City Insider: Why might City sentiment be cooling on the Big Two?

City Insider - FT journalist David Stevenson on the travel industry

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May was a busy month for the travel sector, with the big listed giants in particular making steady progress in repairing their sometimes strained relationship with City investors.

Both Tui Travel’s and Thomas Cook’s half-yearly interim numbers were well received, though I think we have also seen the first stirrings of discontent amongst investors.

Over the year to date the FTSE 350 (an index which combines the blue chip FTSE 100 index and the mid cap FTSE 250) is up by just under 1.5% whereas Thomas Cook’s shares have slid by 7.6% and even Tui Travel’s shares are down 0.2%.

Looking at just the last month, Thomas Cook’s shares have slid back by 14% and even Tui has seen its shares fall by just under 7% – over the same period the FTSE 350 has been roughly stable.

I’d suggest that the proverbial worm is turning and that the attitude of boosterish bullishness that we’ve seen dominate investor attitudes over the last 18 months is turning a tiny bit sour.

My sense is that the City increasingly believes that both the big travel giants face a tougher 12 months – and that growing caution isn’t just based around concerns about what might happen as interest rates start to creep higher.

It’s not even driven by company-specific worries such as whether Harriet Green’s increasingly high public profile is an indicator that she may soon become footloose and fancy free. Deep down the City is beginning to ponder a much bigger question – where’s the growth going to come from in the next few years?

Paradoxically those recently announced interim numbers aren’t half bad – I’m not going to rehash the results, but both were largely in line with investor expectations, with evidence growing that summer 2014 will be a bumper year for bookings, although it’s also fair to say that even Tui has admitted that higher prices will only just make up for slight decrease in sales volumes.

In sum, both of the travel giants seem to be moving in the right direction. Tui continues to deliver on its mainstream business, selling the right kind of margin holidays to the right kind of customers, while Thomas Cook under Harriet Green is also delivering to her detailed and impressive turn-around plan with Wave 1 of change (more on that jargon about restructuring in a moment) firing on all cylinders and Wave 2 about to hove into view.

But once we dig beneath the surface, a number of concerns start to appear. Tui’s interim revenues were actually down by 4%, although the actual operating loss was also pared back by 3% – nevertheless the UK business also saw an increase in losses from £113m to £125m.

Over at Thomas Cook, investors looked past the very positive news about delivering to plan and worried about UK selling prices falling back by 3% – more shorter duration holidays and soft demand in the summer 2013 lates market seems to be blame.

Yet I would argue that on pure financial fundamentals Thomas Cook’s numbers were actually slightly better than Tui’s – Cook’s cash flow is improving, its UK business is recovering and its web platform is starting to race ahead.

But Thomas Cook’s increasingly confident language of renewal is putting off investors – Tui’s unflashy language about a solid mainstream business seems much more reassuring than Thomas Cook’s talk of endless restructuring and change management jargon.

Thomas Cook seems to be awash  with waves of restructuring, lean management systems, concept and partnership initiatives and personalised products, helped along by re-engineering of support structures and ‘ominchannel’ digital marketing pushes.

My own personal favourite is the “spiritualising” of the digital transformation under way in the business built around that aforementioned omnichannel – surely management consultant speak gone mad.

To be fair to Thomas Cook a complete sea change in attitude was desperately needed and probably is still necessary, especially as Cook faced not one, but two existential threats back in 2010.

The first and most obvious was that the business was about to go bust with a mountain of debt that would have swamped more than a few small African nations.

That task is now mostly accomplished, but the good news shouldn’t obscure the bigger, longer-term, challenge – how will it generate enough top line growth and bottom line cash to play catch up with Tui in markets where the latter has a built an advantage over the last decade, all against the backdrop of still crushing debts.

Trying to avoid the management consulting speak, here’s what I understand is the basis of the bullish Thomas Cook case now being presented to boring, narrow minded investor types like me.

