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Stock Recommendation | Lemon Tree Hotels - ADD - Target price : 76

Publish date: OCTOBER 08, 2018

Capturing India's mid-scale hospitality demand. Lemon Tree Hotels is among India’s fastest-growing hotel companies catering to mid-scale demand, mainly from domestic travelers. 71% of the operating keys are in the top-10 cities and it is looking to expand to more leisure destinations. Properties added through the ownership, lease and management contract route in the down-cycle are already operating at high occupancy and will ride the higher ARR curve as the cycle improves.

Initiate coverage with an ADD rating and target price of ₹76/share

We initiate coverage on Lemon Tree with an ADD rating and a DCF-based target price of ₹76/share on September 2020E earnings offering 13% upside to CMP of ₹67/share. Valuations at 17X attributable EV/EBITDA on FY2021E financials appear rich, though should be seen in the context of (1) large properties in high-value markets such as Mumbai (875 keys against current owned portfolio of 3,277 keys) that are currently under construction and will add significantly to earnings growth beyond FY2021E, (2) inflexion point in the hospitality industry with utilizations beginning to improve even though ARRs stay 25% below the FY2007 peak and (3) stabilization period for 550 keys that were commissioned over the past three years.

Capturing the growing domestic mid-scale hospitality demand

`Lemon Tree has added keys at a CAGR of 20% over FY2013-18, and will likely maintain that momentum over the next three years as it increases its keys to 8,236 from 4,870 in FY2018. Lemon Tree is among the largest and fastest-growing mid-priced hotel companies, offering three distinct brands for budget (Red Fox), mid-scale (Lemon Tree) and upper mid-scale (Lemon Tree Premier) categories. Lemon Tree holds 4% of the total market share of chain-hotels in India, and a higher 9.2% market share of mid-priced chain-hotels in India.

Financials: Lemon Tree to deliver 25% revenue CAGR over FY2018-21E

Lemon Tree will likely deliver 25% revenue CAGR over FY2018-21E, improving on the 18% CAGR reported between FY2013-17. Higher ARRs in the coming years along with better staff per room ratio will reflect in 44% EBITDA CAGR over FY2018-21E. Operating cash flow remains positive with the individual properties performing well on occupancy. We note that Lemon Tree has a net debt-equity of 1.2X as of March 31, 2018 that trends down to 1X by March 31, 2021 with net debt at ₹10 bn.

Market slowdown resulting in slower-than-estimated ARR improvement is the key risk

A slow economy, increasing competition from global and local chains and changing government regulations, which could increase cost of compliance for Lemon Tree, are key risks. It has high concentration risk with properties in three cities—NCR, Bangalore and Hyderabad contributing over two-thirds of its revenues.

Exhibit

INITIATE WITH AN ADD RATING AND TARGET PRICE OF ₹76/SHARE
We initiate coverage on Lemon Tree with an ADD rating and target price of ₹76/share offering 13% upside to CMP of ₹67/share. Valuations for Lemon Tree may appear rich at 17X EV/EBITDA on FY2021E financials, though should be seen in the context of (1) 22 hotels with 3,238 keys on extant base of 4,998 keys that are currently under various stages of implementation and will contribute meaningfully to earnings beyond FY2021E, (2) lack of competition in the mid-scale hotels segment and (3) improving occupancies and room rates for the hotel industry in India that would help propel industry earnings at large.

Initiate coverage with ADD rating and target price of ₹76/share
We initiate coverage on Lemon Tree with an ADD rating and target price of ₹76/share offering 13% upside to CMP of `67/share. At 17X EV/EBITDA (attributable) and 36X P/E on FY2021E the stock appears rich, despite the 25% CAGR in revenues between FY2018 and FY2021 that will likely deliver 45% CAGR in EBITDA during that period.
We highlight that a large part of Lemon Tree’s portfolio is still under construction, and will commission by FY2021E, though a three-year (adult hotels) stabilization period for hotels in general implies that earnings contribution from hotels commissioned will aid EBITDA growth well beyond FY2021E. Our DCF-based target price is based on September 2020E earnings and comprises ₹30/share as the value for the attributable ownership in Fleur (58% ownership with the balance held by APG Investments), and ₹46/share for the remaining ownership of hotels business as well as earnings from managed hotels. Exhibit 3 gives the valuation multiples, coupled with growth, margin and return profile of the company.

We further highlight that hotel properties take a three-year period to normalize operations and deliver earnings to full potential. Accordingly, the current earnings are less reflective of the overall portfolio with 550 keys having been commissioned less than three years ago, and another 1,525 owned keys to be commissioned over the next three years. Exhibit 4 and Exhibit 5 highlight the disparity in earnings profile between recently commissioned hotels and those that have been commissioned for over three years.

We note that Lemon Tree has so far been a predominantly city-centric hotel chain with presence across key commercial cities such as Delhi, Bangalore and Hyderabad. Lemon Tree has two large hotel properties that are under construction in Mumbai. While the company retains ownership (wholly or part) in the city-centric hotels, it is broad-basing its presence in Tier-2 as well as leisure destinations through the managed hotels route as well. Ownership of large city-centric hotels will be incrementally valuable, due to prime locations and scarcity of land in such locations, even as the company adopts a more asset-light approach for broad-basing its brand presence in Tier-2 towns. Lemon Tree has done well to compete with global brands and has the largest inventory of owned mid-priced hotels in India, while being among the Top-10 hotel brands in India on an overall basis.
We use the DCF-based approach to value Lemon Tree, as a multiple-based approach is unable to fully capture (1) high-growth with 1,525 keys getting commissioned over the next three years, (2) stabilization period for 550 keys commissioned over the past three years and room inventory that will commission up to FY2021E and (3) inflexion point in the industry due to improving occupancy levels that will reflect in high ARRs over the next three years. Partownership in hotel properties co-owned with APG Investments, prompts a two-part DCF, one for 58% ownership in Fleur Hotels and the balance for wholly owned hotels under Lemon Tree.

