Shangri-La Asia - OCBC Investment 2018-06-18: Another Summit To Conquer

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SHANGRI-LA ASIA LIMITED SGX:S07

Shangri-La Asia - Another Summit To Conquer

• Proxy to China hospitality recovery.
• FY18F EBITDA expected to grow 16%.
• Initiate with Fair Value of HK$21.05.

Luxury hotel player with large exposure to mainland China

• Shangri-La Asia is primarily a hotel ownership and management company, with assets consisting mainly of five-star deluxe city centre and resort hotels based largely in Asia Pacific countries. In particular, Shangri-La’s mainland Chinese hotel assets contributed 49% of the group’s hotel EBITDA and 31% of the group’s EBITDA across all segments in FY17. 
• Given the group’s substantial exposure to mainland Chinese hospitality as well as a high degree of operational leverage, we see Shangri-La as a proxy to what we expect to be a multi-year recovery in the Chinese luxury hotel industry.

You’ve only seen the beginning of the ascent

• RevPAR recovery in China started in 1Q17 after several years of decline. From channel checks and data points, it appears that the growth of luxury hotel room supply in Tier 1 and 2 cities has been slowing down while the domestic tourist spend has continued its relentless pace of growth.
• Feeding the growth of local demand for luxury hotel rooms in China are three key factors:
  1. high-spending millennials
  2. legislation and
  3. massive infrastructure developments within the country
  which are discussed in greater detail in the sector report.
• The hospitality industry typically works in cycles, given the 3-5 years needed to develop new hotels. We believe that the current demand-supply situation is ripe for several years of RevPAR recovery.

Initiate coverage with BUY rating and HK$21.05 Fair Value

• We initiate coverage on Shangri-La Asia with a BUY rating and a fair value estimate of HK$21.05. This is derived through a sum-of-the- parts (SOTP) valuation that consists of applying a 15.3x EV/EBITDA ratio (15% premium to Asian hotel companies peer average) for Shangri-La’s hotel business as well as applying a 30% discount to its investment properties.
• We believe Shangri-La deserves a premium given its strong international branding as well as its exposure to the RevPAR recovery story in China. 
• Investors also stand to benefit from internal cost-cutting and efficiency measures that are expected to bring up to US$80m in savings as well as opportunities to strengthen revenue growth in the next 3-5 years.

INVESTMENT THESIS

• Our investment thesis is straightforward – Shangri-La represents an important proxy to the recovering mainland Chinese hotel industry with undemanding valuations.

Proxy to multi-year recovery in Chinese luxury hotel industry

• Shangri-La boasts equity stakes in 45 hotels in mainland China out of a group total of 83 globally (including 3 under operating lease), which translates into approx. 20.3k hotel rooms (gross) out of the group’s 36.1k. These Chinese hotel assets contributed 49% of the group’s hotel EBITDA (effective share, including associates) and 31% of the group’s EBITDA across all segments in FY17.
• Given the substantial portion of exposure to Chinese hospitality as well as a high degree of operational leverage, we see Shangri-La as a proxy to what we expect to be a multi-year recovery in the Chinese luxury hotel industry.

2017 saw RevPAR uptick after several years of decline 

• In FY17 alone, RevPAR growth in USD for Shangri-La’s Chinese assets increased 7% y-o-y after four years of decline. 
• Going by locations, Tier 1 and Tier 2 cities both posted strong RevPAR growth of 9% and 12% respectively while Tier 3-4 cities posted growth of 8%, in local currency. This trend of accelerating RevPAR growth is also mirrored in the results of Shangri-La’s competitors such as InterContinental, Marriot, and Hilton.

Tightening supply to favor existing hotel owners going forward 

• From channel checks and our data points, it appears that the growth of luxury hotel room supply in Tier 1 and 2 cities has been slowing down while the domestic tourist spend has continued its relentless pace of growth. Furthermore, we believe that the bid-up in land prices in several Tier 1 cities will make it less desirable for developers to construct new luxury hotels in the medium-term until RevPAR recovers.
• The hospitality industry tends to work in cycles, given the 3-5 years needed to develop hotels. Barring any severe economic crisis, we believe that the current demand-supply situation leaves existing hotel owners with the prospect of several years of RevPAR recovery.

