By Chad Mollman
Among the global hotel operators we cover, we expect the companies that both manage and franchise hotels to generate the strongest growth and financial performance over the course of the cycle. Managed and franchised hotel operators have sticky, fee-based management and franchise agreements with high switching costs, resulting in well-established economic moats, high margins and returns on invested capital, lower capital expenditure requirements, and less-cyclical financial results. Long term, we expect InterContinental Hotels Group (IHG), Marriott International (MAR), and Starwood Hotels & Resorts (HOT) to generate the strongest financial results in the sector, but before building a position in these stocks, we'd wait for a price pullback leading to a compelling margin of safety; an uptick in employment growth; and reacceleration in industry revenue per available room growth.
Operators that both manage and franchise hotels have greater exposure to emerging markets and stronger unit growth prospects than pure franchisors. While pure franchisors generate higher margins and returns on invested capital, their lack of capability to manage hotels limits their growth prospects internationally. Many large and developing international markets, such as China and India, do not provide a favorable legal environment for hotel franchising. The lack of an adequate supply of hotel managers also limits the ability of pure franchisors to expand internationally. The result is that companies we cover that both manage and franchise hotels have stronger new-hotel pipelines and a greater concentration of emerging-market new hotels in their pipelines. For operators that both manage and franchise hotels, new-room pipelines as a percentage of total existing rooms average 24%, compared with an average of 12.4% for pure franchisors. Starwood and InterContinental in particular are strong in China, which represents approximately 30% of their pipelines.
Because of their stronger pipelines and greater presence in emerging markets, we expect operators in our coverage universe that both manage and franchise hotels to experience faster unit and EBITDA growth the next five years. We project system size (as measured by total rooms) to increase on average 18.2% over the next five years for operators that combine hotel managing and franchising, significantly higher than our outlook for five-year system growth for pure franchisors Choice Hotels International (CHH) (11.6%) and Wyndham Worldwide (WYN) (9.2%). We expect EBITDA to increase at a five-year compound annual growth rate of 9.5% for operators that manage and franchise, compared with an average of 7.3% for pure franchisors.
Hotel Operators That Manage and Franchise Have More-Defensible Moats
Hotel companies that manage and franchise hotels possess narrow economic moats derived primarily from switching costs and brands that reduce search costs for travelers, as well as, to a lesser extent, a network effect. These companies have sticky fee-based management and franchise agreements, typically 10-30 years in duration, which result in high switching costs for hotel owners. If a hotel owner exits a company's system before the end of a contract, it faces a disruption to business operations and significant contract termination fees and expenditures to renovate and re-brand a property to meet new brand specifications. A managed and franchised hotel operator also benefits from a network effect; as the number of travelers (who tend to be brand-loyal and use the company's loyalty program) in its network increases, it attracts more property owners that want to benefit from the significant number of travelers in its network, which in turn attracts more travelers to the network. This massive network scale would be difficult to replicate, absent acquisitions.
In contrast to owned hotels, hotel managers and franchisors do not incur the up-front cost of constructing a hotel and have minimal capital expenditure requirements. Franchisors typically contribute no capital to the construction of a new hotel, with the franchisee funding construction costs, and hotel managers only on occasion contribute capital, in the form of small equity investments or loans, to finance a portion of construction costs. Capital expenditures as a percentage of sales average 5.9% for operators in our lodging coverage universe that primarily manage and franchise hotels, compared with 8.3% for Accor (OTC:ACRFY) and 14% for Hyatt Hotels (H). In addition to driving higher returns on invested capital, the lower capital requirements for companies that manage and franchise hotels enable operators to expand the number of hotels in their networks quicker and more easily as hotel owners provide the capital required for expansion, lessening the need for operators to seek external debt or equity financing.
Because of the high fixed costs associated with the business model, owned hotels are inherently more cyclical than managed and franchised hotels. In the last recession, operating income declined on average by 68% for companies in our lodging coverage universe with ownership-driven models. Choice Hotels, in contrast, experienced only a 15% decline in operating income in 2009. It's important to point out that operating leverage works both ways, and that owned hotels typically perform more strongly in the early stages of a recovery. For instance, Hyatt and Accor increased operating income in 2010 by 39% and 90%, respectively, compared with an average increase of only 21% for the managed and franchised hotel operators we cover.
