AA running out of road

The last of these points is the most important. As audit committee chair Steve Barber explains in the AA’s annual report, the group’s future viability is dependent on it “being able to refinance its debts as they fall due in 2020 and 2022 at affordable interest rates and without excessive refinancing costs”. Excessive here is meant quite literally: if coupon payments and other debt servicing costs creep up much further, the group could cease to be a going concern.

Of the three bonds, the £200m issue that matures next month has covered the full drawndown of a term facility. In addition, £325m-worth of the £700m ‘A5’ bonds due in 2022 were “de-risked” in February after holders accepted a five-year extension in their maturity date in exchange for a near-doubling of the interest paid to 5.5 per cent. But that still leaves £372m of the A5 principal and the £570m subordinated unsecured ‘B2’ bond, which need to be repaid in the next 25 months.

It’s worth stating here that it is very likely the majority of these amounts will need to be paid through the issuance of new debt or equity, as the group’s pre-exceptional operating free cash flows – while “reasonably predictable” in the words of AA’s audit committee – came to just £100m in the 12 months to January, after capital costs and £128m of interest payments and £26m of top-up pension payments. The scheme remains £162m in deficit on its £2.7bn liability. This year, operating cost savings have been promised, but recovery membership sales and retention rates are down, while the insurance claims environment remains very uncertain.

The audit committee deemed forecast cash flows to be at satisfactory levels when it issued its report in May, after modelling for the effect of Covid-19 on top of several “potential downside scenarios”, higher interest costs, and a negative outcome from the Financial Conduct Authority’s review into so-called loyalty penalties. Somewhat bafflingly, this judgment came despite the committee emphasising “the uncertainty that exists relating to the refinancing options available”.

Options to extend the junk-rated B2 debt are likely to prove especially tricky, as we have previously noted. For the AA to continue as a going concern, analysts reckon a schedule for refinancing needs to be in place by the end of 2020, and yet the bonds trade at a 15 per cent discount to par, suggesting creditors do not believe they are going to be paid in full. Then again, while subordinated bonds do not get top precedence in the event of restructuring or bankruptcy, they rank ahead of equity holders.

Such indebtedness explains why hedge fund Engadine Partners and asset manager Lombard Odier increased their short positions in the stock earlier this month. And while current shorting activity remains well below historical highs, this is likely because AA’s market value has already fallen so much that there is limited opportunity – or enough liquidity – for short-sellers to make a large profit, assuming the stock has further to fall.