Conclusion:

We view Hotel Leela’s lackluster financial performance in F2007 as a by-product of its concentration in the Bangalore market, where we believe RevPAR growth has started tapering off. While the company’s peers (IHCL and EIH) showed strong operational growth in F2007, Hotel Leela lagged considerably despite its smaller size. We maintain our Underweight rating on the stock given the high concentration in Bangalore and slow pace of capacity expansion in other cities.

F2007 results were weak:

Hotel Leela reported consolidated revenue of Rs 4.2 billion (up 21% YoY) and earnings (excluding exceptional items) of Rs 897 million (up 27% YoY) in F2007. Its 46.4% EBITDA margin was a decline of about 80 bps over F2006 – however, higher other income in the form of forex gains helped overall profitability.

Where could we be wrong?

While we expect substantial supply to be released in the Bangalore market, there is a possibility of this being delayed due to various factors. In such a scenario, the Bangalore market might not see as sharp a fall in RevPAR in F2009 as we estimate (we currently estimate a 30% fall).

Implications:

We estimate Leela to show 36% earnings growth in F2008 – however, the induction of new supply in F2009 by other industry players may cause earnings to fall substantially. In our view, the Bangalore risk will remain an overhang on the stock.

Summary & Conclusions

Hotel Leela’s financial performance in F2007 was weak compared to its peers – IHCL and EIH – and came despite continuing strength in sector trends. Revenue grew by 21% YoY and earnings by 27%, against IHCL’s 37% growth in revenue and a 40% growth in earnings over the same period. We believe the Bangalore market, which contributes about 45% of Hotel Leela’s revenue, is slowing, thus affecting overall performance. Also, we believe revenue from Bangalore will slow further as we draw closer to F2009 and F2010, when significant capacity will be added by other industry players. The new supply will cause average room rates (ARRs) and occupancy rates (ORs) to drop sharply, thereby hurting profitability. While Leela is adding 1,554 rooms, most of this capacity will only be added in the next 3-5 years. The stock has underperformed the BSE Sensex by about 35-40% YTD and in the last 12 months. We believe the risk associated with Bangalore has been a stock overhang and will continue to remain one as we move closer to F2009. The stock is trading at 13x F2008E basic earnings and 16x F2009E basic earnings. We remain Underweight.

F2007 Results Were Ordinary

Hotel Leela reported consolidated revenue of Rs 4.2 billion (up 21% YoY) and earnings (excluding exceptional items) of Rs 897 million (up 27% YoY) in F2007. EBITDA margin of 46.4% in F2007 declined by about 80 bps over F2006 – however, higher other income in the form of forex gains helped overall profitability. Hotel Leela’s performance was weaker than its peers despite its smaller size. IHCL and EIH both outpaced Hotel Leela on revenue, EBITDA and net profit growth. We believe the high concentration in Bangalore has been the key reason for the growth slowdown, and will continue to impede growth as RevPAR growth in Bangalore slows further. We understand that Bangalore contributes 45% of Leela’s total revenue and 50% of operating profit. The Mumbai property contributes to about 25% of its total revenue. The company has two FCCB issues outstanding – Euro 57 million convertible into equity shares at Rs 62.20 per share, and USD 100 million convertible into equity shares at Rs 90 per share. Should both these issues be converted, they would increase outstanding shares by 27%.

Capacity Expansion – Some Time Away

Hotel Leela has total room inventory of 1,087 rooms. In F2007, the company increased room inventory in its Bangalore hotel from 256 to 358 rooms. All the 396 rooms in the Mumbai property were refurbished during F2007, and hence will be available in the ensuing years. Hotel Leela has announced plans to add another 1,554 rooms over the next 3-5 years in the cities of Udaipur, Gurgaon, Chennai, Delhi, Pune, Goa and Hyderabad. The company has started work on the Udaipur and Chennai hotels, while steps have been taken to start construction in Hyderabad and Pune. We understand that it will release 200,000 sq ft of IT space in Chennai in December 2007. Leela has also obtained approvals to start a floating casino (on a catamaran) in Goa, which will be ready in the next two months. The company is also looking for opportunities in Jaipur and Kolkata, while on the international front, it is scouting for management contracts in Abu Dhabi and Maldives. It intends to participate only in the super luxury segment and has no plans to enter the budget segment. While the company will more than double its room inventory, we believe the pace of expansion has been slow relative to its competitors. Also, the company is expanding into cities where substantial supply is expected to be released by other industry players.

Valuation

We have taken down our F2008 Basic EPS estimate by 19% and F2009E by 16% to account for the weak performance in F2007 and our slower EBITDA growth assumption in F2008. Our target price of Rs 30 is based on a 20% discount to our target EV/EBITDA multiple for IHCL. We believe such a discount is warranted due to Hotel Leela’s smaller size and significant city concentration.

Our target multiple for IHCL (Rs 124.55; PT Rs 180) is based on a 50% premium to our 12-month forward EV/EBITDA multiple of the Sensex. Historically, IHCL has traded in a premium band of 10% to 130% relative to the Sensex, while the five-year average has been about 64%. Given that we expect IHCL’s earnings to be strong due to a paucity of room supply, we believe a 50% premium to the Sensex multiple is reasonable at this time.

Key downside risks to our Hotel Leela target price are lower average room rates and occupancy rates, especially in Bangalore. Upside risks include increasing ARRs and improving ROE. Other industry-specific risks include significant rupee depreciation, which would be positive for Leela shares, and rupee appreciation, which would be negative. Key downside risks to achieving our target price for IHCL include any decline in average room rates and negative performance of the international business. Increasing average room rates and improving ROE could create upside risk. Other industry-specific risks include significant rupee depreciation, which would be positive for IHCL shares, and rupee appreciation, which would be negative.