EMC-Dell merger provides arbitrage opportunities

Summary

Trading EMC’s merger with Dell provides arbitrage opportunities – a decent upside potential with limited downside risk.

The opportunity arises because the market is significantly mispricing the VMware Tracking Share portion of the consideration Dell is paying. I believe that the significant discount on the VMW Tracking Shares implied at current price will narrow once the merger closes.

There are a number of strategies one can adopt to trade this opportunity. I have explored 3 in this blog – going long EMC Corp, buying EMC calls, and a combination of buying EMC calls and selling OTM VMW calls. Each strategy offers different risk-reward.

As with any investment, there are downsides. I believe three main downsides to this trade: merger doesn’t close, VMW Tracking Share discount doesn’t narrow, and VMware shares experience significant volatility. The strategies discussed either mitigate the downside, or offer a decent enough reward for risk taken.

The deal

Dell, owned by Michael Dell (founder & CEO), MSD Partners and Silver Lake, is to acquire EMC Corporation, while maintaining VMware as a publicly-traded company. EMC Corp currently owns 81% of VMware, with the remaining 19% being publicly listed.

Under the terms of the deal, EMC shareholders will receive $24.05 per share in cash in addition to tracking stock linked to a portion of EMC’s economic interest in the VMware business. Broadly, the tracking shares will track 65% of EMC’s current 81% interest in VMware (i.e., equating to 53% direct economic interest in VMware). EMC shareholders are expected to receive approximately 0.111 VMW Tracking Shares for each EMC share held by them.

The transaction is expected to close in mid-2016 (expected between May and October 2016). Based on recent updates from EMC and Dell, the merger is on schedule and should close within the anticipated deadline.

Deal Structure

The below diagram shows the commercial deal structure post closing.

The key features of the VMware Tracking shares are:

-        -  they will be listed and freely traded (there will be 223m VMW Tracking shares compared to just 80m VMware shares currently traded; this should offer a liquid market for the VMW Tracking shares);

-        - they will track Denali’s 53% economic interest in VMware (Denali is the parent of Dell which will acquire EMC Corp);

-         - Denali will have the ability attribute other assets of equal value in exchange for the VMware shares tracked (subject to authorization by an independent committee which will take care of the interests of the VMware Tracking shareholders;

-        - VMware Tracking Shares will have no voting rights in VMware;

-        - VMware Tracking Shares will be exposed to credit risk of Denali (i.e., if Dell / Denali goes kaput, the Tracking Shares go kaput); and,

-        - Denali will retain the right to redeem and/or buy-out the VMware Tracking Shares or convert them to Denali or a Denali sub common.

The mispricing

Based on the most recent share price for VMware’s publicly listed shares, the market value for the 0.111 VMW Tracking Shares which will be issued as part consideration equates to $5.75. However, based on EMC Corp’s most recent share price, market’s implied value for the 0.111 VMW Tracking Shares is just $2.72. The market is pricing the VMW Tracking Shares at a ~53% discount when compared to VMware’s publicly listed shares as the following tables show. 

In my opinion the market is significantly undervaluing the VMW Tracking Shares. Once the merger closes and these shares get listed, the discount should narrow to a more meaningful range of 10% - 20%. Although the VMware Tracking shares don’t offer voting rights or a direct right to VMware’s assets and liabilities, they economically track VMware. In addition, the independent committee provides sufficient safeguard’s from Denali’s being able to strip value from the tracking shares. Furthermore, the VMW Tracking Shares should offer a liquid market to trade VMware – currently there are ~80m publicly traded shares of VMware; Denali will issue ~223m VMW Tracking Shares, creating significant liquidity. Taking account of all these factors, I believe that the VMW Tracking Shares will trade at a 10% - 20% discount to VMware’s listed shares.

Trading strategies

Strategy 1 – Go long EMC Corp

An easy way to trade this situation is by buying EMC Corp and holding till the merger closes in 4 – 7 months’ time. The VMW Tracking Shares will be listed at this point, and the discount on them should narrow. Using EMC Corp’s current share price, and assuming that the publicly listed VMware shares trade at current price levels and the VMW Tracking Share discount narrows to 10% of VMware’s listed shares, this strategy should generate a 9.2% return (see table below).

