Hilton's Business 'Flywheel' Will Lead To Above-Average Returns For The Next Decade

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About: Hilton Worldwide Holdings Inc. (HLT)
by: Nealster
Summary

Hilton has a new and improved business model since its restructuring under Blackstone and after the spinoffs of its timeshare business and real estate holdings.

The Hilton business flywheel is a self-reinforcing loop that leads to loyal customers and satisfied owner partners.

Shares should compound over 13% annually over the next decade and beyond.

Although Hilton (HLT) has been around for 100 years, the new and improved version of Hilton available to public market shareholders has a new and improved business model that should provide shareholders above-average returns over the next decade.

Hilton was taken private by Blackstone in 2007 in a leveraged buyout before the financial crisis and then brought back to the public markets via an IPO in 2013. Under Blackstone’s stewardship, much of the real estate owned by Hilton was sold off and the number of hotel rooms in Hilton's franchise system doubled to 900,000. Since the IPO, Hilton has spun off a bulk of its real estate holdings and its timeshare business into two separate publicly traded companies. After the restructuring of Hilton's portfolio by Blackstone and the two spin-offs, the current Hilton is an asset-light hotel brand management company that has excellent economics.

The "flywheel" for Hilton's business and economic returns is summarized nicely by the following slide from the company's recent investor presentation. 1) Leading hotel brands serving virtually any lodging needed anywhere lead to 2) Satisfied Loyal Customers, which lead to 3) Premium, Growing Market Share, which leads to 4) Satisfied Owners, which leads to 5) Leading Hotel Supply & Pipeline, which leads to 6) Hilton's Financial Performance.

Hilton's brand and network are the glue that holds this flywheel together. The company owns very little of its own real estate but provides services and intellectual property to hotel owners in its network. Hilton provides hotel owners with the brand name, reservations systems, shared technology such as the Hilton app, standard operating procedures, and access to loyalty members. The company then gets paid growing franchise and management fees by hotel owners for the intangibles that it provides.

Hilton has two major types of business relationships with hotel owners. For the full-service and luxury hotels, it typically has a management agreement by which it fully operates the hotel and gets paid management fees based on the revenues and profits of the managed hotel. For some brands like Hilton Garden Inn and Hampton, the company franchises the hotel name and know-how to the owner-operator, who operates the hotel according to Hilton's chain standards. Franchising is a very profitable, asset-light business model, if managed correctly. Through this model of collecting management and franchise fees instead of owning the real estate, Hilton can grow its network quickly without having to contribute too much capital.

Hilton owns some of the best brands in the hotel business, including Hilton, Doubletree, Embassy Suites and Waldorf Astoria. These brands command a pricing premium over similarly situated hotels. Currently, the Hilton system has over 5600 properties and over 913,000 rooms in 113 countries and territories. As of December 31, 2018, it had 689 managed hotels and 4,874 franchised hotels consisting of 882,873 total rooms. As of December 31, 2018, Hilton wholly owned or leased 62 hotels and jointly owned or leased 9 properties comprising of 21,720 rooms.

The strong brands in the its portfolio lead to satisfied and loyal customers. The company's loyalty program, "Hilton Honors," has increased from 36 million members in 2013 to 85 million members in 2018. Out of all bookings at the company's properties, Hilton Honors members account for 60%. The loyal members in the Hilton system lead to increased profits for its properties and their owners, as most of these members book direct with Hilton and cut out fees charged by online travel agencies such as Booking.com. As the number and activity of Hilton loyalty customers increases, hotel owners increasingly want to be part of the company network. This is a virtuous cycle that is increasingly powerful for both loyalty members and hotel owners as the network size increases.

As the power of the company's brand and network grows, Hilton's fee-based business grows with it. As the slide below shows, Hilton's management and franchise fees have grown 11% annually from 2009 through 2018. Franchise fees make up 70% of its business, and the rates on those franchise fees are set to increase from 4.9% currently to 5.6% as contracts roll over to current rates.

Another powerful aspect of the Hilton business model is the capital-efficient growth opportunity. The company only has to invest a fraction of the money required to build new hotels, since property owners and their banks have to put up most of the cost associated with new development. It then gets to charge recurring franchise and management fees on the hotel owner's real estate for use of Hilton intellectual property.

In addition to its current hotel portfolio, Hilton is focused on growth by expanding share in the global hospitality industry through its development pipeline. As of December 31, 2018, Hilton had more than 2,400 hotels in its development pipeline, representing over 364,000 rooms under construction or approved for development throughout 103 countries and territories, including 35 countries and territories where the company does not currently have any open hotels. All of the rooms in the development pipeline will be managed or franchised. Additionally, 195,000 rooms in the development pipeline were located outside the U.S., and 184,000 rooms in the development pipeline, or more than half, were under construction. The slide below demonstrates the growth potential in Hilton's development pipeline. The company is growing its network much faster than its peers. Even though Hilton only has 5% of the world's hotels in its current system, its pipeline includes 20% of all rooms under construction worldwide. To put that in perspective, 1 out of 5 hotel rooms in the world under construction today will be placed in the Hilton network, at very little cost to the company itself.

Hilton currently has a market cap of $24.5 billion and had $763 million in earnings in 2018, for a trailing P/E ratio of 32. The company is projecting 2019 net income to be between $895 million and $931 million, for a forward P/E ratio of 26.8. This valuation may seem steep compared to the market, but Hilton is a superior business that can both return cash to shareholders via dividends and share repurchases and grow revenues organically with little capital investment. In 2018, it repurchased 23.5 million shares of its common stock, bringing total capital return, including dividends, to approximately $1.9 billion for the full year. This cash return was over 7.7% of the total market cap of the company. In 2019, Hilton expects capital return to be between $1.3 billion and $1.8 billion, which would be a cash return of between 5.3% and 7.3%. Analysts expect the company to increase its earnings per share by more than 17% annually over the next 5 years. Even with some decrease in valuation, Hilton shares should be able to compound at over 13% per year over the next decade.

There are a few additional points to consider when considering Hilton as an attractive long-term investment for the next decade. First, the company was named the best place for employees to work in Fortune's annual rankings. This is a testament to the culture fostered by current CEO, Chris Nassetta, who has ranked highly on Glassdoor.com with a 93% approval rating. Second, Chris Nassetta owns approximately $250 million in Hilton stock and has said that he has not sold a single share. This sounds like the kind of CEO that you can trust to take care of the business in the longer term.

In conclusion, Hilton is a world-class brand and has a great business model that will provide attractive shareholder returns over the next decade and beyond as its network expands worldwide. Increasing the hotel network size and the loyalty member size over time will lead to a self-reinforcing loop of profitability for hotel owners and HLT shareholders.

Disclosure: I am/we are long HLT. 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.