Checking into an Elegant investment

Of course, and as I noted in my market strategy investment column last week ('Financial markets watch', 9 June 2015), once last autumn’s sharp falls in energy prices fall out of the official inflation figures, we can expect a relatively steep rebound in the consumer prices index (CPI) towards the Bank of England’s target rate of 2 per cent. It’s also fair to assume that if the UK unemployment rate continues its marked descent, then there will be a notable reduction in spare capacity in the labour market too. In turn, this should set the scene for the interest-rate-setting committee of the Bank of England to belatedly raise bank base rates in the first half of next year.

The combination of low interest rates, strong economic growth, improving employment data and real wage increases are an appealing mix. It also helps explain why the share price performance of cyclical sectors have a habit of doing rather well in the 12 months prior to the first Bank of England base rate rise in the upcycle when these key economic indicators are moving in the right direction.

That’s relevant to me right now because I have spotted a newly listed company on London’s Alternative Investment Market (Aim) that not only offers exposure to the UK economic recovery, but also to the rebound in the US too. For good measure, the company operates in the leisure sector, one of the best performing stock market sectors historically in the 12-month period preceding the first bank base rise, according to analysts at investment bank JPMorgan.

Leveraging off UK and US economic recoveries

The company is Elegant Hotels Group (EHG: 105p), the largest hotel operator in Barbados, an island in the Caribbean that attracts 520,000 long-stay visitors each year. Around 10 per cent of the population are employed in tourism, so the industry is a major employer as well as a contributor to the island’s GDP of $4.2bn (£2.75bn) last year. With average temperatures ranging from 21 to 31 degrees Celsius, warm waters and a beautiful landscape, Barbados has become an aspiration destination for UK holidaymakers, who accounted for 37 per cent of visitor arrivals last year. And with flight times of under five hours from New York, US investors also vacation there in large numbers, accounting for almost a quarter of visitor arrivals.

Bearing this in mind, the nine airline operators bringing tourists into Barbados’ from the US, UK and Canada all expect decent growth in airline traffic to the island this year. This follows a strong trend last year when tourist arrivals for winter 2014-15 rose by 14 per cent, mainly due to the economic recovery in the UK. Indeed, Barbados Tourism Marketing Board forecasts that passengers carried by US carriers will rise by 14 per cent to 5,840 each week in high season this year, based on arrivals from the four major US airlines (American Airlines, Delta Air Lines, Jet Blue and US Airways); by 3.5 per cent to 6,356 seats from the UK (British Airways, Thomas Cook (TCG) and Virgin); and by 7.7 per cent to 2,810 seats carried by Canadian operators West Jet and Air Canada. In other words, with visitor numbers up, this is a positive for the island’s tourist industry, and the profits to be earned by the major hotel groups.

And make no mistake, Elegant Hotels is a major player on this small island. Operating both four-star and five-star luxury hotel resorts with a total of 150 bedrooms and 333 suites, the company makes up almost 25 per cent of the quality leisure room stock in Barbados. Moreover, having spent $24m (£15.6m) refurbishing its five hotels since 2010, all of which are situated along the prestigious west and south coastlines, otherwise known as The Platinum Coast, about 95 per cent of all guestrooms and most of the public areas in these five hotels are now in tip top condition. Three of the hotels provide European Plan offerings: Colony Club, Tamarind and The House; and the other two are all-inclusive: Crystal Cover and Turtle Beach. The rack rate varies between $304 and $546 depending on the resort, so is definitely upmarket accommodation.

Rising occupancy rates

Importantly, the benefits of restructuring the company in 2008, and the opening of a US marketing office in Florida, combined with the hefty investment in the hotel stock, has led to sharp rises in occupancy rates in recent years. For instance, the most valuable resort, The Colony Club, accounting for a quarter of the portfolio valuation of $235m, has seen its occupancy rate shoot up from 54 per cent in 2011 to 67 per cent last year. But this is not at the expense of room rates, which have risen too: revenue per available room, a key metric for hotel operators, has increased by 12 per cent each year, on average, since 2011. Or put it another way, it's a combination of higher occupancy and room rates that has been driving revenue ahead. The same is true of the other four resorts Elegant Hotels owns.

