LONGE: CITY LODGE HOTELS

Apr 22, 2020

CLH
Yes, the title sounds crazy.
Why would you want to invest in a traditional hotel group during one of the worst periods ever to be a hotel? Well during a crisis there are many opportunities that present themselves and this is one of them. Generally I am of the school of thought to “stay out of the market” during a crisis. Reason being cash is king and I prefer saving liquidity (money) to later use to invest when the market normalizes than potentially losing money in bad investments of having money locked up in bad assets. However in this case I believe it is possible to nibble at a few stocks that present opportunities based on their discounted value or potential price movement. When looking for direct exposure into South Africa’s hotel industry, there are a few stocks that serve to directly track the performance of the hotel/travel/leisure industry, one of these stocks is City Lodge Hotels which is what I am adding to my basket this year.

My Philosophy when investing in South African Assets

Whenever I speak about any South African assets my philosophy is that “there will be winners and losers” in the long term (10 to 15 years). By this I mean that regardless of which direction the South African economy takes in the future, there are going to be companies that emerge as dominant in their various sectors during this time of economic change. This then gives us the opportunity to attempt to predict which companies are going to be the winners and invest in them now in the present in order to benefit from their increase in value. However keep in mind that there is much more to this philosophy then just finding a cheap stock of a good company and investing in it, there are technical considerations, possible scenarios and risk factors to account for before making the leap to “buy”. Now let us discuss City Lodge Hotels.

The Current Scenario

The COVID-19 pandemic has caused the world to come to a standstill economically. Most countries domestic economic activities have been drastically hampered by the various responses and measures that have been taken to decrease the infection rate of the virus. The main responses to the pandemic by most countries have been a ban on global travel, curtailing group activities; social distancing and national lock-downs (forced home stays). South Africa (at the time of writing) has more than 2000 Corona Virus cases and the country has responded by instituting travel bans internationally and domestically, majority of the ports of entry have been closed and a national 21 Day lock-down has been implemented (Expanded to the end of April). As you can imagine from these measures airlines and travel and leisure companies have suffered the most which has been reflected in their share prices. Economic activity has basically come to a halt and investors have expressed their displeasure by dis-investing in many companies driving the share prices to record lows.

The Historical Context

One of the most interesting things about the market is its short term memory. History would tell us that the world will recover from this and adapt to whatever reality presents itself post the COVID-19 crisis. How do we know this?

We know this because similar softer events have happened before. In 2003 there was the SARS pandemic (another corona virus, in fact COVID-19 is called SARS-2) and in 2012 there was MERS. I call these soft because they did not cause wide spread global responses that brought economies to their knees but were isolated to particular regions however as much as they did not cause a mass crisis from a biological stand point they do demonstrate that these issues do pass. In a moment of crisis we tend to be bias and believe that the current crisis is the worst and will ‘end the world” yet they never do. During the 2008/2009 financial crisis there were claims that western capitalism would collapse and that the electricity grid would disappear. Looking back we can see how ridiculous these claims were when we consider that one of the best bull markets (stock price growth) followed after the crisis and from most crises it has been the same. The crisis comes and prices fall, the crisis ends and prices slowly rise again. There are however causalities left behind by the crisis (remember the winners and losers philosophy). The COVID-19 crisis will be no different; there will be winners and losers. And here lays the opportunity, finding the future winners.

Apart from airlines the hotel industry has been hit the hardest by the COVID-19 crisis. Many hotels have had to close down and cancel bookings and not accept any new bookings. This has resulted in the loss of revenue and the loss of the ability to generate future revenue. Non guest generated expenses have however stayed fixed such as salaries and property rentals among others. As you can imagine investors have not responded kindly to the situation and have thus dumped a lot of shares thus lowering prices. This then leads us to the opportunity that can be found in investing small tranches of capital into hotels that are financially sound. Hotel share prices globally are currently depressed; this includes hotel real estate investment trusts as well.

The Opportunity

The opportunity that has been presented by the crisis is the ability to purchase hotel stocks at a discounted value. However it is not going to be an easy ride.

Best Case Scenario (Desired/Expected)

My prediction is that due to the covid-19 crisis hotel stocks will report record losses and revenue decreases which will lead share prices to fall drastically. This is where the opportunity is. The COVID-19 crisis may have a long lasting effect but it is (hopefully) a once off event. This means that as economies recover so too will hotel earnings as people return to traveling. I can describe this as share prices coming down to reset and those companies who are well positioned to benefit from the recovery will have their share prices rewarded with a long-term increase in value. To take advantage of this scenario all we have to do is wait for the prices to fall as quarterly/full-year results are announced and then buy the shares at this discounted rate. One factor though to be weary of is “pricing in”, investors may already price in the expected declines, if that does occur than determining the bottom price will be vital to take advantage of the recovery. The key question is: Will prices be higher in 5 years than what they are today? If the answer is yes, then theoretically you can buy at any moment however it is key to get the best possible entry point which is after reporting, as whether the bad news is priced in or not will be irrelevant because everything would be public and there would be a degree of certainty on the performance of the hotels. Thus the desired scenario is that companies report weak performance and share prices fall, we then purchase good financially healthy companies with positive future business prospects at low prices, the economy slowly returns to health and over the long-term the share prices rise to previous levels as business slowly improves and improvements are reported.

