Thomas Cook SVA Model Case Study

This case study analyzes Thomas Cook's valuation using the Shareholder Value Added (SVA) model. It justifies the variables and proxies used, including growth rate, operating profit margins, capital investment, working capital, tax rate, and Weighted Average Cost of Capital (WACC). The study calculates Thomas Cook's intrinsic value and compares it to its market capitalization, exploring potential reasons for the discrepancy. A sensitivity analysis identifies operating margins and WACC as critical variables impacting the valuation. The analysis also suggests strategies for managing operating costs and optimizing the capital structure.

1. Justification of Variables & Proxies
In calculating Thomas Cook’s value through the SVA model, a number of key variables were
employed (Figure 1). A conservative growth rate of 5.3% was calculated over a 6 year period
(Figure 2). New challenges facing the UK airline industry may cast doubts as to how Thomas
Cook could maintain a growth rate of 5.3%, albeit a very modest growth rate. According to
the CEO of Thomas Cook - Sam Wiehagen, an innovative turnaround programme is to be
implemented, that promises to maintain steady sales growth over challenging times by
“refocusing product strategy, improving yield management and rationalising distribution...”
(Thomas Cook’s Annual Report, 2011, p. 8).
The reasoning behind the assumption that operating profit margins will remain constant at
2% (Figure 3) is hinged on the firm’s ambitious synergy plan that seeks to unlock a cost-
saving of £35m per annum. By joining seventy-one aircrafts within a common fleet, the firm
now commands stronger control over its activities and fuel purchases which leads to
incremental cost-savings of around £19m (Thomas Cook’s Annual Report, 2010). Plans are
already in motion to purchase catering and support services more efficiently, which will
deliver greater reduction in operating costs and in turn preserve a steady growth in operating
margins for the coming financial years.
A small incremental capital investment of 2.4% (Figure 4) is consistent with the firm’s recent
shift towards online operations (Topham, 2012), a move that warrants fewer capital
investments in the way of fixed assets.
A relatively low working capital investment of 6.2% is not unusual, particularly in the tour
operating industry (Figure 5). Demands for holidays are often dictated by yearly trends,
which gives rise to the ‘seasonality of cash-flow’ concept (Evans, Campbell, & Stonehouse,
2002). Simply put, sales peak during summer and weeks immediately following Christmas,
therefore routine injection of working capital to manage supply and demands are not always
a prerequisite.
A tax rate of 27% appears reasonable since UK corporation tax rate tend to remain fairly
static (Figure 7). According to the UK Budget Report, proposals are set for periodic cuts of
1% per annum for the next 3 years (HM-Treasury, 2012). Small cuts over prolonged periods
are unlikely to exhibit any material impact on the firm’s underlying value.
The WACC value of 12.8% was calculated through a number of key inputs (Figure 8). The
Capital Asset Pricing Model (CAPM) was employed to derive the cost of equity of 12.9%.
Thomas Cook’s beta (1.53), a key component in the CAPM, was obtained from the Financial
Times website as at 14th December 2012. Unlike other institutions, Financial Times
computes a company’s beta using a 5-year historical adjusted betas’ measured against
monthly observations of industry average. According to Graham and Dodsville, (2005) a
longer timeframe is particularly useful for stable companies like Thomas Cook, based on the
hypothesis that past performance will be a reliable indicator of future outcomes. Yet, the
impromptu resignation of the incumbent chairman - Manny Fontenla-Novoa, has exposed
Thomas Cook to unprecedented risk (Wearden, 2011). Significant shift in a firm’s risk profile
is unlikely to be recognised promptly by way of a historically derived beta. Similar caution is

