In association with Travelport
Following the surprise departure of chief executive Harriet Green, David Stevenson assesses the prospects for the travel giant which he says has set itself ‘heroic’ targets for the year ahead
Investors are an odd bunch. It’s been blindingly obvious for many months that Thomas Cook’s chief executive Harriet Green was on her way out by the end of 2015.
The cynical journalist in me immediately connects higher media profiles with an attempt to canvas for the next big job.
The hardened investor will have realised that Green was brought in by the banks to do a specific job – recovery from near certain corporate death – and that that job is now largely complete, although other equally important challenges await.
And of course anyone who has read my columns here in Travel Weekly over the last few months could also have worked out what was common knowledge within the City – that Harriet is off to bigger and better things.
Amazingly though, many City types professed surprise, and the share price crashed back 17% in one day – from around 138p to a recent low of 113p, although that price has subsequently bounced back to around 125p as investors realised that new boss Peter Frankhauser is perfectly capable of finishing the job started by Green.
Stepping back from this market short-termism, what are we to make of Ms Green’s short but effective tenure at Thomas Cook?
Too much talk surrounding her departure has been framed around the former chief’s personality, whereas I suspect most boring investors I know would prefer to focus on the challenges facing the business and what she and her team have done to tackle them.
In my simple understanding of the world of business, there are two discrete, different types of challenges facing any corporate.
One is business-threatening and requires drastic action, whereas the other set of challenges require a more considered medium-term approach, involving blood, sweat and tears over a fairly prolonged period of time.
Needless to say, the first set of challenges are usually framed around binary outcomes: Live/die, profit/loss, cash/debt. The second set of organic challenges are by their nature messier, trickier and require patience.
In the first category the achievements of Green and her able team are obvious and you probably don’t need me to repeat them. If nothing else Thomas Cook is now profitable, largely in one piece and still a public business because of Green and her team.
That very public accomplishment rests on two achievements: first ripping cost out of the business and focusing on cash flow, as well as getting the balance sheet in a semblance of shape and order (helped along by the giant refinancing).
Yet I also think we need some perspective on these achievements. All the corporate jargon about different waves of operational efficiency improvement hide some continuing balance sheet issues.
Yes, cash flow (and cash conversion) has radically improved, but in the full year 2014 this huge business only managed to produce free cashflow of £116 million after paying a huge interest bill and funding new capex.
The cynic might contrast this number with a debt pile that still totals £1.3 billion (and costs £143 million a year to service) and sales that are only a little bit up on those achieved back in 2008.
But I’d argue that there are two other achievements where Green and her team deserve much more credit by investors.
They are, unsurprisingly, to do with my second set of challenges facing the business I referenced earlier; namely, how to grow both the top and bottom line over the remainder of the decade.
In this category the refinancing of the business allowed Thomas Cook to modernise its capital base, notably its fleet of planes.
In this column for Travel Weekly I’ve constantly emphasised the huge scale and efficiency advantages (in a low margin sector) that flow from brand new aircraft and cruise ships.
Increased fuel efficiency, increased capacity and a sleek customer experience can all deliver appreciable cost advantages to businesses that find the capital to buy new ‘stuff’.
Part of the challenge facing say FlyBe, for instance, is that its competitors all have bigger, newer planes with better cost structures, forcing it to compete in the niches. It also faces an uphill struggle to raise fresh capital to deploy into new planes.
Thomas Cook’s refinancing has allowed the steady fleet modernisation at Thomas Cook to progress. Fresh cash is being diverted into this modernisation programme which has already seen a wave of A321s enter service, with many more to follow.
I think investors under-estimate the big improvements to the bottom line that will flow from this programme – only possible because the balance sheet and cashflow is in decent shape.
Green’s other great accomplishment is to place huge internal emphasis on product modernisation via omni-digital channels and the new range of differentiated product marketed under the Exclusive Holiday Experience concept.
Quite why it took so long to realise that the future was in selling these more expensive, higher quality product down a cheaper digital line is entirely beyond this observer, but Green has put these two transformations at the heart of what Thomas Cook does.
These also both require extensive investment in the future, although the corporate spin is that the differentiated product set is capital-light – but only if you exclude marketing and product development from the definition of capital.
Yet it’s also these two accomplishments that I think hint at the unsolved challenges that lie in wait for the new boss. Investors will only continue to own the shares if they see that all the drastic cost-cutting will produce jam tomorrow i.e growth and higher margins that are robust over time.
For me the key page in a recent investor presentation looks at strategic targets and KPIs in 2015. One might take fright at the number on this page that says the sales compound growth rate was -1.2% in the third quarter of 2014, yet I’d argue that the big scary numbers are as follows:
- New (differentiated product revenue) will increase to more than £300 million in FY14 (from £167 million in Q3) and a mighty £700 million in full year 2015
- Web penetration will also increase from its current 37% to a stonking 50% in full year 2015.
If I were to cut through the management jargon, I’d say that senior management have bet the entire future of the business on squeezing costs out of the legacy business and investing this hard cash in a bigger, better digital route to market and smart, trendy new products.
Those targets set by Thomas Cook for 2015 are, I suspect, fairly heroic, especially if the Eurozone continues to sink into austerity-fuelled deflation.
Also, jumping from 37% to 50% within a few years for digital penetration is going to require a fairly massive commitment to both IT capex and marketing – money that may not be on the table if cash-flow generation is held back by big interest bills and airline capex.
Which brings me back neatly to my last observation: it’s the free cash flow (after capex and interest bills) that keeps Thomas Cook alive, and I would maintain it’s simply not generating enough to keep up with its own ambitions.
What makes matters even more worrying is that it is going to need to refinance two huge bond issues (£310 million in 2015 in euros and £297 million in 2017 in sterling) just as corporate borrowing rates are set to increase in cost (especially for sterling-based issuance).
If I were a bond investor looking to refinance this business, I’d demand a much higher rate of interest to reward me for the risk of business failure – not from the company going bust but from not producing enough cash to be able to grow the top and bottom line and thus service the debt.
That extra financing cost will feed through into a tighter cash flow just as the business needs to scale up investment in higher margin businesses. My sense is that Thomas Cook could be in for a bumpy ride in 2015.