2012年3月25日 星期日

Special Price for a Special Situation

Question: how to realize superior risk-adjusted high-yield return in LCD panel industry?

That seems to be an oxymoron for a shrewd value investor who cares anything about Asian panel makers. For the record, the total outstanding exposure of Taiwanese banks to AUO and Chi-Mei Innolux ("CMI"), the troubled panel makers with 38% market share in global large-size LCD panel, amounts to US$15 billion dollars, with an average yield of less than 2%. Compared to the US$20 billion cumulative and growing losses of this industry since 2007, and all the money made by South Korean archrivals, the risk-adjusted return is undoubtedly low, and the return-adjusted risk is deservingly high.

And stakes are even higher, according to one local banker involved in the government-sponsored restructuring meetings who prefers anonymity. "Take CMI for example. Big local banks (some of them are government owned) have an exposure of over US$7 billion to this chronic loss maker, of which over US$5 billion is due in one year. This amount almost equals the total net income of the Taiwanese commercial banking industry. If local bankers push out the maturity, it creates a huge drag on balance sheet. If bankers call CMI default, it will not only blow a big hole in their books, it effectively obliterates them."

Restructuring it is, as any sane elected official would nod. Calling LCD panel maker default and puking out 120,000 unemployed engineers are too much pain. The negative ramifications are best absorbed by those obedient bankers who toed the party line and made massive investment at the government's calling in early 2002.

The ultimate solution, says the anonymous banker, lies in the hand of Terry Kuo, the tight-fist boss of the Hon Hai Group, whose Innolux merged Chi-Mei in a 1:2.05 share swap at lofty 2009 valuation. "Clearly Terry has the ability to pay," says the banker, "but whether he has the will to top-up is another issue." Set aside paper loss on stock price, the future strategy of the enlarged LCD business unit at Hon Hai remains murky at best. Will Terry consolidate the large-size capacity and sell them as cheaper alternative to high-cost Japanese TV makers? Or is he carving out small- and medium-size capacity and work out a technological alliance with Japanese panel makers and come up with a better HD solution to Apple? The global LCD panel industry is a bloody business, with Corning and three other players selling high-margin glass substrate on the upstream, and panel makers selling at wafer-thin margin at the downstream, except Samsung, squeezing other Asian players left and right with its global reach and advanced intellectual properties.

Despite tough outlook, this publication argues that, with appropriate selection of financial instrument, the restructuring proceedings introduce a compelling opportunity to invest in Taiwanese LCD industry. The recommended selection is CMI none-recourse Accounts Receivables held by its major suppliers.

A staple product offering at any commercial banks, factoring -- buying accounts receivables is an esoteric exercise for the Masters of the Universe, for most of them would never dream of working in the Trade Finance department of a commercial bank. In a classic non-recourse factoring transaction, a Seller sells the invoice issued to Buyer (of its goods and services), usually 60- to 90-day outstanding, to a Factor (usually a commercial bank) at 10-15% discount. The Factor will extend a credit line to Seller, who will instruct Buyer to pay its payables into an escrow account at the Factor. Upon legitimate transferral, Seller will get cash in advance from the Factor for a small fee and pays a nominal interest margin on the notional amount so factored. Essentially, factoring is no different from trading short-duration discounted bills. The key risk factors to this transaction are the performance risk of the Seller and the commercial risk of the Buyer. In a non-recourse transaction, Factor would suffer a loss should either Seller or Buyer fail to perform under their supply contracts.

And this is where the investment thesis in CMI receivables begins to make sense. While a factoring bank is technically lending to CMI supplier, it is effectively taking CMI receivables as collateral and thus becomes exposed to CMI credit. For those syndicated lenders with CMI exposure, the standard operating protocols from the Credit Risk department would be to cease and decease any business activity associated with CMI, whose debt rating have been downgraded to Default across the street.  Pause for a moment and assess the situation: fateful bankers would rather restructure for a lower coupon which CMI can afford; government, heavily criticized for its failure in rescuing the deathly-leveraged DRAM industry, would certainly prefer bail-out to unemployment fall-out; and Terry would like to improve his entry point and bargaining power with the government in a potential distressed buyout. Logic dictates that it is in no one's interest to allow CMI to default, yet the major shareholder has every reason to hold out. Wary lenders in prolonged bank meetings thus set the panic selling of CMI receivables into motion.

