Growth drivers in hotel industry...

Continued from yesterday

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

The higher price tags will in turn boost hoteliers' financial performance through broader profit margins. Meanwhile, we note that Sri Lankan hotel rates are still lower than those of the other countries in the Asia-Pacific region.

In a bid to support the industry's profitability, the government imposed minimum room rates on all graded hotel properties in the latter part of 2009.

As such, all 5-star properties have a floor rate of USD75 per night, with a USD15 reduction for every star lower down the ladder. A further increase was imposed in January 2011, with the minimum 5-star room rate lifted to USD100 per night.

A third increase was recently implemented, with the rate rising to USD125 per night effective April 1. The minimum threshold will benefit the industry in terms of preventing price undercutting and widening profit margins.

Therefore, this is likely to encourage investment in new properties, the upgrading of existing facilities and the development of human capital in this sector. That said, the imposition of the minimum rate could also reduce pricing flexibility for operators, particularly lower-grade hotels.

New attractions

Traditionally, Sri Lanka's main attraction has been its beaches, which mainly appeal to the European market.

With the tourism authorities now attempting to position the country as a destination that offers more diverse attractions, the hotel sector is poised to benefit from a more diversified earnings base.

For instance, the government has also announced plans to boost Sri Lanka's image as an entertainment destination, thus providing hotels with the opportunity to expand their operations to include night-life attractions such as night clubs and casinos. Furthermore, promoting health tourism allows hotels to add to their regular income sources.

Another opportunity for growth lies in MICE, where Sri Lanka has a cost advantage; this enables the country to attract visitors who seek more value for money. However, we note that hotels would need to invest in the construction of conference halls and related infrastructure to capitalise on this opportunity.

The SLTDA has also classified 45 areas as tourism zones throughout the island, which are open for tourism development by domestic and international parties.

For instance, the Kalpitiya Development Project involves the long-term leasing of 14 islands in the north western region, with a cumulative land area of over 4,000 acres.

Investment opportunities from this project include the construction of luxury accommodations such as chalets, water bungalows and beach cabanas.

The SLTDA estimates that the Kalpitiya region can accommodate up to 4,500 new hotel rooms. Meanwhile, 2 of the 5 islands that were initially put up for auction in 2010 have been offered to potential investors, for nearly Rs 2.9 billion in total.

Due to the magnitude of the investment, most local parties showing interest in the Kalpitiya Development Project are likely to form joint ventures with international or other domestic entities when investing in that area.

Besides Kalpitiya, other regions that will be the focus of tourism development in the short to medium term include Hambantota (along the southern coast), Arugam Bay (the east coast) and the area surrounding Yala National Wildlife Park, thus opening up further investment opportunities for existing players as well as newcomers to the hotel industry.

Issues and challenges for the hotel industry

Funding constraints

The Sri Lankan hotel sector has generally faced challenges when trying to secure funding, as banks have been unwilling to lend to the industry because of its dismal performance during the civil war, coupled with the segment's acute susceptibility to adverse macroeconomic conditions and external shocks. Although we note that loans granted to the tourism sector by licensed commercial banks had almost doubled y-o-y during the first half of 2010, their aggregate exposure to this sector only came up to less than 3 percent (or Rs 30.54 billion) of the commercial banking system's entire loan portfolio as of end-June 2010.

This is also reflected in the relatively low gearing ratios of hotel operators. Moreover, it is evident that large, established hotel operators with their holding companies' support may be in a position to obtain bank funding on favourable terms while the small and medium-sized establishments face difficulties.

On a separate note, raising capital via the stock market is now an attractive option given the buoyancy of the Colombo Stock Exchange ("CSE") and the near-euphoria buoying the tourism sector.

We believe that entities may be reluctant to raise capital via initial public offerings due to their lack of procedural infrastructure and the requisite level of transparency required by the CSE's listing criteria.

Shortage of trained industry personnel

There is currently a severe dearth of employees in the hotel sector vis-a-vis catering to the authorities' target of 2.5 million visitors.

Employment in the hotel and tourism sector comes up to around 300,000 at present; industry experts estimate that close to 1.5 million employees would be required to attend to the anticipated influx of tourists by 2016. As such, the number of such personnel must augment 5-fold within the next five years - a demanding task given the current state of tourism education in the country.

Such education is mainly provided by the Sri Lanka Institute of Tourism and Hotel Management ("SLITHM"), a few national universities and several isolated private institutions.

