Description

EXEC SUMMARY:

Whitbread is an asymmetric short investment as its share price has been artificially propped up by its recent £2bn tender offer which drove its share price to 23x P/E and 14x EV/EBITDA, a valuation that is disconnected from its fundamentals. There are many ways to win and as the odds of a no deal Brexit continue to rise. This could perhaps be the best ways to play it. A hard Brexit is a free option on additional downside.

After the sale of Costa Coffee and the return of the proceeds, shareholders are left with Premier Inn (“PI”), an asset heavy single brand budget hotel business, where ~80% of customers are domestic customers (non-London) and >50% of revenues come from UK corporates. The brand is witnessing RevPARs declines that are in-line with the Great Financial Crisis as it’s reached saturation and overly exposed to the most challenged consumers (UK) in the developed world. Premier Inn continues to lose market share, they are heavily exposed to AirBNB and supply is accelerating while demand which already falling off a cliff.

Management’s strategy is wedded to chasing growth in the face of lower margins and ROICs and they remain unconcerned about their recent underperformance relative to their markets as well as the success of their competitors. Management’s denial of the root causes for weakness will only exasperate the cyclical and structural headwinds associated with Premier Inn’s UK saturation.

Management believes slowing down development in 2008 was a big mistake but this narrative doesn’t hold up as the Company is now 2.2x the size and near full saturation, but still set to grow units ~5%/annum. PI is already putting up -6% RevPAR’s before a recession even starts to impact their results. Now the company is pursuing growth in Germany which will consume all of its FCF, while lead to declining margins and ROICs.

Management is stuck with a catch 22, either they cut growth and admit to market saturation or continue to plow ahead driving its operating metrics lower. Despite estimates being cut by 30% over the last 12 months and comps that are in-line with the GFC, the stock is still trading at a 20-30% premium to its historical average. There is also no silver bullet. Mgmt is vehemently opposed to asset sale leasebacks and there are limited buyers for the asset given its size, its valuation, it’s out of favor business model and a potential hard Brexit.

RECOMMENDATION:

I recommend shorting ~200bps of WTB.LN and look to size short up ~300 bps if shares remain >£4,000 in October and Brexit hasn’t been deferred or cancelled. At this point the bear case is more likely and there is an additional 15-20% downside to my base case.

TARGET PRICE OVERVIEW

At 15x P/E FY 3/2021,  I arrive at a base case of ~£2,765, which is a ~30% downside over the next 12 months. In my bear case I assume a hard Brexit and 13.5x P/E and I arrive a target price of ~£2,390, or ~40% downside. In my bull case I assume there is either no Brexit, or it is very soft and I arrive at a bull case upside of £4,620, or only ~16% upside. However, I think the outcomes are skewed to the downside. 

My WTB multiples are based on FY 2021 EBITDA and P/E multiples while putting into context historical valuation as well as valuation for its comps. In addition, my multiples are reflective upon WTB’s negative RevPAR, declining margins, heavy fixed asset exposure as well as where we are in the economic cycle and risks around Brexit.

In looking at valuation, Whitbread continues to trade at a very high multiple for an asset heavy budget hotel that is facing both cyclical and secular headwinds. Over the last five years, WTB has traded at an average 9.8x forward EV/EBITDA but this included Costa Coffee (>25% of EBITDA, ~15x EBITDA business). This implies that the market was valuing Premier Inn at ~8x forward EV/EBITDA. Currently Whitbread is trading at ~11.5x my PF 3/2020 EV/EBITDA and 10.7x my PF 3/2020 EV/EBITDAR, or a ~25% premium to historical levels.

In terms of forward P/E multiples, which UK investors prefer to focus on, WTB has traded at an avg P/E multiple of 16.3x over the last five years. If we assume Costa would have traded at a 20x P/E then this implies that WTB has traded at ~15x forward P/E. Currently Whitbread is trading at ~23.3x my PF 3/2020 P/E, or a ~35% premium to historical levels

In thinking about comps, there are only a few asset heavy, purely European hotel brands that are focused on the budget segment and none of them are facing recession-like RevPAR in saturated markets. Nevertheless, the best comps are likely NH Hotels (NHH.SM), PPHE Hotel Group (PPH.LN) and Dalata Hotel Group (DHG.ID). These hotels trade at ~10.3x 2020 EBITDA and ~15.6x 2020 P/E. In America, the best comps are Extended Stay America (STAY) and Host Hotels (HST), which trade at ~9.5x 2020 EBITDA and ~15.6x 2020 P/E.

