Editor's Note

Why Lemon Tree is unlikely to be a lemon

Patu Keswani’s agility in managing the business along with its positioning should help the midscale chain overcome these extraordinary times

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.

Lead Story

Is Patu Keswani's back-up plan hospitable enough?

Premium midscale chain, Lemon Tree, may be among the few that could survive when the dust settles down 

Vishal Koul

After losing 97% of his money two decades ago while trading in stocks, Patu Keswani learnt to never bet the bank. And more importantly, to always have a Plan B, Plan C and Plan D. But sometimes, all your contingency plans cannot make up for the disruption unleashed by a pandemic; especially, if it spooks the biggest influencer. For Dalal Street, it is foreign institutional investors. They have always swung the momentum with their hefty dollar investments. While their presence can attract more cool kids from the neighbourhood, their spurning can burn. So, when they sold nearly $8.5 billion worth of equity in March and April, many — including mid- and small-caps — were left bruised, with their valuations completely decimated. None of Keswani’s plans (B, C or D) seemed to have worked.

The founder of one of India’s premium mid-priced hospitality chains, Lemon Tree Hotels, is not too thrilled about a group of foreign portfolio investors (FPIs) liquidating their holding of close to 7.5% in his company. Aberdeen Investment and Kuwait Investment Authority collectively held 3.34% stake at the start of the year. But they, along with other foreign investors, continued to offload, pushing Lemon Tree’s valuation to its all-time low as the stock price plummeted to Rs.14 on May 20. “At least for courtesy sake, they could have sought us out prior to the sale and we could have found a way out for them to offload their holdings to a local buyer,” bemoans Keswani. Thankfully, none of his strategic partners, Warburg Pincus and Dutch pension major APG, sold any shares. But for an entrepreneur who has passionately built a business for the past 15 years and competes with legacy players such as Taj Hotels and East India Hotels, the fire sale came as a rude shock. “A couple of these funds held stake in 15-20 mid-caps and they were probably in a hurry to offload their positions instead of awaiting feedback from each promoter,” he opines.

When the going is good
The 61-year-old industry veteran, who had earlier worked for the Indian Hotels Company, founded Lemon Tree Hotels in 2004, which went public in 2018. That was when it emerged as one of the largest hotel chains in the mid-priced segment with an inventory of nearly 4,700 rooms in 45 hotels across 28 cities. There are three brands under the company: Lemon Tree Premier (upper midscale), Lemon Tree Hotels (midscale) and Red Fox by Lemon Tree Hotels (economy). “The differentiated brand strategy allows for targeting of distinct customer market segments while avoiding brand dilution,” mentions Rashesh Shah, analyst, ICICI Securities.

With 7% market share in the organised segment, Lemon Tree grew by riding the recovery in the hospitality space, after the global financial crisis. After falling to 58% in FY13, occupancy increased to 65% in FY17 as supply started growing at a slower pace — from 14.9% CAGR during FY07-FY13 to 11.7% CAGR from FY13-FY17 (See: Build and they will come). With stabilising supply-demand scenario, Lemon Tree improved its operating margin, leading to robust operating cash flow generation. The company also turned a loss of Rs.650 million in FY15 to a profit of Rs.140 million in March 2018. Thus, when the stock listed through an offer for sale by Warburg Pincus and RJ Corp’s Ravi Jaipuria, it opened at 10% premium over its IPO price of Rs.56, kept gaining steadily and hit a high of Rs.86 in March 2019.

However, the growth was accompanied by rising debt, which nearly doubled from Rs.5.76 billion in FY15 to Rs.10.11 billion in FY18 as the company continued to expand. Thus, despite occupancy of over 70% in each of its brands, the company had low return on capital employed (RoCE) of 6.3%. “This was mainly due to its high capex oriented nature of expansion, which had kept its turnover ratios lower at 0.2x,” mentions Shah. The analyst had advised investors against subscribing to the IPO as he expected the capex intensity to remain high, impacting free cash flow generation. 

