All in all, the U.S. economy has a lot of bearing on hoteliers. A strengthening GDP has the ability to drive hotel stays higher in 2014. Couple this with a number of internal initiatives to revamp its brand and you have Choice Hotels (CHH) continuing its recent trend of solid quarterly earnings and potentially getting back to all-time highs of above $60.
Choice continues to operate a suite of bargain brand hotels, with names that include Comfort Inn and Comfort Suites, however, one of the interesting aspects is the company's traction in the higher-end market.
In the hotel industry, either you own hotels or franchise them. Choice is a franchisor. This gives the company impressive operating leverage, generate impressive returns for investors. Part of what drives a franchisor's revenues is the number of hotels in the market place. 4Q new construction hotel franchise agreements were up 13%. A good sign for future revenues.
As well, Choice is seeing very strong conversion rates, with domestic conversion franchise sales up 14% for 2013. All in all, full year 2013 franchising revenues were up 5%, with a RevPar increase of 3% in the domestic market and 2% increase in the number of franchised hotels.
Refresh the brand, refresh the name
Comfort Inn and Comfort Suites should remain industry staples, which is thanks to the company's rebranding, labeled Comfort Re-Imagined. This movement has helped better bill Comfort as an "upper mid-scale" brand. Choice is also incentivizing its franchisees to revamp their locations. The move is paying dividends, as many hotel owners are investing much more than the incentives in their properties.
Granted the Comfort Inn, and its other brands, are somewhat iconic brands, innovation is quickly becoming one of the key drivers for the industry. Driving traffic means giving hotel goers a unique and low hassle experience.
Branching out and branching up with new brands
Another way Choice is both expanding its geographical reach and strengthening its brand is with its Ascend Collection, the fastest-growing brand in its portfolio. Ascend is a unique opportunity that focuses on historic and boutique properties. The move gives Choice a much needed boost in the upscale segment.
During 2013, the number of hotels in the Ascend Collection grew by 71%, bringing the total to 123. These hotels are performing nicely, which is a big positive for the other upper tier brand its launching, Cambria.
The Cambria brand is showing growth as the new construction environment continues to improve. Cambria is seeing new deals with institutional investors and new hotel openings. The cost to build an economy hotel is almost the same as a mid-tier hotel. So, construction is going toward the upper end of the market. Choice plans to launch 24 Cambria Suites hotels in 2014, while having another 30 under construction by year-end.
Innovation is alive and well in lodging
With the help of technology innovation, Choice developed a new hotel management system, SkyTouch. It's now bringing that to that masses via SkyTouch Hotel OS. The model of SkyTouch is quite simple and intuitive. The cloud based service can help streamline check-ins and ultimately save money for hotel operators.
Choice already has an installed base of over 5,550 using SkyTouch. The segment is generating some $30 million in revenue for the company and the goal for 2014 will be customer acquisition to further drive revenues higher.
SkyTouch is also developing a system for tablet computers and smartphones. I think we'll eventually get to the level of checking in hotel guests with handheld devices. Choice is at the forefront of this trend. Another interesting aspect is using smartphones as room keys. Everyone has lost their hotel key, locked it in the room, or have had it not work. Overall, they are a pain. Our cellphones are something we never forget.
And there's a number of different ways that Choice can monetize SkyTouch. One is spinning SkyTouch off as a an independent company or selling it off. Choice has also launched its first iPhone app, while having launched Rapid Book for mobile booking last year.
Revenue and margin expansion should come with higher royalty rates
Some of the long-term investments the company has made that have temporarily hurt the bottom line include its incentive program related to upgrading properties and discounts for new hotel constructions.
I'd look for the incentive program to taper off in 2014 as the company reaches its re-branding goal, leading to more flow through to the bottom line by boosting its effective domestic royalty rate. As well, the lower royalty rates initially offered for hotel new builds will burnoff over time.
Getting comfortable with the valuation
On the surface, its stock is certainly not a bargain. Despite the volatility, the stock is still up over 20% in the last six months and trades above 25x earnings. The beauty of Choice's business model is that it is less capital intensive. As a result, its return on investment is upwards of 50%. That's what many investors are paying a premium for. As well, Choice is head-and-shoulders above other operators in terms of margins.
The forward dividend yield isn't spectacular at 1.5%, but it's merely a part of the company's robust plan to reward shareholders. The company is very resilient when it comes to recycling capital. Throughout the company's history, it has distributed more to shareholders than it's made. Choice has raked in $1.5 billion over the years, while distributing $1.6 billion.
The free cash flow margins for the business are quite impressive and should remain around 20% as new brands come online. The long-term revenue growth rate should remain fairly strong, historically around 6.5%. Assuming an annual free cash flow growth rate of 5%, coupled with a 10% discount rate, suggests fair value of nearly $60.
Insiders own over 50% of the company. I'm encouraged by the progress the company's SkyTouch tech is making and the opportunities for monetization there. As the market rebounds, and hotel lending standards continue to loosen, there should also be a level of increased buying up of independent hotels with the intention of rebranding. All in all, Choice is a solid play on the rebounding economy. I believe Mr. Market is placing too much emphasis on Choice's multiples and overlooking its ability to grow cash flow over the long-term, setting the company up for market beating returns over the next few years.