Would you buy a Fortress or a Lighthouse!

Thought to do a comparative analysis of two companies as the topic hints. Of course it is a strange question to ask. In fact, I had this question in mind as I was looking to buy one of the Southern Coast based hotel operators. In this regard, my focus was on two companies, i.e., The FortressResorts PLC (RHTL.N0000) and The Lighthouse Hotel PLC (LHL.N0000). Well, going by the analysis that follows, I’d rather opt to buy the Fortress instead of the Lighthouse.

The two hotels

The Fortress is a luxurious hotel located in Koggala and the Lighthouse is located near Galle. In terms of the offering, the Fortress serves a high-end clientele while Lighthouse serves a different segment that is more price conscious. The below comparison of room rates from Tripadvisor (accessed on 2 June 2015) suggests the difference. (On the left side are the quotes for the Lighthouse and on the right side are the Fortress quotes, higher than the Lighthouse as you can see)

The Fortress operates with 53 rooms and the Lighthouse with 86 currently. In my opinion, I don’t expect that the Fortress will increase its key capacity any time sooner (but there may be a requirement for a major renovation in the near future as they have not done it for some time now) although the Lighthouse keeps adding keys slowly (with added properties like Kurulubedda and extensions to the existing main property). Close to a 50% of revenue of the Lighthouse came from Western European market and the Fortress’s revenues are also skewed towards European market. Both, players are now focusing on diversifying in to other emerging market segments like China, USA, Middle East, etc. As per the Fortress FYE2014 Annual Report “Compared to its major competitors in the area the Fortress is maintaining a higher market share in terms of boutique hotels category. In total there are approximately 43,665 room nights available in the area, concentrated amongst three main competitors, of which the Fortress accounted for approximately 13,974 room nights during the year. This secures an approximate 31% of the area market share, based on available room nights”.

Revenue wise, both companies managed to achieve 19% CAGR over the last five years.(the below table shows the revenue patterns of the both Hotels).

Premium offering with premium margins

As mentioned, the Fortress focuses on tapping the high-end clientele who are willing to pay a premium price for a premium offering. It is believed that as a model they have rightly chosen to address a gap in the market with this offering in down south. I believe that the profitability analysis given below evidently shows that. In terms of most of the margins (except the GP margin) the Fortress lead the game with some healthy margins in comparison to the Lighthouse. Even with some significant tax effect, the Fortress’s NP margins are very attractive.

Moreover, the Fortress is ahead of the game in terms of operating cash flow generation. If you look at the Operating Cash Flow to Sales ratio, the Fortress has been able to achieve a very high level of OCF to Sales compared to the Lighthouse. 

Higher administration costs at the Lighthouse have caused this, I believe. Sometimes, there may be management fees paid to the Jetwing Group which is the ultimate holding company of the Lighthouse (however, they have not disclosed anything in to this effect in their Annual Reports).

Shifting debt metrics

The gearing levels of the two entities have moved in opposite directions. Accordingly, the net debt position of the Fortress has gone from positive to negative and their balance sheet is nearing zero debt levels, hence they have enough financial flexibility to go for a debt funded renovation once the decision is made. (in fact I assume that they will go for a complete renovation in FY2017.) Also there is enough evidence to believe that there may be a dividend announcement from the Fortress but subject to how they finance a potential renovation) However, the Lighthouse’s debt free situation has taken a u-turn and net debt is currently at c. LKR137.3 million.

Distinct returns

The two companies show significant differences in Return on Invested Capital (ROIC) as seen in the chart below. 

Over the last five years, the Fortress recorded average ROIC of 14.77% while the Lighthouse only managed to average 4.40% over the corresponding period.

Pricing analytics, can they be justified!

With all the above performance indicators in mind, I’m going to have a look at the pricing of the two hotels in the Colombo Stock Exchange. As of my writing, the LHL and RHTL closing prices were LKR63.50 and LKR17.60 respectively. On trailing 2015 numbers and at those current prices, LHL and RHTL are trading at PER of 22.57x and 10.28x respectively. Similarly on a book value basis LHL is trading at 1.18x PBV and RHTL is at 1.39x PBV. Currently, the Hotel  and Travel Sector trades at PER of 53.2x and PBV of 3.6x, well this is a very broader measure and includes some of the best managed properties to worst managed properties, startups and mature companies, etc and hence the multiples are not without noises. Similarly, for the historical patterns have a look at the below chart.

On what basis can anyone justify the lower Price to OCF paid for the Fortress. (either the Fortress is fairly priced and the Lighthouse is overpriced or vice versa).

Also on a per room basis, RHTL’s revenue per room has always been above that of LHL. More interestingly, the per room EBITDA generation by RHTL is pretty impressive compared to LHL. At current market prices, LHL is priced at c. LKR34.4 million per key whereas RHTL is priced at c. LKR36.8 million. The question is; why are the both properties priced at almost similar level when their earnings are significantly different.

I also looked at enterprise value multiples (just to make sure that I’m not missing something important!). At the prevailing market price of LKR17.60, RHTL is priced at EV/EBITDA of 4.82x and LHL at 13.51x.

Valuation

At the next level, I tried my favorite method. Hence, on both stock I ran DCF’s to see what the numbers say. They are reproduced below.

Assuming my cash flows and other input assumptions, I derived an equity valuation of LKR19.89 for LHL. 

I also used a model to value the company assuming it is in mature growth stage and based on that my value per share of LHL is LKR21.28. 

My valuation and the market prices are ludicrously different. May be one can argue that the land itself is valued at c.LKR459 million as per the financials which is about c.LKR9.97 per share. Even if you add this component as a non-operating asset, the valuation would still be way more lower than the current market price. Someone would also argue that the property was a design of Geoffrey Bawa and hence should attract a premium price. However, none of these premium qualities are reflected in the cash flows. From a valuation perspective, I think anything should be echoed in the earnings capabilities and the quality of the company. 

   

Similarly, I calculated share values for RHTL using the same methods as per LHL. The charts below highlights the values.

So, based on an extended DCF subject to my assumption, I value a share of RHTL ar c.LKR17.56 which is about the current market price. 

Based on the other model, I derive a value of c.LKR19.38, slightly higher than the current market price.

Bottomline

From a market pricing perspective, I can’t seem to find any justification as to why RHTL should be trading at a huge discount when it’s achieving some quality earnings. Moreover, the valuations that I have done subject to my own assumptions do not justify such a higher price for LHL. But, as usual I have to caveat my opinions here saying that I might be missing something!

Also I have to mention here that I currently own shares in RHTL. (Well not on the top 20 shareholders list, yet!! May be one day!)