Sector Screener: three travel & leisure shares with long-term appeal

After a ridiculously tough time for the travel and leisure industry, operating conditions are improving. In his first fortnightly sector column for interactive investor, Robert Stephens discusses the current situation and stocks to own for recovery.

The travel and leisure sector has experienced a tumultuous few years. Covid-19 decimated the industry, with travel restrictions and lockdowns prompting a sudden and prolonged collapse in demand for air travel, hotels and restaurants. Indeed, numerous companies within the sector experienced severe financial difficulties that, in some cases, forced them out of business.

Although Covid-related restrictions have subsequently eased in the UK and across the vast majority of the world, economic problems have continued to weigh on the sector. A period of rapid price rises meant UK inflation reached its highest level in 41 years last October, causing a cost-of-living crisis that has put severe pressure on household disposable incomes.

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Since inflation currently stands at more than four times the Bank of England’s 2% target, discretionary spending such as that focused on the travel and leisure sector could remain constrained, at least in the short run. Higher interest rates designed to cool rampant inflation may also negatively affect household spending levels as mortgage repayments increase.

A staple or discretionary item?

Although travel and leisure spending is classed as a discretionary item, some expenditures could prove to be more resilient than others. For example, consumers have historically been willing to cut back on trips to the cinema and eating out before they are willing to miss out on their annual, or biannual, holiday.

In fact, a recent study by KPMG showed that only 37% of UK consumers who are currently cutting back on their discretionary spending have reduced the amount they spend on holidays. This compares with 63% who are reducing the amount they spend on eating out, 54% that are spending less on clothing and 39% who are cutting back on food and drink shopping.

Since only some, but not all, consumers are reducing their discretionary expenditure in 2023, and while most of those who are cutting back on non-essential costs are maintaining the amount they spend on holidays, the prospects for airlines and hotels could prove to be more robust than their market valuations suggest.

Economic catalysts

While short-term prospects remain somewhat uncertain, the sector’s long-term performance is set to be catalysed by an improving economic outlook. Crucially, the Bank of England expects inflation to continue its recent decline, reaching just over 3% by mid-2024. This is likely to ease the cost-of-living crisis and provide households with greater capacity to spend on discretionary items.

Indeed, consumers have already started look to ahead to an improving financial outlook. Consumer confidence readings in the UK have increased in each of the past four months. Although by historical standards consumers remain relatively downbeat, they are currently more optimistic than they have been for 15 months. This bodes well for the economy and for cyclical industries like travel and leisure.

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While UK interest rates are now expected to reach around 5.5% in the coming months, versus a previous terminal forecast of 4.5%, an improvement in the rate of GDP growth is also widely anticipated. The International Monetary Fund (IMF), for example, recently upgraded its outlook for the UK economy to growth of 0.4% this year and 1% next year. With the unemployment rate currently below 4%, which is roughly the same as it was prior to the pandemic, consumer spending on discretionary items could realistically increase as the economy’s outlook improves.

Long-term investment potential

Despite an upbeat long-term outlook, shares in numerous companies operating within the travel and leisure sector still trade significantly below their pre-Covid levels.

For example, Premier Inn owner Whitbread (LSE:WTB), budget airline easyJet (LSE:EZJ) and British Airways owner International Consolidated Airlines Group SA (LSE:IAG) trade 20%, 62% and 63% below their market values from February 2020, respectively. This is even after they have made gains of 25% (Whitbread), 22% (easyJet) and 16% (IAG) over the past six months.

Since their market valuations continue to include wide margins of safety that do not reflect the prospect of an improving operating environment, they offer long-term investment appeal.

Whitbread, for example, currently trades on a forward price/earnings (PE) ratio of 20 even after recently releasing a highly encouraging set of full-year results.

They showed the company returned to profitability, with adjusted pre-tax profits of £413 million versus a loss of £16 million in the prior year. Profitability was catalysed by sales growth and improved margins in spite of high levels of inflation.

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Indeed, the company’s competitive position has significantly improved since the start of the pandemic. Its solid financial standing, which is evidenced by a net cash position of £171 million, has allowed it to reinvest in its estate. By contrast, many independent and smaller competitors have struggled to remain in business because of the impact of the pandemic and the cost-of-living crisis.

The firm continues to invest in Germany, which has a highly fragmented budget hotel market where Whitbread could obtain a relatively dominant market position. With a £300 million share buyback programme being implemented at a time when its market valuation is at a low ebb, the company has a sound overall strategy that is set to catalyse its shares in an improving trading environment.

Airline opportunities

Airlines easyJet and IAG are also experiencing improved operating conditions that are not currently reflected in their share prices. IAG, for example, recently announced a first-quarter operating profit after three years of losses. It also said full-year profits should be greater than the top end of its previous guidance.

Despite this, it trades on a forward PE ratio of around 7. This suggests investors have not factored in its potential to deliver a fast-growing bottom line, as rising demand and lower fuel prices have a positive impact on its financial performance. And with €15 billion of liquidity currently available, it has the financial means to overcome potential short-term difficulties as the world economy emerges from its present period of uncertainty.

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The company expects capacity for the current year to reach around 97% of pre-Covid levels. It has also strengthened its competitive position over recent months, with its loyalty programme gaining 1.2 million members during the first quarter. This represents a 50% increase on pre-Covid membership growth rates and could further differentiate its offering from rivals over the long run.

Sector peer easyJet also trades at a discount to its intrinsic value. Its forward PE ratio of 12 does not reflect the improving trading conditions it flagged in its latest half-year results. For example, passenger numbers increased by 41% versus the same period of the prior year and the company’s load factor was 10.2 percentage points higher at 87.5%.

It expects revenue per seat to increase by 20% in the current quarter of the year, while 73% of third-quarter bookings have already been made. Meanwhile, it continues to make progress in increasing ancillary revenue, such as via seat selection costs, and growing its holidays business, which is expected to be profitable in the current financial year.

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With net debt of just £0.2 billion, easyJet is in a strong position to ride out short-term economic and industry-related volatility. It is also well placed, alongside IAG and Whitbread, to capitalise on an improving economic outlook that, after several exceptionally tough years, is set to catalyse the performance of the travel and leisure industry.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.