AA (AA.) – Understanding the debt load as both its share price and its customers suffer breakdown
The AA is a much-loved and classic British brand, but it has been an unsettling ride for shareholders since IPO at 250p in 2014 (latest share price 95p, market cap £582 million).
The prime worry for the investing community has been its enormous debt load (a legacy of private equity ownership prior to IPO), and deteriorating financial performance hasn’t helped. The company has reported a 15-year high in the number of breakdowns serviced after a period of extreme weather and a pothole ‘epidemic’ in the UK.
Besides helping us to understand the company’s operations, the latest H1 report also provides us with fresh figures to assess the financial risk associated with this struggling PLC.
Balance Sheet: Major Debts and Negative Tangible Equity
The balance sheet starts off poorly, with a massive £1.3 billion of intangible assets recorded on the balance sheet. Much of this refers back to the 2004 purchase of the company from Centrica (CNA) by a private equity consortium. We can think of this as the value assigned to the AA’s brand at that time. Intangible assets also includes £150 million of software.
Working capital (current assets and current liabilities) is a mixed bag. The net value of AA’s working capital is negative to the tune of almost £200 million.
Then we arrive at the crux of the matter: the non-current borrowings and loans. These add up to a staggering £2.7 billion. Throw in the pension scheme and a few other bits and bobs, and the long-term liabilities add up to some £2.9 billion.
The result is that the company has negative equity of some £1.6 billion, and that’s including the value of intangibles! From a tangible equity point of view, the company is worth negative £2.9 billion, roughly the same as the value of its long-term liabilities.
Understanding the debt load
Not all debt is born equal. Companies with cheap, long-term and covenant-lite loans have a much easier time compared to those encumbered with expensive, short-term and restrictive debt.
For example, a pension scheme might be considered good debt. Pension scheme beneficiaries tend to want their company to survive and thrive for the long-term, without taking on too much risk, so that it can afford to pay their pension.
A team of bankers managing an overdraft facility, on the other hand, will care little for the company’s long-term success and will instead focus all of their efforts on getting repaid. This could mean selling the position at a discount to a corporate predator, who will call in the loan for strategic reasons.
AA’s debt load falls more-or-less into the category of “good debt”. It is medium-term in nature, and the interest rates it pays are by no means extortionate. The weighted average interest rate on its loans is a very reasonable 4.5%.
The debt has been refinanced on multiple occasions, sending it further and further into the future, and this gives the company plenty of flexibility in the short term. The debt profile is currently like this:
Source: AA, Cube Investments.
The £200 million amount that is due for 2020 has in fact already been organised for repayment with a new committed facility that itself will expire in 2023. So the “real” profile is like this:
Source: AA, Cube Investments.
This profile means that there are no further refinancings due until 2022. It will need to stay on very good terms with the bond market between now and then, with almost £1.3 billion in principal to be refinanced that year!
Another positive feature of the debt profile, apart from the years of flexibility it gives AA until 2022, is that the covenants attached to the debt seem to be quite relaxed. According to the 2018 annual report, “trading EBITDA would have to fall to c. £200 million for us to be close to breaching our default covenants”.
At the interim results statement, AA reiterated its outlook for trading EBITDA of between £335 million – £345 million for the current financial year (FY 2019). This allows for performance to deteriorate very considerably before breaching covenants!
Indeed, we can see quite clearly that the company is not panicking from the fact that it continues to pay regular – albeit much reduced – dividends.
Interest Coverage: OK
Cash interest expense incurred in H1 was £63 million, approximately in line with what you’d expect from applying the 4.5% average interest rate to an outstanding principal amount of £2.8 billion.
Operating profit before exceptional items was £121 million. Comparing this number with the cash interest expense, we can see that the company would have been able to pay its cash interest expense almost twice from its H1 earnings.
Last year, operating profit before exceptionals was £304 million, while total finance costs (including both cash and non-cash items and exceptional items) amounted to £167 million. Even by this stricter measurement, the finance costs were covered almost twice by earnings.
We haven’t finished our investigations, and an interest coverage ratio of less than 2x is hardly ideal for all but the most predictable of businesses. However, these simple calculations do suggest that if the company remains stable, and if the bond market remains friendly to it through 2022, then AA’s equity could prove to be worth significantly more than the c. £600 million price tag currently attached to it. We will need to keep studying this one!