COMPANY OVERVIEW

Whitbread (WTB.LN) is a ~277 year old company that was founded by Samuel Whitbread in 1743 as a way to leverage his brewing business into more related consumer/leisure categories. Whitbread went on to acquire…and then later sell several leisure focused businesses over the years until most recently WTB only had two core assets: Costa Coffee and its Premier Inn hotels business.

In August 2017 activist investors, Sachem Head and later Elliot Advisors accumulated ~10% of WTB’s shares and began to pressure WTB to unlock value by separating its high quality secular growth coffee business, which was the #1 coffee chain in the UK, from its asset heavy, more mature and structurally challenged Premier Inn hotel business. In addition, Elliot aggressively pushed for the monetization of hotel real estate assets. At this time WBT, including both its coffee business and its hotel business traded at £3,660, or ~8x EBITDA and 14x P/E

In March 2018, WTB announced that they would separate Costa coffee. Shortly thereafter in August 2018, Coca Cola surprised everyone and announced that they would acquire Costa Coffee and its >4,000 location for £3.9bn, or ~16.4x FY 3/2018 EBITDA. The deal closed in Jan 2019 and WTB received £3.8bn in total proceeds.

In Jan 2019, subsequent to the Costa deal closing, Whitbread kicked off an aggressive £2.5bn capital return plan. Through May 2019, WTB bought back £482mn shares (~5% of DSO) in the open market. Then in June 2019, WTB announced they would do a Dutch tender for £2bn add’l shares with a cap set at ~£5,000 (+10% premium). Given the built in premium, the tender offer was oversubscribed and it drove the share price to >£4,900 before closing on July 19 2019. WTB retired another >20% of its shares at ~14x EBITDA and ~23x PF P/E, which was a significant premium to its historical average valuation when it also included it’s much higher quality Costa Coffee business. It appears that Activists used this as an opportunity to exit a significant portion of their shares.

Whitbread is now a pure play, vertically integrated budget hotel business with over 78,000 rooms in the UK, Germany and the Middle East, operating under the Premier Inn (PI) brand. In the UK (>99% of revenues), PI is the #1 UK budget hotel brand and has ~50% share of the branded budget hotel market. In addition, PI also has a nascent Germany (~1% of revenues) hotel business where they opened their first hotel in 2016 and they will look to replicate their success in the UK after failing to execute internationally in several markets over the last decade.

BUSINESS STRATEGY & BUSINESS MIX

In a time when most public hotel companies have moved to asset light, recurring franchising revenue streams, PI is unique as it remains a vertically-integrated asset heavy hotel model, which combines the ownership of property (2/3 owned, 1/3 leased) and hotel operations.

Premier Inn is essentially a single branded hotel business almost exclusively focused on the UK budget hotel segment. It has ~100% corporate ownership of its hotels. Furthermore, the company owns and operates several hundred casual diner restaurants which are located either inside PI hotels or adjacent to the hotel property, where its guests represent ~50% of revenues. While its casual dining business is lower margin and lower quality and facing continued comp declines, Whitbread contends that it allows them to boost occupancy as well as RevPAR by ~£1-3 night.

Premier Inn is mostly focused on regional, non-London locations which account for an outsized ~80% of locations vs. UK industry average of ~60% and ~100% of rooms fall in the “Budget” category, whereas most global brands focus on Luxury-Mid. PI is also over-indexed to short stay corporate (50% of revenues) with an estimated ~25% of nightly rooms being filled by high RevPAR, short lead time corporate travel, which can be £90-100/night on average vs. £50-70 for leisure forward bookings.

As a result of PI’s vertically integrated approach, and its strong brand, WTB has historically been able to outperform its subscale independent hotel competitors in terms of unit growth, margins and RevPAR performance. Moreover, PI’s end to end control has provided economies of scale, which ensures low cost operations as well as limited revenue leakage. Leveraging PI’s tremendous scale and regional density, also allows PI to drive low customer acquisition costs and limited OTA usage while driving industry leading occupancy (~80%). Direct distribution has risen from ~91% of rooms in 2015 to ~97% in 2018. Its high occupancy and direct booking penetration has led to consistent ~25% EBITDA margins.

