Regular visitors to The Value Perspective will be well aware we hold some strong views on the dangers of taking on very high levels of debt – and we are not slow to express them. When we do though, it is usually in the context of investments that are a step or two removed from our own areas of expertise – private equity, perhaps, or some of the more exotic regions of the world of fixed income.
When it comes to listed equities, however, the reality is that companies can only splash out on debt to the extent that their shareholders are willing to tolerate the burden. Whilst listed companies still regularly take on more debt than might be prudent, leverage still tends to be less than that found in the private sector. As we have recently seen with Glencore – and commented upon in Sudden debt – investors can switch from being very sanguine about debt to deeply unhappy in no time at all.
That being so, we recently found ourselves performing something of a double-take when we had cause to look at the accounts of the AA. The breakdown service floated in the summer of 2014 to relatively little fanfare with a surprisingly high ratio of net debt to earnings before interest, taxes, depreciation and amortisation (‘EBITDA' for short and a crude proxy of cashflow).
As we have found ourselves saying more than once of late, here on The Value Perspective we tend to grow nervous when we see this ratio moving above 2x and it is certainly very unusual to find a listed business above 4x. Yet here is this respectable household name – and FTSE 350 constituent to boot – sitting on a net-debt-to-EBITDA ratio of 6.5x.
Yes, you read that correctly, the AA has a net-debt-to-EBITDA ratio of 6.5x – not to mention a sizable pension deficit and, until very recently, some PIK bonds, which as we have discussed in articles such as Pik-ing holes, definitely fall into the fixed-income category marked ‘exotic’. Indeed, the only way the company was able to refinance its way out of these was by raising new equity via a placing of new shares in March this year – a mere nine months after its initial floatation.
For a listed business to have PIK bonds on its balance sheet in the first place is pretty unusual as they tend to detract from the sense of financial stability that most listed businesses are looking to create. In a similar vein, it is worth noting that although the AA is currently paying a dividend, it is obliged by its covenants to stop doing so should leverage within one part of the business rise above a certain level.
Lenders can be a little twitchy about a business’s debt levels and want full control of the cashflows if things start to go wrong. As such, any investors who felt comfortable – which we do not – about a company using cash to pay dividends to shareholders when it is as highly leveraged as the AA, would still have to recognise it would not take much for those dividends to be stopped very quickly.
More generally – and as is always the case with elevated levels of debt – the margin for error the AA has as it negotiates the ups and downs of everyday corporate existence is very small. Of course, if things go well for the business and it can grow its revenues even a little, its very high degree of leverage will serve to magnify the growth that shareholders see in company profits.
If things go the other way, however – and the AA’s most recent set of results were disappointing in a whole range of ways – then shareholders could be heading for a very painful time indeed. You might even say they could be set for a Glencore-type experience – except for the fact the AA is far more leveraged than Glencore ever was (even on the more stringent metrics we outlined in Sudden debt).
To be fair to the AA, its management have conceded its current levels of leverage are a bit toppy for a listed business although our own view of their plans to reduce the net-debt-to-EBITDA ratio to 5x would be along the lines of ‘Could try harder’. Granted, the AA still has many fans who admire the quality and stability of the business on the basis everyone has a car and cars break down. The trouble is, when high levels of debt are involved, so can companies.