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Update Xx | Europe | Travel & Tourism

European Tour Operators Sector Note with Analysis of Thomas Cook November 2012 Sutherland Research Team

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Travel & Tourism SECTOR NOTE

Current State of the Industry “Mainstream” business of tour operators is in a structural / terminal decline caused by the onslaught of independent travel The traditional high-volume package-tours operating model based on pre-booking flight and accommodation capacity is under threat. As more travelers opt for online and niche solutions to their travel, the traditional model is viewed by many as one in terminal decline. The expansion of low cost carriers on routes to traditional tour operator heartlands such as the Canaries, and now Greece, combines with the ability of agents and travelers to self package with shorter booking lead times and lower costs of doing business, to have a significant impact on operators such as Thomas Cook and TUI. The Mainstream segment represents 86% of 2011 revenue for leading UK operator TUI and 74% for Thomas Cook Group. The UK tour operator market especially for overseas travel is shrinking. After a long period of year on year increases, the total number of overseas holidays taken by UK travellers saw a ~20% decline between 2007 and 2011, and now stands at about 36 million per annum, a level last seen in 1999. In the same period, the number of package trips, which by contrast had hardly increased over the previous 10 years, declined to 14.7 million – comparable levels last seen in the mid-1990s. Despite the structural shift in the industry, we do not believe package-tours are in a situation of precipitous fall, we rather forecast volumes to decline at 1-2% across most major European markets including UK UK Outbound Holiday Market Category Total Leisure Holiday (‘000) Mainstream Packages (‘000) Independent (‘000) Mainstream Package as a % of Total














































Source: Office of National Statistics

“Mainstream” business-margins do not seem to justify the risks anymore The average profit made on package holidays is extremely slender. Many non-travel companies supplying consumer products achieve a higher net margin on sales than tour-operators. The Civil Aviation Authority (CAA) records that the average tour operator's return on turnover in recent years remains around just two to three per cent.

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Travel & Tourism SECTOR NOTE Not only are the margins low, tour operators also have to manage considerable risks not faced by other higher margin industries. For example, holiday prices are set over one year before a holiday takes place and a significant proportion of costs can be subject to considerable fluctuation - especially exchange rates and aviation fuel. Although tour operators are able to protect themselves from some of these fluctuations by "buying forward", this is expensive. Accurate forecasts are vital: unnecessary costs are incurred if too much is "hedged". There is also clearly significant “capital� (capacity, financial, human, systems) invested in the tour operating model in order to match supply with demand. Based on a rough-sketch P&L prepared for the mainstream business segment of European tour operators, by JP Morgan, it is evident that operators have limited levers for increasing business margins, other than by taking more risks and giving larger commitments to supplier-partners Mainstream Package Margins

Source: JP Morgan Cazenove (November 2012)

Adjusted EBIT Margin

Source: Company Filings

Given that LCCs continue their expansion, and hoteliers have scope to improve their margins by selling directly to customers or through online travel agents (15-20% markup), we believe pressure on tour operators’ margins is likely to further exacerbate.

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Travel & Tourism SECTOR NOTE

Operators may resort to increased risks as they aspire for much needed differentiation in a bid to ‘boost’ margins Sub-segments within the mainstream offer include Differentiated and Exclusive products, as opposed to “commodity” mainstream. Differentiated products are defined as packages that can only be obtained through a given Tour Operator. This implies either increased capital commitment by the Tour Operator, creating concept resorts and tailored activities, or increased capacity commitment, through the bulk purchase of services from a given supplier (typically hotels). Already differentiated and exclusive products represented 41% of Mainstream bookings for TUI Travel in fiscal 2011, with a target to take this share to over 50%. While Thomas Cook Group offered exclusive properties for only 20% of its packaged products in summer 2011; 45% of TCG Mainstream bookings in the UK were from exclusive or differentiated products. Differentiated Products – Contribution to Mainstream Business TUI (FY 2011)

Thomas Cook (FY 2011)

Source: JP Morgan Cazenove (November 2012)

Benefits of reduced capacity in the ‘commodity-mainstream’ segment may be offset by pressures from an increasing trend towards last-minute bookings Historically margins of tour-operators have improved in periods of capacity-cuts. With two mega-acquisitions First Choice & My Travel having been consummated and capacities having been consolidated and reduced, we would expect margins to improve over the short-term. However in our opinion the negative effects of the increasing trend of consumers to postpone travel decision to the very-end will offset the positive effects of capacities on product-margins.

