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The AA share price is up 60%! Here’s what I’d do now.

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The AA (LSE: AA) share price has shattered the average returns made from the FTSE 100 index over the last month. Exploding by over 60%, the roadside assistance company’s stock gains left the FTSE’s 3% improvement looking lacklustre.

The circulating chat rumours of a possible takeover of the beleaguered firm are likely causing the boost to the share price. Investors hope a buyer will pay a premium for the acquisition, and that they’ll receive a return on their investment. 

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However, the shares are currently trading at a very low price-to-equity ratio of 2.4, so the market doesn’t appear convinced by AA’s future prospects. And neither are the relatively large quantity of short sellers.  

The AA share price is a short-seller favourite 

Short selling stocks is a highly risky way to invest, which is one reason it is not the Foolish way.  Essentially, an investor borrows a stock and sells it on at a similar price. They then buy it back when the price drops and return it to the original lender. Short sellers bet that the shares they sell will fall in price. And the more the shares drop, the more profit they make.

This is why any investor should at least note that, according to the FCA, the AA is one of the most heavily shorted stocks on the FTSE. One source states as many as one-tenth of AA’s issued shares are held by short sellers.

This matters because to profit from short selling, you have to know what you’re doing.

So when big hitters such as BlackRock and Odey Investment Management take a short position in a company’s shares, as they have with AA, you can be pretty sure they’ve done their homework. They will understand the firm itself, and the market sentiment towards it, before betting against its prospects.

Eye-watering debt

So, why are these organisations so negative about the AA share price? I suspect it’s for two main reasons.

Firstly, AA’s ridiculously high levels of debt. The debt load, currently around 14 times its market value, is a hangover from its initial public offering (IPO) in 2014.

Before the IPO, the company was owned by two private equity firms. These companies appeared to milk the AA for cash while concurrently burdening it with excessive debt, before offloading all their shares by ‘going public’.

The IPO left bondholders ruling the roost and the AA with an uphill battle to improve revenues enough to reduce the debt and to reward equity investors. A difficult challenge at the best of times, even without the second reason for market negativity, the AA’s storm of challenges.   

The AA is yet to overcome the double whammy of dropping memberships, disruptive competition by services such as Uber, and the threat of self-driving or electric vehicles. All these elements reduce car ownership and the need for the AA’s products.

On top of it all, price comparison websites mean insurance is becoming more and more commoditised, reducing profit margins.

To be fair, AA’s current management team appear to be doing a good job in a difficult situation. But, a buy-out by private equity again may now be one of the few sources of refinancing available to them. 

For now, I’m avoiding the AA share price and I’ll wait to see who’s buying. If the short sellers are right, it could be an accident waiting to happen. 

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Rachael FitzGerald-Finch 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.

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