The hotels and resorts industry has benefited from a confluence of factors that have driven sales and revenues higher over the past five years. Rising incomes, increased travel spending, and falling oil prices have bolstered demand while new capacity additions failed to keep pace, allowing for healthy RevPAR growth for most operators. Low interest rates have been a tailwind on both the supply and demand sides. According to IBISWorld, US hotels and resorts revenues grew twice as fast as the US economy between 2011 and 2016, as the number of trips taken by US residents compounded 2% annually. The sector's above-average performance is no surprise as the travel industry is highly cyclical. But it is for this reason that we have grown bearish on the sector, particularly for operators in the US where the data continues to suggest that we are heading for a slowdown, if not an outright recession. One of the sector's most exposed players is Hyatt (NYSE:H), which generates 80% of its revenues in the US. The company runs a fundamentally inferior (and riskier) business compared to its peers of similar size, but trades at a much loftier valuation. The price is not justified, and an overdue correction is in the cards.
Hyatt derives approximately half its revenues from owned and leased hotels, which prevents the firm from being as profitable as its peers that generate a greater portion of sales through fee-based managed and franchised properties. Owning and leasing is more capital intensive and earns lower margins compared to managing and franchising. Managing and franchising provides recurring revenue streams through long-term contracts (typically 20-40 years) that owners are more hesitant to terminate because it is costly to "renovate and rebrand a property to meet new specifications" (Analyst Morningstar Report). This raises switch costs and gives firms operating under such agreements some pricing power. The combination of higher margins and lower capital requirements leads to significantly higher returns on capital compared to owning and leasing. Consequently, Hyatt's five-year median operating margin of 5.6% is substantially lower than the industry average of 9.2% (which includes a number of smaller and less recognized chains). Hyatt's most comparable competitors have operating margins in the low 20s. The company has averaged an ROIC of just 3.1% over the past five years, well below the cost of capital.
Not only is Hyatt less profitable than its peers, but it is also more risky. The inherent cyclicality of the travel industry means that all operators are exposed to economic downturns, but the significant operating leverage that results from an asset-heavy ownership model creates additional operating risk. When sales decline, earnings fall at a faster pace due to high fixed costs that cannot immediately be slashed. Hyatt's beta of 1.42 implies high market sensitivity that reflects the underlying risk in its business model. The company's peers, more asset-light peers, have an average beta of 1.31.
Despite inferior profitability and higher risk, Hyatt trades at a premium to its peers. The company trades at a trailing P/E of 50 and a forward P/E of 31 compared to an industry average trailing P/E of an 18.6 and peer average forward P/E of 21.5. Many companies were left out of this calculation due to expected losses in 2016, making their price multiples irrelevant. The valuation is not justified, especially when you factor in Hyatt's lower growth profile. The company has averaged annual sales growth of just 4.2% compared to the industry average of 10.8%. This again is a product of the firm's ownership model, which makes it more difficult to raise prices.
Management's strategy of adding more managed and franchised hotels to its network is a step in the right direction, but it will not provide the type of earnings growth implied in Hyatt's current valuation. A greater portion of hotels under fee-based agreements will help expand margins, but outright ownership will continue to be a core part of Hyatt's business model according to management. The company's existing hotel base is up 9% year over year, and the majority of new hotels operate under managed and franchise models. Operating margin in the latest quarter was 6.24% compared to 5.6%, and while management would like to attribute the improvement to a shifting business model, inflation (organic RevPAR increased 2.2% in Q1) and higher operating leverage also played a role. Hyatt expects to open a record 60 new hotels in 2016, most of them under fee-based contracts, and while we do see a path to higher profitability, we doubt margins will reach the industry average any time soon.
The margin expansion story is only feasible if demand remains strong. But we think the US is headed towards a long-overdue downturn. Business profits are deteriorating, and rising oil prices will cut into consumer budgets and put a damper on travel plans. Hyatt is more exposed than most to cyclical swings, and its stock price does not reflect this risk. Nor does it reflect the firm's fundamentally inferior business compared to peers. The market is too enamored with the margin expansion story, and too optimistic of long-term tailwinds such as rising emerging market incomes and increased tourism, to see the short-term headwinds. Hyatt's stock has a long way to fall. Based on the consensus EPS estimate of $1.40 and a peer average P/E, Hyatt is overvalued by almost 25%.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in H over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.