Description
Orient Express Hotels/ Sea Containers “A”
The luxury to super-luxury hotel market is characterized by extremely high barriers to entry, primarily due to zoning restrictions and the importance of a status brand name. Demand is inelastic to price changes and occupancy rates are typically insensitive to changes in economic conditions. Furthermore, the numbers of affluent grow twice as fast as the population in general (the number of “affluent” worldwide grew by 7% in the most recent “Economist” survey. This implies that the growth rate in the market for luxury/super-luxury hotels will also be robust in the next decade. In short, this niche represents an ideal and stable growth market for a company with both a strong brand name and a strong balance sheet.
Orient Express Hotels clearly embodies the best of this theme. The company features an exceptionally strong balance sheet, as well as outstanding short and long term prospects. Furthermore, as the company has only been listed publicly on the NYSE since August 2000, the shares have not yet enjoyed the market following that one would normally expect. This is entirely due to the fact that the shares have not yet gathered informed analyst opinions. For this reason, the shares sell for the lowest p/e by far of any company in its peer group.
Investors who purchase Sea Containers Ltd. will participate in the upcoming spin-off of the remainder of Orient Express Hotels. For each share of Sea Container held, an investor will receive .75 of 1 share of Orient Express Hotels. Courts confirmed the vote today.
I recommend those conservative, risk adverse growth investors purchase Sea Containers Ltd. I forecast that investors who hold both companies for the mid term after the spin off may earn return a minimum of 70%, a realistic probability of 105% and a possible return of up to 160% (within the next 36 months).
Description of Orient Express Hotels. Orient Express (hereafter referred to as OEH) owns and operates a total of 29 small luxury to super luxury hotels worldwide. OEH plans to grow its business by increasing prices and earnings at both established properties and newer acquisitions. As the company presently has the strongest balance sheet in its history, management also intends to use this period of economic weakness to acquire further distinctive luxury properties worldwide. A small portion (12%) of their business operates luxury tourist trains and one Asian cruiseship.
OEH has gained a worldwide reputation for quality and service and frequently wins prestigious awards from publications such as Conde Nast Traveler, Tatler and Andrew Harpers.
OEH was a wholly owned subsidiary of Sea Containers until August 10th 2000. They floated 35% of the shares on the New York Stock exchange. This relatively recent listing in part explains the lack of analyst coverage and the steep discount to its peers on a relative valuation basis. At present, the shares of OEH sell for less than 13.3 times my 2001 estimates.
Financial and Earnings History. All revenues are reported in U.S. dollars and conform to GAAP. Unlike virtually all of its competitors, OEH has generated less than 5% of its total profits for the last five years from asset sales.
Earnings per share: have grown by 17% compounded annually for the past five years.
Long term debt as a percentage of the balance sheet: long term debt averaged 44% of the balance sheet over the past five years. This is significantly better than the vast majority of its peers. Presently, long term debt amounts to just 37% of the balance sheet.
Return on shareholders equity: OEH generated a net average return on shareholders equity of 10.5% for the past five years. The trend is steadily higher, despite declining leverage.
Net profits as a percentage of revenues: have averaged 12% over the past five years. They have grown every year and presently exceed 15%.
Operating costs: have been constant at 45% of revenues over the past five years.
SG&A costs: have averaged 27.5% of revenues and have fallen every year over the past five. Currently, SG&A represents less than 25% of revenues in this current fiscal year.
REVPAR: has increased by an average of 13% per year for the past five years, adjusted for U.S. exchange. REVPAR failed to grow in 2000, entirely due to the unusual strength of the U.S. dollar vs. international currencies. In host currencies, revpar in 2000 grew by their historical average of 13% +.
Gross Margins: have averaged 30.5% per year over the past five years. In each year, gross margins improved vs. the preceding year.
