City Insider - FT journalist David Stevenson on the travel industry

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City investors make their judgements by contrasting industry pairs – one firm against its nearest rival. So David Stevenson does just that with Ryanair and Flybe and Tui and Thomas Cook

Investors are trained to compare.

There’s not a fund manager or hedgie that I know who doesn’t start any investment exercise by slapping up two sets of charts comparing the two main companies in a key sector.

For hedgies this comparison between the winner and the loser forms the basis of an actual trade called the pair, in which you short (sell) the number two in a sector and go long (buy) the number one preferred candidate.

Any company caught on the wrong end of a pair is likely to face a hostile trading environment for its shares for many months, if not years.

More generally, most mainstream investors are rather enamoured of the concept of the “winner takes all syndrome” where the number one player in a segment is able to use their scale and power to push the competitive advantage to the hilt.

This pairs concept does sometimes break down, and currently we can see it clearly in the example of Tesco and Sainsburys.

Tesco has traditionally hit Sainsburys for six, and I can’t count the number of fund managers who’ve been massively long Tesco as the quality operator. Not anymore.

Its shares have started to drift and suddenly all pairs trades are off. Crucially the established binary dynamic of that sector Tesco vs Sainsburys has been disrupted by the recent steady return to favour of not only Sainsburys but also the contrarian dark horse Morrisons which has vaulted up the league tables based on a lowly rated share price.

The rise of the Yorkshire giant also reminds us that investors like another dynamic – a once moribund company that has rediscovered its ‘mojo’ and is now looking to unsettle the cosy duopoloy at the top.

The key for this latter process is that the important financial metrics are all beginning to head in the right direction – cashflows tick up, as does the operating margin, with debt on its way down, funded by strict working capital controls.

Crucially, staff morale is also seen to be on the up as everyone around the company begins to recognise that the insurgent is building a head of steam.

Two pairs currently operate within the travel sector, Ryanair v Flybe and Tui Travel v Thomas Cook.

Personally I find the binary relationship between Ryanair and FlyBe fascinating – both are European focused airlines flying to lots of places most people haven’t heard of, and both are struggling with a sector (discount air travel) that is fundamentally going ‘ex-growth’ within its most developed markets.

Consumers have woken up to the tricks of the trade (whacking it to the traveller via endless add ons) and choice within the marketplace is big enough for consumers to make lots of well informed, price driven switches.

Crucially the faster growing business segment of the market is currently under pressure to rein in costs.

The net result? Despite Ryanair’s evident challenges and problems (how much more money can be screwed out of “marketing subsidies”, and how can it make more money out of add ons and extras), Ryanair is able to now use its enormous financial fire power to solidify its position.

Its balance sheet is in excellent shape and is getting better by the day whilst cash flows are (relatively) predictable. Crucially, investors are under no illusions that at its core Ryanair remains a deeply profitable business.

FlyBe, by contrast, is on the wrong side of the pair and although it has many, many strengths (good route network, getting better in Europe, as well as great customer service and a good brand), it doesn’t pass a number of tests for many investors.

The balance sheet looks like it might be heading in the wrong way with cash inflows at the trading level falling sharply to just £3m at the finals stage.

There’s also a number of big questions in many investors minds about whether there really is enough profit to be had long term on the vast majority of its routes for a business of its new scale and size – especially in a new normal, characterised by austerity, lower business sales growth and budget constrained leisure travellers.

Last, but by no means least, there’s the small matter of net debt of £29m at FlyBe, which is a tiny fraction of Ryanair’s debt mountain but needs to be serviced by ample cash inflows (after paying for the necessary capex to keep up with the likes of Ryanair) – ample cash flows which don’t appear to be in existence judging by recent numbers.

It goes without saying, of course, that when Ryanair talks about using its financial fire power to eradicate its opposition, most investors are guessing that FlyBe is the number one or two target in the more mature markets.

That makes shorter term investors nervous to say the least. Nevertheless I’d suggest that there is still everything to play for and it’s quite possible that within a few years of tight cash controls and clever rebranding, FlyBe might find itself in the Sainsburys spot or even Morrisons, as a resurgent competitor to Ryanair.

This “pairs” way of looking at the world is even more compelling with reference to Tui Travel and Thomas Cook, both of which have recently put out trading statements.

