Taylor on Travel

The situation at Thomas Cook could grow worse, says a City analyst - so that must be right, given the City's recent track record.

The analyst in question is Morgan Stanley, which issued a strange assessment of yesterday's profit warning by Thomas Cook and what might follow.

Under the sub-heading "It's bad", Morgan Stanley suggests: "Traditional package holidays seem to be seeing an accelerating market share loss to independent holidays, aided by the internet and low cost airlines."

This could have been penned anytime in the past 10 years and probably was. But where is the evidence at this point?

In an analysis of the latest travel industry trading figures, GfK Ascent reports "more packages being sold and less flight-only and accommodation only products". Its figures show package holiday sales in June up 1% on last year, but overall bookings down 3%. For the season to date GfK Ascent reports passenger numbers 2% down year on year, but package sales up 1%.

We already know sales of package holidays rose last year, when outbound travel numbers from the UK fell. We must deduce, therefore, that independent travel fell last year and appears to be selling less well this year.

Package sales are relevant to Thomas Cook's situation. The overarching problem in the UK is that most people's disposable income is falling. The problem at Thomas Cook is that it is selling too much in the UK at too low a margin - too much at the lower end of the market. Package holidays produce higher margins for tour operators - particularly those comprising 'differentiated product' or exclusive resorts. That is why tour operators like them. Thomas Cook recognises it does not have enough.

The group's investment analysts made the point yesterday. In defending the planned merger with the Cooperative Travel and Midlands Co-op, it said: "We expect 65% of package sales to be through shops . . . Shops are key for better-margin sales (ie packages)." Whether the merger is a good idea is debatable, but that is another matter.

Other analysts made a similar point. Simon French of Panmure Gordon asked: "Has Thomas Cook got enough of the right products? Is it differentiated enough? Is it exclusive enough?"

Back at Morgan Stanley, things go from sloppy to worse. Under the sub-head "And could get worse" (sic), the analyst's note suggests: "Market leaders have collapsed before (MyTravel in 2002, ILG in 1991)."

On one level this is a statement of fact: market leaders have collapsed - although none of these companies were or are the market leader and MyTravel did not collapse, in the sense of go bust. However, the clear inference is that Thomas Cook could collapse.

Maybe Morgan Stanley knows something we don't, but going by what we do know let's consider the comparison. Thomas Cook issued a profit warning - its third in a year - in the midst of the most serious and sustained squeeze on UK living standards in living memory. The company misjudged its third-quarter profits by £5 million on business worth about £9 billion a year. It forecast underlying full-year profits - not losses - would come in at £320 million, when analysts had expected £380 million. I would rate that more disappointing than disastrous, but I'm not at Morgan Stanley.

MyTravel, which is now part of Thomas Cook, ran into trouble as a listed company in 2002 when a previously undisclosed hole in its accounts - a product of misreporting - widened to turn an annual pre-tax profit of £362 million into a loss of £373 million. Misreporting is a cardinal sin in the City. At the time, MyTravel carried debts of more than £3 billion - three times those of Thomas Cook at present.

International Leisure Group (ILG) did collapse. A private company and parent of charter carrier Air Europe and tour operator Intasun, it went bankrupt in March 1991. Having expanded rapidly through the 1980s, ILG faced a cash crunch from 1989 which it carried into the crisis around the first Gulf War and the accompanying economic downturn. In essence, the company was overtrading, couldn't meet its commitments and the banks pulled the plug.

Morgan Stanley's third point is the most strange. Under the heading "But it's not a disaster" it suggests: "There is an argument for further industry consolidation, perhaps even a TT/TCG [Thomas Cook Group] merger?" By TT it means Tui Travel.

This is barking. Given Tui Travel and Thomas Cook are the top two travel groups in every major European market, it is inconceivable any competition authority would allow it.

Sudden falls in share values are not uncommon - ask Tui Travel. It suffered two sharp declines in three months last year (though neither as pointed as Thomas Cook's 28% loss on July 12). The group's shares fell almost 10% on August 10 after a forecast of profits "at the lower end of expectations", and suffered an 11% fall on October 21 when Tui Travel revealed a hole in its accounts - previously put at £29 million - had widened to £117 million.

That led to the loss its finance officer, finance director, auditors and two non-executive directors. Tui Travel suffered a further 7.5% fall the day Thomas Cook plunged.

The markets are nothing if not febrile.

None of this should be taken to mean Thomas Cook is in good shape. It is not. But a failure to fulfil expectations in a deteriorating market is not yet the stuff of nightmares.

What to make of today's Times and its piece on Thomas Cook? It's headlined: "Investors' patience in tour operator running out after shares slump again". This followed a day on which the group's share price rose, albeit 2%. The share price appeared stable today.

