Wyndham's Brand Advantage Intact

We expect Wyndham Hotels & Resorts WH to gradually expand its room share in the hotel industry and sustain a brand intangible asset and switching cost advantage. This view is supported by the company’s roughly 40% share of all U.S. economy and midscale branded hotels as well as its loyalty program, the industry’s fourth-largest by membership, which encourages third-party hotel owners to join the platform. Also, Wyndham has 10% and 5% shares of existing U.S. and global hotel rooms, respectively, with a pipeline that represents around 22% of its current unit base. As a result, we see room growth averaging around 3% over the next decade, above the 2% long-term U.S. supply growth average.

With all but 2 of its 9,000-plus hotels managed or franchised, Wyndham has an attractive recurring-fee business model with healthy returns on invested capital, as these asset-light relationships have low fixed costs and capital requirements. This asset-light model creates switching costs, given the 10- to 20-year contracts that have meaningful cancellation costs for owners.

We see the 2018 acquisition of La Quinta as a strategically strong fit that supports Wyndham’s intangible-asset-driven narrow moat while enhancing long-term growth. La Quinta’s 13 million loyalty members and top-three midscale brand guest satisfaction ranking should lure third-party owners to join Wyndham. Further enticing third-party unit growth is the added scale of La Quinta’s 90,000 rooms, which can drive down procurement costs for owners.

Cyclicality and overbuilding are the main risks for shareholders. Typically, U.S. lodging recoveries last seven to nine years; 2018 represented the ninth year of the current U.S. cycle. We model this U.S. cycle to last through 2019, which we believe is reasonable, considering that over 2009-18, U.S. demand and supply increased around 30% and 10%, respectively, with supply growth expected to roughly match demand growth in 2019.

Brand Advantage Is Evident We think Wyndham has a narrow economic moat driven by sustainable brand intangible asset and switching cost advantages, which we believe will support returns on invested capital (including goodwill) of 12.5% on average over the next five years, above its 7.4% cost of capital. Through decades of service, travelers and third-party owners view Wyndham as a trusted brand. The brand advantage is evident in Wyndham's sustainable unit growth demand from third-party owners, guest satisfaction ranking of its brands, dominant scale and contract length of managed properties, a sizable loyalty program and effective distribution platform, and large room market share. Further, Wyndham's focus on a managed and franchised structure drives a switching cost advantage that we expect will endure.

The company’s intangible brand advantage is seen in its unit room growth, which remained positive even during the downturn in 2008 and 2009, at 7.7% and 0.8%, respectively. With 97% and 3% of total 2017 rooms under franchise and management contracts, respectively, Wyndham depends heavily on its brand to attract unit growth from third-party owners. Over 2007-17, Wyndham saw net unit growth averaging 3% annually, above the long-term U.S. industry supply rate of 2%.

Wyndham’s brand is also supported by high customer satisfaction ratings. In 2018, J.D. Power awarded a handful of the company’s brands a top-five ranking in both the economy (50% of total rooms) and midscale (40%) segments. We believe this quality is driven in part by Wyndham’s high room termination rate, which has averaged 7.7% of its total room base annually the past eight years through the end of 2017. This compares with the roughly 5%, 2%-3%, and 1%-2% that key narrow-moat peers Choice Hotels CHH, InterContinental IHG, and Marriott MAR have deleted on a yearly basis, respectively. While the removal of underperforming units can lift the quality of the portfolio, it also raises a question regarding the overall strength of the brand, offering some offset to the net room share gains Wyndham has consistently posted. Management has told us that the termination rate is beginning to slow, although the Howard Johnson (6% of total rooms), Days Inn (20%), and Super 8 (25%) brands still need some culling in North America throughout 2018. Further, we learned at an investor day in May that 90% of Super 8 owners have implemented the required $1,500 per room of renovation spending to rejuvenate the brand, which has led the concept to return to a 100%-plus revPAR index level (sustained share level) from 94% (share loss) before the program.

Wyndham’s brand advantage is showcased by the number of properties it manages on behalf of third-party hotel owners. Owners that choose to outsource management responsibilities (such as hiring, training, and labor management) seek a strong brand with scale and expertise in reservations, advertising, marketing, and labor management, which leads to strong revenue per available room (most of Wyndham’s rooms garner a revPAR index level above 100%) and profitability (small independent owners entering the platform can see 700-800 basis points of lower online travel agent commission costs). Worldwide, there are several hundred lodging management companies, but only nine manage more than 100 properties. Wyndham is one of those operators, managing 113 hotels at year-end 2017 and now more than 400 with the closing of the La Quinta acquisition in the second quarter of 2018 (Marriott has the most at 1,892 at year-end 2017).

