The Hindu Business Line : Hotels: Venture and gain

HOTEL stocks have had a dream run in the markets over the past two years. So much so, stocks such as Oriental Hotels, Hotel Leelaventure and Asian Hotels, which have provided returns of 75-100 per cent over the past year, have been underperformers in the sector. Valuations of hotel stocks now rule high, with stocks such as Indian Hotels, EIH and Taj GVK trading at between 35 and 40 times their expected FY-06 per share earnings.

Prospects, however, remain bright for the sector. The demand-supply mismatch is likely to persist at least till mid-2007 and if growth in demand continues to outstrip the addition of rooms, the gap could widen further. Shareholders can, therefore, hold on to hotel stocks across the board from a one-year perspective. Long-term investors, however, would be better off sticking to the top-rung stocks, as only leading chains such as Indian Hotels, Taj GVK and Hotel Leela show signs of aggressive expansion.

Most of the fresh supply would come in 2008. As a result, room rates and occupancy rates may decline, but settle at rates higher than what had prevailed in the past. Cities such as Bangalore could, however, be exposed to greater downside risk, as rates have been pushed to unsustainable levels. Hotels on an expansion phase will be better-placed to absorb the decline in occupancies and rates over the long term, as the addition in rooms could partially offset the pressure on rates.

As valuations are high, investors' tolerance to a slack in performance will be low. The performance of hotel companies is vulnerable to events such as terrorism and national disasters. As performance is now largely driven by the boom in the economy, a slowdown in business activity could impact performance as well. Chains such as Hotel Leela and Taj GVK are expanding their presence by way of debt and internal accruals. Successful execution of these expansion plans would depend on their ability to sustain their performance.

The party continues

The party that began in late 2004 continued well up to end-2005, especially for hotels with a presence in Bangalore, Hyderabad, Mumbai and the National Capital Region of Delhi. With near-full occupancies and soaring demand, room rates trended further upwards. The Hotel Leela Palace Kempinski in Bangalore is now one of the more expensive hotels in Asia; a study by UK's leading travel management company, Business Travel International, has rated hotels in Bangalore as the third-most expensive for business travellers in the world.

Expectedly, the likes of Taj GVK, with its dominant presence in Hyderabad and Hotel Leela, with its flagship Leela Palace Kempinski in Bangalore, boasted operating margins of more than 50 per cent in the October-December quarter.

Revenues have been buoyant across the board due to increasing tourist arrivals. There has, however, been a slowdown in arrivals in December. Room rates in cities such as Bangalore have been exorbitant, turning away leisure travellers. A lack of quality hotels in the mid-priced and budget segment also explains the slowdown in arrivals.

The demand from business travellers is expected to be unabated. In Bangalore, Gurgaon and Chennai, substantial commercial space is being created, which can only boost arrivals to these cities. The trend could be similar in cities where business travel has been a key driver of revenues.

These factors will continue to help hotels with a dominant presence in Bangalore, Hyderabad, Delhi and Mumbai sustain their room rates for another year, till fresh supply springs up. Hotels in Chennai and Kolkata, which have been traditionally price-sensitive, have seen a significant improvement in tariffs in FY-06, and are expected to witness stronger growth in rates.

View on mid-cap plays

Given the sharp run up in prices, there are few stocks that trade at attractive valuations. The stocks of Asian Hotels, Hotel Leelaventure and Oriental Hotels look relatively less expensive, trading at less than 30 times their trailing four-quarters' per share earnings. They offer a good exposure from a one-year perspective.

Asian Hotels and Hotel Leelaventure are best placed in terms of their prime locations. Asian Hotels has a presence in key metros such as Delhi, Mumbai and Kolkata. Performance of its Kolkata property, which has acted as a drag on profitability due to lower rates, has improved considerably. Occupancies and room rates in Delhi and Mumbai are likely to remain robust and higher demand will easily absorb new supply in these cities.

Hotel Leela, which has seen a sharp increase in profitability, is now better placed to tackle its debt problem. It has raised convertible debt from overseas to partly fund its nearly Rs 800-crore expansion plan. Its properties in Hyderabad, Chennai and Pune are expected to be commissioned in early 2008, contribute to revenues from FY-09 and to earnings beyond that period, indicating a long gestation period. (The manner in which it deploys cashflows over the next two years would be a key driver of valuations. Its Bangalore property could suffer a decline in rates, if all the supply proposed in the city does come up. Its new properties, if executed on time, could partly offset this risk.) Investors with an appetite for risk can consider Oriental Hotels.

The company has been a relative under-performer, with a presence in leisure destinations and a price-sensitive market such as Chennai. There could, however, be room for upside in room rates in its properties located in Chennai, Vizag, Mangalore and Kochi. Chennai, in particular, is likely to emerge as a strong business destination. Trading volumes tend to be thin in this stock. The downside risk to performance, however, appears minimum.

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