As an alternate approach, we compute a multiple-based target price on FY2024E estimated financials that we discount back to September 2020E, yielding a target price of `78/share. We benchmark the target price to FY2024E, as the current stock of hotels under construction will reach normalized earnings after a three-year ramp-up phase. Exhibit 9 shows the computation of target price based on FY2024E financials, discounted back to September 2020E.

Focus on the mid-tier hotel segment with superior earnings profile
Lemon Tree focusses on the mid-tier segment unlike traditional Indian hotel chains that have been focused on the upper-end of the hotel segment. The mid-scale segment offers a large untapped opportunity with limited competition from chain-hotels. The large opportunity set aside, mid-tier hotels offer a superior return profile owing to (1) lower capital cost, (2) lower operating cost owing to smaller room configurations as well as lesser amenities and (3) higher occupancies owing to low-price prospects. Exhibit 10 illustrates the return profile build-up for a mid-tier hotel such as Lemon Tree in comparison to upper-scale hotels in citycentric locations. As can be seen, the build configuration of the hotel is important (to keep capital and operational cost low), which prompted Lemon Tree to build hotels as per specified low-cost configurations even as they now pursue management contracts for hotels built as per their specification.

Large hotels in Mumbai to stabilize beyond FY2021E
Lemon Tree currently has 50 hotels, with total room capacity of 3,238 keys that are still under construction that will likely commission by FY2021E with normalized operations and earnings accrual that will materialize a few years beyond that. Two of these hotels account for 19% of the overall portfolio size, but more importantly they are located in the highrevenue market of Mumbai (both in terms of occupancy as well as ARR) as can be seen in Exhibit 10. In our view, the Mumbai market was a critical and yet an important piece that was missing in the hotel portfolio of Lemon Tree. Commissioning of two large hotels adjacent to the Mumbai airport marks a critical milestone in the development portfolio of Lemon Tree. The two properties in Mumbai will have a combined EBITDA of ₹3.4 bn (incremental ₹2.8 bn) in FY2024E compared to estimated EBITDA of ₹4 bn in FY2021E.

Industry at inflexion point with improving occupancies; ARRs will likely follow
The hospitality industry in India is at an inflexion point with occupancy levels having improved to 68% in FY2018, after having remained at an average of 61% over the past 10 years. Room tariffs have still not recovered with average tariffs at ₹5,745/day in FY2017 compared to ₹7,543/day seen in FY2007. We estimated room tariffs to further improve as demand for hospitality sector remains robust, though pipeline of incremental capacity addition stays lean suggesting that the current up-cycle will likely last over the next few years. The hospitality industry has a high operating leverage, with most cost being fixed in nature, and the benefit of improved tariffs flowing through the bottom line on a post-tax basis.

We currently factor average utilization for Lemon Tree to improve to 78% by FY2021E from 76% in FY2018, with blended room rates improving to ₹5,417/day in FY2021E from ₹3,896/day in FY2018. We note that the improvement in blended room rates is also attributable to contribution of hotels in Mumbai that operate at higher realizations compared to those in other cities.

Premium valuations to factor superior return profile, aggressive growth path
Lemon Tree trades at 17X EV/EBITDA on FY2021E, a premium to both local as well as global hotel stocks though the same should be seen in the context of (1) superior growth profile of Lemon Tree, especially with commissioning of two hotels with 875 keys in the prime market of Mumbai, (2) superior return profile owing to its low capital cost as well as low cost of operations, and presence in the mid-tier space that ensures better occupancy, (3) presence in the mid-tier hospitality segment that has so far seen limited competition and promises high growth potential and (4) presence across the hotel value chain, that helps the company capitalize on growth opportunities and still maintain a less capital-intensive business model. Exhibit 14 gives the comparable valuation of local as well as global hotel chains in the listed space.

Ratings and other definitions/identifiers

Definitions of ratings

BUY	-	We expect this stock to deliver more than 15% returns over the next 12 months.
ADD	-	We expect this stock to deliver 5-15% returns over the next 12 months.
REDUCE	-	We expect this stock to deliver -5-+5% returns over the next 12 months.
SELL	-	We expect this stock to deliver

Our target prices are also on a 12-month horizon basis.

Other definitions

Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

Other ratings/identifiers

NR	=	Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
CS	=	Coverage Suspended. Kotak Securities has suspended coverage of this company.
NC	=	Not Covered. Kotak Securities does not cover this company.
RS	=	Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
NA	=	Not Available or Not Applicable. The information is not available for display or is not applicable.
NM	=	Not Meaningful. The information is not meaningful and is therefore excluded.

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Correspondence Address: Infinity IT Park, Bldg. No 21, Opp. Film City Road, A K Vaidya Marg, Malad (East), Mumbai 400097. Telephone No: 42856825.
CIN: U99999MH1994PLC134051. SEBI Registration No: INZ000200137(Member of NSE, BSE, MSE, MCX & NCDEX), AMFI ARN 0164, PMS INP000000258 and Research Analyst INH000000586.
NSDL/CDSL: IN-DP-629-2021

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