Ruchi Agrawal Moneycontrol Research
The IPO of Lemon Tree Hotels comes with an opportunity to invest in an emerging mid-segment domestic hotel chain. While the business proposition looks interesting, the heady valuation of the issue leaves us cold.
The upcoming hotel chain has presence in the midscale economy segment in India. The company is positioned to benefit from the growing popularity of branded economy hotels, growing disposable income, increased preference for travel & tourism for the Indian middle class, and the flight of customers from the unbranded to the branded segment.
IPO Details
Lemon Tree’s issue comprises of an offer for sale for around 185.5 million equity shares from existing PE investors totaling Rs 1,038 crore. The issue is priced in the range of Rs 54 – Rs 56. The IPO forms around 24.9 percent of the total capital of the company.
About the company
Delhi-based Lemon Tree Hotels is one of the largest mid-sized domestic hotel chain which started operation in 2002. The company has a room portfolio of around 4700 rooms spread across 45 hotels in 28 cities and is strategically positioned under upper midscale – Lemon Tree Premiere, midscale – Lemon Tree and economy – RedFox segments. The company has a value for money proposition and aims to attract Indian middle income guests and deliver differentiated yet superior services.
What we like about Lemon Tree hotels
Growing Mid-scale hotel – Positioned in the mid-priced range, the company derives major portion of revenues from the domestic middle income customer and is positioned to benefit from the increased tilt towards branded hotels, growing disposable incomes, preference for tourism as a major form of entertainment and internet awareness/penetration.
Strategically positioned in key geographical areas - The company has very strategically developed its hotels in areas with high entry barriers or near major business hubs and is positioned to capture both economy middle income leisure along with business travel customers. With presence in upper midscale to economy segments, we see the company being well positioned to rapidly capture market share.
Improving operating performance - The company has shown an improvement in operating performance over the years. They have reported a decent topline and EBITDA growth every year. After consecutive years of losses, the company has turned net profitable during the 9 months ended December 2017.
Move towards management contracts - The company has created a strong brand image in the mid economy segment and now plans to monetize the brand value with growth targeted through management contract model. This asset light model will help in de-leveraging and also help in capturing market share rapidly in the coming years.
What makes us cautious on the IPO
Rapid entry of well- known branded players in the mid segment - The surge in domestic demand in the middle and economy segments is being eyed by major international hotel chains who plan to rapidly expand their presence and capture the growing segment. We, therefore, foresee intense competition in this space. We see international chains with deep pockets as a major threat in the coming years.
High debt on balance sheet - Hotel industry in general is capital intensive business. The decent topline growth has come in at the cost of rising debt on the balance sheet of Lemon Tree. The company has a Debt Equity ratio of 0.9x. Owing to the capital intensive nature of business, this leverage limits the future expansion potential of the company.
Highly cyclical Industry - Hotel industry is highly cyclical with a close relation to economic growth. Although the economy segment is impacted less by the cyclicality, yet the company is exposed to the vagaries of severe slowdown. Given the growing phase of the company and high finance cost, any significant slowdown can have a telling impact on financials.
Online travel bookings, channel conflict - As with the entire hotel industry, online bookings channels dominate. With their breadth of offerings along with scale of operations, they stand in conflict with the direct booking channel and eat away a portion of profits. Negotiations with online channels are a significant point to watch out for and can impact performance negatively.
High Occupancy - The company is already operating at a good occupancy rate of around 70 percent. Given this, there is little room for growth from the occupancy route in the future.
Peer Analysis and valuation
On analyzing the performance of the company with its listed peers it seems the topline growth in the past two years has been above the average peer group. EBITDA margin at 29 percent is ahead of peer average. However, the growth has come at a price and the company has accumulated debt on its balance sheet. Moreover, the issue is a complete offer for sale, so there would be no relief on the debt front post the issue.
Given the high debt, at the higher price band of Rs 56, Lemon Tree is priced at an EV/EBITDA of 42x which is considerably above the average peer multiple of established brands at 27x. This along with a FY17 debt equity ratio of 0.9 limits its growth potential (9mFY18: 1.15x). Moreover, the company has an interest coverage of around 0.96x (9mFY18: 1.1x). This is a point of caution.
The current price band leaves little upside for investors in the near term. Investors waiting for listing gains should therefore avoid the IPO. However, given the long term growth visibility in line with overall industry growth, we believe only long term investors should consider investing a portion in the IPO and wait for correction post listing to accumulate more.
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