Elegant Hotels Group's operational financial data

Interestingly, directly booked business (which accounts for 17 per cent of the company's annual revenue) has increased significantly in the past five years, growing by 14 per cent a year since 2012, helped by the new central reservation office in Florida and much-improved call handling. This is much higher-margin business, earning the company around 15 per cent more per room than bookings generated through tour operators, which account for around three-quarters of all bookings. Online sales make up the balance.

Bearing this revenue split in mind, the company’s strong relationship with the major tour operators has been a key factor in increasing room rates alongside the hotel refurbishment programme. British Airways and Virgin are the two most important, accounting for around 40 per cent of Elegant Hotels' trade receivables of $5.7m at the end of February 2015. Both airlines run daily non-stop flights during peak periods from London Gatwick. Furthermore, the average stay for guests arriving from the UK is typically twice as long as guests from other markets, including the US. In fact, around 70 per cent of all Elegant Hotels' guests arrive from the UK, significantly higher than the 37 per cent average for the island as a whole.

In other words, the company is heavily exposed to the strength of the UK economy and the feelgood factor of consumers. Clearly, this works both ways as the global hotel industry was hit by the 2008 financial crisis. But as I pointed out at the start of this investment column, the UK economy is recovering strongly and, with net disposal incomes on the rise, you would expect Elegant Hotels to benefit from this positive dynamic too.

Profits on an upward trajectory

And this is clearly the case as Elegant Hotels' revenues have risen by 12 per cent on average each year between 2010 and 2014 during which time cash profits more than trebled to $19.6m. In the two-year period to September 2014, revenues increased by 25 per cent to $58.5m and underlying operating profit more than doubled from $8.1m to $16.5m (£10.8m). A $3.1m depreciation charge explains the difference between last year's cash profits and reported profits.

Elegant Hotels Group's historic financial performance

Importantly, this trend has been maintained in the latest five-month trading period to end-February 2015 as the company reported a 17 per cent rise in adjusted operating profit to $11.7m, driven by a 10 per cent increase in revenues to almost $30m. Analysts expect this momentum to continue; for the financial year to end-September 2015, analysts at brokerage Zeus Capital predict a 13 per cent rise in operating profit to $18.4m based on 12-month revenues of $61.5m, up from $58.5m in the previous year. For the 2016 fiscal year, Zeus is forecasting revenues of $64.1m and operating profit of $19.9m.

Please note that there is a seasonal skew to these figures as high season is during the UK winter months; the summer months are traditionally quieter. I have used the operating profit line, rather than pre-tax profits in my analysis because the company raised £63m in a placing at the time of the Aim-listing, which has materially changed its balance sheet, the implications of which are worth discussing.

Effects of capital raise

About £27m of the funds raised through the placing have been used to pay down borrowings, so the company now has net debt of $45.8m (£30m) under a five-year credit facility which accrues interest at 4 per cent a year. Borrowings are equivalent to 44 per cent of pro-forma shareholder funds of $103m (£67m). Around £30.8m of the capital raise was a selldown by existing shareholders, £3.2m of the proceeds were used to cover the cost of the Aim listing, and a further £1.6m was designated for working capital. This means the company’s balance sheet is now more sensibly geared; the company had been owned by a fund managed by Vision Capital Partners since 2004.

Although Vision Capital Partners still owns a 23.8 per cent stake, it has entered into a lock-in agreement (six months), as have all other selling shareholders, including directors and senior management, who between them own 5.3 per cent of the shares in issue, and have agreed to a 12-month lock-in. This should ensure an orderly market. New investors on the share register include Schroders, Fidelity, Miton Asset Management, River Mercantile and Artemis.

