Why we chose not to jump on board Thomas Cook

Horror travel tales may be as old as tourism itself but of late it has been Thomas Cook’s shareholders who have had to endure a nightmare journey.

From July 2016 to May 2018, the share price of the world’s oldest holiday company soared from 59p to 136p but, since then, it has steadily nosedived – recently crashing as low as 5p.

So why is it we have at no point chosen to jump on board, here on The Value Perspective?

After all, value investors are supposed to be interested in cheap businesses and Thomas Cook is clearly that – although Citigroup analysts had a different description for the shares back in May, when they described them as “worthless”.

Even so, the last year has seen mutterings the price might be attractive – particularly last December, at 28p, and even the previous August, at around 88p – but we have resolutely kept our distance.

Value is not the same as cheap

The other – crucial – part of the value equation, of course, is that there is no point buying cheap businesses if they are only likely to remain cheap or grow even cheaper.

And the two rounds of analysis we carried out ourselves – in August and December last year – raised a number of cautionary red flags that, for us, made Thomas Cook’s shares a ‘pass’ no matter how low the share price went.

And indeed has gone.

As ever, we would stress that none of what follows is intended to gloat – as we illustrated in pieces such as ‘Sorry’, here on The Value Perspective, we are keenly aware of our own fallibility – or as any sort of comment on the future flightpath of Thomas Cook’s share price.

It is merely intended to offer an insight into our investment thinking and some pointers that readers might care to incorporate into their own process.

One of our biggest concerns: balance sheet

This time last year – and despite the company’s £1.6bn rights issue in 2013 – one of our biggest concerns was Thomas Cook’s balance sheet.

For one thing, while that refinancing five years ago had seen it offering good disclosure when reporting interest rates and covenants on its borrowings – thus allowing average annual debt to be calculated more reliably– the business’s debts now seemed to sport an element of ‘window-dressing’.

The following table charts our calculations – in millions of pounds, for the years from 2012 to 2017 – of the difference between the company’s average annual debt and the year-end gross debt it reported in its annual accounts.

As you can see, the difference was significant each time but especially so in 2017, when Thomas Cook’s average annual gross debt was 73% larger than the year-end figure.

_{Source: The Value Perspective}

Going on to adjust Thomas Cook’s 2017 balance sheet metrics to reflect average-year debt rather than year-end reported net debt, the ratios of debt to EBITDA (that is, earnings before interest, taxes, depreciation and amortisation – plus ‘rent’ for ‘EBITDAR’) look weaker – particularly when compared with the average of the preceding 10 years, as the next table shows.

_{Source: The Value Perspective}

The same metrics also look weak in comparison with 2010, which was just before a previous crash in the company’s share price.

And while we would immediately go on to stress Thomas Cook does not appear to be close to breaching any of its debt covenants, we would also observe the company’s reporting of these is currently less transparent than it has been in the past.

Furthermore, while it may no longer be deteriorating, it is worth noting the composition of fixed assets on the business’s balance sheet is now dominated by goodwill – indeed, by 2017, goodwill comprised 68% of total fixed assets and was more than 9.3x net assets.

Such a situation could weaken Thomas Cook’s balance sheet from the perspective of its bondholders when considering any collateral the business is able to offer.

_{Source: The Value Perspective}

Cash conversion

Turning to cash conversion, while its profit and loss statements showed Thomas Cook as cumulatively loss-making from 2013 to 2017, cumulative free cashflow was positive at £182m.

This was down to the business’s working capital – over the previous five years, £130m of cash inflows came from changes in receivables (money coming in) while £412m of cash inflows came from changes in payables (money heading out).

Are such movements sustainable, though?

To investigate this further, let’s plot the balance sheet working capital items as a percentage of revenue over the past 10 years: as the following chart shows, payables have been generally increasing and receivables decreasing relative to revenue since 2011. This has increased total trade working capital from an average of -20% of revenue from 2007 to 2011 to -32% of revenue by 2017.

_{Source: The Value Perspective}

Within this time, Thomas Cook’s reported average credit period taken for trade purchases has increased from 59 to 82 ‘days payable’.

Using rival travel group TUI as a benchmark, both numbers appear unsustainably high – a rough calculation suggests the latter’s trade working capital stood at around 10% of its reported revenue by 2017, and it had an average of 57 days payable.

Given its history of a lack of liquidity combined with large seasonal fluctuations in money coming into and heading out of the business, it is perhaps understandable that Thomas Cook would have had some motivation to increase payables and decrease receivables as such an approach would have helped to free up some much-needed cash.

To bring its days payable average back to 60 days – and thus much more in line with TUI and its own historic levels – Thomas Cook would have to pay off around £420m of payables.

This in turn would bring its balance sheet payables as a percentage of revenue to 37% – again, much more aligned with the company’s history.

To be conservative, we used this cash adjustment in our calculation of Thomas Cook’s enterprise value (EV).

December 2018 analysis

We returned for a second round of analysis in December, after the shares fell 60% following a second profit warning in two months – which the company blamed on a prolonged summer heatwave that led to a drop in bookings and thus profits.

Even so, our earlier justifications for passing – that is, the large debt and payables adjustments to the EV – still held, meaning that, regardless of the heatwave, the business still left us cold.

One possible wrinkle for us was the news Thomas Cook’s chairman had been buying up shares.

As plenty of other investors would see that as indicating an imminent turnaround for the business, it naturally made our decision feel a little more uncomfortable.

Nevertheless, as investors who attribute far greater weight to the objectivity of numbers than the subjectivity of emotions, we stuck by our ‘zero’ valuation and, again, passed.