Saturday, 21 February 2015

On the Orient Express

When it comes to trophy assets few companies do it like Belmond. It owns hotels such as the Cipriani in Venice, Grand Hotel in St Petersburg, 21 Club in New York and operates the fabled Venice Simplon Orient Express train, amongst others. Now combine this collection of assets with an awkward shareholder structure and you have an interesting situation on your hand.

Source: Belmond

The company (originally Orient Express Hotels) was founded in the late 1970s with the acquisition of the Hotel Cipriani followed by the Orient Express. OEH was housed under a shipping company called Sea Containers founded by James Sherwood, which later filed for Chapter 11 and was forced to spin off OEH. Over the last few years the company hasn't been managed in the best possible way and there was a lot of shareholder discontent, while the liabilities side of the balance sheet began to baloonTo bring the story to the current years, the CEO resigned in 2011 for personal reasons and the board began a search for a new one. In 2012 it hired John Scott, which also marked the beginning of a turnaround of the company (profile on him in Fortune). He has a good track record in the hotel business and previously was the CEO of Rosewood Hotels, which he turned around then sold to a company belonging to HK’s New World group.

He began to restructure OEH's operations, initiate $50-70m asset sales and seek out management contracts. His team also began a rebranding effort to move away from OEH to Belmond. Apparently, most people thought that what OEH does is operate old trains between London and Venice only. With the new branding they can consolidate hotels and use it to cross sell customers. In addition, by establishing themselves as a strong hotel operator they can position the company better for management contracts. In short, the new team aims to rid the business of non-core assets, reinvest in what’s core and pay down debt. The company entered the recession with a lot of leverage (at some point over 9x EBITDA) while currently it's at a more manageable (though still high) 4x. In addition, a new board was also brought in (more on this and governance below).

All of the above was reflected in the share price which has steadily climbed from around $11 to over $15 but then 2014 came and things started to go wrong in a few markets, such as the exposure to Russia (the St Petersburg hotel is about 10% of keys) and the share price started to tumble to the $11 levels.

It’s worth noting two things here: (i) these sort of assets attract a lot of attention from suitors and (ii) an odd governance structure.

In 2007/2008 Indian Hotels (publically traded leisure arm of Tata) tried to make a run for the company when it owned over 11%. It did the same in 2012 when it had a 7% stake (you can read a good summary here from the Economist). In 2013 the bid was ultimately rejected by the board on low valuation but Indian Hotels still owns that stake. In addition to Indian Hotels, the Reuben Brothers (UK based investors, mostly involved in real estate) also own a 6% stake in Belmond. Back in pre-recession times there were rumours that they were looking to buy the company (at a $3bn valuation!).

Recently I re-read Peter Lynch’s classic “One Upon Wall Street” and he talked about trophy assets. At some point in his career he came across a company trading OTC that owned Pebble Beach with a $25m market cap. He didn’t buy the stock but Twentieth Century Fox did buy the whole company for $70m a few years later. They eventually sold assets off, starting with one piece of land that was alone worth $30m i.e. there was substantial underlying value but it needed a catalyst.

Apart from better operational performance a key catalyst would be getting rid of the current governance structure. Basically, there are class A and B shares. While it’s generally not such a big deal in this case the B shares don’t trade, instead are held by a subsidiary of the company, which also happen to carry a 10x vote vs class A shares, essentially giving control to the board / company (this is a legacy setup by the previous owner). While it enables mgmt. to act for the long term (assuming the incentives are aligned) it also makes people jittery given missteps from the old guard.

Now, what is it worth? Current market cap is $1.2bn and $1.7bn EV trading around 15x current and 14x forward EBITDA vs historical avg of 16.5x. Current EBITDA is estimated to be around $110m and mgmt. guides for $18-32m to be added by 2017 (vs 2014) from renovations / additions, increase in mgmt. fees, cross visitation etc on top of organic growth. Taking this at midpoint (and assuming no organic growth) indicates $8m increment p.a. so Belmond could be around $135m by 2017 (implied share price of $17, assuming historical multiples).

Based on the historical multiples for the various segments, the market implies around $700k/key valuation for the owned hotels. Now assuming the valuation would get back to pre-crash levels ($800-900k/key) it would imply $14-17 per share. Global trophy hotel asset transactions have been pushing $1,000k/key recently; assuming this for a second would imply valuation of $19/share. The two M&A attempts were made at average EV/EBITDA of 18-19x. Applying this on 2017 earnings gets you to similar valuation. Looking at an absolute downside, Belmond has traded at book before when things looked really bleak, which would imply $8/share.

While it appears that there is value in Belmond, keep in mind that history shows a lot examples of investors falling in love with trophy asset hoping for a greater fool, only to find their hands burnt in the process. However, I think that mgmt. has every incentive to carry on with their plan and so far they’ve made rational decisions, which (as noted above) were reflected in the share price before all the events around Russia etc kicked in.

The two key catalysts for getting to the above valuation ranges are (i) mgmt. delivering on their plan and (ii) board doing away with the shareholder structure (for those wishing for some kind of activist involvement…there is no chance). Also for the same reason M&A is unlikely for now (unless they get a $30/share offer tomorrow).

Having said all the above about the shareholder structure I do think there is hope. I’d urge you to listen to the company’s November 2014 investor day (or read the transcripts) where the topic of the shareholder structure has been debated to death. The CEO noted that this is being discussed in board meetings but actual progress has been slow to date. Let’s see. If the board would eliminate this the valuation uplift would be accelerated for sure.