This report analyses the financial and non-financial performance of Thomas Cook in the 2011 financial year with a recommendation on whether One-World Investment Consortium should invest £150 million in the company. Thomas Cook is a leading leisure travel company but faced tough operating environment in 2011. The performance of the company is also analysed in light of the Chairman's statement because the statement highlights areas where the company needs to focus upon in the immediate future. The report also analyses company's budgetary control system as mentioned in the Chairman's statement to make recommendations on possible actions that can be taken to improve performance of the company.
Company profile
Thomas Cook is one of the world's leading leisure travel companies. The company operates in 22 countries and had 23.6 million customers in 2011 (Thomas Cook business segments, 2012). The company has a number of leading travel brands that occupy top positions in their respective categories.
The products/services of the company can be classified into two main categories - Mainstream and Independent. Mainstream includes charter packages where various products are bundled together for sale as a single product and it includes retail foreign exchange. As the different components of a package are owned by the company, Mainstream bookings are recognised on a gross transaction basis. Independent segment allows individuals to design their individual packages and includes financial services excluding retail foreign exchange. Revenue is mostly recognised on commission basis in the Independent segment. The products are distributed through retail, online, call centres and third parties. The strategy of the company is to maximise value from the Mainstream business segment and leverage its scale by building a leading position in the Independent travel business segment (Thomas Cook about us, 2012).
The revenues and net loss for the financial year to 31 December 2011 were £9,809 million and £521 million respectively. However, the underlying profit for the period was £303 million. The company operates in six geographic segments. The percent shares of revenue and profit from operations of each geographic segment are shown in chart 1. UK, Ireland, India and Middle East geographic segment contributed highest in terms of revenue. However, it was the Northern Europe region that accounted for the highest share in profit from operations.
Chart 1 - Percent share in revenues and profit from operations
(Source: Thomas Cook business segments, 2012)
Analysis of financial and non-financial performance
Profitability
Thomas Cook recorded a 10% increase in sales in 2011 which is a strong achievement given the economic and political environments in its markets. Chart 2 shows the percent change in sales in different geographies in 2011. Thomas Cook reaped the benefits of diversification as low growth in the UK segment was compensated by high growths in other regions.
Chart 2 - Percent changes in revenue in 2011
The growth in sales was at the expense of gross margins which declined from 24% in 2010 to 22% in 2011. However, the company managed to keep its operating margin constant in both years at 2.8% implying that the management took steps to keep operating costs under control in 2011. Thomas Cook reduced its operating costs by 2% of sales, the difference between the gross margins in 2010 and 2011. One of the main factors in reducing operating costs was personnel expense which declined from 12% in 2010 to 11% of costs in 2011. This is also reflected in 9% increase in sales per employee in 2011. The reduction in operating costs was in line with one of the main areas of focus as mentioned in the Chairman's statement in the 2011 annual report of the company (Thomas Cook, 2012 p. 2). The economic climate in developed countries is unlikely to improve in the short term and competition is going to be severe as customers' travel budgets are impacted by high unemployment and lower income. Hence, reduction in costs is likely to be key to improving profits in the near future.
Chart 3 shows profit margins. The EBITDA margin declined in 2009 to 4.8% from 5.7% in the previous year and has remained constant at that in the last two years. The EBITDA of the company increased 10% to £475 million in 2011 which shows the strong resilience of the Thomas Cook brand name. However, the net income margin declined sharply in 2011 due to high impairments of intangible assets.
Chart 3 - Profit margins
Among regions, the revenues of the Northern Europe are one-third of the UK, Ireland, India and Middle East but its profits are three times higher. This implies that the profitability of the Northern Europe was nine times that of the UK, Ireland, India & Middle East region.
Liquidity
Chart 4 shows the current ratios of the company (refer appendix I for details). The current ratio was less than 50% in 2011, that is, the current assets covered less than half of the current liabilities. It implies a weak short-term liquidity position from creditors' perspective.
Chart 4 - Liquidity ratios
Gearing
Chart 5 shows the total debt to total assets ratio of the company (refer appendix II for details). The ratio increased sharply in 2008 and remained at around that level since then. 18.4% ratio in 2011 implies that less than one-fifths of total assets of the company were financed by debt, which is not a high ratio.
Chart 5
However, the total debt to total equity of the company increased sharply over the years (refer chart 6). The ratio was more than 103% in 2011, a sharp increase from 23% in 2007 because of increase in debt and decline in equity over years. The underperformance in the UK and political tensions in the Middle East were main reasons behind the poor performance by the company and hence, an increase of loan facility by £200 million in December 2011 (Thomas Cook, 2011 p. 2). The increasing debt to equity ratio implies two things. Firstly, the company is funding higher proportion of its assets through liabilities. Secondly, it raises bankruptcy concerns as the equity has declined over years. The Chairman's statement also mentions that the company should focus on strengthening its balance sheet.