This means that Vision Capital Partners, the directors, and the top eight institutional investors own just shy of 79 per cent of the enlarged share capital. But there should still be a liquid enough market in the shares to be able to trade them on a modest spread and in decent bargains.

Elegant Hotels' major shareholders

Hidden balance sheet value

It's worth noting that at the listing price of 100p a share Elegant Hotels was priced on a very reasonable multiple of eight times its historic cash profits of $19.6m to its enterprise value (market value plus net debt). Also, the enterprise value of $180m represents a significant discount to the open-market value of its properties.

That’s because property assets are only in the books at $145m, but in April they were valued independently by commercial chartered surveyor CBRE at $235m. So, if you mark properties to market value, then the company's adjusted net asset value is closer to $193m, or £126m at current exchange rates. That's around 144p a share, which compares very favourably with Elegant Hotels' current share price of 105p, based on the current market value of £92m.

Of course, hotels are hardly liquid assets, and there are a limited number of buyers for these multi-million dollar resorts. Also, values can be impacted by a number of factors including economic conditions, competition, tax, regulation and changing supply. Nonetheless this substantial asset backing is reassuring.

Dividend policy

Solid asset backing aside, it's worth noting that the company's board has committed to paying a dividend equivalent to 7p a share based on the listing price. This will cost £6.2m a year, or 44 per cent of Elegant Hotels' likely cash profits of £14m in the 2015 fiscal year. I think a full-year dividend of this magnitude is sustainable by the cash profitability of the business, assuming cash profit margins can be maintained at around 34 per cent, as analysts believe is achievable, and in the absence of a global economic downturn affecting the hotel trade.

I would also add that Elegant Hotels' board believes there is potential to enhance profitability, by leveraging the existing infrastructure and enlarging the hotel portfolio through management contracts and selective acquisition of additional properties in Barbados and surrounding islands. They will also continue to invest in improvements to enhance the company’s properties, bringing existing unused room stock on line and, in the longer term, developing unused land, all of which should enhance the financial performance of the company and provide scope for a progressive dividend policy.

And of course the UK market listing raises the company's profile, adds prestige and reassures potential customers. It also gives the company a paper currency and access to capital markets in order to expand the business more quickly.

Modest valuation relative to peers

It goes without saying that I am keen on the investment case. So is non-executive chairman Simon Sherwood, who led the IPO of Orient-Express Hotels in 2000 and saw the share price of that luxury hotel group treble during his tenure. I think we are in safe hands. Mr Sherwood is supported by chief executive Sunil Chatrani, chairman of the Barbados Hotel & Tourism Association, and a director with over 15 years of industry experience.

So with Elegant Hotels' shares priced on a discount to book value, offering a prospective dividend yield of around 6.7 per cent, and rated on 8 times forecast cash profits to enterprise value, I can see value here. To put this valuation into come perspective, London-listed PPHE Hotels (PPH: 585p) is valued on nine times cash profits to its enterprise value and Millennium & Copthorne (MLC: 558p) is priced on 11.7 times.

On the same basis, and perhaps a better comparable, the average multiple for the five listed non-European listed hotel operators is nearer 15 times forecast cash profits to enterprise value. Companies here include Starwood Hotels & Resorts Worldwide (US: HOT and cash profit multiple of 13.9 times), Marriott International (US: MAR and 14.8 times) and Hilton Worldwide (US: HLT and 14.3 times). Elegant Hotels' prospective dividend yield of 6.7 per cent is three times that of Millennium & Copthorne and 80 per cent higher than PPHE's.

It's worth pointing out that the broker and nominated adviser to the flotation is Zeus Capital, the same company behind the successful Aim floats of UPVC window company Safestyle (SFE: 219p), building materials group Epwin (EPWN: 135p), Flowtech Fluidpower (FLO: 133p), the UK's leading specialist supplier of technical fluid power products, and Entu (142p), a UK supplier and installer of windows, doors, solar panels and other energy-efficient products. I advised buying shares in all four early on and they have done incredibly well.

