Growth drivers in hotel industry

RAM Ratings released the hotel sector report last week. Here is the full report.

Increased tourist arrivals and the resultant higher occupancy levels are expected to be the sector’s key propellers going forward

The economic prospects of Sri Lanka's post-war development hinge primarily on a few key industries; among these, tourism has emerged as a frontrunner. A sector that is positioned to benefit directly from the anticipated boom in tourism is the Sri Lankan hotel industry.

After nearly three decades of operating in an extremely challenging environment amid the military conflict, the outlook on the industry has now completely turned around; and it is expected to play a wider role in Sri Lanka's future economic development.

According to the Central Bank of Sri Lanka ("CBSL"), the hotel industry only contributes around 2 percent to the country's gross domestic product ("GDP") at the moment.

The domestic hotel industry comprises tourist hotels that are graded establishments, along with other establishments such as guest houses, inns and youth hostels registered with the Sri Lanka Tourism Development Authority ("SLTDA"). With tourist arrivals into the country hitting a record high of over 650,000 last year, the hotel sector recorded an average occupancy rate of nearly 70 percent.

During peak periods, occupancy levels exceeded 90 percent.

Increased demand has enabled hotel operators to elevate their room rates, leading to stronger revenues and broader margins for most establishments.

Looking ahead, the sector's growth prospects appear very promising, particularly in the short to medium term. According to industry experts, the current capacity of approximately 15,000 rooms (from graded hotels) can only cater to around 800,000 guests per annum; this is insufficient given the Sri Lankan government's ambitious target of 2.5 million tourist arrivals by 2016.

Industry experts estimate that the current capacity will have to be doubled to accommodate this influx; this is perceived to be unattainable over the medium term due to the long lead time for hotel development.

In view of the above, existing establishments will continue benefiting from the shortage of rooms and rising rates in the interim. Recent regulations require 5-star hotels to raise their minimum rates from USD100 to USD125 per night effective April 1, 2011; this also affects those in the lower categories.

The sector's performance will also be propelled by improved domestic demand against the backdrop of the generally better economic conditions and higher disposable incomes. Moreover, opportunities abound for existing operators to expand to the northern and eastern regions as well as other tourism zones, in turn brightening their growth prospects and financial performance in the long run.

That said, we have identified several key challenges that the sector may face when attempting to capitalise on the opportunities presented by the tourism boom.

While banks are willing to lend to established hotels that are part of larger diversified groups, stand-alone hotel owners, particularly small and medium-sized establishments, face funding constraints over the construction of new hotels and the refurbishment and upgrading of existing facilities.

The banks' conservative stance on the hotel sector could be due to the latter's vulnerability to both global and local economic conditions and events.

An additional challenge lies in the area of human resource ("HR"). Currently, employees in the hotel and tourism sector come up to around 300,000; industry experts estimate that close to 1.5 million employees would be required to cater to the government's targeted tourist arrivals by 2016. As such, the country needs an integrated framework for HR development in the hotel industry.

Overview of the Sri Lankan hotel industry

Industry structure

The Sri Lankan hotel industry primarily consists of tourist hotels and other establishments that include guest houses, inns and youth hostels approved by the SLTDA.

Lodging establishments registered with the SLTDA numbered just above 780 as at end-2010, with a capacity of 20,609 rooms.

These accommodations are dominated by tourist hotels, which accounted for 71 percent (or 14,714) of the industry's total room capacity last year. The SLTDA defines tourist hotels as all establishments that are considered to be up to international standard of operations.

Nonetheless, we note that 55 percent of such establishments are unclassified in terms of grading, as they do not meet the specific grading criteria set out by the SLTDA. The authority's grading criteria is based on the classifications set out by the World Tourism Organisation ("WTO"). However, this does not mean that unclassified hotels are of lower standard; in fact, their ranks include some luxury establishments.

Meanwhile, most of the remainder are relatively lower-level establishments (with 1- or 2-star grading); mid-range and upmarket establishments accounted for less than 18 percent of the capacity of tourist hotels while supplementary establishments contributed another 29 percent. All said, the inadequate supply of upmarket hotels may prevent Sri Lanka from attracting more big spenders from abroad.

Regional distribution

The Sri Lankan hotel sector has been mainly focused on Colombo, the main economic and financial hub as well as the gateway to the rest of the country. The southern region comes second as hotel owners take advantage of Sri Lanka's beach attractions. As such, the Colombo area accounted for around 39 percent of the capacity of tourist hotels as at end-2010, followed by the southern region and ancient cities. Elsewhere, the newly liberated eastern and northern regions constituted less than 2 percent, highlighting their growth potential.