“We’ve righted the ship and now we are going to cut back on lower margin businesses to invest in faster growing, more exclusive product lines such as exclusive hotels and flexible products out of season. To fund this we’re freeing up cash flow by centralising costs and also growing the top line in order to fund investment in growth”.

This all sounds fine and dandy but investors fixate on just two sets of numbers. The first concerns top line growth.

Since UK consumer spending hit rock bottom in the summer of 2009, we’ve seen a 6% total growth in aggregate national consumer spending and an 11% increase in household disposable income (through to late spring 2014).

Over an equivalent period (from the September 2009 numbers through to forecasts for the full year to September 2014) Tui Travel has seen its top line sales grow by 11.5% whereas Thomas Cook has increased by a paltry 1.9%.

Lots and lots of factors make this comparison difficult, but there’s a sense that Tui is still growing (at a slower rate) while Thomas Cook is just holding its head above water. Investors believe Peter Long when he says he can target operating profits growth of 7% to 10% per annum but the jury is out on Thomas Cook’s growth transformation.

The other number is the debt level, which is still a very big bad number. The astonishing number for me is Cook’s admission that it has paid over £250 million in debt servicing and bonding costs (including advisory fees) over the last two years. That’s money that by rights should have gone into building up that portfolio of more exclusive hotels and fixing the old omnishambles of an organisational and digital structure.

Put simply, Thomas Cook still has too much debt to really grow the business at the turnaround rate sold to investors – remember that investors are currently pricing the shares at more than 40 times projected earnings versus Tui’s modest 12 times profits.

I think a parallel narrative springs to mind when thinking of Thomas Cook and the juncture it finds itself in – IBM.

The massive American technology giant is also led by an inspirational female chief executive, Ginni Rometty, who inherited a successful transformation process from old bosses Sam Palmisano and Lou Gerstner Jr.

Plenty of investors thought that IBM’s traditional computer businesses would go the same way as Thomas Cook’s high street travel agents – to be proved wrong by an aggressive and largely successful restructuring operation.

But investors have now forgotten that phoenix-like recovery and are instead focusing on the growth challenge – what’s IBM going to do next ? In the case of the tech giant it bet its very big piggy bank first on consulting and then on cloud computing. But revenues have continued to stall even though profits per share have pushed ahead.

High profile investment bigwigs like Warren Buffett may buy into this growth strategy, but plenty of critics worry that competitors who were first to the cloud space, such as Amazon, already boast an insurmountable advantage  – and even if IBM were to clamber into top spot, margins by then will have collapsed in the cut-throat world of supplying internet-based servers.

Thomas Cook has also bet big on building up its franchise of more exclusive hotels, with all-inclusive as the key selling point, while also building up its direct-to-consumer digital travel business.

Yet neither of these mammoth opportunities is what I’d called terra incognita, ie. unexplored and virgin territory – Tui already boasts a great franchise in mainstream and plenty of big global hotel and leisure businesses are muscling into all-inclusive resorts, while digital travel margins in Europe are starting to fall sharply.

Investors worry that  Thomas Cook might just make enough money from its endless waves of restructuring to invest in growth markets, just as margins in these niches head south.

And the comparisons with IBM don’t end there. There’s a sense that the endless management change mantra in both IBM and Thomas Cook hides a more basic problem – the old core business is still in decline.

Possessing a big retail business that also happens to own a decent set of operating travel assets (Thomas Cook) is not the same as owning a world class travel business that also happens to own a few stores (Tui).

But Tui Travel doesn’t entirely escape unscathed from this analysis. Competition is heating up in its mainstream business and if consumer confidence does start to become more robust, I sense that more and more middle and upper middle-class customers might want to think outside the box a bit more.

They might tire of the core Tui product and want something a bit more upmarket. That might leave Tui to slug it out with a resurgent Thomas Cook in the dreaded world of margin discounting.

Sourced from Travel Weekly

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