COMPARATIVE ESTIMATES AND FORECAST
The majority of large publicly traded hospitality firms with luxury or superluxury operations tend to have many hotel chains with multiple price points. Pure peers are difficult to find. The best peer to evaluate OEH against would the Four Seasons Hotels. However, the capital structures of FS and OEH are completely different. Four Seasons serves purely as an operator and owns no physical properties in of itself. Therefore, FS has not imbedded cost of capital insofar as real estate. The operating profit margins are higher at FS, due to little or no depreciation in its capital structure. Hilton and Marriott, on the other hand, generate significant profits from acquiring and then selling/leaseback of many of their properties. Therefore, their earnings stream is less predictable (less reliable) than OEH. Nevertheless, the attached spreadsheet may serve to enlighten you as to the relative valuation of OEH vs. other companies in the sector.
Company Name Current Price $ Net Profit Margin $ Forecast 3 Year Earnings Growth % Estimated 2001 P/E Estimated 2001 EPS $ Estimated 2004 EPS $ P/Estimate of 2004 Earnings (EST)
Four Seasons Hotels (FS) $54.42 29% At 15% 27.1 2.00 3.05 17.1
At 17% 3.20 16.9
Hilton Hotels (HLT) $11.26 9.3% At 7% 16.0 .70 .85 13.2
At 9% .91 12.3
Marriott Int. (MAR) $47.63 4.9% At 7% 23.1 2.07 2.54 18.8
At 9% 2.68 17.8
Orient Express (OEH) $21.45 15% At 12% 13.1 1.61 2.28 9.2
At 15% 2.51 8.4
As evidenced by the comparative analysis, there seems to be significant room for multiple expansion.
Growth Opportunities. OEH management has steadily reduced long term debt as a percentage of the total balance sheet. Long term debt is now the lowest (37%) in corporate history. This affords the company great flexibility to significantly grow operations through acquisition and expansion of existing hotels. For example, one property (Caruso near Naples) has been completely closed in 2000 for a complete renovation and refurbishment. It is expected to reopen late in 2002.
Recently, the OEH purchased two hotel properties in Bora Bora and Peru for a total cost of $39.5 million. This purchase is being funded entirely from free cash flow, and will not result in any additional debts to the company by year end 2001. These properties have the potential to add as much as $.20 per share in gross profits by 2002.
They have consistently added new properties throughout their history, without impairing the balance sheet with undue leverage. OEH policy is to only make immediately accretive purchases. In my analysis I assume no further purchases between now and 2004. Therefore, any new acquisitions could render my forecast to be conservative.
What Should OEH Be Fairly Valued At?
In this analysis, I use .75 of 1 share of OEH on a dividend-adjusted basis from Sea Container. This allows you to quickly add up the potential total return when you combine OEH and SCR.A
Due to a limited trading history and scant analyst coverage, OEH trades at a mere faction of its peers. Yet, the consistency of earnings increase (17% per year in the last five years), pristine balance sheet and future prospects would make for a strong argument that it deserves to trade at least at the valuations of its peer group (22 times 2001 earnings). Nevertheless, I prefer to be conservative.
If you assume that the company will grow as per my table, and that the price/earnings ratio will remain stable at 13, the shares of OEH could be valued at between $19.8 to $21.35 (per Sea Container share) in 36 months.
If you assume that the OEH grows as per my table, and that the p/e averages 15 times over the forecast period, the shares of OEH could be valued at between $22.28 to $24.64 per Sea Container share.
If you assume that OEH grows as per my table, and that the p/e averages 17 times earnings (still a discount of 25% vs. its peers), then the shares of OEH could be worth $25.25 to $27.66 per Sea Container share.
To summarize, using modest organic growth projections, stable interest rates, stable occupancy levels, revpar increases of 10% per annum, and no acquisitions through 2004…the value of OEH to SCR.A shareholders could be worth between $19.3 to as much as $27.66. I would argue that this analysis is quite conservative.
SEA CONTAINERS “A”. Each share of Sea Containers will result in a dividend of .75 shares of OEH. At the conclusion of the spin-off, you will still own 1 share of Sea Containers. My analysis concludes that ownership of SCR.A may represent an extremely attractive investment for the next 36 months.
