While there are many publicly traded hospitality stocks, not all of them are attractive investments. Most hotel operators suffer from the cyclical nature of the travel industry and the profitability drag caused by the asset-intensive nature of hotel ownership. InterContinental Hotels Group (NYSE:IHG) is one of the outliers in the crowded hospitality market.
InterContinental's operating margins in excess of 30% are significantly higher than that of its peer Hilton Worldwide Holdings (NYSE:HLT), which has operating margins in the low teens. What's the magic behind InterContinental's superior profitability?
InterContinental operates with an asset-light business model, generating close to 90% of its 2013 operating profit from franchised and managed hotels. Its owned and leased hotels contributed the remaining profits. In contrast, Hilton's owned hotels still account for more than a third of its EBITDA.
The difference in the proportion of franchised and managed hotels explains the disparity in margins between InterContinental and Hilton. Compared with hotel owners, hotel franchisers don't have to commit to huge upfront capital investments and ongoing maintenance capital expenditures to keep the properties in tip-top condition. This means higher profits (lower depreciation) and higher free cash flow (less capital outlay.) In addition, the franchise royalty fees received by InterContinental are recurring in nature, mitigating the volatility in room revenues experienced by hotel operators.
In addition to its highly franchised hotel model, InterContinental also benefits from active asset management. It earned $444 million from the sale of assets in 2013, notably the InterContinental London Park Lane, which contributed $408 million.
InterContinental also announced the planned disposal of InterContinental New York Barclay and InterContinental Mark Hopkins in December 2013 and February 2014, respectively. These transactions, to be completed by this year, are expected to generate sales proceeds of more than $300 million. Overall, InterContinental's capital recycling strategy helps to further "lighten" its balance sheet and allow it to deploy excess cash flow into other value-accretive projects.
For the record, InterContinental's Return on Capital Employed (ROCE) increased from 7% in 2003 to 62% in 2013 as a result of its transition into a hotel franchise model and strategic asset disposals.
In the case of Hilton, it has made progress in transforming into a more capital-efficient model. Management and franchisee fees now account for 51% of its EBITDA, compared with 27% in 2000. However, it is still some way off in reaching InterContinental's degree of franchising.
Size does matter
When you go to any foreign land, it's natural to seek familiar names that provide a sense of security and comfort. InterContinental benefits from the fact that it owns some of the biggest and most well-known hotel brands in the world.
According to its internal estimates, InterContinental Hotels & Resorts is the largest global luxury hotel brand (178 hotels and 60,000 rooms as of end-2013), twice as large as other competing luxury brands. InterContinental Hotels & Resorts was also named as the "World's Leading Hotel Brand" for the fifth consecutive year at The World Travel Awards in 2013.
Another notable brand in InterContinental's portfolio is Holiday Inn, a brand family with a heritage spanning more than six decades. Holiday Inn was ranked "Highest in Guest Satisfaction among Mid-scale Full Service Hotel Chains" by J.D. Power and Associates for the third year running in 2013.
In addition, as the pioneer of the loyalty program in the hotel industry, InterContinental is now also the market leader with more than 70 million members. Members of IHG Rewards Club are very important customers for InterContinental, contributing approximately 40% of rooms revenues. More importantly, these members are more also profitable, spending 20% more per stay than non-members.
While most investors use a mix of discounted cash flow and earning-based multiples like P/E or EV/EBITDA to arrive at the valuation of a company, the precision of such valuations is usually significantly dependent on the accuracy of earnings and cash flow estimates. In contrast, asset-based valuation is far more stable and represents a huge margin of safety in the worst-case liquidation scenario.
InterContinental has 10 owned and leased hotels on its book as of the end of 2013, valued at $959 million representing approximately 8% of its current market capitalization.
More importantly, these hotel properties are valued at historical cost on the balance sheet. This suggests that their market value or sales price should be much higher. Given InterContinental's track record of asset disposals, investors can either expect future cash flow growth from more asset sales or downside stock price protection supported by the asset valuation.
Similarly, Hilton also owns high-quality, trophy property assets which have substantial underlying net asset value. These include iconic buildings such as Waldorf Astoria New York, Hilton San Francisco, Hilton Sydney, and London Hilton on Park Lane. Its property and equipment valued at $9 billion accounts for slightly more than a third of its market capitalization.
Foolish final thoughts
My top pick in the hospitality sector is InterContinental. Its asset-light business model, strong brand name, and downside asset protection make it the most attractive investment candidate among hotel stocks.