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Stockwatch: A speculative binary call

Does a 90% rebound in the mid-cap shares of roadside assistance and car/home insurance group AA (AA.) reflect a turning point in the underlying business, or a technical jump as (some) short sellers buy back?

Mark Breakwell, the appropriately-named chief executive of the AA, believes in potential to create value and has bought £169,000 worth at 118p promptly after results for the year to 31 January – the price now having breached 140p.

The context is a long slide from a 432p high in 2015, having floated at 250p a year before, slumping from 177p to 74p this year which correlated with AA becoming one of the most shorted stocks – 12.6% was out on loan in early March. This continues to edge down, now at 9.5%, although three of the largest such traders have raised their short exposure.

Debt and dividend cut made AA an obvious target

Under private equity ownership, AA was floated with a £3 billion debt millstone, as yet reduced to £2.7 billion. More positively, and which helped the stock rise from about 100p a week ago, S&P Global Ratings reaffirmed a BBB- credit rating on AA's Class A Notes and a B+ rating on the class B2 notes.

While some institutional stockbrokers are keen on AA's bonds, its income statement shows their net interest cost swiping 54% of operating profit ie a drag on shareholder value. Shares in heavily-indebted companies have typically sold off since the Bank of England raised interest rates last November and hinted at further rises.

The stock fell 28% on 21 February after underlying profit for the current year to end-January 2019 was guided down from about £390 million to a £335-345 million range. It doesn't necessarily reflect weaker trading, but £15 million extra investment for roadside and £11 million for insurance, albeit which could be seen as vital to withstand competition.

A new members' app is aimed to reduce demand on call centres and AA's Car Genie technology is said to predict car breakdowns before they happen, the chief executive enthusing as if it's a game-changer for the group, although online user reviews are mixed.

 chart1

Source: interactive investor                     Past performance is not a guide to future performance

It's also unclear what extent this can boost membership as rival Greenflag pitches with "50% off your AA or RAC renewal quote" and links eg with Churchill car insurance's offer of a year's free roadside help.

AA's principal revenue is from roadside help, only 1% ahead at £814 million amid a flat customer retention rate of 82%, within which new membership grew 7%. Otherwise, insurance revenue is up 11% to £145 million, mainly reflecting growth from AA's in-house underwriter which supports 6% growth in car policies while home fell 5%.

Crucially, for defining a support level, annual dividends were guided down to 2p per share from the current year to end-Jan 2019 "until profit and cash flow enable a change in policy." Thus, with the stock priced at around 140p, the prospective yield is just 1.4%. Meanwhile, the balance sheet has £1,755 million net liabilities with £1,300 million goodwill, keeping negative net tangible assets at around 500p per share. Understandably AA has got volatile as traders struggle to decipher a risk/reward profile and sentiment clings to changes in the narrative.

In marketing respects a bit like Saga

Both AA and Saga (SAGA) are effectively insurance groups trying to hold their positions in competitive markets and drive profit from well-established customer bases – ie quite a database marketing challenge. For example, AA claims the value of its data and brand imply potential to grow home/car policies also underwriting which is growing well.

The new chief executive since August 2017 is initiating much change, and the hope is for operating profit growth of 5-8% in financial years 2019-23. The current 2019 year is expected to be the low point of cash generation with £80 million free cash flow in 2020 "and in excess of £100 million a year thereafter, excluding the cost of any refinancing. (The nature of such refinancing also being crucial to equity value, I would add. Will the debt be rolled forward at a fat exceptional cost, or will there be a debt for equity swap?)

Previously, Breakwell had for three years been an AA non-executive director. His main accomplishment is having been a founder of Expedia, the online travel group, and his appointment comes across as a safe pair of hands after a blazing AA boardroom row led to the dismissal of executive chairman Bob Mackenzie after alleged fisticuffs with the boss of the insurance side, said to be linked to an attempt to spin it off.

Saga is more robust on key financials: a 7% yield covered 1.5 times by prospective earnings also distributable reserves, likely to tempt investors despite its modestly negative net tangible assets (due to goodwill). Saga also has relatively modest net debt of £432 million, its annual expense covered about 10 times by operating profit. Operationally both groups' narratives are sullied by mixed performance from insurance, with AA touting potential from its new breakdown apps and Saga its new cruise ships.

Key questions are whether AA's investment will prove revenue growth, and whether on the insurance side it will mainly be in low pricing. Certainly, I've found in recent months, AA has given me best value policy quotes for home and car insurance, significantly better than Saga, for example, which could also relate to AA's in-house underwriter.

I'm dissuaded to ditch AA membership because Greenflag employs local garages for roadside assistance, hence waiting can involve several hours versus half an hour typically for an AA van, although the AA does resort to garages when all its vans are busy. But I have no interest in the various gimmicks AA offers with its "gold" service such as 20% off food and drink at Moto service areas.

Year ended 31 Jan                         forecasts awaited
    2013 2014 2015 2016 2017 2018
Turnover (£ million)   968 974 984 935 940 959
IFRS3 pre-tax profit (£m)   275 193 61 9 100 141
Normalised pre-tax profit (£m)   304 207 109 46 125  
Operating margin (%)   35.5 35.9 32.7 24.5 30.1  
IFRS3 earnings/share (p)   37.4 27.7 13.3 -0.2 12.2 18.2
Normalised earnings/share (p)   43.3 29.1 22.5 7.2 16.6  
Earnings per share growth (%)   13.4 -32.9 -22.6 -68.1 132.0  
Price/earnings multiple (x)             7.8
Historic annual average P/E (x)     9.8 15.5 35.7 15.4 7.1
Cash flow/share (p)   53.7 51.5 26.9 34.2 33.3  
Capex/share (p)       4.2 10.7 8.7  
Dividend per share (p)         3.5 9.1 5.0
Dividend yield (%)           9.0 3.6
Covered by earnings (x)         2.1 1.8 3.6
Net tangible assets per share (p)       -634 -535 -524 -500
Source: Company REFS              

Balance sheet issues tip my stance

Buying AA shares now amounts to trusting the chief executive's agenda for growth, ie a turnaround speculation. Meanwhile, there's insignificant yield and the debt burden sits as a monument to private equity owners' folly of gearing up businesses to extract gains and later sell out.

Ironically, the finance director has said in response to the latest S&P rating: it "confirms the resilient and low risk nature of our balance sheet". He adds: "the strategy set out in February will allow the AA to stabilise and grow roadside support and accelerate growth in insurance, to create shareholder value and, in time, de-lever." That's the hope, also that when a hinted refinancing comes it will not penalise shareholders. Clearly, those remaining "shorts" take a different view.

Thus, AA is a speculative, binary call. I'd expect a chief executive to be naturally positive but, from an investing perspective, it's impossible as yet to define intrinsic value, so despite the enticing rally, Avoid.

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