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Source: Hotel Property Investments
With concerns about global inflation, interest rates, and an economic downturn, it is fair to say the outlook for 2023 is uncertain. That’s not to say that investors should sit out of the markets and accept the impacts of inflation in reducing their purchasing power. For an investor to successfully navigate their way through the markets in 2023, it will require some thoughtful strategising.
You should be asking yourself questions such as:
What type of company will be able to defend its earnings in an economic slowdown? What company will offer a return in light of the global macroeconomic backdrop?
The answer to this might be closer than you think. Famed fund manager Peter Lynch had popularised the concept of ‘local knowledge’ when it comes to investing. Taking a leaf out of his book, consider your local pub.
With a strong pub culture in Australia and a desire to stay social after lockdowns, hotels have been doing well. In general, tighter hip pockets aren’t going to prevent Australians from enjoying themselves, it’s just that where they choose to consume might shift. With higher mortgage repayments and inflation, fine dining at upmarket restaurants might become out of reach for many, causing many people to turn to more affordable options. That’s not to mention the combination of old-timers through to young adults who are a part of the fabric at their local pub. Inflation or not, most people will still be able to keep enjoying a beer or two at their local watering hole.
Additionally, hotel owners have made a concerted effort to broaden their establishment’s appeal. Whilst beers and ‘pub grub’ are still a staple of most pubs, many venues now have a more sophisticated offerings in terms of high-quality meals, range of craft beers and more expensive wines. Many pubs now have more lavish sections such as a rooftop bar, which appeals to certain customers who may not enjoy the experience of a traditional Australian pub. With a mix of both worlds, a wider range of customers are well catered for.
Australian Venue Co CEO Paul Waterson sums it up quite well, stating that “pubs have found a really nice middle ground between high-end dining and QSR [fast food].” Being both affordable and nice is a combination that will serve hotels well during economic conditions. Combine this with a successful strategy in appealing to new customers while retaining their old ones, hotel businesses are well situated to defend and grow their earnings.
With this in mind, we have identified an opportunity in Hotel Property Investments (ASX: HPI). HPI owns a portfolio of over 60 properties, primarily hotels and pubs in Queensland. HPI also owns pubs in South Australia and a few in NSW and Victoria. Now you may not have a pub owned by HPI near you, but local knowledge about the general pub theme applies.
These pubs are primarily leased to two joint ventures, which generate over 90% of HPI’s income. One is called the Queensland Venue Company (QVC), a joint venture between Coles and the Australian Venue Company. The other is Australian Leisure & Hospitality (ALH), which Endeavour Group has a 75% stake in. Endeavour Group was formerly the liquor segment of Woolworths until it was spun out as its own entity in 2021 and owns hotels and recognisable brands such as BWS and Dan Murphy’s.
HPI’s focus on Queensland pubs is primarily due to a Queensland law that restricts supermarkets from selling alcohol without a pub licence. Seeing this advantage, HPI invests in major cities and regional hubs in the Sunshine State, knowing that it is highly likely that one of the joint ventures will want to lease their pubs. This is because your local Dan Murphy’s or Coles Liquor cannot operate in Queensland without it. With Queensland being a significant market, companies such as Endeavour Group and Coles cannot afford to stay out of this market. Thus, HPI has identified a market with reliable customers to take up their leases.
Although these companies could buy their own pubs, in which they do own some, it is not part of their business model to buy pubs just to be able to sell liquor. This would place too much of a burden on their balance sheet. Singing onto a lease offers these companies the opportunity to reallocate capital to higher returning operations such as Coles with their supermarkets business. The leases provide a reliable income to HPI, which is paid out to investors as dividends. HPI has a dividend yield of over 5% and a stable dividend profile as lockdowns are behind us. This reliable income from a reliable customer base is something we look for in an investment during 2023.
The reason why we like HPI’s Queensland strategy in particular is that it holds up throughout the economic cycle. Whilst earnings at pubs are generally defendable in economic downturns, liquor stores are more resilient. With their strategy of focusing on customers who lease in order to operate their liquor businesses, HPI will maintain willing customers even in an economic downturn, which reduces the company’s vacancy risk. This is reassuring to know if leases roll over during a downturn. The risk is further mitigated by the fact that HPI tends to have long average lease terms of around 10 years. This level of predictability in earnings is highly desirable.
Additionally, HPI’s contracts include annual rental increases which are above inflation, arguably making HPI an inflation hedge play. Whilst other companies may struggle with the decision of either raising prices at the expense of losing customers or absorbing the hit to their margins, HPI’s earnings are contracted to increase above inflation with minimal risk of losing their reliable tenants.
In an environment of elevated interest rates, everyone is keenly aware that property market valuations are suffering. This may keep some readers sceptical about investing in a REIT. However, unlike residential, office, and retail properties, the value of hotels have actually been rising. There have been large hotel acquisitions in 2022, including the Crossroads Hotel in Casula selling for $160 million, and the Strathfield Hotel going for almost $80 million.
We also note that there is some potential takeover interest in HPI as real estate manager 360 Capital recently building a stake above 10% in the company. 360 Capital’s modus operandi for takeover is to build a sizeable stake in a target that is trading at a discount to book value and is underappreciated by the market. This does not necessarily mean a bid will materialise, but there is certainly a probability.
In brief, we believe the hotel asset class has some desirable characteristics that will weather an uncertain economy in 2023. More specifically, Hotel Property Investments stands out as a company that is both undervalued and underappreciated, and has a good strategy to generate stable income through identifying a market with reliable tenants and long term lease contracts. This will flow through to stable dividend returns, a strategy that we are placing more emphasis on in 2023, with the business currently yielding over 5% per annum. With a P/E ratio of 17x, we are comfortable with this valuation considering its ability to defend its earnings.
