Here at StreetAuthority, we don't talk about Chinese stocks very much. They've proven too risky, and more than a few have blown up in the face of major accounting scandals. In short, the risk usually seems to outweigh the reward when it comes to investing in the world's fastest-growing major economy.
Yet I've been watching one stock, quarter after quarter, and I'm now increasingly convinced that it's not just another Chinese house of cards waiting to topple over. It has solid auditors that have been in place for quite some time, has been steadily growing for many years, and just as important, is now quite inexpensive.
The industry is led by Home Inns & Hotels Management (Nasdaq: HMIN) with roughly 16% market share. 7 Days is the second-largest player with 9%, and Jin Jiang Hotels, China Lodging (Nasdaq: HTHT) and Motai round out the top five. The industry is heavily concentrated in the Beijing and Shanghai regions, and further expansion is expected to come from major cities in the country's interior. 7 Days has rapidly expanded during the past five years, and now owns, leases or manages 2,000 hotels in roughly 150 cities.
7 Days focuses on the economy end of the lodging market, catering to Chinese consumers that have only recently entered the middle class and are just beginning to travel, primarily to domestic destinations. It's also become an increasingly popular choice for other travelers as the Chinese economy has slowed.
"Business and leisure travelers with increasingly tight budgets have switched out from 3- and 4-star hotels. This makes the [economy segment] particularly more attractive than the general lodging industry," note analysts at Brean Murray.
7 Days differentiates itself by seeking out locations close to –- but not inside -- the prime real estate of a particular city. That lowers development and operating costs, enabling it to pursue aggressive pricing. It also spends less than others on advertising or travel agents, instead capturing consumers through its website, which is the leading hotel site in China.
The company's growth has mirrored the expansion of the Chinese tourism sector, as sales grew from $40 million in 2007 to more than $300 million in 2011. Yet, as that sales base expands, robust growth will be harder to achieve. Analysts expect sales to grow 30% in 2012 to above $400 million, and less than 25% in 2013 to just above $500 million. That slowing growth may be what scared off investors. Shares have fallen from the low $20s in early 2011 to around $8.50.
Management now appears more committed to expanding the bottom line than before, slowly migrating the base of hotels from company-owned to franchises. This "asset light" approach is expected to boost EBITDA margins from the historical rate in the high teens to the low 20s this year, and perhaps the mid-20s by mid-decade. Looking ahead to 2013, analysts expect operating profits to expand roughly 45%, or nearly twice the rate of sales growth.
The move to a franchising model should also free up cash, which management intends to use in a share buyback. The current $25 million buyback authorization should shrink the share count by around 5%, though management may expand that program when second-quarter results are released in early August.
The buyback comes at a good time. Shares are trading for less than five times projected 2012 EBITDA and less than four times projected 2013 EBITDA, according to Brean Murray. The firm stands by its $25 price target, representing nearly 200% upside, even as other investors have cooled on Chinese stocks in general, and lodging stocks in particular.
Risks to Consider: Chinese stocks like this have been slumping badly in anticipation of further economic weakness in China in the quarters ahead. Recent stimulus moves by the government may blunt those concerns.
Action to Take --> Brean Murray's $25 price target reflects a world where investors embrace Chinese stocks and few are concerned about the possible fallout from a slowing Chinese economy. Still, this stock looks quite undervalued, and a move back to the upper teens seems quite realistic once 7 Day's transition to more franchised hotels starts to boost its income statement.