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AA's prospects broken down

The motor services provider has too few personal members and too much debt
February 15, 2018

AA (AA.) is struggling to shake off the demons of its private equity-backed past. Despite raising £200m via a share offer eight months after its flotation in 2014, net debt has been reduced by just £300m during the past three years. Declining numbers of paid-up personal members and an increase in insurance premium tax – which management is reluctant to pass on to customers – has eroded sales at its roadside assistance business and group profits. What’s more, the additional spending required to kick-start the insurance and roadside operations forced management into a profit warning in September.   

IC TIP: Sell at 117.9p
Tip style
Sell
Risk rating
High
Timescale
Long Term
Bull points

Brisk performance at insurance services

Fat dividend yield

Bear points

Declining membership numbers

Falling profit margins

Too much debt

The shares are heavily shorted

At the flotation, management set out three priorities to propel growth: grow membership numbers, reduce borrowings and improve technology. Progress has been poor on all three counts. Paid personal membership at the roadside assistance business stood at 3.96m at the end of July 2014, but had fallen to 3.33m three years later. That fell further to 3.29m by the end of January. There are several reasons for the decline, but, in particular, management scrapped the offer of free membership for the first year. That meant the business no longer had a pipeline of customers converting to paid membership. Management estimates this cost it around 70,000 personal members during 2017.

Customer retention has also been an issue, not solely due to the rise in insurance premium tax. While the number of new members has increased by 13 per cent, on renewal members are typically retained at a lower rate. In April, the Financial Conduct Authority introduced new rules for insurers to provide greater transparency for consumers when their policy comes due. The regulation is designed to encourage policyholders to shop around. Management also believes that most of the 17,000 customers identified as paying for duplicate breakdown cover would give up their membership altogether. Unsurprisingly, roadside assistance sales were flat year on year in the first half, and analysts at broker Liberum expect that trend to have continued in the second half. Meanwhile, breakdown costs rose as erratic workloads meant AA was forced to use expensive third-party garages. That eroded profit margins by 1 percentage point to 47 per cent.

The insurance services business has put in a better performance. Its in-house underwriter has helped bring in more new business, helping drive an 8 per cent increase in motor policies during the first half. However, this failed to offset a decline in home insurance policies, the result of a fiercely competitive market.

AA is highly cash-generative, claiming a cash-conversion rate of 101 per cent in the first half of 2017. This means it has managed to maintain the dividend that now generates a really fat dividend yield (see table). However, the anaemic growth at its core roadside business means cash profits have flatlined during the past two years. So its leverage remained at a massive 6.7 times adjusted cash profits at the end of July.

The motor specialist has also been investing in a new IT system, to which customers are in the process of being transferred. However, the completion has been delayed until 2019, meaning additional capital spending of £35m will be incurred that year. Management also revealed in September that additional investment would be needed for its call centres and insurance business, as well as more work on improving the way it forecasts its capacity needs. This additional spending means management looks for cash profits of between £390m and £395m for 2017, below the £399m initially expected.  

AA (AA.)    
ORD PRICE:117.9pMARKET VALUE:£720m
TOUCH:117.9-118.05p12-MONTH HIGH:274pLOW: 116p
FW DIVIDEND YIELD:7.9%FW PE RATIO:5
NET ASSET VALUE:negativeNET DEBT:£2.7bn
Year to 31 JanTurnover (£m)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20159846113.3nil
20169359-0.29
201793310012.29.3
2018*95716120.79.3
2019*98617322.29.3
% change+3+7+7 
Normal market size:7,500   
Matched bargain trading    
Beta:0.5   
*Liberum forecasts (profit & EPS not comparable with historic figures)