Description

Company information  

“The AA” is one of the best known and trusted brands in the UK, operating primarily in the Roadside Assistance market (similar to AAA in the US) and Insurance brokerage (earns fee for selling auto and home insurance written by other companies).  It was formed in 1905 as a mutual company to help members avoid police speed traps, but evolved into a general roadside assistance and travel advice business.  After going public in 1999, it was quickly purchased by Centrica (UK gas company) and sold to private equity in 2004.  The AA was under private ownership for a decade, re-emerging as a public company in 2014.  Shares have declined over 60% from their post-IPO peak, and now seem attractive relative to a stable underlying business.

Thesis

The AA, as commonly known in Britain, is a very good business, as proven by stability despite a decade of underinvestment after being owned by larger conglomerates and private equity.  ROIC consistently exceeds 20%, industry market shares are stable and AA has shown pricing power.  The private equity era ended a few years ago, and as a result of finally investing in the business, the AA is likely poised for future growth.  The risk is its high debt levels, although debt and pension appear manageable given stable/improving operations.  Leverage has steadily declined in recent years, which should continue.  There are many ways to win here.  1) debt paydown in steady state scenario, 2) accelerated growth and cost savings from nearly completed IT upgrade, 3) optionality from insurance underwriting, 4) interest rate rise, among other possibilities.  Even if EV remains unchanged, FCF should continue to sustain double digit returns to equity.  Historical median is 14x, and EBIT margins have been stable in low-30%s.  There is a cost savings plan in place which could add 300bps+ to normal margins.  If new CEO executes reasonably well, investors should greatly benefit from owning a compounder trading at very modest multiple.  My initial 14x EV/EBIT valuation (pre-cost savings) is £2.45 (~50% upside).

Recent events

AA.LN has declined 50% in the last year due to missed expectations and a management change.  

On expectations: The company stated out of the IPO that it would reinvest in the business and upgrade its decades old IT system, delivering better service to customers.  This was the right business decision.  However, they said it would cost £128m over 3yrs, and in Sept17 the new CEO announced it would take an extra year and cost an extra £35m.  While this is mildly disappointing, the share price reaction seems extreme.  After years of declining membership, latest results showed a rebound, largely attributable to better service provided by IT.

On management: In one of the more bizarre situations I’ve seen, Executive Chairman Bob Mackenzie was abruptly fired in Aug17 after allegedly punching a colleague at the bar following a company offsite.  His interim replacement, Simon Breakwell, was made permanent in September and was made has been on the board since 2014.  Breakwell has a very interesting background, as one of the founders of Expedia in the 1990s, and leading its European business until 2006.  He most recently led Uber’s European entry in 2012-13.  From what I’ve been able to glean, he appears to be a very capable executive, and potentially even an upgrade over Mackenzie, given the increasing digital nature of the AA.  His initial comments are as follows:

“In the 4-6 weeks that I’ve been here, there’s absolutely nothing that I’ve been surprised with.  The company is a fantastic business, and actually it’s been quite surprising at how that’s affected me.  It tries to do a worthy thing.  There aren’t many companies around today that try and do something that’s really worthy.  It’s got a fantastic brand.  It delivers truly outstanding service, on the phones and on the muddy ditches on a Friday night.  And we’ve got a group of people who are running the business that are trying their very, very best to make the AA a better business…The strategy is not about some radical shift, it’s about taking the investments that we’ve made and using them to redefine the customer proposition so that it is night and day better than our competitors and something that is fantastic to our consumers.”

“The AA is a fantastic company with a fantastic offering and services.  But if you look at the great companies of the world, they always have great products that are really distinctive from their competitors.  It’s our intention to make AA one of those companies.  I’m a great believer in the approach of less is more, and that it is better to do a few things very well instead of being spread thinly.”  Simon Breakwell, CEO; 9/26/17

I wouldn’t spin abrupt CEO change as a positive, but given the Breakwell’s background and familiarity with the business, the shift is tolerable.

IT

As mentioned, the AA is toward the end of an IT upgrade that will save money and provide better customer experience.  The prior system was several decades old.  It is a testament to business quality that a customer facing company with 30yr old IT was not overwhelmed by competitors.  Still, management was wise to overhaul the former system.  This has enabled basic services like calling for help via app, renewing policies online, viewing entire customer history on a single screen, etc.  These capabilities drive:

1. cost savings (reduced inbound call center volume)

2. member satisfaction (quicker patrols, personalized service)

3. revenue growth (cross-selling, 3rd party partnerships, etc)

Benefits are already beginning to appear in the form of greater app usage, customer retention improving from 79% to 82% and improved service in the field.

These are just a few of the benefits achieved, very little of which appears discounted in 12x EV/EBIT on depressed earnings.  Although this £128m program was intended to complete in CY17, the fact that an experienced technology CEO decided it was better to extend until CY18 to ensure successful transition and spend an extra £35m on redundant staff during the switch seems reasonable.

