Is it time to book profits in Thomas Cook?

2012 was the year of Thomas Cook Group; back from the brink of bankruptcy, and ending the year with a share-price rise of more than 270%. But is it time for investors to book their profits?

Holiday demand on the wane

Trading in 2012 benefited from the UK, which accounts for 32% of Thomas Cook's sales, experiencing the wettest summer on record.

But what goes up must come down. Findings from market research agency Explore highlight that 40% of British consumers are expected to spend less on holidays abroad in 2013. And earnings growth is expected to remain muted in the coming year given significant job insecurity and an ongoing need for many companies to limit their costs in a very challenging environment, resulting in low consumer purchasing power.

"In addition we have concerns over [Thomas Cook] using easyJet as a third-party flying partner as there must be a risk this will lead to customers on these flights constructing their own holiday in future years rather than booking a package," warns Simon French, analyst at Panmure Gordon.

Thomas Cook's other regions don't seem to be doing too well either.

In its latest presentation, in November, the company stated: "[The] Eastern European businesses experienced difficult market conditions with general economic uncertainty together with local over-capacity", while "West Europe has continued to be affected by the ongoing political unrest in the Middle East and North Africa (MENA) region and the economic uncertainty caused by the European debt crisis".

The Dutch and Belgian markets were said to be "very price competitive", with Belgium also characterised by flight over-capacities. A decline in performance in North America was attributed to "over-capacity in the market which drove down average selling prices" as well as "a very mild Canadian winter which impacted the performance during the peak holiday period".

Nothing has changed since then. The eurozone debt crisis is unsolved; the MENA region is still in upheaval following the Arab Spring; while North America is now likely to be overshadowed by the fiscal cliff crisis.

Central Europe, West Europe, North Europe and North America account for 26%, 15%, 12% and 3% of sales respectively.

Single pricing a mirage

Bulls will say demand will pick up, as the tour operator offers uniform pricing across all three distribution channels of retail, online and phone.

However, there could still be variations in pricing across channels for components such as flight-only or room-only bookings. And French questions what the impact will be, "particularly when TUI Travel continues to offer discounts on holidays booked online".

James Hollins, analyst at Investec, adds: "Uniform pricing should be well received by most consumers (less confusing and lower likelihood of a customer feeling they have overpaid relative to another), although some individuals used to getting the warm feeling of securing a discount online may not appreciate the strategy."

Poor track record of cost savings

Secondly, the group has outlined £100 million worth of cost savings, with more due to be announced in the spring. With an operating profit margin of just 1.6%, there is a clear need to reduce costs.

However, French points out that travel companies have a poor track record of cost savings being delivered to the bottom line, and believes that investors should be conservative when assessing how much of these should be included in profit forecasts.

He is assuming £60 million of UK improvement this year, and half of the £30 million of lost profits from bad publicity last year, will be recouped, along with all £13 million of the first year's cost savings. In years two and three, he forecasts only a third of cost savings will be delivered to the bottom line.

Rights issue on the way?

Thomas Cook has gross adjusted debt of £3.5 billion, with £540 million of EBITDAR.

French is of the opinion that the group needs to raise between £150 million and £300 million of equity to strengthen the balance sheet, which would reduce the 2014 pro-forma earnings per share from 3.9p to 3p.

Expensive valuation

Bulls attribute the share price reaction to the strength of new management, as well as a coherent and aggressive cost-saving programme being implemented that they say should ensure improved cash flow and earnings.

While there is some scepticism about how effective the cost-savings programme will be for the bottom line (see above), there is no doubt that Harriet Green as chief executive is an immensely impressive appointment for Thomas Cook.

However, it does appear that the hiring of the new management team, as well as any potential recovery, has been priced in. The stock is trading on a 2013 price/earnings (P/E) ratio of more than 20 times.

Next catalyst

Thomas Cook will unveil its interim management statement on 8 February.

Sector alternatives

Hollins' key picks elsewhere in the leisure sector include Carnival, InterContinental Hotels Group and Compass Group.

On the other hand, French warns against buying TUI Travel. Despite trading on a 2013 P/E ratio of between 10 and 11 times, a sharp discount to Thomas Cook, French points out that TUI's five-year average forward P/E is just shy of nine times.

"We also have concerns around rising fuel prices, a weak macroeconomic backdrop in the group's major markets and note the problems with the Dreamliner aircraft the group has made significant investment in," he adds.

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.