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!) 

Everything is politics but ….

Even though I hate to write things about Sri Lankan politics, it has come to a point where I can’t just ignore and stay back. (well, no one can just ignore politics as it affects everyone’s’ day to day life as well as their decisions in life). This reminds me of the book of which the topic was “Everything is politics but politics is noteverything: A theological perspective on faith and politics” from which I actually borrowed part of my topic today. But, don’t worry that I’m not going to write good things about any political party or anything bad about another party. (that is done big time currently in all types of media!). But, if anything that I write here looks as if I’m partial please bear with me. (Because I know that in Sri Lanka if you say something political, there is a culture that you will be labeled. You will agree with me, don’t you!).

Anyway, I just wanted to shed some light on some of the news that comes up in a very urgent fashion in the run up to the elections. As an investor and a blogger who cares about the markets and the equity valuations, I do need to look at those news from that angle. How does these news affect the markets and in turn me. After all, businesses and investors do conduct this analysis called “PEST Analysis” of which the letter “P” stands for political analysis.

Media behavior

An important aspect of these news items is that they have found their way in to the mainstream media and it seems like that they have not done any sanity check on these items. That makes me be skeptical about the accuracy, relevance and importance of these items. But what can I do there are inherent problems in the way the media is handled as this book by Robert W.McChesney argues. (I think these arguments are more or less valid in Sri Lankan context as well).

One recent news item that was very interesting was about introducing Google Loon in Sri Lanka. In fact, one of the Sinhala medium websites mentioned it as the first time something like this was ever done in the world and the witty fact was that they did not seem to have logged on to Google Loon’s website to simply check the truth. On the other hand some web sites depicted it as free wifi internet connections for everyone in Sri Lanka. (if that was the case it will be really good and I also hope and pray that it would happen one day). This was shared on social media by many and none of them seem to have given a thought to some questions like:

• why Sri Lanka at this particular time (when there is an election forthcoming);

• if this is free, why would Google want to do this (they are a for-profit listed company in the USA);

• if not for free who is going to bear the costs (as a balloon is said to have a 100 day life span and then need replacement, i.e., three times a year);

• some articles say that it will be in collaboration with local internet providers (if that is the case it would not be free or may be the government will have to subsidize in order for it to be affordable to poor. In that case, government subsidies will have to be borne by someone, tax payers or everyone);

• if this was available free what will happen to listed companies like Dialog, SLT (if you are investors in these companies) and other commercial operators like Airtel, Etisalat and Hutch;

• Google Loon is still in test stage and why wasn’t it rolled over in most of the poorer nations.

I believe, like anything else there are pros and cons to anything so try to think of any sectors in the market that will be benefitted directly out of this, if this happens. Also note that there will be a lot of ground work to be done in order for the benefits to spill over to the corporate sector. For instance, the English knowledge of the rural populations are very low hence even if they had affordable internet connections most of them would possibly not use these services. For instance, Banking, Finance and Insurance sector can significantly reduce costs if they resort to online solutions. A study conducted by one of the friends found that the usage of online banking services even in Colombo is very low. (I can put you in touch with her if you wanted to!). I also believe most companies will be able to reduce their marketing spend if they use more online services.  

In other instances, it was mentioned that the Board of Investment of Sri Lanka signed agreements to revive a Sugar factory and to build the tallest tower in the country. The sugar factory investment is a USD110 million project, supposedly. But, the names appearing on the article do not seem to even have a proper website for those companies (I know that you can set up a company in Singapore in like hours!). I believe an investor who is bringing in USD110 million to the country should be a reputed company with a track record. Besides, from my encounters with the investor community I do not believe that any investor would look at investing in a country when there is political uncertainty and especially an election at the door. Will this be history after the election! Wouldn’t they conduct a PEST analysis before entering! Or they must be having some deep pockets to take this level of risk.

Sri Lanka currently consumes about 572,300 MT of sugar per year. Of this about 91% is imported with an approximate cost of USD255 million. This is c. LKR64,142.28 per MT. If the Kantale Factory was opened and start producing the quantum of 72,000 MT per year as the BOI mentioned, we should be able to reduce imports by about 13% and increase the local production to c.22% of the market demand. Also thereby save c.USD32 million in forex. What remains in dark still, is the fact whether we will be able to achieve a lower retail price per Kilo of sugar if we increased production locally as compared to imports. Also will this be another political thing as it has always been. (because consecutive governments have promised this as per this article). Further, the Central Bank of Sri Lanka Annual Report 2014 mentions (page no.38) that “while the Kantale factory, which was not in operation in 2014, continued with sugar cane cultivation with an intention to recommence operations in the near future”. (so what was the arrangement there!). I hope something good for the country and economy will happen, at least this time.  

The other company (the real estate one) has one of the candidates in the election as the chairman so I have lots of doubt there as well. (politicians are politicians!). Weren’t we against this type of involvement by politicians!

Another news item read that Volkswagen was considering setting up a plant in Sri Lanka.  The interesting thing was no official from the company itself was involved in any of these discussions and the company is 50.73% owned by Prosche not the Government of Germany. (Only about 20% voting rights are with a State). Refer their Annual Report in page 92. So, I was wondering how the government officials can sign agreements on behalf of a company which is owned by someone else. As far as I know the company has not confirmed this venture. For me, I need more concrete evidence to believe that this deal is done. As the Chrysler CEO puts it, the Auto industry is struggling with some fundamental issues, have a look at this preso.    

Similar items appeared on oil exploration in Sri Lanka’s east coast by French company Total, re-entry by Shell in the LPG market. Shell’s exit was explained in this by the Company.  

   

Bottomline

Don’t fuel a culture of blindly following news, especially the ones published with a view to gain political advantage. Just double check the accuracy and always try to evaluate the importance of these to the economy and thereby our decisions. (on the investments if you are an investor, cost of living and the real earnings for a person in the general public, etc). Because everything is politics…. I think thereby we can also work toward disciplining politicians and making them more accountable to what they do and say. (Broadly, in nurturing a conducive political culture and media  that is responsible).