Description

 “One property, Two property, Four Property, Eight Property……………” my favourite investment strategy for companies in the long-lived asset space: hotels, hospitals, ships, property, casino’s etc.

Now many of you already know that these fast growing companies typically trade on ratings that make cowboys cry. But, watch out!!! The real tears are usually shed when these “expensive” companies become multi-baggers and you look like an idiot for walking away because the “PE was too high”.

After leaving one too many of these multi-bags on the table I have come to realise that if you want the multi-bagger you need to put valuation on the back burner and focus all your effort on the growth vector. [I wrote up ERET on VIC, it was cheap, but, had no growth. While I think I will eventually make money on the trade I would have been much better off going for more expensive companies with strong growth vectors.]

Anyway, enough about my coal-miners route to investing in long lived assets as the company in this write-up is not expensive (actualy, it is cheap) even though it has a very strong growth vector.

The company is EasyHotels (EZH LN) listed in London. EasyHotels will report 1H2015 earnings on June 3, 2015. This earnings report will be impressive as EasyHotels had an inventory of 65,000 room nights for sale versus only 28,000 room nights in the 2014 base. I am hoping that this announcement will boost the share price in the short term, but, my longer term investment goal is a multi-bagger.

Business Description

EasyHotels is 56% owned by the EasyGroup, owner of EasyJet. EasyJet is a budget airline which flies over 60mil passengers a year. A powerful brand has been built from this broad exposure and the “easy” brand and values are very well known in Europe and beyond.

EasyHotel opened it’s first hotel in London in 2005. The initial strategy focused on franchising hotels, but, following the successful launch of their first owned Hotel (Old Street London) in Dec2013 EasyHotel changed their strategy.

The goal of the new strategy is to open “owned” hotels in European gateway cities (already identified 150 locations) and to continue with franchised hotels outside Europe.

To fund the “owned” hotels, EasyHotels listed on the LSE in June2014 raising GBP24.1mil after placing 31.5mil shares at 80p each.

Today EasyHotel operates three owned hotels (390 rooms) and 18 franchised hotels with 1,448 rooms.

The Super Budget Hotel Business Model (15% unlevered ROI)

We have a direct relationship with our customers and provide them with a “clean, comfortable and safe” hotel room at the “best branded room rate in town”, encouraging repeat custom and driving high occupancies.

Let’s cut out the MBA mumbo jumbo and follow the money. The EasyHotel in Old Street, London advertise rooms for GBP33 per night. The HolidayInn Express in Old Street charges GBP196 per night and the closest Travel Lodge will cost between GBP140 and GBP200 per night. To share a room with strangers in a London hostel/backpackers will set you back GBP50 per night.

http://www.tripadvisor.co.za/Hotels-g186338-London_England-Hotels.html

Clearly, EasyHotel is one of the cheapest places to stay and because it is a brand you pretty much know what you are going to get. No nasty surprises.

Now, the main reason I find EasyHotels so attractive is that management are obsessed with a 15% unlevered return on invested capital. When it comes to companies with long lived assets I am very wary of the “return on ego” risk so the constant reference to “return on capital” targets is reassuring.  Also, to make things even more attractive EasyHotel has expressed a willingness to gear (3 times debt/ebitda) and it is not unrealistic to predict an ROE above 25%.

 To achieve these returns EasyHotels employ the following strategies

• ·         Covert office buildings into hotels. To maximize the number of rooms the rooms are very small (10m2 vs the 20m2 industry norm) and many rooms do not have windows (inside facing rooms).
• ·         Don’t use intermediaries (travel agents/web based aggregators) to book rooms. Saves 15% commission. Rely on the power of the “easy” brand to take bookings through the EasyHotel website.
• ·         Minimize fixed costs. Only need 5 staff to man hotel 365 days a year. Variable costs (eg cleaning) are outsourced and limited. To have room cleaned everyday guests must pay extra.
• ·         Strong brand limits need for marketing, mostly pay-per-click advertising.

What impresses me about the strategy is management’s view of the super-budget hotel space. While management acknowledge that the hotel industry is very competitive they believe that EasyHotel has no competition in the super-budget space as they are the only competitor with a brand. Further, they believe that the “easy” brand is an effective barrier to entry as their competitors can’t afford to spend money on marketing or building a brand.

Valuation

I will calculate a SOTP value for 

• ·         The 18 franchised hotels (1448 rooms)
• ·         3 owned hotels (390 rooms)

Franchise Value

Revenue              GBP1.3mil                                                                                                                                      

PBT                     GBP1.0mil

Franchise agreements with the hotels typically run for 20 years and involve a mix of fees for royalties and reservations, as well as a marketing fee which is reinvested into advertising.

