The financials of Lemon Tree Hotels reflect the difficult times the hospitality sector in India has gone through over the past few years and the recovery it has been making in the recent past. After many years of losses at the net level, Lemon Tree turned the corner and posted profits, though marginal (about ₹3 crore) in the nine months ended December 2017.

The highly cyclical nature of the sector squeezed many hotel players in the country between 2009 and 2015. Oversupply of rooms and modest demand growth took a toll on parameters such as occupancy levels, average daily rate (ADR) and revenue per available room (RevPAR) and dented bottom-lines. The troubles were worse for players which had borrowed heavily to fund expansion during the boom years earlier.

The tide has been turning for the better over the past couple of years, with the sector now poised to move into the up-cycle with the supply of rooms slowing down and demand growth picking pace. This has meant improving occupancy levels and room rates in the sector. Lemon Tree is set to benefit from this change in dynamics.

Despite the positives, the company’s primary offer that opens on Monday seems suitable only for investors with a long-term perspective and high-risk appetite.

Healthy metrics

Players such as Lemon Tree held their own even in the tough times, thanks to the focus on high-growth mid-priced market and strong balance sheets. The company is the leader in the country in the mid-priced hotel sector with three brands to address different segments across the value chain — Lemon Tree Premier, Lemon Tree Hotels and Red Fox Hotels. It has a pan-India presence with 45 operating hotels and 28 under development.

Despite the challenges in the sector, the company’s room count, room rates, revenue and operating profit grew at a healthy pace over the past few years. Revenue grew from about ₹215 crore in FY 2013 to ₹352 crore in the nine months ended December 2017, while operating profit grew from ₹40 crore to ₹99 crore during this period.

Its occupancy levels, about 70-80 per cent across segments, have been much better than industry levels. Also, the company has been posting and growing cash profits (net profit plus depreciation) — from ₹22.5 crore in FY 2016 to ₹42.7 crore in the nine months ended December 2017. It has also managed to keep leverage under control, with consolidated debt-to-equity at 0.79 times as of December 2017.

With the up-cycle in the sector expected to continue for a few years, expansion plans in high-growth segments and the shift towards an asset-light model through management contracts should help Lemon Tree grow its net profit at a strong pace. The room count is expected to increase from about 4,700 now to about 7,700 over the next three years. Nearly half the additional rooms will be under the management contract model wherein instead of building a hotel ground-up, Lemon Tree will re-brand and manage the property of smaller players for a fee and profit share.

While the company may continue borrowing for expansion, the debt-to-equity ratio should stay reasonable at under 1 time. Occupancy levels are expected to cross the 80 per cent mark.

Needs watch

The offer is not cheap. At the price band of ₹54-56, the company’s enterprise value to annualised FY 2018 operating profit (EV to FY 2018 EBITDA) is 39-40 times, costlier than the 30-35 times of other sector players such as Indian Hotels and EIH. While valuations should moderate with expected profit growth in the coming years, the bottom-line that has just shown signs of revival needs watching. After listing , the Lemon Tree stock will be a small-cap with market capitalisation of about ₹4,200 crore-₹4,400 crore.

This could make it more susceptible to hits from the ongoing market volatility. The public issue is an offer-for-sale giving some investors an opportunity to exit; no funds will flow into the company.

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