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Travel & Tourism SECTOR NOTE

Tour Operators Margins vs. Capacity

Source: Morgan Stanley

Low Cost Carriers are expanding the competitive eco-system for package-tours Tour operators are now facing competition from unlikely quarters. Low Cost Carriers like EasyJet, that sell directly to consumers, have taken a step further to offer the complete package holiday, in conjunction with partners such as Lowcosttravelgroup, who act as the providers ‘delivering a full outsourced service including stock, systems, marketing and fulfillment’.

LCCs have expanded aggressively in the UK while Tour Operators have been forced to cut capacity

Source: Morgan Stanley

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Travel & Tourism SECTOR NOTE With c55m annual passengers and the benefits of flexibility afforded to a company with >200 aircraft and covering >550 routes, we regard EasyJet as a credible threat to the tour operators. If the EasyJet venture is a success, we would expect Ryanair to follow suit, adding a further fleet of >270 aircraft and a customer base of c72m passengers per annum

Increasing propensity of customers to book online With increasing penetration of broadband and mobile broadband along with the improvement in the technology to index and search the content on web, the number of online avenues where prospective visitors can discover and compare the travel and accommodation arrangements are increasingly becoming default options for consumers planning holidays. Particulars (FY 11) Mainstream Holidays (Mn) Retail Outlets Controlled Distribution Online Distribution Booking per shop Booking per shop per day UK Germany / Central Europe No of Aircraft Customers per Aircraft ('000)

TUI 20.3 3,500 65.0% 30.0% 2,030 7 8 5 145 140

TCG 17.7 3,784 53.0% 27.0% 1,217 4 10 2 92 192

While TCG is also adapting to these developments, the business model brings number of undesirable characteristics to the conventional business of tour operators, viz: (i)

Search Engines: Easy discoverability through search engines is accentuating the trend towards consumers as active and informed decision makers. (ii) Price is the key, if not the sole, criterion: Most consumers are becoming budget conscious as a result of uncertain economic climate and price being a quantified and directly verifiable parameter gives them an impression of forming the basis for objective comparison. Thus, the ‘cheapness’ for a particular destination offered by an online aggregator may take precedence over other much subjective parameters like quality and reliability of service. (iii) Engagement model with the customer is different: Opportunity to interact with a prospective customer is indirect and limited in the online model as compared to a retail store where a prospective customer can be persuaded to choose the higher priced alternative by providing convincing explanations about differentiated quality of experience. (iv) Independent reviews: Many of the online aggregators as well as independent websites offer consumers to express their opinion about a particular destination/hotel. This allows prospective visitors to these locations an independent view which has much more potential to appear

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Travel & Tourism SECTOR NOTE unbiased as compared to the representative from traditional operator like TCG who may be perceived to have a vested interest in selling particular location. For all these reasons, even if tour operators increase their online presence, it will still have detrimental effect on their overall business model in terms of diluting an already slim margin. For TCG, although the trend of shifting to online booking has remained at around 20-22% of revenues over the past three years, it is also associated with substantial decline in the number of passengers travelling through TCG.

Business model remains vulnerable to the risk of a rapid shifts in destination preference International travel is susceptible to a number of unpredictable developments. The year 2010 saw the volcanic ash eruption from Iceland and in 2011 the Arab Spring severely reduced travel to MENA region – one of the main destination for TCG, especially from countries like France. The nimble footed market avoided these destinations and showed increased preference for locations in Spain and Greece. The organized tour operators like TCG which heavily depend on pre-procurement of inventory for travel as accommodation arrangements cannot quickly be spread in new markets and hence, they had very limited offerings in these regions. The overall decline in the number of visitors along with inadequate offerings in the new destinations resulted in significant fall in the number of tourists travelling through TCG.