also granted for the 4.5% risk-free rate (Debt Management Office, 2012). Critically speaking,
using the official 3-month government bond rate as a proxy for the risk-free rate is easier
said than done. It is only recently that Fitch, a leading credit-rating agency, issued a warning
to downgrade the UK’s triple ‘A’ ratings should debt levels remain high (Giles, 2012).
Stripping the country of its long-standing ratings would immediately raise the risk-factor of
bonds and compel the government to hike its interest rates. With Greece and Spain on the
verge of outright default (Alessi, 2012) and countries like the US - otherwise known to have a
fairly stable economy, in fears of further downgrade (Charlton, 2012), a true risk-free rate
appears more to be the figment of one’s imagination as opposed to reality. Similarly, the cost
of debt at 12.8% may also be of questionable origin. Due to the difficultly in tracing market
prices of each individual bond, an overall book value was obtained through the firm’s annual
report. In absence of any indication of interest rates, an implicit rate of 17.5% was thus
generated from total interest payments divided by debt liabilities (Figure 8).
2. Employment of SVA Model
With reference to Figure 9, Thomas Cook’s sales revenue of £9,808.9m (31st September
2011), was increased periodically by a growth rate of 5.3% over a 5 year planning horizon. A
2% operating margin was then applied to sales revenues to arrive at the firm’s operating
profits. To compute Thomas Cook’s operating cash-flows, a corporation tax rate of 27% was
charged and subsequent deductions of 2.4% in incremental capital investment and 6.2% in
working capital investment were made respectively. The present value of future cash-flows
was then approximated by discounting the firm’s operating cash-flows by 12.8% cost of
capital. The firm’s £183.11m residual value as at 6+ year was discounted twice, the first of
which determined the value at year 5, and then the value in present day terms. Adjustments
to £1,186.6m net present value were made by adding £391.5m marketable securities/cash
(Figure 6) and then subtracting £1,147.3m total debt to derive Thomas Cook’s intrinsic value
of £430.76m.
3. Comparative Analysis
Under the SVA model, the economic value of Thomas Cook was determined at £430.76m
whilst its market capitalisation equated to £160.04m (Figure 10). It is worth pointing out that
there may be a number of factors explaining the deficit of £270.72m. One such possibility
could be that share prices may not accurately reflect all relevant information to yield a fair
market value (Financial Times, 2011). Fama, (1970), in his Efficient Market Hypothesis
(EMH) champions the idea that the reliability of share prices will vary depending upon the
efficiency of the markets. In a weak-form market efficiency, a share prices will only reflect
past information pertaining to historical share price trends (Malkiel, 2003). If indeed,
conditions did mimic a weak-form efficiency, the market value of £160.04m may well lack
reliability. Under a strong-form market efficiency, the sum of £160.04m would present an
accurate reflection of the firm’s value, since it implies that share prices reflect all past,
present and insider information (Jarrett, 2010). However, some critics have refuted this
simplistic understanding. Kehneman and Tversky, (1973) purports that due to a range of

contributory factors including: “...overreaction, representative bias, information bias, and
other predictable human errors in reasoning and information processing” (p. 12) share prices
will always be prone to inaccuracies irrespective of the degree of market efficiency. In light of
the agency theory, absence of key data due to information asymmetry between Thomas
Cook’s management and its shareholders could potentially lead to ill-informed judgements
on corporate value (Adams, 1994). Consider the high-profile case of Facebook and its
flotation on the NASDAQ stock exchange. Share prices peaked £29 and swiftly plummeted
to £20 after it was exposed that Mark Zuckerberg deceived his shareholders by failing to
disclose Facebook’s struggle to achieve its optimistic growth forecasts (Levine & Stempel,
2012). Indeed the discrepancy between the two values may well be indicative of the binding
assumptions made under the SVA methodology. The model posits that sales will grow at
5.3% in ‘perpetuity’, an assumption clearly out of touch with the current economic reality and
perhaps over inflating the firm’s SVA valuation. Similarly, the view that WACC (12.8%) will
remain constant throughout the 5 year planning horizon undermines any subsequent
changes that are likely to materialise in the firm’s capital structure. In fact, since the balance
sheet date, Thomas Cook’s outstanding shares rose by 15.97m (Financial Times, 2012), a
shift that would, in all actuality, increase the firm’s cost of capital and consequently reduce its
approximated £430.76m value.
4. Sensitivity Analysis
Following a sensitivity analysis, we can deduce that Thomas Cook’s valuation of £430.76m
is most susceptible to subtle changes in the firm’s operating margins (2%). A negative
adjustment of 2% translates into a 315.6% loss in the firm’s underlying value (Figure 11).
The identification of the critical variable stresses the importance of devising strategies
consistent with managing the Thomas Cook’s operating expenditure. According to the
Annual Report, the firm’s operating costs are in large part, driven by the advertising and
marketing activities, accounting for £180.5m (Thomas Cook’s Annual Report, 2011, Note 4).
Using the recent merger between Thomas Cook and the Co-operative Firm as a pretext, it is
advisable that the newly unified firm operates under a single brand name. The rationale
behind this radical step is anchored on the premise that instead of investing copious amount
of money in separate marketing campaigns for the respective Thomas Cook and Co-
operative brands, the firm could now coordinate a single marketing campaign for a single
brand name, in turn optimising its investments and mitigating undue advertising costs.
Further, we find that WACC of 12.8% is only second to operating margins, as the critical
variable. An increase of 2% in the WACC rate results in a 41.8% decline in the firm’s overall
value (Figure 11). In line with the Pecking Order Theory, debt should be given precedent
over equity when reaching an optimal capital structure (Donaldson, 1961). Since the firm’s
cost of debt (12.8%) is cheaper than cost of equity (12.9%), logic would dictate that Thomas
Cook secures more bank loans to finance its long-term operations, ensuring that cost of
capital is kept to a minimum. Alternatively, the firm could perhaps raise additional finance
through bond markets. In the majority of cases, bond holders are willing to fix a more lenient
long-term interest rate compared to their banking counterparts (Tanaka, 2005).