City Insider: Will private equity interest prevent Cook being caught short?

City Insider - FT journalist David Stevenson on the travel industry

At the end of May I spent a very entertaining afternoon with a notorious hedge fund manager who likes to ‘short’ shares. ‘Shorters’ are a strange breed in that they go out of their way to find companies that are in trouble and then sell those falling shares into the market, hoping to make a fat profit on an even larger fall.

Their antics cause chaos among the companies they track – high-street retail brand HMV, for instance, constantly tops the ‘short interest’ list of UK companies. My old college friend has made – and then lost – a small fortune shorting outfits like HMV, but on this late May afternoon he reckoned he had acquired a new target.

Step forward Thomas Cook.

I could reel off a long list of gripes, suspicions and analysis that fuels the work of a short investor, but a graph could do the job just as well.

The chart below is from the week before the Thomas Cook update that prompted the collapse in its share price. In fact, this graph is almost an exact replica of the graph shown to me by the hedge fund manager.

It’s from a financial software package called Sharescope and shows the share price of Thomas Cook – the thin (blue) line – and the FTSE 100 benchmark index (the thick blue line) over the period starting a year ago through to July 8.

Not surprisingly, given the travel sector’s woes, Cook’s share price began to fall behind the benchmark index almost from the get-go in 2010. But the collapse in relative performance since the beginning of this year is nothing short of astonishing.

And in case you thought my hedgie was being a little too mean-spirited by using the FTSE 100 index, bear in mind that the FTSE 250 index (where Thomas Cook’s shares currently reside) has significantly outperformed the FTSE 100. Thomas Cook’s shares are currently the biggest underperformers in that mid-cap index, a rather miserable honour given how bad some of its peers are. 

I have not updated the chart because we all know what happened last Tuesday. Thomas Cook shocked its investors with a profits downgrade and announced a fundamental review of its UK business. We can all guess what may happen in that strategic review – Andrew Monk, chief executive of VSA Capital may be right when he says Thomas Cook needs to move upmarket.

Lots of investors I talk to are rather more direct. A few even reckon the Co-op deal should be junked and the group reorganised from top to bottom.

What I can offer is an assessment of what the hedge funds are thinking – arguably they matter more at this point than anyone else. They have it in their power to push the share price even lower and to force a real crisis at the firm.

Quote: A few have opened up a short position on Thomas Cook, but they are spooked by the subsequent steadying of the share price around 85pAt the beginning of last week my friend wasn’t shorting Thomas Cook stock and neither were any of his colleagues. The company was on their radar, but they hadn’t made the move. What is now happening is that the shorts are edging away from any potential investment – a few have opened up a short position, but they are spooked by the subsequent steadying of the share price around 85p. They are now juggling a number of factors, waiting for the moment to pounce.

But every hedgie knows profit warnings always come in threes, like buses. The sheer audacity of guiding the earnings downwards is usually a cathartic act and encourages all sorts of Augean stable cleansing which results in a few more restatements and much ‘facing up to the facts’.

All of which brings us to the issue of leadership. One hedge fund manager I know summed up that challenge thus: “Manny has to stay around long enough to clean up the mess.” Leadership uncertainty is always bad news for the price of a share, as most institutional funds tend to hold off investing until they understand the likely direction of a company in the next few years.

The biggest risk from here is a breach of the debt covenants. No ordinary mortal will be allowed to see these, but I would guess that unless the debts are secured on a covenant-lite basis, someone has written in a clause that triggers ‘discussions’ if the market capitalisation falls below a certain level in relation to the debt.

That discussion need not be terminal in any way, but it could be awkward. My guess is we would have heard if the clause had already been triggered (the regulatory authorities would require an announcement) but I would worry if the price began falling below 70p.

However, there is good news – and it explains why my hedgie friends have not swooped on their stumbling prey. If profits are still holding up (but at a reduced level) and cashflow generation is still strong, Thomas Cook is now effectively ‘in play’ with private equity. Most hedgies are former investment bank traders and many of their mates took a slight detour and ended up in the weird and wonderful world of private equity.

These deal-makers like a major company with a strong franchise that needs some ‘attention’. The classic private equity play is an industry that generates strong cash flow, has a financial structure where some‘re-engineering’ could improve matters, and where the hard work of axing capacity has already started.

Travel, and especially Thomas Cook, now ticks those boxes. The only debate is over what the entry price is for the private equity boys. Watch this space.

I leave you with a final thought. All our attention may have been focused on Thomas Cook, but I found myself drawn inexorably towards Tui Travel’s share price, which slumped to within a whisker of 200p, down more than 8% at one point last Tuesday.

Clearly the Thomas Cook earnings downgrade wasn’t good news for the industry and confirmed the dark rumours emanating from the retail trade. But the City has known it’s bad for an age and already priced that into the shares.

Thomas Cook’s woes can only be good news for Tui Travel at an investor level – whatever happens, the management at its rival will now be focusing their attention internally, leaving Tui clear to launch some major strategic initiatives.

That might prompt a 1% or even 2% ripple in the share price, but not an 8% fall. Surely at this price it’s time for Tui AG to act?

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