Re-think Impact Investing

As of late, Impact Investing (II) and Socially Responsible Investing (SRI) has drawn attention of a wider audience. The two are used interchangeably and hence become difficult to draw lines between II and SRI. Member Bodies (Global Impact Investing Network) and Policy Initiatives (The Forum for Sustainable and Responsible Investment.) have also been launched to look in to this area of investment. A survey by GIIN and J.P. Morgan in 2014 points out that about 55% of Impact Investors surveyed look for market rate of returns – like any other typical investor, not categorized under II or SRI.

To narrow it down to Impact Investing, the GIIN defines the “Impact Investments are investments made in to companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return”. The report further highlights that the Financial Inclusion is the most commonly pursued theme which actually includes investments in micro-finance, small and medium enterprise (SME) finance, and community banking.  The vast majority of Impact Investment funds that reached Sri Lanka are also predominantly towards micro-finance and SME finance, apart from concessionary funding which came from Multilateral Agencies or other Development Funding Agencies (DFIs).

From the individual II Fund Manager perspective, their expressed high-level expectations are social, economic and financial – most of the time, broadly understood as targeting double or triple bottom line. However, at a more operational level, the focus is not different to conventional investing where you focus on certain financial/performance parameters in screening, executing and monitoring deals. It all may boil down to a very concise Term Sheet which does not even give an indication on the social and economic returns that are expected of through such investments.

Interestingly, most of the recipients of II funding are themselves not interested in measuring the outcomes in the Social and Environmental parameters rather than certain key financial/performance parameters like Portfolio-at-Risk (PAR), Non Performing Advances (NPA), Loan Growth Ratio, Debt-to-Capital Ratio, etc. In one hand, those are the criteria looked at by the II Fund Managers and on the other hand, most of these funding recipients are locally listed/unlisted return maximizing companies. Hence, the platform is well set for a conventional investment to take place – in the pretext of Impact Investment. The ultimate result is simple. The II Fund Manager funds the recipients at commercial rates or expects normal market returns. Consequently, these organizations on lend their clients – who are inevitably vulnerable (socially, economically and/or financially) segments in the economy – at exorbitant rates. In some instances, the interest rates can range between 27% - 47% in an economy like Sri Lanka where Sri Lankan Government bills are issued at approx. 7% and corporate lending rates can range between 11.5% - 14.5%. Ironically, neither II Fund Managers nor their beneficiary local organizations do evaluate what type of returns their ultimate clients earn by investing the financing received.

Now this entire process raises several concerns. Firstly, it raises the question whether it is moral/humane to treat an already vulnerable group – behind the name of Impact Investing. Secondly, the practicing organizations in the economy might engage in malpractices – such as multiple lending, loan rollovers, etc with the intent of preserving PAR and NPA - due to excessive pressure exerted upon them by the II Fund Managers. Thirdly, the beneficiaries might also be pushed – as has been the case - to go for multiple loans with different organizations further amplifying the issue. In the final analysis, a disruption caused – by practices like these – to the industry may prove to be alarming as it is the only source of financing accessible to these vulnerable segments – most of the time poor women, marginalized communities, etc.

The situation can be simply conceptualized with the help of a hypothetical example. Let’s say one helps – financially- a Needy in the street. Obviously, the helper would not ask the Needy to pay back interest as well as see him succeed in life as a result of him helping the Needy. But, the helper has achieved something that is not financially measurable -but measurable in other qualitative terms. For instance, the helper may have supported the Needy with his next meal for the day, funded part of the Needy’s medical bills, or could be anything or if not helper will at least have the inner self-satisfaction that he/she helped someone - without actually knowing how the Needy made use of his/her money.

However, in contrast now think of conceptualizing the so-called Impact Investors, who tries to help some vulnerable group while expecting them to pay market rates on the money, and also expect them to enjoy the social and economic upgrades as a result of their funds, wherein the investor enjoys the qualitative outcomes/returns -like the helper did in the example above.