His concerns came to the fore when, in 2019, Lemon Tree made its first acquisition — of Berggruen Hotels for Rs.4.71 billion, which owned the Keys chain — taking its total inventory to 7,800 rooms in 77 hotels across 45 destinations. Keswani was bullish about the buyout when he said, “We will add value to the topline of these hotels both in terms of higher yield and greater occupancies.” His move was backed by the premise that domestic travellers were spending more and demand growth (12.4%) at an industry level was still outpacing supply (7.9%). The management was confident that the average room rate of Keys (Rs.2,750) could be increased at par with Lemon Tree’s (Rs.4,856).

Even though the company was optimistic, analysts started turning cautious since the company now had a debt of Rs.15.1 billion. The stock fell below its IPO price for the first time in September 2019, to Rs.53. But by the next quarter, it seemed that Lemon Tree was going to close FY20 on a strong note as occupancy levels continued to be robust. And just when the stock price was finding its feet in late February, COVID-19 struck.

Pandemic blues

Even as revenue grew 22% to Rs.6.69 billion in FY20, the pandemic drove the company to a loss of Rs.104 million against a profit of Rs.556 million in FY19. Now, its Keys acquisition was making it look like a highly leveraged player. “EIH has the lowest leverage, with debt/equity below 0.5x, combined with strong institutional investor backing. While Indian Hotels has strong promoter backing, its debt/equity is 0.8x. Lemon Tree is highly leveraged versus peers with debt/equity of over 1.1x. That could be a matter of concern at this point,” feels Shah (See: Leveraged growth).

Moreover, due to the pandemic, corporate travel has taken a big hit, which has been a constant revenue stream at close to 60% for Lemon Tree. Shobit Singhal, analyst, Anand Rathi Research, estimates that as 70% of branded hotel rooms in India are primarily for corporate purposes (travel and conferences), the situation over the next three to four months is likely to be grim. “With a ‘no-travel’ policy and companies adopting ‘work from home’, we expect business to pick up only in H2FY21,” says Singhal, who has a ‘hold’ rating on the stock.

With only 6,500 rooms operational, its occupancy rate has fallen to 30% and average room rent (ARR) has fallen from Rs.4,350 in Q4FY20 to Rs.2,500 (See: Room without a view). This major dent has come for an industry that has high fixed cost (~70% of total costs) in the form of power/lighting and employee costs. “With a drop in room rates owing to abysmally low levels of occupancy and a sharp fall in non-room (most profitable) revenue, hotel players are expected to take a massive hit on their profitability,” adds Shah.

However, Subrata Ray, senior group VP at rating agency Icra, does not believe Lemon Tree is in dire straits. “Healthy equity infusion from private equity players, Warburg Pincus, and Dutch pension major, APG, in the past has helped the company maintain a comfortable capital structure (total outside liabilities to tangible net worth of around 1x) despite undertaking significant and consistent capex towards portfolio expansion,” he stated in a ratings update. The ratio measures how a company uses its net worth to garner external funds. A lower number means a bigger safety net for the company. For instance, to fund the Rs.4.71 billion acquisition of Keys, APG infused Rs.3.60 billion via compulsory convertible preference shares (CCPS) into Fleur Hotels (58% subsidiary of Lemon Tree). “The balance amount was funded from internal accruals, thus limiting an adverse impact on Lemon Tree’s capital structure,” mentions Ray.

Meanwhile, in true Keswani style, the company is already in reset mode with several plans in place to deal with the crisis. In late February, they had worked out three possible scenarios — of revenue falling by 40%, 60% and 80%. “We weren’t sure back then, but when the fall was near 80% in mid-March, we had to drop our expenses by 70% so that our expenses were less or equal to revenue,” explains Keswani. To achieve the planned cost reduction, all discretionary spends were put on hold. Importantly, one of the key overheads - power costs, was addressed. “The highest consumption is due to HVAC (heating, ventilation and air conditioning) and pumps. We adjusted the pump pressure, while the AC temperature was regulated at 22°. This has lowered our cost by another 15%,” mentions Keswani.

