Monday, 3 December 2012

Update on Recommendations

Since its only been 4 months since I've started this exercise and I've only had 3 trade recommendations, any performance numbers are just as likely to be the result of flukes  as they are result of actual value-added research. However, it should be a good time to reassess my thinking behind the trade ideas and expectations going into these trades. After all this is a learning exercise.

Trades Summary:
HMIN Long (Closed): +36%
SVN/HTHT Long/Short (Closed): +15%
KBH Short (Open): +10%
Average Return for Long or Short recommendations: +20.3%
S&P 500 Return from July 27 to Dec 3: +4.1%
100% batting average means it can only go downhill from here.

Opportunities passed on:
DSX - wait and see (no trade)- +14%

Marvell Technology - No trade (didn't understand business): +18%

Trade 1: Long HMIN at $17.65 with a $33 target, unfortunately closed my recommendation on August 15th at $24.00 (+36%). Currently trading at $27.42 (+55%).
Expectation: Due to the seasonality of the hotel business HMIN's acquisition of Motel 168 did not add any value to earnings for Q4 2011 & Q1 2012. This resulted in an extremely cheap valuation of the business as a whole. At the time, it was trading at a 6.1x EV/EBITDA for 2012 (even with relatively weak expectations of 2012 EBITDA contribution from Motel 168). As per my expectations, after a positive earnings contribution from Motel 168 in Q2, markets valuation of the business improved drastically.
Error: Trying to time to market. After the stock was up +40% in a month I decided to close the trade, thinking about short-term macro headwinds. At the time I justified the decision because the decision for QE3 and European Debt deal were looming. Lesson learned!

Trade 2: Pair trade- Long SVN at $9.00 and Short HTHT at $14.73. SVN is awaiting board decision on proposed acquisition at $12.70 (+41%), closed at $12.00 (+33%); HTHT trading at $16.98 (+15%)
Expectation: Extreme relative valuation disparity. Although the trade was profitable and the proposed acquisition of SVN helped bump it's share price relatively quickly, it also hurt the long term profit potential  a) it limited the relative appreciation of SVN to the acquisition price, b)it  boosted HTHT share price - the market thinks if one hotel chain is cheap, the other must be as well. 

Since there is now limited upside for SVN due to acquisition price, I would recommend closing the pair trade.

This graph shows the opportunity missed for a longer term improvement in the relative valuation of SVN.

Even at the target price of $12.70 SVN days is valued at approx. RMB45,000/Room, which is a 25% discount from the price paid for Motel 168 (a business with a 13% EBITDA margin at the time, SVN's EBITDA margin is above 20%), 18% discount from HMIN currently, and 54% discount from HTHT. On a EV/EBITDA basis, the acquisition price yields a 6x multiple.

Overall, a good trade, SVN remains cheap, and currently my only holding as the acquisition price still represents a 10% upside and I'm hoping there might be a competing bid from somewhere.

Trade 3: Short KBH at $16.14, currently trading at $14.50 (+10%). 
Expectations: Either a miss in housing starts (nothing goes up in a straight line), or the lag of KBH's new orders relative to housing starts continues. One reason why KBH will continue to underperform the headline housing starts is that growth has been driven by multi-unit housing starts. Also, as shown in initial analysis, valuation remains stretched.

DSX: $6.54 No trade, Currently at $7.44 (+14%)
Expectations: As lucrative longer term contracts expire, the company will experience a meaningful hit to earnings over the next 6-12 months. Low shipping rates persist for the time being.
Possible Error?: Current shipping rates cannot persist indefinitely because the lifetime earnings potential of a ship is much lower than it's purchase price (approx. 50% lower). Eventually ship owners will stop buying new vessels. Therefore, it's only a matter of time before the supply/demand balance is restored, and ship values start trading close to their cost of production. However, I believe the short term headwinds facing DSX will dominate investor sentiment for the time being. This is really the opposite of what any long-term oriented value investor would have done. Nevertheless, I'm sticking to my original negative catalyst and will be hoping for a more attractive entry point! Lesson learned?

