Recessions are difficult for any consumer-related industry to overcome, but the travel and hotel segment is always particularly affected by budget cuts. Nevertheless, with a 20% boost of the domestic revenue per available room, the lodging industry is well on the recovery road, with several large companies leading the way. Investment guru Pioneer Investments (Trades, Portfolio) recently bought almost 80,000 shares of InterContinental Hotels Group PLC (NYSE:IHG), the world’s largest hotel owner, franchiser and manager, with over 4,500 hotels in 100 countries. But let’s see what really makes this company a solid long-term investment.
A Majority Franchised System
This company is known for its famous midscale brands Holiday Inn and Holiday Inn Express, as well as the upscale hotels InterContinental and Crowne Plaza. The interesting factor, however, is the high rate of franchised and managed hotels among these brands, compared to industry rivals Hyatt Hotels Corporation (NYSE:H) or Starwood Hotels & Resorts Worldwide Inc. (NYSE:HOT). With more than 99% franchised or managed hotels in the InterContinental system, this company profits from excessive operating margins of 33.2% (the industry average is 8.70%) and minimal capital expenditures.
Additionally, the typical 10 to 30-year contracts for hotel franchises create high switching costs for property owners, while simultaneously generating high returns on invested capital. Since 2010, for example, InterContinental has averaged a 29% return on capital, and currently reports a 57.8% return, all due to the firm’s asset-light strategy of selling owned hotels and converting them to management or franchising contracts. The latest transaction of the InterContinental New York Barclay, for example, sold at $300 million, was a well strung deal for the company, which will maintain a 20% ownership in the property, as well as manage the hotel for the next 30 years. This transaction is bound to boost free cash flow, as well as revenue growth, which has been somewhat stagnant throughout fiscal 2013 (4.0%).
One of InterContinental’s key growth segments is its international business. Since 1984, this company has been taking advantage of the underpenetrated Chinese market, and today this hotel operator holds the best infrastructure to grow and expand its brand presence in the country. With an estimated 50,000 rooms in its new Chinese hotel pipeline, representing 90% of the firm’s total existing rooms in Asia, the company will enjoy a solid 15% annual unit growth in China over the next several years. Also, the current 10% revenue income generated by this nation will reach 25% by 2021 making InterContinental the best represented U.S. lodging company in Asia.
Fiscal 2014 is looking promising for this hotel operator, with a forecasted increase of room numbers by 3.1% annually until 2022, in addition to boosts in revenue per room over several continents. America is expected to deliver 5.3% annual growth, Europe 4.4% and China 8.4%, as the economy in these regions recover and travel spending continues to surge. Although this lodging firm remains vulnerable to the risks of a recession, which led to revenue declines of 14% from 2007 to 2009, I believe the almost integrally franchised business model will be able to sustain profits in the long term. Furthermore, with the stock currently trading at a 35% price discount relative to the industry average of 22.60x, and the 2.04% dividend yield should be appealing to investors.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.