Managed and franchised hotels benefit from minimal hotel-level expenses; their expenses are mostly centralized, such as expenses for a central reservation system, national advertising programs, and technology support. As a result, operating margins are typically 80% or higher for franchised hotels, 40% or higher for managed hotels, and often below 30% for owned hotels. Returns on invested capital are also significantly higher for managed and franchised hotels, which we attribute to the narrow moats for managed and franchised hotels keeping competition at bay and managed and franchised hotels requiring relatively little capital investment relative to owned hotels. ROICs for operators that primarily manage and franchise hotels average 48.2%, compared with an average of 5.6% for ownership-driven operators.
Lodging operators are strengthening their economic moats through divestitures of owned hotels. This asset-light strategy has helped operators to strengthen their economic moats and also deleverage and return capital to shareholders in the form of increased regular dividends, special dividends, and share repurchases. For example, in 2012 InterContinental announced a $500 million special dividend, prompted by the expected sale of the InterContinental New York Barclay, and Accor's divestiture of Motel 6 enabled the company to reduce its net debt by $1 billion.
Among global lodging operators we cover, Hyatt is the only one that has not pursued a strategy of selling owned hotels and converting owned hotels to management and franchise contracts. In fact, its August 2011 acquisition of LodgeWorks further concentrated its portfolio in owned hotels. Hyatt management has indicated that it has no plans to shift strategy, but we think moving toward an asset-light model could act as a major catalyst for the stock.
We Expect U.S. RevPAR Growth to Decelerate, With Europe Weighing on Results
The critical question for investors at this point is the sustainability of the current lodging recovery. The previous two U.S. lodging upswings lasted five years (2002-07) and nine years (1991-2000), and the current lodging recovery is now close to the four-year mark. In 2013 and 2014, our outlook is for the U.S. lodging recovery to continue, albeit with a moderation in growth of revenue per available room; for Europe to weigh even more on results; and for lodging operators to continue to de-emphasize time-share operations to focus more on hotel management and franchising. While our near-term outlook is for the lodging recovery to continue, the key risks to our near-term outlook include a slowdown in job growth and industry room supply growth materially increasing.
Our current outlook is for the industry to continue its recovery, albeit at a more moderate RevPAR growth rate of 5.4% in 2013 and 4.9% in 2014. Historically low room-supply growth is creating a favorable environment for increased room rates and RevPAR. Supporting our view, real RevPAR in 2012 was still approximately 10% below peak real RevPAR in 2007, and since the 1970s, coming out of each cyclical downturn for the lodging industry, real RevPAR in the subsequent recovery has exceeded the prior real RevPAR peak.
The number of hotel rooms in the U.S. increased only 0.5% in both 2011 and 2012, well below the historical average of 2.6% the past 25 years. Supply growth currently is historically low, as the Great Recession led to tight credit conditions among commercial lenders and weakness in the commercial mortgage-backed security market. In the past 25 years, domestic RevPAR has never declined when industry room supply grew less than 1%.
While we have a positive outlook for the domestic lodging industry, we expect Europe to weigh on results for global hotel operators in 2013 to an even greater extent than in 2012 due to a continuation of increased unemployment in the region. In 2012, RevPAR for the European region increased 4.8% after a 5.8% rise in 2011. Of particular concern is that in 2012, the increase in RevPAR was driven solely by an increase in average daily rates, as occupancy started to decline in the second half of the year and ticked up only 0.1% for the full year. For context, in 2008, a drop in occupancy rates reported during the first part of the year presaged a decline in average daily rates and a double-digit decline in RevPAR in the fourth quarter of 2008.
In our view, unless occupancy rates start to stabilize, operators in Europe will be increasingly challenged to increase RevPAR primarily through room rate increases. Of additional concern, throughout much of 2012, RevPAR growth for Europe was bifurcated, with RevPAR declining in periphery countries, such as Italy and Spain, with the declines offset by strength in the core of Europe. In the fourth quarter, though, occupancy in stronger markets like Germany, France, and the United Kingdom exhibited signs of weakness. Our current outlook is for European RevPAR to increase just 1%-3% in 2013, with downside risk of RevPAR contracting.