Worst Case Scenario (Unwanted/Risk)

The worst case scenario is that the hotel industry faces a total collapse. As revenues decline, it will be slowly more difficult to raise capital from lenders and difficult to service debt which will negatively impact hotels. Furthermore consumers may avoid traveling for an extended period as negative sentiments about traveling take time to change. Governments may also extend travel bans from certain countries; some of those countries would be income staples for the travel/leisure and tourism sector. This would further make operating even more difficult for hotels. South Africa’s hotel industry is vital for the country’s tourism sector and South Africa is reliant on the tourism sector for future GDP growth and jobs. This means a protracted global slowdown of travel or a heavily regulated travel industry will result in slow growth of the tourism sector and thus hotels. Local companies would also be negatively impacted from a drastically contracting economy and that means domestic travel would decrease with less events, corporate and private, declining and consumers tightening their belts and cutting out traveling. It would take more than 10 years for the sector to recover from this scenario.

One thing to note

Hotel stocks are not the greatest assets. Before the COVID-19 crisis hotels were facing declines due to a changing consumer landscape. Digital platforms such as AirBnB and VRBO have democratized the hotel business to everyday people; these people are slowly pinching market share away from hotels. Smaller establishments are also competing and offering better and better services. Debts on balance sheets are restricting how much hotels can do as servicing debt diverts cash away from investing in new systems and experiences. The biggest factor of all that was negatively affecting hotels is the decline in the global economy as growth had been slowing down prior to the COVID-19 pandemic. Local hotels also for the past 7 years have had to contend with government policies that prevent growth in the tourism sector and a declining local economy. This means that not all hotel stocks are the same, some companies will not fully recover as they already had operational and external challenges that negatively affect their business. So if we are to invest in hotel stocks in South Africa, how can we do it?

The Chosen Asset(s)

South Africa has very few listed companies whose sole business activity is operating local hotels. Most of the listed assets in the travel and leisure industry on the JSE function more like investment companies with a focus on investing in travel and leisure activities. Thus Sun International, Taste Holdings and Grand Parade among others were ruled out in our stock pick for not having local hotel operations in South Africa as their main business activity. This then would not make them the best assets to track the local hotel industry exclusively.

Three stocks that popped up as companies whose revenue is mainly sourced from hotel operations, with South Africa being their main location were Tsogo Sun Hotels, Hospitality REIT and City Lodge Hotels. Tsogo Sun Hotels was ruled out as the stock has a limited history because it was listed only last year July 2019,the company has a weak balance sheet with debts, no long-term history of paying dividends and a high P/E ratio that is not justified in my opinion. However Tsogo Sun Hotels can still be a good stock pick based on it's current price, historical earnings and the future prospect of the business. Hospitality Property Fund REIT was ruled out as REITS have been suffering for the past 2 years and with this crisis will continue to suffer even more. Hospitality Property Fund’s source of income is the hospitality industry (mainly Tsogo Sun operations) and so increasing dividends is going to be difficult for the foreseeable future under the current economic conditions and short-term future conditions. A low and not increasing dividend will keep the stock price low. So let us look at our stock pick, City Lodge Hotels…

Who is City Lodge Hotels?

The City Lodge Hotel Group is a multi-brand chain offering a variety of locations, features and budget choices to business and leisure travelers. The company was founded in 1985 and now has 55 hotels in South Africa and 6 hotels divided between Kenya, Tanzania, Namibia and Botswana, this means 90% of the groups business is in South Africa with Gauteng constituting 47% of it. Thus it’s a good stock in regards to direct hotel exposure in South Africa. Before South Africa’s first CORONA VIRUS case was reported the share price was trading above R40 per share. The share had suffered some declines due to decreasing occupancy rate caused by low levels of business and consumer confidence, high unemployment, uncertainty around power utility Eskom’s sustainability and land expropriation. In August 2019 the share price dropped below R100 for the first time in 7 years. In February the share price dropped to R67 after a trading update and the release of the interim results, since then the share price has dropped to a range of between R24.00 R27.00/share as COVID-19 fears have set the hospitality industry into a major activity decline.

The company currently has a Market Cap of R1.1 Billion (at time of writing) and a Net Asset Value of R4.5 Billion. As already stated the stock trades at a range of R24.00 to R27.00 per share with a dividend yield of 10%. These figures are indicative of a company that has valuable assets and at this price the dividend yield is currently attractive. The Price-to-Earnings Ratio (P/E) currently stands at 9.5 and the Price-to-Book ratio is at 1.04. In the context of the current market downturn these numbers are indicative of a company that is currently undervalued due to external factors (the travel ban etc.) while the internal health of the company remains solid. In the long-term the external factors will change and growth will return. City Lodge Hotels is well positioned to survive these turbulent times. Investing in the company will result in long-term share price appreciation and as well as earning a good dividend.