Demand continues to climb, spurred on by three growth drivers 

• Feeding the growth of local demand for hotel rooms in China are three key factors:
  1. high-spending millennials
  2. legislation and
  3. massive infrastructure developments within the country
  which are discussed in greater detail in the sector report. 
• Going forward, we expect a RevPAR growth of 9% for Shangri-La’s Chinese hotels in FY18 and 8% for FY19.

RMB appreciation to be the icing on top 

• In addition, barring any rapid depreciation in 2018, we see a boost in China’s contributions given the ~8% strengthening of the RMB against the USD throughout 2017 and through early Jun 2018.

Striking a new asset balance with more managed hotels

• Shangri-La owns or leases 81% of the hotels and 85% of the rooms in its portfolio. Management hopes to increase the proportion of managed hotels in an attempt to strike a better asset balance. 
• Currently, out of the 13 hotels under development, eight or 61% of them are to be under management contracts. We believe the group will continue focusing on Tier 1-2 cities in China as well as gateway cities in Asia.
• We believe such a strategy will help to increase the group’s EBITDA margins as well as to add stability to the group’s operational results. As of FY17, Shangri-La’s hotel management segment boasted an EBITDA margin of 71%, 46 ppt above that for hotel ownership.
• Shangri-La’s management has not given many details on the target split between managed and owned hotels, but for the purposes of our model, we assume that Shangri-La will increase the percentage of managed hotels to 25% group-wide.

Internal measures to improve the bottom line

Cost-cutting measures of up to US$80m per annum

• Shangri-La is creating shared platform for reservations and other back- room functions like HR and IT. We expect this stream-lining process to generate US$80m of cost savings annually in three to five years’ time. 
• Management sees the scheme as more of a growth initiative that generates sourcing synergies for the group and supports the increase in the number of owned hotels going forward. Furthermore, they believe it will develop into a competitive advantage to secure more management contracts.

Golden Circle App could help support room rates

• Shangri-La’s plans to expand their means of direct sourcing through their Golden Circle app. Currently around ~30% of revenue is generated through Online Travel Agents (OTA) and Wholesalers, which may charge a commission of 15-20% on the list price. The remaining 70% is split between corporate demand (which consists of both hotel stays and function room rentals) as well as bookings through their through their website and call centre.
• We believe that if successful, the app can help strengthen brand equity and support ADR growth by winning over regular customers who would have otherwise used OTAs and wholesalers. Furthermore, within each hotel, corporate demand generally commands a lower ADR relative to the rate charged through Online Travel Agents (OTA) and Wholesalers, net of their commission. As such, increasing the proportion of leisure travelers – especially in Tier 1-2 cities – could further support room rate strength.

Attractive valuations

• With these three main thrusts in mind – recovering China RevPARs, a move towards more managed hotels as well as complementary internal strategies – we believe Shangri-La offers value at current share prices. 
• Against 15 Jun’s closing price of HK$16.50, our fair value estimate of HK$21.05 offers a 27.6% 12-month upside.

BUSINESS OVERVIEW

• Shangri-La is primarily a hotel ownership and management company, with assets consisting mainly of five-star deluxe city centre and resort hotels. The majority of the city centre hotels have over 500 guestrooms, whereas the resort properties tend to be smaller. 
• The group currently owns and/or manages hotels under four brands.

Brands under Shangri-La Asia as of FY17.

• Shangri-La Hotels are five-star luxury hotels characterized by extensive facilities and exceptional hospitality, located in premier cities.
• Shangri-La Resorts offer travellers and families relaxing and engaging holiday experiences in some of the world’s most exotic destinations.
• Kerry Hotels are five-star hotels with unique contemporary design and sincere, intuitive service.
• Hotel Jen caters to an emerging generation of independently-minded business and leisure travellers with vibrant, mid-range hotels in key locations in Asia.
• Traders Hotels are four-star business hotels that also appeal to leisure travellers, offering smart functionality and practical efficiency.

FINANCIAL SUMMARY

• Shangri-La’s revenue has grown at a CAGR of 8.3% from FY05 to FY17, clocking with positive y-o-y growth every year except FY09 and FY16. Meanwhile, Shangri-La’s EBITDA grew at a comparatively slower pace of 6.0% CAGR in the same period. 
• While gross profit margins have stayed rather consistent, ranging from 55% to 59%, EBITDA margins have declined since its peak of 36% in FY07 to 24% in FY17. We believe this decline is largely due to the fast pace of expansion during the period as well as the softening in China RevPARs from FY12 to FY16.
• The group has a gross gearing ratio (gross debt over equity) of 74% and a net gearing ratio of 61% as of FY17, though we project it to decrease down to 68% and 55% in FY19F respectively as the group slows its capex-heavy expansion.

