Choice Hotels: Why You May Want to Check In to This Stock

May.19.11 | About: Choice Hotels (CHH)
Investment Thesis
My positive investment thesis on Choice Hotels (NYSE:CHH) focuses on the likely near term improvement in the four key areas that have contributed to the stock’s recent weakness:
  1. RevPAR growth;
  2. SG&A trends;
  3. domestic unit growth; and
  4. share repurchases.

Over the next year, as the environment becomes more conducive to expansion, the lodging up-cycle favors moderately priced chain scales like Choice, with the ability to quickly add capacity.

RevPAR Held Back by Stubborn Pricing
System wide occupancy has risen solidly, to 42% from 40.1% in the prior year’s Q1. However, given CHH's franchised-based model, which makes little distinction between price and occupancy, the company may need to become more price competitive if occupancy gains are to remain the growth engine in an environment where unit growth is weak.
Overall RevPAR at only around 5% to start the year suggests growth that slightly lags the industry, especially in the mid-scale category. Within this segment, brands like Quality and Clarion may need to be more aggressive on room rates, since it appears franchisees have underspent rivals like Ramada on marketing or Holiday Inn - in its final stages of a system wide revamp.
Meanwhile, Comfort’s overall RevPAR growth remains modest due to firm pricing at the hotel level. It is important to allow for room rate increases to keep cash flows attractive for owners of these flagship brands. However, Comfort (Inns and Suites) can ill afford to lose guests at these chains, which combined account for about 40% of the company’s royalties, even as a number of units have left the system.
Choice’s units in mid-scale without F&B, the largest chain scale category, have been susceptible to competition from the economy segment below it. Occupancy, as well as rates, are stagnating at brands like Sleep Inn, such that its rooms are now priced in competition with the economy segment (starting at $65 a night). Rival Wyndham (NYSE:WYN), the largest in the economy category, has increased rates to around this $65 threshold at its budget properties, like Days Inn and Travelodge, while becoming more promotional at the corporate level to fill rooms at these higher prices.

A sizable drop in the stock since Q1 results is likely to have refocused management, which is heavily incentivized toward growth, and CHH's controlling family. Meanwhile, broader trends favor more favorable growth going forward.

Occupancy industry wide within mid-scale is now trending toward 2008 levels, (i.e., before the lodging downturn), which should ease competition, further supporting overall RevPAR gains. Meanwhile, broader trends, like gas price increases – which have leveled off – and higher employment levels, should help the key mid-scale category outpace Choice’s 4% overall RevPAR growth goal in 2011.
SG&A Impact from Stock Bonuses
SG&A is the only P&L expense that management directly controls. As reward for bringing operating profits within reach of pre-crisis levels, the company paid out an abnormally large $4.5 million in Q1 stock compensation, causing overhead to rise 40 bp’s, its first increase since 2009.
Absent this signifiicant (non-cash) stock payout, SG&A would have fallen more than 100 bp’s. Recent underperformance – in terms of growth and shareholder returns – should limit future payouts. Assuming RevPAR growth of about 5% in 2011, CHH should deliver SG&A declines of at least 50 bp’s for the remaining three quarters, making management’s recent profit guidance ($1.73 - $1.75 EPS) conservative.
Modest Unit Growth Could Spur Acquisition
Q1 2011 was the first quarter in which domestic unit growth had declined in at least five years. Brands dependent on new-builds, such as Comfort Inn, Comfort Suites and Cambria, continue to face a weak construction-lending environment, while the pipeline for conversion brands, like Quality Inn, is trending downward.
To be fair, key rivals Intercontinental (NYSE:IHG) and Wyndham, like Choice, have modestly reduced their room counts. However, the broader unit growth outlook appears to be improving as the upcycle has entered its second year.
Although CHH should do better than the flat unit growth it recently guided, external growth could be a game changer. Having reduced net debt ($184 million in March 2011) to around the full year EBITDA level, Choice is now better positioned to boost internal franchise lending or to fund an acquisition. For more than a year, management has talked about purchasing a brand in the upscale or upper upscale segment, where its only 5,500 rooms of Cambria Suites and Ascend leave it under-represented.
At the same time, large hotels owners/operators within higher end categories, like Blackstone’s Hilton (owner of Embassy Suites – the largest US upscale chain) and Strategic Hotels (NYSE:BEE), are heavily leveraged. A disproportionate amount of debt maturing in 2011, and 2012, at each could prompt divestitures in these categories performing the best. Although deal valuations in the space reflect higher-end hotels’ favorable economics, investors should welcome any purchase.
Share Repurchases
Buybacks have historically been a key element to CHH’s shareholder returns. But since the stock rose above $35 in early 2010, CHH’s share count has flat-lined, with buybacks about offsetting option-related issuances.
Three arguments for buybacks starting up again:
  1. 2011 capital spending, seen at $10 million in 2011 and 2012, is trending at less than half of the 2010 level;
  2. net debt has been reduced by $44 million since Q1 2010; and
  3. The stock’s P/E of <19x (my 2011 estimate of $1.90) is at its lowest level since 2007.

Unless the company is preparing for a costly strategic event (i.e., acquisition), as mentioned above, share repurchases should markedly accelerate. (Please see cash flows and share buy backs assumed in table below).

Depreciation and amortization
Capital expenditures
Working capital
Free cash flow (full capex)
Purchase of treasury stock
Dividends paid
Decrease (increase) in net debt
Click to enlarge
Steady profit growth, along with industry leading margins and returns on investment support CHH’s firm valuation. On my 2011 EBITDA forecast of $185 million I apply a 15.5X multiple, a slight discount to where it traded in 2004-5, the early part of the past upcycle. The resulting $46 price objective is confirmed by a discounted cash flow that uses an 8% cost of capital and 13% growth from 2010-2015 and growth of 4% after year five.
Business Summary
Choice Hotels International is a hotel franchisor with nearly 500,000 rooms throughout its system. Operations at its more than 100,000 international rooms, conducted through master franchising agreements, contribute less than 10% of revenues. Its franchise fee based business model places a premium on unit growth and royalty rate, currently around 4.3% overall. With a focus on mid-scale ($65-95 room rates) and economy (<$65), CHH’s main hotel brands include Comfort Inn, Econo Lodge, Quality, Sleep Inn, and Rodeway Inn.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.