Key consumer segments

Foreigners make up the majority of the patrons at Sri Lankan tourist hotels, contributing nearly 70 percent of their total room nights. In the first half of 2010 ("1H 2010"), holiday makers accounted for 79 percent of the country's tourist arrivals, underlining Sri Lanka's dependence on this segment that is highly vulnerable to global macroeconomic conditions and events. Business travellers comprised around 17 percent of the tourists that arrived in the same period. Notably, striking a better balance between leisure and business travellers would enable hotels to smoothen out the seasonality factor in their revenue as the number of holiday makers typically peak in November and December.

A tourist's average stay in a hotel, meanwhile, came up to around 9 days in 2009; this has remained relatively unchanged in the past few years.

During the era of military hostilities, hotels had primarily survived on domestic demand, which had somewhat compensated for the lack of tourist arrivals. In particular, domestic patrons had dominated room nights in supplementary establishments.

Local demand had also supported hotels' food and beverage ("F&B") revenue. More recently, there has been a shift in foreign patrons towards both supplementary and graded establishments, especially after the end of the civil war.

Revenue composition

Besides room-based revenue, F&B has been generating a significant portion of the revenue of most Sri Lankan hotels. F&B revenue comprises income from in-house restaurants that are frequented by resident guests and also non-residents. In some instances, F&B revenue even outstrips room revenue. Historically, F&B revenue has accounted for an even larger proportion of revenue than shown.

Contribution from room revenue has only recently risen as occupancy and room rates have picked up. Income generated by the F& B segment (particularly in city hotels) has somewhat compensated for the lower occupancy levels during the time of military conflict.

Industry risk factors

The hotel sector's dynamics are driven by a range of factors such as cyclicality and variability in revenue, pricing flexibility, level of competition and ease of entry.

It is globally considered to have a high level of industry risk, chiefly due to its capital intensity and susceptibility to macroeconomic conditions, movements in travel fares and event risk.

In the Sri Lankan context, the cyclicality of the hotel sector is mainly due to its dependence on foreign tourists - a segment that is vulnerable to the global macroeconomic environment and event risk. Nonetheless, increasing focus on other markets such as meetings, incentives, conferences and exhibitions ("MICE") and medical tourism can reduce the sector's dependence on the leisure market.

That said, we note that it is essential to develop the infrastructural framework and other amenities needed to cater to these new markets in Sri Lanka.

Given the rather anaemic demand prior to 2009, most hotel operators had been compelled to compete on price. Price undercutting had been evident among most city hotels and those in the southern region, with certain 5-star establishment only charging about USD60 per night. To curb excessive price competition, the government started imposing minimum room rates in 2009.

With tourist arrivals hitting a record high in 2010, occupancy levels have also surged, thereby reducing the pressure to compete on price. As such, room rates exhibited a year-on year ("y-o-y") spike of over 20 percent as at end-December 2010.

Looking ahead, the robust demand outlook and inadequate supply over the short to medium term will continue supporting occupancy levels and room rates. Part of the latter will be regulation-driven as the minimum room rates imposed by the government will be increased.

Five-star properties have been charging a minimum rate of USD125 per night effective April 1, 2011, from the previous floor of USD100 per night. Furthermore, more robust demand has also alleviated some of the competitive pressure on hotel operators. Although a minimum room rate has been imposed, we note that rates of more upmarket establishments tend to vary within a wider range, whereas mid-range properties have less pricing flexibility.

Meanwhile, the magnitude of capital investment required and the lengthy gestation period serve as entry barriers, particularly for larger upmarket properties. Even though the capital outlay is lower for smaller establishments, funding constraints may pose as an entry barrier too. All in all, we opine that the Sri Lankan hotel sector's risk parameters have moderated, albeit still higher than those of most other industries.

Growth drivers of the Sri Lankan hotel industry

We believe that several key factors propel the growth of the Sri Lankan hotel industry, as follows:

Tourist arrivals

After nearly three decades of operating in an extremely challenging environment amid the military conflict, the outlook on the industry has now completely turned around. Tourist arrivals to the country hit a record high in 2010, leaping 46.12 percent y-o-y to 654,476 ; the strong growth trajectory continued this year, with arrivals up 34.1 percent y-o-y as of March.

The increased tourist arrivals and the resultant higher occupancy levels are expected to be the sector's key propellers going forward.