Technical Analysis

Moving Average Indicator (Yellow Line):

At present we can see the share price is below the 40 Day moving average, signalling that large amounts of capital are currently decreasing their exposure to the stock which has resulted in a major price decrease

Bollinger Bands Indicator (shadow area behind yellow line)

The price is currently moving along side the bottom line (band) of the bollinger bands, this indicates that the price is decreasing and the bands path is currently widened which indicates the price is currently volatile.

Volume Indicator (green and red blocks that look like buildings)

The volume indicator shows us the amount of buying or selling there is of the stock. As we can see on the above chart there has been a lot of selling (Red blocks spiking upwards), this tells us that the share price is going to drop further and in conjunction with the Relative Strength Index we can follow when it is overbought or oversold.

The Relative Strength Index (Chart with Line at the bottom below Volume indicator)

The RSI which is set to 20 Days, 80-Green, 20-Red is under the oversold levels (20-Red Line). Because of the current economic environment it would not be unusual for it to stay there however there will be some pullback and the share price will momentarily rise before falling again.

All of these points to the share price having momentary pullback which will be followed by a further decline in the price. Remember the opportunity we are foreseeing is a share price decline that we can take advantage of by buying the stock as cheap as possible. Thus ideally after the final report or a few days prior we will see the share price below the 40 Day MA, the price will be moving along the lower line of the bollinger band, there will be a spike in volume of sellers and the amount of shares being sold and the RSI will indicate the stock is being overbought. Once we see these conditions we will wait to confirm the scenario and then buy the stock in anticipation that the share price will be higher in 5 years than what we buy it for.

What Risks are expected for City Lodge Hotels?

As already stated hotel brands like City Lodge Hotels have faced competition from smaller quality brands in key competitive locations, especially in the budget section which is a key segment for the group. AirBnB private hosts and small BnB’s are offering equal quality or better quality stays at a much lower and flexible rate. This is resulting in the loss of market share for City Lodge. The consumer is also changing. The millennial's do not unfortunately see brands like City Lodge Hotels as go to places as they are perceived to be “corporate” and “franchise” with “no character”. The change in culture is going to be the biggest challenge for brands such as City Lodge Hotels in the long-term. Furthermore City Lodge Hotels is plagued by the usual South African economic woes such as Eskom’s future, policy uncertainty, anti-growth tourism policies, tough labour market, low consumer confidence etc, so even without the corona virus the operating conditions were already difficult. City Lodge Hotels has a great opportunity to restructure and re-brand in the long term and I have no doubt that management will find a solution to ensure the hotel group stays relevant to its changing consumer base and navigates South Africa’s economic conditions.

So how should we play this trade?

City Lodge Hotels will be releasing their final results on 20 August 2020 for the period ending in June. During this period the company will report one of the worst performances ever due to the travel ban, shutting down of business and the worst half year for the tourism sector we have seen in a long time. In my opinion I expect management will cut the dividend or cancel it completely as earnings would have dropped too low to support payments. The company will need its revenue to pay down debt, restructure the business or simply sustain it until there is a recovery and also maintain the business. This will prompt shareholders to further dump the stock and push prices lower. After the report there would also be clarification and a degree of certainty as to what the future of the company will be and also what management’s plans are. During this period is when the opportunity to buy the stock at a very low price will avail itself. The risk that exists is that there is 4 months between now and the release of the report, the share price may fluctuate and swing up or down during this period depending on the Corona Virus reports and if travel returns or not. I predict the share price dropping 10% after the report and steadily falling thereafter. When the stock has been oversold there will be an opportunity to buy it at a cheap price.

The long-term Scenario

In the long-term there will be an economic recovery globally and locally things will return to normal with our usual problems and challenges. During this period of growth and returning to normally City Lodge Hotels will be one of the hotels that benefit. Travelers, especially corporate, will be looking for affordable places to stay and City Lodge offers this. This will lead to the company benefiting from the burst in demand for affordable hotels and earnings slowly increasing. Thus the share price will rise once more in response to the slow growth.

Implementation/Input:

Stock: City Lodge Hotels [JSE:CHL]
Buy @: between R13.00 to R20.00 (low end is better)
Price Target: R45.00
Duration: 4 years (excluding 2020)
Take Profit: between R40.00 to R45.00
Expected Gain Percentage: 80%
Max Drawdown: 30%
Stop Loss: 30% below your buy price.
Benchmark Against: JSE TOP40
Dividend: uncertain. (Currently 10%)
Hedge/Defense: Buy a Government Bond ETF to off-set losses with earned interest rate.