However, it should be understood that the suggestion is not to provide funding free of charge like the helper did in the above hypothetical example but to provide funding at rates/returns that are not commercial or exorbitant given the segment served. The justification for giving up on commercial rates/returns would be that the Impact Investors are enjoying the other non-quantitative outcomes as a result of their funding being used without a burden by the recipient.  The resultant returns would thereby be the quantitative plus the qualitative elements. As the ultimate recipients graduate to small and medium scale – when they are able to pay higher returns - progressively higher rates/returns may be applied by the II community. 

 

Or else, it looks that it is not humane or moral to exploit vulnerable segments in any market under the appearance of Impact Investing. Or accept to compromise on the financial and qualitative returns. Isn’t that what Impact Investing should be or else why do we need alternative terminology to identify Investing.

Greetings for 2016

We just bid farewell to an eventful 2015 and looking forward to even more thrilling year, 2016. Here’s my very best wishes to all of the readers, from around the world, for a fantastic 2016. I would also like to thank every one of you for your continuous patronage shown towards LanakanMarkets over 2015 and I do hope to see same (or even more) level of support and interaction in this year.

Year in review: 2015

Colombo Stock Exchange (CSE)

CSE ended the year down 5.54% (All Share Index – ASI) and with a double digit dip in the S&P SL20 Index of 11.33%. Following corporate/other actions were noticed:

• Three Equity IPOs were concluded: (namely completion of Arpico Insurance PLC (AINS.N0000) listing, Singha Hospitals PLC (SINH.N0000) and lastly People’s Insurance PLC of which the listing yet be completed as of my writing). The three offers raised a combined c.LKR 1.08 billion (c. USD 7.5 million) from the public. SINH performed poorly as an IPO. It only jumped 12% at the debut and closed the year down 16%. In contrast, AINS was trading up 36% when it reached its highest price during the year and ended the year up 20%. People’s Insurance will debut in 2016 and it is likely to see a significant pop at the debut. (it is the only IPO which got oversubscribed in the first day after about 3 – 4 years);
• After about a 4 year break, another Closed-End Fund was listed on the CSE, namely Candor Opportunities Fund (COF.U0000) which raised c.LKR504 million (c. USD 3.5 million). On the inauguration it recorded an 8% hype though not sustained with volumes. Closed the year 5% below offer price;
• The public corporate bond market remained active as more and more companies tapped the market. A total of c. LKR83.5 billion (c.USD 579.61 million) was raised by 23 corporates. Interestingly, 84% of that was raised by Bank and Finance Sector companies while the balance was raised by Non-Bank corporates. In another event, the debentures that had been earlier issued by Urban Development Authority matured in October. Due to a conflict of interest issue, the Securities and Exchange Commission of Sri Lanka (SEC) suspended temporarily a debenture offering of EAP Broadcasting Company Limited;
• One of the Credit Rating Agencies, Lanka Rating Agency (formerly, RAM Ratings Lanka Ltd) were suspended by the SEC due to non-compliance. On the Sri Lankan Credit Ratings Industry I wrote several posts in this blog which you can search here: they were themed, Learn from the Past, Prevention is always better and lastly Now What; 
• CSE also adopted GICS towards the end of the year and will be parallel run until it is fully adopted in place of old classification; 
• The government, in its recent budget, removed the Share Transaction Levy (STL) whereby stocks trading on CSE will be 0.30% cheaper from 1 January 2016;
• Market PE was 17.98x, PBV 1.99x and Dividend Yield 2.18% by the end of the year; and
• S&P SL20 rebalancing took place in December, as usual.

CBSL policy

With the change in the political scene beginning in January, the Central Bank of Sri Lanka (CBSL) governor quit his job and a new Governor wasappointed. Before Long, in March 2015, the new Governor got himself entangled in a Bond Scam which I personally did not expect to see under a government which came to power pledging to bring in Good Governance and eradicate corruption. But, as usual things did not happen the way we wanted. I also wrote about my expectations in this post.

In terms of Monetary Policy, several decisions were implemented as pointed out below:

• In March, the Standing Deposit Facility rate of 5%, which was instituted under previous Governor, was removed by the CBSL;
• In April, the CBSL Policy Rates were reduced by 50 bps, a very unexpected move by the CBSL at the time, thereby bringing the SDFR and SLFR to 6.00% and 7.50% respectively; and
• Most recently, in December, the Statutory Reserve Ratio (SRR) was increased by 150 bps to 7.50%. This increase would affect the Banking Sector profitability, albeit not significantly.