The biggest challenge has been deployment of staff. Even though they have frozen hiring and announced 50% cut in senior level salaries, Keswani had to bring down employee count from 8,000 to 3,200, in line with occupancy rate. But the company ensured that none of the permanent staff was laid off. “Even if things get back to normal, I might not be able to keep more than 5,500 employees,” laments Keswani. Assuming an average salary of Rs.400,000 per employee, the exit of 2,500 would lead to nearly Rs.1 billion in savings every year. “The Rs.1 billion will go straight to the bottomline if we see revenue recovering to FY20 level,” he elaborates.

Even if it doesn’t, he is confident that they have enough liquidity to ride this out.

Survival of the fittest

For one of the worst quarters that the industry has seen in decades, Lemon Tree’s revenue declined by 71% to Rs.407 million in Q1FY21. Occupancy for the quarter stood at 28.9% and revenue per available room declined 72.5% year-on-year, to Rs.759. However, Keswani is hopeful of breaking even, excluding payment of interest and principal. In Q1FY21, Ebitda fell 90% to Rs.44 million, while Ebitda margin contracted 2,104 basis points to 10.7%, even as operating expenses fell by 62%. Keswani’s initiatives seem to be paying off with the cost control measures helping it emerge Ebitda positive. “I have created a contingency plan for the next 10 quarters, assuming that the current situation continues, and we achieve operational break-even,” says Keswani. In addition to cash of around Rs.2.25 billion as of Q1FY21, including the Rs.1.75 billion raised from APG, the company can drawdown an additional Rs.1.25 billion from APG, besides an rights issue of Rs.1.5 billion, most likely during Q2FY21. “Currently, the revenue is covering costs. So, all I have to take care of are the interest and principal. Thus, for the next 30 months, I need roughly about Rs.5 billion,” explains Keswani. APG will be infusing Rs.3 billion through compulsorily convertible preference shares to be converted into equity at the end of 30 months. Of this, Rs.1.75 billion has already been raised, with Rs.1.25 billion to be released at a later stage. To avoid dilution in its Fleur stake, Lemon Tree will transfer 100% owned assets to Fleur at the end of 30 months. According to Shah, the total asset value of Lemon Tree, including its investment in subsidiaries, is Rs. 32 billion, including capital-work-in-progress of Rs 2 billion. "The market value can be much higher," points out Shah.

Not leaving anything to chance, Keswani has assumed that the pandemic will continue to hurt the industry for at least two and a half years. A believer in “never betting the bank”, he has forecasted the Rs.5 billion liquidity requirement as a worst-case scenario. “I am expecting an operating profit of Rs.30 million in the month of July. And even if the trend continues for the next 30 months, I won’t need more than Rs.4 billion,” says Keswani. For the next two years, (FY21) the principal repayment is Rs.0.50 billion, while interest is Rs.1.4 billion. For FY22, principal repayment is Rs.1.05 billion and interest, is Rs.1.3 billion.

Unlike players that have seen their revenue fall to zero during the pandemic, Lemon Tree has listed its rooms for quarantine-related activities. It is housing asymptomatic guests at prices capped by the government since no one knows when demand will pick up. The company is gradually making its hotels operational — 85% of owned/leased inventory was operational in June against 57% in April. The big positive for Lemon Tree could be the likely exit of weaker players. According to industry reports, out of the 160,000 branded rooms in India, around 60,000 have been shut since April. “When things look up, the remaining 60,000 rooms will not be back. I believe 20,000-30,000 rooms will be shut permanently,” says Keswani.

While analysts don’t see the company turning profitable for the next two years, Keswani believes any player who can weather the storm will be a winner. “He who survives the next two years, will be the king in his business,” sums up Keswani. King or not, every player is battling to get out of this war alive.