Description

Thomas Cook has benefited over the last three years from an aggressive cost cutting plan. At this point, they low hanging fruit has been picked and incremental cost cutting will be difficult. The secular trends (the shifts to low cost carriers and online booking) in the travel industry continue to work against them. Investors are mistaken about the company's valuation -- EV/EBITDA and P/E look low but the company generates little FCF and the company has an underfunded pension overlooked by many analysts.

• General description of Tour Operators like TCG
• Tour operators offer travel packages to leisure travelers. They combine the various components (flights, hotels, airport transfers) of a trip into one purchase for the consumer. A typical package would be a trip for a UK or German family to spend a week in the Canary Islands.
• TCG offers its packages under the Thomas Cook brand as well as a variety of other brands
• For flights, TCG both operates its own airline and contracts with 3rd party airlines.
• For hotels, TCG has different sources of supply. They offer exclusive hotels where they have contracted for all the hotel rooms over a period of time (say, 3yrs) so they are the only sellers. This gives them guaranteed inventory that cannot be price compared. They also offer differentiated properties where they are not only exclusive but TCG has also been able to influence the design of the rooms -- adding things like ipod docks, kids centers, etc. that can be advertised consistently across a brand or subbrand. Finally TCG has offers that include hotels available through other channels.
• TCG's model remains fundamentally challenged by online travel agencies (OTAs) and low cost carriers (LCCs)
• TCG relies on its high street retail operations and traditional travel agency partners for the majority of its bookings. Despite lots of talk of moving bookings to its direct, online channel, only 38% are done online. The remainder are through traditional channels that carry much higher costs. TCG itself estimates the cost difference at £50 per customer.
• Online-only competitors like LowCostHolidays, LoveHolidays, and OnTheBeach can apply this cost advantage to offering lower prices. They also have a go-to-market advantage in that they know who their customers are and can message and target them over time. TCG doesn't have this information for the material portion of its customers that come through 3rd party travel agencies. Furthermore, it is our understanding that, due to poor tech infrastructure and lacking a cohesive data warehouse, TCG can't always track their retail customers online -- while all of LowCostHoliday's markets are on the same tech platform, TCG still operates several disparate ones. As a result they overspend on online marketing relative to competitors.
• On the air side, TCG has a unionized work force similar to national flag carriers. They will remain higher cost and lower performance than LCCs like Ryanair.
• More broadly, the growth of OTAs and the internet have reduced the need for tour operators and eroded their ability to earn profits (similar to traditional travel agencies). A decade ago, booking through Thomas Cook gave the customer some certainty about the quality of the experience they would receive when traveling to a foreign country and staying in a hotel they had never experienced. Furthermore, even if you knew the quality of a hotel, it was hard to compare prices. Today, travelers can easily check the price and quality of any hotel worldwide using Tripadvisor, Booking.com, or other OTAs. This allows travelers to combine the lowest airfare with the best value on a hotel in a way that makes earning a margin difficult for tour operators.
• TCG's Nordic business -- their best geography -- is coming under increased pressure
• Northern Europe has been a bright spot for TCG as they mostly competed with flag carriers in a cozy competitive environment. TCG has its highest direct booking percentage (73%) and its highest EBIT margins (8.7% vs. 3.8% overall) in the Nordics
• This business is becoming more competitive due to the aggressive moves of Norwegian Airways, a LCC that is now the 2nd largest airline in Scandinavia
• Norwegian has partnered with LowCostHolidays.com, the top tour OTA, to offer holiday packages in region
• It took 10yrs for the OTAs and LCCs to fully impact the UK and continental markets but will likely happen much faster in the Nordics now
• Core business declines have been masked by cost cutting, one-time charges, and business disposals
• TCG reported EBIT growth from £225mm to £323mm in FY14
• This improvement came from cost reductions -- the company reported ~£200mm of cost savings from its transformation plan
• The company separates out £49mm of "strategic investments" such as IT upgrades, marketing new products, and brand advertising. These are core, recurring costs to us.
• TCG also reported a £19mm reduction in corporate spending. Given that corporate overhead overall is now £19mm, we do not think this will be repeated
• Underlying profitability change was actually £(61mm), a fairly large decline on a base of £225m
•  TCG's last CEO Harriet Green left abruptly in Nov14. New CEO is longtime insider w/o experience needed for TCG.
• Harriet Green, who lead TCG's turnaround, left without warning to investors in Nov14
• TCG stock decline from 137 to 113 but has since recovered to 127
• The charitable view of her departure is that the triage phase of TCG's transformation is now over and the company needs someone focused on execution and growing the business. Harriet was not considered a "tour operator" by trade
• New CEO is longtime TCG exec Peter Fankhauser
• Our take is that Harriet left because TCG is failing to get traction beyond the cost cutting measures which have now run their course
• While Fankhauser has more travel experience, he has the wrong type. He does not have the background to transform TCG's technology or embark on a new, more direct & online business plan
• From 2003-2012, Fankhauser was first in charge of Thomas Cook Germany and then the Continental European segment. Keep in mind that the TCG German business has a 2.6% EBIT margin (lowest in the group), its web penetration is only 7% (lowest in the group), and its reliance on retail and 3rd party agents is highest in the group.
• Reported results overstate profitability; FCF valuation not attractive
• TCG's reporting of FCF in its presentations is confusing. They report a FCF number that includes interest paid. FCF was £116m in FY14 up from £53mm in FY13. Adjusting for interest exp FCF increased to £246mm from £183mm.
• They also report a "converted cash" figure that increased to £307mm from £203mm but this excludes capex and their exceptional items
• A more traditional and accurate calculation of FCF would include capex, intangibles capex (which is capitalized software development as well as computer and software purchases, and capital leases for TCG aircraft