Wyndham has a solid loyalty program, which offers an immediate demand channel for third-party owners, further validating the company’s brand intangible advantage. Its loyalty program hosts around 70 million members, trailing only narrow-moat Marriott, InterContinental (both over 100 million members), and Hilton HLT (over 80 million). Travelers are drawn to Wyndham’s loyalty program as it provides the ability to use and accumulate points across nearly 900,000 hotel rooms (third-most rooms in the industry behind Marriott and InterContinental) and over 20,000 Wyndham timeshare and rentals (the most of any hotelier; Accor is number two with around 10,000 vacation rental rooms). This in turn supports loyalty guests, who stay at Wyndham twice as much and spend nearly 100% more than nonmembers.

The company offers third-party hotel owners an effective distribution platform. Wyndham has migrated its platform to a cloud infrastructure, which provides owners improved cost and revenue optimization. Further, an increasing mix of bookings are occurring through Wyndham channels, representing 61% of the total in 2017 from 41% in 2013, which can reduce marketing costs to acquire customers.

The hotelier’s brand advantage is also supported by its meaningful market share of rooms. In the United States (65% of Wyndham’s 2017 total rooms), the company has 10% of the roughly 5.1 million existing industry rooms, fourth behind Marriott, Hilton, and InterContinental. In its core economy and midscale markets, management says it has around 40% share of all domestic brand hotels. Meanwhile, Wyndham holds around 2.5% share of all 11.9 million international rooms (fourth behind Accor, Marriott, and InterContinental), including 6% of the 2.3 million rooms in the China market (17% of 2017 total rooms). This scale offers third-party owners advertising, reservation, and loyalty program reach that cannot be achieved by smaller competitors, especially in suburban, interstate, and smaller metro locations where the vast majority of its domestic company hotels are.

Beyond its strong brand, we see a switching cost advantage in Wyndham’s franchised and managed contracts, which typically extend for 10-20 years. Termination of these contracts could require significant expenditures to renovate and rebrand a property to meet the new brand specifications, resulting in a disruption to business operations for the owner while leading to termination fees that must be paid by the owner (typically around two years’ worth of average monthly franchise fees).

We believe a wide moat rating is not warranted, given the competition we see from hoteliers, alternative lodging (Airbnb, Booking BKNG, and HomeAway EXPE), and leading online travel agency platforms. Franchisees have an increasing set of options as large chains have launched additional brands the past several years--Ascend (Choice), Tru (Hilton), Curio (Hilton), Tribute (Marriott), Autograph (Marriott), Moxy (Marriott), Aloft (Marriott), House (Hyatt H), Place (Hyatt), Indigo (InterContinental), and Kimpton (InterContinental). We believe alternative lodging options, such as apartment and home rentals, will continue to grow. Narrow-moat companies Airbnb and Booking Holdings both offer over 5 million nontraditional hotel rooms on their websites as of mid-2018, which compares with Wyndham’s room count of 898,000 at Sept. 30. In addition, we believe that much of Airbnb’s business is still focused on the economy and midtier price points, where Wyndham has around 50% and 40% of its room base, respectively. Finally, leading online travel agency Booking Holdings hosts over 28 million lodging choices on its booking.com platform (5 million alternative accommodations and 23 million traditional hotel and resort rooms), which is multiples of even the world’s largest hotelier, Marriott, which has 1.3 million hotel rooms in its portfolio. With booking.com seeing 500 million monthly visitors versus around 35 million for Marriott, we expect the platform to remain a top destination for travelers to shop, compare, and book hotels across all hotel brands. Further, it’s not inconceivable (although not our expectation) that Booking, Expedia, or other leading online travel agency platforms could leverage their platform and loyalty membership to develop a branded hotel portfolio, bringing more competition to the industry.

Cyclical Travel Industry Is Primary Risk The travel industry is cyclical and is the main risk for prospective shareholders. In a downturn, consumers and businesses look to cut back on expenses like travel. Industry U.S. revPAR was down 17.1% in 2009, while U.S. GDP growth was down 2.8% that year. This drop in revPAR meaningfully affected the top line for Wyndham; in 2009, total revenue was down 12.4%, with comparable revPAR down 15.1%.

Overbuilding can lead to lower occupancy and room rates, which would then affect growth and profitability. The last two lodging cycles peaked in the late 1990s and in 2008, once supply was comfortably above 2%. We believe supply growth will reach this level in 2018. Economic or terror-related events in the U.S. could greatly affect Wyndham’s financials, given that around 65% of the company’s rooms are located there. Also, we expect competition to continue from other brands, online travel platforms, and alternative lodging options such as home, apartment, and vacation rentals.

The company’s asset-light business model drives our forecast for an average of 13.9% free cash flow/sales annually over the next five years versus the 17.6% averaged in the prior three years. We expect Wyndham will use its excess cash to return cash to investors through dividends (modeling a 30% payout) and share repurchases (averaging $275 million annually the next five years), reinvest in the business either organically or via acquisitions, or work down leverage.