Sunday, 18 November 2012

Philip Fisher on Bonds

Philip Fisher is most famous for his stock picking ability, especially in growth companies; most of his book "Common Stocks and Uncommon Profits" is also on the subject of picking enterprises with long-term growth prospects. However, I find his views on debt/bond investing extremely interesting and they should be on every long term investor's mind.The following blurb is from the end of chapter 1:

"As already explained, our laws, and more importantly our accepted beliefs of what should be done in a depression, make one of two courses seem inevitable. Either business will remain good, in which event outstanding stocks will continue to out-perform bonds, or a significant recession will occur. If this happens, bonds should temporarily out-perform the best stocks, but a train of major deficit-producing actions will then be triggered that will cause another major decline in the true purchasing power of bond-type investments. It is almost certain that a depression will produce further major inflation; the extreme difficulty of determining when in such a disturbing period bonds should be sold makes me believe that securities of this type are, in our complex economy, primarily suited either to banks, insurance companies and other institutions that have dollar obligations to offset against them, or to individuals with short-term objectives. They do not provide for sufficient gain to the long-term investor to offset this probability of further depreciation in purchasing power."

Mind you these views were written in the late 1950's when inflation and interest rates were drastically different so lets note some fundamental changes that have happened since and see if his views still apply.

1. Central bankers, even of developed nations were yet to gain credibility on their ability to control inflation. Inflation has been under control for developed markets for the most part since early 1980's.

Although inflation levels are low despite the easing efforts of central bankers, bond yields are not providing much margin for real returns. Investors currently purchasing 10 year government securities are locking in 2% annual return and 0% real return at the current level of inflation. Obviously investors in such securities are still individuals with short-term objectives hoping for another short-term reduction in yields. The risk of higher inflation is obviously still real.

2. Some could argue that recessions have become longer or more severe, especially considering two decades of persistent deflation in Japan and the Great Recession of 2008.

This point is a bit tougher to address since I'm not an expert on the Japanese bust or an economist. I'm not sure of the role that fiscal and monetary policy decisions have played in the Japanese economy but it is clear that other major economies are not suffering from the same problems or policies. Growth has been positive in most developed and developing nations since 2009 with the exception of a few European economies. The credit expansion leading up to the 2008 burst has certainly made it tougher to re-inflate economies out of the slowdown. However even during these extremely tough conditions with many overhangs on individuals and businesses, growth has managed to crawl back to the positive range.

3. Austerity (fiscal restraint) is being considered in many European nations as an alternative method of dealing with recessions.

I suppose this is the one change that if it does start to receive broad support from central bankers, could nullify most of the factors that make bonds unattractive as long-term investments. Two key results of such policies would include 1) corporate profits will suffer from longer periods of negative profit growth, meaning the bust period of the business cycle will be longer 2) no persistent budget deficit that needs inflation, meaning if bond yields offer high enough yields, they could be realized as decent real returns.

Obviously even with persistent deflation or the adoption of austerity, a successful growth company will always outperform bonds; picking growth businesses in such an environment could be much tougher though.

Wednesday, 14 November 2012

Margin of Safety in a real life example - Marvell Technology

Many of us have heard the stories that Buffet can reach an investment decision after a 5 minute look at a company's business and financials. After trying to replicate this exercise tonight and spending an awful lot more time than 5 minutes I've learned a) why Buffet doesn't invest in technology companies b) I'm no Buffet.

Marvell Technologies has been a hot pick for many investors and fund managers of late and despite it's incredibly cheap valuation, it continues to get cheaper. David Einhorn, Joel Greenbalt, and David Dreman (one of the first investment books I read was by Mr. Dreman) are some of the investment managers disclosing new/additional positions in Q3 and the stock is down more than 20% from the lowest possible price they could have bought it for in Q3 - it's not a shabby place to be in when you can buy a stock for more than 20% (most likely 30%-40%) discount than some of the best investors of our time.