KEY dRIVERS OF THESIS

DRIVER #1: Crummy Asset Heavy Hotel Business Facing Cyclical Peak & Structural Issues

After the sale of Costa, what remains is Premier Inn, a high fixed cost hotel business that just put up its worst RevPAR (-6.3%) performance since 2009 and this is an environment where UK GDP has slowed but still remains +1%. The single-branded hotel business is losing occupancy with ADRs declining at an accelerating pace and it is on the verge of a potential no deal Brexit. WTB’s RevPAR was -6% in Q1 FY ’20, -4% in Q4 FY ’19 and this was while unemployment remained at multi-decade lows. One can only image how bad it can get for them in the next recession. There’s a potential storm lurking and Premier is out to seas with a rickety boat

To begin with PI’s focus on budget hotels is the most challenging segment of the entire hotel industry given low RevPAR’s and challenging unit economics given continued cost inflation. In addition, while almost all other major hotel companies have moved toward asset light franchising and/or management contacts, PI remains a capital intensive hotel owner/operator and restaurant business. In regards to operating metrics, WTB has CapEx/sales of ~30% and targets 10-14% ROICs. In comparison to capital light franchise businesses like MAR where CapEx/sales is <5% and ROICs on new units are almost infinite as they can grow units without significant capital invested.

Also as an owner/operator it leaves PI much more exposed to economic cycles as high fixed costs leads to high decremental margins caused by dropping revenues in conjunction with high fixed costs. PI is also left fully exposed to input cost inflation tied to rising labor costs, driven by rising min wage, as well as rising utilities and foods costs as a result of a weakening GBP.

PI is also already getting clobbered as it remains over-indexed to the some of the worst exposures in the developed world: UK regional assets (non-London) and the UK corporate travel market. In regards to London, where PI only has ~20% of revenues, these markets tend to be more durable as leisure travel is less cyclical and a weaker GBP, which oftentimes accompanies a weak economic back drop, leads to a stimulation of both leisure and corporate travel to London. This is simply not the case for regional UK hotel markets.

In addition, there is asymmetric downside to WTB earnings as RevPAR is highly correlated to GDP and business confidence as corporate travel is highly discretionary and remains one of the first things to be cut in a downturn. Furthermore, the UK has proven to be one of the most sensitive markets to GDP as RevPAR declined at a rate of 3x GDP during the last downturn vs. ~2x for the US. In regards to the current UK economy, the outlook has remained challenged by a lack of clarity around Brexit and as a result UK business investment has already been declining for four quarters. In addition, consumer spending continues to soften.

Thus far, Premier Inn has been disproportionality hit by a drop in short lead time corporate travel which accounts for ~25% of PI revenues and comes in at much higher ADR’s than their average. This is apparent in PI’s recent figures as RevPAR has dropped >6% but most of it has come from ADR declines rather than occupancy declines. In a traditional hotel downturn hotels usually see occupancy first drop and then ADR’s follow as hotels seek to fill hotels and cover fixed costs. Given the reverse has been the case, PI has stated that its lower ADR leisure booking have remained stable, but its missing out on high ADR corporate which is what really hurts.

Around late 2018 and March 2019, when Brexit was last officially supposed to occur PI’s business was hit by an acute drop off in demand for corporate travel and this was just in anticipation of a potential Brexit. Now it looks like Brexit will actually occur on October 31, 2019 and the odds of a no deal Brexit continue to rise

As we get closer and closer to October 31, PI should see another dramatic drop off in high RevPAR corporate travel and the timing couldn’t be worse given that these are high occupancy times of the year. On top of macro risks, it appears that Whitbread’s issues are more structural in nature.

Premier Inn was once known as one of the best managed hotel chains in the world and one of the best values for your money, but under Alison Brittain’s rein this narrative is changing. In speaking to a previous Whitbread CFO he explained how Whitbread used to be obsessive over the customer experience and that refurbishments were a key element of its strategy. Under Alison Brittain, Premier Inn may have lost its way and the business is now struggling with both a Chairman and CEO that have limited hotelier experience. Moreover, PI intends to keep maintenance CapEx flat for the next several years despite continued 5% supply growth.

