AA is UK’s largest road side breakdown recovery provider (it rescues a broken down motorist every 9 seconds). The company also provides insurance brokerage (mainly motor & home insurance) and driving lessons (~84k driving school students across the UK at FY18). The company IPO’d in 2014, after being held in private equity hands for 10 years. AA’s share price has fallen ~80% from its post IPO peak and by ~65% from the IPO price. I believe that the shares today offer good odds for a potential ~50% - ~70% return over a 2-3 year hold.
AA investment case in detail
Most of AA’s share price fall (~65%) has come in the last year (particularly since August 2017). The main reasons for the fall have been repeated profit warnings, increased capex outlay on a major IT project to revamp the legacy CRM system, and the more recent strategy presentation on 22 Feb 2018 where the new management set out the company’s new strategy (throwing in ~£145m of additional capex into the mix along with a dividend cut and substantially reduced profit forecasts for FY19). I will start off by listing what I believe are market’s chief concerns with AA, and then go on to set out my view and investment thesis.
Market’s concerns with AA
1. The road side recovery business has been steadily losing paid personal members (B2C). From 3.58m B2C members in FY14, the business today has ~3.29m. B2C members are the lifeblood of the road side recovery business, contributing ~72% of the road side divisions EBITDA and ~56% of group EBITDA. There has also been downward pressure on the B2B / corporate membership base lately (weak new car sales in the UK is generally seen as a negative for this business). Competition from upstarts like Greenflag has disrupted the duopolistic nature of the business - whilst AA and RAC continue to be the two main operators in the UK road side recovery market, Greenflag, with its aggressive pricing strategy, has been claiming members. The market’s view appears to be that AA will continue to leak members (unknowns like the impact of electric vehicles and autonomous vehicles on the business doesn’t help either).
2. Net debt / EBITDA stands at >7x, with my forecast net debt to EBITDA for FY19 at >7.6x. Whilst the AA is not at any immediate risk of breaching debt covenants and the maturity profile of its debt is sufficiently staggered with a weighted average maturity of just over 5 years, market will be concerned of the impact down the line if the core business continues to suffer – e.g. dilutive equity offer in future or a debt for equity swap, debt costs on future refinancing if AA’s bonds get de-rated to non-investment grade…
3. AA’s new strategy announced on 22nd February 2018 brings with it significant capex spend (~£280m of capex over the next 3 years, of which ~£140m more than previous forecasts). In addition to the ~£35m of additional spend on the new CRM system, management wants to invest substantial amounts in new technology, marketing and its insurance offerings (e.g. Car Genie – AA’s new telematics system to predict faults before they occur, app and digital initiatives, additional capital for the insurance business). While management view the new strategy as paving the way for long-term growth, market will be concerned if this is the company trying to throw the kitchen sink at an unwinnable problem (i.e., the slow dying roadside recovery business).
4. In addition to the above concerns, market appears to give no credit to AA for the growth prospects it has in its insurance offerings (e.g. only 9% of AA’s personal members hold AA motor insurance, AA has recently kick started its own underwriting business).
My view and investment thesis
Road side recovery business
In my opinion, the road side recovery division is an extremely attractive business. It consistently generates ~49%-50% EBITDA margins and high ROIC of ~17% - 20%. In spite of increased competition the division has demonstrated pricing power over long periods. AA’s scale and quality of service helps in this regard- it has the biggest patrol network at >~2900 patrols across the UK and based on my research, it provides the best quality service compared to competition.
The economics of the road side recovery business is extremely attractive. Looking at the last six year numbers, the business generates average revenue per user (ARPU) of ~£54 per annum. This is across both B2C & B2B membership base, with B2C members generating ARPU of ~£158 per annum, almost 8x the ARPU of B2B members. The average cost per member per annum is ~£26, giving the business a juicy ~£49%-50% operating margin. The main attraction of the business is that whilst all member pay a yearly membership fee, the number of breakdowns attended per annum works out to ~27% of the membership base (people pay for the peace of mind).
For example, in FY17 the AA attended to 3.6m breakdowns, which works out to ~27% of its membership base in the year of 13.52m members. ARPU per member in FY17 was £55 and average operating cost per member was £27 [average cost per breakdown of £105 * 27% of the membership base]. These economics have been consistent over the last six years (see table below).
Based on the above economics, if the AA can show stability in the number of members and ARPU per member, there is no justification to market’s concerns in my opinion.