So what is the case for Marvell - luckily many others have done a great job of covering the opportunity on and

Will David Einhorn Buy Marvell Again As Price Drops Further?

Stocks Trading For Less Than David Einhorn Paid For Them

Let me summarize their analysis for you - 
MRVL Price: $7.38
Net Current Assets: $3.50 (using 50% inventory value, which is a small part of NCA anyways)
Price - Cash: $3.88
2011 Earnings - $0.99
Projected 2012 Earnings - $1.15-$1.25
Without getting too far ahead of ourselves with 2013 earnings estimates (which are higher than 2012). You are paying under 4x earnings. This should provide you with plenty of safety margin, right?
Cash is cash!
The management has been extremely aggressive in preserving SH value and returning cash to shareholders - share repurchases of 16% last year and a newly instilled dividend of roughly 25% of earnings. If even after these efforts the market doesn't want to treat cash as cash, well then you shouldn't have any problem sitting there and watching your EPS and dividends grow.

My Concern
Sadly, that is where the margin of safety ends, at least for me (someone that doesn't understand the semiconductor market).

Marvell is in the business of designing semiconductors and is not a manufacturer. Their future earnings are dependent on whether their intellectual property is still relevant in the market place. They have a pretty broad product line and their chips are used in devices for data storage, enterprise-class Ethernet data switching, Ethernet physical-layer transceivers, handheld cellular, Ethernet-based wireless networking, personal area networking, Ethernet-based PC connectivity, control plane communications controllers, video-image processing and power management solutions. HDD memory is one of their biggest end-use products and the industry is cyclical and has undergone significant consolidation in the manufacturer space. Western Digital and Toshiba are their two largest customers representing 23% and 10% of revenue respectively.

At this point, I have no knowledge of the HDD memory market - I don't have the answer to what differentiates Marvell's product from it's competitors, what threat substitute products pose to HDD memory, how the business cycle affects designers and manufacturers, how the supply chain of the industry interacts, what the long-run trend is for HDD memory, and endless other relevant questions.

And unfortunately my perceived margin of safety from a bargain valuation has disappeared. I could go with the layman's reasoning that Mr. Einhorn, Greenbalt, or Dreman must have done their homework, or the company has been consistently increasing revenues over the last decade and will continue to do so, or some rhetoric about the fact that even if the company's earnings fall by 50%, well you still have a stock trading at around 8x earnings. But the point of a margin of safety is so that you can sleep worry-free at night and until you fully understand a business, you will not (or should not) be able to do so!

So until I have the time to revisit and understand this industry, I will have to pass up on attractive valuations such as Marvell at $7.36.

Thursday, 1 November 2012

Buffet on EBITDA

From 2002 Berkshire Hathaway Annual Report
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.  Enron’s descriptions of certain transactions still baffle me.

Finally, be suspicious of companies that trumpet earnings projections and growth expectations.  Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).

Wednesday, 31 October 2012

KBH - From the doghouse to the penthouse (October 30 - $11.00 target)

KBH The Company:
KBH is a low-cost no frills US home builder operating in four geographic regions: West, Southwest, Central, and Southeast. The company focuses on first-time home buyers and their average home price as of Q3 12 is $245,000. KBH is not the lowest cost producers for the first-time buyer segment, the largest US home builders, DR Horton, wins that battle.

Over the last five years KBH, like many other US home builders has been scaling back its operations in order to return to a more efficient and sustainable level of business. Company revenues are down from 11billion in 2006 to it's current pace of 1.45billion in 2012. Number of communities have decreased from 42 to around 30 currently. The company has been in losses every year since 2007 however much of that has been due to inventory write-downs.

