Why this Neil Woodford stock is on my watchlist after merger news

The Motley Fool
AA breakdown cover
AA breakdown cover

It has been a rough year for investors in AA(LSE: AA). Over the past 12 months, shares in the motor services group have declined by around 44% as investors have become concerned about its growth potential and management's ability to produce returns for shareholders.

The sell-off only intensified after a boardroom bust-up, which resulted in the ousting of chairman Bob Mackenzie with immediate effect for "gross misconduct" at the beginning of August. Since Mackenzie's ousting was announced, shares in AA have lost around 30%.

However, it looks as if the group's management is now trying to re-ignite growth. Indeed, it has emerged over the past few days that management held talks with insurer Hastings Insurance(LSE: HSTG) over the summer concerning merging its insurance business with Hastings' existing operations.

Trying to unlock value

Unfortunately, talks between the two parties have now broken down. Nonetheless, it looks as if the AA is still seeking potential partners. The company said in a press release published this morning that, "the AA regularly reviews all strategic options, including whether a spin-off of any of its business lines would unlock further value and be in its shareholders' interests." According to the Financial Times, the firm is still looking to spin out its insurance division.

The insurance business is an area of growth for the company, but it is tying up capital and is relatively small compared to the likes of Hastings, so it can't really compete with larger peers. For the fiscal year to the end of January, the company reported its first rise in car insurance policies since 2008, writing 115,000 policies during the year.

If management does decide to sell or spin-off the insurance business, shareholders should profit as AA unlocks capital from the divestment. The firm could return the extra cash to investors, and by concentrating on its core market, the group should be able to boost margins and growth.

And the shares look like a steal after recent declines. Based on current City estimates for growth, shares in the company trade at a forward P/E of 7.3, falling to 6.4 for the fiscal year ending 31 January 2019. The shares support a dividend yield of 5.5% at the moment.

A better growth buy?

AA looks like a steal, but shares in Hastings might be a better buy for growth investors. City analysts have pencilled in earnings per share growth of 47% for the insurer this year and are projecting further growth of 16% for 2018. Based on these estimates, the shares currently trade at a forward P/E of 14.2, which looks cheap compared to the company's growth potential. The shares support a dividend yield of 4.2%.

Unlike the AA, Hastings is an insurer through and through, and the company has been aggressively investing in expansion opportunities to drive growth. For the first half, operating profit grew 22%, and the number of customers with the group expanded 15%. Strong cash generation helped the firm reduce net debt to 1.7 times equity, from 1.9 times during the period, while its Solvency II ratio rose to 173% from 140% in the same period last year.

Balance sheet improvements gave management the confidence to announce a 24% increase in the interim dividend payment. If this trend continues, Hastings is on track to become one of the market's top income stocks.

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Rupert Hargreaves does not own shares in any company 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.