Also while WTB had always outperformed its peers during slower growth periods, this is simply not the case anymore. Yet management, which appears to be in denial, continues to claim that this will be true. Travelodge (privately owned) the #2 budget hotel brand in the UK with a 27% share continues to gain share and outperform PI. Over the past three years Whitbread has underperformed the UK budget hotel market and as well as Travelodge, leading some investors to question how much of the current poor performance in structural rather than just cyclical. In fact, this gap has only accelerated from Travelodge’s ~300 bps outperformance over the last three years to a ~500 bps RevPAR advantage in the most recent quarter.

Aside from the rapid expansion of Premier Inn and Travelodge, there has been an explosion in low-cost brands owned by major chains. Premier is now also facing increasing competition from India’s OYO Hotels, which is backed by AirBNB, and is rapidly growing in the UK budget market. OYO, which started five years ago as a platform to book budget hotels in India, now has ~500,000 rooms across China, Malaysia, Indonesia and the UK. OYO says it is growing faster than the world's top three hotel chains combined and that it aims to have more rooms than global leader Marriott (MAR) by 2023.

Premier Inn also remains heavily exposed to AirBNB as it appears competition is impacting budget hotels in the UK market the most. As alternative accommodations continue to grow and take share this is yet another structural risk factor that Whitbread needs to contend with.

Lastly. Whitbread has consistently been able to grow share at the expense of unbranded Independents which are ill equipped to compete in the face of consistently rising input costs and an increasing dependence of OTAs to fill its rooms at a ~20% commission. The decline of Independents is specifically what PI cites as its growth opportunity. However attrition of independents has largely slowed down. While management continues to believe that their growth will continue to take share from Independents this is simply not the case. Alas, Premier remains committed to continued supply growth in the face of increasing cyclical and secular issues.

DRIVER #2: GROWTH STRATEGY = AGGRESSIVE GROWTH AND VALUE DESTRUCTION

After growing hotel rooms at ~6.5% CAGR since 2010 in an environment where demand has only been +2%, Premier Inn is now the largest UK hotel brand with >800 hotels and >76,000 room and it has increased its market share from 6% in 2010 to >10% currently. Over the past four years Premier Inn alone has added >17,000 new rooms to the UK, but it now appears that all of this supply is starting to take its toll and now WTB is faced with much weaker hotel demand.

In Q1 2019, Premier Inn’s total accommodation revenues were -1.5% y/y in Q1 (with -6% RevPAR), which was far worse performance than the budget market, making it hard to reconcile management's view of an ongoing structural growth opportunity. Nevertheless, Premier Inn continues to pursue rampant growth that is cannibalizing (~80 bps headwind to FY 2019) its existing hotels as they have reached market saturation in many markets. In fact, Premier Inn is already the most saturated hotel brand in the world given population density.

However, at its Capital Markets Day (Feb 2019), WTB announced that they see the potential for 110,000 hotels in the UK market with ~13,000 rooms in their pipeline and they envision Germany room count reaching 85,000 by 2020. Nevertheless, ROICs have now declined for several years and given changes to IFRS 16 accounting standards, management can no longer use sale/leasebacks to boost their ROIC.

Post IFRS 16, WTB’s ROIC will decline >300bps and ROIC is now <10% yet mgmt still refers to its ROIC as within its 10-14% target. Pre IFRS, if sale/leaseback benefits were to be stripped then ROICs have been steadily declining since 2010.

Despite this cannibalization, management continues to focus on total room and revenue growth instead of ROIC. Management acknowledges weakness in their performance metrics, but they remain committed to investing despite this weakness as they attempt to gain market share in a downturn. It now appears that management’s strategy is wedded to chasing growth in the face of lower margins and ROICs and they remain unconcerned about their recent underperformance relative to their markets as well as the success of their competitors.

Moreover, management even admitted in April 2019 that they didn’t expect weakness in the UK to be as bad as it was and they were a bit caught off guard. This led to a double whammy as PI held supply off the market for corporate travel that never appeared. Nevertheless, Alison Brittain (CEO) claims that slowing down unit growth in 2008-2010 was a strategic failure and they have confirmed multiple times that they intend to consistently grow UK units 3,000-4,000 per year in any environment. Management recently changed its FY 2020 UK room target to 3,000-3,500 due to timing, but this is still >5% room growth into a saturated and declining market.