KBH's current strategy amidst a gruelingly slow housing recovery has been to 1) accumulate land, 2) strengthen its balance sheet, and 3) achieving profitability at the low pace of new housing

The Market:
US home building has undergone the worst slow down in decades. The level of the housing starts and duration of slowdown are unprecedented historically. Even the 35% increase in September over last year only brings the number to 872,000, which is still miles below historical levels.

The Bull Case Scenario for Housing

Homebuilding has been one of the best performing sectors over the last 12 months. Stocks have been boosted by future expectations. Strong growth rates in starts from exceptionally low levels, optimism over the broad US recovery, house prices bottoming, high home affordability, and attractive valuations at the end of 2011 have all contributed to the rise. 

In order to understand KBH's earning potential in a robust housing market; I've created a bullish housing market recovery scenario. Highlights of the scenario include:
  • Demographic need for housing of around 1.5 million
  • An increase in ownership rates creating a strong demand for housing over the next few years and completions running at 1.4m in 2013, 2.1m in 2014, and 1.9m in 2015, before stablizing at 1.5m.
  • An increase of 36% in home prices over the next 4 years. 
Graph below charts housing supply, demand, and vacancy. As seen from the graph, vacant housing has been rising considerable since 2006. According to the 2010 Census, vacancy rates stood at 11.4% in 2010 compared to 9.0% in 2000. A recovery in home prices will require absorption of the excess inventory built up.

I've tried to break-down the demand for housing into 1) actual demographic demand for housing 2) depletion of old stock 3) changes in home ownership rates. After peaking in 2004 at 69%, home ownership rates have been the biggest drag on housing demand. My steady-state home ownership rate assumption is 67.8% yielding a demographic+depletion need of around 1.5m homes, with a 1.05% growth rate.

Housing Assumptions Applied to KBH:
I've continued on with the bullish scenario and laid out further optimistic assumptions about the operations of KBH along with our optimistic home building scenario. Highlights of the KBH operations include:
  • KBH's market share increases from the present 0.86% of the US market, to 1.40% by 2016. Combined with the increase in home building; KBH's deliveries increase by 236% over the next 4 years.
  • Gross margin increases to 20% before stabilizing at 18% in 2016; currently at 16%.
  • Inventory to sales ratio decreases from 1.20 to 0.50.

Even with the bullish assumptions, we end up with a steady-state P/E ratio of 7.8x in 2016.

Valuation: $11.00 Target
Using the bullish US housing scenario combined with the bullish KBH scenario I arrive at a DCF value of $17.43, representing an 8% upside from the current price. This includes $2.84/share in deferred tax assets. I believe this is an extremely bullish scenario and even the biggest optimists on the U.S. housing market would probably have lower housing market estimates. In order to realize this value, we would need to assume       a) housing will definitely recover to a 1.5mil starts rate; b) KBH is able to turn around its shrinking market share which currently stands at around 0.9% - KBH's performance in new orders has been extremely sluggish and that was the main reason it was trading close to it's inventory value not 6 months ago. Not much has changed and new orders came in at +3.5% y/y last quarter, this is much lower than it's competitors and the rate of growth in housing starts.

KBH's current market share even with a fully recovered housing market yields a price of $10.89. Given that KBH has been decreasing its number of communities, currently around 30 down from 42 at it's peak, and has been struggling to increase new orders, currently growing at 3.5% vs. 25% growth rate of US housing starts; I believe this is a more realistic valuation.

Another method for valuation is looking at current inventories. Given that KBH has a 15% gross margin, a 15% premium to inventories could be treated a bottom price for the stock, which would yield $6.00 bottom price where you are paying nothing for the business. A more generous premium to inventories of 40% given the positive long-term outlook for the industry yields a price of $11.11.