"Anecdotally, we've heard quote from distressed lenders as high as 8% for CMI 90-day receivables," our banker betrays. "To be more specific, 8% actually means 3.5% margin per annum on the factored amount and 4.5% upfront transfer fee," continues our banker. "The margin is just peanuts, for the actually interest period is only 90 days. The real meat is the upfront fee. At 4.5%, the lender is making 18% annualized return for betting on CMI to honor its payment to upstream key suppliers, whose receivables should rank supersenior in any restructuring proceeding, for merely one quarter. Surely Terry will game brinksmanship on the negotiation table, but for CMI not to sustain production and pay its upstream suppliers is almost surely impossible. From risk-reward perspective, this deal is a no-brainer."

As of March 16th, CMI Board of Directors finally approved Mr. Tuan, the incumbent CEO, as the new Chairman, and the operation seems to be bottoming out, the whether Terry can finesse the structural conundrum remains to be seen. Judging from the smile on the anonymous banker's face, whoever dares to bet on CMI receivables must have made a small killing at the expense of short-term market irrationality.

In the long term, the outlook for the global LCD panel industry, and particularly for Taiwan, remains extremely opaque. Samsung is going full force on AMOLED, a niche display technology cultivated by typical South Korean persistance. With Samsung Mobile Display as the core value chain aggregator, Samsung fetches a 90% market in this technology and charging a premium for its limited supply. In addition, Mainland China is slashing higher import tariff on LCD panel import in order to promote its own panel makers, who are also ramping up losses of grand magnitude. Higher tariff may force Taiwanese panel makers to make further capacity investment on Mainland which has been delayed by previous embargo. Political calculations aside, it is crystal clear that capital intensive investment in a severely over-supplied market means more value destruction ahead. A portfolio of high-yield receivables from these Asian tech companies may be a suitable financial placebo for disgruntled taxpayers. As for CMI equity, we leave that to daring vultures.

2012年1月14日 星期六

La Tecnologia è Mobile

Race Against Pride & Cost

For those less familiar with the acrimonious history between South Korea and Taiwan, the bitter-sweet attitude of Taiwanese tech industry towards its Korean archrival can be best understood by analyzing Samsung Electronics, the global consumer electronics powerhouse that generates over $140 billion of revenue in 2011, or roughly the total revenues of TSMC, HTC and Hon Hai Precision, the three pillars of the Taiwanese Tech Pride. 

A casual look at Samsung's financials suggests it has four major segments: memory, display, handset and TVs. Samsung is the largest and the most profitable DRAM, NAND Flash and TFT-LCD makers, the largest digital TV maker, the largest handset maker second only to Nokia, whose volume is shrinking by the minutes. A deeper look, however, tells more of a story of industrial migration of the past 20 years and how different industrial mindsets lead to different path dependency and outcome.

Take memory chips for example. Technological advancements and cost-down efforts by Taiwanese and Koreans over the past twenty years have forced the Americans, Europeans and Japanese out of the market. At each downturn, Samsung quickly increased capex, handsomely spent on R&D, and fiercely compete on price. The goal is not to make contrarian capital allocation decision, but to drive competitors out of the market with concentrated force.

The economics is simple: a 1Gb DRAM chip costs $0.5 to make, $0.4 to package, and $0.4 to finance the 50nm immersion equipments that render the production in Taiwan viable. The going price is $1 and en route to $0.6 within two years. Only Samsung and Hynix can survive on this cost curve. A more telling story is that, when DRAM price staged a short-lived rebound in 2009, the Koreans were buying advanced semiconductor production equipments to effectuate process upgrade, while Taiwanese were busy restructuring their overdrawn bank credit lines and shareholder loans to pay technology licensing fees to Americans and Japanese.

The result of this bifurcation, is to empower Samsung to control over essential patents and semiconductor manufacturing processes in DRAM, NAND Flash and SSD, thereby making a respectable 23% of EBIT margin for DRAM and NAND Flash in 2011, or about $5 billion of operating profits. On the other hand, Taiwanese DRAM makers, five of them in total, have been responsible for almost 100% of the $20 billion of global losses in memory sector since 2007. Nice little pair trade to have there.

Small & Fast beat Large & Fat

The history of display industry has a similar flavor. The first generation of large liquid crystal display was developed by NEC in 1990 and attracted many Japanese firms to follow suit. By 1995, the 3rd generation technology encouraged Samsung to enter the market and begin fostering its own supply chain. Japanese branded display makers, facing heightened costs and reduced risk appetite, ceded the thrown of global top TV brands to Samsung and LG following the Korean dumping amid Asian Financial Crisis in 1998.