There was no clear guidance from the CBSL in regards to the ongoing Consolidation of Financial Sector initiative that they carried out through 2014. The last communique in this connection was issued in 31 December 2014 and afterwards there was no any indication from the CBSL whether it was called off or still in operation. I would have expected them to come out and provide clear guidance to those companies which were forced by CBSL to merge. However, in the recent Budget of the Government they mentioned that companies are welcome to merge voluntarily.

Treasuries performance

Both primary and secondary market treasury rates moved up shifting the yield curve upward. The Primary bill rates increased significantly as reflected in the below table:

In the secondary market, the rates showed a similar fashion increase as evidenced by below table:

The yield curve signified a positive curve and an upward shift, though not a parallel shift. 

As reflected by the yield spread, it looks like that the investors are expecting interest rates to increase. The yield spread has increased to 3.93, a 1.58 increase compared to the beginning of the year 2015. 

LKR trajectory

2015 was not a good year for Sri Lanka Rupee (LKR). LKR showed significant depreciation against the US Dollar (USD) and Japanese Yen (JPY), 8.47% and 7.49% against USD and JPY respectively. A marginal depreciation of 3.71% against Sterling Pound (GBP) was witnessed while a 2.06% appreciation against Euro observed.

In terms of USD borrowings, Lanka borrowed closed to USD 7.5 billion via Sri Lanka Development Bonds (SLDBs), International Sovereign Bonds and Reserve Bank of India (RBI) Currency Swap Agreement. (Please note that this does not include other forms of borrowings by the government). The table below shows the issuances in chronological order:

The table shows each instrument’s tenure, amount raised and the interest rate. One noteworthy thing about the RBI Currency Swap facilities is that CBSL was not as transparent as it was with regard to SLDBs and International Sovereign Bonds of Government of Sri Lanka. Hence, it was quite tricky to find out exact periods on which they were utilized. However, from available information I assume that the first tranche of USD400 million was availed in April and the other USD1,100 million was made use in August. Going by the mechanics and as I posted in my articlehere, I also assume that the CBSL extended these facilities in August and December. (every three month tenure, purely my assumption). As of end of November 2015, the official gross reserves position stood at USD 7.3 billion compared to USD 8.8 billion by end of November 2014. 

My initiatives

Personally, I also took some initiatives to broad base the readership and to enhance my own excitement to blog more and more. Hence, as determined inthe beginning of 2015 I kept posting at a faster pace. Additionally, I have the LankanMarkets email which is active where you can directly send your feedback. [lankanmarkets@gmail.com]. Moreover, I have added social media widgets using which you can comment, share, and follow your favorite/interesting posts. The search button will allow you to search for anything that you want. The most popular posts are also organized for your quick access.

Final thoughts

As I always mention I do welcome your valuable comments/thoughts/ideas, either good/bad as it will help develop the blogging experience, for me for sure and hopefully for you as readers. Further, should you want any particular topic be discussed please do let me know as I’ll be happy to do that. In addition, should you need any research sent directly to you, I will also try to get that done beginning from this year. 

Anyway, I will try to outperform the last year with more posts in 2016.

Thank you again.   

Why a Hutch; when no rabbits inside!

I was interested in anarticle that discussed about an acquisition in the Sri Lankan Telco Industry. The story was interesting to me in several ways. Firstly, I have a small holding of Sri Lanka Telecom PLC (SLTL.N000) shares and hence this is of importance to me as a shareholder. Secondly, the story talks about an acquisition and some valuation numbers for the target company (Hutchison TelecommunicationsLanka (Private) Limited) and thirdly there is underlying politics to all this.

Rotten story

In fact, this acquisition story is not a new thing to the market. It has been floating around for quite some time. This story suggests that Hutch was on the lookout for a sale in Sri Lanka. This article gives more color to the industry’s rumors to the possible consolidations. As per this article it looked like the acquisition of Hutch by SLT was imminent. Likewise, I can give many examples of this nature and the fact is none of these contemplated acquisitions have taken place as of my writing.