  • Short-term housing boom such as one that occurred in the early 2000's. A surge in home building above 1.5million would make KBH seem extremely cheap and investors may overlook the fact that such levels are not sustainable in the long-run.
  • Strong US housing starts continue to push investor sentiment higher about US home builders. Even though our bullish scenario incorporates high housing starts growth, investors sentiment can always push valuations beyond their fundamentals.
  • KBH regains market share and US housing growth continues to surge. Although if only one of these events take place, target price of $11.00 still makes sense; however if both occur simultaneously the bull-case price target of $17.43 would be more realistic. 

Wednesday, 26 September 2012

Diana Shipping (DSX) - don't jump on board just yet

The Market:
Shipping is a complex industry with many moving parts. What makes it complex is that supply is inelastic in the short-run and takes years to increase or decrease, and the demand for ships (a commodity) is based on the demand for other commodities (iron ore, coal, grains).

To increase supply from the natural rate there needs to be excess ship building capacity, new inflow of capital to finance the ships, and the time period required to build ships and ship yards. Demand for ships is based on the need to transport goods, mainly raw materials, which is dependent on economic cycles, fixed asset investment, regional production and prices of commodities, trade agreements, local substitutes, and other factors. Given the complexity of the beast that is the shipping industry I will not try to forecast shipping rates but present the value of Diana Shippings vessels, where they stand relative to their historical prices, and what their fair value would be if current shipping rates persisted.

Anyone looking to invest in the shipping market should know that it is an industry with extremely inelastic demand; no one is going to ship more goods because shipping rates decreased, on the other hand if there is high enough demand for a commodity, producers will ship at extremely high rates to reap the benefits of high commodity prices. This creates an extremely volatile market which can be seen from the table below:

Yearly AveragesCapesizePanamax
2006         45,139       23,778
2007       116,049       56,815
2008       106,025       49,014
2009         42,656       19,295
2010         33,300       25,037
2011         15,713       13,943
2012           6,068         8,416
Y/Y Average Change
This is a table of the average prices throughout the year therefore it doesn't capture the full volatility in the market, however the volatile nature is still quite clear. In May 2008 Capesize vessels reached their peak rate of $230,000/day and crashed to $2,300/day later that year.
So how has Diana been able to maintain positive earnings and a balance sheet with a net cash position in a horrendous shipping market.
1) They entered into long term contracts during the 07-08 period and continued to do so at opportune times over the last few years as well. Currently Diana's average rate per day for Panamax vessels is $17,500 and for Capesize vessels is $36,000. This is at a time when the Baltic average rates in 2012 for Panamax and Capesize have been $8,400 and $6,000 respectively.
2) They did a massive share issuance in 2007 at peak valuation and paid down debt, deleveraging the business during a boom rather than waiting for the bust.

Stock Price  $6.54
Shares Outstanding                        81.4
Market Cap$532.4
Total Debt$417.3
Enterprise Value$498.1

Scrap value for the vessels                          $207.9

I've built 3 scenarios for looking at the value of Diana's vessels.

First one is simply based on ship values from the 2010 Maritime Report, 2011 report is not yet available, hence prices are a little stale. Provides an EV of $932 million.

Second is based on a DCF of vessel earnings using the average rates Diana charged for contracts entered in 2012, which were $11,000 for Panamax and $18,000 for Capesize. These rates are higher than the average daily rate in 2012 because a) Diana's vessels are young, average age of just over 6 years b) they were entered at the start of the year when shipping rates were higher c) these are long term contracts, therefore include future price expectations as well. Long term contracts entered in 2007 and 2008 were at rates much lower than the daily rate. This method yields a $467million EV. So even at rock bottom rates for the entire life of vessels, they still yield a value just 6% below current EV. At this valuation ships are being priced at almost a 50% discount from their 2003 prices and a 80% discount from their 2008 prices.

Last one is another DCF using Diana's current average daily rates. This yields a value of $830 million.