Less Emphasis on Time-Shares
Before the Great Recession, lodging operators were focused on building their time-share operations, but the collapse in time-share sales in 2008 and 2009 caused operators to re-examine their strategy. Since then, all of the large lodging operators have succeeded in reducing their exposure to time-share development. Marriott spun off its time-share division in late 2011, and we believe that Starwood, which generated more than 30% of its revenue from its time-share division in 2012, may spin off its time-share division in 2013 or 2014, once it completes the sale of residential properties at the St. Regis Bal Harbour. We view Starwood's time-share division as an unattractive business relative to its managed and franchised hotel operations and think shareholders would benefit from a divestiture or spin-off. The time-share industry is mature, highly cyclical, asset-intensive, and generates significantly lower ROICs than managed and franchised hotel operations.
Wyndham Worldwide, which generates more than 80% of its revenue from time-shares, is currently focused on growing less through capital-intensive time-share development and more through its Wyndham Asset Affiliation Model program, which offers fee-for-service turnkey solutions to other time-share developers, including time-share sales, financing, and property management services.
Risks to Our View
While we expect tepid employment growth and limited supply growth to drive RevPAR higher by the midsingle digits in 2013 and 2014, we think there is downside risk of a slowdown in job growth leading to low-single-digit RevPAR growth (or in our bear case, a decrease in nonfarm payrolls leading to a contraction in RevPAR). Key to our outlook for mid-single-digit RevPAR growth is job growth of approximately 150,000 per month, approximating the average monthly job growth reported in 2011 and 2012.
Also, while supply growth is still well below the historical average, it can shift rather quickly. Industry room supply increased only 0.3% in 2006, but a loosening of credit conditions and lower interest rates led to room supply growth reaching 2.7% in 2008 and 3.2% in 2009. We expect room supply growth to experience an uptick to 0.9% in 2013 and 1.2% in 2014, as new hotel signings have recently picked up, driven by a moderate loosening of credit conditions and a revitalized commercial mortgage-backed security market. CMBS issuance in 2012 increased more than 70% to $48 billion, and CMBS spreads, which were at 400 basis points as recent as September 2011, have recently decreased to below 200 basis points.
We Have a Neutral View of the Sector, Given Full Valuations and Decelerating RevPAR Growth
Since the onset of the lodging recovery in the second quarter of 2009, the Dow Jones U.S. Hotels Index has increased approximately 140%, compared with about a 60% increase in the S&P 500, and we currently view the lodging sector as fairly valued. Global lodging stocks in our coverage universe currently trade at an average price/fair value ratio of 1.1 and at an average current-year enterprise value/EBITDA multiple of 11.8 times, slightly above the 10-year historical average for the sector. We don't view these valuations as compelling. Our overarching concern is that the industry is in the midcycle of a recovery, and RevPAR growth decelerated to 6.8% in 2012 from 8% growth in 2011. Historically, the strongest returns for lodging stocks are generated when RevPAR growth is accelerating, which typically drives operating margins expansion and earnings beats.
Our list of preferred operators to own for the long term includes InterContinental, Starwood, and Marriott, but before taking large positions, we'd wait for a pullback in stock price, leading to a compelling margin of safety; an uptick in employment growth; and a re-acceleration of industry RevPAR growth, which we think would act as positive catalysts for the stocks. Our preferred operators collectively currently trade in line with other operators in our coverage universe, with an average current-year EV/EBITDA multiple of 11.8 times (compared with 11.9 times for other lodging operators in our coverage universe), and Marriott trading at a 7% premium to the industry average EV/EBITDA multiple. In contrast, when we last had 4-star ratings for InterContinental and Starwood, in the fall of 2011 (before both stocks rose more than 50% during the past 15 months), these two firms traded at current-year EV/EBITDA multiples of less than 10 times.
While we do not find valuations particularly compelling at present, we're reluctant to short any of the stocks in the sector, as we think that the lodging stocks we cover can continue to move upward in the near term. Employment growth has continued (albeit at a tepid rate), supply growth remains low, and RevPAR growth in the mid-single digits would drive improved operating margins and earnings per share growth.
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