Presidential attention

Interestingly, this is not the first time that country’s presidential attention, albeit in different presage, was driven to this story as per the above article. In 2014, the then president also interfered in this matter as this article suggests. Further, this latter story from 2014 points out to the fact that there were disagreements on the value of the acquisition target. At the time, SLT has offered to buy Hutch USD132 million (c. LKR17.1 billion at LKR/USD of 130) whereas Dialog had offered USD78 million (c. LKR10.14 billion) as per the article.

The Telco Industry in Sri Lanka

Well, let’s quickly look at the Sri Lankan Telco Industry. Telco industry in Sri Lanka is regulated by the Telecommunications Regulatory Commission of Sri Lanka (TRC) and there are currently 6 operators offering Landline, Mobile, Data, Enterprise, TV, etc services. See the below table for a brief analysis:

Clearly, these things suggest that the Lankan Telco Industry is now in a saturated situation and I attribute to it an Oligopolistic market structure (well, except that fact that they can’t set prices and earn abnormal profits as a result of regulation). The 3 firm concentration ratio as per my calculations (based on subscriber base) is about 82%. To give it a different flavor I looked at the Herfindahl-Hirschman Index – HHI value for the Lankan Telco Industry and based on my calculations I arrived at an index value of 2,588 which suggests that it is a highly concentrated industry.

Refer below chart from Central Bank of Sri Lanka annual report.

Value vs Price

With that brief discussion I move on to value the target. No, I can’t do it. Why? I don’t have any revenue or cash flow figure to do a valuation model. Hutch is not a listed entity in Sri Lanka and hence no information is publicly available except what I gathered so far. I can only make some approximations by looking at the other players and their performance.

Also based on the available information, I think I should be able to do some sort of pricing of the target. That should be better than nothing, I suppose!

The new deal value is mentioned in that above article as being USD130 – 135 million (c. LKR19.17 billion using LKR/USD 142). Which is equivalent to a Price to Subscriber ratio of c.LKR9,585. More than Dialog’s Price to Subscriber ratio and a 33.75% discount to that of SLT itself.

As with my approximations please look at the above table. Accordingly, based on mobile revenue and mobile subscriber base, I arrive at LKR6,020.49 and LKR6,120.00 of Revenue per Subscriber for Dialog and SLTL respectively. Quite contrast to that, the same figure for Airtel is LKR4,939.09. I think this is explained by Dialog’s and SLTL’s market leading positions, product offerings, etc. If I try to approximate the revenue figure for Airtel using an average of Dialog and SLTL Revenue per Subscriber figure, I arrive at a LKR10.926 billion whereas it’s actual is LKR8.89 billion. Hence, I reject leaders’ ratio as an approximation figure for Hutch and Etisalat. (May be for Etisalat it may be ok to use and average of all three: Dialog, SLTL and Airtel. However, Etisalat is not the focus in this post, hence I don’t bother too much about it). I, therefore, utilize Airtel’s ratio to approximate the sales figure for Hutch and arrive at a LKR9.878 billion as their topline. (I’m sure Hutch must also be operating at a loss like Airtel and Lanka Bell). The proposed payment consideration is at an implied Price to Sales multiple of 1.94x which compares with the same of 1.33x for both Dialog and SLTL. (Actually a premium of 45%). Or to look at it from another angle. Hutch should be at least making LKR14.4 billion or more to justify paying that much to acquire it by SLTL.

Figures in LKR '000s except ratios which are times.

As per the blow chart, as per my approximations (I accept that my approximations may be wrong!) I derive a Price/Sales based price of LKR13.15 billion for Hutch. Similarly, applying the SLTL and Dialog Price/Subscriber ratios I derive a pricing range of LKR28.94 billion to LKR18.86 billion.

Bottomline

Given that it is a horizontal integration strategy, my doubt is why should anyone (especially one of the dominant players already) pay Hutch market leading multiples? In fact, in this case all what SLTL would be acquiring is Hutch’s subscriber base and I don’t see any other synergies to them in this deal. Specially, given that no one is competitively bidding and the only bidder came at very low level, I think they should let Hutch voluntarily exit the market (let them bleed and die and then later lure its subscriber base at a cheaper price, simply) or offer at a cheap price now that would be worthwhile. Or else numbers should speak for themselves.      