Challenges apart - the market remains sizable and consolidation has increased concentration in favour of Thomas Cook & TUI Tour operator has historically been a concentrated market in most parts of Europe. Despite the low barriers to entry, the insurmountable barriers to growth have ensured that the market remains concentrated. Following the consolidation of 2007, Thomas Cook & TUI have emerged as the two market leaders in the UK with the scale and brands to survive. Despite the structural challenges, the market for package tours remains sizable across Europe and any rebound in customer sentiment will certainly improve the demand environment for their products. Furthermore, while we regard the industry, particularly in the UK, as in a state of flux that will ensure margin progression is weak to negative, some countries are facing softer headwinds based on lower levels of competition from LCCs (eg the Nordic region, although the competitive threat from Norwegian Air Shuttle, and its January 2012 order for 222 new planes, is building) and consistently solid consumer sentiment (eg Germany)

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Travel & Tourism SECTOR NOTE

Tour Operators – Concentrated Segment

Source: Morgan Stanley

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Travel & Tourism SECTOR NOTE

Outlook on Thomas Cook (TCG) TCG is caught up in the cross-winds of changing industry dynamics and issues with its capital structure and liquidity. Although the management has initiated significant steps to improve the operating performancehas negotiated some breathing space with lenders and changed management in the four of its regions, the positive fruits of these actions are yet to be seen in numbers. TCG bond prices have recovered from the low 30% to the current levels of 66.7% and 62.6% for the 2015s and 2017s respectively. The price performance can be attributed partly to the initial knee jerk reaction of the market to liquidity crunch and subsequent signs of TCG remaining a going concern entity.

£ in millions














Exceptional Items





Total Interest Expense Income Taxes


























Change in Working Capital CAPEX Proceeds from disposal Free Cash Flow for Debt Servicing Net debt






Net debt with market value of












Leverage at MV






Required EV/EBIT Required EV/EBIT at fully drawn facilities

2.28x 8.79x

The table above shows Net Debt Bridge to FY15. As can be seen in the table, the level of cash generation is highly dependent on exceptional items. If the management is able to reduce the cash exceptional items to a minimum level, TCG should break-even on the FCF basis from FY13 onwards. In our base case, at the end of FY15, the company will have net debt close to £732m and leverage of about 1.87x. The cumulative cash cost of exceptional items from 2HFY12 to FY15 is assumed to be £150m, which appears high as compared to management’s own estimates, but is much lower than what TCG has historically

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Travel & Tourism SECTOR NOTE incurred. To recover the principal investment in the unsecured bonds at the current price of approx. 65% of par, TCG needs to have a valuation of just 2.3x at EV/EBIT level which looks plausible. However, TCG has a history of being affected by exceptional items for reasons varying from business realignment to geopolitical unrests. If TCG is caught in various industry headwinds and its own internal problems right at the time of maturities, things would look dramatically different. It is possible that TCG would have drawn down all available facilities to their limit (£1.4bn) and is still caught in the liquidity crunch. Under these circumstances, TCG would require valuation of 8.79x EV/EBIT for 100% recovery on credit facility which would be next to impossible to achieve under difficult circumstances. Thus, the outcomes for credit investors are binary – if the business continues to operate as usual – the recovery at current prices is a high probability event. But if TCG continues to be mired in its own and industry issues, then recovery would certainly be limited in the mid-20s. Given that bonds have had a good run up in price this year, the scope for unusual upward movement is unlikely. Nonetheless, the nearest catalyst for change would be the pre-close trading update by the management on November 28. Even if the results are in line with the industry – a likely outcome – it may provide a marginal upside from current levels.

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Travel & Tourism SECTOR NOTE

Investment Highlights Significant one-off items and restructuring costs and uncertainty over future earnings From FY08 to 1HFY12, TCG has incurred cumulative exceptional costs of approx. £1.7bn. Exceptional items reduced operating margins by 200 to 300 bps during FY08 to FY10 and 600 bps in FY11. The FCF situation is even more grim – exceptional items took away £690m of cash cumulatively from £77m of cumulative FCF, resulting in a large negative FCF of £611m.

The exceptional items come from restructuring initiatives, lease adjustments and M&A amongst others. Of these, at the least, the restructuring costs will likely

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Travel & Tourism SECTOR NOTE continue given the ongoing restructuring of the business in the UK and other geographies such as France and North America. There is a possibility that the business review of the new management which is expected to be completed by Spring 2013 may alter the course of business and involve more restructurings than currently announced. While the restructurings in the UK are expected to bring about £140m of savings annually post 2014, part of these will be offset by reduced operating profit (£20m) and additional financing charges (£3m) because of disposals of HCV and India operations and sale and leaseback arrangements related to aircraft.

