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Franchising - The Path to Success in the Hotel Industry?
Posted by: Patricio Kehoe (IP Logged)
Date: November 4, 2013 04:58PM

The lodging industry is known for its high returns on invested capital (ROIC), yet some firms struggle with the high capital costs involved in hotel ownership. Whereas Marriott International Inc. (MAR) has opted for a franchise business model in order to elude the challenges of ownership. Meanwhile, Hyatt Hotels Corporation (H) continues to rely on company-owned hotels for 70% of its revenue.

A Successful Business Model

Marriott is active in over 50 countries, operating a total of 3,500 hotels and 600,000 rooms. The company portfolio includes renowned brands such as Marriott, Ritz Carlton, Courtyard, Residence Inn and Fairfield. The firm’s primary focus is on management and franchising of hotels, with only 2% of assets actually listed as owned or leased property.

The franchise strategy gives Marriott a narrow economic moat, since property owners have high switching costs. The company on the other hand is not affected as strongly by the minimal customer switching costs, unlike ownership based hotel operators. Also, the network effect generated by the firm attracts customers, but ultimately ties owners to the desired brand. Especially the long term contracts help to ensure franchises remain loyal. Property owners also have much to gain, since the Marriott brands are well recognized, and loyalty program serves as a customer trap. The 26% ROIC average of the past five years are evidence of the success the company’s business model has enjoyed.

When it comes to international markets, Marriott has been slacking. Their weak pipeline of new rooms compares weakly with that of rival Hyatt. However, the core business seems to come from North America, with 80% of revenue stemming from that region. Also, thanks to the franchise model, if the firm truly wants to create a larger international network, expansion can be undertaken at a low capital cost. Marriott, which is backed by investment guru Ray Dalio, is well positioned in the lodging industry, and due to its successful franchising operations I too feel bullish regarding this stock.

Betting on Ownership

Hyatt operates luxury hotels in 40 different countries, through its Hyatt Regency, Grand Hyatt, Park Hyatt, Hyatt Summerfield Suites, and Hyatt Place. With 496 properties to its name, the company has a very different business model than Marriott, which focuses on managing franchises. The firm’s owned hotels contribute around 70% of cash flow, which is quite a number considering the industry average lies at less than 50%.

Owning hotels is capital intensive, since expansion requires huge investments. Over past years, the significant fixed expenses have left Hyatt exposed to the economic downturn, making it impossible to reach the 3% mark on ROIC. This ownership-driven business model, which seems like a thing of the past for the industry as a whole, deprives Hyatt of an economic moat, and gives rival hotel operators a competitive advantage. To put this in perspective, it is worthwhile looking at adjusted EBITDA as a percentage of assets. For company-owned hotels, this value is less than 10%, whereas the firm’s franchised assets reach values upwards of 40%.

In addition to the rather sluggish business model, which makes expansion difficult and reduces ROIC, the firm is subject to the will of the Pritzker family, which holds 60% of Hyatt’s stock. Due to the dual class stock structure, this gives the family 77% voting power, leaving minority shareholders powerless in the face of management decisions. Investment guru Steven Cohen doesn’t seem happy with this, and his bearish feeling is expressed by the recent 93% reduction in his Hyatt shares. I surely don’t like the firm’s business model, and feel pessimistic about its future outlook, as competitors such as Marriott are far better positioned for prolonged success.

The Business Has Changed, Franchise Is the Key!

In this highly lucrative industry, Hyatt seems to be failing due to a lack of innovation in terms of company structure, as well as ownership. With a family acting as majority shareholder, and a business model based on ownership, the company is failing to address the real challenges presented by an uncertain economic outlook. Marriott on the other hand has implemented a large network of franchises which allow it to operate with flexibility, while generating higher ROIC, much to the joy of shareholders.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

Guru Discussed: Ray Dalio: Current Portfolio, Stock Picks
Stocks Discussed: MAR, H,
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