City Insider: Why Thomas Cook should avoid China – for now

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


Investors want to see considered moves from Thomas Cook. A rush into the tricky Chinese market would terrify them


This week it was the turn of Thomas Cook to receive the usual business press brickbats about declining turnover, declining sales, never-ending exceptionals and opaque black boxes.
 
To be fair to Thomas Cook, its actual results didn’t contain anything untoward or unexpected – most City analysts I talked to were rather more interested in the strongly improved cash flow numbers and declining debt levels.


A few City scribblers seem to be worried by the prospect of a five-year capex commitment to replace some of the narrow-body fleet (potential debt concerns and execution risk) but most appeared to be enthused by the steady growth of financial services as a new business line, with sales of FX and insurance now accounting for 14% of group turnover – insurance is going to be the big battleground for British consumers in the next few years.
 
Overall, the name of the game for Thomas Cook doesn’t seem to have changed very much: contain costs, cut capacity in the poorly performing UK and generally invest overseas, especially Russia.
 
The big Russian deal with InTourist preceded the annual results by a week. The key narrative being spun here is that this deal is a careful, considered move into a big BRIC market at a reasonable price. Nothing too big or too expensive.


Yet the InTourist deal does involve a majority stake in a $90m business, in a national market that is still very small when compared to China and India. My idea of a discreet move would have been a small $10m deal for a business that’s growing organically but fast. InTourist by contrast is big and important, and even though targets of six times EBITDA are being bandied about, that’s not as cheap as it first appears.


Precisely because Russia is such a basket case, single multiples on the price-to-earnings ratio are incredibly common – most of the big Russian oil companies can be bought for less than five times 2011 estimates for earnings. Six times EBITDA is reasonable but an awful lot of extra money will be needed to make this venture prosper.
 
And Russia is only the beginning. China is clearly on the radar, although the key words here again are considered, patient and careful. Nothing too expensive. Given that Thomas Cook’s idea of small is to build a $90m business for teensy Russia, god alone knows how big the future China investment will be.
 
Most investors I talk to would rather hear a different message – that Thomas Cook absolutely won’t be investing in China for the next two to four years. Most institutional investors would much prefer a continued emphasis on cashflow management, the Co-op merger actioned and some investment in growing the North European business and sorting out Germany, where national economic growth is rebounding strongly.


Given these enthusiasms, maybe a commitment to stay out of China until 2015 would go down well. But Thomas Cook cannot hope to avoid the siren calls – nearly every major investment bank I know is trying to work out how to structure a deal in not only the Chinese consumer space but specifically the China travel space.


Travel is hot in China. One banker I talked to reckoned that Thomas Cook and Tui are probably being pitched some new line from a large bank M&A department on a weekly basis. You can almost imagine the lines being used – “Dear Mr CFO, China China Travel (so good they named it twice) is an amazing growth business. Superb cashflow. Amazing profits. Compound annual growth rates of at least $30m. A bargain at only 10 times 2011 estimates for profit. Please sign here.”
 
That company-level pitch will then be followed by lots of powerpoints with names like Big Trends In China. Private equity types will tell you about the 2010 Hurun Wealth Report which reported that there are a staggering 875,000 Chinese with more than 10 million RMB or $1.47m in wealth.


They’ll probably also mention the awesome statistic that there were 1.9 billion trips taken within China’s borders last year. Maybe they’ll even mention that from 1999 through to 2008 the number of star rated hotels in China increased from 3,856 to 14,099 – that’s a CAGR 10% plus.


This might be followed by the WTTC observation that China has the second biggest tourist industry in the world, but that it ranks just 81st in terms of size of the industry in relation to the country’s overall economy. Think of the potential for growth!
 
But there are other, less appealing trends. The Chinese consumer is already addicted to buying holidays online – local brand Ctrip dominates with over 50% of this market. And the Chinese are even more price-conscious than the British – the fastest growing segment in the hotel business, apart from five-star luxury hotels in the big cities, is ultra-cheap budget properties.


Even worse, Chinese online consumers make very active use of user generated content and regularly make purchases only after checking other consumer’s comments. Maybe all this internet potential excites tech savvy Thomas Cook execs, but if I were an investor I’d be terrified.
 
In particular I’d recognise a number of themes. Most key parts of the Chinese travel market are gerrymandered by the state. It suits the government to have dominant players like Ctrip or the big three local airlines (Air China, China Eastern and China Southern) who between them control over 75% of all capacity. The Chinese state likes to carefully manage markets, which is why there’s only one GDS in China, Travelsky.
 
These big companies dominate China, with the state owning the biggest stake in most of them. But the smaller companies have their own problems. They may be more entrepreneurial but corporate governance is absolutely dreadful and foreign investors must navigate their way through dense local patronage networks and family ties.
 
Smart local analysts will tell you that all this is worth it as long as you are very focused on specific segments. Travel insiders will point to the exponential growth of the premium golf market or the fast-growing cruise market.


The point here is to leave the mass market behind and focus on the wealthy consumer, and I would accept that the potential in these segments is indeed huge. But be aware of one small word of wisdom imparted to this author by Jaguar’s head of marketing. Here in the UK Jaguar cars tend to sell to older types, whereas in the key urban Chinese markets many of the best premium car buyers are under 30.


Yes, under 30. Here they’re still paying off their student debts and trying to scrounge together some money for a deposit on a house. In China, they’re buying a new Jaguar. Flash and bling appeals more than reliability and quality. Consumer brand appeal and snobbishness are everything, and I’m not quite sure Thomas Cook is in the right space to appeal to a young local millionaire.


Add it all up and you have one simple message, as communicated to me by a successful local venture capitalists. “Not one major Western consumer brand has succeeded here without taking 5 to 10 years of hard labour, most of which involves abruptly changing direction midway through when managers realise what a big mistake they’ve made. It gobbles up senior execs’ time and costs a fortune. Be ready to have deep pockets.”
 
If I were an investor in Thomas Cook I’d want a firm declaration that my money isn’t going to be spent on China anytime soon. Conquer Russia first and then worry later about other emerging markets. This is a big brand that can’t afford any more big cock ups, and it absolutely doesn’t have deep pockets.

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