Chart 6
Dividend
The Chairman's statement indicates the focus on cash management for improving the financial strength of the company. The statement mentions the stoppage of dividend payments for the time being till the financial strength of the company is restored. This is a major corporate finance decision as investors analyse dividend announcements for their signalling effect. Empirical studies have shown that reduction in dividend is met with negative share price reactions (Neale and McElroy, 2004 p. 357).
Also, the Pecking order theory suggests that companies prefer internally generated cash over external finances for capital investment (Myers, 1993 p. 7). The management of Thomas Cook wants to retain internally generated cash to reduce debt or spend it on capital expenditure rather than distributing it to shareholders and borrowing.
Overall, the profitability of the company remained stable in terms of operating profit margin but net profit margins declined due to high write-off of intangible amounts. The major concern is regarding the short and long-term financial strength of the company. Gearing ratios have increased sharply due to a reduction in equity and an increase in debt in 2011.
Budgetary control systems
The Chairman's statement raises some key issues that are related to the budgetary control system in an organisation. The Chairman's statement mentioned that the performance of the management of Thomas Cook fell short of the expected standards. It indicates that the management of the company did not perform as per the budget at the beginning of the 2011 financial year. A budget is an important document for planning and controlling activities of an organisation as it involves measuring actual performance against the budget (Greenwood, 2002, p. 153). The variance between the expected and actual results of the company was probably high for the Chairman statement to include underperformance in the annual report. Proper variance analysis can throw light on factors that resulted in poor than expected performance (Hobbs, 1964 p. 905).
The fact that performance was substantially different across regions was also highlighted in the Chairman's report as it was said that the company can benefit from sharing of best practices across the Group. It indicates that budgetary discussions are held between senior management and individual regions at a time.
The Chairman's statement also mentioned that the company should implement 'proper pay for proper performance'. Budgetary control systems are useful tools in analysing and rewarding performances of employees. However, if performance incentives are not properly defined, budget based performance rewards can increase short-term focus over long-term goals of the company. Budgeting can also result in managers putting their interests before that of the organisation (Warren et al., 2009 p. 230).
Recommendations
Thomas Cook has a strong brand and has managed to increase its EBITDA in 2011 in spite of tough operating and economic climates in its markets. The company also has a strong infrastructure in terms of retail outlets, aircrafts and multiple-channel presence. Leisure travel businesses do well when economy improves and Thomas Cook can leverage its top brands to improve its profits.
However, the main issue with the company is its balance sheet. Increasing debts and reduction in equity has caused major concerns about the long-term viability of the business in the current form. The uncertain economic condition also does not help the company. The company was cash positive before financing in 2011 which is good point from an equity investor's perspective. The management has also made progress in terms of improving operations and meeting its strategic objectives. These are positive signs and their potential impact on profits could be substantial when economy improves.
It is recommended that One-World Consortium should explore the proposed investment of £150 million in depth. The Consortium should also engage the management of the company with a view of making changes in a number of areas. Firstly, Thomas Cook can improve its budgeting process. Discussions across divisions at the time of budget preparations can help in sharing of good management practices. The company should encourage higher participation of employees in budget preparation. Additionally, pay packages of senior management should be designed in a way to reflect higher correlation to the performance of the company as opposed to individual divisions. This would result in better sharing of management practices as underperformance in one division will negatively impact bonuses in other divisions also.
Secondly, the UK, Ireland, India & Middle East geographic segment is the largest in terms of revenue but has the lowest profitability in terms of margins. Thomas Cook needs to focus on this segment as percent gains in profit margins in these markets will result in highest absolute increase in profits of the company. The underlying profit from operations from the UK, Ireland, India & Middle East region in the financial year 2011 were £73.4 million lower than the previous year and therefore, there is substantial potential to increase the current profitability of this region. UK operations should look at management practices, pricing of products and distribution channel mix of other regions to analyse factors that could result in higher profitability. However, the differences in demographics, economic environment and competition across regions should be taken into account when comparing performances across geographies. Economies in Northern Europe have suffered less as compared to those in the UK, Ireland and Middle East. Exchange rate movements in GBP and Euro should also be analysed for the year 2011 to understand the differences in operating performance in the UK and Europe.
Thirdly, the company should explore reducing the number of retail outlets. This will reduce fixed expenses of the company. It will also improve cash generation and help in reducing debt and bankruptcy concerns.