Unable to tolerate Koreans to take the top seats,  Taiwanese came in with government-backed funding again, transferring Japanese IP, ramping-up capex on large-size display, thinking it might be able to ride the coat tail of Sony, Sharp and Toshiba and be the shadow manufacturing partner of global consumer brands.

Unlike Samsung and LG, none of the Taiwanese display firms can control upstream raw materials and core technology, nor do they have the political freedom to penetrate Mainland Chinese market and build profitable brand equity. In display, as in memory, or in any other hi-tech industry, speed to invest in efficiency upgrade is paramount: if you cannot keep up with others, you are bound to lose. In 2011, Samsung lost only $500 million of EBIT in display, thanks to its small and midsize panel growth initiative and Galaxy product lines, while the five Taiwanese display makers, loaded with debt, lost nearly $3 billion. This stark contrast has made many Taiwanese tech bosses publicly ask government to come up with a better, comprehensive policy package (or backstop facility) to sustain the Taiwanese competitiveness, while taking orders from Samsung and enjoy good rally of their stock prices.

A perfect example is the Taiwanese LED industry. Backtesting these LED stock price performances to the announcement of receiving Samsung order suggests strong correlation and has been a well-known trade to make a killing. The real killer, however, remains firmly in Korean hands. It has been the history of Samsung to ping competitors' strength and weakness by giving them orders with demanding product specifications. For example, Samsung would give large LED orders to Taiwanese makers on one hand, and buy or build advanced MOCVD, the core LED production technology, on the other. Once Taiwanese firms become dependent, they would serve as convenient virtual fabs for Samsung to optimize its manufacturing efficiency.

Miniaturization & Militarization

To say that Samsung is benefiting from global brand and currency manipulation to beat opponents is a gross misunderstanding of its competitive mindset. The common feature of this ongoing annihilation war against Taiwanese tech industry is Samsung's will and ability to mount capex offensive through economic and product cycles to drive favorable changes of consumer behavior. More importantly, Samsung has demonstrated its ability to establish dominance in both upstream and downstream parts of the supply chain: its memory, panel and battery products account for over 40% of key electronics component costs globally, its $20 billion worth of brand is no. 1 in China. With digital convergence continues, Samsung can leverage, if not militarize, its global design, manufacturing, and logistic resources to rapidly introduce affordable and fashionable consumer gadgets while beating Taiwanese tech firms left and right. The key question then becomes: How long can TSMC sustain? 

A recent news article in Taipei may point to a possible crack in TSMC seemingly impregnable position. It is reported that last November, a 18-inch wafer foundry was being built in SUNY Albany, New York and top engineers from every major global semiconductor firms were present to test their equipment prototypes. The purpose of this joint project is not only to test the next-generation technology for 10nm geometry, 3nm  away from the physical limit of miniaturization, but also to size up competitors' readiness. TSMC, the global leader in wafer making, approached this project as an industrial espionage battleground, for a very logical reason. After dominating memory that are easier to make, it is only a matter of time before Samsung takes on logic chips and challenge TSMC head-on. The most advanced 18" foundry could cost over $5 billion to build and requires over 120 different types of equipments and over 900 manufacturing processes that requires absolute precision. If Samsung could exert influence over several processes, it could sabotage TSMC's cost structure. After losing several key executives to Samsung in recent years, TSMC fully understood the gravity of the situation.

When the testing results were announced, TSMC was shocked: of all the qualified equipments for the follow-up 18" foundry R&D, one key equipment for making mobile chipset was of Korean origin. This piece of Korean technology blocks a crucial bottleneck TSMC cannot bypass. This not only implies Samsung's continuing investments in South Korean semiconductor equipment makers have cultivated several firms that can compete against Intel, but also spells a dim future for TSMC: what if Samsung announced that all mobile device orders must be made with Korean equipment? A global shipment volume of 300 million units and growing can buyout loyalty and patriotism much more easily than you think.

In the future, there are probably only a handful of semiconductor equipment makers who can afford to invest in the 18" geometry. With Moore's Law approaching its theoretical limit, the equipment cost might eat up scale benefits of large wafer size. More importantly, such a future requires a device maker to produce antenna, micro machinery and analog chips more efficiently. If Samsung can break into 18" equipment making, it can quickly build a more sustainable integrated supply chain and sell retrofitted legacy equipments to other competitors who are late to the R&D game. Intel also reportedly has the ability to fit the most advanced process technology to old equipments. The cost saving can be enormous.