Things may have moved on if the Competition Commission has ruled on Thomas Cook's retail merger with the Co-ops by the time you read this. But let's stick with the Times. There is no doubt investors' patience will be wearing thin, but the second half of that headline is grossly misleading. There had been no "shares slump again" when it appeared.

The Times story incorporates three 'news' elements and a resume of Thomas Cook's position: quotes from two unnamed institutional investors, a reference to Standard & Poor's latest credit rating for the group, and a quote from a leisure analyst at investment banker and broker Numis.

One of Thomas Cook's ten biggest institutional investors is quoted as saying it is going to be a "hard winter" for the company, adding: "It's a real mess. There is definitely pressure building on the chief executive." You could say this is stating the bl***ing obvious.

A second investor expresses disenchantment with chief executive Manny Fontenla-Novoa. This cannot be a surprise to anyone, least of all to Manny.

Standard & Poor's did revise its outlook on Thomas Cook yesterday (July 19) from 'stable' to 'negative'. However, it also affirmed the group's credit rating, while noting: "The outlook revision reflects . . . the event-driven deterioration of the group operating performance." This tallies with Thomas Cook's own outlook.

Numis analyst Wyn Ellis is reported as predicting the share price will fall further to 60p - obviously a possibility. But people in similar positions to Ellis were saying the shares were undervalued at £1.90 a year ago.

The second investor, identified as a fund manager, is quoted saying: "This is not a complex business. Why didn't they see the problems coming?"

I may be stupid, but tour operating strikes me as pretty complicated - contracting in advance for foreign rooms and flights, taking account of the future state of the economy, the oil price and exchange rates, in a sector at the mercy of ash, bombs, hurricanes and snow, with most sales dependent on price and margins to make a broker weep. It might be easier in a booming market, and Rupert Murdoch might sooner be in Beijing, but he's not.

Let's come to the problems and not seeing them coming in a minute.

The Times repeats the error of multiple other press reports in the past 10 days of describing Thomas Cook's profit warning last week as "its third negative trading statement of the year". Maybe I'm picky, but it was not. It was not the third negative trading statement of this year or of this financial year. It was the third negative trading statement in the past 12 months. The previous two - in August and September 2010 - were during, and related to, the previous financial year. To me that makes last week's profits warning the first this year, following two last year.

The newspaper notes Thomas Cook's operating profits in Britain have sunk from £162 million in 2009 to an expected £70 million this year. Three points are worth noting on this. Thomas Cook expects to make an operating profit in Britain. It will make profits elsewhere too. The decline in Britain coincides with the biggest-ever contraction in the UK travel market as a result of factors totally unconnected with the market itself.

The contraction is a direct consequence of the financial crisis of 2008 and the recession of 2009, neither of which the City or the Times foresaw. How could Manny have foreseen it? He probably did not foresee last year's volcanic ash or this year's Arab spring either. Any investors working with a broker or analyst who foresaw these would be blessed.

Towards the end of the article, Ellis questions the wisdom of creating a chain of 1,200 shops in a downturn - a legitimate point - and the Times refers to Thomas Cook offering "too many low-margin beach holidays in two or three-star hotels". Thomas Cook offers a rational if debatable defence of the former - it sees better-quality, higher-margin sales through shops - and has recognised the latter by making it the subject of a "fundamental review". The problem is what to do about it.

These aspects of the story are relegated to the last third because they are not 'new' news, are non-sensational and do not reduce the news to a clash of personalities (such as 'investors in battle to oust chief executive') - always a media favourite.

Three final points:

First, the underlying problem at Thomas Cook plc is that it was formed from a merger of the best-known brand in the business (Cook) and a busted flush (MyTravel). The latter piled high product and sold it cheap through the boom years before coming unstuck in 2002 and limping on from there. The former was the product of the marriage between a UK company with a terrific name, but confused tour operator product (remember JMC), and the number-two German group (Condor & Neckermann) put together by an airline (Lufthansa) and a retailer (Karstadt). Thomas Cook brought the tour-operating nouse.

The 2007 merger was timely - God-knows what state the industry and the majors would be in without it - but events since (world financial crisis, prolonged recession) have made it impossible for the company to deliver on its promises to investors at the time.

Second, there has been no suggestion of a wider problem at Thomas Cook, beyond a failure to fulfil City expectations of its profits. The issue at the moment lies as much with the City - with those expectations - as with Thomas Cook.

Third, it is amusing to read anything in a News International title about a chief executive under pressure. I'm loving every minute.

The London Stock Exchange took fright when Thomas Cook issued a profits warning on Tuesday.

