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Is AA headed for breakdown?

Despite signs of resilience amid the crisis so far, the road recovery group’s balance sheet leaves almost no room for error
April 15, 2020

So far, car insurance and roadside recovery memberships are not among the products and services most affected by the current economic and health crisis.

IC TIP: Sell at 25p

For investors in AA (AA), that’s very welcome. This week, the group said that while car breakdowns and vehicle incidents had declined by almost half, Covid-19 had still not had a “material” impact on its operations. And though a sharp drop in driving has not stopped mechanic call-outs for flat batteries, a decline in overall activity has helped to reduce costs, including third-party garaging – a persistent source of margin erosion in recent years.

However, in an otherwise bullish trading update on 31 March, the group said there was little certainty on the future impacts on its business. That has prompted the group to defer or reduce operating costs and capital expenditure. In keeping with the broader market trend, the final dividend for the January year-end has also been culled.

In the near term, those actions should support cash flow. A review of the AA’s pension liabilities should save a further £10m a year. But such is the scale of the group’s debt position, analysts are starting to signal that a small downturn could be enough to wipe out shareholders.

Holders of bonds, rather than equity, are already in the ascendancy. While management could point to being “well within” financial covenants at the end of January, the assurance failed to mention that these are based on the ratio of free cash flow to debt service charges. Analysts at Barclays estimate that the AA’s net debt to adjusted cash profits ratio – a more conventional measure of indebtedness – was at 7.8, and rising.

Leverage pressures were already apparent before the current crisis began. In January, the AA was forced to swallow a 280 basis point increase in coupon payments to refinance a portion of one tranche of bonds maturing in 2022. Analysts at Berenberg calculated that this will add a further £9m in annual interest payments – equivalent to a £7.3m drop in free cash flow –  on top of £10m in one-off transaction costs.

Since January, credit markets have become considerably rockier. And with a further £942m in bonds set to mature in 2022, that means the AA is facing the prospect of higher interest rates, which means more pressure on free cash flow. That starts with the refinancing of the group’s remaining subordinated ‘B-notes’ debt, which Berenberg estimates could lead interest payments to rise by an extra £27m a year, at least.

 

The timing for such a high-wire and expensive debt issue could hardly be worse, and might ultimately herald a restructuring. In February, credit rating agency S&P reaffirmed the B-notes’ junk status, while assigning the remainder of AA’s bonds a ‘BBB-’ rating, the lowest possible rung for investment-grade credit.

Despite this bleak outlook, AA shares climbed two-thirds to 25p in the four trading days to 14 April, suggesting either that hedge funds are unwinding some of their short positions, or investors have turned spectacularly bullish on the company.

The latter scenario would conform to the views of Peel Hunt, which sees a “significant” potential for rerating as investors latch on to the company's resilience, and the opportunity to strengthen cash flow. Liberum stuck to its ‘buy’ rating, but reduced its target price for AA shares from 130p to 50p, citing challenges to its existing market, in addition to “the leverage, deteriorating credit conditions and market de-rating”.

Others were bearish even before the Covid-19 crisis took hold. In downgrading earnings per share forecasts for 2021 and 2022, Berenberg pointed to both AA’s debt and refinancing issues, as well as the threat posed by a Financial Conduct Authority (FCA) review into so-called “loyalty penalties”, which is due to conclude this year. The bank believes that “excessive differences between premiums charged to new and existing insurance customers” is a large part of the AA’s revenue model.

Barclays also dropped its rating on the stock to 15p, siding with a market view which it said “is very close to implying the enterprise value of the firm could be overtaken by its debt and pension liabilities”.