Choice Hotels: Outperforming Its Peers

We are initiating Choice Hotels (CHH) with a BUY rating. Based on its franchise model and presence in the economy and mid-scale space we expect CHH to outperform the lodging group.

INVESTMENT THESIS

• The hotel brands in CHH’s portfolio are predominantly "economy" and "mid-scale" and should marginally benefit as travelers seek out less expensive lodging.
• CHH operates a franchise model, which is less capital intensive than outright property ownership. In a difficult economy this model produces a number of benefits.
• Global footprint provides diversification. Although the current recession is global, a diversified footprint enables the company to benefit as certain areas fare better than others.
• Management is committed to returning capital to shareholders via dividends and share repurchases, both of which help drive value when done at appropriate levels as they have been.
• We find the current valuation attractive and initiating coverage with a BUY rating. Our $28 target is 16.9x our FY:09 GAAP EPS estimate of $1.65. Based on the reasons we will discuss, we believe CHH merits a premium multiple to its peers.

RISKS

• Continued economic weakness weighs heavily on travel, resulting in the proverbial “sinking tide” that affects all boats.
• CHH is reliant on franchisees to maintain the integrity of its brands.

SUMMARY

As the broader market continues to fall we believe investors will be well-served to focus on companies that have quality balance sheets; are outperformers in their industry; and have a competitive advantage. Companies that meet these criteria but have been pulled down along with the broader market, such as CHH, offer investors an opportunity to begin building a position that should pay off handsomely down the road. CHH has a quality balance sheet, especially when compared with its peers; is currently outperforming its peers based on operating statistics such as REVPAR; and has a competitive advantage via its market positioning. These factors, combined with an attractive valuation, lead us to initiate CHH with a BUY rating.

Our thesis on CHH centers on both its franchise model and economy brands. Nearly all consumer-driven industries are currently seeing a trade-down effect as customers seek out more affordable options, whether it be for food or fun. This trend is a function of stretched household and corporate budgets, but is also significantly driven by ever-increasing pessimism regarding what lays around the next corner. Economic indicators such as consumer confidence, personal consumption, and unemployment continue to be negative, prompting further rationing by consumers and thus by the business that serve them.

On the corporate side, there have been several highly-publicized instances where a large, well-known company has cancelled a scheduled corporate event due to public outcry regarding excessive spending. These events were scheduled to take place at upscale resorts in high-profile locations. On a more granular level, everyday “road warriors” such as salesman have an incentive to rethink their lodging expense in the face of declining sales numbers. Our informal poll of salesmen reveals widespread sub-quota performance and nervousness regarding job retention. Given this backdrop, it appears quite logical to conclude that many business travelers will look to demonstrate some cost-saving initiative to their superiors. With respect to leisure travel, we expect to main scenarios to persist. Overall leisure travel is sure to be pressured, but amongst those still travelling, we expect increased gravitation to mid-scale and economy locations. This trade down effect should work to CHH’s favor as it is one of the largest worldwide operators of mid-scale and economy brands.

Lastly, CHH operates a franchise model which we also expect to be a plus in current environment. In addition to lower capital requirements, CHH is able to quickly add locations to its footprint via conversion. As of December 2008, nearly one third of all hotel rooms (1.5 million out of 4.6 million) are independently operated.

Comments

[MichaelSchm...:]

You write that "CHH has a quality balance sheet . . . ." I don't see it that way. CHH's most recent financials showed that the company had, as of December 31, 2008, about $328 million in total assets and about $465 million in total liabilities. Total current assets were about $120 million while total current liabilities were $135 million. In other words, the company is insolvent by most tests for insolvency. The company might have decent revenues and be generating cash for the time being, but a quality balance sheet? It looks pretty ugly to me, which is why I am short.

Mar 13 02:25 PM