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Tuesday, May 25, 1999

An Investment Opinion
by Warren Gump

Struggles At Promus

Promises, promises. Company management teams usually have the best intent to meet guidance that has been provided, but sometimes it just doesn't happen. Today, two big companies came out with earnings warnings for the year. First Union (NYSE: FTU), the nation's sixth largest bank, warned that earnings would fall well short of expectations announced in January, as discussed thoroughly in today's Fool Plate Special. Promus Hotel Corp. (NYSE: PRH), the franchisor of Embassy Suites, Doubletree, Hampton Inns, and Homewood Suites, also announced that it expects earnings for the year to be in the mid-single digits rather than the mid-teens as previously expected. Not surprisingly, disappointed investors checked out of the stocks. First Union was down 9%, while Promus fell 18% to $25 1/8.

Lambasting current Promus management for today's announcement isn't really appropriate. While investors will understandably be irked, these people are not the real cause of today's problems. Norm Blake, the company's Chairman, President, and CEO, just took over these positions in December after the prior management team resigned due to differences in philosophy arising from the merger of the "old" Promus and Doubletree hotels in late 1997. Since assuming his positions, Blake has been reshuffling and beefing up the leadership team to prepare the company for future growth. Up to now, the team has been developing strategies for the company's growth and reworking models adopted from prior management.

When Promus and Doubletree merged, hopes were high that the best of both companies could be extracted to form a true lodging giant. Promus was best known for having strong operating systems and control over a dispersed franchise system. They were renown in their industry for a 100% satisfaction guarantee. Doubletree, on the other hand, was an upstart growing rapidly through acquisitions. Although operating controls and consistency were not their strongest attribute, it had emerged from virtually nothing into a substantial brand in less than a decade through deft leadership and successful acquisitions. Investors were hoping Doubletree management's acquisition finesse would complement the Promus team's operating insight.

Less than a year after the merger was completed, Promus shocked its investors by announcing that key players from both sides of the acquisition were resigning due to philosophical differences. Neither team could agree on how Promus should proceed. To solve the stalemate, Chairman and CEO Ray Schultz, COO Richard Kelleher, and two board members, Michael Rose and Richard Ferris all agreed to resign. Schultz and Rose were from the old Promus organization, while Kelleher and Ferris were from Doubletree. The company would search for a new leader from outside the firm to carry it forward.

As we now fast-forward six months into Blake's leadership, we find that earnings expectations for Promus are too high for the year. For the most part, this shortfall is associated with adjustments made to models not developed by this management team. Part of the problem is that revenue growth for the whole hotel industry is slowing down. RevPAR (revenue per available room, the hotel industry's version of same-store sales) growth of 1%-3% is now expected for the company brands, which is one to two points less than prior projections. Although Promus, which is primarily a franchisor, is less immune to RevPAR fluctuations than hotel owners, such a decrease still impacts earnings.

Another part of the change is driven by a strategic shift decided upon by this management team to beef up consistency at Doubletree. The company feels that the brand is not reaching its potential because of the significant quality variation among its hotels. Promus intends to implement new standards that will kick at least 29 hotels out of the brand. Some of these properties will be reflagged to Promus' Red Lion brand, but 10-15 may leave the Promus system entirely. Improved quality should help restore some luster to the Doubletree brand, but Promus can't immediately make up the revenue loss from these hotels. Until the Doubletree system is better defined, Promus will be hard-pressed to find new franchisees for the brand.

In addition to raising standards at Doubletree, Promus has decided to try to revitalize the Red Lion brand in the Pacific Northwest. This brand was acquired by Doubletree a couple of years ago, but was virtually destroyed as most properties were converted to the Doubletree name. The remaining locations, which didn't fit into the Doubletree brand, were expected to be sold and possibly reflagged as something else. The fact that Doubletree is trying to revitalize the brand seems strange to me. I don't really understand why management is devoting such attention to this regional brand when it seems to need to focus on international brands.

The stalwart brands of the old Promus system, Embassy Suites, Hampton Inns, Hampton Inns & Suites, and Homewood Suites are continuing their growth streaks, albeit at a slower pace. These brand may have lost some of their strength with franchisors during this period of management turmoil, but they are still very powerful brands domestically. As the leadership team at Promus stabilizes, so should growth from these brands.

From my perspective, it seems that the operating culture of the old Promus has been selected by the new management team as the modus operandi. The next two years will be spent getting the Doubletree and Red Lion brands up to standards and reinvigorating the old Promus brands. The big question is where the company will go after that. Investor enthusiasm at the time of the Promus/Doubletree merger was premised on the hope that Doubletree's acquisitive nature would lead to a move into the luxury and international sectors, two gaping holes in Promus' portfolio.

Despite its successful mid-price and upscale brands, Promus doesn't have any product that competes in the luxury sector with the likes of Ritz Carlton, which is owned by Marriott International (NYSE: MAR), or Four Seasons (NYSE: FS). Many experts believe this sector is poised for substantial growth due to demographic trends and the current small size of most luxury brands. In addition, although Promus is very strong in the U.S., its exposure to international markets is limited. In the decades ahead, this will be another major area of growth for many lodging companies. Promus will need to figure out how to get itself involved in this sector if it wants remain a lodging leader.

After today's tumble, Promus seems to be priced as if the stabilization of operations is in question. The first step management needs to take, which already appears to be underway, is to ensure that the core business is under control. The strength of old Promus' operating culture should prove invaluable in that endeavor. Looking further out, to a point when operations have been stabilized, Promus will have to show that it hasn't completely squashed the Doubletree culture. If it really wants to be a growth company, it will need to exhibit some of Doubletree's flair and finesse in moving into new ventures.

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