The lodging industry is characterized by three differing business models that each company utilizes independently or in conjunction: ownership, franchising, management (hybrid). From Choice Hotels’ (CHH) 2009 10-k:
Ownership requires a substantial capital commitment and involves the most risk but offers high returns due to the owner’s ability to influence margins by driving RevPAR (Revenue per Available Room = Average Daily Room Rate, or ADR x Average Occupancy Rate) and managing operating expenses. The ownership model has a high fixed-cost structure that results in a high degree of financial leverage. As a result, profits escalate rapidly in a lodging up-cycle but erode quickly in a downturn as costs rarely fall as fast as revenue. Profits from an ownership model increase at a greater rate from RevPAR growth attributable to average daily rate growth than from occupancy gains since there are more incremental costs associated with higher guest volumes compared to higher pricing.
Franchisors license their brands to a hotel owner, giving the hotel the right to use the brand name, logo, operating practices, and reservations systems in exchange for a fee and an agreement to operate the hotel in accordance with the brand standards. Under a typical franchise agreement, the hotel pays the franchisor an initial fee, a percentage-of-revenue royalty fee and a marketing/reservation reimbursement. A franchisor’s revenues are dependent on the number of rooms in its system and the top-line performance of those hotels. Earnings drivers include RevPAR increases, unit growth and effective royalty rate improvement. Franchisors enjoy significant operating leverage in their business model since it costs little to add a new hotel franchise to an existing system. Franchisors normally benefit from higher industry supply growth, because the benefits of unit growth usually outweigh lower RevPAR resulting from excess supply. As a result, franchisors benefit from both RevPAR growth and supply increases which aids in reducing the impact of lodging industry economic cycles.
Management companies operate hotels for owners that do not have the expertise and/or the desire to self-manage. These companies collect management fees predominately based on revenues earned and/or profits generated. Similar to franchising activities, the key drivers of revenue based management fees are RevPAR and unit growth and similar to ownership activities, profit based fees are driven by improved hotel margins and RevPAR growth.
The difference boils down to ownership vs. non-ownership (franchising & management model) of the underlying properties. Ownership models outperform where RevPAR grows as a result of high operating and financial leverage. Of course, the knife cuts both ways, so in a declining RevPAR situation, the ownership model will underperform. Franchisors, on the other hand, perform well both where RevPAR grows and where the number of units increases, as a result of low marginal costs (on RevPAR growth alone, we would expect ownership models to outperform, since franchisors only participate in RevPAR growth to the extent of the royalty increase).
The United States’ lodging industry (which comprises approximately 30% of the worldwide hotel industry by units) has been hit particularly hard by the recession and consequent reduction in travel. RevPAR declined both as a result of declines in the ADR and Occupancy Rate. Operators engaged in expense reduction programs, but many also decreased ADRs by significant amounts in order to stabilize occupancy (ADR declined by 8.8% from 2008 to 2009). So far, 2010 has shown improvement, though the industry is far from its 2007 figures.
The recovery in RevPAR will, as we learned above, produce the greatest positive impact on companies following the ownership model. This presents a problem for value investors, as the ownership model often involves high levels of financial leverage which introduces a riskiness that most value investors shy away from. The alternative, investing in a franchisor, can be a welcome compromise with low debt but upside related to industry recovery. Unfortunately, from my research thus far, it appears that a pure franchisor with low levels of debt does not exist, with many franchisors highly levered from past acquisitions (some with negative equity resulting from subsequent write-downs of the same acquisitions – a red flag for value investors).
Disclosure: At publication, the author does not have a position in the securities of this company.