Tourism Holdings — Update 3 May 2016

In our view the investment case for THL is based on these key positives:

Restoration of ROCE. ROCE was destroyed by a period of market over-capacity (estimated by THL to be 25%) in the recreational vehicle market in NZ where THL has a dominant position (now ~70% of the large recreational vehicle market). THL moved to consolidate the industry with the acquisition in 2012 of Kea and United and a subsequent reduction in fleet numbers. It has now right-sized its fleet in NZ and Australia and is on a path to emulate the capital-light model employed in its US operation. While the market dynamics in NZ and Australia will not allow THL to achieve the returns it enjoys in US (where the scale of the recreational vehicle market means THL can turn the fleet over every 12-18 months, lowering the capital employed and ensuring 20%+ ROCE) action has already been taken with the ‘flex fleet’ initiative to reduce capital employed. Key to this are the pod/re-fit strategy, the buy-back plans and THL’s plans to ship vehicles used in its European operations to NZ for use in the Southern Hemisphere high season and then for re-sale into the recreational vehicle market in NZ. Actual ROCE and our forecast performance are below.

Strong historic earnings performance. Guidance has been lifted at each results period for the last two years and to date reported results have all exceeded guidance. This gives us confidence about management’s conservative and realistic attitude to providing earnings guidance to the market.

Tourism growth. THL has a direct exposure to tourism growth in NZ and Australia. In 2015 both markets significantly out-performed expectations and the early indications for 2016 are that forecasts will again be exceeded. This is particularly the case for both countries with the strongest growth in visitors from China. This note focuses on visitor growth from China, where the strength of the tourism market provides us with greater confidence in our forecasts and in the company’s expectations of NZ$30m NPAT by 2019 (our forecasts assume NPAT of NZ$28.5m in 2018).

Visitors from China. Growth in the number of visitors from China provides some evidence that NZ and Australia appeals to Chinese visitors, some of whom could be seeking some relief from the crowded/polluted conditions at home, among other things The flight is relatively short and the change in time zone is not as arduous as the change in time zone and flight times experienced when visiting Europe or the Americas.

Debt and dividends. THL’s strategy is to keep debt within the benchmark Baa/BBB rating. At 31 December 2015 the net debt level of NZ$90.4m provided some headroom for acquisitions as well as continuing to fund dividends at an assumed pay-out ratio of between 75-90%. The current share price implies a forecast yield of 7.1% and 8.0% for FY16e and FY17e respectively, which is ahead of the forward CY2016e dividend yield of 4.3% for S&P NZX All Index and THL’s peer group average FY16e dividend yield of 4.6% (at 26 April 2016).

THL’s business is leveraged to the inbound tourist markets, in particular those of New Zealand, Australia, UK and Germanic Europe (Germany, Netherlands and Switzerland) and its business is therefore leveraged to the tourism cycle. Management advises that the key factors influencing demand for recreational vehicle rentals in THL’s key markets of New Zealand, Australia, the UK and Germanic Europe are consumer confidence, GDP growth and how customers feel about their financial position. Therefore, THL’s business can be seen as leveraged to the economic cycle. In THL’s view, the most significant threat to its business would be a catastrophic event such as terrorism, an airline strike or other event that dramatically reduced international air travel.

The company announced on 29 April 2016 that it expects to meet or exceed its FY16 NPAT forecast of NZ$24m. It also made the following statements:

We have increased our forecasts in line with THL’s upgraded NPAT guidance for FY16 and FY18. Details of our changes are set out below:

In both countries 2015 was a stellar year for both domestic and international tourism. In New Zealand the importance of tourism to the local economy is underscored by Prime Minister John Keys also taking responsibility for the Tourism portfolio. In the year to 30 June 2015 spending by international visitors increased NZ$2.4bn to reach NZ$11.7bn ranking it second in importance after dairy exports at NZ$12bn (down from NZ$16bn in 2014). The NZ Institute of Economic Research is forecasting that tourism will become the number one export earner for NZ within a year. The World Travel and Tourism Council forecasts that by 2025, tourism will contribute 13.4% of GDP (13.7% of GDP in 2014). The contribution to employment is estimated to be 17.2% by 2025 (15.5% in 2014). The director of the NZ Tourism Research Institute, Professor Simon Milne, is quoted as saying that the kind of tourism being promoted in NZ is ‘one that focuses on free and independent travel’. This is a further endorsement of the THL recreational vehicle product in NZ.

In Australia international visitors grew 8.2% y-o-y, which is almost three times faster than any annual growth rate achieved in the last 13 years. The momentum appears to be building with the July to December 2015 period up 9%, a rate last seen in 2000 when Sydney hosted the Olympics. Domestic tourism in Australia in 2015 was up 7% compared with the annual average growth rate of 1% achieved since 2000.

