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

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