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This Neil Woodford-held share’s superficially low valuation masks a terrible secret

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I reckon most people have heard of breakdown cover and roadside assistance provider The Automobile Association. These days, it’s better known under its stock exchange listing AA (LSE: AA) and it’s come a long way since it was founded in 1905 by a group of motoring enthusiasts. But not all of the change is good.

A rich heritage and financial tragedy

The days of AA patrols on motor-bike-and-sidecar saluting passing motorists are long gone. Today, the firm has grown to offer services such as car insurance, driving lessons, breakdown cover, loans, motoring advice and roadmaps. But there’s a big problem – the company has an awful lot of debt. I think it’s the firm’s out-in-the-open ‘secret’, masked by a superficially low valuation, which could trap the unwary investor.

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My Foolish colleague G A Chester explained earlier in February, how AA ended up with its deadweight of borrowings. The firm’s previous private equity owners floated it on the stock market in 2014, but only after they had “milked its cash flows” and “loaded it with debt.” It’s an old trick involving the metaphorical pillaging of an otherwise decent business and then fobbing off the crippled remains to an unsuspecting public by dumping the carcass on the stock market. It seems a shame that such a venerable institution as the AA has been tarnished in that way.

But you don’t need to be a forensic accountant to spot the problem with minimal effort, which is great when it comes to speeding up your initial research time when hunting for investments. At first glance, today’s share price close to 92p throws up a price-to-earnings ratio of about 6.4, which makes the company look like a screaming bargain. However, you can quickly get better insight by comparing the market capitalisation of around £563m with the enterprise value, which sits at about £3.23bn.

A shortcut to uncovering debt

Looking at enterprise value is a shortcut to identifying debt because it’s calculated by adding the market capitalisation to the borrowings, minority interests, and preferred shares, then deducting total cash and cash equivalents. So enterprise value is a measure of a company’s total value and the figure is often published in newspapers and on stock research websites.

Straight away you can see that a company with more cash than debt will have an enterprise value less than its market capitalisation, and a company with more debt than cash will have an enterprise value greater than its market capitalisation.

If you divide AA’s enterprise value by last year’s earnings before interest and tax (EBIT), you get a more-realistic valuation multiple of just below 11. Suddenly, it doesn’t look as much of a bargain as it did before. And I think all those borrowings — and the gigantic interest payments the firm makes — are worrying because there’s a great deal of cyclicality in the enterprise. If the firm’s trade goes down in the future because of a half-decent general economic slump, those debt payments could become problematic.

If you want to find out a bit more about recent trading, which has been lacklustre in my view, you can read today’s pre-close trading update. But I’ve made up my mind and this stock’s on my ‘avoid’ list, despite its rich heritage.

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Kevin Godbold has no position in any share 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.

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