TSMC, because of its traditional insistence to focus on core business, never ventured into upstream equipment R&D seriously. Even with experienced engineers, it would still take two to three years to design next-generation equipments. In the world of semiconductor arms race, such speed gap almost spells defeat. No wonder TSMC immediately sent engineers to every major equipment suppliers to develop bespoke technology for TSMC. Samsung, on the other hand, announced record high wafer capex of US$7 billion in 2012. If Samsung spending continues, it is possible that TSMC, without compromising its NT$3 cash dividend per share to shareholders, will access debt capital market for ammunition. How wide should a TSMC credit trade? Would that event sound the overture of yet another DRAM-style Götterdämmerung ? Only time would tell.

Will HTC be the next?

The origin of HTC's great rally which peaked in April 2011 can be traced back to a eureka moment on a business trip: Cher Wang, Founder and Chairwoman of HTC, feeling tired ot packing her bulky laptop and cellphone en route to airport, once lamented how wonderful it would be if she could browse the web, check emails and do conference call in a single, light-weight device. That lament triggered HTC to focus on hand-held computer and smartphone in 1997, and became the largest OEM of PDA by 2002. Knowing the future of wafer-thin margin of a contract manufacturer too well, in 2006 HTC shifted to branding and innovation in mobile devices, thus embarking on a path to challenge its customers head-on, a path seldom chosen by fellow Taiwanese technology firms. Again, looking at the HTC share price versus Acer, Asustek, Quanta etc., the contrast cannot be starker.

HTC is arguably the only brand that can mount a credible threat to Samsung in its ongoing battle against Apple and Nokia. However, it still has a fatal weakness versus Samsung: HTC cannot make TV. In the era of digital convergence, the power of TV as a distribution channel for digital contents cannot be underestimated. Just imagine a world where you can voice-control your TV from your smartphone to play iTune contents while playing AngryBirds. Samsung is the only company in the world that can make money in memory, display, handset and TV simultaneously. Without a strong platform supported by patents and branding, HTC's only remaining leverage is its Mainland China business, where it only shipped less than 10 million handsets in 2010.

Given the size of Chinese market, such volume clearly suggests growth ahead. It is the intention of Beijing to foster its own telecommunication standards and leverage its market access to dictate the terms to foreign firms. It is also politically expedient to treat HTC as a native Chinese firm with global ambition and design a new set of rules to facilitate its Mainland growth. Given Cher Wang's all-out support for the pro-unification ticket in the 2012 Taiwanese Presidential Election, this publication smells value in HTC's depressed valuation. When will Beijing come to the rescue? We shall see.

2011年12月17日 星期六

Home and Away

Home and Away 

When I first traveled to Mainland China in late 1990s as a young kid, I was surprised by how strangely at home I felt, and yet so distinctly away from the world I knew so well. The first thing that got my attention was the hotel. 

Growing up in Taiwan, the island province deemed as “unsinkable aircraft carrier” by the US general staffs during World War II and Cold War, I am no stranger to political indoctrination. Even after Deng’s economic reform had been in full force for almost 20 years, lots of Taiwanese, mesmerized by distorted propaganda, still viewed Mainlanders as poor rural cousins living in People’s Commune. While my precocious mind was largely immune from such misperception thanks to my journalist parents (who enjoyed better access to true information) the idea of people living in a collective dorm haunted my mind. 

The Beijing hotel I stayed at was not really a hotel. It was commonly referred to as “guest house” (招待所) by Chinese people. In a typical guest house the service is quite modest: no concierge to greet you, no bellhop to carry your luggage, no plush pillows and cozy bed. Typical amenities include a tiny soap, some toothpaste, and a thermal carafe to fill hot water in the corridor. Bathroom malfunction is very common. At night you are forced to share other people’s life because the room wall is very thin, and some guests simply do not bother to close the door. For less than RMB90 per night, very soon a foreign traveler learns to affect an indifferent attitude like other Chinese guests. Complaints are futile. 

When I revisited Beijing in 2007 with other Wall St. investors from New York, I stayed at the China World Hotel, a five-star premise providing all lavish services and amenities up to the global standard. Friends told me many other new 5- and 6-star hotels were in construction and the going room rate was reaching RMB3000 per night. However, numerous guest houses were still in business, serving millions of Chinese for less than RMB100 per night. In retrospect, that was my first true lesson in wealth inequality of contemporary China. And the best classroom to review that lesson is in Chinese budget hotel. 

