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Ram Prasad Sahu / Mumbai May 5, 2008

Despite worries of a supply glut, the long-term story for the hotel sector is intact.

With the exception of Bangalore, room rates have surged up to 21 per cent in the premium category in key tourist and business destinations in the country. It is this pricing power brought on by a lack of supply, which is prompting a slew of domestic and international players to build hotels across the country to catch the price upturn.

The Ministry of Tourism estimates that about 80,000 new rooms will be added to the existing capacity of about 1 lakh rooms across all categories by 2010. The demand by that time will however shoot up to 1.5 lakh rooms. No room The tourism ministry believes that as the economy expands, the extreme shortage of rooms will be particularly felt in Delhi, Mumbai, Bangalore and Goa—the hubs of tourist traffic.

Unprecedented tariffs in these locations and increases ranging up to 22 per cent across metros in the last one year is the outcome of a supply gap, which in the long term, is likely to continue.    IN DEMAND City Occupancy  Average Room Rates  (%) FY07  (Rs)  FY08 (%) FY07 FY08  change Bangalore 75.5 73.0 10,545 10,100 -4.22 Kolkata 77.1 77.0 5,366 6,300 17.41 Chennai 74.7 76.0 5,610 6,600 17.65 Delhi 78.1 78.0 9,842 10,200 3.64 Goa 73.5 75.0 5,846 6,500 11.19 Jaipur 66.3 71.0 5,364 5,800 8.13 Mumbai 78.7 80.0 8,614 10,200 18.41 Hyderabad 73.5 69.0 6,091 6,600 8.36 Pune 83.5 76.0 4,885 5,700 16.68 Ahmedabad 70.8 73.0 3,118 3,778 21.17 4, 5 and 5-star deluxe hotels,                                   Source: HVS International

Revenue hit? While the tariff increase bodes well for the existing hotel majors, will the new supply of rooms lead to price wars and declining revenues? The short- to medium-term outlook would indicate that in certain pockets such as Bangalore, a cooling off will take place to balance excess supply.

According to Crisil Research, average room rates (ARR) in the premium category in Bangalore, for example, are expected to taper off to around Rs 10,000 levels in two years from Rs 14,000 levels prevailing now, due to the addition of 300 rooms in the premium category.

However, analysts believe that the decline in room rates will be limited to certain cities where the rates had moved up substantially in a short period.

Says Daljeet Kohli, head, research, private client group at Emkay Share, "Rates in some pockets will soften and rationalise to adjust to the availability of excess inventory. However, this is a temporary blip and should rebound as demand continues to be strong."

How will this short to medium term price rationalisation affect listed hotel scrips? With room rates having a direct bearing on revenues and profitability any decrease in rates will have a negative impact on the financials of hotel companies whose balance sheets are leveraged due to massive expansions.

Says Amol Rao, analyst, Pioneer Intermediaries, "Hotel stocks might be affected in FY10 as the release of supply crystalises." Industry majors are, however, not worried.

Says Ketaki Narain, director, The Oberoi Group, "The average occupancy among branded hotels last year was around 72 per cent, as against 65 per cent four years back. With increased awareness and interest in India, both in terms of business opportunities and a leisure destination, and demand outpacing supply, the industry will continue to do well for the next couple of years."

Analysts believe that new airports and convention centres can change the demand-supply situation and improve occupancy rates. Thanks to the new airports in Hyderabad and Bangalore, tourist traffic is expected to pick up and balance the excess supply situation, keeping occupancies high and stabilise room rates. Concerns A dip in room rates is not the only concern for hotel companies. Inadequate infrastructure, high land cost, licensing and development norms, slowdown in sectors such as information technology which contribute a significant chunk in cities such as Hyderabad and Bangalore could also pose serious threat to the growth of the sector.