Conclusion
It is recommended that One-World Consortium should analyse the proposed investment of £150 million in depth because of Thomas Cook's brand name, strong network and potential from gains when economy improves in the future. The Consortium should also engage the board of the company to improve its budgetary control systems in terms of timely variance analysis and better alignment of pay and performance. The substantial differences in profitability also shows that the UK business segment can benefit from applying some of the better sales and cost management practices adopted by other regions such as Northern Europe.
Part 2 - Investment appraisal
Introduction
A number of capital investment appraisal methods are used to evaluate the financial feasibility of long-term investments. The methods differ in their approach and use different criteria to evaluate investments and therefore, are useful in gaining a perspective from multiple angles. This report analyses four investment appraisal methods - payback period, accounting rate of return (ARR), net present value (NPV) and internal rate of return (IRR) - for evaluating long-term investments. The advantages and disadvantages of each method along with its applications are reviewed.
Payback period
This method calculates the time required to recover the initial investment from its associated operating cash flows (Jiambalvo, 2010, p. 334). For an investment to be superior over another under this method, the time required to recoup initial investment should be shorter (Armstrong, 2006, p. 427). The payback period as calculated as below.
Payback period = (n-1) years + (-Cumulative net cash flow outstanding at the end of (n-1)th year/Net cash flows in the year 'n'1)
Where 'n' is the year in which cumulative cash flows turn positive for the first time.
The payback period method is useful for a quick analysis as it gives an idea about when will the company recover its investment. However, there are major limitations of this method. Firstly, the payback period ignores the time value of money as the future cash flows are not discounted in this method (Baker and Powell, 2005, p. 249). This is a major drawback as it does not take into account the risk associated with long-term cash flows. Secondly, the method can result in suggesting an investment that yields lower returns over another investment that gives higher returns. Hence, the payback period method is not recommended for evaluating long-term investments.
Accounting Rate of Return (ARR)
The Accounting Rate of Return is the ratio of the average annual profit over the life of an investment to the average investment (Armstrong, 2006, p. 429). This method, similar to the payback period method, is also relatively simple to calculate as it needs accounting projections only. However, the simplicity of this method is also the main reason behind its major limitations. Similar to the payback period approach, this method also does not take into account the time value of money (Baker and Baker, 2011, p. 179). For long-term investments this is a major drawback as cash flows over long term carry higher risks due to a number of reasons such as political, currency exchange rates and interest rates. Ignoring these risks, by not discounting the future cash flows is makes this method unsuitable for evaluating long-term investments. Additionally, the ARR as it can be calculated in a number of ways and this can create misunderstanding and miscommunication (Arnold, 2008, p. 132).
Net present value (NPV)
The method discounts the future cash flows of an investment by an appropriate rate that reflects the risks of those cash flows. This is better from long-term investments as discounting future cash flows will reflect the true profitability of an investment. It is also better when comparing two investments with different investment horizons. The discounting element of the NPV method makes it better than the payback period and ARR methods when evaluating long-term investments. The discount rate used to calculate the present value of the future cash flows can be adjusted for a number of factors such as political risks and interest rates.
However, the NPV method has disadvantages too. The major drawback of this method is that it takes effort to determine the cost of capital for discounting cash flows and even then its accuracy cannot be guaranteed. Discount rate depends upon a number of factors such as political risk and financial gearing, and hence subjective elements come into picture when determining a discount rate. Variations in discount rates can significantly impact the value of an investment. Also, additional work is required when comparing two long-term investments that use different amount of initial capital.
Internal rate of return (IRR)
This method is a variation of the approach used in the NPV method. The IRR method calculates the discount rate at which the NPV of an investment is zero. So rather than determining the discount rate, this method gives the discount rate that can be compared with the cost of capital of an investment for decision making. A project would add value it its IRR is higher than the cost of capital and vice-versa. The IRR approach is also useful for long-term investment analysis as the future cash flows are discounted.
As observed in case of the previous three methods, the IRR method has limitations too. The major limitation of this approach is that it can result in multiple IRRs for same set of cash flows when net cash flows change signs frequently during the life of a project (Besley and Brigham, 2008, p. 368). Multiple IRRs can make it difficult for the management of a company to decide. This method also does not show the value addition by a project and hence can result in incorrect decision when two projects differ substantially in their initial investments.
Conclusion
The above analysis shows that each method has certain advantages and disadvantages. The NPV and IRR methods are more suited for long-term investments because they discount the future cash flows by a rate that reflects the risks of those cash flows. Hence, these two methods should be preferred over the payback period and accounting rate of returns methods when evaluating long-term investments.
Appendix I - Liquidity ratios
Appendix II - Gearing ratios