However, the above is a simplistic scenario and doesn’t capture the impact of volatility in VMware’s publicly listed shares (which will impact the value of the VMW Tracking shares) and the extent to which the discount narrow’s on the VMW Tracking Shares. The below table captures the returns under different scenarios and is a more realistic view of possible outcomes.

As can be seen from the above, all scenarios generate a positive return bar where VMware shares fall by 50% from current levels. Fall in VMware shares of less than 50% from current levels should generate positive returns as long as the discount on the VMW Tracking Shares narrows to 20% or less. Furthermore, any increase in VMware shares increases also has a positive impact on returns.

Strategy 1 is a safe and easy way to trade this situation if you believe that the VMW Tracking Share discount should narrow to 10% - 20% level. The returns may not look great, but this is a clearly defined situation with a short holding period of ~ 4 – 7 months (or max 1 year if one wants to give the listed VMW Tracking Shares some time).   

Strategy 2 – Buy EMC Corp Call

The July 16 EMC Corp Call option with $24 strike is available for a premium of $3.2. Buying this call could generate a 64% return assuming VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%.

The below table shows the returns for a selected menu of EMC Corp Call options (I have used July 16 and Oct 16 expiring options & strike prices ranging from $24 to $26). As can be noted, longer duration increases the option premium and reduces the return; similarly, higher strike price increases the cost and reduces the return. The best option seems to be the July 16 option with $24 strike price. 

The above table doesn’t fully capture the impact of volatility in VMware shares and VMW Tracking Share discount. The below table shows the available returns under a number of scenarios and offers a more realistic picture. I have used the July 16 call option at $24 strike price as the basis.

As can be seen from the above table, all scenarios generate a positive return bar where VMware shares fall by 50% from current values. Furthermore, the returns generated are significantly higher compared to Strategy 1 – for example the above strategy returns 64% compared to 9.2% returned by Strategy 1 for the base case scenario where VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%. However, it is also worth noting the higher risk being assumed under this strategy for where VMware shares fall by 50% from current levels.

The gearing offered by the option clearly juices up the returns, but also exposes one to higher downside risks if VMware tanks significantly. But it is worth noting that VMware shares have fallen by 37.09% over the last 12 months, and have just rebounded from 1 year low of $43.25, currently trading at $51.8. The median price target of 26 brokers covering VMware is $60, with a low target of $40. The probability of VMware falling by 50% from current levels in the next 4-7 months appear low.

Strategy 3 – Buy EMC Corp Call & sell VMware Call

This strategy is aimed at reducing the overall cash cost by selling Out Of The Money (OTM) calls over VMware shares. The premium earned by selling calls partially offset the cost of buying calls of EMC Corp, and increase the overall returns. The EMC Corp Call used for this Strategy is the same as the one shown in Strategy 2 above (July 16 expiry with a $24 strike). As for the VMware calls that can be sold, a number are available – depending on how much OTM one would like the call to be. The more OTM the call, the less the premium earned and lower the overall return; but on the other hand, way OTM calls protect the downside if VMware shares were to go up.

Below is a table showing the available returns for a selection of VMware calls sold in combination with buying EMC Corp July 16 call at $24 strike (again assuming VMware shares trade at current levels and the VMware Tracking Share discount narrows to 10%).

The below 3 tables show the available returns for each of the VMware call option listed above taking account of the impact of volatility in VMware shares and VMW Tracking Share discount.

This strategy has the potential to significantly increase returns compared to Strategy 1 and Strategy 2 – for example, under Strategy 3a, the base case where VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%, the return generated is 1194%. But the potential downside under this strategy is way too high in my opinion. Furthermore, you can see from the above tables that the more OTM the sold VMware call is, the less the return, but better the downside protection VMware shares increase in value.

In conclusion, Strategy 1 is the easiest and most risk averse to implement but I believe that Strategy 2 – Buying EMC Corp call option – provides the best risk-reward outcome.

Other risks

As discussed upfront, there are three major risks to this thesis:

The Merger doesn’t close- I believe that the risk of this merger not closing is low. Based on recent updates from EMC and Dell, the merger is on schedule and should close within the anticipated deadline of between May and October 2016. The regulatory approvals are progressing smoothly, and it looks like the EMC Corp shareholders should vote in favour of this deal. Dell needs to raise $50 billion of finance to close the deal, and given Dell and its promoter’s track record, it doesn’t look like this will be an issue. It is worth noting that significant termination fee is payable by either party in case of termination (EMC will have to pay $2.5 billion if it terminates the deal, and Dell will have to pay anywhere between $4 billion and $6 billion if it terminates the deal).

