Executive Summary

• We RECOMMEND doing the deal and acquiring 7 Days Inn for $4.60 per
share (LTM EV / EBITDA of 7.4x) in a leveraged buyout transaction
• Even in our base case scenario, we could achieve a 5-year IRR of 20% and
MoM multiple of 2.5x, and even with more pessimistic assumptions, an IRR
between 15% and 20% is plausible

• The company’s shift to Managed Hotels makes it a higher-margin, less

capital-intensive, and far more appealing business model, and that will
offset the continued Occupancy Rate declines
• The qualitative factors also support the deal, since the company is the #2
player in a fragmented and fast-growing industry, the management team
and existing investors are rolling over a high %, and there are plenty of exit
strategies
• For the numbers not to work, the company’s business model shift and/or
ADR and/or Occupancy Rate would have to fall catastrophically below
expectations

7 Days Inn – LBO Case Study 1

Market Overview
• The budget hotel market in China is growing rapidly, with 1,000+ new hotels
per year for the past few years; it may eventually grow to 50,000+ hotels
• 70% of the 1-3 star hotel market is divided among 8 different companies:

• 7 Days has the potential to become #1 with several roll-up acquisitions and
its continued success with the franchise model

• Company uses the same management and service levels with its franchised
hotels, giving it an advantage over competitors

7 Days Inn – LBO Case Study 2

The Competition
• 7 Days will point to several differentiating factors:
 Membership Program: Over 56 million members, with 98% of online
bookings from members

 IT and Cost Advantage: Superior booking system and online platform,

and lower conversion costs, rent, and staff-to-room:

• Reality: These factors make a difference, but ultimately the company isn’t
THAT much different from other budget hotel chains (not much of a network
effect because customers still shop based on price)

• Its biggest differentiating factor is likely its success with franchises

7 Days Inn – LBO Case Study 3
Growth Opportunities
• Most growth is likely to come from Managed Hotels, especially those in 2nd
and 3rd tier cities:

• L&O hotels will continue to expand modestly, and rising ADRs will offset the
expected drop in Occupancy Rates

7 Days Inn – LBO Case Study 4

Risk Factors
• Occupancy Rates: These have declined substantially,
and continued declines represent a major threat given
7 Days’ high fixed cost base:

• Managed Hotels: Execution may stumble or the company may not be able
to find enough qualified staff, given Chien Lee’s comments:

• Pricing Risk: Expansion into 2nd, 3rd, and 4th tier cities may represent some
risk of falling ADRs

7 Days Inn – LBO Case Study 5

Other Factors
• Management and existing investors will roll over significant % of shares and
own ~51% of NewCo, indicating high degree of confidence in deal:

• Debt used is minimal (1.3x EBITDA), but IRRs and MoM multiples are still
healthy, indicating potential to use more debt or do a recap later on

• We believe the company has approximately 256 million RMB (~$41 million
USD) in excess cash that could be used to fund the deal; currently, less
than 50% of this is used to fund the transaction fees
• Business model shift to Managed Hotels makes for less capital-intensive
company and boosts FCF generation significantly, further supporting
capacity for dividend recap and/or additional debt to fund the deal

7 Days Inn – LBO Case Study 6

Valuation
• Acquisition at $4.60 per share values company at LTM EV / EBITDA of 7.4x
and 1-Year Forward EV / EBITDA of 5.6x
• Very reasonable, even cheap, vs. the public comparables (1-year forward
figures shown below):

• Only 1 relevant precedent transaction of a China-based budget hotel

company, but also significantly lower than that multiple:

7 Days Inn – LBO Case Study 7

Revenue Drivers
• We split revenue into L&O vs. Managed Hotels; key drivers are the # of
hotels, # of rooms per hotel, average Occupancy Rate, and ADR:

7 Days Inn – LBO Case Study 8

Revenue Drivers (Cont’d)
• Managed Hotel segment under our base case assumptions:

7 Days Inn – LBO Case Study 9

Expenses and Cash Flow
• We assume modest increases in operating costs per L&O hotel, along with
substantial decreases in CapEx per hotel due to the franchise model:

7 Days Inn – LBO Case Study 10

Financial Projections

7 Days Inn – LBO Case Study 11

Returns in the Base Case:
• 20% IRR and 2.5x multiple in the base case, with 64% of returns coming
from EBITDA growth:

7 Days Inn – LBO Case Study 12

Why the LBO Math Works
• The company repays its debt very quickly, and its FCF conversion improves
rapidly as it moves to Managed Hotels:

7 Days Inn – LBO Case Study 13

Under Different Assumptions
• The # of new hotels per year and the final number by Year 5 do not make a
huge difference to the 5-year IRR:

• Similarly, even if operating costs per L&O hotel increase by more than
expected, the IRR remains reasonable:

7 Days Inn – LBO Case Study 14

The Numbers, In Short
• The 20% IRR falls to 15% under more pessimistic assumptions, such as
fewer hotels than expected or higher operating costs than expected
• Multiple contraction presents a bigger risk, but given that the deal was done
well below the median EBITDA multiple for both public comps and
precedent transactions, this seems unlikely

• We also believe there’s an opportunity to use more debt or more excess

cash to further enhance returns:

• BUT… the declining Occupancy Rates represent a major, very plausible,

risk factor
7 Days Inn – LBO Case Study 15
The Downside Case
• As shown previously, 7 Days’ Occupancy Rate has fallen substantially in the
past 3 years – and if it’s 5-10% below our expectations in the future, the
deal stops working:

• For reference, here’s what each % differential above corresponds to:

 (5%) Differential: ~71% Year 5 Occupancy Rate

 (10%) Differential: ~67% Year 5 Occupancy Rate

 (15%) Differential: ~63% Year 5 Occupancy Rate

7 Days Inn – LBO Case Study 16

What Are the Real Risks?
• Declining Occupancy Rates: The biggest risk; the entire deal hinges on
whether rates decline to only 75%, or 70%, or 65% by Year 5
• Higher-Than-Expected Operating Costs: Marginal risk next to the
Occupancy Rates – we could offset much of this simply by using more debt
or excess cash in the beginning

• Multiple Contraction: This is a more serious risk, but we don’t think

serious contraction is likely based on the comparables; we could reduce
some of the risk with more debt, a dividend recap, or by acquiring a smaller
stake in the beginning
• Mitigant #1 – More Debt: Each ~10% extra debt adds ~1% to the IRR;
could be helpful for the operating cost risk
• Mitigant #2 – Switch to Managed Hotels More Rapidly: IRR increases to
25-26% in a scenario where the company completely stops building L&O
hotels and makes 100% of new hotels Managed

• Mitigant #3 – Acquire a Smaller Stake: Only helps in extreme downside

cases with negative IRRs
7 Days Inn – LBO Case Study 17
Will Occupancy Rates Fall?
• In the luxury segment, yes, Occupancy Rates were closer to 50-60%:

• But Home Inns, the closest comp, maintained an 80-90% Occupancy Rate
for the past 5 years
• And the regional average for Asia-Pacific was close to 70%, which reflects
lower rates at luxury hotels:

• So we’re skeptical that rates will drop 70%, though the 75-80% range
seems possible

7 Days Inn – LBO Case Study 18

The Worst Case Scenario
• If the average Occupancy Rate really falls to ~60% by Year 5:

• Company has no extra cash in this scenario, and debt actually increases by
the end
• But it did have ~2.0 billion RMB of Net PP&E in its most recent fiscal year…
that might increase to ~3.0 billion RMB by FY 17
• Assets minus Liabilities is also around ~2.8 billion RMB by FY 17 in our
model (unclear what Tangible Assets might be)

• Even if we took one of those approaches and liquidated the company, the
IRR would still be negative but at least we could recover ~75% of the initial
equity contribution (due to the post-deal ownership split)
7 Days Inn – LBO Case Study 19
Conclusions
• We RECOMMEND doing the deal and acquiring 7 Days Inn for $4.60 per
share (LTM EV / EBITDA of 7.4x) in a leveraged buyout transaction
• The valuation is very reasonable, the IRR is ~20% in the base case
scenario, and even under more pessimistic cases it only falls to ~15%

• The fast-growing and highly fragmented market supports the deal, as do the
business model shift to franchising and the high equity rollover %
• The biggest risk is if the Occupancy Rate falls from ~80% to 65-70%, but
this is unlikely given the rates at peer budget hotels and historical trends
• And there are ways to mitigate this risk and other possible risks, such as
higher-than-expected growth in per-hotel operating costs

• Using more debt to fund the deal, doing a dividend recap, using excess
cash, or switching to Managed Hotels completely or more rapidly would all
boost the IRR even in these downside cases

7 Days Inn – LBO Case Study 20