The government is pursuing an ambitious target of 2.5 million tourists by 2016, requiring an almost 30 percent annual increase. To realise this target, the authorities have embarked on several initiatives to put Sri Lanka on the tourism map. To this end, the government is focusing on the development of non-traditional markets such as China, the Middle East and Russia, besides positioning Sri Lanka as a destination that offers diverse attractions such as wildlife and culture in addition to pristine beaches.

The government has also declared 2011 as Visit Sri Lanka Year. All these efforts will directly benefit the hotel industry vis-a-vis increasing tourist arrivals.

. Domestic economic conditions

Previously, domestic demand had been a stabilising force for the sector, providing hotels a certain level of resilience amid lackluster tourist numbers. As such, domestic-related room nights had on average accounted for 25 percent-30 percent of the industry's collective while also supporting F&B income, particularly for Colombo hotels. In the medium to long term, domestic demand will be anchored by the improvement in the overall economy and the resultant rise in disposable incomes. With peace restored and maintained, Sri Lanka's economy is poised to record strong growth in the next few years. The nation's gross domestic product ("GDP") expanded 8.0 percent y-o-y in 2010, the second-highest growth rate since it gained independence over 60 years ago.

We estimate Sri Lanka's GDP to increase 6.5 percent y-o-y in 2011. Growth is also expected to be supported by the opening up of the northern and eastern regions as well as the influx of foreign direct investment ("FDI") amid the more conducive business climate. Although the inflow of FDI into the country has been below expectations in the last two years, the Board of Investment of Sri Lanka is aiming for approximately USD1 billion in 2011 - significantly higher than the almost USD600 million last year.

Meanwhile, the government is pursuing a target of doubling per capita income by 2015. Although contribution from local tourism activities to total earnings is likely to ebb as income from foreign tourists picks up, we believe that domestic demand will still chart healthy growth over the medium to long term, supported by better macroeconomic conditions and higher levels of disposable income.

Occupancy levels

Historically, the average annual occupancy rates of graded hotel establishments in Sri Lanka have been kept below 50 percent, albeit climbing up to around 65 percent during the peak months of November and December. Given the more recent boom in tourist arrivals, however, occupancy rates were lifted in 2010, averaging at nearly 70 percent for the year; the peak months achieved over 90 percent. Traditionally, hotels along the southern coast and Colombo have recorded the highest occupancy levels.

Looking ahead, the sector is expected to chalk up higher occupancy levels in 2011, driven by the influx of tourists into the country, events such as the International Cricket Council World Cup co-hosted by Sri Lanka, and stronger local demand amid the more favourable macroeconomic landscape.

We believe the scenario of high occupancy levels is likely to prevail in the short to medium term, as the industry faces a room-supply deficit amid more robust demand. The current capacity of nearly 15,000 rooms is sufficient to cater to only some 800,000 guests per annum - indicating a substantial deficit in supply should the government's target of 2.5 million tourists be achieved. Industry experts contend that the current capacity of graded rooms should be nearly doubled to around 28,000 rooms, although the exact number will depend on the market mix.

According to plans already announced by local and foreign hotel operators, 1,000 rooms will be added over the medium term, albeit still insufficient to cater to the expected influx of tourists. Furthermore, the closure of hotels for refurbishment could tighten supply further in the short term.

Against this backdrop, we believe that hotels will continue enjoying high occupancy levels and lucrative rates in the short to medium term.

In line with the industry boom, many foreign and local hotel operators have already expressed their intention to build new properties in the country. For instance, Hong Kong-based Shangri-La Asia Ltd is building a 500-room luxury hotel in Colombo at a cost of USD 500 million; China National Aero-Technology Import and Export Corporation is planning another USD500 million hotel development adjacent to the Shangri-la's site. Several local companies have also announced plans to build new properties as well as to increase their capacity and refurbish existing facilities; these include John Keells Holdings PLC, Aitken Spence PLC, Softlogic Holdings, Lanka Orix Leasing Company and Sierra Cables. On a related note, higher-quality accommodations are necessary for Sri Lanka to attract foreign big spenders; the SLTDA estimates that only around 6,000 of the currently available rooms are of medium to high quality.

Hotel room rates

The upsurge in demand for hotel rooms has led to a concurrent rise in room rates across the industry. According to the Global Hotel Price Index, Sri Lanka's 5-star room rates had been elevated 21.38 percent y-o-y to an average of USD105.63 by end-December 2010; this represents the fifth-largest spike in room rates globally.

A further increase was seen in April 2011, in accordance with the government's requirement to raise minimum room rates. The scenario of escalating room rates is likely to prevail in the short to medium term as the industry will be challenged to expand its capacity to meet the surge in demand.

To be continued