VMW Tracking Share discount doesn’t narrow –I see no rationale behind the current 53% discount market is applying to VMW Tracking Shares. As noted earlier, there is no doubt that the VMW Tracking Shares should trade at a discount to VMware’s publicly listed shares, but this discount should be in the region of 10% - 20% instead of the current 53%. Once the merger closes and the VMW Tracking shares are listed, they should clawback the discount.

VMware publicly listed shares experience significant volatility – Significant volatility (in particular fall) in VMware shares will lead to a fall in VMW Tracking shares. VMware shares are down 37% over 12 months, and have been clawing up from their 12 month low of $43, currently trading a $51 - $52. Both Strategy 1 and Strategy 2 generate positive returns under all scenarios excepting where VMware shares fall by 50% from current levels. Strategy 3 – being the high risk strategy – is exposed to higher downside risks if VMware shares increase or decrease in value significantly (depending on which VMware call option is sold). But overall the less risky strategies (Strategy 1 and Strategy 1) are naturally hedged against significant volatility in VMware shares. I also see less likelihood of VMware shares falling by more than 50% from current levels.

Afterword

I am sure there are many more creative ways of trading this special situation. For instance, Strategy 1 could be combined with selling VMware OTM calls. This should reduce the cost of that strategy and increase returns – for example, roughly 1 VMware OTM call could be sold for every 9 EMC Corp share purchased (roughly 9 EMC Corp share equate to 1 VMW Tracking Share). Such a strategy provides a natural hedge to the sold OTM VMware call (VMW Tracking Shares will also increase in value if OTM VMware calls turn In The Money).

Amira Nature Foods Ltd (ANFI:NYQ)

            

       Summary
       On first look, Amira Nature Foods appears to be an attractive small cap stock with a very simple business, impressive growth, and appealingly priced at a PE of 7. 

       However, upon closer inspection, cash flow is a real concern. The company’s reliance on expensive short term debt to fund its operations and material working capital requirements means that it does not generate any free cash flow for equity. In fact, it needs to keep borrowing more simply to fund its costly short-term debt. This business model is not sustainable. 

The risk is compounded by the nature of the business – there is no moat or pricing power, and the business is exposed to margin squeeze. In short, there is plenty of downside on margins but the costs (due to the expensive short-term debt) are high and fixed. 

Unless the business can materially change the way it funds its working capital needs it is not a safe investment for those investors who value preservation of capital above chasing high returns. 

       

       Brief overview of the business
       Amira’s business is simple – it sells Indian specialty rice and related rice based products, with sales in over 60 countries. Approximately 67% of its revenue come from the sale of Basmati rice, a premium long-grain variety of rice grown only in certain regions of the Indian subcontinent.

Amira buys rice paddy from the farmers (via independent agents), processes and ages the paddy before selling it as finished rice. Basmati rice requires ageing – typically 8-12 months before being sold. This exposes the business to significant working capital needs.

       Based on FY2015 results – approximately 41% of its sales were in India and 59% abroad (bulk of foreign sales were in EMEA and Asia Pacific). Amira sells rice both under its own Amira brand, as well to 3rd parties who sell it on under their brand.

       Moat and pricing power

       In terms of the businesses moat and pricing power, this is not a great business. If we take the sales in India, most of India’s retail still happens through so called mom and pop shops. Here brand hardly matter. Shop keepers and buyers don’t care about packaging and shopkeepers frequently sell rice loose in quantities demanded by the buyer.

       India’s organised retail market, where brand matters, is very small at present (approximately 10%), but should grow in future. However, there are many large players in this market who have better scale and visibility than Amira. Furthermore, rice as a product hardly offers significant distinguishing features so suppliers with scale and market share at the outset have a distinct advantage.

       As for the international market, Amira not in the top brands at present. For example, a visit to some of the retailers in London where Amira claims to have a presence shows that it has negligible shelf space compared to the other brands (Tilda is by far best known rice brand in Europe).

