turnaround but getting there sort of thing. A sort of reflexivity from mgt in how they choose to report results as they react to where the price is today. If it has retained its 140p level it hit in 2018 then they'd need to manage message more tightly...but let some bad out tomorrow so as there is more upside to gather in medium term.That'll flatten the share price. I'd probably see that as a buying opp. 

The other reason for my hunch of a bit of disappointment is even more insubstantial than my PR management based hunch above.  Their RNS has reported a number of prizes won in recent months. The cynic in me thinks this is rather fluffy news for RNS...why post fluff?...I guess a need to provide non report and accounts based positives to back up the Breakwell progress and turnaround narrative.  

The flux in this stock is huge. A good announcement and its rapidly up to 140p with short covering and something to believe in. Note, IMO the short sellers of this stock have a tendency to run it by numbers rather than deep dive fundamentals. So their screening based approaches will run diversified short positions with a tendency to overweight high debt, falling margins and negative price momentum. A bad announcement and the stocks down to 60p if its jam tomorrow and all the positive is narrative and non balance sheet based...and well down past 60p if its more fundamental and dire. For me there could be a chance to take a full weight on falls depending on how I view the news.

Anyway, its all hunch stuff and I'm expecting a damp squib announcement with a lot of narrative from Breakwell coming in it or results presentation in April of non financial factors that show progress. If its not clearly broken it will probably drift up into the actual full year results release in April.

Medium to longer term

My horizon on this is an arbitrary 7 years. I need to think long term. I believe over that time frame I'm looking for at least a 5x gain on my 85p purchase with a chance at something much greater if Breakwell develops upside opps for the brand. 5x is mere "normalisation" and acceptance that its got a bit too much debt but can manage it long term. The drivers of this are:

  1. Lessening of debt rollover concerns as they first show they have the business future in hand and then manage down debt gradually 
  2. Breakwell is the right guy to be in charge. His background as founder and builder of Expedia and then roll out of Uber in Europe is spot on.
  3. AA finds successful channels to monetise its brand as well as enhancing roadside (I haven't gone into it at all here but creating a valuable insurance business is core part of growth)

Okay. That's enough for now. I'm going to read over past results now through tomorrow morning to be ready for what comes. There's a lot to be said about strategy and moving parts. There's a chance of non cash write down of some past investments (duff tech stuff under last management).

Other views welcome.



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AA plc is a United Kingdom-based roadside assistance company. Its segments include Roadside and Insurance. Roadside consists of two divisions; Roadside Assistance and Driving Services. The Roadside Assistance division helps stranded motorists at the roadside or at home utilizing a workforce of approximately 2,900 patrols attending on average around 10,000 breakdowns daily. The driving services division consists of its driving school and the British school of motoring and DriveTech. Its insurance segment comprises of insurance services, insurance underwriting and financial services division. The insurance services division consists of its insurance broker which sells motor and home policies, operating a diverse panel of underwriters. Its insurance underwriting underwrites motor and home insurance policies which originate from its insurance services segment. The financial services division provides competitively priced savings, loans, credit cards and mortgages. more »

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7 Posts on this Thread show/hide all

JohnWigg 12th Feb 1 of 7

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 -

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!

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mojomogoz 12th Feb 2 of 7

In reply to post #446093


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

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JohnWigg 12th Feb 3 of 7

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

So maybe your timing was good!

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mojomogoz 12th Feb 4 of 7

In reply to post #446193

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.

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brucepackard 13th Feb 5 of 7

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?

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mojomogoz 13th Feb 6 of 7

In reply to post #446903

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

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mojomogoz 13th Feb 7 of 7

In reply to post #446903

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)

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