The lodging industry is characterized by its cyclical nature, thereby subject to spending cuts during an economic downturn. In this scenario, franchised business models, like those of Hyatt Hotels Corporation (H) or Marriott International Inc. (MAR), tend to suffer less under a recession, although credit conditions can make it more difficult to finance new properties. Choice Hotels International Inc. (CHH) is one of the largest hotel companies in the U.S., and also one of the few purely franchised operations in the midscale and economy segment of this industry. As such, its high ROIC model is attractive to prominent investors like Jim Simons (Trades, Portfolio) and Murray Stahl (Trades, Portfolio), who recently added company shares to their portfolio. But will this hotel operator’s profitability continue going forward?
A Pure Franchisor
Choice Hotels account for 8% of all hotel rooms in the domestic market, spread out amongst the company’s many brands, including Comfort Inn, Quality, Clarion, Sleep Inn, and Econo Lodge. The company’s growth has been fuelled by its franchise model, which requires minimal capital expenditures, while generating high operating margins (2013 averaged 27.9%) and impressive returns on capital above 40%. Furthermore, the 20-year long-term contracts tying hotel property owners to Choice ensure the firm will have attractive recurring fees, as well as revenue and cash flow stability. In addition to this, the contracts create high switching costs for property owners, as rebranding a hotel and reconfiguring it to fit another brand’s system is a very expensive procedure.
This hotel operators business strategy, with its low fixed costs and network effect, have also helped maneuver the latest recessions in the U.S. better than other industry rivals like InterContinental Hotels Group PLC (ADR) (IHG) or Hilton Worldwide Holdings Inc. (HLT). In fact, while 2009 marked a 17% revenue decline for the overall industry, Choice barely scratched 12%. The same goes for EBITDA margins, which dropped only 22% for Choice, while the average plummeted by over 50%. However, investors looking for short-term profit boosts should abstain from buying this company’s stock, since growth will continue, but at a slower pace than in the past. With one of the weakest pipelines of new hotels in the industry (represents merely 8% of existing hotels) and low royalties of 15% through international hotels, revenue growth can be expected to continue at a sluggish 7% for 2014.
Slow Growth, but High Margins
Although Choice’s scale in the economy hotel segment is difficult to replicate, therefore limiting market entrants, its focus on midscale personal travel may be detrimental in the long run, as that area is currently growing at a slower pace than high-end business travel. While the company’s earnings per share increased 10% in the last quarter of fiscal 2013, revenue per available room is expected to continue a slow 3% to 5% growth rate for 2014. EBITDA can also be expected to carry on its 10% growth path, driven mainly by a leverage of fixed costs.
In spite of an only moderately strong balance sheet, Choice still holds potential for future growth, due to its 20-year franchise contracts. Moreover, the low cost model has shown returns on assets of 23.6%, as well as solid net margin growth of 17.50%, compared to the industry median of 5.30%. Also, while the stock’s current trading price of 26.10x trailing earnings is currently at a price premium relative to this industry average of 22.90x, I think investors looking for a stable hotel operator with high returns may benefit from a shareholder position.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.
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