OPERATING SEGMENTS

• Shangri-La has four operating segments: hotel ownership, hotel management services, property rentals, and property sales.
• Shangri-La’s hotel ownership segment made up 92% of FY17 revenue and 64% of the group’s effective share of EBITDA including contributions from associates. While property rentals made up only 3% of FY17 revenue, it contributed 26% of the group’s effective share of EBITDA when we include contributions from associates. As mentioned above, we expect the contribution from hotel management services to gradually increase going forward, as suggested by the direction of management’s plans.

Geographical split within the Hotel Ownership segment

• In terms of geographical split within the hotel ownership segment in FY17, China contributes the lion’s share of revenue at 39%, followed by Hong Kong at 15% and then Singapore and The Philippines at 9% each. 
• In terms of EBITDA (effective share), China contributes 49% of the hotel ownership segment total, followed by Hong Kong at 17% and then the Philippines at 11%.

EBITDA margins

• EBITDA margins for Mainland China hotels increased 2 ppt in FY17, a trend we expect to continue as ADRs in Tier 1-2 cities continue to grow from their low base.
• Note that EBITDA data by segment and geography was only released in the latest set of financial results. Generally, segment results margins (after accounting for interest and depreciation) for China hotels has ranged in the single digits (positive and negative) since 2009.

RevPARs trends for Shangri-La’s assets in major markets

• Group RevPAR has seen an uptick in FY17, mainly due to the 7% RevPAR recovery in China.

RISKS

• There are a number of risks that Shangri-La faces during the course of its operations. While the following list is not exhaustive, we highlight some of the more pertinent risks.

Threats to RevPAR growth

• The hospitality sector is subject to economic and political developments both locally and abroad which may in turn affect the demand for luxury hotel rooms for the locations in which Shangri-La operates. For instance, the group’s Chinese hotels suffered a 27% decline in RevPAR in 2009, after the global Credit Crisis. From our understanding, the impact was delayed by a year (2008 RevPAR growth was -1%) because of the Beijing Olympics. For Shangri-La’s China assets, we see internal economic conditions and regulatory conditions as being more important than foreign ones, given that much of the local tourist industry is supported by domestic travel.
• Similarly, unpredictable occurrences such as terrorist attacks and earthquakes can also have a significantly negative impact on travel.
• In addition, an increase in hotel room supply can dampen room rates as hotel operators compete with each other for the tourist dollar. On the other hand, hotels which do not compete on price may lose out in terms of occupancy during such periods of stiff competition.

Interest rate hikes

• Shangri-La has a gross gearing ratio (gross debt over equity) of 74% and a net gearing ratio of 61%. Interest costs made up around 25% of EBITDA in FY17. A faster-than-expected pace of interest rate hikes would increase the interest burden of the group, decreasing profitability. 
• We currently assume four hikes per year for FY18F and FY19F.

Risk of RMB depreciation

• As the group reports in USD, contributions from its operations in China will likely be negatively affected by any significant depreciation in the RMB. In the current year, however, we expect Shangri-La to benefit from a stronger RMB relative to 2018.
• As the HKD is pegged to the USD, we are not as much concerned about currency fluctuations for Shangri-La’s contributions from its Hong Kong assets.

VALUATION & RECOMMENDATION

• We initiate coverage on Shangri-La Asia with a BUY rating and a fair value estimate of HK$21.05. This is derived through a sum-of-the-parts (SOTP) valuation that consists of applying a 15.3x EV/EBITDA ratio (15% premium to Asian hotel companies peer average) for Shangri-La’s hotel business as well as applying a 30% discount to its investment properties. 
• We believe Shangri-La deserves a premium given its strong international branding as well as its exposure to the RevPAR recovery story in China. The comparables we have chosen for Shangri-La include luxury hotel owners/operators in Asia as well as global hospitality companies.
• Shangri-La is currently trading at an attractive 12.9x EV/EBITDA to our FY18F forecast.
• Against 15 Jun’s closing price of HK$16.50, this translates to a 12 month upside of 27.6%.

Deborah Ong OCBC Investment | https://www.iocbc.com/ 2018-06-18

SGX Stock Analyst Report BUY Initiate BUY 21.05 Same 21.05