High levels of attrition due to a shortage of personnel, the development of corporate guesthouses and standalone hotels by IT majors such as Infosys and Wipro and the rupee appreciation—all will have a negative impact on prospects for the sector.    HEALTHY GROWTH Rs crore Indian Hotels EIH Hotel Leelaventures Taj GVK FY08E FY09E FY10E FY08E FY09E FY10E FY08E FY09E FY10E FY08 FY09E FY10E Net sales 2900.00 3240.00 4031.00 1125.60 1373.23 1716.54 539.50 620.42 713.49 257.00 298.00 339.00 Operating profit  915.00 990.00 1266.00 427.73 521.83 652.29 280.54 328.83 371.01 122.00 139.00 155.00 Net profit 417.00 469.00 709.00 225.12 247.18 343.31 140.27 167.51 189.07 70.00 80.00 87.00 EPS (Rs) 7.00 6.70 9.00 5.74 6.31 8.76 3.05 3.64 4.11 11.20 12.80 13.90 P/E (x) - 17.46 13.00 - 23.79 17.13 - 13.66 12.10 - 11.80 10.86 Source: Analyst estimates

Long-term growth drivers Despite these trends there are a number of positives going for the hotel sector, which will keep demand strong and ensure steady revenues over the next five years.

Economic environment: Tourist arrivals have a strong link with economic activity. With GDP growing at 8 per cent per year, the flow of business travelers, who constitute 70-80 per cent of tourist traffic into the country, will be good. Infrastructure impetus: Airport privatisation, budget airlines and the development of national highways will improve the traffic flow between cities. Foreign tourists: 50 lakh tourists came to India in 2007. This, according to industry body World Travel and Tourism Council, is expected to double by FY11, which means a growth of 19 per cent against 13 per cent annual growth recorded over the last five years. Domestic tourists: Higher disposable incomes have meant that five star hotels are getting more domestic leisure travelers whereas previously it was confined to foreign travelers and business executives. Domestic tourism is expected to grow by 15-20 per cent per year over the next five years. Limited supply: The current scenario is more favourable for companies, which have properties in the business districts in key metros and cities. Due to the high land prices and limited supply, existing players have been able to command high prices. The Hotel Benchmark Survey carried out by Deloitte concluded that ARRs in Mumbai grew by 46 per cent in 2007 and pushed revenue per available room to Rs 8,300, the highest in the Asia Pacific region. Supply crunches will ensure high room rates, push budget hotels out of the picture and increase the payback period of new entrants in the premium segment further. Light on assets: Almost all major hotel groups are now looking at management contracts to free up their balance sheet and improve their return on equity. This helps them to use capital for expansion and increase their portfolio of properties. International players: The hospitality sector is likely to see investments worth $11 billion over the next two years with 40 international hotel brands expected to start their operations in the country by 2011. The entry of these hotels will help push up the ARRs for domestic hotels. Four Seasons which is expected to open its first hotel in the country in Mumbai is reportedly pricing its rooms starting at Rs 20,000. Implementation issues: Room inventory will continue to be low due to the government approval process, high cost of land and unavailability of skilled manpower. HVS International, a hospitality consulting firm, believes that only 58 per cent of the announced hotel projects are expected to be developed.

We have identified hotel majors who are asset light, with a diversified revenue stream and a strong presence in the premium category (accounts for 65-70 per cent of revenues of the entire hotel sector) with hotels across various locations.

These companies, with total existing room inventory of over 800, are not only best positioned to overcome a dip in room rates in certain pockets, but also be able to generate good returns for investors over a two-year period.

Indian Hotels Company (IHCL) With over 10,000 rooms, IHCL is the largest listed hotel company, which owns and operates 83 properties under the Taj brand in India and abroad.

The company has chalked out an aggressive plan to add 9,000 rooms to its existing portfolio by FY11 at a cost of Rs 2,500 crore. The biggest strength for the company is the spread of its properties across Tier1 and Tier2 cities as well as 16 hotels outside the country. The management contract model has helped it to reduce capital costs and expand its reach. Currently, it is operating 16 hotels (1,591 rooms) under this model and plans to double the room count by 2011.

Given the diversified revenue streams, properties in key locations, aggressive expansions and manageable debt to equity ratio, IHCL is well positioned to tap into the tourist demand in the country.