Scrap ValueValue based on Maritime Report DCF Value based on  2012 Rates  DCF Value based on  Average Rates
 EV  $       207,899,276  $       932,500,000  $         467,747,595  $          829,631,186 

The Concern:
As you can see from the valuation above, Diana and its ships are dirt cheap from a historical point of view. However the concern I have is about the number of lucrative long term contracts coming to an end over the next  6 months. 15 of the 28 vessels have their contracts expiring within the next 6 months and their average rates are $17,000 for Panamax and $45,000 for Capesize. This will surely have a huge impact on earnings unless there is near term rally in rates (remember 2012 average rates are $8,400 Panamax and $6,000 Capesize). Total Operating costs are also close to $9,000/vessel per day. Diana hasn't had to face a year or even a quarter of negative earnings post financial crisis and such a scenario will definitely test the nerves of its investors. 

It may be years before excess shipping capacity is absorbed by increased demand and if you had to pick a company to succeed in such a market, pick one with a strong balance sheet like Diana. Diana has plenty of cash lying around to make purchases if and when other companies fail to stay afloat. I would however watch from the sidelines until supply and demand settles into a more favorable range. Luckily for us, we can observes this easily with the daily Baltic rates.

I did not attempt to explain the effect of additional shipping capacity on rates and it probably would be a futile activity given the number of factors which have an impact on daily rates. However I assembled a few graphs to give the reader some idea of how shipping capacity has evolved over the last few years.

Demand for dry bulk products is predominantly controlled by China with influence from Japan, European countries, and other Pacific rim countries.

Thursday, 20 September 2012

Pair Trade (Long SVN $9, Short HTHT $14.73)

7 Days Group (SVN) and Chinga Lodging Group (HTHT), which operates as Hanting hotels, are both economy hotel chains growing rapidly in China. Below is a graph of the Enterprise Value/Room ratio of the two hotel chains. The point is to see the relative price you are paying per room when investing in the two chains. The average since May 2010 has been 0.69, meaning you can buy a room in the 7 Days Group chain at a 31% discount compared to an investment in Hanting. Currently the ratio stands at 0.39, meaning a 61% discount!
Reasons for the relative valuation
  • Within the economy hotel industry, HTHT is a premium brand whereas SVN is the thrift brand. In Q2 2012 the average daily rate for a HTHT room was 180RMB vs. 155RMB for SVN.
  • Profitability wise in 2011 SVN earned 7,665RMB/Room based on EBITDA margin and HTHT earned 6,900RMB/Room.
  • HTHT has a larger % of leased and operated hotels vs franchised hotels. (HTHT owns  48% hotels, whereas SVN owns 41% of its' total rooms)
  • Even though both brands are leaning more towards franchised growth, SVN has been following the strategy more aggressively.
  • HTHT delivered a strong Q2 whereas SVN had a relatively weak quarter.
  • HTHT is still smaller with 860 hotels vs 1,130 for SVN making growth easier and faster in the short run. Addition of 100 hotels has a much bigger impact of HTHT at the moment. 
  • These are relatively small cap, illiquid, Chinese equities, with not much mainstream interest creating short-term mispricing. 
I do not expect the relative ratio to reach parity due to some of the reasons stated above, and such a move would be an opportunity to enter the opposite trade. However, the current relative valuation of the two companies is extreme and should return closer to it's historical average of 0.69. A return to the historical average represents a 77% move in the ratio, meaning there is still significant upside potential.

In order for the EV/Room ratio to reach 0.69, SVN would be valued at $16.75, meaning 86% price appreciation from current levels of $9/sh. Or for HTHT to reach the 0.69 average, it would have to drop to $8.37 or a 43% decline from current price of $14.73/sh.

Will update the ratio every month, I'll also add some share price and market cap charts to make it easier to track the pairs performance.