Strong growth in tourist numbers has continued into 2016. In Australia total visitors for the first two months grew by 11.7% driven by a 23.8% increase in visitors from North East Asia, including China, which provided 50,000 more visitors than in 2015. In New Zealand for the first three months of 2016 arrivals grew by 13.1% with China up by 19.5% or ~22,000 on the same period in 2016.

In Australia tourism remains a significant industry. The World Travel and Tourism Council has forecast that the total contribution of tourism to the Australian economy would increase from 10.1% in 2014 to 10.5% of GDP by 2025. The contribution to employment was estimated to be 11.6% by 2025 (12.2% in 2014). Tourism forecasts published in November 2015 by Tourism Research Australia, suggested that by June 2017 the number of inbound visitors would increase to 7.9 million (7.4 million in 2015) and then to grow by 4.1% pa to 10.6 million by 2025. In the period to 2025, 29% of the growth in arrivals is expected to come from China when it is thought that 18.4% of all visitors to Australia will be Chinese. (In 2015 Chinese visitors comprised 13.8% of the total.)

Deloitte’s Tourism and Market Outlook for Australia, February 2016, states that it expects tourism to grow ‘at rates not witnessed for decades with the outlook strengthening despite global macroeconomic uncertainty’. Deloitte forecasts that by 2018 demand from China (estimated to grow at 9% a year for the next three years) will need an extra 10 A380 services per week and that average growth in international visitors will be 5.4% a year for the next three years.1

The most important markets for THL’s recreational vehicle product are UK and Germanic Europe (Germany, Switzerland, the Netherlands). These markets accounted for 17.2% (311 million) of total visitors to NZ excluding those from Australia and 15.2% (925 million) of visitors to Australia excluding those from NZ. China, which is the fastest-growing market in both countries, has demonstrated a capacity to convert quickly from a guided tours market to a FIT (free independent traveller) market seeking unique experiences. The THL Waitomo Caves product is proving very attractive to Chinese tourists (both the FIT and the guided tour segment). It recently received a boost from Taiwanese singer and actor Nicky Wu and Chinese actress Lui Shishi selecting it for their pre-wedding photo shoot. Wu has 40 million fans on Chinese social media platform Weibo (operated by Tencent [HK:700]). Publicity such as this and Waitomo Caves’ location (within two hours’ drive of entry port, Auckland, NZ, so an easy day-trip) could attract increased numbers of visitors from China.

Demand for THL recreational vehicles in Australia and New Zealand and its other tourist offering (Waitomo Caves and the Kiwi Experience bus) in New Zealand is mainly driven by inbound tourism. We focus on the China market, which is the second visitor group in New Zealand and Australia, and in both markets exhibits the strongest growth of any market. The China market is an important fast growing market for the Waitomo Caves attraction and a small but fast growing market for recreational vehicle rentals.

In 2015 the Chinese economy recorded its weakest GDP growth (6.9%) compared with 2014 (7.3%) and the weakest annual growth rate since 1990. It is transitioning from an export-led growth economy to a consumer-led economy so the expectation is that growth rates will continue to ease and expenditure on services and consumption will continue to strengthen. In 2015 the services sector grew by 8.3% (2.4 percentage points higher than 2014) and accounted for 50.5% of GDP whereas manufacturing and construction growth slowed to 6% (7.3% in 2014) and accounted for 40% of GDP. The view of the IMF is that the China slowdown is essential to create safe sustainable growth, which will mean a slowdown in manufacturing and construction offset by a lift in consumption. In our view, increased consumption has the capacity to fuel more out-bound journeys and therefore could prove beneficial for tourism operators such as THL. Another important point on the Chinese market is that the incomes of those with the purchasing power to make an overseas holiday trip and visit Australia or NZ is growing faster than the growth in average incomes.

China growth forecasts are set out below:

With an estimated 120 million outbound travellers in 20152 the China market is a significant growth driver in both the NZ and Australian tourism markets. This growth is driven by increases in Chinese household income, which is now estimated to be US$5tn per year3 without taking into account the impact of unreported income. McKinsey forecasts Chinese discretionary spending growth to exceed 7% per year between 2010 and 2020. GIK Consumer Life estimates that by 2020 more than 200 million Chinese people will be holidaying outside China and will spend an estimated US$400bn in destination markets. More than half of China’s outbound travellers are less than 30 years old and two-thirds are classified as ‘high income’. These millennial travellers spend more than the older cohort, are likely to seek ‘once-in-a-lifetime’ experiences and share their experiences on social media channels.4 In our view this shift in visitor behaviour is likely to benefit THL, which offers unique independent travel experiences (in recreational vehicles and Kiwi Experience bus trips) and attractions (Waitomo Caves).

