Why Lemon Tree is unlikely to be a lemon

While COVID-19 has wreaked havoc on a lot of businesses, none has been hurt as much than the travel and hospitality business. Given that people were literally locked up meant that these businesses bore the brunt of the pause in spending. And it is not as if the situation is back to normal now and these businesses are set to recover what they have lost in potential revenue and opportunity. The existing fear psychosis of infection means that it will be a while before people really start living their lives like they did in the pre-Covid era.

The collateral damage on the hospitality business is much more because of the multiplier effect the industry has in terms of employment creation. Revenue going to zero meant they had no option but to lay off people in thousands. The hotel business was already dealing with a slowing economy and the double whammy was just too much to bear, even for a savvy player like Lemon Tree Hotels.

Founder Patu Keswani is a first-generation entrepreneur who has built the premium midscale chain, room by room over almost two decades. Through smart positioning and cautious expansion, he now has many a marquee property throughout the country. Given the sweet spot mid-market hotels enjoy in a economy like India, chasing scale is unquestionable. So Keswani’s acquisition of Berggruen Hotels last year felt like a great move.

In one shot, Lemon Tree would end up as the biggest player in the mid-market segment. That is what Keswani did in March 2019. Just that no one foresaw the disruption that was awaiting the world a year down the line. Now, with cash flow having dried up, Lemon Tree looks over-leveraged, especially compared to other players, even with an otherwise acceptable debt-equity ratio of 1.1x.

Due to low occupancy, Q1FY21 was so bad that the company’s interest payout was more than the operating profit. But Keswani managed to swiftly cut operating costs to align with revenue during the worst quarter ever. Some of those costs may never come back when business revives, and that may boost profitability going forward. At the same time, it needs to be seen how much business travel stands altered because of cheap video conferencing. The latter is a tricky call, and one cannot make a reliable forecast.

Even though some major portfolio investors have dumped the stock and fled, investors such as APG Asset Management have infused more capital into the company. Hence, Keswani is confident of withstanding the current storm having cut costs and raised fresh capital. The equity infusion is a show of faith in Keswani’s credibility as an entrepreneur, as well as the potential of the India story.

But an inherent characteristic of the hotel industry remains. It is capital intensive, and for all the lost time and revenue, the potential to profit in good times usually tends to be capped due to constant supply. For investors, that just means a longer payback period.