Is it Time to Check Out from Indian Hotels? 

Hi guys, this is Aditya Vora here...

If you want to know how things turn fast in the stock markets, you should look at 2 sectors, one is the hotel industry and other is real estate.

I mean, who could have thought in 2020 that over the next 2 years these 2 sectors would be the best performing.

You open any newspaper, the headlines read about highest bookings in both the real estate sector as well as hotels.

However, it is during such times that people forget that these are cyclical sectors.

Contrary to public opinion, I thought let me take cues from the past and analyse the hotel sector from the point of view of booking profits.

While in my opinion, the time to enter this sector has passed long ago, the billion-dollar question and probably the most difficult one is when to exit from this sector.

After all, cash in bank is more important than notional profits. Or as they say in hindi, Rokda haath mein hona chaiye.

Let me start by explaining how an upcycle works in the hotel industry.

In a hotel, there are 3 parameters which you should focus on.

First is obviously the occupancy which means how full the hotel is, now the second parameter is the average room rate or ARR what they call, that is the average cost of the room which is the realisations for the hotel and the third important parameter is the F&B revenues which the money which hotels make in their restaurants.

Apart from these, the traditional metrics EBITDA margins and profitability are the normal ones.

Now what happens at the start of an upcycle is that gradually occupancy rates go up first... So from a 40-50% occupancy, it starts rising gradually to 60-65%, and then rises to 70-75%.

Now obviously if the occupancy rates are going up, the hotel starts increasing the room rates.

The last metric which is a sharp jump in F&B revenues indicates that the customers are spending. Also, hotels get highest margins from F&B revenues.

This is like a cocktail, where all the parameters blends.

Let me substantiate this via Indian Hotels, the largest chain of luxury hotels in India. The Taj Group.

2014-2015 was the bottom in the cycle, with dismal margins and occupancy rates. The next 3 years till 2018, things marginally improved but there was no great trigger. In fact, till 2017, most of the hotels were barely break even including Indian Hotels.

The main reason was the oversupply of hotels and moderate demand. This led to lower room rates and moderate occupancies for the industry.

It was in 2018, when the hotel space started gaining momentum, with jump in operating margins along with profitability. Margins for Indian Hotels doubled from a low of 12.1% to 24% in 2020 before Covid struck.

Obviously 2021 was a washout year, with strong recovery in 2022 due to the pent-up demand.

Financial Year 2023 has just ended, and Indian Hotels in its December 2022 quarter recorded its highest PAT in the history of the company. An EBITDA margin of 37% for the quarter while the nine-month EBITDA margin stood at 32%.

The PAT of December 2022 quarter is higher than the full year PAT in most years in the past.

Rs 383 crore of PAT during this quarter and a 9-month total of Rs 674 crores.

That is a huge by any standards.

Let us also look at the operating parameters too.

There is an improvement in all parameters as can be seen in the slide.

So, in terms of operational performance, it is a goldilocks scenario.

One more point which is relevant to the discussion is debt and capex.

Hotel Industry is a high capex and debt heavy industry.

If you look at the slide, while gross debt levels are steady, it is the net debt to EBITDA and Debt: Equity ratios which are coming down on account of strong cash generation in this upcycle.

In fact, during the December 2022 quarter, Indian Hotels has turned net cash positive on account of strong free cash flow generated.

Also, the company is on an expansion spree, over the next 4 years, 8854 new rooms are expected to be added which amounts to 67 new hotels.

This is not only the case with Indian Hotels, but the entire industry is adding insane supply over the next 2-3 years.

So, friends, from the face of it, everything is going right for the company... Right from occupancy to average room rates to operating margins.

Debt is reducing on account of increased cash flow.

In this case, if I tell you to now is the time to be cautious, I am sure you would say whats wrong with this guy?

Well, let me tell you, why I think so...

The hotel industry is a cyclical industry where cycles last for 6-7 years ideally.