I think that management is making a large mistake and their denial of the root causes for weakness will only exasperate the cyclical and structural headwinds associated with Premier Inn’s UK saturation. While management believes that they could have gained more market share if they did not slow down the pace of development in 2008, this narrative doesn’t hold up as the Company is now 2.2x the size. Also, in the depths of the previous GFC, PI’s RevPAR was only -6% at trough. Yet, PI is already putting up -6% RevPAR’s before a recession even starts to impact their results.

In addition, ~70% of its UK growth will come in catchments like London and Southeast UK where property prices and operating costs are much higher. Ultimately, this will lead to additional margin pressures and lower ROICs. In addition, London is a more global market where standards are higher and familiarity with the Premier Inn brand is much lower.

While Whitbread is the largest driver or new supply in the budget segment there are others swarming. In fact, despite budget hotels showing some of the weakest performance, it has the highest supply growth across any market. Total UK budget hotel supply expected to grow +3.3% this year.

PI margins and ROICs are declining and competition continues to steal share. I believe WTB is faced with a catch 22. Either management continues to chase growth in an oversupplied and declining market or they acknowledge that they are reaching saturation and slow their unit growth, which will likely lead to a revaluation in the company’s multiple. Or Premier can remain in denial and continue to chase growth at any cost. This set up is attractive as management remains anchored to their 2008 worldview and it will likely be too late before management can put the brakes on its unsustainable unit growth.

DRIVER #3: GERMANY GROWTH HIGHLY DILUTIVE TO EPS, ROIC AND CASH FLOW

In speaking with Whitbread’s previous CFO he suggested that as far back as 2014, Whitbread’s management realized that they needed to create another long term driver of unit growth given they might only have 5-10 more years of TAM opportunity remaining in the UK. As a result, Whitbread tried to tap into fast growth budget markets like India and Thailand. Yet this strategy failed and recently they announced that they would be exiting these markets due to underperformance, lack of scale and challenges in replicating their UK success. Premier Inn remains committed to a JV in the Middle East, but this has dropped from 14 hotels two years ago to 8 currently. PI has proven over time that its brand just doesn’t travel well overseas.

Next in 2016, Whitbread announced its next large geographical target: Germany. Premier Inn has elaborated on why they think the German market is attractive and why they should be able to replicate their success in the UK. First, the market is big. There are ~30% more hotels in Germany and the market has historically grown ~1-2% faster than the UK. In addition, Germany is significantly more regional which drives greater demand for domestic, short-stay business-led travel. The market remains extremely fragmented and it has an underdeveloped branded budget hotel industry. In fact, the total budget branded hotel sector in Germany is only around 8% of the total market vs. ~27% in the UK market meaning there are way many subscale independents competing in the market.

While I agree Germany is an extremely attractive market, it will come with dramatic margin dilution and it will dramatically depress ROIs for Premier Inn. Moreover, these losses will be accelerating at the worst possible time for Premier Inn given its existing issues in the UK. In the end, PI is faced with the prospects of investing £1bn in CapEx over the next 2-3 years while EBIT will be negative until FY 2022.

In February 2016, Premier Inn opened its first hotel in Frankfurt. Thus far, PI has been happy with its results, but it wasn’t until Feb 2019 when they opened their second hotel in Hamburg. Given tremendous weakness at home in the UK it appears that PI is finally focused on accelerating growth in the Germany market. In Feb 2018, Whitbread announced that they would acquire Foremost Hospitality for £300mn or ~12x EBITDA for leasehold hotel assets which are currently being managed under the Holiday Inn Express brand. This deal effectively doubled PI’s Germany backlog adding ~2,140 rooms that are expected to close on the last day of this FY in Feb 2020. With this deal Premier will take control of 13 hotels with another 6 in backlog. During 1H 2021, PI will be focused on converting and refurbishing these hotels which will cost another £100mn and it could take a few months for some these hotels to reopen.

PI expects to have ~20 hotels in Germany by FYE 2020 and they are targeting 6,000 hotel rooms by FY 2021 YE. In all, Germany currently has ~7,000 rooms in its backlog which represents ~30% of Premier Inn’s backlog. Longer term, Whitbread has aspirations of opening ~60,000 rooms in Germany and over time its backlog will move more towards Germany, but this will come at a significant cost.