TPP, the never seen formula for success

Recently, I came across thistweet by a well-known Professor, who, as usual, tries to argue that the recently signed Trans-Pacific Partnership (TPP) was a once in life time opportunity Sri Lanka missed. It was not the first time he voiced his dissatisfaction over this, as this earlier tweet of him says, with a link to the New York Times article. 

Well the learned Professor must be praising the TPP for its merits to countries like us in the APAC, I thought! Is that true? If yes, what is in it for us? How does it help countries like us? And how are we disadvantaged due to not being a signee to the Pact, as he claims in his tweet?

With these questions in mind, I tried to find anything in the public domain that would help answer these questions. But, it was very difficult to even find a draft of an agreement signed by any nation. But, as the New York Times article which the Professor shared says, “The pact, part of Mr. Obama’s strategy to balance China’s economic ascent, would knit together a largest-of-its-kind trading system in the Pacific”. Further, as the Office of the United States Trade Representative puts it in its website, it is another Made in America product which is aimed at “Leveling the playing field for American workers & American businesses”. As thisarticle by Koichi Hamada highlights “with the TPP, the US is catching a big fish with small bait. But the increased trade and investment flows brought about by the TPP’s ratification and implementation will benefit even the countries that must make larger sacrifices”. So, it is evident from these that this is not a Pact deliberated for the bilateral benefit of signees, rather to largely fulfill unitary requirements of one signee. (also not forgetting the fact that USA is heading to an election and that they need to give the US citizens something if they were to be in power. Further, their efforts to come out of the GFC and the subsequent recession via Fed lead measures have not really worked out and the Europe is also in really bad shape). 

The non-existent Free World

If I go to mainstream media, capital market or listen to any politician, I’m made to understand that we live in a globalized Free World where there are no barriers to trade. (or for years, from the Imperial times, they are boasting of Free Trade). Further, to facilitate such free trade or the free world, they invented apparatus like World Trade Organization, etc. If this is the case, why on earth do we need these other Trade Agreements, which I don’t even know whether override the already existing WTO or other stipulations, to benefit countries? May be this so-called Free World is non-existent and it only exist in documents. Still they are talking about Trade Liberalization and also at the same time some form of protectionism. (I know it is easier said than done!).   

Different views

I think it is worthwhile looking at different views so that we can form some sort of understanding that is not partial or biased. As I mentioned above that this agreement is not something drafted transparently, as the US Senator Bernie Sanders points out in thisarticle. Further, I also think that we should look at merits and demerits of previous Trade Pacts that countries and regions have signed before. Just because it is a very new pact and that the world is in a shaky situation, we should not just opt to this. (I don’t think that it is easy to reverse it once we penned it!). At least, if the Professor points out the great benefits that we derived from any such agreement with other nations (like SL and India Free Trade Agreement, etc), that would be greatly appreciable. I know of this article by economistMartin Feldstein, wherein he argues that trade agreements by Chile with USA have benefitted both.     

Bottomline

As I conclude the post, I have to mention that I do not personally know the Professor nor have I met him. Hence, I do not have anything personal rather than my own reactions to his thoughts. Honestly, I accept some of his thoughts on some other topics like the Appointments to Government positions which appeared in ft.lk as an article, etc. But, on the TPP I have my doubts and it may be true that I’m also one of the Sri Lankans swimming in the Pond called Sri Lanka listening to only our Mass Media such that I’m amazed why countries should go for these types of pacts, as the Professor mentioned in his Ravaya article. I hope that he may also write about the great aspects of the TPP and how it benefits us in an already (non)existent so-called Free World (which is assumed to be facilitated by apparatus like WTO, etc) where there are tariffs to protect their interest, in country, and pacts to protect their interests elsewhere. 

Thought to share this and wrap up. 

Follow the herd! Win or lose?

It’s been a while since I last posted on My Views. I was attracted to a very interesting stock this time, Hayleys Fibre PLC (HEXP). HEXP is a subsidiary of diversified holdings, HayleysPLC. HEXP is an exporter of coir fibre. However, they generate approx. 15% - 20% of its revenue from the local market. They manufacture a variety of products which fall under five main categories, Erosion control, growing media, horticulture, bedding and upholstery and industrial fibre. In terms of revenue Asia (I assume Russia is also categorized under this by the company) and Europe account for about 75% of their export revenue while the balance is split between Japan and USA. (refer below Sale by region graph, Sourced from Company’s latest published Annual Report).

