Stockwatch: A finely-balanced stock for all traders

It's seen better days, but there may be an opportunity here for alert traders comfortable with risk.

Is the debt-laden disaster of Thomas Cook (LSE:TCG) a lesson for the likes of AA (LSE:AA.)? At 61p it is nowadays a small cap stock capitalised at around £375 million versus £2.7 billion net debt that is barely coming down.

What's more, while it's not the most shorted stock on the London market (Thomas Cook went into administration with 10.7% of its equity out on loan) the position on AA is 5.57% with two disclosed hedge funds raising their shorts, albeit three are trimming. 

AA can seem the classic over-borrowed, ex-private equity owned stock to avoid, its price down from over 400p mid-2015 to below 50p in July.  Since then its price has crept back to a 200-day moving average and could be viewed in a bullish "bowl" formation, marking a turning point.

In June, at 52p, I suggested the stock had become more interesting as a speculative stock, albeit rating it "Avoid" on investment grade criteria.  I'd still be careful of AA's current technical appeal given for example BlackRock had a remarkable 5.91% short as of June, since reduced to 2.2%, implying that short closing could be painting an enticing image here.

Yet latest interims to 31 July showed the roadside assistance and insurance group bumping along well enough to maintain a 0.6p dividend, for a prospective yield of 3.3% based on a total 2p payout continuing.  

If consensus for normalised earnings per share (EPS) of 14.5p in the current year to 31 January 2020 and 16.5p in 2020/21 are fair, the prospective price/earnings (PE) is sub-4 times.  Obviously, much hinges on manageability of debt, although on a key score of bankruptcy risk, AA is faring OK.

This week saw a brief blip to 74p on news of a partnership with Uber for roadside assistance and service/maintenance/repair.  "SMR will become an increasing area of focus for the AA," said the company, "a significant opportunity to grow new revenue streams without incurring substantial capital expenditure."  The three-year partnership will enable drivers to access breakdown cover and book SMR via AA's dedicated platform.  It adds something new to the story, but the stock fell back, probably because, for now, debt outweighs it.

• Stockwatch: A speculative binary call
• Should you follow directors into this bombed-out stock?
• The Week Ahead: AA, Babcock, Halma

Risk analysis

It may help to pick out and consider key risk factors cited in AA's financial statements.  Funnily enough, they're presented on a worst-case scenario:

"We are unable to maintain roadside market share or command a price premium." (risk point 2)

A typical swipe against AA is hiking up "roadside" renewal fees (as most insurers do), prompting switching unless you get on the phone and haggle.  I can at least offer direct experience of this, having used AA home and car insurance and also its roadside assistance for over 35 years.

With the latter they tried to make me feel special, upgrading to "Gold," although most of the extras seemed bells and whistles I wouldn't use.  When dealt with a hefty renewal hike I rang up "retentions" (as you do), saying on this basis I'd be off to rival Greenflag, to which they responded with a fixed-price multi-year offer not a lot more than Greenflag. I accepted.

Greenflag's reviews appear overall to be improving but, like car insurers offering roadside assistance, it relies on local networks where performance can be mixed.  As for RAC, they do not cover vehicles over 10 years old, which could soon be a disadvantage as people hang onto their cars until longer-running electric become available.

My personal experiences tally with the numbers/narrative in AA's interims.  Roadside membership is flat around 3.2 million people, with hope entertained of returning to growth in the next financial year.

Average income per member has risen 4% to £165, which I treat warily lest it reflects churn - an element of membership not challenging annual price rises while others leave, and some, like me (so far), staying put.  In due respect, the AA topped a Which? survey gaining 5 stars in the "fix at roadside category".

Management says it "needs to improve, innovate, demonstrate and deliver a superior proposition and ensure our pricing is competitive relative to this proposition."  AA's Smart Breakdown is a plug-in device able to read data and relay issues that could lead to a breakdown. AA will also know any parts required and the vehicle's exact location.  

