Budget chain easyHotel (LSE: EZH) has evidently been taking notes from its rapidly expanding sister company easyJet as the hotel group is adding new hotels in the UK and overseas left, right and centre. But despite a very attractive growth story, I'll be steering well clear of easyHotel's shares because the company is looking increasingly risky to me.
My first worry is simply the fact that the company exists in a highly cyclical industry that appears to be reaching its peak if it hasn't already done so. This puts it in a relatively vulnerable position as unlike larger competitors, such as Intercontinental Hotels Group, it does not have the balance sheet to withstand a prolonged downturn while still growing its brand.
At the end of March the company had £36.31m in cash, which at first glance looks great for a company with £3.14m in revenue in H1. Yet, this figure is flattered by a rights issue in September that raised £38m at the cost of expanding the amount of shares in issue by a whopping 60%.
And current cash reserves won't last the company very long as it invested a full £18m in purchasing land and hotels in the six months to March alone. The company also can't rely on its business for cash to fund expansion because operations only generated £0.63m in net cash in H1.
And while the company is profitable, it is barely so. Pre-tax profits in H1 more than halved year-on-year to a meagre £60k as costs related to hotel openings ramped up and margins decreased due to increased back office expenses as a percentage of sales. With its shares astronomically valued at 136 times forward earnings, very low operating margins of 3.4%, continued expensive expansion plans and a cyclical industry I'll be avoiding easyHotel at this point in time.
Will big investments pay off?
Another growth share that makes me nervous is discount alcohol emporium Majestic Wine (LSE: WINE). The company has run into troubles of late, with earnings per share dropping in each of the past two years as it embarked on ambitious acquisitions and invested heavily in attracting new customers at home and overseas.
Analysts are forecasting a further 39% fall in earnings for the year to September and, if anything, these estimates look conservative as adjusted earnings per share in H1 fell from 8.8p to 0.7p year-on-year. Much of the blame for falling profits is due to the company investing in logistics, marketing and discounting to attract new customers. But it remains to be seen whether these new customers, particularly online ones in the US, will ever prove to be a sustainable source of profits.
The company is right to invest as it is in future growth but with its shares priced at a full 31 times forward earnings there is little room failure. At this point the company's lofty valuation, falling profits and rising debt are enough to put me off until there are more concrete signs that turnaround plans are paying off.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.