Home Inns Vulnerable to China Lodging

Home Inns & Hotels Management (HMIN) is scheduled to report earnings this evening after the market closes.  Typically you would see excessive volatility after an earnings announcement, but on Tuesday the stock rallied more than 12% with no company specific news.  The move was apparently in sync with an earnings report from Ctrip, the China equivalent of Expedia or Travelocity, which noted strong air travel and hotel bookings.

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HMIN is a leading China lodging economy hotel chain spread throughout the Chinese mainland.  Most of the hotels bearing the HMIN name are leased properties where the company develops and manages each location.  Currently there are 326 hotels in operation under this arrangement with another 54 in development (although I expect these numbers to be updated with the earnings announcement).  A second strategy is for the company to franchise its brand to existing hotel owners and collect royalty fees.  There are currently 145 locations operating under this arrangement and another 60 in development.

It seems that today every stock with the name “China” is being bought hand over fist.  Recent economic reports have shown China as outperforming in what has otherwise been a worldwide recessionary environment.  While China growth has been under pressure, the growing population and some political moves toward a more free economy have certainly stoked the growth.  But unfortunately “growth at any price” can be a dangerous approach when investing.

Looking at the fundamentals for HMIN, the company is expected to earn $0.39 per share this year which represents 11% growth over 2008.  Any growth at all is impressive given a difficult market environment.  In 2010, analysts are expecting a sharp 46% increase to an annual earnings level of $0.57.  Currently the stock is trading near $19 which represents a multiple of 48 times this year’s estimates, and 33 times next year’s numbers.  The price seems a bit dangerous to me - especially considering the long-term prospects for earnings growth.

One of the primary drivers of the optimistic expectations for 2010 is the Shanghai World’s Fair which is expected to draw as many as 70 million visitors.  The surge in travel will certainly bring significant revenue and earnings for 2010, but my concern is that investors are extrapolating the expected 46% increase as a sustainable growth trajectory.  In actuality, it will be very difficult for HMIN to see any growth in 2011 after the one time boost from the world fair.  If investors find themselves holding a stock valued at 33 times earnings next year - and the growth estimates for 2011 and beyond come in flat - we could quickly see shares drop.  In fact, as investors work through this logic in the second half of 2009, I expect a decline in the earnings multiple on the stock.

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Shorting stocks during a market rally can be a difficult and dangerous strategy.  But as this advance becomes more overbought, short opportunities are looking more and more attractive.  HMIN is one of those opportunities as I think the stock could quickly trade down to the low teens, offering a significant percentage gain to traders willing to step in.  There are several ways to play this opportunity - some with more risk than others:

• Shorting the stock outright today - This approach is a bit risky as a positive report by management could propel the stock into the $20’s.  Recent history has shown that investors will still buy a good story even at extended prices.  So while shorting the stock today would get you in front of a potential decline, there is risk of getting stopped out quickly


• Buying puts outright today - Currently you can buy the August $20 puts at about $1.90 per share and these puts already have $1.00 of intrinsic value built in.  While your total exposure is capped at the $1.90 price of the puts, the disadvantage is that you have to make up the roughly 90 cents as the stock drops in order to recognize a profit.  That may be difficult in the next two weeks.


• Covered Short Position - If you’re familiar with covered calls, this strategy should be relatively familiar.  Essentially, you could short the stock and then possibly sell the September $20 puts for $2.15 or so.  This strategy caps your potential gain, but also gives you a bit of protection if the stock were to rally and hover a bit above $20.


• Set a “sell stop” entry order - While tyically we consider a “stop” order to be an exit strategy, we can also use stops as an entry point.  The idea is to set up a short that is automatically triggered if the stock drops below a certain point.  This way if the stock begins to give up its recent gains you are quickly involved in the situation and able to participate on the way down.

There are many ways to initiate short exposure on stocks, but the important thing is understanding what your potential returns look like, and what you have at risk.  If you’re new to trading and have questions on how to execute any of these strategies, please send me an email or leave a comment and we can discuss this and similar opportunities.  In summary - HMIN appears to be overpriced and could decline sharply as investors realize that long-term growth is still in question.  Traders can initiate short positions at current levels or after the earnings announcement.  Please use risk control and expect to cover shorts in the low teens.

FD: Author does not have a position in HMIN

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