Stockwatch: Crux for confidence looms for this share

Stock-picking is often categorised as turnarounds, cyclicals and growth. But when economic recovery steadily takes shape there can be hybrid "recovery-to-growth" stocks with twin advantages. You benefit in the early years from management recouping margins and then any new strategy may enhance progress as the economy improves. The risk/reward characteristics can be more attractive than turnaround plays it is better to sell and move on from, also highly-rated growth stocks where any disappointment is costly.

The Mid 250-listed Thomas Cook Group is one such example. Extreme lows around 10p a share in 2011/12 related mainly to debt distress, but a financial restructuring and resilient demand for packaged holidays despite the recessionary years meant the five-year chart had regained nearly all its plunge by early 2014.

If the market consensus forecast is fair then at about 143p currently the stock trades on a modest 12 times earnings for the current year to end-September, falling near 9 times for 2015/16, and the price/earnings-to-growth ratio is a highly attractive 0.2 to 0.3 (where values under 1 represent value).

The earnings forecasts rather depend on management recovering revenues back to £9 billion and better, and ratchet margins higher too. The stock is not trading on an elevated price/earnings (P/E) in terms of expectations but is on nearly 20 times earnings for the last financial year. This is largely why it dropped from 189p in 2014, like so many which consolidated after the 2013 "risk-on" rally.

Q1 2014/15 was no great shakes but met expectations

The three months to end-December 2014  saw like-for-like revenue only marginally ahead by 1.6% albeit a 3.9% improvement in the operating margin to 3.9%, while the seasonal loss fell. A latest update ahead of interim results cites UK bookings ahead of last year, albeit with continental and northern Europe still tough but improving.

For context, those two European areas accounted for 59% of 2013/14 revenues. Airlines Germany represented 11% and is growing strongly with bookings up 10% and load factors ahead of last year. Mind the consensus forecast for the 2014/15 year implies revenue of £9 billion with a pre-tax margin of 2.5%, up from 1.3% on £8.6 billion last year, so hurdles exist - similarly for 2015/16 hopes. The five-year table does at least show fairly recent precedent for profitability over £200 million.

Various positives coming together

The 20 May interims will therefore be a crux for confidence, coming soon after the general election and amid seasonal sentiment whether to "sell in May". Moreover, there is a read-across to consider TUI Group, another principal travel operator which is similarly rated. Thomas Cook is not an exclusive play on consumer travel however this theme is likely to gain interest assuming the economic recovery evolves to include wage increases. Note that UK consumer confidence is at a 12-year high and fund managers are tending to favour continental European stocks on the basis the European Central Bank's quantitative easing will provide an extra boost just as economic indicators are turning up anyway. This corresponds with Thomas Cook management saying that tough trading conditions previously reported in some markets, are showing early signs of improvement.

So consumer travel is a good area for exposure, with a few qualifications. It remains to be seen what could be the effects of a UK hung parliament on confidence generally. Stocks such as Thomas Cook and TUI Group are right to be prioritising but are not without risks.

Lower oil prices are more a medium-term benefit

Travel-related stocks have tended to benefit on days of falling oil prices, as a knee-jerk reaction, but remember these firms are substantially hedged against oil price volatility so there is unlikely to be much benefit unless and until a lower pricing regime is established. This could quite easily apply though, with recent years of $100 oil becoming an aberration. Oil's supply/demand profile, and power balance, are changing. For example, Thomas Cook has hedged 99% of its summer 2015 and 90% of winter 2015/16 fuel costs. Similarly exchange rates have been hedged in a 73% to 97% range. Probability suggests the stockmarket is right to anticipate lower oil prices and their eventual benefit, just don't expect to see this soon. Bear in mind also, conflict in the Middle East anytime can shift perception to fears over supply, and push prices up.

New chief executive since November 2014

Another significant factor is how the latest chief executive shapes up. Dr Peter Fankhauser was an internal replacement for Harriet Green's abrupt departure last November causing a 22% drop in the shares to 107p. While Green was largely responsible for steering the group from the edge of bankruptcy, it appeared her management style caused difficulties and Fankhauser had already been identified as her replacement - the natural sense of a turnaround generalist having largely done that job, then a travel industry specialist assuming the driving seat. He still needs to prove himself in the role, when market forecasts have set high expectations.

Net debt still high but on a reducing trend

The end-September 2014 balance sheet showed some improvement while management also invested significantly in the business. The effect was mainly in long-term debt, down from £1.1 billion to £715 million while short-term debt rose from £177 million to £449 million. Net assets of £285 million were overwhelmed by nearly £2.9 billion intangible assets, making this is no balance sheet for conservative investors. On an underlying basis, the net finance cost was £143 million, taking nearly half of £323 million operating profit. This aspect can be regarded according to prevailing sentiment, i.e. "risk-off" and Thomas Cook is still substantially indebted, but if "risk-on" then the stock is liable to react positively to ongoing reductions in debt. The H1 results cited net debt reduced by £55 million on a like-for-like basis, to £1.262 billion.

Risk/reward profile is therefore quite wide-ranging

These key points in the investment rationale define Thomas Cook as a stock more for long/short traders than tuck-away investors - but all-considered, one that favours medium-term upside. You can never be so sure about consumer confidence and deflationary/political risks could still inject uncertainty. Yet the latest update points positively and the resumption of dividends, anticipated for this year onwards, would mark another stage of progress. If a hung parliament is avoided on 7 May and Thomas Cook re-iterates positively on 20 May then its stock should rise. A political upset may also provide a buying opportunity.

For more information see thomascookgroup.com

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.