Company going forward

As per the latest annual report, the management intend to focus on the following in order to grow revenue and increase profitability from the business:

• -       More focus on erosion control, specifically to focus and rationalize the product portfolio and consolidate business with more emphasis on value added products (I hope it the most profitable product category and they will stop producing loss making products);
• -       Invest in new technologies (hope they will increase efficiency and also reduce operating costs);
• -       A backward integration project (this should help reduce raw material costs);
• -       Energy saving initiatives; and
• -       Aggressive marketing at the Joint Venture company level.

With this in mind it is good to look at historical performance to get an idea about how they have performed. (refer below for profitability ratios of HEXP). The performance numbers says the story that HEXP is operating in a very competitive market (globally competing) and are a price taker when it comes to sourcing raw materials.

As a result, returns on capital has been shockingly low. (refer the ROIC chart below). 

Recent explosive growth

At the beginning of this month, REXP was at LKR44.90 (6 October 2015) and as of my writing the stock appreciated rapidly to reach LKR88.40 as 97% return in less than a month. (refer the graph below).

As far as I know, there was no any significant news about the company which should trigger this type of appreciation. (as usual, may be market possesses some information which I’m not privy to).

However, I was interested to find out a reason for this. From what I understand, one reason may be the recent drastic depreciation in the Sri Lankan Rupee. Hence, technically, HEXP being an export company become price competitive in the market and their foreign currency earnings are now converted to higher LKR value. To see how this plays, I ran a correlation analysis in to HEXP’s revenue and LKR/USD to see if they are correlated. However, I was surprised to see that they show a negative .0.8240 correlation.

Alternatively, it is merely due to excessive retail participation due to some market rumour and subsequent herd behavior where everyone else jumped in to enjoy the rally.   

HEXP valuation

In order to value the shares of HEXP, I conducted a discounted cash flow valuation, as I usually do. As always, the valuation is based on assumptions made by me and I certainly do not possess expert knowledge as to how this business operate (but I think my assumption here are more generous than in any other case). However, I have used assumptions that I believe are reasonable and I would be glad to change them and see the impact on valuation if you can come up with more robust assumptions.

My cost of capital calculation is based on few parameters like beta of 1.17 (against All Share Index) for the stock which was taken from Colombo Stock Exchange, risk free rate of 9.85% (current 10 year Sri Lanka treasury bond rate in the market), Equity Risk Premium of 8.00% (my subjective judgment as I currently don’t have a scientific method to calculate, I will soon rectify this), pre-tax cost of debt of 9.50% and a tax rate of 15.31%.

On the tax rate I want to specifically mention that the company’s export earnings are only taxed at 12% concessionary rate while other earnings are taxed at normal 28% rate. Hence, I used a weighted average tax rate for cash flow calculations. Equity and debt weights of 79.59% and 20.41% were used respectively. Using these assumptions I derived a cost of capital for the firm of 16.93%.

The other assumptions are as per the below calculations.

Based on all these, I derived an equity value of c. LKR367.67 of which about 88% is coming from non-operating assets. These non-operating assets consist of Investment Property (property in Ekala that is rented), investment in joint venture company (carrying value of 50% ownership in Bonterra Lanka Ltd, which is equivalent to 50% of the net assets value of the entity) and other financial assets (investment in unquoted shares of Toyo Cushion Lanka Pvt Ltd and Rileys Pvt Ltd which are valued by them based on DCF method).

The derived value gives a per share value of LKR45.96 per share of REXP. The market price as of my writing of the share was LKR88.40 which is 92% higher than my valuation.

Bottomline

As I always say, I’m a very bad trader and every time I try to profit from this type of stock rallies, I end up buying in at the peak. So, now I tend not to join the bandwagon. But, if you are good at trading please go ahead and do it. But, if you are not, please be careful as the stock is currently heavily overvalued as per my valuation (you are welcome to argue with me on my valuation). If you are a believer in technicals, then be mindful as it is now in the overbought territory and a similar fashion drop is also all possible. 

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!)