After the spin-off of OEH, Sea Containers will be a primarily European conglomerate involved in 5 distinct business segments.
1. Passenger transportation through ferry services worldwide.
2. The world’s largest lessor of cargo containers directly and through a 50% partnership with GE Capital Corp. They presently own over 1,200,000 containers.
3. Real Estate development and property management in the UK
4. Printing and publishing of specialized trade periodicals.
5. Management of one of the seven rail transit franchises in the United Kingdom. Their franchise consists of the highly popular service connecting Scotland and NorthEast England to London.
Despite excellent diversification and market leadership in many of the divisions that it operates in, SCR.A has little analyst coverage. Perhaps this is in part due to no requirement for equity capital from underwriters. That being said, the firm has never historically commanded an S&P multiple. The share price sold for as little as 6.4 times earnings at one point in the last decade. At one point, the shares sold for as much as 15 times earnings. The average p/e for Sea Containers has been 10 for the past decade.
The spin-off will temporarily depress the value of SCR.A. Assuming that for a brief period, the shares fall by the amount of the dividend, SCR.A shares would be valued at $2.125. Should they fall to this price, the total equity value of SCR.A. will be a modest $42.5 million. Yet, after the spin-off, SCR.A should have net book value equity in excess of $400 million dollars. This undervalues the remaining assets significantly.
I would put forth those investors who continue to hold shares of SCR.A. have a high probability of earning significant returns over the next 36 months after the spin-off takes place. My proforma estimates suggest that the combined value of OEH and SCR.A could range from between $28.60 (conservative) to as much as $46.68 through mid 2004.
THE VALUE OF SCR.A.
Sea Containers presently owns 19.5 million shares of OEH, with a present market value $419 million. They intend to sell 5 million shares, with the proceeds being applied against outstanding debts. The remaining shares will be spun out. This will leave the company with total assets of $1.7 to $1.8 billion and total debts I estimate at $1.3 billion. The reduced profits from the foregone equity in OEH will be partially offset by the reduction in interest paid on $100 million of bank debt. In total, I forecast that SCR.A’s profits will decline by $.80 per share in 2001 as a result of the spin-off. A recession led decline in profits from their container led operations in 2001 leads me to conclude the SCR.A. may earn a total of just $1.25 per share (post spin-off) on remaining operations.
SCR.A’s remaining assets have historically generated a return on shareholders equity of roughly 9% for the past decade. This implies net profit potential in excess of $1.80. However, 2001 and possible 2002 look to be abnormal years, due to the slowdown of global economies. Based upon business trends at each of the operating subsidiaries, I forecast that SCR.A. may only be able to earn a return on equity of 6.25% in 2001 and 6.25% in 2002. This has not happened in the last 15 years.
By the end of 2003, I estimate that the global economy will rebound somewhat, and that SCR.A. will once again earn a 9% return on equity.
Sea Containers is a distinct business from OEH and carries different business risks. Summaries of those risks are as follows.
1. SCR.A remaining operations could suffer more severely than I have estimated, due to a more severe global slowdown than forecast. I am assuming that for the next two years, SCR.A. may generate the worst return on equity in their last fifteen. This encompasses two recessions prior to this one. However, the severity of this recession is as yet unknown. I assume –2% GDP growth in North America for 2001, and 0% GDP growth in Europe and Asia for 2001. For 2002, I assume the inverse, 0% growth in North America and –2% growth in Europe and Asia. More severe declines would render my forecast to be optimistic.
2. Political risk inherent in European and Asian or South American operations are a variable impossible to quantify. Sea Containers’ rail franchise in the UK is currently up for renewal. A competitive bidder (Virgin Rail) has offered to assume the franchise, and the two bids are presently up for review. Although Sea Containers has been informed by regulators that its bid is superior to Virgins, it is not 100% assured of success. Failure to renew this franchise could reduce net profits by an additional $.40 per share in 2002.