The initial years, the pickup in cycle is gradual with fundamentals of companies slowly improving for good while it is the last couple of years where aggressive rise both in share price and fundamentals happens.

When you look at this slide, this is almost the replica of what I currently happening to the fundamentals of Indian Hotels.

The upcycle started in 2002-2003 with operating margins at 17%. Over the next 5 years, margins from 17% jumped to a peak of 31% in 2008.

That's 5 years of margin expansion. Also do note that the first 2 years margins gradually expand while it's the 4th and 5th year which will see a strong jump in margins as operating leverage starts to play out.

Now for a moment let us look at the current scenario.

In 2016, the cycle looks to have bottomed out and is preparing for a jump.

For the first 2-3 years, there is no meaningful expansion while the jump happens in FY19 and FY20.

Just that the cycle was catching steam, unfortunately Covid happened, and the hotel industry was jolted with shutdowns.

If we exclude FY21 and FY22 as the second and the third wave was dominant during FY22, the cycle restarts again in FY23, with sharp margin expansion.

Only this time, there is another tailwind in the form of revenge travel and pent-up demand in the hotel industry.

The margins have touched 35% on a quarterly basis and we are likely to close FY23 with an operating margin of 32-33%.

So technically, we are in the 5th year of the upcycle, however unlike last time, this cycle is elongated due to Covid and thus the cycle could go on for may be a year more in terms of fundamentals staying strong.

In my view, it is extremely difficult for hotel companies to maintain such strong trajectory for an extended period.

Also, if you take cues from history, it is during such good times that managements become complacent and start venturing in acquisitions.

In 2006 it bought Ritz Carlton Boston, for US Dollars 170 m while in 2007 it acquired hotel Campton Place in San Francisco for US dollar 60m.

During the good times, when cash flow is abundant, often, companies across most sectors make blunders of buying assets to fuel in organic growth.

Also, it is during the best times that companies plan for capex.

Over the past 2 years, with revenge travel, the gap between supply and demand was higher. This led to improvement in Average room rates along with occupancy.

However, with every hotel company planning massive capex, over the next 2 years supply will outpace demand.

And I am sure you don't need me to tell you that the market discounts everything in advance.

These peak margins of 33% for Indian hotels is already in the price.

Since I spoke about how fundamentals can peak soon, let me end by talking about valuations.

This slide shows you the peak valuations using 2 different metrics.

The price to book as well as EV/ EBITDA.

The data is interesting.

While in 2008, the stock peaked much before the company reached its peak margins of 30%. Also from a valuation perspective, the price to book ratio was 6.2 times when the stock peaked.

Another time frame is in 2018, when the stock peaked at 7.2 times price to book. In fact, 7.2 times was due to earnings not coming in... if earnings were strong the stock would have peaked earlier.

I am not taking the 2021-2022 period as hotels were closed due to Covid.

Currently the valuations stand at 6.5 times the book value, while the mean price to book value is 4 times.

So technically, on an average the stock has always peaked at 6.5-7 max over the past 20 years.

Also, if you look at EV/EBITDA, the stock peaked at a multiple of 22 times in 2007, in 2011 it peaked at 26 times and in 2018 it was at 34 times before it started to correct.

Current EV/EBITDA is 30 times while the median stands at 22 times.

So net net, the stock looks expensive on all counts.

And just out of experience, it is when everything is perfect and brokerages are upbeat and give high target prices along with best fundamentals which is the case for Indian Hotels, it is in my view, time to be cautious.

Also please note that I am not telling investors to sell the stock, the only thesis I am trying to put forth is that the stock from a valuation perspective is approaching danger zone and investors should evaluate it.

Generally, stocks peak out first and fundamentals later. The stock will stop rising or start to mildly correct even when the operating performance is fine.

That's how the markets operate.

My thesis can be wrong, if Indian Hotels grows at a higher rate along with sharp improvement in EBITDA margins and room rate.

So friends, this was Indian Hotels for you...

Thank you for watching my video and if you have any queries do post in the comments section. I will be happy to answer them.