AA

Description

The AA provides roadside assistance, motor and home insurance and other driving services, and is seen as Britain’s fourth emergency service, by many of its more than three million members and ten million business customers. Formed more than a hundred years ago by a few driving enthusiasts, keen to represent and protect motorists and their interests, the group has grown in scale and purpose, at a rate which reflects the rapid evolution of the automotive industry.

Initially a membership organisation, its members voted to demutualise in 1999 and become part of Centrica. It was acquired by private equity in 2004 and returned to the stock market in June 2014.

Investment case summary

We have been invested in AA since its IPO in 2014, initially attracted to a business with many appealing characteristics including strong cash generation, a well-recognised brand with strong customer loyalty and a dominant position in its core market. Meanwhile, following years in private equity hands, there was an opportunity to invest for growth and, by reducing the level of debt on the balance sheet, transfer value from debt holders back to shareholders.

After a promising start, the investment case has not played out as originally anticipated. The original management team failed to successfully execute its plans to transform the growth prospects of the business and make a meaningful dent in the company’s debt burden. This has resulted in a series of profit downgrades and a prolonged period of share price underperformance.

Nevertheless, we have maintained the funds’ exposure to the shares, believing that the share price has persistently, and increasingly, undervalued the intrinsic worth of the business. Despite the downgrades, it has made some progress in recent years, including improved brand awareness, better customer retention and growth in new business, and it retains many of the characteristics which initially attracted us to the business.

A new management team was appointed in 2017 and has announced a clear and compelling strategy to return the business to long-term growth and restore the company’s reputation with investors.

Ask a question about our investment in AA

Fund exposure
Income Focus Fund 0.52%
Equity Income Fund 0.72%

As at 28 February 2019

Segmentation
Geography United Kingdom
Industry Industrials
Themes UK domestic exposure

Source: Woodford

Share Price

Market Quotes by TradingView

Commentary

Interim results

Today, AA reported its interim results which were mostly in line with our expectations. The company’s revenues were up by a modest 2% but its interim dividend came down to 0.6p (as previously guided) while its trading earnings before interest, tax, depreciation and amortisation (EBITDA) declined by 17%. However, most of this decline can be explained by increased investment in the business, as part of its CEO’s reset plans which are designed to prepare AA for future growth. Indeed, despite extreme weather conditions, its management expects to achieve its targeted EBITDA for the current year (around £335m – £345m) and from there to increase it.

Furthermore, its insurance arm saw 7% growth in motor policies claims, benefiting from additional marketing spending and increased in-house underwriting work. That said, its road side business delivered a more mixed performance, with its retention rate down 1% as a result of increased competition. Also, its membership numbers dropped by 2% but, more positively, the average income per member increased roughly in line with inflation. Finally, AA won a three-year contract with Arval, representing a significant win in the fleet and leasing sector. Overall, these results are as we have anticipated, given that the company is still in its transition phase towards a more growth-orientated path.

Stephen Lamacraft
26 September 2018

Stabilising the ship

AA has this morning released a pre-close trading update covering six months to end of July 2018. The company confirmed that it remains on track to hit its targeted EBITDA for the full year.

However, while its Roadside division continues to perform well, it experienced a slight decrease in retention rates and paid memberships due to increased competition. Nevertheless, the division has now more than one million customers registered on its app, which has seen a 29% increase in its usage. Once the clients download AA’s app onto their smartphones, they can request the company’s assistance directly from the road. Additionally, in the second half of 2018, AA will integrate Car Genie functionality into its app which aims to predict a breakdown before it happens.

The company’s Insurance division saw 7% growth in motor policies, while its home policy book has stabilised. Also, following recent refinancing, AA’s average debt maturity is now just below 5 years.

Overall, we see this as a good set of numbers. Maintaining EBITDA guidance despite extreme weather is no minor feat. However, reducing membership losses in light of more intense competition will be a priority for management and we’ll keep an eye on progress in this area. It looks like the CEO is beginning to stabilise the ship prior to a return to growth, at which point the focus will be on reducing debt and, in time, returning some of the prodigious cash to shareholders.