South American operations are always subject to expropriation, nationalization and or terrorism. Any of the aforementioned would result in lower profits for SCR.A.
3. Fuel prices could rise significantly above present levels. Ferry and rail operations have their 2001 fuel costs fully hedged at levels much lower than in the previous year. This should be positive for 2001 (up to $.58 per share in savings fully taxed). However, 2002 fuel prices could rise significantly. As mass transit represents an important business segment for SCR.A., dramatic increases in fuel costs could lower profits in 2002.
4. Currency. Only 20% of SCR.A revenue comes from U.S. dollars. The balance is in foreign currencies. The major increase in the value of the U.S. dollars vs. most other worldwide currencies in 2000 hurt SCR.A profits accordingly. Should this trend repeat for several years, SCR.A., profits would be reduced accordingly.
5. Interest rates could rise. Much of SCR.A debt is at floating rates. This is an important positive in 2001. Management forecasts that total interest charges will decline by almost $18 million in 2001 (roughly $.90 per share). However, a rapid increase in rates would be bad for SCR.A.
Potential Positives for SCR.A.
1. Their franchise rights in UK rail could be renewed for the next 20 years, as per their bid. A winning bid would eliminate share price concerns and significantly boost profits and potentially the share price.
2. Sea Containers and other rail franchisees could purchase their pro-rata share of Railtrak. In the UK, the rail franchises are for management only, and do not include the operating and fixed rail assets (including track). Railtrak has been under continual attack for failure to adequately maintain the infrastructure. This has resulted in less than optimum profits for the franchisees due to scheduling delays, etc. Consequently, the shares of Railtrak have fallen in half during the past year, and indications are growing that the British government may be agreeable to a complete takeover of the lines by the franchisees. Should this ever occur, bidding wars on routes would be eliminated, and the assets could be more profitably managed.
3. Interest rates could remain stable or decline somewhat further. Should that occur, SCR.A would continue to earn windfall profits from low rates for equity holders.
4. Fuel prices could drop or remain at levels lower than in 2000.
5. The global economy could recover in 2002. Faster recovery than forecast could unlock windfall profits from the container leasing division. During periods of economic growth, the container division routinely earns $2. + per share in net profits for the corporation.
6. SCR.A could continue to raise the dividend. The shares of Sea Containers have historically paid out handsome dividends. The annual dividend of $1.20 per share was reduced to just $.30 per share in anticipation of the OEH spin-off, but should soon start to rise. Sea Containers typically pays out an average of 35% of profits as dividends. Based on earnings of up to $1.50 in 2003, the dividend has room to increase to as much as $.52 per share. Rapid dividend increases would support the share price at levels much above the spin off proforma.
Potential Valuation Scenarios for Sea Containers.
I use three scenarios in forecasting the future price of SCR.A.
1. The shares sell for 6.4 times earnings from now to 2004. This implies a three-year share price of just $9.30. Although the shares of SCR.A. sold for this low multiple briefly in 1994, it would be quite conservative to forecast this for three consecutive years.
2. The shares sell for an average of 10 times earnings though 2004. This would imply a three-year share price of $14.60.
3. Numerous events go right, and the shares trade at a multiple of 13 times earnings by 2004. This would imply a share price of up to $18.12.
In summary, SCR.A shares appear to be very undervalued on a post spin-off basis. I would continue to hold them for the next 36 months for strong capital gains potential.
In conclusion, ownership of SCR.A. appears likely to offer potential for significant gains over the next 36 months. The short-term catalyst will be the unlocking of value with the OEH spin-off. Future gains will come from steady increases in profits at OEH and increased investor favor. As for SCR.A., future growth potential may arise from inherent growth potential at all divisions. Furthermore, the massive discount of the equity prices of SCR.A. may narrow to approach something closer to book value. All in all, this low risk opportunity may prove to be very rewarding for the patient.
Catalyst
spin off of OEH was approved on June 22nd.