On membership, it is a fact that AA has been leaking personal member. Since the IPO it has lost a total of ~650k personal members. But it is worth noting that the majority of lost members (~360k) was suffered due to discontinuance in December 2015 of free roadside membership for AA’s insurance customers. This closed the pipeline of AA insurance customers who were getting free membership, with a view to later converting them to paid members (but discontinuance also helped improve ARPU). Ignoring the free membership base and looking at paid membership base alone, the CAGR since IPO has been -2.1%, with recent years actually showing stability in the paid membership base (the paid members ship base showed a modest growth of 0.3% in FY17).
In addition, the AA has been adding an average of >500k new paid members each year since the IPO, and improved membership retention rate from 79% in FY14 to 82% now.
My forecast for membership base going forward
In forecasting the B2C membership base, I take account of AA’s retention rate (82% over last 2 years) and new member additions since FY14 which has averaged more than 0.5m over the last 4 years. Management strongly asserted in the Feb strategy day that the retention rate has held strong at that level. Assuming the retention rate holds stable and new members continue to be added at current levels, I forecast the membership base stabilising by FY22, and returning to a modest growth thereafter.
On B2C membership base, I take a fairly conservative view. AA currently has close to 10m B2C members with a 65% market share in the UK B2B roadside recovery market. It has very strong retention rates (100% in the last 3 years). However, B2C revenues are correlated with new car sales and I discount for the negative trend in UK new car sales in my estimate. I forecast B2C membership falling steadily over the next 5 years and stabilising at just over 9.3m mark. This is a fairly conservative estimate in my opinion and I expect the company to exceed this level.
Forecast for membership base (FY18-23)
There are plenty of factors which should help AA meet (and probably exceed) my membership base forecast above:
- the new AA app has good features compared to competition and has shown uptick in usage rates amongst members;
- the Car Genie telematics product is to be rolled out across the membership base and is able to predict ~1/3rd of breakdowns; more importantly, it differentiates AA’s offering against competition;
- the increased patrols (addition of 65 patrols takes AA’s total patrol numbers close to 3000) and call centre staff should help AA meet its service delivery targets of arriving within 45mins of a call and targeting call answer time of 20secs. Better service = higher retention rates + better reviews + growth in new members;
- the new CRM system should help the AA improve membership retention and increase cross selling (e.g. better cross selling across its insurance, driving services and road side membership platforms). For a company that is 110 years old, it is amazing that before the new CRM system it had no way of knowing much about its customer base across its business lines and target its offerings (the monopolistic nature of the business in the past meant the company could get away with this).
The operating cost side of the roadside recovery business
As discussed earlier, the economics of the roadside recovery business is very attractive. The business is helped by the fact that most of its operating costs are fixed (e.g. majority of the break downs are attended to by AA’s own patrols and it has its own call center staff). Breakdowns attended in a year have ranged between 24% - 27% of the membership base, meaning that the business consistently makes 49%-50% operating margin given ARPU of ~£55 and average cost per breakdown of ~£102.
However, there are times when the business has to use independent garages - e.g. at the time of peak demand due to weather conditions. This erodes the businesses operating margins. If you study the margins over the years, it is clear that the number of break downs during the year and operating margins show a negative correlation. Management recognises this and is working to reduce reliance on independent garages by improving patrol/resource allocation by targeting peak times and areas (e.g. the company is working on forecasting patrol needs by postcode based on past data and is targeting patrol allocation accordingly).
The other factors which should help margins going forward are:
- app usage has steadily been increasing since introduction in 2015, with ~35% of the members now registered via app and ~45% of the breakdowns now tracked on the web and app. 20% of the member breakdowns do not involve a call and management has a target of reducing calls to call centres by 20% by FY21. The app has good features with members being able to access all membership benefits in one place, plan journeys, get live traffic updates, report and track breakdowns etc. Average app session of >3mins for an app of this nature is impressive. As more members use the app for recovery assistance, the reliance on call center should reduce, improving operating margins
- Car Genie should help AA patrols better manage calls (e.g. by knowing more about a call in advance, a patrol should be able to spend less time and better prepare for each call; some calls could also be solved remotely)
- the new CRM system should make it easier to track and renew members helping increase efficiency
However, I don’t give any credit for the above upsides and my forecast assumes that the margins in the roadside recovery business drop from the current 49% - 50% to 45%.
Marrying all of the above, my forecast for the roadside business is below:
A word on EVs and autonomous cars
There is some speculation on the impact electric cars and autonomous vehicles will have on a business like the AA. It is difficult to predict car reliability for EVs and autonomous vehicles with any certainty. Moreover, penetration of EVs currently is <3% and forecast to rise to ~10% by 2021. AA predicts that ‘self induced’ faults (e.g. tyres, locked out) will remain unchanged. Moreover, there could be new types of faults these vehicles suffer from (e.g. battery faults, technology malfunction etc). There is nothing to suggest that EVs won't breakdown. AA has already got trained patrols who can handle EV breakdowns. As for autonomous vehicles, they are some way away; and again there is nothing to suggest that autonomous vehicles will not need break down cover.
