As good as Tui gets

It may seem odd that, while the world has been sinking deeper into an economic mire, Tui Travel, along with other holidays operators, has been enjoying a spell in the sun. A combination of cost cutting and reductions in the volume of package tours on offer mean that profits have been on the rise. But while these beneficial factors will continue to be evident for some while, it increasingly looks as if the stock market already knows the good news. In turn, that could means investors start paying increasing attention to the likelihood of a weak winter season and the uncertain outlook for demand next summer.

What's more, shares in Tui Travel, which is the sector giant, are trading at a clear premium to those of its big rival, Thomas Cook. That's because there is a share overhang at Cook caused by the failure of its majority shareholder. However, Tui's biggest shareholder has its own financial problems and, as the issues at Thomas Cook get closer to being resolved, investors in the sector may be tempted to switch out of Tui's shares into lowly-rated Thomas Cook.

Tui's results for the third quarter to end June underlined the factors that have been going right for the company. Even though European consumers are not booking holidays until closer to their departure date, holidays are still being sold. In fact, while economic strains means bookings have fallen, this drop has been outpaced by Tui's own reduction in the number of holidays it offers. The success of this capacity reduction has been helped by similar action by Thomas Cook, and the collapse of rivals such as XL Travel. Stockbroker Charles Stanley estimates that about a quarter of the European package holiday market's capacity has disappeared over the past two years.

Capacity cuts have supported profit margins because they mean fewer last-minute deals, which are often sold at a loss. But investors may view further capacity cuts less favourably, by focusing on their potential to limit growth in profits.

Besides, the question of the further cuts could become increasingly pertinent during the months ahead, because winter bookings are expected to be weak. The worry is that consumers will prove much more willing to sacrifice their winter holiday than their main summer break. And, with unemployment continuing to rise, summer 2010 is likely to start playing on investors minds. That said, the signs of economic recovery now coming from France and Germany should help sentiment.

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The other big positive factor for Tui is the cost savings it has achieved since its merger with First Choice in 2007. Charles Stanley expects savings of £115m for the financial year to the end of September followed by savings of £180m next year before yearly savings plateau at £200m. However, as Tui gets further down this particular road the chances of further positive surprises diminish.

The fate of a large stake in Tui's rival, Thomas Cook, could also create issues. Thomas Cook's 53 per cent shareholder, Arcandor, has become insolvent, leading to speculation about the future of this holding. Currently, the best guess is that the shares will be placed with institutional investors during the remainder of the year.

The overhang of Arcandor's holding in Thomas Cook is the obvious explanation for the gap in the share rating of Cook and Tui. Based on forecasts from stockbroker Evolution Securities, Cook's shares are rated at 9 times this year’s earnings and 8 times those to the end of September 2010 whereas Tui's are rated at 10 times and 9 times the same year ends. The concern is that, as the Thomas Cook issue is resolved, investors could be tempted to switch out of Tui's shares and into Thomas Cook's.

Besides, other issues involving Tui's 52 per cent owner, Tui AG of Germany, make the switch more likely. Tui AG may need to find €180m (£150m) to fund a rescue package for the container shipping company, Hapag-Lloyd, in which it has a 43 per cent stake. This has prompted speculation about the future of Tui AG's stake in Tui Travel and that a major source of Tui's finance, a €1bn loan from Tui AG, may not be renewed when it matures in January 2011.