WTB has ambitions to accelerate organic development and tuck in M&A. Including the Foremost deal WTB has guided towards spending an additional £700mn on its ~30 first hotels and it only hopes to breakeven by 2021. Going forward, WTB has guided to CapEx of around £200-300mn per year in Germany alone which should lead to negative FCF post dividends.

Whitbread has explained that the Germany market will have higher revenues and higher EBITDA per room, but they will have higher CapEx and Opex. Longer term, management believes that returns will be similar at 10-14% ROIC, but this will take time as they state it will take ~4 years for hotels to reach maturity instead of 2-3 years like the UK.

PI  is hoping to earn a ~4% EBIT margin in 4 years, but in the meantime there is significant investment ahead and ROICs are likely to go down significantly. Whitbread must first accelerate its investment in the market by building out its corporate functions such as marketing, IT and by putting more people on the ground that can manage ~30 hotels. Premier Inn is also hiring an entire team that is responsible for construction and property management capabilities as well as a team that is focused on tuck in M&A. As Germany will be subscale for several years corporate costs will create significant headwinds.

In January 2019, Whitbread guided toward EBIT losses of £12mn in FY 2020 vs. £8mn in FY 2019 and PI’s old CFO stated that Germany will likely remain extremely dilutive to margins until they achieve ~10,000 hotels which might not occur until FY 2025.

Also, for Germany to replicate the UK’s margins and ROICs they desperately need to achieve scale. Scale is essential for the economic model that underpins budget hotels where value for money and price is so critical. Scale is an important factor to achieve brand awareness, repeat bookings and large corporate accounts. Also, scale is paramount to replicating PI’s success in the UK as its near ubiquity drives increased loyalty as well as a strong direct distribution model, where they are able to cut out the use of OTAs.

Germany will not benefit from having great legacy real estate locations like Premier Inn in the UK and they will lack the restaurant/pub business that drives higher RevPAR’s. The Premier Inn brand is mostly a local UK brand and it is not well known in Germany, where >80% of travel is done by local Germans. Until Premier Inn achieves scale, brand recognition and a strong network across geographies they will likely be required to pay OTAs ~15-20% of revenues to fill rooms or suffer from ~60-65% occupancy.

On top of this, PI is pursuing a unique strategy in Germany where their initial focus will be on the top ~25 cities in Germany and they will look to grow out their network from there. These top markets like London, will require higher CapEx and OpEx and will present another headwind to PI as they attempt to achieve success outside the UK after failing in previous attempts. To achieve this coveted scale and for its hotels to reach maturity, Premier Inn typically focuses on getting high occupancy as fast as possible and it isn’t until Year 4 when occupancy reaches a level where Premier Inn will look to drive ADR.

Alas, Premier Inn is forced to put the pedal to the metal and accelerate growth in Germany or risk failing again. However, they aren’t the only player looking to achieve this same goal. In Germany PI is faced with several formidable competitors like Ibis and B&B which are already posting ~10% unit growth and the branded budget hotel segment is already growing at ~7% per annum. Over the last two years, Ibis has opened 29 hotels, B&B 32 hotels and Holiday Inn + Motel One have opened 23 hotels combined. Premier Inn has only opened 2 hotels.

While Germany does present an attractive market opportunity it will likely lead to tremendous pressure on margins and ROICs just as its core UK market approaches tremendous cyclical and secular growth pressures. However, Whitbread must forge ahead or they risk becoming known as a single broken brand hotel with a saturated no growth market.

DRIVER #4: ATTRACTIVE TECHNICALS WITH ASYMMETRIC DOWNSIDE

Whitbread is a compelling short because it has an attractive asymmetric set up with many catalysts to drive the share price lower with limited silver bullets to drive outperformance. The tender offer drove the share price to unsustainable levels and led to tremendous price support, but now that this is complete event driven investors will look to move on. As the tender offer can no longer support the share price, WTB’s shares have started to fall and I believe it will only get worse as investors are now forced to focus on fundamentals. Activist investors see the writing on the wa11 and they have exited the stock or dramatically reduced their position.