At Rs 117, the scrip which is available at P/E of 13 times its fully diluted FY10 earnings of Rs 9, trades at a discount to its Asian (Shangri La Asia, Mandarin Oriental) and Indian peers (EIH, Hotel Leela). With a price target of Rs 175, the stock can deliver 50 per cent over 15-months. EIH Ltd Part of the Oberoi group, EIH owns and manages about 3,000 rooms in 20 hotels across the country under the Oberoi and Trident brands. With 874 rooms in South Mumbai's business district, it controls 36 per cent of the available 5 star premium rooms and with the Trident hotel coming up in the Bandra Kurla Complex further north of the city, it will have a room inventory of 1,300.

Other than Four Seasons (expected to open shortly) and Shangri La to open in 2011, no new property is expected in the future making Mumbai, which has high room rates, one of the most lucrative in the hotel business.

To reduce cost and risk of constructing and owning its own property, the company is changing its strategy and expanding through joint venture or entering into management contracts. This asset light strategy is estimated to improve its return on equity from under 15 per cent to over 20 per cent in FY10. In addition to its strong presence in the metros, the company also has a leisure hotel portfolio in Jaipur, Agra, Udaipur, Shimla and Ranthambore.

Key risks for the stock are the lack of revenue diversification with its two metros contributing 70 per cent of revenues and no presence in budget hotels which is fastest growing category in the hotels space. At Rs 150, the stock is trading at 17 times its FY10 estimated EPS of 8.8 and should be able to give about 25 per cent returns in a year. Hotel Leelaventures The company operates four properties in Mumbai, Bangalore, Goa and in Kovalam, Kerala with room count of 1,086. Its location advantage (business hotels near airport, leisure near beaches) and lack of rooms supply in the market has helped it to command a premium in tariffs compared with other premium offerings and pushed up its operating profit margins at around 60 per cent.

In addition to this, its premium positioning and policy of not compromising on revenue rates despite lower occupancies has meant high room rates across all properties.

The Leela Palace Kempinski, Bangalore registered the highest ARRs in the country at Rs 19,000 in FY07, which was much ahead of the city average of Rs 12,050.

To reduce its dependence on Mumbai and Bangalore, which account for over 80 per cent of its revenues, the company is expanding into Udaipur, Hyderabad, Gurgaon, Pune, Chennai and Delhi more than doubling its rooms to about 2,700.

While Delhi would need additional rooms for the upcoming Commonwealth Games (it will face a shortage of 9,000 rooms), the Rs 600 crore it paid for a 3-acre property, analysts believe, is on the higher side pushing the payback period to nearly eight years.

The company plans to diversify operations outside the country in association with Kempinski to jointly manage luxury projects. Its expansions in India and abroad, its premium positioning and the demand supply mismatch will help Hotel Leela maintain a robust revenue growth.

At Rs 50, the stock discounts its F10 estimated earnings of Rs 4 by 12.1 times. Due to its high dependence on a few properties and high debt, the valuations are not attractive. Investors can buy at declines.

Taj GVK A dominant player in the Hyderabad market, Taj GVK has about 700 rooms in its portfolio at Hyderabad and Chandigarh. The company is expanding capacities at three of its properties in Hyderabad and setting up a 220 room hotel in Chennai for Rs 160 crore.

A robust performance by its Chandigarh property helped Taj GVK increase its sales by 5 per cent y-o-y in Q4FY08 to Rs 71 crore. While ARRs grew 19 per cent y-o-y to Rs 7,750, occupancy rates rose 1,100 bps to 82 per cent in Chandigarh. This helped push up the operating profit by 6 per cent to Rs 35.6 crore and net profits by 7 per cent to Rs 20 crore. Its Hyderabad properties experienced negative or flat growth with ARRs ranging from Rs 7,250 to Rs 10,000.

Going forward, the company should be able to sustain room rates on the back of a large number of events and conferences and the commissioning of the new airport at Hyderabad. The biggest risk for the company is the lack of diversification of its properties with 3 out of four properties located in Hyderabad.

The company hopes to improve its reach further with the launch of its Chennai property in May, 2008. The company has been able to sustain increases in ARRs across its properties and would continue to command high prices due to demand from the business segment. The stock should give healthy returns over a 1-1.5 years.