Is the hotel sector on an upward trajectory?
The global hotel chains Millennium and Copthorne (LSE: MLC) and InterContinental Hotels (LSE: IHG) have posted results for the first half of 2010 showing a substantial improvement on 2009. Both companies have also sounded a cautious note about future prospects. So is the hotel industry on an upward trajectory, or are the recent results merely flattered by comparison with a dire 2009?
A cyclical industry
The sector is inherently cyclical. The volume and spend of business travellers and tourists is driven by the economy. Both segments were severely hit by the global recession in 2008/9, but the business sector seems to be recovering first. The travel operator TUI (LSE: TT) warned on Tuesday that weak consumer sentiment in the UK was leading people to delay booking holidays.
Hotel operators have a high proportion of fixed costs, creating large operational leverage: a small rise or drop in revenues generates a magnified rise or drop in operating profit. Put that together with the cyclicality, and it is no surprise that owning hotel shares can be like riding a roller coaster. Both M&C and InterContinental have betas of 1.5, which means that their share prices have historically been more volatile than the overall market.
The hotel sector
Hotel operators range in scale from single properties to tens of thousands. But in fact there is a considerable degree of concentration at the top level: the ten largest companies represent some 20% of the global supply of rooms. InterContinental, which includes the Crowne Plaza and Holiday Inn brands, is the largest.
There are several different business models. Whilst once the hotel operator was expected to own its real estate, these days it just as likely has a management contract and the property is owned by a third-party investor.
A third model is franchising. This goes even further in reducing the operational leverage, but does not eliminate it as the franchisor is paid according to the revenues earned.
Ownership confers the value upside (and downside) of being a quasi-property company, especially as asset heavy companies are likely to be more highly geared. Asset light business models and low interest rates have saved the sector from the failures which have accompanied prevous recessions.
A mixed strategy
M&C is pursuing a mixed strategy, owning two thirds of its hotels.
|Number of hotels||Owned||Managed||Franchised|
* Includes 6 hotels in a Singapore-listed REIT in which M&C has a 35% shareholding
The group's hotels are branded as Millennium (4 and 5 star properties in major international cities), Copthorne (midscale properties in regional business centres or resorts), and Kingsgate (a leisure chain in New Zealand).
M&C was formed in 1995 when the Singapore group City Developments Limited acquired the Copthorne Group of hotels in Europe. M&C was floated but CDL still retains a controlling 53%.
|Number of hotels||Americas||EMEA||Asia Pacific|
Asia remains the focus, and revenues have rebounded more quickly in this region. M&C suffered a setback in China earlier this year when its joint-venture partner allegedly sold assets without its permission, and it has identified a potential exposure of £12m which it has not provided for. It is a salutary lesson that such operational difficulties arise in China as in all emerging markets.
Nevertheless M&C is well-positioned to take advantage of Asia's growth, and it is developing its first hotel in India with a joint-venture partner.
RevPAR, the revenue per available room, is the industry's favourite metric. Measured at constant currency rates, M&C's overall RevPAR was up 9.3% for the half year, resulting in profit before tax up 54.0%: that's the operational leverage at work again.
M&C say that the top 20% of properties generate over 80% of total earnings. To my mind, that means there is value in the remaining 80% which could be unlocked through asset management when property markets have stabilised.
| ||Prospective PE||Dividend yield||Gearing*|
* net debt ÷ equity attributable to shareholders
M&C has a robust balance sheet, which will give it flexibility to grow. The trouble with cyclical companies is that the best time to buy is when their earnings are low and they look expensive. But I think three things will drive M&C's growth:
- economic recovery;
- new hotel openings, especially in Asia and the Middle East; and
- asset management.
A new chief executive will be appointed later this year, and the new incumbent may aim to shake some value out of the portfolio -- assuming he can get the agreement of the majority shareholder. If I didn't already own shares, I'd buy.
More share ideas from Tony Reading:
> Tony holds shares in Millennium and Copthorne.