Turning to the fundamentals it appears that Analyst estimates remain too high and they are likely to come down. In addition, WTB’s valuation remains divorced from its fundamental reality. Whitbread stopped providing guidance in early 2019 given the sustained uncertainty. But, consensus is still assuming RevPAR is only -3% y/y in FY 2020 and flattish in FY 2021. This is overly ambitious as RevPAR was -6% in Q1 and 2H will be faced with increasing odds of Brexit and perhaps a disorderly no deal Brexit. Moreover, if Brexit were to happen it is likely that this would create more corporate austerity which would filter into FY 2021 RevPAR’s.

In addition, despite WTB’s cost savings plan inflation continues to increase and they are already planning on not being able to cover inflation this year. In Feb 2019, WTB announced a new £220mn three year cost savings plan with £120mn coming from OpEx and £100mn coming from CapEx. WTB is guiding towards £50-60mn of savings this year and for the balance to come in a straight line over the following two years. However, WTB has guided towards £60-70mn of inflation this year and that was when the GBP was at £1.29. Now the GBP is at £1.21, or ~6% lower. The UK hospitality industry continues to experience high inflationary pressure, primarily from rising wages (~50% of OpEx) and rising input/procurement costs including food and utilities as they are forced to buy goods abroad using a devalued GBP.

Whitbread has also cited £10mn in dis-synergies due to stranded Costa costs and they will be facing EBIT losses from their Germany expansion. In all, these headwinds will create a £30-40mn OpEx headwind y/y. Despite this, consensus still expects EBITDAR margins to grow this year. On top of this, IFRS 16 has gone into place starting this year, which will effectively bring PI’s leases on balance sheet, which should create an additional ~7% headwind to EPS. Ultimately, I think consensus #s will continue to come down and they remain asymmetric to the downside.

On top of this valuation, isn’t attractive as WTB is trading at 20-30% premium to its historical multiples and at a significant premium to other higher margin budget hotel brands that are enjoying similar unit growth, EBITDA margins as well as much better RevPAR’s and LT growth prospects.

DRIVER #5: LIMITED UPSIDE DRIVERS & NO SILVER BULLET

With the storm clouds mounting and performance under pressure, it appears that there is no silver bullet. After the £2bn tender offer, Whitbread’s leverage has moved to ~2.5x ND/EBITDAR including leases and the company intends to retain its investment grade rating so it is targeting a cap of 3.5x ND/EBITDAR or ND/FFO. This implies that the company has ~£800mn of capital allocation wiggle room before hitting its target.

In regards to capital allocation, another buyback seems unlikely and its dividend will likely rebase ~25% lower in Oct 2019 and then it’s expected to growth in-line with EPS. What is most likely is that Whitbread continues to deploy this capital towards growth CapEx in the UK and Germany. Given Whitbread’s guidance for a continued 4,000-5,000 rooms per year CapEx will likely be ~£625mn/yr, or a staggering ~30% of revenues. Over time, the mix of hotels will shift from UK to Germany and Germany hotels will have higher CapEx per location. After dividends, cash flow will likely be negative but Whitbread must accelerate its Germany growth ASAP for the unit economics to start to improve.

In regards to M&A, management states that they are continuously assessing the market to identify potential assets, but there aren’t any needle movers in Germany given the market fragmentation. It’s unlikely that they do anything larger than Foremost (£300mn) for the foreseeable future. In speaking to the former CFO, bankers and other hotel specialists there are only three assets that Whitbread could acquire in Germany. One was B&B, which Goldman Sachs just acquired for >15x EBITDA. Whitbread was interested but not willing to pay that price. Another is owned by an Egyptian family that is not likely to sell and last one is Motel One, which does £150mn in EBITDA. Assuming ~15x EBITDA this would be a 2.5bn deal and much larger than Whitbread is interested in doing.

In terms of monetizing assets through sale/leasebacks both Elliot and Sachem Head were very aggressive in pressing management to pursue this approach but this is unlikely to happen as management team believes that they must ensure 50% freehold ownership to optimize their cost of capital as well as their pension covenants. Given existing hotels in their pipeline this will likely drop this mix to 60%. In addition, while the company did £250mn of sale/leasebacks over the past three years most of these were in London, which have already all been monetized.

