Shares in roadside assistance and insurance provider AA (AA.) crash 22.5% to a record low 90p on Wednesday as the company slashes its dividend and downgrades profit guidance.

Chief executive Simon Breakwell, permanently appointed in September 2017, has been charged with reviving the business and his plan will require significant investment.

Investors could be forgiven for asking why such a cash generative business needs to drastically cut dividends in order to invest. AA converted 101% of its earnings into cash in the first half of the current financial year.

The answer lies in its substantial net debt which stood at £2.68bn at the half year stage. Like many companies which join the market directly from private equity ownership, AA had a highly leveraged balance sheet on stock market arrival.

THE NEGATIVE IMPACT OF DEBT

This was initially seen as manageable given the healthy cash generation, but an uncertain operational performance has left the business exposed and the shares are now substantially below the 250p issue price from the June 2014 IPO.

In the January 2017 financial year, the company paid a dividend of 9.3p but that is set to fall to 5p for the current year and 2p thereafter until free cash flow and profitability can justify a higher payout.

AJ Bell investment director Russ Mould notes: ‘Management note earnings would have to drop to £200m to risk breach banking covenants, while this is materially lower than the reduced guidance of £335m to £345m for the January 2019 financial year, if the restructuring is more difficult, expensive or time-consuming than expected then this apparently comfortable position could end up looking more precarious.’

WHAT IS AA INVESTING IN?

Whether the pain endured today can be the starting point for a recovery depends on the success of the new strategy. This involves investing in new technology and rolling out more breakdown vans, amounting to an additional expenditure of £45m in the current financial year. Breakwell says: ‘These investments, while reducing our short-term profitability, are vital to our long term success.’

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Issue Date: 21 Feb 2018