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Why This Franchised System May Not Be Profitable
Posted by: Damian Illia (IP Logged)
Date: February 7, 2014 04:50PM

In the lodging industry, high returns on invested capital are a key market characteristic. However, this market segment also suffers from its vulnerability to economic recessions, which can lead to sharp declines among business and leisure travelers. Marriott International Inc. (MAR) was particularly affected by the last few downturns and is in fact still recovering from the 2008 crisis. Maybe that’s why investment gurus Joel Greenblatt (Trades, Portfolio) or Caxton Associates (Trades, Portfolio) recently sold out all their company shares. Nevertheless, not all is gloomy in this company’s future, although profitability may also only arise in the distant future.

A Franchised System

Marriott is one of the world’s prime hotel operators, with over 3,500 hotels and 600,000 rooms, distributed among 50 countries. However, its main business lies in the U.S., where this firm operates over 9% of all domestic hotel rooms. Some of the most popular brands in the portfolio include Ritz Carlton, J.W. Marriott, Fairfield Inn & Suites by Marriott, Residence Inn and Renaissance Hotels. A key trademark of the Marriott business strategy is its focus on franchising, thus 98% of the company’s hotels are either managed or franchised, generating over 80% of the consolidated cash flow. The low fixed costs, as well as minimal capital expenditure, due to the 10 to 30 year contracts created for these hotels, make this system highly beneficial for the company.

In addition to this, Marriott also benefits from a network effect between traveller increases and property owners looking to profit from this numeric raise. The high switching costs necessary to rebrand a hotel make it less tempting for property owners to exit the company’s system, therefore assuring some sense of long-term stability. Thus, the number of franchised rooms is expected to grow at a 3.3% rate over the next seven years, given the firm’s current pipeline of new hotels. Leverage in fixed costs will also boost 2013’s 12.9% EBITDA margins of company-owned hotels to 16.5% by 2021, while the 81% to 82% margins for franchised hotels remain stagnant.

Lack of International Presence Affects Valuation

The last recessions put a significant strain on Marriott’s growth margins, given the company’s 80% revenue income deriving from the domestic market. In comparison, other hotel operators, like Hyatt Hotels Corporation (H) or Hilton Worldwide Holdings Inc. (HLT), enjoy larger international market presence and are therefore more resistant to a national economic crisis. However, this is not the case of Marriott International, which suffered from long recovery periods during each crisis, leading to negative metrics in 2009, like a 15% decrease in revenue, from which the firm is still recovering. With operating margins currently at an 8.0% growth rate, below the industry’s average of 8.81%, Marriott is ranked lower than 36% other hotel operators.

However, in terms of shareholder returns, the firm has not disappointed yet, with returns on capital well above the industry average, at 61.1%, and returns on assets growth rate of 9.0%. The company’s 3.2% share buyback rate is also bound to be profitable for investors, compared to the average of -1.1% in the industry. With the P/E at 22.9x its trailing earnings, Marriott is trading at a slight premium to the 22.4x industry average, and the stock price has also jumped from $39.09 to $48.3 in a one-year period.

Despite these metrics, I remain bearish about Marriott’s long-term future, given the overall decline in growth of the lodging industry. With hotel rooms in the U.S. increasing only by 1% in 2014, and the overbuilding of properties which could hurt occupancy rates and margins, I think investors might be better off looking towards a company with stronger international presence.

Disclosure: Damian Illia holds no position in any stocks mentioned.

Guru Discussed: Caxton Associates: Current Portfolio, Stock Picks
Stocks Discussed: MAR, H, HLT,
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