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IHG: focus on
quality pays off
Sanlam Active UK Fund
Apr 01, 2021
As managers of the Sanlam Active UK Fund, our investment strategy is simple – we focus on high-conviction, buy-and-hold investing in good-quality businesses. The quality overlay reduces risk considerably – when a crisis hits, owning superior businesses allows us to keep our faith in our existing holdings instead of running for the hills. It also allows us to buy more when these companies do experience irrational sell-offs. We can be bold in times of uncertainty.
A good example is our holding in Intercontinental Hotels Group (IHG). After thorough research, we established a large position in IHG in the Sanlam Active UK Fund in 2019 at around £46 a share. The share price soon rose to a high of £57.
Enter 2020. As news of the COVID-19 virus spread and stocks started to sell off as early as January last year, the IHG share price fell dramatically from its highs and we used the opportunity to top up our position at around £45.
A little over a year ago, we wrote about the exceptional opportunity available in the shares of IHG, detailing our investment case. At that stage, IHG was one of our biggest positions – it is currently our largest.
Our views seemed somewhat bold at the time – investors really were in a position of trying to look through the fog. COVID-19 was spreading throughout the world and economies were shutting down. The MSCI World Index had fallen by 11% and the S&P 500 had dropped by 12%. IHG shares had come off from their peak of £57 in 2019 to around £42, a fall of 26%.
We argued then that IHG, notwithstanding the immediate crisis of the pandemic, was a very high-quality hotel franchise business, with a normalised return on invested capital of over 100% and exciting prospects for growth. The group’s key market is the US, but it has a strong and growing business all over the world. China is a particular focus, and its business there is growing in leaps and bounds. While COVID-19 resulted in a very scary crisis – the worst in the history of the hotel industry – we believed IHG had the balance sheet and business model to survive and indeed to flourish after it was all over.
We also laid out a mathematical valuation argument that short-term disruptions to cash flows have little impact on the intrinsic value of a good business with unimpaired prospects that will be generating cash flows decades into the future. The share price at that point had fallen far more than in any reasonable scenario we could paint of the virus’s impact on the value of IHG. We really only had to answer two questions: Is the long-term outlook for the company still attractive? And can the company survive the crisis? The answer to both these questions a year ago, and now, is a resounding yes.
What has happened since then? The share price continued to fall as the crisis intensified. Many governments worldwide started ordering lockdowns, as death rates and infection numbers went through the roof. The share price finally hit rock bottom on 19 March 2020 at around £23, before rebounding quickly to the low £30s and beginning a mostly steady climb back to today’s levels at around £52 a share. A year ago, investors had taken their eye off the ‘long-term ball’, so to speak, but the market is again focusing on the quality of the business and its growth prospects.
Looking at the financial impact on IHG’s hotel operations last year lays bare the severity of what happened. The group earns royalty revenue from its hotel franchisees on each room night sold. Room occupancy and room rates are thus the key revenue drivers. Normalised occupancy for IHG hotels is around 65%. As the table below shows, this fell to 42% last year, the lowest in the group’s history. There were some months last year where occupancy struggled to stay above 20%. To put last year into context, room occupancy ‘only’ fell to 57% in the 2009 financial crisis. Daily room rates also fell dramatically.
IHG fee business revenue drivers
The net effect was that IHG revenues fell an unprecedented 55% in 2020. Despite this, the group managed to generate an operating profit of US$219 million (down 75%). Free cash flow fell from US$550 million to US$29 million. These are dramatic but temporary falls, and the fact that IHG remained profitable and free-cash-flow positive in the hotel industry’s worst year was a validation of the franchise business model and a strong confirmation of the quality of the group’s hotel brands.
Things have started to get better as vaccines are rolled out globally. IHG’s Chinese business is already back to where it was pre-COVID-19. Steady improvements are being seen at the group’s hotels worldwide, the vast majority of its hotels are open, and countries like the UK are about to reopen. By our estimates, we think that IHG will produce more profit and cash flow in 2022 than it did in 2019, and that the long-term growth trajectory will resume. We are happy holders of the share. IHG is the largest position in our fund at 6.1% and we think the shares are still undervalued, even after they have more than doubled from the lows.
High-quality companies with structural growth opportunities are often priced expensively. True bargains are rare – unless there’s a short-term crisis that makes investors sell shares and flee. For most of last year, and even now, there has been a lot of uncertainty around hotels and the future of travel. IHG’s high-quality business model, and our long-term approach, gave us the confidence to hold on to our large position, and also to buy more shares. A well-known investor from Omaha once advised investors to ‘be greedy when others are fearful’ – and we were.
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