The group reported an underlying profit for the three months to June of £5 million less than a year ago. That does not sound a lot lower. Thomas Cook will still make a profit and expects to report underlying profits of £320 million for the year to September - albeit £42 million less than last year and £60-£70 million below analysts' forecasts.

But within an hour the warning had triggered a 26% fall in the Thomas Cook share price. By midday on Tuesday, the group's shares were down 30% on the day, 33% on the week and 55% on six months ago. The company had lost half its value.

Part of the fall was due to an overall decline in the stock market. But Thomas Cook's decline went way beyond that.

A profit warning from a major group often triggers a drama. Shares are a claim on future profits and City analysts, brokers and big investors can desert a company in droves if spooked.

In the words of analyst Nick Bartram of KBC Peel Hunt: "The stock market does not like surprises or uncertainty. It was a pretty savage reaction, but the market always operates around extremes."

One immediate impact of the market fall was that it took Thomas Cook's total share value - its 'market capitalisation' or the company's nominal worth - to £1.05 billion. That was marginally below the group's net debt, reported in May as £1.09 billion.

This need not be a problem so long as Thomas Cook can service the debt - meet its payments - and nothing leads its lenders to believe the group cannot pay it all back. But as Bartram says: "It does not look good."

The ratio of debt to market capitalisation is one of the measures analysts and institutional investors use to assess the health of companies. The lowered share price might tempt some investors to buy into Thomas Cook, but the debt ratio will deter just as many.

Thomas Cook blamed "difficult trading conditions" in the UK and the higher-than-forecast impact of unrest in the Middle East and North Africa - particularly on sales in France.

These explanations make sense. The UK is caught in the worst squeeze on household spending since the Second World War - people have less money to spend after paying bills and buying food than last year or the year before - and this is hitting every retail sector.

The downturn to Egypt, Tunisia and Morocco has hit the French market, where these are key destinations, even harder than here.

But there is a sense that something more is wrong.

Bartram says: "Is the business model not as flexible as Thomas Cook said? Are there areas they have not got right? Did they call North Africa wrong?

"What's a surprise is the extent of the downgrade. It's a slashing of forecasts."

A number of things are likely to happen next, but there is a huge degree of uncertainty. Senior departures are imminent, although not necessarily connected to Tuesday morning's announcement.

Thomas Cook promised "a fundamental strategic and operational review of the business". Details have yet to appear, but this will inevitably mean changes in the areas regarded as under-performing - primarily the margins on UK sales and the product on offer.

It places a substantial question mark over the planned retail merger with The Co-operative Travel and Midlands Co-operative, on which The Competition Commission is believed to be ready to publish its findings.

No one anticipates the commission ruling against the merger - it is expected to order a disposal of some parts of the business and a set of guarantees to rival businesses.

But why would Thomas Cook seek to increase its high street presence by 50% to 1,200 shops when it has just been caned for a lacklustre performance with what it already has? Does it need the distraction of merging the businesses now?

Bartram says: "That is a very good question. Retail is struggling. Clearly they will look at it."

The group will no doubt give scant further detail until August 11 when it is due to publish results for the nine months to June. It will use the time in between to consult investors, review its business and draw up a plan.

The company is trading profitably. It is not in any danger. But everyone working for Thomas Cook faces a deeply unsettling period.

The industry is in trouble if you believe the Daily Mail. "Desperate holiday firms are slashing prices amid a collapse of bookings and profits," it said on Saturday. "Many are giving up on the idea of a sunshine holiday."

The Mail reported companies offering big savings on summer 2011 brochure prices.

Discount deals are not what tour operators want in July, but they are hardly remarkable.

'Research' by online bank ING Direct suggested "as many as four in 10 Britons are going without a summer holiday to balance household finances".

That is not remarkable either: serious surveys show that proportion is the typical figure for those who do not take a holiday away from home each year.

Times are tough. In the words of a senior industry figure last month: "Everything is late. The margins are diabolical."

Thomas Cook was reported to have slashed its margin on late sales this week and Gill's Cruise Centre went down at a cost of possibly £10 million to the cruise companies.

Yet the cruise lines themselves describe the market as "in good shape" and latest figures from industry analyst GfK Ascent paint a more complex picture.

Summer 2011 bookings in June were 3% down year on year. GfK Ascent managing director Sarah Smalley suggests this is because a reduction in operator capacity is working. "There are fewer holidays to sell at the end of the season," she says.

GfK Ascent reports a 1% increase in the value of sales, suggesting "there has not been wide-scale discounting". Smalley says: "A four-percentage point difference between volume and value at this stage is positive."

