City Insider: Is Thomas Cook a takeover target?

City Insider - A City perspective on the travel industry from FT journalist David Stevenson

The markets are taking a dim view of Tui and Cook’s fortunes this week – but private equity investors rightly disagree, says David Stevenson

Poor old Tui and Thomas Cook have had a fairly horrid week on the London Stockmarket. Both reported lower than expected numbers, impacted by a triple whammy of ash clouds, the World Cup and slowing consumer spending.

Their shares received a good kicking as investors digested missed guidance, lower profits (and losses in the case of Thomas Cook), and a generally grim reading of UK consumer spending patterns.
I’d take all of this pessimism with a pinch of salt (as Travel Weekly’s Ian Taylor also did – Ed). The City likes to punish companies that miss guidance even if the causes of much of that under-performance are adverse FX moves and extra-ordinary circumstances.

And the City is also scaring itself senseless about the impact of a double-dip recession – it just so happens that these two trading statements have poured fuel on those flames.
Personally I found the following passage from Thomas Cook’s statement much, much more interesting:

“Despite the impact of the volcanic ash cloud, the Group has continued to deliver strong cash flow performance. In the nine months to June 2010, the operating cash inflow was GBP157m, an improvement of GBP195m on the prior year period. Net debt at 30 June 2010 was GBP789m, a GBP163m reduction since the half year.”

Although there’s some volatility around day-to-day trading, Thomas Cook is getting its finances in order. I’ve quoted these numbers at length because it is the cashflow that is the focus for the two sets of investors that really count in this listless and volatile market.

The first group are long-term, institutional, value-orientated investors who are increasingly buying Thomas Cook’s shares for the yield. They’ll be reassured by the underlying cash flow generation and will sit tight and ignore the swing traders marking down the share price.
The other group of investors who will matter much more in the next year sit in the large private equity houses. They are frequently very similar types to our first group – many used to work in banking or asset management and switched over to private equity because the rewards were greater.

Crucially private equity analysts tend to subscribe to the same set of value-driven ideas as the mainstream fund managers. In particular all their financial models are built around cashflow projections.

The buyers start circling

This week I met up with an experienced private equity type to discuss recent research from leading City analyst Graham Secker at Morgan Stanley.

On August 6 Mr Secker produced a strategy note suggesting that UK investors shouldn’t be frightened into selling shares, and that they should “keep the faith” as there was “more to go” in terms of increased prices. He deploys a barrage of statistical and macro-economic analysis to underscore his central argument that UK shares represent good value in aggregate.
Dig to the back of his note and you’ll see a particularly interesting table. It features a long list of very respectable FTSE 350 companies that have been identified as passing a filter or screen. Graham’s screen uses many of the ideas prevalent in private equity circles and is designed to identify future acquisition targets.
As an investment strategy his screen has worked very well – Graham’s screened candidates have a much higher chance of falling prey to private equity buyers.
And who is number four on the list? Thomas Cook.

Based on this analysis, on a market cap of just over £1,600m Thomas Cook boasts a free cash flow-to-enterprise value (this measures the equity and debt value of the business) of 17%, well above any cost of acquisition funding.

Over lunch my contact and I worked our way up the list. When we reached Thomas Cook, silence ensued. After much badgering and promises to stay off the record he admitted that Thomas Cook was not only on his radar but also popular with bunch of colleagues at rival houses.

“Look at the cashflow, it’s obvious really,” he noted. “We’ve just got to work out whether the volatility of the trading model is worth the risk of making a bid.”
Big private equity houses are flush with money at the moment, ready to pounce on big companies unfairly valued by the market relative to their cash flow and balance sheet. In my humble opinion – and that of my contact’s – Thomas Cook would make a perfect target.

Two days later my contact sent me another list: the shareholder register of Thomas Cook. I’ve copied it out below. His comment was, “Those are exactly the kind of companies who would fall over themselves to accept a decent bid – no strategic blockers there!”
My gut tells me that Thomas Cook is on private equity buyers’ radars and that it is only a matter of time before someone makes the first move.

More slightly dismal trading results coupled with decent financial underlying numbers will only sharpen the knives of the private equity boys and girls. Remember that Thomas Cook is almost the perfect size in market cap terms and it also boasts a cracking collection of disparate business with no major strategic shareholders who will block a takeover.
Major shareholders at Thomas Cook

  >AXA S.A.: 85,369,991 shares, 9.95% of holding
  >Lloyds Banking Group plc: 77,191,766 shares, 8.99% of holding
  >BlackRock Inc.: 65,754,701 shares, 7.66% of holding
  >Standard Life Investments Ltd: 36,908,650 shares, 4.30% of holding
  >Legal & General Group plc: 26,098,414, 3.04% of holding
Thomas Cook statement : The highlights and lowlights

  > The group lowered capacity again in the U.K. by 1% for the summer 2010 season as cumulative bookings fell 1%. 
  > The news that over the past four weeks, customer bookings have fallen 2% although Thomas Cook has sold 85% of its summer program
  > “The average selling price of holidays from the U.K. rose 3% year-on-year, they are still lower than the company had expected.”
  > Initial booking trends for the winter 2010/11 season “are encouraging,” with the programme now 23% sold in the U.K. and 31% sold in Northern Europe,
  > The group is also going to focus on selling more four and five star hotel holidays in Greece. According to a wire report, these premium  trips are “generally all-inclusive, meaning holiday-makers know most of their costs before they depart…Two star hotels are generally self-catering, meaning holiday-makers can’t account for the amount they may have to spend on food and drink while on vacation”

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