The AA share price is falling. Should you buy on bid hopes?

The market is hoping for a cash bid, but so far there’s no news. Roland Head explains why debt risks mean that the AA share price could go either way.

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Stock market investors sold AA (LSE: AA) stock when they returned to work after the bank holiday. At the time of writing, the AA share price is down by 10% at 31p.

Today’s fall came after the company said it had extended the deadline for potential buyers to make a cash offer for the business. Although AA identified three possible bidders a month ago, it seems none of them are ready to commit.

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As things are today, its situation is troubled. The group made a pre-tax profit of just £107m last year, but it has £2.6bn of debt, £913m of which must be repaid in the next two years.

In my view, there’s no way the AA can continue without some kind of refinancing. Given these risks, AA shares could still have further to fall. But a friendly bid could also deliver a quick profit for buyers today. So what should you do now?

There is some good news

There is some good news here. The AA’s operating performance has improved since chief executive Simon Breakwell took charge in 2017. In 2019, breakdown membership returned to growth with a 0.2% increase to 3.125m members.

The number of motor insurance policies sold by the firm rose by 19% to 869,000, while home policies also rose. Importantly, the average income from each customer increased in both insurance and breakdown.

However, despite this improvement, the group’s adjusted pre-tax profit fell by 7% to £107m last year.

Surplus cash produced by the business that could be used to repay debt was just £83m. That’s just not enough to make any difference when £913m is due for repayment within two years.

The AA share price could be crushed by debt

Three private equity buyers are interested in making a cash offer for the firm. That’s good news for shareholders — it’s no surprise the AA share price surged when this news was released on 4 August.

But there’s no guarantee an offer will be made. If not, then the AA will have to find another way of refinancing its debts. One possibility is that existing lenders will swap some of their loans for new shares. This is known as a debt for equity swap. If this happens, existing shareholders would face heavy dilution and perhaps further price falls.

Even if a buyer does make a cash offer for the whole firm, they won’t necessarily offer a premium to the current share price. If there’s no other refinancing plan on the table, AA shareholders could have little choice but to accept a lowball offer.

Change is coming

The firm’s net debt of £2.6bn is 13 times larger than its market cap of £200m. With big repayments on the horizon, there’s no doubt that the company’s lenders have the upper hand in this situation.

As creditors, they could force AA to accept a refinancing deal — even if shareholders lost money.

In my view, this risk is why the AA share price keeps falling.

A cash offer for the company could deliver a last-minute rescue for shareholders. But there’s no guarantee of this. This situation is too risky for me. I’m staying away.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Should you invest the value of your investment may rise or fall and your Capital is at Risk. Before investing your individual circumstances should be considered, so you should consider taking independent financial advice.

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