Making Room for Expansion: The Lodging Industry

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The lodging industry took a huge blow with the last world economic recession. Some went under, others managed to stay alive. For those who remained in the game, recovery was not easy. Marriott International (NYSE: MAR), Wyndham Worldwide (NYSE: WYN), and Intercontinental Hotels (NYSE: IHG) are three companies that were able to stay at the table. Today, all three hold good future prospects, although some are better than others.

Do you speak Chinese?

Economic cycles offer opportunities when at their lowest. Intercontinental is quickly reaching that point. The company is  No. 1 in the U.S. hotel operation business, and has been present for more than a decade in China. As the world economy continues to grow, the firm will see revenue increments become ever larger.

Intercontinental has created for itself a significant economic moat through its franchise business model. The effectiveness of the model has reflected upon higher return on invested capital and franchising reaching nearly the 100% mark. In addition, franchises are leased for 10 to 30 years, rooms are expected to continue growing by 3% annually, and brand-switching costs are quite high; in few words, the model is far from being exhausted. Revenue increments since 2009 can attest the firm’s successful path.

In comparison with competitors, Intercontinental has made big fuss about entering Europe. However, the firm has concentrated its efforts on establishing a solid position within China. Having entered the Asian market in 1984, the company holds an important edge over competition. Since only 20% of the hotels are branded in China, there is plenty of room for expansion – and for the company to put its know-how to work.

Back in the U.S., Intercontinental also holds more and better-known branded hotels than is competition. Already possessing an economic moat and holding the best infrastructure, coupled with economic recovery, the firm offers the best growth prospects in the industry. There is little to wonder then, if the company’s indicators stand above industry averages, as they do now.

In the end, Intercontinental is the industry’s best-positioned firm to reap the benefits of economic recovery. On the down side, the company has not paid much attention to shareholders. And, even if more attention can be paid to them, the results have been above average. So, I would recommend buying this stock, not because it is shareholder-friendly, but because performance has been very good. Trading at 15.1 times its earnings, about a 36% discount to the industry average valuation, this sure looks like a value stock.

Bye bye timeshare, welcome

With the U.S. economy steadily returning to normal, hotel reservations will see an increase in activity. Marriott will benefit specifically, because it is the second largest hotel operator in the U.S. The argument is pretty simple: Marriott’s big dependency on U.S. economic performance will continue to strongly affect the company’s results, for bad and good. Let us look at other variables that may impact the firm’s future prospects.

Marriott does not hold a great capital liability thanks to its business model, inhibiting the creation of an important economic moat. On the flip side, the company has created a small economic moat based on hotel operators’ high switching costs. Also, the firm has modified the business model with respect to its timeshare business. Telling evidence of the successful approach can be found on the average return on invested capital for the last five years. So, creating an economic moat is important, but business models and management are as important for earnings to materialize.

Now that Marriott is recovering, will shareholders enjoy the rewards too? I’d say they will; the company has a history of keeping investors happy, and management will prove it in the following three years; the firm is expected to allot $3 billion for the purpose. The question that remains is whether that kind of money will be available, given current debt levels. If history is worth anything, the company’s finances have been on the rise since the end of the recession.

Marriott has a few catalysts to exploit in order to increase earnings and keep shareholders content. Namely: strong brand recognition, the recovering U.S. economy, its cost-saving strategies, room for international expansion, and successful acquisitions. International expansion has been accomplished successfully by acquiring Gaylord and IKEA, with its subsidiaries, in order to cater to less exquisite customers. Such an approach has opened a new geography to the company – Europe, and a wide new pool of customers. Hence, the company holds good future prospects, and since its stock trades at a reasonable price (at 21.4 times its earnings, slightly below the industry mean), it is recommended to buy before it rises.

Shareholders over profits

There is no better stock than that which shares earnings with stockholders, and Wyndham has a history of doing so. Barron’s has pointed that a new handout is around the corner, and there are no doubts there are enough greenbacks to do it. But, are there other reasons to buy stock from the firm? Yes.

Besides being the largest global hotel and timeshare operator, measured by units, the company maintains its competitive hunger. Evidence can be found in Marriott’s timeshare spinoff. Good performance and competition elimination is a direct result of its management’s decision to strengthen its fee-for-services business, while at the same time raising the market’s entry price. The point is, the firm has established a strong enough network to maintain its leading position.

Unlike Marriott, Wyndham serves not-so-high-end customers. Focusing on mid-scale and economy segments has allowed the company to curb recessionary effects, and return to an upstream flow quicker. Such recovery has allowed the company to maintain its small but important economic moat, by raising switching costs for hotel franchises and managers. It is relevant to point out that most of hotel revenues come from franchise mid-scale and economy segments.

As the world economy returns to an improving trend, Wyndham will find more suitable operating environments and finances will keep improving. North America represents a big part of the business, but risks have been diversified through acquisitions; the firm has expanded hotel operations to Germany and the UK, and increased its timeshare market presence.

So, the company has displayed management qualities by re-aiming its focus, expanding market share and operational geography, while remaining financially sane. In the end, however, I would recommend holding because market positioning, rapid recovery, recent expansion, and management have yet to prove recovery is not a cyclical mirage.

Bottom line

None if these stocks is a bad buy, and all face the same risks: cyclical volatility and economic slowdown. In my opinion, Intercontinental holds the best future prospects. Shareholder indifference is a blow, but the company has taken an important advantage over competition and that is, sometimes, more important.

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Damian Illia has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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