The Blue Sea of Lodging in China 

The volume of domestic travelers in China has expanded to 2.1 billion people in 2010 from 744 million people in 2000. The industry revenue during the respective period grew four-fold to RMB1.3 trillion from RMB318 billion. The volume is expected to grow further as Chinese GDP and disposable income grow. China’s lodging sector includes both hotels (star-rated and non star-rated) and other forms of accommodation (e.g., guest houses). The industry grew from 250,061 lodging premises in 2004 to 328,007 lodging premises in 2010, and from 21 million rooms in 2004 to 29 million rooms in 2010. 

Budget hotel was first introduced in late 1990s and the industry experienced substantial growth during the past decade. Several branded budget hotel chains, including Home Inns (如家) Hainting (漢庭), Seven Days (七天), Jinjiang Inns (錦江) and Motel 168 (莫泰), emerged primarily from China’s prosperous coastal region. Typical room is about 200 sqf, mostly priced under RMB200 per room night. The key target customers are value conscious domestic business and leisure travelers who demand cleanliness, safety, convenience, and value features such as high quality bed and bedding, air conditioning, in-suite bathroom and free Internet access. 

Despite rapid unit growth, branded budget hotel industry is still small and fragmented: it only accounts for 1.6% of total lodging premises in China and the top three budget hotel operators in China accounts for 36% of the total rooms in the branded economy hotel sector versus 67% in the United States. 

Among these branded budget hotel chains, Home Inns (NASDAQ: HMIN) has probably one of the most legendary start-up story in China. An US-listed company since 2006 with about $1.2 billion market cap, HMIN was founded by the original founders of Ctrip.com (NASDAQ: CTRP) the Chinese equivalent of Expedia in 2002. Through its online booking platform (whose volume already reached 100,000 hotel rooms per month in 2002) the Ctrip founders realized that mid-end budget hotel was a “blue sea” for lodging in China. With the help of Beijing Tourism Group, HMIN was founded to fulfill this customer demand. 

Within a decade, HMIN grew from less than 10 hotels to a national chain of over 1000 hotels. The business model follows typical two-pronged chain store format: leased-and-operated hotels and franchised-and-managed hotels. HMIN leases properties located in good areas from State-Owned Enterprise. These properties usually come with legacy issues that render them under utilized for years. Deep local expertise allows HMIN to navigate the bureaucracy with finesse and rents these assets with 15-20 years lease with attractive rent stabilization clause, convert them into hotel, and install HMIN IT system and managers. Once HMIN feels comfortable with a city, it will franchise its brand to property owners for an upfront fee and annual revenue off-take of 3%. As more franchised-and-managed hotels are added, margin expansion can be significant. 

A typical HMIN hotel has 80 to 160 rooms. The size of each room is about 15 to 25m2 (150~250 sqf) and conversion capex per room at a leased-and-operated hotel is about RMB60,000 per room or about $1 million per hotel. The conversion costs vary greatly across regions and minimum cost requires to attain a “Home-Inn-look-alike” room is RMB2,000/m2 or RMB30,000 to 50,000 per room, depending on quality. Further cost-cutting is possible. The biggest capex item is restroom, where HMIN has standardized its design and because of HMIN’s scale, it has good bargaining power against vendors and contractors. 

Because the model is highly scalable, HMIN has quickly expanded nationwide, for a simple reason: the unit rental cost in tier-2/tier-3 cities ranges between RMB0.9 to 1.2/m2 /day, or about RMB18 to 24 per room per day, much lower than RMB30-60/room/day in tier-1 cities. Budget hotels in China primarily accept domestic travelers (over 90% of total customers) who are more value-conscious. Without a broad national portfolio of low-cost, long-term lease, its leading position shall not be secured. 

The reported average day rate of HMIN has been fluctuated between RMB157-192 since 2004, with quarterly volatility of ±6% ex-Shanghai Expo and occupancy rate seldom dips below 85%. This RevPAR stability largely reflects HMIN’s strong location selection and early-mover advantage in securing long-term lease (10-20yrs). As these leases expire, the convenient location and strong brand should enable HMIN to maintain pricing power to grow with inflation. 