       In short, although the business is simple, it is highly competitive. To keep and grow market share requires fighting on price.

       Income statement

       Analysing the last three years income statement since Amira’s IPO paints a strong growth story with revenues showing 30% CAGR, operating profits showing 35% CAGR, and EPS showing 52% CAGR. Consensus estimates for revenue growth at 25% predicts a continuing positive trend for the income statement.

       However, this doesn’t paint the real picture in my opinion. Due to the high risk inherent in the business model and cash flow, I want to look at the quality of the business. To understand the risks behind the current business model, one needs to look at the business working capital, cash conversion cycle, and cash flow.

       Working capital

       Amira procures most of its Basmati paddy in the 7 months between September and March, processes it and holds it for approximately 8-12 months for ageing before it sells the rice as finished product. Due to the amount to time between procurement of raw material and sale, significant amount of working capital is tied up in the business. The company finances this working capital with expensive short-term debt secured by its inventory.

       Of the total assets on balance sheet of USD 490 million, USD 470 million constitutes current assets (mainly inventory, receivables, and cash required in operation). Over the last 3 years, the company’s working capital needs have grown at 44% CAGR (compared to sales growth of 30%) as the table below shows.

       

       The debt to fund working capital doesn’t come cheap at 15%. As you will see from my analysis of the cash flow below, this debt more than eats into Amira’s operating cash flow. Therefore, Amira needs to be able to borrow more each year simply to repay interest on the short-term debt. This, in turn, is only possible by building up higher and higher inventory (as debt is secured on inventory). Any downward pressure on margins exposes the business to significant crisis. This is a vicious cycle for a business that doesn’t have a strong moat or pricing power.

       Cash Conversion Cycle

       Based on my analysis of the company’s Cash Conversion Cycle [Days inventory outstanding + Days sales outstanding – Days payable outstanding], it’s on an average 280 days (or just over 9 months). The below table shows the cash conversion cycle for each of the last three financial years for which results are available. 

       Nine months is a significant amount of time for cash conversion for a business that is exposed to downside on profits – the business is exposed to margin squeeze if the price of rice falls in the 8-12 months after it has acquired rice paddy – but with costs largely fixed due to its short-term debt financing.

       Cash flow

       As discussed earlier, Amira funds its operations with expensive short-term debt. Therefore, I have adjusted the company’s reported operating cash flow for interest costs on the debt. In my opinion, interest cost should be considered as part of Amira’s operating cost. The company currently shows its interest cost as part of its financing cash flow (a treatment IFRS allows). In addition, I have also adjusted operating cash flow for capex (cost incurred to maintain its processing facility), and tax.

       As can be seen from the table below, once I make the above adjustments, Amira does not generate any cash from its operations. 

       In my view, I don’t see the current business model changing this situation. I don’t see how short-term debt getting any cheaper – banks in India are under pressure to tighten lending standards due to high exposure to NPLs from corporate loans.

       Therefore, unless there significant drop in the cost of Amira’s debt, I can’t see it generating positive cash flow from its operations. Any downward pressure on margins or sales also exposes the company to liquidity risk (as debt is secured by inventory which needs to continually increase to keep the funds flowing). This in turn exposes the shareholders to additional capital calls or dilution – with the worst case being insolvency.

       In conclusion

       Although Amira has shown impressive sales and earnings growth since its IPO three years ago, reliance on expensive short-term debt to fund operations means that it is unlikely to generate free cash for equity. Liquidity and financing costs make the risk of permanent capital loss high. This is compounded by the nature of the business –no moat, lack of pricing power, and exposure to margin squeeze – which has downside risks to profitability but where the costs are high and largely fixed. Unless the business can materially change the way it funds its operations, it presents significant risks for shareholders.  

       Afterword

       Short attack

       Prescience Point initiated a short attack on Amira in February 2015 where it alleged that Amira’s revenues were inflated, its related party transactions were not fully disclosed (implying that revenue inflation may be happening with the assistance of transactions undisclosed related party transactions), its margins are were stressed due to falling spread between rice paddy and finished rice, and that Amira’s CEO was mismanaging company assets and possibly stripping value. Prescience Point reiterated its allegations with a few additional ones in another report in July 2015. The Prescience Point report led to a material fall in Amira’s stock price – to a low of $2.51 at one point.  But Amira’s stock price has largely recovered from the height of the short attack and recouped most of its loss. The market appears to be giving the benefit of the doubt to Amira, largely due to the robust and confident defence put forward by the company.

