Will You Feel at Home Investing in This Extended Stay Hotel Group?

Source: Extended Stay America


Extended Stay America
(NYSE: STAY  ) , the largest mid-price extended stay hotel operator in the US with close to 700 hotels in 44 states across North America, delivered an excellent set of results in 2013. It grew revenue and EBITDA by 12% and 19.2%, respectively, last year. Comparatively, the U.S. hotel industry expanded its top line by a much more modest 5.4%, based on research by STR Analytics.

What's the magic behind Extended Stay America's outperformance relative to the industry? Also, what similarities does it share with hospitality peers La Quinta (NYSE: LQ  ) and Wyndham Worldwide (NYSE: WYN  ) ?

Attractive business model
Different travelers have varying expectations for accommodations. While some prefer the 'home-like' lodging experience of extended stay, others might prefer a no-frills stay at select-service hotels.

Extended Stay America's extended stay hotels boast many traveler-friendly features such as in-room kitchens, unlimited local phone services, on-site guest laundry services, and free grab-and-go breakfast, among others. This has strong appeal for self-sufficient and budget-conscious guests who seek alternatives to full-service hotels or rental apartments.

The results speak for themselves--Extended Stay America's guests stay for an average of 28 days, compared to the overall lodging industry mean of a mere 2.5 days. This suggests that those longer-term travelers who want accommodation for more than a week are attracted to the extended stay model. Extended Stay America's 74% occupancy rate also surpasses the industry average of 61% because of the lower guest turnover associated with longer term stay.

In contrast, La Quinta, an operator and franchiser of more than 800 select-service hotels in the country, has benefited from the economic resilience of this accommodation category. The numbers speak for themselves as the occupancy rate for its hotels increased in every single year from 2009 to 2013. This is likely because its core customer base is made up of cost-conscious single travelers who are less likely to cut back on their travel plans in tough times, while full-service hotel guests usually trade down to select-service options when their budgets tighten.

The results of Extended Stay America and La Quinta show that there are successful lodging models besides the traditional full-service format. Furthermore, the operating margins of Extended Stay America and La Quinta of 53% and 47%, respectively, surpass the 30% average for full-service hotels.

Extended Stay America enjoys higher profitability because it generates all of its revenue from higher-margin rooms (as opposed to lower-margin food & beverages). In the case of La Quinta, its outlays for operating expenses and capital expenditures are significantly lower than those of full-service hotels.

Source: Extended Stay America

Supply and demand
Running a hotel business is all about picking the right locations and leveraging positive supply and demand dynamics. Extended Stay America generates two-thirds of its hotel operating profit from hotels in supply constrained coastal states.

Moreover, it also benefits from the overall supply and demand imbalance in the extended stay industry. Based on research by The Highland Group, demand outpaced supply in the extended stay business by three times in 2012. In addition, the 2010-2012 average new-room supply in the extended stay industry was approximately 70% below the 2007-2009 mean. Opportunities remain for Extended Stay America to take market share from traditional full-service hotels, which are still dominant in the market for guest stays beyond five days.

Capital allocation
Investors are generally wary of hospitality stocks because of the cyclicality inherent within the industry. To make things worse, some hotel operators are particularly bad at market timing, choosing to splurge on expansion when the cycle isn't in their favor. As a result, hotel companies with shareholder-friendly capital allocation policies are preferred.

Extended Stay America scores well on this count as it sports an attractive 2.6% forward dividend yield. In addition, its paired share structure allows it to retain some of the tax benefits of the REIT structure, which results in approximately 20% greater free cash flow. This is because Extended Stay America is listed as a paired common stock which comprises one share of the company and one Class B share of ESH REIT.

Another hospitality stock which has a capital allocation policy in place to create shareholder value is Wyndham Worldwide. In 2013, it paid out $156 million in dividends which represented about 30% of adjusted net income and spent another $590 million on share repurchases. Wyndham retained the remaining free cash flow for investment into potential cash flow generative M&A targets such as fee-for-service businesses.

Foolish final thoughts
Extended Stay America stands out from its hospitality peers with its differentiated business model and favorable supply and demand dynamics within the extended stay segment. Furthermore, its capital allocation practices offer investors assurance that it won't splurge by spending excess cash on over-expansion.

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