At a recent Goldman Sachs conference, Hilton (NYSE:HLT) CFO Bob La Forgia outlined the hotelier's strategy for the next couple of years. Given the industry's strong stock performance -- just check out how Hilton, Marriott (NYSE:MAR), and Starwood (NYSE:HOT) have been doing -- I was paying close attention to see what Hilton could do for an encore.
Company snapshot
Hilton owns, manages, and franchises more than 2,800 properties worldwide, including nine brands that range from the Hilton Garden to the upscale Waldorf-Astoria. Profits come about 40% from owned properties, 40% from franchised and managed properties, 13% from leased properties, and 7% from timeshare properties.
Lean and mean
Hilton plans to significantly reduce its number of 54 owned properties by selling off hotels and retaining a handful of roughly 10 "flagship" properties in strategic locations. Owning hotels is a capital-intensive operation, and Hilton thinks it can earn higher returns by recycling that capital into franchising operations to earn a more stable earnings stream and higher margins.
La Forgia noted that most of Hilton's franchise contracts run for about 20 years and typically get a 3% cut of gross sales, plus an incentive fee that might be 10% of profits after the franchisee earns a 9% to 11% rate of return.
Because the bulk of franchise fees is tied to sales, which tend to be less volatile, and because Hilton doesn't have to put up much in capital, this revenue source serves up higher margins and better returns on capital. As a result, Hilton believes that investors will perceive its earnings stream as being of high quality and will reward the stock with a higher multiple.
Expansion
Hilton also has the largest pipeline of signed deals among its U.S. competitors, with a total of 800 hotels and 111,000 rooms. A big part of that figure is international expansion, with a lot of activity in emerging markets in China, India, Russia, and Central America. In 2007, Hilton expects to bring online about 35,000 of those 111,000 rooms in the pipeline, and it's targeting 7% annual room growth over the next couple of years.
Expansion is a big part of the Hilton story, because every time it signs a deal with a new franchisee, it can then expect to receive a future stream of franchise fees for decades to come. Hilton estimates the net present value of its pipeline at $1.7 billion, in comparison with the company's $13.5 billion market capitalization.
Checking in or out?
La Forgia presented a rather solid growth strategy for Hilton's future. So is it time to scoop up some Hilton shares? Well, potential investors should consider a couple things.
First, consider that Hilton's international expansion is partly a bet on continuing success in the emerging economies of Russia, China, and India. Because Hilton's offerings tend to be full-service, upscale hotels, they're naturally betting that the nouveau riche in those countries will continue to prosper.
The good thing is that because Hilton is franchising, it has something of a free call option, since it shares in the upside but not so much in the downside. The franchisees, who put up the capital, bear most of the downside risk. What's more, a successful expansion strategy will help to diversify Hilton's cash-flow streams.
On the other hand, hotel demand is governed by supply and demand. If there is a recession in the U.S., then Hilton's profits will follow the downward slide. After all, a U.S. slowdown would probably also mean a worldwide slowdown.
Overbuilding?
There's been some rumbling that hotel construction is set to outpace demand. According to a PricewaterhouseCoopers study, hotel room construction in the U.S. is at its highest point since 1999. For the past couple of years, tight supply has allowed hoteliers to raise room rates, and higher rates help boost bottom lines. As supply catches up with demand, pricing power will also start to fade.
Hilton's stock is up 32% over the past year, but shares trade at a reasonable 12 times enterprise value to forecasted adjusted 2007 EBITDA. Shares could continue to benefit from successful international expansion, or the incredible amount of private-equity capital floating around might even find its way into Hilton shareholders' pockets.
I think Hilton already has a lot of good things going for it, but the risk/reward rubric doesn't excite me. I'm more interested in beaten-up stocks for which the expectations are low, so I'm hesitant to dip my toe in the water here. However, Hilton does have a great brand, so it's definitely a stock investors should put on the back burner in case they eventually spot a chance to pick up shares at a cheaper price.
Related Foolishness:
If beaten-down stocks are your thing, too, see what Philip Durell has found in the market's bargain bin by taking a free 30-day peek at Motley Fool Inside Value.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
