Investing In The Travel Industry: Aggregators Or Hotel Chains?

Includes: EXPE, IHG, MAR, PCLN
by: Drew Handy

The hotel industry in the United States is competitive but has grown consistently over the past decade. There are many industry trends to like: the number of room nights (a traditional metric in the hotel industry that identifies the number of revenue-generating nights stayed in hotel rooms) continues to rise, the weak United States dollar makes U.S. hotel properties more attractive to foreign demand, and low interest rates have enabled debt-laden hotel firms to recapitalize their debt or issue new debt for remodels and additional units. However, the hotel industry in the United States is highly competitive and fragmented, with a large number of players competing in every market for consumers' dollars.

Since 2001, Hotels in the United States have grown in revenue from $103.5 billion in 2001 to $137.5 billion in 2011, which represents annual growth of 3.2%. However, competition has risen, causing hotels to lose 100 basis points of gross margin during that same time frame, falling from 37.1% to 36.1%. Although a major player in the United States hotel market, Hilton Group, was purchased by Blackstone (NYSE:BX) in 2007, there are a number of other equity investments that investors can make to gain exposure to the space.

Intercontinental Hotels Group (NYSE:IHG), which operates its namesake brand in addition to Holiday Inn, is the largest hotel operator in the United States in terms of number of properties, with 4,400 hotels. Their struggles at raising revenue, with revenue gains of 13% from FY '09 to FY '11, reflect the shift toward luxury offerings. IHG has a sizeable dividend payout amounting to a 3.2% dividend.

The largest public hotel operator in the United States in terms of market capitalization is Marriott (NYSE:MAR), which has over 3,000 hotels (owned or licensed) and a market capitalization of $12.8 billion. Marriott saw 13% revenue growth from FY '09 to FY '11 and pays a 1.3% dividend.

The second-largest publicly traded hotel company by market capitalization and the most active firm in developing properties is Starwood (HOT), which operates just over 1,000 hotels, a $10.3 billion market capitalization, and a 1% dividend yield. Starwood's properties, which include St. Regis, W, Westin, and The Luxury Collection, skew toward the luxury segment relative to Marriott. Starwood saw 21% of revenue growth from FY '09 to FY '11.

Travel aggregators purchase rooms in bulk from hotel operators and then provide a share of that discount by offering consumers low prices for hotel (and other aspects of travel such as flights and car rentals) stays. The spread between what the aggregator paid for the rooms and what consumers pay the aggregator is the basis for their profit. The most popular travel aggregators in the United States are Priceline (NASDAQ:PCLN) and Expedia (NASDAQ:EXPE).

Should an investor wishing to take advantage of the increase in travel demand and weak dollar purchase stock in a hotel company or travel aggregator?

Some of the best performers in the travel industry have been travel aggregators such as Priceline and Expedia in terms of share price gains and growth in revenues and profit. Much of the decrease in hotel margins is due to extensive use of travel aggregators by consumers. PCLN grew 87% in terms of revenue from FY '09 to FY '11 while EXPD grew by 26% during the same period.

When determining whether to invest in the hotels or the aggregators, hotel investors must first consider that the number of middle-market hotels in the United States satisfies or oversupplies demand in many markets around the country. Second, any future increase in interest rates and an economic recovery is likely to hurt the cost side of the income statement for hotel chains. Third, hotels depreciate significantly over time and require consistent remodeling and refreshing. This is extremely expensive, and requires continual access to credit facilities, which can put a drain on corporate finances in the industry.

There are, however, a number of positive elements supporting equity investment in hotels. A sustained economic recovery is likely to help hotels immensely, particularly those at the high end of the market, if business travel and convention businesses pick up. Business travel and conventions have become increasingly important to hotels due to the higher margins and lower level of discounting associated with them.

Another case for investing in hotel chains (this is particularly true in the long run) is that the major chains have acquired large and valuable holdings of land across the United States. Over the long run, as the amortization of debt on these holdings runs its course, these firms could be in a position to capitalize on these assets and generate large returns. This could also put them in a position to dramatically increase dividend rates relative to what is seen today in the industry and return significant levels of cash to shareholders. Finally, many brands have been slow to expand their holdings worldwide and no brands are anywhere near saturation of global markets, even in regions like Europe. Therefore, global market expansion opportunities abound for many firms in the industry.

On the other hand, travel aggregators are able to capitalize on secular growth in travel but have far lower cost structures. They also benefit from diversified earnings streams due to their offerings of other travel services. Because of this, they have experienced explosive growth in share prices, with PCLN rising threefold and Expedia nearly doubling (after accounting for the December 2011 spinoff of Tripadvisor (NASDAQ:TRIP)) over just the past two years. Travel aggregators also benefit from requiring relatively little fixed investment. Although they generate gains in the form of higher prices from the construction and redevelopment of hotels without facing any capital expenditures related to those developments. Despite their fast growth, they are still gaining new customers.

However, the pace of new customer growth for aggregators is likely to slow in the coming years, at which point market share could cause the firms to have to reduce margins as they shift toward competing with each other on the basis of price. Further, it remains to be seen if barriers to entry are an issue. Many analysts have expressed concern about the potential for future competition either from the hotels themselves or other aggregators entering the market.

Ultimately, the appetite for risk and timeframe should separate the hotel investor from the travel aggregator investor. Aggregators have massive scale economies that have enabled them to grow rapidly, while hotel operators are saddled with debt and limited domestic opportunities, yet have extensive real estate holdings and foreign market development opportunities. The secular trend of increased travel, both domestically and globally, is highly likely to reward both groups of investors handsomely.

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

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