(Debtwire) AA plc still highly levered but earnings resilient as bid talks open Class B notes upside potential

01 October 2020 | 10:11 BST

AA’s net leverage is still hefty at 7.3x whilst FCA regulation risks have been hanging over the sector. But the UK-headquartered roadside assistance provider's earnings are resilient while FCA investigations are not focused on its Roadside business, which is its largest earnings contributor. Meanwhile takeover talks could lead to event-driven upside on its Class B notes, according to two buysiders.

The listed company reported 1H20/21 results for six-month period end 31 July on Tuesday (29 September) and held an earnings call that lasted just 24 minutes. Trading EBITDA was up 4.8% YoY to GBP 173m with EBITDA margins improving to 36.2% versus 33.6% in the first half last year.

The numbers were clean with the trading EBITDA excluding furlough support of GBP 6m from the government, which was reported below trading EBITDA as part of adjusted operating items.

On the earnings call management reaffirmed its guidance that FY20/21 EBITDA will only be slightly down YoY. It also added that whilst there had been a softening of demand in the Roadside business, its recovery is continuing. Management also expect an acceleration of membership numbers in 2H20.

"We have been long AA for a while, and although the numbers were slightly weak, we remain happy," independent buy-side desk Sarria said. Membership numbers were behind the RAC combined numbers who don’t report individual segments, but churn is static, and the strong EBITDA performance means there is not much to be concerned about. However, this is all secondary to the bid process and potential deleveraging, it added.

“I’m constructive and thought results were better than expected. EBITDA could have been down, but furlough schemes came below the line and EBITDA shot up YoY in a difficult environment,” a second buysider said. “The guidance is unchanged for FY20/21 and conservatism is built into the guidance. AA have delevered around half a turn in one year, and for a highly levered capital structure this is good.”

Metrics were up at 7.3x at 1H20/21 but this was down versus 7.8x net leverage at 1H19/20. Company-defined free cashflow was GBP 21m for the six-month period and down versus GBP 44m in the prior-year six-month period. The decrease was partly driven by a GBP 5m working capital outflow versus a GBP 19m inflow in the prior year period due to COVID impacting cash receipts and a payment made in extending a contract with the Bank of Ireland.

Liquidity still is reasonable with cash of GBP 166m at 31 July and GBP 56m available of the group's GBP 60m working capital facility.

Despite the deleveraging since 1H19/20, the AA plc shares are down over 52% in the past year at GBP 28.8 per share leaving a market capitalisation of just GBP 179m.

The group's market cap was bigger previously when it was 8x levered than now with lower 7.3x net leverage, the second buysider noted. “They should generate equity value given the deleveraging. We are constructive, it is an opportunity,” he said.

Change of control pick-up

The AA could benefit in the coming months from positive headlines regarding potential takeover bids. On 24 September, AA confirmed it is in discussions with Towerbrook and Warburg Pincus about an all-cash offer, as reported. Apollo is also waiting on the sidelines of the AA sale talks and has focused on the large debt component of the AA capital structure, as reported. The deadline for the Towebrook Warburg Pincus consortium to make a decision has been extended to 27 October.

This could mean significant upside for the Class B noteholders the notes. There is an obligation on AA Senior Co Limited to offer to purchase the Class B Notes at 101 upon a change of control according to point 26 of a public company frequently asked questions statement. The senior term bank facility and working capital facility each include a change-of-control prepayment trigger while the Class A notes do not, the company noted.

Management stated on the earnings call that the company is still in discussions with the bidding consortium. If the process terminates then it will discuss refinancing options with shareholders going forward, which could include raising equity.

Should any debt refinancing emerge, AA Class B notes are callable at par. The GBP 735m 5.5% 2022 Class B notes are steady at 92-mid yielding 10.4%, according to Markit.

"Due diligence was confirmed ahead of closing a transaction, which would be positive for the bonds, with a change of control for the B notes at 101 although for the A notes this would not be the case," the second buysider said. If it that does not happen, the CFO said the company were looking at all options to address the capital structure, which would involve deleveraging and a possible equity raise, which would also be positive for the bonds, he added.

“Simply put, a takeover bid will involve a degree of deleveraging, which is a positive for the B notes. And if no bid happens, the company will pursue alternative methods to deleveraging, either rights issue or more likely an equitisation of the B notes. That’s when the differing motivations of the B note holders will become apparent,” Sarria said. “It is likely there are some holders who will seek to take control via the B notes equitizing. But given there is no immediate default, no fresh cash requirement and given the Bs are value covered, a mandatory conversion would be hard to justify.”

Roadside assistance avoided

One risk for the credit story revolves around FCA regulatory investigations. The FCA on 22 September published its General Insurance Pricing Practises market study on home and motor insurance markets whilst it also published a consultation paper on remedies to support competition.

Firms have until 25 January 2021 to respond to the FCA proposals with their intention to publish a policy statement in 2Q21. The AA said it welcomes the FCA Report and opportunity to participate in ongoing consultation.

Positively, the FCA study remains focused on the smaller Insurance business rather than the Roadside business. The Insurance business generated just GBP 29m of GBP 173m group 1H20/21 trading EBITDA with the Roadside business contributing GBP 144m.

There had been previous concerns on regulatory risks, as reported. A December 2015 Occasional Paper Number 12 encouraged consumers to act at renewal with evidence from field trials in the home and motor insurance markets, while an April 2017 transparency in insurance renewals report encouraged customers to engage on renewals, followed by a June 2018 Insurance Distribution Directive reportthat aimed to enhance consumer protection when buying insurance.

In addition, in May 2018, the Association of British Insurers and British Insurance Broker’s Association published a new plan to tackle excessive premium differences between long-standing and new customers, while in January 2019 there was a FCA CP 19/8 General Insurance Value Measures reporting consultation paper.

“The FCA risks were a concern but their latest findings are far from the worst-case scenario and Roadside is not in their scope, which is the biggest profit generator,” the second buysider said. “The worst-case seems to be that the Insurance segment, which is [about 17%] of EBITDA may lose around 15% of earnings whilst churn rates could also be lower with average pricing remaining the same. The M&A or equity raise will be easier and the FCA outcome is now a downside scenario that you can price in.”

AA plc declined to comment.

by Adam Samoon