Insurance
Management has laid out a new 5 year growth plan for the insurance business under which it targets 2m+ motor and home policies by FY23 from the current ~600k. It plans to grow EBITDA by 9% - 14% in its insurance business between FY19 – 23. I believe managements target is achievable for the following reasons:
· of the AAs 3.3m B2C members, only 9% have AA motor insurance. There is a large captive customer base ready to be tapped. The new CRM system should help in this regard. New management brings real focus in this regard and initial growth figures are noteworthy (motor insurance policies have returned to growth and now stand at over 600k, and the in-house underwriter has now written over 400k policies across home and motor insurance, a growth of 4x in the last year)
· AA has now rolled out insurance hosted pricing (IHP) in its brokerage business. IHP allows live price feeds to the underwriting panel and greater speed to market for its insurance brokerage. This is already having a positive impact on policy growth in the brokerage business.
· AA is putting in place plans to use its proprietary data to enrich its in-house underwriter (e.g. anonymised data from Car Genie and its B2C membership base to better quote and write policies)
· The new CRM system should enable better targeting and cross selling opportunities
· Over 87% of the quote requests to AA come from non AA members. AA currently doesn’t offer quotes to non-members, but this is set to change. This offers a sizeable opportunity for the AA, not only to broaden its underwriting footprint but a new customer base to be targeted for its roadside recovery business.
I forecast CAGR EBITDA growth of 6% over FY19-23, 300bps below management’s lower end forecast. I believe the AA has more than a decent chance of beating this.
Driving services
The driving lessons business comprises of the AA Driving School and BSM. It is a steady business with ~84k students at FY18 generating EBITDA margins of ~29%. Management considers this business to be core and expect to cross-sell insurance and roadside breakdown cover to this student base.
I keep my forecast for the driving services business steady at current levels.
Debt structure
A net debt/EBITDA ratio of >7.6x would be a no-go for most equity investors, but in my opinion the key risks for equity owing to high debt are remote in AA’s case for two key reasons: 1) given the debt’s maturity profile there is a very low risk of a dilutive equity offering; and 2) AA has significant headroom above its financial covenants given its strong cash generation and risk of a default is remote.
The blended cost of AA’s debt is 4.52%.
The spread out maturity profile gives the company headroom to refinance itself on a continuing basis; the strong credit (the A notes have an investment grade rating) attracts institutional investors. AA’s bonds trade at good levels - the shortest maturity A3 note and the longest maturity A2 note both trade above par and have nearly always done so. The remaining notes (A6, A5 and B2) with maturities around 2022-23 saw sharp declines in value at the time of the strategy update, but have since recovered.
The AA has a covenant light structure. There is only one maintenance Debt Service Coverage Ratio (DSCR) covenant associated with the Class A Notes. This covenant, which effectively is an interest coverage ratio, is set at 1.35x. With c.£100m of annual interest cost for the Class A Notes (fixed in nature), Class A Free Cash Flow would need to more than halve before any breach could potentially occur. At FY17 the ratio was 3.3x and even at the FY19 low, I predict a ratio of 2.7x. As such, the risk of default is very low.
The high net debt/EBITDA leverage does not have a covenant impact as the AA does not have any leverage-based maintenance covenants.
While I don’t see any risk of a dilutive equity issue, there are a couple of points worth noting re the debt structure from an equity investor’s point of view:
1. The next refinancing date for AA is on its 4.25% £500m A3 notes in July 2020. All of AA’s A notes currently have an investment grade rating from the S&P. However, if S&P were to review AA’s investment grade rating (e.g. due to increased capex, execution risk on under the new strategy, reduced profitability forecast for FY19) and downgrade AA, this could have a bearing on the interest rate AA has to pay when it comes to roll-over the A3 notes in July 2020. For example, AA’s B2 notes currently have a B+ rating with a coupon of 5.5%; a similar rating and coupon would increase the cash interest costs by £6.25m per annum, reducing eFCF. That said, I expect interest costs to steadily decline post-July 2020 due to the following reasons:
a. given free cash flows, AA could simply chose to repay a substantial portion of the principal at maturity. For example, AA should easily be able to repay £100m of the A3 notes, requiring only £400m to be refinanced, in which case its cash interest hardly increases even assuming a 5.5% coupon on the new notes.
b. When S&P last downgraded AA’s B2 notes back in July 2016, a key factor was the IFRS pensions deficit which stood at £622m; this has now fallen to ~£390m in FY17, reducing the risk of a downgrade.