       In December 2015 Amira filed a formal complaint in District Court in New York against Prescience Point and affiliates stating false accusations and disseminated materially false, misleading and defamatory information about Amira. The Company is seeking damages for defamation, trade libel, tortious interference with business relations. In addition, Amira commissioned an independent forensic analysis with respect to some of the allegations made in Prescience Point’s report. The outcome of the independent forensic analysis cleared Amira of any wrongdoing.

       Having been though the Prescience Point reports and Amira’s stated defence, I have summarised my take on the key points raised.

       Inflated export sales – This is Prescience Point’s main allegation, and it is based on data from an Indian Government agency which publishes market values for exported Basmati rice by licensed exporters. Based on data reviewed by Prescience Point, it claims that Amira may have inflated its export revenue by 145% in FY13 and 117% in FY14 – broadly, the difference between Prescience Point’s estimate for Amira’s Basmati sales and Amira’s the reported Basmati exports in the Government Agency’s records.

       Amira has countered Prescience Point’s allegations by saying that not all basmati exports appear in the agency’s export list. For example, some of the rice which is sold as basmati may not meet the stringent requirements for what qualifies as Basmati rice under Government standards – due to breakage etc. In addition, Amira claims that not all of its sales consist of rice exported directly in its name as it also buys rice from 3^rd parties (both from India and abroad). Amira also disputes Prescience Point’s estimates for Amira’s Basmati sales – Amira doesn’t report this number specifically, whereas Prescience Point has derived this from assumptions.

        I would like to give Amira the benefit of the doubt on this one – its financials have gone through a forensic analysis to check this point and apparently there were no issues raised. However, I would have liked Amira to have provided a more detailed rebuttal with numbers backing up its position – e.g. how much of its total sales consisted of Basmati rice, what proportion of this consisted of rice which did not qualify as Basmati under Government standards, and how much was purchased from 3^rd parties.

       Inflated domestic sales – Here Prescience Point alleges that Amira may be inflating its domestic sales by over 100%. But Prescience Point’s allegations here appear weak and the analysis shallow. For example, Prescience Point’s estimate of market size for rice in India (USD 767m) and for Amira’s share of that market (5%) seems to be based on telephone conversations with Amira’s competitor and not on thorough independent analysis.

       A bit of research shows that the Indian rice market is likely 2 times the size estimated by Prescience Point and there no clear rationale behind its claim that Amira only has 5% of the market. Here again, I would give Amira the benefit of the doubt.

       Related party transactions – Here Prescience Point has alleged that Amira has numerous undisclosed related parties which may be being used to inflate sales. Prescience Point’s allegation is based on the fact that there are a number of company’s which share Amira’s corporate address, and have Amira’s CEO and his affiliates on the board. In addition, there is mention of a Dubai based related party – a company owned by the father of the current CEO – being Amira’s largest customer.

       However, there doesn’t appear to be any evidence showing transactions between related parties other than names, addresses, and a passing remark by a previous director (who has denied making any remark of this nature). Amira has strongly denied that there are any undisclosed related party transaction, and stated that no transactions have occurred with the Dubai entity since IPO. Considering Amira has got its last three year financials re-audited and undergone a forensic test, I would give Amira the benefit of doubt in this regard.

       Promoters land sale to Amira – In addition to raising a number of red flags on misuse of corporate resources and personal enrichment by the promoter and CEO, Prescience Point’s main allegation in this regard is a proposed sale of a land by the promoter to Amira for $30 million. Prescience Point claims that this land it overvalued by ~3 times and that this is a case of value stripping by the promoter. Prescience Point also alleges that Amira doesn’t need this land, and the capacity expansion it aims for can be achieved in the land that it already holds.

       Amira in turn claims that it has always been transparent on this land deal and this was clearly disclosed in the IPO documents. Amira claims that the market value for the land is supported by a third party valuation report it has obtained, and that this transaction has been signed off by the board as a whole. In addition Amira defends the need for and the benefits of this land by stating that the additional processing capacity cannot be obtained without this land. Amira claims that the increase in processing capacity will bring more of its processing in-house and increase its margins (currently 1/3^rd of its rice is processed by 3^rd parties, where its margin is eroded).