Using the US market as precedent, where Choice Hotels International (CHH) operates and franchises over 6142 hotels (495145 rooms) across 10 brands, the Chinese lodging market should be able to accommodate two or three economy hotel chains with over 3000 to 4000 hotels per chain in the next 10 to 15 years. In that case, blended occupancy rate is unlikely to sustain at 85-90% as customer segmentation drives brand differentiation. Based on interview with Chinese hoteliers, 70-75% as a sustainable long-term occupancy rate for economy and mid-end hotels. However, the sector occupancy rate might not revert to this long-run mean during the 12th Five Year Plan period as more unprofitable stand-alone hotels being consolidated and Chinese disposable income continues to grow. Most importantly, high-cost foreign hotel brands like Accor cannot compete with domestic budget chains for a very simple reason: budget hotel guests in China don’t care about Western hospitality, and they can always sleep on a couch in a distant relative’s house. If you are dealing with unappreciative customers, spending $5 million on a Sofitel project should be viewed as a marketing expense instead of capital investment looking for handsome return. 

While the lodging sector overall is highly sensitive to economic growth, the budget hotel sector has shown strong resilience and rational pricing behavior during economic down cycle: during 1Q 2009 amid aftershock of the Global Financial Crisis, the three listed budget chains all delivered positive quarterly EBITDA margin (HMIN: 13.8%, HTHT: 0.9%, SVN: 11.4%) and high occupancy rate (HMIN: 83% , HTHT: 85%, SVN: 83.5%). HMIN quarterly revenue during 1Q 2009 grew 43% yoy and EBITDA rebounded strongly (up 200% yoy) in 2Q 2009. In addition, from 2008 to 2009 HMIN ADR dropped 7.5% yoy to Rmb160 from Rmb173 but occupancy rate increased 6.5% yoy to 91.5% from 85%, resulting in 1.4% yoy growth in RevPAR. The national average occupancy was around 60% in the respective period. Barring significant slowdown, if not systemic meltdown of Chinese economy, HMIN’s strong track record suggests it should be able to sustain defensive growth even during stagflation period. 

The Big Gets Bigger 

In May 2011, HMIN entered into a definitive agreement to acquire 100% ownership interest in Motel 168, the 5th largest budget hotel chains, for $470 million. Approximately $305 million was paid in cash, and approximately $165 million paid through new issuance of 8.15 million ordinary shares of HMIN. The deal was originally auctioned at $10 billion by Morgan Stanley’s real estate investing team that was looking for an exit due to capital call. The cash portion was funded with a combination of existing cash and a new credit line. This deal is largely being viewed as a must for HMIN as it seeks to solidify its leadership position. Post-acquisition, the combined portfolio of Home Inns and Motel 168 will represent the largest (over 1,215 properties, immediate access to 11 additional cities, expanding coverage to 175 cities in China with 152,512 rooms) and most geographically diverse economy hotel operation in China, with nearly twice as many hotel locations and more than double the total number of rooms of the No. 2 player (7 Days Inn) and accounts for a market share of approximately 24% in the China budget hotel industry. HMIN CEO Mr. Sun believes he can grow the chain to over 3000 hotels in 4 years. 

On P/E basis, the deal looks a bit pricey, as Motel 168 has been printing losses for years due to poor management. On EV/room basis, HMIN was buying Motel 168 at the cash renovation cost per room. With a strong presence in the most affluent Yangtze River Delta region and long-term lease portfolio that is almost impossible to replicate in Shanghai, Motel 168 might be quite an interesting turnaround opportunity misunderstood by the market. Assuming HMIN can maintain +20% EBITDA margin and deliver $1 billion of sales, with a net debt of less than $200 million, or about 1x leveraged, HMIN is offering decent value. This publication argues that, despite its modest appearance, HMIN is actually an Internet company with Ctrip genes inside. A sustainable budget hotel business is not just about getting low rental cost, but more of a play on building a customer service platform supported by strong brand equity and consistent quality, both of are characteristics of a good Internet business. With millions of loyal members, the HMIN ecosystem looks very robust. 

Given bearish dataflow from China these days, especially after Ctrip reported disappointing 3Q2011 results, the sentiment is bad. After all, Ctrip processes over 10 million hotel bookings per month and if its gross margin is shrinking due to lackluster volume, something is wrong with the Chinese middle-class consumers and SME employees who always travel on budget. However, Ctrip only accounts for less than 5% of HMIN bookings. While this publication seeks to aggressively invest in value, it is no fun fighting the tape. In this regard, HMIN’s 2012 or 2015 convertibles look quite interesting: both are sporting a healthy yield and their respective outstanding amounts are covered by healthy cash flow. HMIN might not have a strong track record in rewarding shareholders, it is not incentivized to default on lenders either. While HMIN is busy consolidating the newly acquired business, patient investors should feel at home holding these papers to par.