The current price offers an attractive opportunity to acquire HMIN, the market leader in the fast growing economy lodging sector of China.  Not only does HMIN have the best financial performance metrics, but also it trades well below industry multiples and is attractive on an absolute basis.

Home Inn is the leading economy hotel chain in China.  The company started operations in 2002 and has grown rapidly to become the market leader.  As of March 31, 2011 it has 848 hotels with over 97 thousand rooms.

($ = US dollars, Rmb = Chinese yuan; Shares = ADS, each of which represents two ordinary)

The good

It is in China.  It benefits from a fast growing economy, and more specifically from the dynamic growth in the lodging segment.  Foreign investors also benefits from the appreciating currency.

Healthy growth prospects.  The lodging industry in China is very fragmented, with most economy lodging outlets being guesthouses and other small operations.  Over the last ten years, the economy hotel chain market has grown in excess of 50% per annum; albeit from a very small base.  Further, the penetration of economy chain hotels is a small fraction of that of more developed markets like the US.

Market leader.  HMIN is the largest economy hotel chain by revenue and by rooms.  After its acquisition of Motel168 it will be twice as large as each of its publicly traded peers.  While not a key differentiator, there are advantages that come with scale and that are currently manifest in better financial performance.

Industry-leading margins.  HMIN has been consistently profitable; none of its public peers have.  It achieves better operating margins, and importantly has a better cash flow profile.  In 2011, a big investment year for HMIN, HTHT, and SVN, only HMIN will see positive free cash flow (i.e., cash from ops - capex).  Taking this into consideration by adjusting the current trading multiples, HMIN is even more attractive.

Higher returns on invested capital.  HMIN has attained higher ROIC than its peers.  While the average historical absolute level is not extraordinary, the trend is encouraging and current levels are on par with worldwide heavyweights.  This trend is fueled by its fast growing franchising business.  ROIC (little book definition) has increased form less than 10% in 2008 to 35% in 2010.  Naturally, operating leverage and the positive effect of the 2010 Expo in Shanghai have benefited ROIC.

Fast growing franchising model; which reduces capital intensity (and increases ROIC).  The company and its peers are rapidly moving towards a franchising model.  This is very attractive as it allows for faster growth and reduces capital intensity (and correspondingly increases ROIC).  To give you some flavor, at the end of 2007 less that 27% of the company's hotels were franchised-and-managed, whereas as of 1q11 the proportion had increased to more than 46%.  The company's peers and Motel168 have a very similar mix.

Strong balance sheet (net cash $143 million as of 1q11) and negative working capital.

Accretive acquisition of Motel168 (expected to close 4q11).  Purchase price is $470 million ($305 cash + 8.15 million shares @$40.37).  To use cash on hand or $300 million credit facility.  Motel168 has 281 hotels (of which 137 franchised) with a total of 45,669 rooms (30-35% in Shanghai).  Motel168 had gross revenue of $262 million in 2010 (average exchange rate of Rmb6.77/US$ -current exchange rate 4.5% higher).  The purchase price is 1.8x 2010 revenues.  In comparison, HMIN and its peers trade above 3x, and international heavyweights like IHG and MAR above 4x.  Given Motel168's concentration in Shanghai, it is likely that 2011 revenue will be below 2010.  Nonetheless, the multiple seems advantageous.  On a per room basis, the multiple is also well below (~30% discount) the company's and its peers.

Large insider ownership (41% combined direct and indirect).  The company was founded by the, very successful serial entrepreneurs, co-founders of CTRP.  I would say the founders of this company are very impressive and have created substantial shareholder value.  First, CTRP is a $6.5 billion market cap company.  HMIN is a $1.75 billion market cap company.  HTHT, one of the company's competitors also founded by one of CTRP co-founders and the original CEO of the company, is a $1 billion market cap company.  Also, there are at lest two transactions that demonstrate a sharp focus on capturing value.  The first one is the opportunistic 18% stake acquired by CTRP during the 2008/2009 financial meltdown (roughly half in the open market, and half primary).  While value for this transaction did not fully accrue to the shareholders of HMIN, it is indicative of the value driven nature of the leadership of the founders.  The second, where valued did accrue to the shareholders of HMIN, is the repurchase of its convertible debt at a discount.

Very attractive acquisition candidate.  For someone like CHH, this would be The acquisition.  My gut feeling, however, is that the company sees itself more of a predator than pray.  Having said that, the chairman seems to be an economic animal...  Also, I am sure that Motel168 was at least casually offered to CHH or other international players.  Thus, the company's attractiveness as an acquisition target is not central to the thesis.

