Description

Hoteles City Express is a chain of budget hotels in Mexico that has recently rebranded under the Marriott name. I believe we are provided with a timely investment opportunity given the market’s misunderstanding of the implications of their recent franchise agreement with Marriott. The market is focused on the drop in margins caused by the 4.5% royalty that HCITY now pays to MAR. However, the ‘synergies’ of the deal, or more accurately - the benefit of the Marriott brand - takes some time to work through and should more than offset those costs. This thesis was partially proven correct in Q4 where margins largely recovered, but the market has so far failed to respond.

In addition, the US$100m that HCITY has received for the deal with Marriot has been put to good use to 1) pay down and refinance their debt 2) catch up on some much-needed deferred maintenance and 3) finish the hotels that were under construction at the time Covid came and which have been mothballed ever since.

As a result, 2024 might be the year where HCITY finally generates material AFFO (before growth Capex). I’m getting to a 20% yield, combined with a growth rate that should more than offset inflation.

Approaching valuation from an asset perspective, the current share price implies an EV / room of US$24-28k, versus a replacement cost of ~$80k. To be clear, HCITY is not worth replacement cost because 1) some of their rooms smell like sewage (I visited) and 2) like most EM stocks they don’t earn their cost of capital. But just to illustrate the cheapness: if the shares were to trade at replacement cost, you’re looking at $35 MXN per share, or a 7-bagger from here.

Hoteles City Express was written up in 2018 by skca74. It was a different company at the time but the writeup provides good context to the current situation. At the time, HCITY was a developer of hotels that had grown its portfolio rapidly, but failed to generate meaningful FCF because of the 3 years it generally takes before a new hotel reaches its steady state occupancy. In 2019, Mexico experienced a recession (GDP -6%... something to do with making America great again), followed by an even worse Covid downturn from 2020 until late 2022. On October 19th 2022, HCITY sold its brand to Marriott, which prompted this writeup.

In my understanding, the core of the HLT, MAR and H business model is that being a franchisee generally pays for itself. As a franchisee, you pay 4-7% of revenues of your topline to the brand owner, but because of the more valuable brand, you get to increase room rates by a couple of percent. In addition, you get customer referrals from the franchisor’s loyalty network and you get to use the franchisor’s bargaining power when setting rates with OTAs. Higher ADR and lower costs to OTAs should more than compensate for the royalties paid.

At the time of the acquisition, HCITY believed they needed 15 months to get back to similar levels of profitability. The deal closed on May 1st 2024. The margin progression over the last few quarters is telling:

HCITY has 1 large bank covering their stock, which is JPM. On January 24th 2024, JPM downgraded HCITY (from 9 MXN / share to 6 MXN share) on lower margins and because in the last rate cutting cycle, hotels underperformed the market. JPM now models HCITY with margins of only 24%. Only 1 month later, on February 28, HCITY reported EBITDA margins of 34.9%. Now note that Q4 is a seasonally strong quarter which you cannot annualize. HCITY also communicated that they have to invest in IT. They’re also growing their food & beverage business which is only 2/3rd of their average margins. But the 34.9% is only slightly lower than the 36.2% reported in the prior year, in which HCITY did not have to pay 4.5% royalties to MAR. I’m guessing that if you’re a sell-side analyst, it’s not easy to upgrade a company on higher margins only weeks after you downgraded a company on structurally lower margins.

Note that 2019 EBITDA margins (a recession year) were 31.2%, while 2018 EBITDA margins were 34.2%. Those margins were also still held back by the rapid development of new hotels.

 For 2024, my very rough estimate is:

-          ADR up 7-8% YoY

-          EBITDA of $1150m MXN

-          Interest Expenses of $455m (average rate of 11.25%)

-          Maintenance Capex of $175m (4.5% of revenue)

-          $50-100m of taxes

-          That adds up to a little over $400m in AFFO, or a >20% yield

HCITY has historically been able to grow ADR by 150-200bps over the rate of inflation. For 2024, they expect to grow ADR by 7-8% versus an inflation rate that has dropped to 4.4%. The excess growth comes from the rebranding to Marriott, reinvestment in deferred maintenance and the opening of hotels with higher ADRs.

A quick thought on real estate in emerging markets. I have never been able to make valuations work based on FCF alone. 20% is just not impressive if MXN interest rates are at 11%. The reason why real estate in EM can still work is because of the inherent inflation protection. 20% yield + growth that exceeds inflation is more attractive.

I believe the downside to be limited because:

1)      HCITY is actively buying back its own shares: they bought around 10% in the last 2 years and have an authorization of 800m MXN, or 40% of the current market cap.

2)      HCITY owns about $397m MXN of land at cost and I doubt land values have fallen in the last couple of years.

3)      HCITY owns $1.14b MXN of ‘work in progress’. Together with the land, that’s >75% of today’s market cap.

So most of the cash either gets returned through buybacks, or gets reinvested in deferred maintenance or work in progress, both of which should be very high ROIC. Hotel rooms that sell like sewage simply sell for less than hotel rooms that don’t. The risk of course is that management goes back to their old playbook of developing new hotels. Marriot would certainly encourage this because all they care about is unit growth.

Management has also been focusing on growing their food & beverage business, and reported that this added $190m MXN in 2023. They expect further growth going forward, which lowers margin but I think it greatly improves the value offering of their hotels.

Finally, there is the macro. On March 21st 2024, the Mexican Central Bank cut interest rates from 11.25% to 11.00%. More interest rate cuts are likely given the inflation rate of just over 4%, as well as the strong FX. I’m a tourist when it comes to the Mexican economy, but lower rates and a weaker FX should be bullish for a hotel chain with significant debt servicing costs and a decent percentage of foreign customers. These benefits get offset by the fact that 1) 70% of the debt is hedged at 9% + 2.25%. The duration of these hedges is undisclosed. And 2) HCITY is more focused on business travelers than on tourism.

The thesis doesn’t get more complicated than this. Marriott’s $100m payment deleveraged the company. Marriott’s royalties lowered margins. And now margins are recovering.

Catalyst

Margin Recovery, ADR growth, Share Repurchases, Sell-Side updating their margin assumptions