At the CMD, Whitbread laid out an extensive analysis of its property and aggressively defended its strategy around property ownership. Investor relations also stated that shareholders were overwhelming in support. Mgmt presented their hotel by hotel analysis and eluded to 10-15% of its properties that could potentially be asset sales in the future. But none of these are likely to happen in the near term because Whitbread already has sufficient capital given £800mn in untapped B/S and it doesn’t need the cash. Moreover, post IFRS, sale/leasebacks make even less financial sense as the leases are still retained in its liabilities and run through an income statement. Also, management would prefer to just add leverage to its balance sheet and borrow at 2-3% vs. a long term lease which they claim would cost them 6-7% if you include tax leakage as well as rent inflation. Lastly, if more assets are sold then pension payments likely go up.

In addition, freehold ownership limits risk to higher operational gearing and the risk of rising rents in a cyclical industry. In fact, Travelodge learned this lesson the hard way. In 2002-4 Travelodge monetized most of its real estate and then announced an aggressive growth plan. They were then hit with the GFC and forced to file for bankruptcy.

In July 2019, Elliot Capital started trimming its stake in Whitbread as they had become increasingly frustrated with Whitbread's strategy of owning Premier Inn hotels outright. Investor relations stated that Elliot is no longer agitating for asset sales and it appears that Elliot has sold all its shares.

It also unlikely that someone would look to acquire Whitbread, especially at a premium to current valuation given the circumstances. As part of the Costa separation plan management comp packaged included bonuses tied to the sale of either asset. It’s safe to assume that there are limited buyers as it was already shopped and no one bought it. Also, there is no longer a change of control premium in place at Whitbread which specifically incentivizes manage to sell the company.

Given the nature of the asset there is no natural buyer for Premier Inn. Most global hotel brands have moved asset light or they are in the process of doing so like IHG, Accor and Hyatt. There are limited local foreign buyers as Chinese and sovereign wealth funds are focused on global brands that their home markets are familiar with.

Also, this is not seen as an attractive asset to PE given its current business model and the size of the check required. While Whitbread recently disclosed that its property value was worth £4.9-5.8bn using a 4.5-5.0% yld and 2.25-2.4x rent coverage, this value is somewhat illusory. The real estate value is based on FY 2018 profits and for most of the property there is no better use for the assets. The valuation was also done on a property by property basis and realistically if they were to try and sell large chunks of property or the entire portfolio they would likely garner a lower price.

MANAGEMENT OVERVIEW

·         Adam Crozier - Chairman since 2018. Previously CEO of ITV from 2010-2017. Owns 3k shares.

·         Alison Brittain - CEO since 2015. Joined Whitbread from Lloyds Banking Group, where she was Group Director of the Retail Division, with responsibility for the Lloyds, Halifax and Bank of Scotland retail branch networks, remote/intermediary channels/products and the business banking and wealth businesses. Prior to joining Lloyds Bank, Alison was Executive Director at Santander UK PLC. She previously held senior roles at Barclays Bank. Owns 21k shares.

·         Nicholas Cadbury-CFO since Nov. 2012. Previously worked at Dixons Retail PLC, in a variety of management roles, including CFO from 2008 to 2011. Member of the Cadbury family. Owns 39k shares.

THINKING BACKWARDS

·         Brexit doesn’t happen or it is a very soft Brexit

o    Potential Mitigants: PI is already a competition short with continued market share loses and declining ROICs. Valuation would not have much room to re-rate

·         Management slows down unit growth and conserves capital

o    Potential Mitigants: In this case the stock is likely much lower because the macro environment will have dramatically surprised to the downside

·         Whitbread is able to acquire Germany hotel assets to accelerate growth.

o    Potential Mitigants: There’s nothing of scale and if there was then WTB would likely have to pay >12x EBITDA. At £1bn most this could add ~5-7% to EPS

·         Whitbread pursues a more aggressive real estate strategy

o    Potential Mitigants: Selling 10% of its real estate and using capital to buyback shares would only add 4% to EPS

·         Whitbread is acquired by an LBO fund or another strategic investor

o    Potential Mitigants: At current valuation plus a premium it’s hard to see how an LBO would generate >20% IRRs. There are very few hotel investors interested in owning asset heavy brands in the budget segment. Also, with Brexit overhang this is unlikely to happen in the near term

Catalyst

·         1H 2020 results: October 22

·         Brexit: October 31 (or any changes to likelihood and/or magnitude of risk)

·         Potential Germany M&A

·         Potential revision to unit growth