Friday, 27 July 2012

Home Inns Hotels - Long Term Hold $17.65 July 27, 2012

Q2 Update - August 15, 2012
Without getting into too much detail, HMIN is on pace to meet my expectations of 1.171 billion RMB adjusted EBITDA. Motel 168 finally added positive EBITDA in the quarter adding approx. 17% of the total EBITDA for the quarter, still low considering they account for around 35% of the rooms. Occupancy for Motel 168 continues to improve the company achieved 80.8% in Q2; still much lower than HMINs 92.1% for the quarter but significant improvement from last quarter (70.4%) and same time last year (73%).

Even though my fair value price remains around $33 and my goal here isn't market timing, the stock itself is up over 40% in less than a month (36% from my previous post). Therefore, I think those who were able to catch this rally (not myself) should welcome it and book some profits. There is still significant uncertainty around all 3 key global regions: US, Europe, and Emerging Markets.
Overview: HMIN currently at $17.65 - long term hold - July 27, 2012
Currently based on my 2012 EBITDA estimate of around 1.171 billion RMB, HMIN is trading at a 6.1x EV/EBITDA multiple. Assuming 30% tax rate (historical average), that is still close to 11.5% cashflow return. This isn't a dirt cheap valuation, but there are a lot of positives HMIN has to offer. The company is in an attractive industry/geographic location, industry leadership position, first movers advantage in new cities they've entered and are still entering, recent deleveraging, strong cash flow generation, tangible competitive advantage of first-class locations, strong internal growth through new hotel openings, decreasing operating leverage through focusing on franchised growth, and long term plan to grow to 5,000 hotels by 2020. That may seem like a farfetched target, but that's less than 400 hotels/year, last year the company added 300 hotels internally and another 300 through acquisition.

Using a 10x 2012 EV/EBITDA multiple, I arrive at a price of $33.10. A 10x EBITDA multiple may seem high for a discretionary business, but given its growth and consistent historical performance I think it's reasonable. Also luxury hotel chains with much lower growth rates are trading at higher multiples.

Based on a DCF I arrive at a price of $32.82, with the following assumptions:
Reaching 5,000 hotels by 2020; zero growth thereafter
Final hotel mix of 30% leased & operated and 70% franchised
Maintaining current margins on a per room basis
2% RevPar growth starting in 2013
Discount rate of 15%

The biggest risk would be of default; does the company have strong enough of a balance sheet and cashflow generation to weather a China hard landing scenario?

At the time of their share issuance in May, the company had roughly 100million RMB of convertible bonds coming due in December 2012. The 500million RMB or so raised will be used to pay off the remainder of this issue and the subsequent issue coming due is in December 2015; so there is lots of time for refinancing.

In terms of CF required for opening new hotels; over the last 3 years the average cost/new hotel opened has been around $1million USD (2009 - 1.03m, 2010 - 0.91m, 2011 - 1.10m); it should be noted that costs increased in 2011 due to changes in safety regulations causing longer building periods. Having said that their CF from operations is sufficient to finance their new hotel openings going forward. This was not the case in the past when they were opening more company operated hotels vs. franchised and their CF generation was also smaller.

The two key overhangs on the stock are the broad China pessimism and execution in their Motel 168 business.

The Motel 168 business might not ever be as profitable as HMIN on a per room basis, however currently the acquisition has not been able to add anything to the earnings and this is clearly worrying some investors. At the time of the acquisition, management did expect a 12-18 month period to bring the operations up to speed and close to their 20% EBITDA margin target. Right now we are only 6 months into the acquisition, so the earnings boost might still take some time to materialize. In the last conference call, management did say that for the month of April, Motel 168 achieved 80% occupancy rate, significantly higher than 70% last quarter and 73% for full-year 2011; so progress is being made.

As for broad China pessimism, I don't think I can add any value in that discussion.

Home Inns & Hotels Management Inc. (NASDAQ: HMIN) is a leading economy hotel chain in China. As of March 31, 2011 the company operated 1479 hotels including 702 leased and operated hotels and 777 franchised hotels. Founded with 8 hotels in 2002, HMIN in now the leading economy hotel chain in China based on number of hotels, rooms, and geographical coverage. The company has grown over the last decade using a combination of company-operated hotels and franchised hotels and now has hotels in 174 cities across China, with Beijing and Shanghai being the most concentrated cities with 90 and 70 hotels respectively.