       Considering the fact that Amira had has been transparent about this transaction, I don’t see this as being fraudulent.

       Paddy – Rice spread not reflected in Amira’s margins – The other allegation of Prescience Point’s is that Amira’s financials do not seem to reflect the falling margins between rice paddy (raw material) and finished rice. Prescience Point claims that even though Paddy – Rice spreads have been falling, Amira’s reported margins seem not have taken a hit.

       I could not find any clear explanation from Amira on this particular allegation. I would have like Amira to provide a more robust defence on this point – with a detailed explanation backing its reported margins – other than simply rubbish Prescience Point’s allegation.  

       Cash flow and liquidity issues- Prescience Point also focuses on the cash flow and liquidity issues at Amira and claims that the current situation is unsustainable. Amira simply rubbishes the allegation that it is haemorrhaging cash, without providing any detailed defence.

       

       Issues around Q4 15 numbers – In its July 2015 follow up report, Prescience Point has alleged that Amira’s inventory may be inflated, that its Q4 receivables have shown a suspicious increase (implying inflated sales), and that it was highly suspicious that the Q4 freight, forward, and handling expenses declined by 66.5% when its sales went up by 21.6%. Prescience Point points out that the fall in freight costs accounted for all the reported growth in adjusted EBITDA in the quarter – making this even more suspicious.  

       To me the above questions seem important and I am surprised that Amira has not provided a robust defence. In particular, the fact that freight costs so significantly when sales increased, needs a better explanation than simply a claim that more was sold as Free On Board (FOB). This is not entirely convincing – e.g. why a sudden material change in what must be key terms of business with buyers, and is FOB a trend that Amira expects to see continue?.

       In summary, I am not entirely convinced that Prescience Point has got most of its allegations right and its analysis appears loose and based on hearsay. However, although I give Amira the benefit of the doubt with respect to the material allegations (e.g. inflated sales, land transaction, related parties), that still leave some valid questions raised in Prescience Point’s report for which Amira should have provided a more detailed rebuttal (e.g. with respect to margins, cash flow, and the Q415 numbers). 

Accor Hotels

Asset-light is asset-right

International hotel chains are difficult to operate and require specialist skills – marketing, customer service, e-commerce & digital offerings, brand management, staff training and retention etc. Moreover, it is a cyclical business with wild swings in business performance. Check the steep falls in occupancy and Revenue per Available Room (REVPAR) during recessions (most recently in 2008).

Considering the specialist skills required, and the importance of building a brand, it makes sense that most large international hotel chains, in the last decade, have moved to the asset-light business model – franchising and managing hotels for fee versus owning real estate. For example, Marriott and InterContinental (IHG) hardly own any real estate, with almost all their income stream now derived from franchising and managing hotels (real estate is owned by others - typically property investors). The most recent example of a large hotel chain moving to the asset-light model is Hilton – which announced just a week ago that it will spin-off its real estate holdings into a REIT, leaving Hilton as primarily a hotel management company.

The asset-light model makes a lot of sense. If you specialise in running hotels, you should concentrate on that. Owning real estate is a different ballgame and ties up significant amount of capital. The asset-light approach of franchising and managing hotels is highly cash generative with high ROCE, and allows the manager to focus on growing the brand and the business. Furthermore, for a cyclical business, it makes sense to have most of its costs as variable, which the asset-light model achieves.

Therefore, when Sebastien Bazin, chairman and chief executive of Accor, the French based global hotels group, was appointed two years ago, Accor’s shareholders widely expected him to announce the asset-light strategy as part of his revamp initiative. Instead, what they got was a halfhearted approach splitting the business internally into two divisions – Hotel Services and Hotel Invest – without any real economic spin-off or sale of real estate. Accor owns and leases approx. 33% of its hotel portfolio (1,288 of its 3,873 hotel portfolio). Accor call’s its strategy asset-right (pun intended I guess). But management has not provided any details behind why this strategy is right instead of an asset-light model? If Accor’s shareholders want property exposure, they have other/better ways of getting it. They would much prefer Accor to focus on improving margins in its operations and improve its digital and e-commerce offerings (it lags behind competition on both fronts).