I expect Elegant Hotels to produce decent returns too over the next 12 months or so. In fact, I have placed a fair value of between 130p and 135p a share on the company's equity using a more realistic cash-profit-derived multiple to enterprise value of 10.5 times current-year forecast cash profits of $21.5m, a valuation that would also be underpinned by a dividend yield in excess of 5 per cent. On a bid-offer spread of 103p-105p, I rate the shares a buy.

MORE FROM SIMON THOMPSON...

At the end of April, I published an article with all of my share recommendations this year. Since then I have published articles on a further 44 companies:

■ Marwyn Value Investors: Buy at 220p, target price 260p ('Exploiting a value play', 5 May 2015)

■ Pure Wafer: Buy at 113p, target 140p to 150p; Paragon: Run profits at 440p, but buy on a confirmed breakout above the 445p and new target of 500p; 600 Group: Buy at 16.5p, target 24p; Fairpoint: Buy at 127p, target 190p; AB Dynamics: Buy at 207p, target 230p ('Repeat buy signals', 11 May 2015)

■ Globo: Buy at 56p, target 69.5p; Greenko: Hold at 70p; Pittards: Buy at 128p ('Breakout looms for mobile wonder', 12 May 2015)

■ Macau Property Opportunities: Buy at 214p; Dragon-Ukrainian Properties & Development: Hold at 28p; Raven Russia: Hold at 53p ('Overseas property plays', 13 May 2015)

■ Trakm8: Run profits at 135p; Redde: Buy at 120.75p, target 140p; STM: Run profits at 45p, but conditional buy on close of 48p and new target of 60p ('Smashing target prices', 14 May 2015)

■ Bilby: Buy at 75p, target 100p ('Buy to build' growth play, 18 May 2015)

■ Bioquell: Buy at 148p, target 170p to 185p; Somero Enterprises: Buy at 140p, target 185p; KBC Advanced Technologies: Buy at 109.5p, target 165p; Inspired Capital: Hold at 14.25p ('Three value plays', 19 May 2015)

■ Renew Holdings: Buy at 315p, target range 350p to 375p; Manx Telecom: Buy at 198p, target 210p ('Renewing old acquaintances', 20 May 2015)

■ Marwyn Value Investors: Buy at 228p, target 260p; Charlemagne Capital: Hold at 13.5p; Bloomsbury Publishing: Hold at 178p ('Lights, camera, action', 21 May 2015)

■ Anite: Buy at 91.5p, target 110p ('Testing a breakout', 26 May 2015)

■ Character Group: Buy at 415p, target 525p ('Playtime', 1 Jun 2015)

■ Tristel: Run profits at 96p; Pure Wafer: Buy at 123p, target range 140p to 150p; Crystal Amber: Buy at 153p ('Hitting target prices', 2 Jun 2015)

■ B.P. Marsh &Partners: Buy at 150p, target range 170p to 180p; Moss Bros: Buy at 110p, target range 120p to 130p; SeaEnergy: Sell at 15p ('Exploiting a valuation anomaly', 3 Jun 2015)

■ Globo: Buy at 59p, target 69.5p; London & Associated Properties: Buy at 38.5p; Greenko: Hold at 44p ('Catalysts for share price moves', 4 Jun 2015)

■ Burford Capital: Buy at 148p, target 190p ('Legal eagles', 8 Jun 2015)

■ Market strategy ('Financial Market Watch', 9 June 2015)

■ Software Radio Technology: Buy at 29.5p, target 40p to 43p; Tristel: Run profits at 92p; Creston: Buy at 136p, target 150p; Sanderson: Buy at 69p, target range 80p to 85p (‘Blue sky potential’, 10 June 2015)

■ 1pm: Buy at 67p, target 80p; Vislink: Buy at 58p, target 70p (‘Small-cap growth stocks’, 11 June 2015)

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'