Description

Summary:  Hoteles City Express (BMV: HCITY) is a limited service hotel chain in Mexico that has grown impressively since its founding.   We believe the company's business model offers investors multiple ways to win: through the maturation of its existing property portfolio, through continued growth in that portfolio, and through creation of a REIT that would optimize funding for the company.  

Business Overview:  Founded in 2002 by a team of 5, City Express now has 139 hotels with 15,691 rooms in its platform.  It is the second largest hotel chain in Mexico (after Grupo Posados), but the largest limited service brand.  The company's limited service hotels target business travelers who seek high quality, safe, comfortable lodging at an affordable price. City Express develops and manages hotels for its own portfolio, and also operates hotels under its brand for its investment partners.  

Key Pillars of the Thesis:

1. Maturation of the Existing Portfolio.   Given its high growth, approximately 1/3 of the portfolio has not yet reached stabilization, implying embedded profit upside.
2. Continued growth runway.  We believe that City Express is extremely well-run and has significant room for growth in front of it.
3. Upside potential from REIT and more optimized funding.  The company is looking for additional, efficient sources of funds.
4. Attractive Valuation.

#1. Maturation of the existing portfolio.  Of the 139 hotels in the platform, they have 101 in their own portfolio (54 owned, 33 co-owned, 14 leased) and manage the rest.  Given that the company has been adding hotels so quickly, approximately 1/3 of the portfolio is under 3 years old, the age at which their properties reach stabilization.  These "non-established" hotels have occupancy and RevPar below the levels of the more established hotels and are a drag on reported numbers. In recent disclosures, they have said that the non-established assets generate EBITDA margins around 22%, while the more mature properties produce are around 36%.  The company estimates that the existing portfolio - were it to mature and operate at the same level as the mature assets - would contribute nearly $350mm in additional EBITDA to the $700mm the hotel operation segment currently produces. While that won't happen immediately, it should come in over the next several years, implying a significant amount of upside baked in.  

#2. Continued growth even in a slower market.   We believe that City Express management has done an excellent job of growing and managing the company.  Almost all of the senior management team have been with the company since its founding. Since 2002, the company has opened a new hotel every 6 weeks on average.  

That pace looks to continue:  they currently have 35 hotels in their project pipeline. Over the next 12 months, they expect to open 18 new hotels with 2,128 rooms.   

While they have certainly benefited from strong occupancy, travel and ADR trends in the Mexican business market, we believe there are several factors that will allow them to continue to grow the company's portfolio, revenues and profitability even if a slower economy appears.

Meeting an unmet need in the Mexican hotel market:

• Overall underpenetration of hotel rooms:  Relative to the US, Mexico is underpenetrated with hotel rooms.  Per the Secretary of Tourism, there were a little over 750,000 hotel rooms in Mexico at the end of 2017 (versus a population of 131mm).  This compares to the US, which averages nearly 200,000 hotel rooms under construction each year. Mexican hotel room supply has been growing slightly faster than 3% per year in recent years but tourism and travel has continued to grow as well, with overall occupancy remaining robust even as more supply comes on.   
• Need for reliable limited service brand in Mexico:   We believe there is significant potential for a branded chain to grow in Mexico. 75% of the country’s hotel rooms are not part of chains/are owned by independents (compared to 34% in the US).  This implies a fragmented market where it is easy for customers to substitute. City Express saw a niche for a business traveller focused brand that will inspire loyalty and repeat business.

So far, they have been very successful at reaching their target business customer:  87% of room nights in 2017 were to business travelers, 90% of them domestic travelers.  Over 600,000 people now belong to the company's loyalty program. 

We believe they have been successful because they are filling a niche that is underserved in the market.  From their IPO prospectus: "We offer rooms with attributes and features in line with international hospitality standards at lower prices than most chain hotels in Mexico   We offer a range of amenities that are essential for the business traveler, including wireless internet, complimentary breakfast, meeting rooms and business centers, along with fitness centers in our City express and City Suites hotels, which are not common to most independent limited-service hotels in Mexico." To quote founder Luis Barrios, "We established new standards for properties at this price. We had many things that people did not know and started to learn as we grew and created a brand image. We named it City Express, as it had to be a brand not tied to one place of origin."  