Recent Developments
In May 2011 the company also entered into an agreement to acquire the Motel 168 economy hotel chain with 295 total hotels for $470 million USD. The transaction was completed up in the third quarter of 2011 and HMIN will start reporting earnings from Motel 168 starting Q4 2011. To finance the transaction HMIN used $305 million cash and issued 8.15 million ordinary shares at a price of $40.37 to pay for the remaining $165 million. (Each Nasdaq traded ADS represents 2 ordinary shares)

Operating Overview
HMIN has two business models; company-operated hotels and franchised hotels. The company is responsible the operations and profits of the company-operated division; whereas for its franchised hotels, it simply earns a 5-8% royalty on the hotels revenues. Thus having a higher percentage of franchised hotels decreases its operating leverage and lowers earnings volatility.

Below is a summary of HMINs company-operated hotel rooms. Please note that margins increased in 10Q2, 10Q3, and 10Q4 due to Shanghai Expo.

As you can see, excluding Shanghai Expo in 2010, the revenue per room (RevPar) and margins per room are fairly stable. Which makes sense since HMIN isn't really a luxury hotel chain, the average price for a room is less than 180RMB or less than $30/night. There will obviously still be some cyclicality in the business as seen in late 2008 and early 2009, however maintaining a positive EBITDA during one of the worst financial crisis should be applauded for a discretionary company. Overall EBITDA margin for HMIN is around 23%-24% on an annualized basis, however due to the seasonality of the travel industry, margins range significantly from quarter to quarter.

Industry Overview
Chinese hotel industry is highly fragmented and competitive In terms of room rates, quality of accommodation, location, amenities, brand recognition, and geographic coverage. HMIN competes in the economy hotel segment and its two biggest competitors are 7 days and HanTing Hotels Management. HMIN is priced in the middle of the three companies and has the most number of hotels and is by far the most geographically diversified. HMIN also has the highest margins on a per room basis.

The graph below shows the Average Daily Rates (ADRs) and Occupancy Rates for the three hotel chains; the increase in 10Q2 and 10Q3 was due to the Shanghai Expo and should be treated as a onetime event.

Again, a fairly stable business excluding the seasonality of the travel industry.

What makes HMIN interesting: Investor sentiment surrounding the company ranges wildly from overly optimistic to overly pessimistic. The company trades closer to a Chinese internet company than an economy hotel chain.

The EV/EBITDA multiple has ranged from 4x to almost 15x over the last 5 years, and current trailing EV/EBITDA multiple is around 7.5x. However this might not give the full picture of the volatility surrounding the stock because of 2 reasons:
a) EBITDA was exceptionally high in 2010 due to Shanghai Expo and it doesn't reflect the true nature of speculation during a one time event.
b) EBITDA/Room is exceptionally low currently due to almost 0 contribution from Motel 168 rooms, which is roughly 36% of their total rooms

The graph below shows EV/Room. This is the price investors are willing to pay for a room and not including fluctuations in earnings due to cyclicality, seasonality, or one-time events. At it's peak valuation in November 2010, HMIN was valued at 170,000RMB/room, compared to 40,000RMB/room now.

EV (LHS) and EBITDA (RHS), this serves as a good example of expanding and contracting multiples with earnings staying relatively stable

Please feel free to comment below

Tuesday, 5 June 2012


Hello Everyone, I'm a passionate student of finance always looking to learn and apply the different investing principles. For starters, through this blog I hope to document some of the ideas highlighted in prominent investing books of our time and apply these ideas to the current markets. Therefore, this will also act as a journal of what my rationale and expectations were at the time of a recommendation, see what actually transpired, and then try to understand where the differences lie and find ways to improve.