15th December 2011
The collapse in the share price of Thomas Cook (TCG) at the end of November, which followed the travel operator's announcement it was talking to its banks about increasing its borrowings, provides an illuminating illustration of the potential dangers of a company taking on debt.
In common with many businesses, Thomas Cook has picked its year-end to fall at a time when it has the most cash and least debt on its balance sheet, thereby making its accounts look as favourable as possible. However, because it is an extremely seasonal business, anyone analysing the company as a potential investment has to be especially careful.
They cannot simply run a quant screen and decide if Thomas Cook is a cheap investment because of how its balance sheet looks at the point its accounts are published – instead, they have to understand how the company trades throughout the year.
First, it is important to realise a fair amount of the cash on the balance sheet is not actually Thomas Cook's but deposits paid by customers ahead of their holidays so, when adjusted for that, the balance sheet looks weaker. If you then adjust away from the year-end to average debt, the balance sheet looks less impressive still.
However, there will of course be periods when the debt is a lot more than average. The times the debt level spikes highest are when the cash coming into Thomas Cook is at its lowest but the company is paying out money, booking hotel rooms and so forth. As such, it is important for businesses such as Thomas Cook to have banking facilities in place that can cope with these peak points.
In normal years, the money paid out would be recouped as more holidays are sold and more deposits are paid. This year, however, factors such as a beleaguered consumer and the unrest across the Middle East meant that, once the debt had peaked, it did not come down as much as it usually would and Thomas Cook was forced to talk to its banks about additional funding.
When it initially asked for an extra £100m loan facility, many analysts were surprised by the comparative leniency of the terms imposed by the banks but the same certainly cannot be said for when the company asked for a further extension.
Hearing from Thomas Cook twice in a month made the banks a lot more nervous and the resulting £200m facility came with far more onerous conditions. In addition to a large fee, the interest on the loan rose from a 2.75% premium to base rates to a 5% premium, with an additional increase of 0.5% each quarter, while another condition granted the banks the right to take a 4.9% stake in the company at any time over the next three-and-a-half years.
None of this is to pass comment on whether Thomas Cook is a good or a bad business or whether it has been well or badly managed but, for the value investor, the story has two morals that are actually different sides of the same coin.
First, investors need to understand the shape of a balance sheet, how it trades through the year and where it peaks because, ultimately, debt comes home to roost. Things may tick along for a while but it reduces a company's margin of safety and so small deteriorations or unforeseen events, such as the Arab Spring, means equity holders are no longer in the driving seat – the banks are.
That leads to the second moral – when the balance of power shifts in favour of the banks, the terms of any borrowing can change very significantly so any new lending the banks are making should be extremely profitable. Bad news for companies in the position Thomas Cook finds itself tends to mean good news for banks.
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