• Many analysts and bloomberg exclude TCG's pension from the calculation of enterprise value.

• Actual EV / FY14 actual FCF = 18.4x
• TCG frequently records restructuring charges, adjustments, "strategic investments", etc. and discusses concepts such as "like for like results" and "new product revenues." The net result that the numbers in TCG presentations bear no relation to the IFRS accounts. For instance, FY14 IFRS EBIT was £54mm (FY13: £13mm) whereas management presentations and discussions referred to underlying EBIT of £323mm (FY13: £263mm). Some of these adjustments may be legitimate but others are definitely misleading.
• Given TCG's secular challenges and inability to growth the top-line, a reasonable valuation would be 10-12.5x FCF

We see 20-40% downside over the next two years as competition makes management's goals unreachable. In an economic downturn, shares could go much lower due to the operational and financial leverage in the model

Risks

• Headline valuation is very low
• Bloomberg & analysts exclude pension from EV (£447mm)
• EBITDA is much higher than FCF due to poor cash conversion
• Street multiples
• 3.9x FY15 EBITDA and 9.5x FY15 EPS
• 3.6x FY16 EBITDA and 7.5x FY16 EPS
• Lower oil could benefit the travel industry
• ~50% decline in oil will flow through to jet fuel prices and help consumer spending
• TCG claims they may only see 20% flow through with the remainder of savings passed through to consumers due to competition
• Offsetting factor is that TCG has hedged its near term oil costs (through summer '15) whereas LCCs are less hedged and thus can price more aggressively
• In conversations, TCG has been aggressively pushing back on any suggestions that oil will be a big benefit for them

Catalyst

• Thomas Cook's top-line will continue to be pressured by secular challenges in the tour operator business model. Furthermore, EBIT margin gains will peak out as the easy cost cuts have been made. Expect EBIT margins to decline as competition increases in the Nordic business
• TCG operates a highly seasonal business vulnerable to an economic downturn. 4Q has averaged 39% of revenues and ~150% of EBIT. There are substantial fixed costs in the model such as a unionized air labor force, hotel guarantees, and retail location staff and leases costs. They will be hard pressed during the next economic downturn or shock.