Hitting target prices

It’s good news if you bought the shares earlier this year at 99p ('Small-cap trading updates', 24 May 2017), or the previous month at 89p ('Value opportunities', 11 Apr 2017) when I highlighted the investment potential. It also means the holding is up almost 50 per cent since I initiated coverage ('Check in for a profitable booking', 14 Dec 2015). The question is whether there is more upside to come?

Outperforming rivals

It’s easy to see why investors have got excited: like-for-like revenues from easyHotel’s five owned hotels, comprising 520 rooms and accounting for 80 per cent of the company’s turnover, increased by 13.7 per cent in the 12 months to the end of September 2017, massively outperforming analysts forecasts, and rivals, too. For example, analyst Alastair Ross at brokerage Investec Securities had been factoring in an 8 per cent growth rate. He also notes that rival Premier Inns posted 4.7 per cent underlying revenue growth in the quarter to 1 June. easyHotel’s franchise chain of 20 hotels, comprising 1,750 rooms, are also proving popular, delivering like-for-like revenue growth of 8.6 per cent.

The directors led by chief executive Guy Parsons, the former chief executive of leading budget hotel chain Travelodge, note that the five hotels opened in the period, two of which were owned hotels in Manchester and Birmingham, and three franchises in Brussels and Amsterdam, have traded “exceptionally strongly since opening, and are expected to reach maturity ahead of budget”. Given that the accelerated roll-out of the brand is a key factor in the bull case, the fact that easyHotel is over delivering clearly augurs well for next month’s opening of its 78-room Liverpool hotel, and the four owned hotels currently under construction – comprising over 520 rooms – all of which are planned to open in 2018. These are located in Ipswich, Leeds, Sheffield and Barcelona.

Furthermore, the company has over 2,500 owned rooms under negotiation, of which just under half have board approval. Having raised £38m in a placing at 100p a share 12 months ago, and refinanced bank facilities, Mr Ross at Investec believes the company spent around £40m on capital expenditure to end the 12-month period with net funds of £3.5m. Bearing in mind the company’s robust balance sheet, the directors believe that they have capacity to fund three additional new projects from the identified committed development pipeline of 775 owned and leased rooms.

easyHotel is also ramping up its franchise hotel chain, increasing capacity from 1,405 to 1,750 rooms in the past 12 months, and targeting a committed franchised pipeline of 1,636 rooms. New franchised hotel projects currently under construction and anticipated to open over the course of 2018 include: Lisbon (101 rooms); Bernkastel-Kues (100 rooms); Reading (54 rooms); Belfast (81 rooms) and Dubai (300 rooms). The important point here is that the bumper revenue growth being reported by the existing franchises bodes well for new franchisees to commit the capital required to build new hotels.

Old Street issue resolved

The other issue worth commenting on is a resolution to easyHotel’s Old Street owned hotel, located on the edge of London's financial district, after Islington Borough Council refused retrospective planning permission in relation to 78 of the 162 bedrooms, which were built without planning consent by the previous management. I was fully aware of the planning issue when I initiated coverage, and flagged it at the time. I also highlighted in my column six months ago that all options available to the directors would be value accretive to shareholders ('Value opportunities', 11 Apr 2017).

For example, analysts believed that given its location and development potential, an outright sale of the property could generate proceeds more than double its net book value of £13m, and could be recycled into the pipeline of developments that aims to deliver a 15 per cent return on capital employed on an unleveraged basis. The £13m carrying value of the Old Street hotel is also very conservative considering the hotel’s profitability: it generated cash profits of £1.6m on revenue of £2.7m in the 2016 financial year based on an average occupancy rate of 85 per cent and an average room rate of £54 per night.

That valuation is set to become even more conservative because the directors have opted to retain a smaller 92-room hotel which will be refurbished, so benefiting average revenue per available room rates and occupancy rates, extend the office use on the upper floors of the building, and apply for planning permission to add additional floors. The property only has five floors, whereas the neighbouring one has seven, so offering potential to build further office floors subject to planning consent in order to exploit the valuable location of the site. When Mr Ross at Investec last crunched the numbers he assumed prevailing rates for such office space in the locality between £45 and £50 per sq ft, implying an annual rent roll of £900,000 to £1m, a significant sum in relation to the hotel’s cash profits of £1.6m. The bottom line is that easyHotel’s profits from the Old Street site are now likely to rise, and possibly by quite a sizeable amount.

Crunching the numbers

Admittedly, valuing a fast-growing hotel chain is not an exact science and there is execution risk in easyHotel’s accelerated roll-out programme: revenues are expected to rise from £7.9m in the year just ended, after factoring in 30 per cent growth, to £11m in the new financial year, rising to £20m in 2018-19, and £24.9m in 2019-20, based on Investec’s latest forecasts. However, if these targets can be achieved then analysts' models suggest that cash profits could rise fivefold to £11m by 2020 to deliver pre-tax profits of £6.4m and EPS of 4.8p. This is based on the current issued share capital of 100.5m.