The season-to-date position to the end of June also confounds the doom-mongers. GfK Ascent reports high street sales down 2% in volume year on year, but 2% up in value. Smalley says: "High street agencies must, on average, be performing at a higher level."

Package holiday sales have outperformed the market to date - up 1% on a year ago. All-inclusive sales were up 12% at the end of June. Short-haul sales were up 5% in volume and 11% in value. It is the long-haul market that is suffering, with bookings down 10% year on year.

A few other points are worth noting. The squeeze on consumers does not extend across Europe. Thomas Cook and Tui Travel are doing well in Germany and Scandinavia.

The high rate of Air Passenger Duty is probably hurting long-haul sales, but the evidence is inconclusive. GfK Ascent reports summer 2011 bookings to Mexico up 38% year on year in June, when flights to Mexico carry the same APD as to the Caribbean. US government figures show a 6% rise in visitors from the UK.

GfK Ascent also reports a year-on-year rise in sales for this winter and "encouraging" growth for early summer 2012. Smalley says: "It was a very positive June. All three seasons outperformed last year for passengers."

Latest UK outbound figures from the Office for National Statistics also suggest a market in recovery, although reports that travel was back to the level of 2008 were wrong. Holiday departures in May where 11% up on a year earlier and just 2% down on May 2009.

Total outbound trips, including business travel, were up 1% on two years ago, making it the best result since the recession.

None of this changes the fact that the squeeze on UK consumer spending is making life hard. A lot depends now on late sales and whether companies slash prices.

At first glance, Holidaybreak and Cox & Kings make an odd couple. They are strong, independent companies in their own right, but who would have predicted a marriage before news of their love interest this week?

Holidaybreak is a specialist in school trips, short breaks and camping and caravans in the UK and on the Continent. It is headquartered in Cheshire.

Cox & Kings deals in luxury long-haul travel, is headquartered in Mumbai and has offices worldwide. Imagine Noel Coward with Gracie Fields.

Yet the tie-up is not crazy. The document outlining the offer explains: "Through expansion into adjacent business areas, Cox & Kings seeks to maximise its service offering to an enlarged customer base.

"The combination will provide Holidaybreak with a platform to expand internationally by offering the company's products to Cox & Kings customers in India, the rest of Asia and Oceania ... Holidaybreak's education business will capitalise on the latent demand for European education programmes and facilities fast emerging in India."

In an odd phrase, the document points out: "In these new geographies the peak periods for outbound travel coincide with the European off-peak travel season and as a result the seasonality of Holidaybreak's businesses will be reduced."

It notes: "The acquisition represents a transformational step for Cox & Kings, providing scale and critical mass in key international regions. The complementary nature of the two businesses will diversify Cox & Kings' revenue streams."

The key to the deal is India - its rapidly advancing economy, booming outbound travel market and English-speaking population's thirst for education.

The companies are close in size, although Holidaybreak is bigger, yet it is a straight cash acquisition. Cox & Kings had a market capitalisation of £373 million at the start of this week. Its assets were valued at £285 million at the end of March when the company reported an operating income of £69 million and pre-tax profit of £27 million. It is not Tui Travel.

Holidaybreak reported revenue of £461 million in the year to last September and a pre-tax profit of £26 million. The Cox & Kings offer, embraced by the Holidaybreak board, values the group at £312 million.

This is a deal about Indian money - Mumbai market investors buying into the UK. It is Mittal taking over Corus. In a tabloid paper it might be headlined 'The Empire strikes back'.

Two points are of interest. First, given the cigarette-paper difference in size between the companies, the deal is of necessity financed by borrowing.

Cox & Kings, or rather its subsidiary Prometheon Holdings (UK) Ltd - referred to in the offer document as Bidco - will finance the takeover with two letters of credit: one for £200 million and one for £121 million. The company has standby letters of credit for somewhat more, provided by Axis Bank of India.

The deal will leave Cox & Kings with quite a debt - although not as first appears both the £321 million (or £331 million with the full standby facility) as well as the £140 million of debt on Holidaybreak's books at the end of March. The latter has been accounted for in the new credit facility. That debt is not small for a company reporting an annual profit of £27 million, swelled by the £26 million a year brought by Holidaybreak, but it is manageable.

Second, the Cox & Kings offer is clear on what would break the deal: a regulatory hold up. The offer document states the deal is conditional on "it being established ... that neither the Office of Fair Trading nor the Secretary of State intends to refer the proposed acquisition ... to the Competition Commission ... [and] that no request had been made to the European Commission by the competent authorities."

This is going to be no re-run of Thomas Cook and The Co-operative Travel. But why should it? The deal could complete before the end of September.