This is a very attractive income stream as it requires no capex. While I am sure I could get a fantastic price from the world’s central bankers, ex-Four Seasons investors or bond funds eagerly chasing negative yields, I will use a conservative cap rate of 8% to value the business at GBP12.5mil.   

Note, that my valuation ignores the potential to grow this business outside Europe even though EasyHotel receive a constant stream of applications to use the EasyHotel brand. 

 Owned Hotels

Details of the three owned hotels are shown below

Examining the table highlights the impressive increase in value for the established Old Street Hotel. Independent valuators valued the hotel at GBP18.65mil which is more than double the GBP8.2mil invested in this venture. My long thesis is a bet that this type of value accretion can be repeated. Buy office building, convert, stick up EasyHotel sign, value increases, rinse, repeat.

This uplift in value is not yet reflected in the Glasgow and Croyden assets as they are new and it is too early to accurately determine the earnings power of these hotels.

If these two hotels hit their return targets then it is fairly easy to estimate the potential increase in value. Original cost (R6mil) times by 15% and an industry cap rate of 7% and the value of the two hotels increases to GBP13mil. This increases the value of the owned hotels from GBP25.1mil to GBP31.65mil.

SOTP Valuation

Using an upper and lower limit value for the owned hotels implies that EZH should trade between 87p and 98p. Let’s average this out at 93p which is marginally above the current share price of 80p.

The 93p target price will allow an investor to make a small profit on an 80p investment. However, my experience tells me that there is a potential for a multi-bagger as EZH continues to roll-out new hotels.

The potential upside can be illustrated with a simple calculation which assumes that the GBP24mil cash balance is used to buy additional hotels yielding 15%. Using a cap rate of 7% more than doubles the GBP24mil investment to GBP52mil. This will add 43c to the current value raising the target price from 93p to 136p.

If a further GBP24mil of debt is used to buy more hotels the target price increases by a further 43c to 179p.

Bottom line, given the current balance sheet and gearing policy, EZH has the capacity to spend GBP48mil on hotels which will boost the intrinsic value of the share to 179p.

With a 150 potential locations the runway for the roll-out strategy is very long and the potential for a multi-bagger is a real possibility as EasyHotels pushes it’s brand into the super-budget hotel market.

The Growth Vector

At the beginning of this write-up I emphasised the importance of a strong growth vector if you want to make the big money in the long-lived asset space. It is clear to me that the current share price does not reflect the potential growth and I am hoping that the next two earnings announcements will motivate investors to start paying up for the growth.

The first earnings report will be published on June 3, 2015 and I am expecting a very impressive report as the room nights grew to 65,000 compared to only 28,000 in the base.

To help investors become more comfortable with the growth vector I include some of my workings showing the growth that can be expected for the year ended Sep 2015.

Growth in Room Inventory from 28,000 nights to 65,000 nights

The following timeline shows how the number of owned rooms has grown and predicts that revenue will grow by 183% for 1H2015 and by 78% for the year ended Sep 2015.

Gearing the Fixed Cost Base

My projected income statement for the year ended Sep2015 is shown below. The prediction shows an impressive 275% growth in EBIT which is much faster than the 78% growth in revenue. The faster growth in EBIT highlights the effect of adding income streams to a constant fixed cost base. The benefits from the economies of scale are especially visible in the early stages as the fixed costs are large in proportion to the revenue generated.

Risks

I am not very concerned about the downside as it is protected by the current real-world asset values.

My only real concern is that I don’t get the upside because management fail to identify new hotel opportunities which meet the return requirements.

I must say that I would rather stick needles in my eyes than stay in a 10m2 hotel room with no windows. To get more comfortable with the super-budget hotel space I have spent a lot of time reading reviews on tripadvisor and playing with booking engine on www.easyhotel.com. In general I have been impressed and have been encouraged by the strength of the room rates.

Monitoring these room rates is a good indicator of demand as EasyHotel manages these rates to fill the rooms. If rates start falling then I guess one could become concerned about the demand for windowless rooms. The funny thing is, because these rooms are cheaper, they are generally the first to be sold out so my concerns for the attractiveness of small windowless rooms seems to be groundless.

Conclusion

The ”Easy” Brand and it’s values are well known in Europe and beyond.

The power of the “easy” brand will help EasyHotels exploit the “super-budget” hotel space with an operating model which targets a 15% ROIC.

EZH currently only owns three hotels which they think they can replicate in 150 locations across Europe. This is a very long runway which you get for free at the current share price. Given the strong growth vector I am pretty sure EasyHotels is a multi-bagger even if we just get “three hotels, six hotels, twelve hotels”. Twenty four hotels……and you have a very serious winner.

Catalyst

Earnings report June3, 2015, expect strong growth in revenue and profit.