AA still looks like a private equity accident #AA
It’s been a while since I last covered the AA (latest share price 80p, market cap £490 million), whose shares were thrust onto the stock market by private equity firms with a mountain of debt.
Since my last article, the company has been relegated from the prestigious FTSE-250. It’s now firmly rooted in the FTSE Smallcap Index.
See my previous article for an overview of the company’s balance sheet and debt position. My conclusion then was that the equity could be significantly undervalued, but the company needed to stay on good terms with the bond market until loan maturities start to hit it from 2022.
Results published last week were initially met with a flat share price, but the valuation has been sliding again in recent days.
AA’s results statements focus on “trading EBITDA“. This is a tortured measurement but it can be used as a proxy for operational cash flow, and is a key input for the satisfaction of its debt covenants. The company previously said that this measure would have to fall to £200 million “for us to be close to breaching our default covenants”.
It’s defined as follows:
“Earnings before net finance costs, tax, depreciation, amortisation, exceptional operating items, share-based payments, contingent consideration measurement movements and pension service charge adjustments. “
Unsurprisingly, the gap between trading EBITDA and operating profit is huge: £341 million of the former was translated to just £219 million of the latter in FY 2019.
Net income was a measly £42 million, after a panoply of one-off costs.
The EBITDA result was in line with guidance, but all profit measurements declined, along with the AA’s profit margins. The following reasons were given:
- more resources put into front line service.
- marketing and hiring to grow the insurance business.
- hiring spend across the group as a whole.
While it’s tempting to assume that these expenses will reduce in future years, I would be very hesitant to take this for granted and would instead choose to reset my base case assumptions.
Breakdown – the number of customers declined, as the company says it wanted to invest in its service before making a big marketing push. Marketing spend will be used in the current period to maintain a “broadly flat” membership base, with growth targeted in FY 2021. Trading EBITDA in this division has declined from £320 million to £283 million.
Insurance – 16% growth in policies in the motor book, so the marketing spend appears to have paid off. Margins declined due to the expense of acquiring new customers, which naturally is recognised upfront.
The cash flow performance was very poor, in my view. Free cash flow to equity was an outflow of £22 million. This is where all the money went:
- Pre-tax, pre-exceptional cash from continuing operations +£296 million (not much lower than trading EBITDA)
- Exceptional items minus £38 milion
- Capex minus £104 million
- Interest & leases minus £132 million
- Other minus £44 million.
The company is guiding that capex will reduce from FY 2021, after its IT transformation programme has come to an end.
I’m a bit jaded when it comes to companies saying that their IT spend is only temporary. Even if it drops back for a couple of years, how long will it be before they want to transform their IT operations again? These things come in regular cycles, in my view.
Even if there had been zero capex in 2018, the money saved would not even have reduced the debt load by 4%. Which brings us to…
Net debt is £2.7 billion, and net debt/EBITDA is 8x. The CFO acknowledges that this leverage multiple is “far too high”.
Compared to a year ago, there has been no movement in net debt, and declining profitability has increased the net debt/EBITDA leverage multiple. Management did forecast that it would increase (to c. 7.8x) in last year’s statement. Their EBITDA forecast was very accurate, so they do have that in their favour.
Future cash generation will require a meaningful improvement in trading EBITDA and a reduction in capex.
Until we see good evidence that this is occuring, I’ll view these shares merely as an equity stub on £2.7 billion of debts. Beyond my risk tolerance.