At this point, the next largest limited service brand in Mexico (One Hotel) has only 50 hotels versus 139 in the various City Express brands.

• Targeting submarkets where there is additional need:  The company focuses on areas of Mexico that have higher than average GDP growth while also having fragmented and substandard existing hotel inventory.    

Longer-term potential growth in other Latin American countries:

While we believe there is still significant upside in the Mexican market, City Express has opened properties in Costa Rica, Colombia, Chile, and Guatemala.  While each of those markets has its idiosyncracies, they all share a need for new hotel product and City Express believes that limited service has an opportunity in each of these markets.  While this international operation is small now (e.g. in Colombia they have 4 hotels), we believe there could be significant upside over the long-term. The CEO recently said he would interested in potentially franchising the company's brands in these countries, implying the potential for an asset-light, high return runway in its international operations.  

Infrastructure to support growth and operating leverage:

We believe they can achieve some degree of operating leverage with growth.  The company says have the infrastructure in place to operate more than 200 hotels (up 40+% from today) with minimal cost increases.  Over the past 4 years, they have achieved nearly 250bps in margin expansion at the EBITDA line and nearly 300bps at the EBIT line.

A degree of downside protection from limited service model:

The limited service business model has the advantage of lower capex and opex relative to more traditional full-service hotels (though they also end up charging lower rates).   The company claims they have designed their hotels to be operationally profitable at a 30% occupancy rate at their target ADR. That said, they have indicated that fixed costs are a fairly significant portion of the operating costs of their owned hotels.  As an offset, during periods of corporate belt tightening in an economic downturn, travelers will often shift from more expensive properties to the limited service product.

#3.  Potential for REIT and more efficient funding.  Given the disparity in operating results between the new properties and the more mature, City Express announced in January plans to put 42 mature owned properties into a REIT called Fibra Stay, which would then be offered to the public.  HCITY would continue as a property developer and hotel operator/manager while owning the less established properties.

This structure offered several advantages:  

1. The company expected to raise $2.0-2.5b  from selling 49% of Fibra Stay. The proceeds would help to fund their development plans for the next several years.
2. It would give the market a more efficient way to see and value the different pieces of the City Express operation (presumably leading to a higher valuation).  
3. The REIT would provide a more efficient place to dispose of mature assets and recycle the capital back into new development projects.  
4. It would allow the company to raise the pace of hotel development from 10-15 per year to 24.

This transaction was approved by shareholders and expected to start trading in May.  As uncertainty about NAFTA and the Mexican presidential election amped up, they pulled the deal.  

We expect them to revisit this topic in the near future.  NAFTA looks like its coming together on the Mexican side.  AMLO has now been elected, but Luis Barrios recently said that  after meeting AMLO, he expects a positive investment environment to largely continue.  The incoming tourism secretary is Miguel Torruco, who has spent 30 years in the tourism/hotel industry and was most recently Secretary of Tourism for Mexico City, so the industry expects him to be sympathetic and understanding of their needs.  The company recently commented that it "is confident it can relaunch the FSTAY transaction when a suitable market window opens".

Given the delay in the REIT transaction, they will have to rely on other sources of financing.  After pulling the REIT transaction, they have secured a $1.2b unsecured bank line to finance their 2018-2020 development.  Management has used debt prudently. Net debt to EBITDA stands at 2.2x.

Additionally, they will recycle capital produced by the portfolio.  At stabilization, the properties generate an average ROIC of 12-14%.  From 2019 onwards, they have said they can develop 10-15 hotels per year (75% wholly-owned and co-investments) using only the new credit line and internally generated cash flow.  Assuming an the average fully owned property requires about $100mm in equity to develop, it implies that the company expects to generate approximately $1b per annum in cash flow that can be recycled.  

#4.  Attractive Valuation.  The stock currently trades for 11x 2018 EV/EBITDA.  If the company just maintains the status quo, growing its portfolio by 10-15 properties per year and maintaining margins, they should be able to generate approximately $1.4b in 2020 EBITDA.   At 11x, this yields a $30+ stock, up 40% from here. If the company can accelerate its development by executing the REIT transaction, we expect there could be significant upside to our Revenue and EBITDA estimates.  A successful REIT transaction could also give the company a higher rating on its mature portfolio, implying additional upside.

Catalyst

-Execution

-REIT transaction