The bad

HMIN is not what I consider truly cheap on current numbers.  However, it seems inexpensive on conservative numbers for the installed base as of the end of 2011.  Also, it is cheaper than its publicly traded peers HTHT and SVN, and much cheaper than well-known lodging companies like CHH, IHG, MAR, etc.  I don't see a solid argument supporting this valuation discrepancy.  With respect to its Chinese peers with whom it shares the same growth opportunity, HMIN shows better scale, margins, ROIC, and cash flow profile.  In my opinion, a well managed hotel operator in China should trade at a premium to that of a mature market.  To me, HMIN has a far more attractive opportunity than CHH and its peers.  The main reasons are a faster growing market and an appreciating currency.  Relative to international lodging companies, in my view HMIN has a much brighter future, a much younger installed base, and trades at a much lower NOPAT multiple.

Pro forma for the acquisition of Motel168 and assuming zero synergies (despite management seeing significant opportunities):

Shares outstanding:  54 million

Today's closing price:  $33.73

Market cap:  $1820 million

Net debt:  $130 million (e 12/31/11)

TEV:  $1950 million

Rooms:  170 thousand (as of 12/31/11)

Net revenue run rate:  Rmb5500

Ebit margin x pre-opening expenses:  20%

Ebit x pre op:  $3.15/shr (@current exchange rate)

Eps (taxed @statutory rate):  $2.36

TEV/Ebit:  11.4  (vs HTHT 12.1x and SVN 15.5x -ex 2011 cash burn)

P/E:  14.3

Could this be another Chinese stock fraud?  I don't know, but it seems unlikely.  First, the founding entity CTRP bought 18% of the company during the market meltdown of 2008/2009.  This is after the same entity sold its interest prior to its own IPO.  Also, the company repurchased its convertible debt at a gain in 2009/2010.  Second, it is relatively easy to verify that these hotels exist and the prices they charge...  Third, the company's founders are very successful, with too much at stake, and too far removed and with diverging interests to be able to orchestrate a fraud.  For once, one of the co-founders and the current CEO or HMIN has clearly a diverging interest.  Additionally, after all the very well publicized Chinese stock frauds, it seems reasonable to expect that each of the due diligence teams at Morgan Stanley, JP Morgan, and Credit Suisse checked and double-checked every detail before committing hundreds of millions of dollars to this company.  Finally, most of the common elements of Chinese stock frauds (i.e., RTO, fantastic financials, lesser-known auditors, etc.) do not seem to be present in this situation.  PwC are the auditors of HMIN.

Multi-brand, multi-format strategy.  HMIN has a wider variety of brands and hotel formats than its peers.  This was probably what I disliked the most when I began my analysis of the space.  It seemed inconsistent to what I have seen work in other low-cost providers.  However, the reality is that despite this apparent weakness, the company has better financial performance than its publicly traded peers.

The ugly

Low barriers to entry and no pricing power.  RevPAR has been essentially flat for the company and the industry since these companies were founded a few years ago.  However, I have yet to find a large hotel chain with pricing power?  Looking at what I paid for a hotel room this year, it is substantially the same as what I paid five and ten years ago.  This is true across the board; from Motel6 to Marriott to the Four Seasons.  I haven't done the analysis, but my instinct is that RevPAR at companies like IHG and MAR if very much flat if measured in Rmb.  Regardless, inflation in China is not insignificant and clearly has a negative effect on the industry's operating expenses.  Thus, in the absence of RevPAR increases, the industry has to some extent to keep running just to stand still.  This dynamic is clearly a headwind and I don't think it will go away in the foreseeable future.  Mitigating factors include the company's relentless focus on profitability, its advantageous position within the industry, and the currency tailwind (RevPAR up in $).

Competitors growing aggressively.  Despite weaker financial metrics, the company's competitors are growing fast, have been successful franchising their brands, have strong balance sheets and negative working capital.  There has been some noise regarding competition for locations, which are a negative on rents.  However, at least the management of SVN is convinced that "there will continue to be a large supply of qualified buildings in desirable locations suitable for conversion to economy hotels."  As a whole, it seems to me that this competitive dynamic translates into industry growth.  And while the need to fill new capacity generally pressures pricing, I wonder how meaningful the overlap is outside of big cities.

* * *

Ah, and lest I forget, at $33.73 you are buying at a 16% discount to Morgan Stanley's (without agreeing to a six-month lock up).  This is 16% below a contemporaneous private market transaction among sophisticated investors.

The best catalyst will be the market assessing the company on 2012 numbers based on the installed base as of 12/31/11, which will include the acquisition of Motel168.  This, in concert with the assessment of HTHT and SVN on their 12/31/11 balance sheets that will account for their 2011 cash burn, should highlight the value of HMIN.