Tourism New Zealand predicts that total visitor arrivals from China will increase by 116% over the next seven years to reach 600,000 by 2021. Its 2015 forecast of more than 305,000 total visitor arrivals from China was exceeded by 50,000. The number of FIT tourists (the potential market for the THL recreational van product) comprised 20% of total Chinese visitors in March 2014, 27% in March 2015 and by 31 December 2015 had reached 31%. Chinese travellers now stay 8.3 days compared with 6.2 days in 2010, which again is a reflection of the move from guided tours to FIT. FIT travellers see NZ as a place to flee the pollution of the city and their hectic lives and are looking for a pure and clean escape.5

A Consumer Demand survey conducted by Tourism Australia found that the preferred Australian experience was wildlife and a survey conducted by Tourism New Zealand (Project Kiwi – China FIT qualitative research November-December 2015) found that Chinese FIT tourists saw NZ as pure and clean with a variety of peaceful landscapes offering pleasant weather in an opposite season and consider ‘it’s the last clean place in the world’.6 The growth of Chinese visitors to both NZ and Australia is shown in Exhibit 5 below.

Presentation material from Tourism NZ (China Market Webinar – Chinese FIT expectations when visiting NZ) stated that Chinese FIT travellers are experienced travellers with high expectations and the expectation of both comfort and freedom. The characteristics of these travellers are defined as those that:7

Many of these characteristics make a motor home (recreational self-drive) holiday an attractive proposition. With a dominant position in the large van recreational vehicle market, THL remains well placed to exploit the growing Chinese FIT market. For example, in Australia, China Is the seventh largest international source8 for THL’s recreational vehicles (RV) market with more than half these travellers aged between 25-34 years. The China FIT market is small but growing in significance in both NZ and Australia.

The following table shows actual per-household annual consumption in China for 2005, 2010 and 2013 and forecasts for 2020 and 2030 made by McKinsey. The category that is relevant for tourism expenditure is the ‘recreation, education and culture’ category, which is expected to grow from 13% of per household annual consumption in 2013 to 21% in 2030. This forecast was made in 2015 when GDP growth expectations were 7.1%9 (actual GDP growth for 2015 was 6.9%).

The Credit Suisse Global Wealth Report 2015 notes that China’s middle class of 109 million adults outnumbered the USA middle class of 92 million adults for the first time. Credit Suisse predicts that the middle class ‘will continue to expand in emerging economies overall with the lion’s share of that growth to occur in Asia’. In this report, ‘middle class’ was defined as having wealth double the annual median income for their country.

The Tourism Australia profile for 2015 provides details of flights to Australia from China. There are 24 flights from Shanghai to Australian ports, 39 flights from Guangzhou per week, three from Chengdu, three from Beijing and two from Wuhan.

In New Zealand there have been increases in air capacity provided by the two direct carriers, China Southern Airlines and Air New Zealand with new players Air China and China Eastern establishing year round services in 2015. There are now more than 20 flights per week to Auckland from Shanghai, Guangzhou and Beijing.

Therefore, THL stands to benefit from China’s rising middle class and their growing disposal income over the long run, despite the recent concerns about its near-term GDP growth. Although the Chinese FIT market is a small part of THL’s revenue profile currently, the positive medium-term prospects reinforces our confidence in our forecasts and valuation for THL.

Our DCF valuation has increased from NZ$3.14 to NZ$3.44 due to updating our net debt figure, the inclusion of the issue of ordinary shares and upgrading our forecasts to be in line with management’s NPAT guidance for its longer-term NPAT target, which is now NZ$30m in FY18 rather than FY19. We have used a WACC of 10% and a terminal growth rate of 2%. The terminal value in our DCF accounts for 45% of our DCF valuation of NZ$3.44. It does not take into account potential value added from acquisitions, which remains part of THL’s strategy. We believe that the gap between value and share price will continue to unwind as the company delivers on its strategy, improves ROCE and attracts more yield-focused investors.

There is no directly comparable company in the peer group. Nonetheless, we have examined five similar companies. The peer group has an average market cap of NZ$1.5bn, which is ~5x the market cap of THL; however, all peers share are capex-heavy businesses with some tourism exposure. The average FY16e EV/EBIT multiple for the peer group is 12.0x. We believe that THL should trade at a discount to its peer group because of its lack of size and diversity. A 15% discount to the peer group FY16 EV/EBIT of 10.2x implies a market-based valuation of NZ$3.34 and a 10% discount implies a valuation of NZ$3.57 compared with our DCF of NZ$3.44.