2. The other point worth noting re AA’s debt structure for an equity investor is the opportunity it provides for significant transfer of value from debt to equity over time. Whilst AA cannot repay it’s A and B notes at present due to onerous make whole prepayment penalties, it is able to start repaying its 5.5% £570m B2 notes from August 2020 without any prepayment penalties. Moreover, it has ~£2.2bln of its ~£2.7bln total debt coming to maturity around 2020/23. Given its free cash flows, AA has an opportunity to: a) repay a fair chunk of the notes, reducing the debt and future interest costs, and b) reduce its blended average interest cost from the current 4.52%. As an example, if AA uses ~70% of its eFCF to start repaying its £570m B2 notes starting August 2020 when the prepayment penalty falls away, it adds ~£8m to eFCF in FY21 and ~£16m to eFCF in FY22. There are a number of options available to AA to reduce its cash interest costs as its notes come to maturity.
In my calculations I have not modelled any upside to cash interest before FY23, which is conservative in my opinion. From FY23, I model a reduction to cash interest of £15m from the current ~£115m – this is easily achieved either by reducing the blended average interest costs on the notes by 60bps from the current 4.25% to 3.6%, or by reducing the total debt by ~£380m using AA’s FCF, or a combination of the two.
In summary, I believe the risk of a dilution for equity holders is remote, and in the longer term there is good prospect of transfer of significant value from the debt to equity holders.
Free cash flow
In what should be the trough year for profitability and cash flow, eFCF is forecast to hit a low of £20m in FY19. But this is largely as a result of ~63m of exceptional (see below). I forecast eFCF to recover to £80m in FY20 and average over £100m thereafter.
As can been seen from managements presentation above, they forecast normalised FY19 eFCF post adjustments at £107m. The bridge between the forecast FY19 eFCF of £20m and normalised eFCF of £107m is - £55m of transformational capex, £12m of punitive swap costs which terminate in FY19 and £20m of exceptional owing to disposals and one-off working capital adjustments. I agree with all but one of management’s number – on capex, I would only given credit for the ~£31m of capex spend in FY19 on the CRM system, which is genuinely one-off; the rest of the capex initiatives could be a regular occurrence. My normalised FY19 eFCF comes at ~£80m. However, from FY20 onwards, I expect eFCF to average above £100m. Based on the current share price of £0.94, this works out to a eFCF yield of ~15%.
In my cash flow forecast, I budget capex post FY21 of ~75m. Management’s forecast for normalised capex post the implementation of the new strategy is £55m per annum, but I expect some of the expenditure to have to continue (e.g. IT spend is likely to be at elevated levels owing to the need to constantly innovate the digital offerings and market spend is likely to stay high owing to competition).
Valuation
DCF
My DCF value for AA comes to £1.65 per share, which is a ~75% upside to the current share price.
EV/EBITDA multiple
Using normalised EV/EBITDA multiple, I value AA at ~£1.49 per share, which is a ~58% upside to the current share price. I use a multiple of 10.5x EV/EBITDA on normalised EBITDA of £370m. The 10.5x multiple is backed up by the following variables back up by my forecasts: a cash tax rate on EBITDA of 7%, reinvestment rate of ~31% on EBITDA, WACC of 8% and EBITDA growth rate of ~1.9%.
EV/EBITDA of 10.5x = [(1- 7% tax rate)*(1- 31% reinvestment rate)] ÷ (8% WACC – 1.9% growth rate)
It is worth noting that AA has traded at an EV/EBITDA of 10.5x on average since its IPO in FY14.
Note, my CAGR EBITDA growth rate over FY19-23 is well below managements forecast range of 3% - 6%. If management hit their forecast, there is additional upside to my valuation.
Catalyst and support
1. Stability in road side membership
2. Growth in insurance business
3. Execution of the new strategy - CRM rollout, Car Genie, cross selling, app usage, better reducing reliance of independent garages
4. Transfer of value from debt to equity over 2020 – 2023 period by reducing blended interest costs and debt
5. Potential takeover bid – I think there is less prospect of a bid in the near term given the substantial pre-payment penalty on the B2 notes on a change of control. However, the A notes have no change of control payment trigger, which could be attractive for a bidder and the B2 prepayment penalty reduces substantially in FY19 and completely falls away in July 2020.