Due to lack of information, the number of graduates from these private institutions cannot be estimated; the SLITHM and national universities only produce some 3,000 graduates each year.

Meanwhile, the quality of the training offered by the private institutes is also a concern, as they are not regulated.

Going forward, the hotel sector needs integrated HR development to address the shortage of trained industry personnel.

Quality of offerings

As the local hotel sector has been operating under extremely challenging conditions in the past few decades, there has been inadequate emphasis on upgrading facilities and infrastructure to international standards.

It is thus clear that many Asian neighbours have progressed significantly in terms of the quality of their offerings relative to Sri Lanka's.

Unless there is substantial investment in the refurbishment and upgrading of hotel rooms (particularly for mid- and low-end properties) and amenities, the industry will not find it easy to capitalise on the opportunities arising from the country's post-war development.

Rating Considerations

The credit profile of a hotel operator is analysed under two main categories of risk: business and financial. Business hazards are tied to several factors such as country risk, industry risk, and the entity's relative competitiveness. Financial risk involves capital structure, cashflow as well as liquidity and financial flexibility.

Business risk

While country risk has an impact on all the businesses operating within an economy, industry risk focuses on factors that are specific to that particular sector. In general, Sri Lanka's level of country risk has eased substantially following the resolution of its three-decade-long military conflict; its current government is deemed politically stable.

With regard to industry risk, the vulnerability of a hotel depends the intensity of competition within the market and on its business model, i.e. whether it is a luxury, mid-range or budget establishment.

In addition to country and industry risks, competitiveness is also crucial when evaluating a company's business risk. Competitiveness depends on a range of factors, including the company's market share, extent of diversification, brand value, operating efficiency, growth strategies, and its earnings volatility.

While the latter appears to be common to most hotel operators in Sri Lanka, the revenues of groups that operate a number of establishments (e.g. John Keells Hotels PLC, Aitken Spence Hotels Holdings PLC and Ceylon Hotels Corporation PLC) are understandably less volatile because of their geographic diversity.

A hotel's competitive position is also reflected by its operational efficiency, including average occupancy rates, average room rates and revenue per available room.

Meanwhile, relative profitability is also a measure of a hotel's competitiveness; this is reflected by the company's profitability indicators such as margin on operating profit before interest and tax ("OPBIT"), return on assets ("ROA") and return on capital employed ("ROCE").

An analysis of the samples' OPBIT margins reveals that upmarket hoteliers with an array of properties typically enjoy high, relatively stable margins.

For instance, John Keells Hotels PLC and Aitken Spence Hotel Holdings PLC have demonstrated better profitability due to the strategic location and high quality of their properties as well as the high service levels offered, which allowed the companies to charge a premium while maintaining high occupancy levels.

On the other hand, mid-range establishments such as Sigiriya Village and Ceylon Hotels Corporation have suffered depressed margins on the whole.

All said, it is evident that margins have generally been trending upwards in recent quarters, in line with rising occupancy levels. Prospectively, margins are expected to surpass traditional levels, partly driven by increasing room rates that are anticipated to prevail in the short to medium term. Meanwhile, hoteliers' overall profitability will also be supported by a range of tax incentives for the sector under the government's 2011 budget.

These include a tax reduction on earnings from tourism and related businesses, from 15 percent to 12 percent, as well as lower duties and taxes on passenger transportation vehicles. At the same time, custom duties and value-added tax have also been cut on certain machinery and equipment that need to be imported to facilitate hotel refurbishment and expansion.

Analysis of a company's financial risk essentially encapsulates determining the adequacy of its cashflow in servicing its financial obligations.

Key considerations include the entity's debt level, operational cashflow as well as liquidity and financial flexibility.

Given the capital-intensive nature of the hotel industry and the consistent need for refurbishment, operators are likely to have high gearing levels - although this has generally not been the case in Sri Lanka.

Due to the unexciting tourist arrivals into the country amid the military conflict, most operators had incurred limited capital expenditure on refurbishment and upgrading their properties.

Meanwhile, most hoteliers (particularly those without strong parents) had been challenged vis-a-vis obtaining debt funding as banks had been unwilling to lend to the industry.

Furthermore, the environment of high interest rates that had prevailed in the last few years had also discouraged hotel operators from incurring further debt.

In line with hotels' better profit performance of late, they are expected to use internal funds to finance their refurbishment and upgrading needs.

Should their internal cashflow prove insufficient, hoteliers are expected to resort to borrowings; the equity market may also be a viable option for listed operators.