There are three luxury hotel companies listed in Asia: Mandarin Oriental International (M04.SI, OTCPK:MAORF), Shangri-La Asia (69.HK, OTCPK:SHALF) and Hongkong & Shanghai Hotels (45.HK, OTC:HKSHF). As part of my research on Great Eagle Holdings (41.HK, OTCPK:GEAHF), I have spent some time valuing and benchmarking these companies. All three offer reasonable value, although none is an obvious bargain. Note all these stocks are much more liquid in their local market.
Mandarin Oriental (MO) is part of the Jardine Matheson Group. It owns ten hotels worldwide, including the flagship Mandarin Oriental in Hong Kong, and has shareholdings in another five. It has management contracts for a further 12 Mandarin Oriental-branded hotels.
Shangri-La Asia (SLA), controlled by Robert Kuok, is significantly larger than the other two. SLA has equity interests in 62 hotels; it has controlling shareholdings in 47 and a further 15 associates. More than half of these hotels are in mainland China. It opened its first European hotel in Paris in 2010. SLA currently has no hotels in the US.
Hongkong & Shanghai Hotels (HSH), which is controlled by the Kadoorie family, operates the Peninsula hotel chain. It currently owns seven hotels, including the original Peninsula in Hong Kong, and has equity interests in two more. A new hotel in Paris is due to open later this year, while a London hotel is also planned. HSH owns a number of investment properties, notably luxury apartments in the Repulse Bay Complex on Hong Kong Island.
The following points are worth highlighting:
- All three companies are still in effect property companies: the majority of hotel earnings are derived from hotel ownership rather than management. Therefore, they are not "asset light". However, each company has taken a different approach to expansion.
- Both SLA and MO are rapidly increasing the size of their hotel portfolios. SLA continues to take equity interests in the majority of its new hotels, whereas MO's expansion is mainly through management contracts. MO plans to add 18 new hotels in the next few years, all of which will be under management contracts, without any equity investment, although the recent purchase of the freehold to the Mandarin Oriental in Paris (for US$400m) demonstrates a willingness to invest in strategic assets. SLA also operates hotels under management contracts in certain geographic regions, including the Middle East. HSH is expanding at a much slower pace than the other two. It has equity interests in all of its hotels, although recent developments have been in conjunction with a partner.
- All three companies earn the majority of their hotel revenue (and profits) in Asia: ranging from nearly 90% for SLA to around 60% for MO. Mandarin Oriental and Peninsula are global chains, concentrating on major cities, whereas Shangri-La is focused almost exclusively on Asia, with hotels in smaller cities and resort hotels. For all three companies, Asia, and in particular Hong Kong, provides a core profit base.
- SLA has a much bigger presence in mainland China than the other two. It opened its first hotel there in the mid-1980s and now has interests in 33 hotels. It has expanded well beyond the major tier 1 cities and continues to add new hotels each year. HSH has just two hotels in mainland China: the Beijing Peninsula opened in 1989 and the Shanghai Peninsula, which opened in 2009. MO has taken a cautious approach in mainland China: it has just three hotels, all under management contracts, although it has several more in the pipeline.
The table below summarises the key valuation metrics for the companies.
MO has a relatively mature hotel portfolio: the only company-owned hotel opened in the last few years was in Paris in 2011. It is unclear whether the hotel is profitable yet: in the 2013 annual report, the company says that it "continues to stabilize", repeating what it said in 2012. The Paris hotel has been open for less than three years so profitability should continue to improve. Further profit growth should also come from new hotels under management contracts.
MO's profit margins are high in all regions except the US. The profitability of its US hotels has been depressed since the financial crisis. Occupancy is back to pre-crisis levels. However, although RevPAR (revenue per average room) has recovered from the precipitous fall in 2009, for all the US hotels, it is still below the prior peak in 2007.
MO is currently trading at 1.9x book value, but only around 0.6x adjusted book value, which includes the hotel properties at market value rather than depreciated historical cost. It is trading on an historic P/E of 20x and EV/EBITDA of 11x (including EBITDA from associates). EBITDA is not an ideal valuation metric, as it does not take into account capital spending. Nonetheless, it is useful for comparing companies without distortions from different asset bases and depreciation amounts. MO has a reasonably high dividend yield of 4%.
MO's capex on existing properties has been around 1.3x depreciation over the last 10 years, which includes a major refurbishment of the Hong Kong hotel. This suggests that P/E multiples are a valid valuation metric. MO's business is relative mature; it therefore provides a useful valuation benchmark for the other hotel companies. MO's current valuation appears reasonable, although it is not especially cheap on an earnings basis.
SLA continues to open new hotels at a rapid rate, primarily in mainland China. It has added around 3-4 new hotels each year in the last few years, increasing the number of hotels in which it has an equity interest from 45 in 2008 to 62 at the end of 2013. The rate of growth is likely to increase over the next few years given the pipeline of new hotels.
The shares are currently trading at 0.8x book value. Since many of SLA's hotels are relatively new, book value may be a better indication of the hotels' underlying value than it is for MO, although some of SLA's older properties are probably worth considerably more than their book value. Unlike MO and HSH, it does not provide a market valuation of its assets.