My concern is, the kind of drivers able to afford this kind of add-on (£5 a month or £49 a year) may be less likely to own cars liable to break down; and those owning older bangers will avoid extra cost, especially if a hard Brexit hits consumers; this being the kind of "extra" you'd cut.

Source: TradingView Past performance is not a guide to future performance

"Price comparison sites will further damage the insurance broker model... (risk point 6) ...and may continue to transfer value away from our broking business."

Initially, that doesn't appear supported by the interim results which cite "strong" performance for car/home insurance, especially underwriting, while broking saw a 22% growth in motor policies to 803,000 and home policies 3% growth 841,00 – albeit with average income per policy at £67 "reflecting investment in new business volumes".  This seems low to me, as if reflecting aggressive discounting, and we should be aware that regulators are pushing insurers away from this, with multi-year fixed price offers emerging.

When I searched the market to renew my policies last December and April, AA was among the keenest offers, albeit for new policies.  This would explain the low £67 average figure.  In price-comparison searches AA scored well for new buyers.

So, the risk from price comparison sites appears to relate chiefly to price, especially for retentions, otherwise they can help new customers get a good insurance policy from AA.

"Inability to repay or refinance debt at an acceptable price." (risk point 8)

This appears the crux for holding AA shares:

"£1.5 billion debt is due to be refinanced by July 2022, of which £200 million relates to Class A3 notes due July 2020 and can be fully funded by a committed facility with a maturity date of July 2023."

The current bond market suggests debt would need to be refinanced at a much higher interest rate than the current date and this is considered an emerging risk.

Says AA, "Consistent with our approach to proactive debt management, we continue to regularly assess a range of strategic options and are monitoring market conditions closely."

The short-selling rationale for AA, therefore, is this coinciding with a hard Brexit knocking "roadside" renewals as some car insurers offer this freely as part-incentive to switch, and Greenflag remains at a discount to renewal rates AA pitches for.

As yet, however, AA's debt appears to trade around par value, rather than the discount that emerged for Thomas Cook: the debt market at least, prices for viability.  Risk point 8 in the interims continues more positively:

"Modelling indicates that even at higher interest rates, the business remains cash generative and able to meet its financing commitments at the same time as being able to pay down debt."

The interim numbers are fairly positive on free cash flow, which has jumped from £14 million to £44 million, albeit excluding an £8 million final dividend and last February's £20 million bond-buyback.  Management says it is on course to generate £80 million free cash flow (pre-dividends and bond buyback) this year, i.e. after capital expenditure (not expected to exceed £70 million and guiding for £60 million in the next year).

Net finance costs eased 11% to £78 million, albeit due to lack of a £15 million penalty arising on the July 2018 refinancing; and cash flow ratios to debt service costs are in a 2.9x to 2.1x range (according to definitions), so decent headroom over covenants stipulating over 1.35x to 1.0x respectively.

Liquidity ratios are a mixed bag

These are typically what investors look to, following Stern business school professor Edward Altman's "Z-score" model of bankruptcy risk.  

While AA's liquid assets like working capital, are only about 0.2x total assets, the group doesn't have consistent operating losses – the usual context for alarm, where current assets are shrinking – hence a "yes and no" on this score.

Earnings before interest versus total assets works out at 0.12, where Altman stipulates a minimum 0.082 – saying this score persistently outperforms other profitability measures in assessing risk of corporate failure, including cash flow.

Shareholders can take heart in this.

On market value of equity versus total liabilities however, AA is weak at 0.1 where Altman specifies at least 1.4.

Such ratios conclude no firm buy/sell view.  Overall, I think AA’s dynamics merit this update and remain worth watching, albeit for alert traders - long or short – rather than tuck-away investors.  I suspect a hard Brexit would harm the group in a tougher consumer environment, especially if coinciding with a higher debt cost.  So, broadly: Avoid.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.