Stephen Lamacraft
1 August 2018

Transition underway

Yesterday, AA reported its full year financial results, which were in line with previous guidance given by the company in its strategy update in February 2018. AA reported growth in revenues of 2% and in earnings per share of 5% (year-on-year) – both numbers were ahead of consensus expectations. The strategy reset outlined in February is now underway and although it remains early days, these results are encouraging.

The company’s shares have rallied from a very depressed level this month, assisted by these results and, earlier in the month, by news that S&P had maintained its investment grade credit rating, reaffirming that the company’s risk profile remains satisfactory. We have consistently believed that the debt burden, though substantial, is not as much of a problem for the company as the market believes. The rating agency appears to agree with this assessment – AA’s debt is relatively low cost and there is no immediate refinancing requirement. As such, the risk of a covenant breach is low.

Stephen Lamacraft
18 April 2018

New management’s new strategy

The AA has today announced a strategy update and I’m fresh back from the accompanying presentation. In short, we are very encouraged by what we have read and heard today about what the new management team plan to do. The company is taking the necessary steps to invest for sustainable growth, which is exactly what it should be doing.

Simon Breakwell (the new CEO) is clearly positioning this business for growth rather than running it for cash. He is very clear that this is a business capable of delivering sustainable growth after incremental investment. The business continues to have strong fundamentals and is the clear market leader in its segment. The brand remains amongst the most trusted in the UK. The investments made since IPO have strengthened the business and staunched membership attrition, but more is needed to see a return to growth.

Admittedly, the dividend has been cut in order to help fund the required investments, but this should be viewed as a short-term sacrifice which is insubstantial in the context of the long-term value that can be delivered from here. Clearly, the share price reaction suggests that the stock market has focused more on the short-term sacrifice, than the potential long-term rewards. But it has done so, yet again, in a manner which ignores the history and a starting valuation which is already very depressed.

For example, even after the latest downgrades, the business expects to deliver trading EBITDA (earnings before interest, tax, depreciation and amortisation) of between £335m and £345m, in the current financial year (which ends 31 January 2019). Its market cap at the time of writing is £536m. The company is now forecasting a growth rate of between 5% and 8% through to 2023 – we believe these targets are eminently achievable and have been set at a level that is designed to be beaten, given the company’s hitherto track record of over-promising and under-delivering.

From the perspective of cash generation, the business should be able to deliver in excess of £100m in free cash flow by 2021, which represents a free cash flow yield of more than 18%. Longer term, £150m free cash flow generation looks achievable.

The risk remains that this management team fails to execute its plans, as its predecessor did. Looking at the business from a fundamental long-term perspective, however, persuades us that we should continue to embrace that risk and give this management team the opportunity to deliver.

Alex Correia
21 February 2018

Neil's view

Admittedly there has been a series of earnings downgrades from AA since its IPO in 2014 and the news of the dismissal of its executive chairman Bob Mackenzie that accompanied the trading update won’t have helped even though the dismissal does not disrupt the investment case. Indeed some aspects of the trading update such as membership numbers and cash generation were encouraging.15 September 2017

In my view AA is a very high-quality utility-like business which has been around for a long period of time. It has a great consumer reputation and it is viewed as Britain’s fourth emergency service. I believe that AA has suffered from underinvestment and from having too much debt on its balance sheet. The business has now IPO’d and it is in a very good place now to start to capitalise on the strength of the brand.24 July 2014

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address 9400 Garsington Road, Oxford OX4 2HN.

Woodford Patient Capital Trust plc is incorporated in England and Wales, company number 09405653. Registered as an investment company under section 833 of the Companies Act 2006. Registered address Beaufort House, 51 New North Road, Exeter, EX4 4EP.

© 2019 Woodford Investment Management Ltd.
All rights reserved.

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