SLA's rapid growth has a substantial impact on its financial performance. First, it reduces current profitability: new hotels are generally loss-making initially, particularly in the first year when one-off opening costs are incurred. It takes several years to reach full profitability. Second, new hotels require substantial investment: SLA's free cashflow has been negative every year for the last decade, with a cumulative cash outflow of more than US$3bn, financed by rights issues and increased debt.
These distortions create problems when valuing SLA using earnings multiples. SLA's historic EV/EBITDA multiple is similar to MO's at around 12x. However, its historic P/E multiple excluding non-operating items is much higher at 77x, as the majority of EBITDA is offset by depreciation, interest and tax expenses.
SLA's more mature Asian hotels, in particular the two Hong Kong Shangri-Las, together with its investment properties, provide a solid base of profits. However, in the last couple of years, profits in mainland China have fallen significantly; mainly due to overcapacity in various markets, as a large number of competing hotels have been opened. Returns should improve as the excess capacity is absorbed. In addition, both the Paris and Tokyo hotels (opened in 2009) continue to lose substantial amounts.
Valuing SLA is therefore quite difficult. On a net asset basis, it appears good value. Profits should increase significantly as the portfolio matures, although profitability will remain depressed while it continues its rapid expansion.
Hongkong & Shanghai Hotels
HSH has equity interests in all its hotels, although recent hotels, in Shanghai (in which it has a 50% interest) and Paris (20%), and the planned hotel in London (50%), have all been undertaken with another investor. HSH has been quite cautious in its expansion: adding hotels at a relatively slow pace and focusing exclusively on major cities (apparently it took decades to find a suitable site for the London hotel). The Paris Peninsula, which opens this year, will be the first in Europe, while the hotel in London is unlikely to be open much before the end of the decade. HSH is likely to remain a small, niche operator.
Investment properties, including luxury residential and commercial properties, primarily in Hong Kong, account for around three-quarters of the company's assets. These properties are included in its balance sheet at fair value. HSH is currently trading at around 0.5x book value, or just over 0.4x adjusted net asset value, if the hotels are included at fair value. While this looks cheap in absolute terms, if HSH is viewed primarily as a property company, there are plenty of other mid-cap Hong Kong property stocks trading at similar discounts to book value.
The hotels' fair value is based on an independent valuation using a discounted cashflow methodology. This inevitably, involves a number of estimates and assumptions, although no details are provided. Therefore, the valuation provides an interesting data point, but has no greater validity than any other third-party estimate of the hotels' value. Furthermore, such valuations, in my experience, tend to be too aggressive.
Based on historic earnings multiples, HSH looks expensive: trading on an EV/EBITDA of 15x and a P/E of 32x, a significant premium to MO and SLA. This is partly due to the mix of assets, as investment properties generally enjoy a higher rating. It may also reflect expectations that the profitability of the hotels will improve significantly. Similar to MO, capex for existing properties has been around 1.3x depreciation over the last ten years.
The profitability of the hotels is depressed for several reasons. The Hong Kong Peninsula recently underwent a major renovation, which was only finished in mid-2013; so 2014 will be the first full-year after its completion. The Asian hotels outside Hong Kong have a combined EBITDA margin of 11%. The Beijing Peninsula seems to be lagging behind some of its newer competitors and a major renovation is planned. As discussed above, there is overcapacity in many cities in mainland China due to the number of new hotels opened recently. The Shanghai Peninsula, which opened in 2009 is profitable at an EBITDA level, but is loss-making after depreciation, and on a cash basis due to high interest costs from its heavy debt burden. Finally, similar to MO, the EBITDA margin for its US hotels in New York and Chicago is low at just 1%: RevPAR remains below pre-financial crisis levels at both hotels. It seems that low profitability is a widespread problem for capital- and labour-intensive luxury hotels in the US. Some buyers of luxury hotels may view them as "trophy assets", which could distort both the prices paid and the market's profitability, if they are not run on a fully commercial basis.
I have done my own sum-of-the-parts valuation of HSH (see below). I estimate it is worth around HK$14 per share, which is around 25% above the current share price. This is a rough estimate, but it suggests that HSH is good value at the current share price, although not an outstanding bargain.
Arguably, my valuation of the hotels, based on EBITDA multiples, understates their intrinsic asset value, since a valuation based on hotel transactions would probably give a much higher value. However, HSH is unlikely to sell any of its properties in the near term, so a transaction-based valuation is largely irrelevant. Furthermore, the company does not adequately explain the reasons for the low profitability, merely alluding to "continuing oversupply of new luxury hotels in certain cities". Therefore, it is unclear, what, if anything, is being or could be done to improve it. My concern as an investor would be that profitability remains low: I am reluctant to assume a significant improvement as part of my valuation.
I have included the recently acquired commercial properties at the prices paid, and the hotels in Shanghai and Paris at book value. The Paris hotel appears to have had a number of problems during its development, including cost overruns and delays, and it will be interesting to see how its profitability develops once it is open. The book value of these properties may overstate their underlying value, but for current purposes, they probably represent a reasonable estimate.
All three companies appear to offer reasonable value; however, unlike Great Eagle, which remains my preferred choice, none appears to be an obvious bargain. MO looks to be a solid investment. SLA is potentially cheap, provided the long-term strategy in mainland China is successful. HSH also appears good value, but the low profitability of some of its hotels raises concerns. I am therefore not as bullish about HSH as another recent author.
Disclosure: I am long GEAHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.