Trend of Reducing Capacity across UK and Europe The overall trend of reducing capacities will impact the earnings growth of the business even more significantly than the disposals. TCG has reduced capacity in every year since 2007-08 in all geographies except for Northern Europe. For this reason, the cost savings may prove to be only sufficient to balance the reduced operating profit because of industry, structural and issues specific to TCG but not to provide any material upside to the earnings.

Limited Exposure to Emerging Markets Growth in outbound travel from emerging markets is expected to be much higher than that from the developed markets. However, post disposal of India operations, TCG also lacks exposure to emerging markets which would have been able to add some growth to the earnings. In the light of relatively stagnant industry, economic issues faced by the consumers in Europe, structural issues with the industry, threat of online portals and TCG’s internal issues, the earnings are not expected to grow in the short to mid-term horizon.

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Travel & Tourism SECTOR NOTE

Liquidity and capital structure issues At the end of November 2012, TCG management was forced to negotiate emergency credit facility due to liquidity crunch. As per management, the crisis arose because of changed booking pattern and subsequent lock up in the working capital. Although management is taking various steps to improve the health of business, the acquisitions of Co-op in UK and Russian operations have further added to the seasonal swings as per interim statement for H1FY12 where outflow due to working capital deteriorated by £231m over the last year. For 3QFY12, the company did see £400m of positive working capital coming through – an improvement of £60m over the prior year, however these gains did not translate into material increase in CFO which, at £386m was only up by £15m y-o-y. At the end of 3QFY12, TCG had net debt of £1,099m (up by c. £100m) and total liquidity (cash + revolving credit facilities) of about £1,010m (up by c. £110m).

The management has also negotiated with the creditors to do away with any fixed repayments in 2013 and 2014 to retain the proceeds from asset disposals instead of being applied for debt repayment. The cautious stand of management to keep all the

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Travel & Tourism SECTOR NOTE proceeds from disposals/divestments (except for proceeds from sale of India operations of £87m which will be used to repay the credit facility), rather than repaying debt does show cautious stance of the management. These steps including others such as suspending dividends and acquisitions (for a company that has historically grown through acquisitions) till the Balance Sheet can support it, show management’s eagerness to avoid being cornered in another situation like this at any cost. Even the covenants governing the credit facility have been relaxed displaying the confidence of creditors in the management’s actions. Given these actions, under normal circumstances, the chance that TCG will suffer another liquidity crunch of the scale of 1HFY12 are limited.

Management focus Over the past year, the management’s failure in number of areas is evident. Firstly, being required to negotiate for additional facility within just a month of negotiating the £100m facility shows the extent to which the management was not able to anticipate the trends in the business. The acquisition of Co-op can similarly be criticised – at the time when the industry momentum is moving towards online bookings, the investment in the traditional retail distribution may not give best returns. Nonetheless, TCG appointed a new CEO and CFO in May 2012 who are undertaking thorough review of the business and have increased the estimated cost saving targets from the initial estimates. TCG has also changed management in France and Russia, its other underperforming regions and hopes that new management will get the business back on track for profitability and growth.

Behind competition on a number of parameters TCG group has historically lagged its closest competitor TUI Travel across a number of operating benchmarks and is playing the catch up in management’s own admission. TUI Travel pursued the business in right direction in terms of offering more differentiated packages which have higher margins than the commodity packages, more exclusive tie-ups or having higher proportion of low risk A&D business or more online bookings. Mired in the internal issues, TCG lags behind TUI on all these benchmarks. Even the advanced booking trends for TUI have been ahead of TCG in most of the seasons enabling it to get better pricing than waiting for late season bookings. However, TCG does fare better on some selected parameters – it has been able to grow its top line faster than its peers and on an adjusted basis, the company has better operating margins than its peers. If the new management is able to control the exceptional costs better TCG’s attractiveness would certainly go up.

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Travel & Tourism SECTOR NOTE

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Credit analysis thomas cook