My colleagues at Travel Weekly will have already spilled the beans on most of the key headlines but I find myself drawn to the Thomas Cook numbers – the Tui numbers by contrast are almost predictably reassuring with very few obvious weaknesses.

The good news for Thomas Cook is that things aren’t obviously getting much worse, with the board expecting that in the fourth quarter the ‘variance’ will narrow delivering a full year set of numbers roughly in line with the (already low) market expectations.

Revenues are down, and the group moved into an underlying loss of £26.5m. As with Tui, the abysmal British weather seems to be helping summer sales which look to be performing well, and the UK turnaround seems to be on track with the new chief executive Harriet Green obviously beginning to make her impact with her strong emphasis on using technology to engineer a turnaround.

The banks will also have been cheered by free cash flow of £125m which helped reduce net debt, although the total debt at June 30 remained a massive £1.1bn – that number should come down closer to £900m after a series of aircraft refinancing deals and sell offs are accounted for.

I wish the new management team at Thomas Cook all the luck in the world but I’d simply make three observations.

Whatever progress has been made in the last few months, most investors still regard the travel giant as fundamentally a bad investment – it produces vast amounts of sales with no perceptible immediate prospect of profit, let alone a profit that might actually increase.

Cashflow could continue to degrade over the coming months, although asset sales must surely help stem the flow, and investors will be crossing every part of their body that another nasty surprise doesn’t come along in the shape of geo-political turmoil, the weather, Icelandic volcanos, Arab terrorists, the Eurozone, and the US presidential elections….the list is long and growing by the day and any one of these could smash into the travel sector, causing Cook yet more pain and suffering.

The next key observation is that the new chief executive looks like she is about to conduct yet another review of the business, with the recovery plan presented in Spring 2013.

These are dread words for any investor (cue more management consultants telling everyone the bleeding obvious) and although one can understand why the new boss needs to look in detail at the business, I would have thought the answers are pretty clear to all and sundry by now – the current business structure isn’t producing enough free cashflow to pay for the debt.

Talk of not ruling out any further international expansion into Asia will also have deeply depressed investors, as the very last thing that Thomas Cook needs to be doing now is expanding in new territories.

Compare and contrast with Tui Travel. Operating cashflows powered ahead in Q3 (underlying net cash flow at £897m), although both revenues (at £3690m, down 2%) and underlying profit (£74m, down 16%) fell back.

The business improvement programme continues to push through operational efficiencies and as with Thomas Cook, key markets including the UK continue to show positive growth. There’s also an “encouraging start to the winter 2012/13 season” and news that the board is “confident of exceeding our full year forecasts” provided forex rates don’t move around markedly.

Given these contrasting fortunes, it’s easy to understand why pairs traders will continue to quietly buy Tui Travel for its dividend and sell Thomas Cook because its equity is essentially a punt on paying down the bank debt quick enough.

In effect Thomas Cook is simply seen by many investors as a slightly more encouraging version of high street chain HMV.

But could Thomas Cook ever turn itself completely around, adopting the mantle of Sainsburys or Morrisons taking on the Tesco (Tui) of its sector?

I’d keep a watching eye very carefully on the core German market. Local consumers are still in remarkably buoyant mood but I don’t think this will last. France has already turned back into a recession, and the Nordic markets are beginning to look wobbly.

Demand in Switzerland could begin to turn soon and I think it’s only a matter of time before Germany faces its day of reckoning from the Euro crisis.

June factory orders in Germany declined by 1.7% month on month, which was much worse than expected and I can absolutely see the wheels coming off the export machine in 2013 as Eurozone austerity and slower Chinese growth have their impact.

If that’s the case, expect an awful lot of noise in the first three months of 2013, and some drastic action at both Thomas Cook and Tui.

The net result, paradoxically, could be greatest at Thomas Cook – the banks might decide to swallow their pride and decide to take dramatic action by swapping huge amounts of debt for equity, pushing Thomas Cooks net debt position below £400m.

Out of this financial inferno might emerge a leaner, sharper Thomas Cook with a new chief who’s finally found her feet, a better balance sheet, and a determination to take an axe to costs whilst also fighting their way deeper into Tui’s core differentiated products.