Of course, some of this growth will be debt funded which is why Investec expects easyHotel’s net borrowings to hit £37.4m within two years after factoring in £50.3m of total capital expenditure. Add this forecast debt to the current market value of £120m, and the enterprise valuation of £157m is the equivalent of 14 times likely cash profits for the 2019-20 financial year. From my lens at least, that  rating is still not over stretched given the scope for easyHotel to outperform. Also, the shares are still only priced on 1.7 times book value even though there is clearly hidden value in the balance sheet, and the company continues to create significant bricks and mortar value in its new owned hotels.

In the circumstances, I feel there is scope for easyHotel’s share price to run up to Investec’s 135p target, and perhaps beyond if the board delivers another robust trading update when the company releases its full-year results on Wednesday 6 December. Run profits.

An elegant investment

The pre-close trading statement from Elegant Hotels (EHG:87p), the largest operator of luxury hotels on the Caribbean island of Barbados, has confirmed the company is trading in line with the profit estimates I outlined when I last rated the shares a buy at 95p ('Check into small-cap value plays', 20 Jun 2017).

Analyst Mike Allen at joint house broker Zeus Capital predicts full-year pre-tax profit of $11.4m (£8.65m) and EPS of 9.9¢ in the 12 months to the end of September 2017, an outcome that should enable the board to maintain the dividend at 7p a share even though cover is wafer thin. The dividend looks sustainable as depressed forecast operating profits of $13.5m for the year just ended easily cover the cash $8m cost of the payout, and around $2.1m interest payments on likely year-end net debt of $72m secured on property assets worth $267m.

True, and as expected, Elegant Hotels' pre-tax profits will be well down on the $14.2m in the 2016 financial year, but there are sound reasons to believe that a profit recovery could be on the cards in the new financial year, not least of which is the fact that sterling has rallied 12 per cent against the US dollar from its October 2016 lows, easing some of the currency headwinds the business has been facing. That's because 80 per cent of Elegant Hotel’s customers are from the UK, so last year’s collapse in sterling against the greenback – the currency declined 16 per cent to £1:$1.23 – impacted their spending power and meant that the hotelier needed to discount its rates in a sensible and controlled manner to maintain bookings from this important segment of the market.

The effect of discounting resulted in the average daily room rates contracting by 5 per cent to $443 in the all important first half to the end of March 2017 when the business makes all its money, excluding the 2016 summer acquisition of Waves Hotel & Spa which has a lower blended average room rate. However, Elegant Hotel’s is now marketing its luxury hotels with the benefit of a current exchange rate of £1:$1.32 rather than £1:$1.185 at this time last year, giving it far more flexibility to attract UK customers.

Secondly, the directors have confirmed that the 35-suite Treasure Beach Hotel, acquired in May 2017, is on track to reopen for the peak tourist season following a refurbishment. The hotel is budgeted to deliver cash profits of $1m in its first year, rising to $1.45m in 2018-19 which takes into account a full 12-months' contribution, a decent financial return on the $10.6m invested by Elegant Hotels.

Thirdly, the company will benefit from a full 12-month contribution from the Waves Hotel in the 2017-18 financial year, and average room rates at the property will not be impacted by the initial discounting that took place after it reopened following last year's acquisition and subsequent refurbishment. There are cost savings being made, too. By importing a large proportion of its food and beverages, the company should reduce annual costs by around $500,000.

The bottom line

Taking all these factors into account suggests that analysts at Zeus Capital are not being too bullish in expecting Elegant Hotel's revenues to rise by around 10 per cent to $65.7m in the 2018 financial year to deliver a 21 per cent hike in cash profit to $20.7m. On that basis, pre-tax profit is forecast to bounce back to $14.7m and deliver EPS of 12.7¢, or about 9.6p using current exchange rates, implying the shares are trading on nine times forward earnings and offer a near 8 per cent dividend yield. Of course, the company has to deliver on those expectations and it is early days in the season. However, bookings are currently running ahead of the same period last year, suggesting that this year’s currency appreciation of sterling against the US dollar is having a positive impact on business to some extent.

It’s only fair to add that I first advised buying Elegant Hotel’s shares at 105p when the company floated on Aim ('Checking into an elegant investment', 15 Jun 2015) so, even after taking into account dividends of 14p a share banked to date, the holding is slightly under water. However, I feel the recovery story is not reflected in the current rating, nor is the fact that the shares are trading on a huge discount to net asset value (NAV) of 175p, so there is scope for balance strength to play a part in the share price recovery, too. It’s not only the hotelier’s customers who could be sporting a warm glow come results day on Tuesday 9 January 2018. Buy.

BP Marsh’s results bang on the money

Half-year results from cash-rich insurance sector investment company BP Marsh & Partners (BPM:260p) were even better than I had expected when I suggested buying the shares three weeks ago, at 230p, ahead of yesterday’s announcement (‘Exploiting hidden value’ 25 Sep 2017).

Having crunched the numbers in quite some detail, I felt that BP Marsh’s NAV would be heading towards 300p a share, up sharply from 273p in January 2017, and 253p in July 2016, suggesting the share price was on an unwarranted discount to book value. And because the board have a policy of buying back shares when the discount to NAV exceeds 25 per cent, then this effectively creates a floor. In the event, the company lifted its NAV by 11 per cent to £88.8m in the six months to the end of July 2017, and this was after paying out a maintained final dividend of 3.76p a share at a cost of £1.1m. There were some eye-catching gains on the portfolio’s largest investments worth noting.