Case studies

Another way to gain comfort with the situation at AA is to look at prior examples.  

• First, its #2 competitor RAC shown below implemented a similar strategy of spending on IT, delivering cost savings and revenue growth while under private equity, helping to increase revenue from £417m in 2010 to nearly £500m in 4yrs.

• Although a different industry, Ticketmaster is another example of a dominant business with a 28yr old IT system that managed to not seriously impair itself while woefully underinvesting in its technology.  Their re-platforming began in 2011, and took several years.  Functionality to their venue and individual customers is vastly improved.  Building a mobile-first platform hampered profitability in the early years of upgrade, but has paid significant dividends to customers and shareholders through the last several years.  LYV transcripts read very similar to the situation at AA today.

• AAA in the US is provides another example of a business that has been able to grow despite facing the same technology/aging population/autonomous vehicle, etc. threats as AA

Advertising

Another area of increased spend is advertising.  Despite brand being one of AA’s biggest assets, private equity owners vastly cut marketing spend.  It has resumed, which should help membership growth.  In FY17, the average UK consumer received 60 impressions from the AA, versus 22 during FY16.  This is the new normal.  Resumed ad spending should help growth.

The fact that membership held reasonably steady during a period where advertising was completely gutted is further testament to the quality and stickiness of this business.

Insurance Premium Tax (IPT)

This is a UK tax on consumer insurance premiums that was surprisingly increased in Nov15 from 6% to 9.5%, and currently stands at 12%.  This increases AA’s cost to members and has been a headwind to pricing.  AA estimates IPT has cost them ~£25m EBIT annually.  Further rises are not expected, but possible.  The European high is 18% in Germany.

Insurance

The other segment of consequence besides Roadside is Insurance, comprising 17% of EBITDA.  This is a brokerage business, with almost no underwriting risk.  However, in the last 18mos, management began underwriting its own motor insurance policies (nearly all reinsured at this stage, limiting downside risk).  This is very low hanging fruit, as the AA is one of the UK’s best known insurance companies despite only recently writing its own policies.  

Particularly for Roadside members, the AA already has a lot of data that should enable them to underwrite reasonably well.  The AA is the #2 considered brand for switching motor insurance, despite having entered the underwriting business in 2016.  Today, 35% of AA’s auto policies are written in-house (and growing).  AA’s ability to scale insurance so quickly speaks very highly to the brand.  By comparison, Hastings plc has 2.3m members and a ~£2B valuation.  The optionality here is attractive relative to AA’s size.

Driving school

This is a very small part of the business and likely to be sold for a modest amount, judging by the CEO’s stated desire to focus on one or two key areas.  AA bought this business out of receivership in 2011, it had been purchased in an MBO for £10m in 2009.  This highly fragmented industry is probably not worth the trouble at this stage for AA.

Debt/pension

Debt is the major risk to investing in AA.  At 7/31/17, they have a £2.7B debt and a £364m pension deficit.  This is another vestige of the private equity era.  Management has refinanced to lower interest expense, and levels should continue to fall, although prepayment penalties limit near-term opportunity.  There is no maturity until 2021, which is manageable relative to sustainable cash flow.  All debt trades above par.

The chart below, with net debt versus share price shows that paydown is already underway:

Pension risk has been contained by closing the program to new members and shifting from a final salary to average salary calculation.  The deficit is also highly rate sensitive, impacted roughly £132m for each 25bps change in interest rates.  This could become a tailwind if rates rise.  AA still views its pension as a key tool to attract quality patrols, and claims to offer the industry’s most generous.

Valuation

There are several ways to estimate value, I use EV/EBIT below, but it generally squares with a DCF using not heroic assumptions, a current FCF yield of 12% and the fact that Carlyle sold distant #2 RAC for £2.2B in 2015 (4.5x revenue, 12.0x EBITDA).  Based on a multiple in line with historical levels, which seems reasonable given likely future improvements, and margins incorporating partial cost savings, I arrive at a value of 280p.

Optionality

The core business at AA seems very stable and improving, but additional sources of upside could come from:

• Accelerated growth in insurance underwriting

• Car Genie product (self-diagnosis etc) accelerates sales, improves services and cuts costs of repair while creating a halo effect of AA as an innovative company

• 3rd party partnerships (restaurants, gas stations, etc) and other reward programs accelerate, enabled by more flexible IT platform.  Improves customer satisfaction, retention and overall value proposition

• Rising rates drive pension surplus

• Simon Breakwell exceeds expectations and investors become excited about potential of Expedia/ Uber/ VC guy driving optionality in an already high quality business.

Catalyst

Execution

Solid FY18 results under new CEO

Asset sales