Furthermore, most of its competitors, have adopted the asset-light approach and sold their real estate returning billions back to their shareholders. Accor should to do the same, or provide a valid reason – backed by some numbers – for why its current strategy is right (or asset-right as it calls it). 

Valuation

IHG, with its asset light approach, trades at an EV/EBIT multiple of 13.3; and Accor with its asset rich approach also trades at an EV/EBIT multiple of 13.7. On this basis there doesn’t appear to be a need for change. Accor appears to be doing fine with its current strategy. But this does not provide the full picture.

A good thing about Accor is that it reports two sets of numbers – one for its Hotel Services business, and one for its Hotel Investment business. Hotel Services’ numbers reflect a 100% asset-light profile (Hotel Services receives 100% of its revenues from franchising and managing Accor’s 3,873 hotels – including the 1,288 owned).  Dig into the two sets of numbers a little more, and the justification for the asset-light approach becomes clearer. Here is a brief comparison between Accor and IHG.

Accor reported a fair value of €6.9 billion for its owned & leased hotel portfolio as at 31 December 2015. The owned and leased portfolio generated NOI (EBITDA less Maintenance Capex) of €437 million for FY 2015, implying a cap rate of 6.33% [NOI/Market value]. Considering that nearly 85% of its owned portfolio is located in the mature markets of France, Europe and America (1,086 of the 1,288 owned hotels), this valuation appears reasonable (if anything, one could argue this is conservative given how strongly Accor’s operations have performed of late and the prevailing low interest rate environment).

As an additional check, hotel REITs trade at an LTM EV / EBITDA multiple 17X-18X and estimated 2016 EV/EBITDA multiple of 11X (for example, Jeffries has recently cut the multiple of 11X due to expected increased competition from low cost competitors such as Airbnb and others). If use the EV / EBITDA multiples as comparable for valuing Accor’s owned portfolio, we get a value of between €7.1 billion (11X EV / EBITDA) to €11.1 billion (17X EV / EBITDA), both of which are greater than the current €6.9 billion value I have used.

Accor’s Enterprise Value is €9.2 billion, giving an implied value for its hotel operations of €2.3 billion (€9.2bln EV less €6.9bln hotel portfolio). The Hotel Services division generated EBIT of €359m for FY15, giving an implied EV/EBIT multiple of just over 6.

IHG, which runs an almost 100% asset-light model (it only owns 7 of the 5,032 hotels it manages), generated FY15 EBIT of $680m; of this $27m came from its owned hotels. Valuing IHG’s owned hotels one the same basis as Accor (i.e., at 6.33% cap rate), give a value for IHG’s hotel portfolio of $426m. IHG’s Enterprise value is just over $9billion; giving an implied value for its operations of $8.6 billion. This implies that IHG's  operating business is valued at an EV/EBIT multiple of 13 ($9.025 billion EV/$653 million EBIT).

The market seems to be applying more than a 50% discount to Accor’s operating business. In my opinion this is not deliberate; the more likely reason is that market is unable to clearly separate out Accor’s operating business from its real estate assets (note that the EV/EBIT multiple for Accor’s entire business, at 13, is similar to the multiple for IHG).

If we separate things out, and apply a similar multiple to Accor’s operating assets as exists for IHG, the value of Accor’s operating business should be €4.7 billion – increase of €2.5 billion from current values (or €10.8 per share).

Taxes – potentially a challenge

Spin-off’s and asset sales can be challenging from a tax perspective. In addition to a whole host of complexities around execution, tax liabilities could eat up a significant chunk of any upside. Without detailed knowledge of the applicable tax rules and the ownership structures for each hotel, it is difficult to know if tax planning opportunities exit. Furthermore, details on tax basis and available tax losses are required to calculate the tax liability (numbers which aren’t disclosed in the financials). However, using the available information, my high level estimate of after tax proceeds is as follows:

Assuming net book value approximates to tax basis, the potential tax liability for a taxable sale or spin-off of the real estate would be just over €1 billion. Adding 5% transaction and execution costs on top would net proceeds of €5.5billion on the sale of the hotel assets (assuming fair value of €6.9 billion). In my opinion, this is likely to be the worst case scenario –tax strategies and tax attributes will likely bring any tax liability to a lower number. The implied per share value after tax and costs comes to:

Taxes – potentially an opportunity

Taxes also provide a potential opportunity to achieve a higher valuation for the real estate. Most jurisdictions – certainly the main ones in Europe where most of Accor’s owned hotels are located – offer REITs as an investment vehicle for real estate. Rules have been significantly modified in recent times to allow captive or private REITs (i.e., REITs held by one or few investor’s without the need for a listing or free-float). REIT structures take out tax liability at the asset level – broadly, REITs are exempt from tax on income and gains in return for ensuring that most of the income and gains are distributed to the shareholders). France for example has captive REIT regimes – called SPPICAV’s – which exempts income and gain from being taxed provided 85% of profits and 50% of capital gains is distributed to the shareholders. Similar structures are available in other jurisdictions.

Accor could consider spinning off its hotel assets into a REIT, potentially wiping out future tax burden in the property portfolio, achieving a higher valuation for its assets. In short, not only does Accor's property portfolio could merit a significantly higher valuation to the current €6.9 billion under a REIT structure. 

Qualitative reasons for a spin-off or separation of the hotel assets

In addition to the valuation discussed above, I believe that there are at least four good qualitative reasons for Accor to pursue the asset-light strategy.

1.  Majority of Accor’s owned hotels are located in the mature markets of Europe and America. Most of the successful hotel operators who pursue the asset-light model largely operate a franchised business model in the mature markets. Franchised model is extremely lucrative – real estate and employees belong to a third party, has very low capital intensity, and enjoys a very high ROCE. Franchised model does bring its risks – e.g. risk of damage to the brand. But operating a franchised model in mature markets is a lot easier and less risky. IHG’s for example operates 84% of its hotels (mostly in mature markets of America and Europe) under a franchised model. Accor has an opportunity to free up significant capital by putting in place a franchised model for its owned hotels.

2.The hotel industry has enjoyed unprecedented growth in recent years – with key performance metrics (REVPAR and Occupancy rates) surpassing previous peaks and reported profits beating expectations. But this is a cyclical business; the next downturn may just be around the corner. Previous downturns were a catalyst for many of the well know operators to sell down real estate and pursue the asset-light strategy – improving balance sheet and profitability, and keeping them in good stead for the next downturn. For a cyclical business, it makes sense to pursue a strategy where all or most of the costs are variable – easier to control based on demand. Real estate not only ties up significant capital, but also incurs a lot of fixed costs. Furthermore, there has never been a better time to sell quality real estate – with yield hungry investors and SWF’s chasing quality assets.

3. All the well-known operators are investing heavily in digital and e-commerce initiatives and loyalty programmes – this not only ensures repeat business, but also builds customer loyalty. There is no doubt that this is going to be a key factor in the success. Accor’s EBIT margin at 26.8% in its Hotel Services division - although improving - trail those of its competitors (IHG for example achieves well above 50%) largely due to its poor digital and e-commerce systems. Accor is currently pursuing a 5 year Digital Plan with a total expected outlay of €250m. Freeing up capital by selling down real estate should help focusing on improving margins in its core operating business.

4. Accor has a ROCE of less than 10%. IHG on the other had has a ROCE of 44% using the same metric. It is worth noting that IHG’s ROCE was approx. 9% back in 2004, before it pursued the asset-light strategy. 

Spinning off its real estate should help Accor significantly improve on its ROCE and profitability. 

In conclusion

Accor’s reported results for its two divisions, and a comparison with IHG – which operates the asset-light strategy – show that market does not fairly value Accor under its current strategy. The current strategy diverts focus from what is important (improving and growing the business), ties up significant capital, and erodes profitability and return. Management’s halfhearted approach of splitting the business internally into two divisions – Hotel Services and Hotel Invest – without any real economic spin-off or sale of real estate hasn’t achieved much.

Accor’s shareholders are more than capable of deploying capital to real estate as they see fit. Accor should focus on the operating business. The time is right for Accor to now pursue the asset-light strategy, return significant capital back to its shareholders, and set itself in good stead before the next cyclical downturn hits hotel industry.

Almost all of Accor’s peers (most recently Hilton) have or are moving to the asset-light strategy. Accor doesn’t have any reason to delay this anymore.