Major investments still undervalued

For example, BP Marsh invested £7.14m to increase its stake from 43.1 per cent to 60.87 per cent in LEBC, an independent financial advisory firm, effectively valuing LEBC’s entire equity at £40m, or a third more than the implied value in January 2017. However, the valuation committee believe LEBC’s equity is currently worth £42.85m, or 42.8 per cent higher than in January 2017, so BP Marsh has made a quick-fire £500,000 gain on the £7.1m new investment to add to a near £5m gain on the previous 43 per cent holding. This places a value of £25.9m on BP Marsh’s 60 per cent stake, making it the company’s largest investment.

There is substance to the valuation as LEBC’s trading profit trebled to £2.1m in the three years to the end of September 2016, and expect another substantial increase again in the financial year just ended, according to chairman Brian Marsh. The 20 per cent ratings discount to listed rival Mattioli Woods (MTW), which is rated on 23.5 times forecast net profits for the 12 months to the end of May 2018, is overly harsh. Moreover, there is ample scope for more valuation gains driven by LEBC’s rising earnings in light of the explosive growth the firm is generating from developing its traditional advice model to incorporate the best in technology advancement and steadily grow its corporate project work. In fact, its 'bionic' advice service has just passed £1bn of new clients' assets invested, up from £500m at the start of 2017, and now has more than 37,000 clients using the service. LEBC is also in the running to close a substantial contract that will have a material impact on profits, and is not reflected in the valuation of the company in BP Marsh’s latest accounts.

Broking for profitable gains

The 18.1 per cent equity investment in Nexus Underwriting, an independent speciality Managing General Agency, produced a similar valuation gain, rising 39.3 per cent in value from £13.9m to £19.4m. This effectively values Nexus’s equity at £107m, hardly a punchy valuation when you consider the company’s premium income has risen by 180 per cent to £157m in the past three years and forecast cash profits are expected to hit £11m this year, up from £2.6m in 2014. Part of the latest growth spurt reflects three debt funded acquisitions: Zon Re Accident Reinsurance, a US-based Reinsurance Underwriting Agency; marine cargo specialist Vectura Underwriting; and trade credit specialist Equinox Global.

However, Nexus’s organic growth is robust, too, underpinning the valuation uplift. Taking into account the £18m drawdown of its £30m debt facilities, which helped fund the acquisitions, this implies Nexus is being valued on a modest 11.4 times multiple of its 2017 forecast cash profits to enterprise value of £123m. To put that valuation into some perspective, earlier this year Hyperion Insurance sold its majority stake in CFC Underwriting to a consortium of private investors and the management team on a multiple of 22 times cash profits. There is clearly more upside to come from the investment in Nexus.

Importantly, none of the companies BP Marsh invests in have insurance risk to the US hurricane season, but will benefit from an expected tightening of the insurance market when the major insurers start hiking premiums to try to recover catastrophe losses in the range of $100bn to $130bn.

Smart recycling of cash

The other point to note is that BP Marsh has been shrewdly recycling the £25m proceeds from the disposal this year of its interests in Besso Insurance, a top 20 independent Lloyd's broking group, and Trieme Insurance, deals I commented on at the time ('Four undervalued growth plays', 24 Apr 2017). It acquired a 35 per cent stake in CBC UK, a retail and wholesale Lloyd’s insurance broker, for nominal value, backing the management team and providing a £4m loan facility at commercial lending rates to the business. This equity stake is valued in the accounts at £690,000, reflecting CBC’s likely cash profits of £630,000 this year on revenues of £5.55m. However, this is just the start as it’s the potential to grow the business that will provide the investment upside.

The company has also just bought a 30 per cent stake in Mark Edward Partners, a US firm offering a range of risk management services to commercial and private clients and one with licences to operate in all 50 states with offices in New York, Palm Beach and Los Angeles. Cash and treasury funds accounted for a quarter of BP Marsh’s NAV of £88.8m at the end of July, and following recent investments the company has £8.6m uncommitted cash available for investment, offering significant firepower for more deals.

Importantly, the company’s interest income from its £12.5m loan portfolio, dividends from investee companies and other fees earned covers its operating costs, so the directors can afford to play the long game to reap the returns: the holding in Besso generated a thumping internal rate of return (IRR) of 22 per cent on the investment over a 21-year holding period. It’s not the only one as the company’s NAV has grown at a compound annual rate of 11.7 per cent since 1990.

Indeed, it was the prospects for further valuation creation that prompted me to recommend buying the shares at 88p ('Hyper value small-cap buy', 22 Jan 2012), and I last rated them a buy at 230p (‘Exploiting hidden value’ 25 Sep 2017). With the company continuing to exceed my expectations, the holdings in Nexus and LEBC accounting for half NAV and valuation risk firmly skewed to the upside, I feel that my previous target price range of between 260p and 275p is likely to prove too conservative. I rate the shares a buy at the current offer price of 260p, and have a new target price of 290p. Buy.

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