Hilton's Brand Advantage Gets Stronger

We expect

The company currently has a mid-single-digit share of global hotel rooms with more than 20% of all industry pipeline rooms under construction. Further, its U.S. share of existing rooms is low double digits, with a pipeline share of rooms under construction at roughly 25%. We see its room growth averaging midsingle digits over the next decade, above the long-term U.S. supply growth average of 2%, implying market share gains ahead for Hilton.

In addition to an intangible brand advantage, Hilton has switching cost barriers through its managed or franchised rooms, which now generate 90% of total EBITDA after the spin-offs of its time-share business and the majority of owned assets. These asset-light rooms offer not only high returns on invested capital, but also contract lengths of 20 years that are costly to terminate.

We expect Hilton’s intangible brand asset and switching cost advantage to strengthen, driven by new hotel brands and its highly rated loyalty program. Hilton has added five brands in the past few years, including Tru brand, which launched in January 2016 and already has around 420 hotels under commitment as of the second quarter of 2017. Hilton also has a solid loyalty membership base at 63 million (as of March 31), up from 51 million at the end of 2015, and the program continues to be ranked toward the top by J.D. Power in regard to customer satisfaction.

Cyclicality and overbuilding in the industry present the main risk for shareholders. Typically, lodging recoveries last seven to nine years, and 2017 represents the eighth year of this cycle. We model this cycle to last through 2017, which we believe is reasonable considering that between 2009 and 2016, U.S. demand has outpaced supply (growing at respective rates of mid-20s and high single digits), and demand is expected to match supply in 2017.

Brand and Switching Cost Advantages Build Moat We see Hilton as having a narrow economic moat through an intangible brand and switching cost advantage in its asset-light business model; 90% of cash flow is from franchised and managed hotels. We believe this will continue to support strong adjusted returns on invested capital comfortably above its cost of capital over the next several years. Through decades of high-quality service, travelers and third-party owners view Hilton as a brand they can trust to deliver a consistent high-level experience. The brand advantage is evident by its dominant scale, leading loyalty presence, and sustainable unit growth demand from third-party owners. Further, the strong Hilton brand and focus on a managed and franchised structure drive a lasting switching cost advantage.

Globally, Hilton has large scale, with midsingle digits of existing industry rooms; this is set to expand further, given the company’s 20%-plus room share of the industry’s pipeline under construction. Further, the company has a low-double-digit industry room share in the United States (around 70% of total adjusted EBITDA), with about 25% share of the pipeline under construction. Internationally, it is a top-five hotel brand by room count; Accor, InterContinental IHG, Starwood, Marriott MAR, and Hilton combined control around 10% of the total foreign market. This scale offers third-party owners advertising, reservation, and loyalty program reach that cannot be achieved by smaller competitors.

Hilton’s scale is also evident in its leadership position in managed properties. Owners that choose to outsource management responsibilities seek a strong brand and management team with scale and expertise in reservation, advertising, marketing, and labor management, which lead to strong revenue per available room, occupancy, and profitability. Worldwide there are nearly 900 lodging management companies, but only nine manage more than 100 properties. Hilton had 606 at year-end 2016.

The scale and quality of Hilton’s loyalty program attract third-party owners, further validating the brand. Hilton has one of the largest loyalty programs in the industry at 63 million members, trailing only Marriott’s and InterContinental’s roughly 100 million members, and according to J.D. Power, it ranks tops in customer satisfaction. The importance of the loyalty program is highlighted by around 57% of all room nights being booked by its members.

Hilton’s scale and strong loyalty program support its brand advantage, which is apparent in the company’s ability to successfully expand into new hotel concepts. Recent brand launches are predominantly focused on the growing lifestyle segment, which targets the next-generation global traveler. The company currently has 14 brands, with 5 of those new since 2011. Curio is a soft lifestyle brand launched in 2014 that focuses on unique hotels in a locale. Canopy, also launched in 2014, is a lifestyle brand that focuses on neighborhood hotels. Home2 was launched in 2011 and focuses on upper midscale extended stays. Tru was launched in early 2016 and caters to millennial travelers at a midscale price point, and Tapestry Collection was launched in January 2017 and focuses on upscale full-service lifestyle. Together, these five brands total around a high-single-digit percentage of Hilton’s total pipeline.

Hilton’s strong brand is further showcased by its unit room growth. With 97% of its total rooms under franchise and management contracts, the company depends heavily on its brand to attract unit growth from these third-party owners. Managed and franchise unit growth has averaged around 6%-7% each of the past three years (through 2016) and is set to remain strong, driven by an average of midteens annual pipeline growth the past three-plus years (through the first half of 2017).

Hilton’s managed and franchised contracts are typically for 20 years and drive a switching cost advantage. Termination of these contracts requires significant expenditures to renovate and rebrand a property to meet the new brand specifications, results in a disruption to business operations for the owner, and leads to termination fees that must be paid by the owner (typically around two to three years’ worth of average monthly management fees plus the previous year’s incentive fee).

We project Hilton’s next five years to show improving adjusted ROIC, expanding margins, and sustained mid-single-digit average annual room growth. These quantitative trends support our narrow moat rating.

Even after the spin-offs of Hilton’s time-share and portion of ownership assets, we believe the moat of the remaining assets is still narrow as opposed to wide because of the competition we see from hoteliers and alternative lodging like Airbnb and aparthotels. Franchisees have an increasing set of options as large chains have launched additional brands the past several years--Ascend (Choice Hotels CHH), Cambria (Choice Hotels), Tribute (Marriott), Autograph (Marriott), Moxy (Marriott), Aloft (Marriott), House (Hyatt H), Place (Hyatt), Indigo (InterContinental), and Kimpton (InterContinental). Additionally, we believe that alternative lodging options, such as apartment and home rentals, will continue to grow. Airbnb offers around 3 million rooms on its website, which compares with Hilton’s room count of 825,000. Airbnb booked around 100 million room nights in 2015 (of which we believe around 40% were in the U.S.), which compares with the 1.2 billion room nights booked in the U.S. that year. Surveys point to over one half of all travelers considering vacation rentals as an alternative to hotels. We believe Airbnb has taken most of its low-single-digit accommodation share from the economy scale segment of the hotel industry, an area Hilton does not have exposure to. That said, Airbnb could expand its presence in higher price points over the next several years, presenting more competition to Hilton.

Cyclicality of Travel Is Biggest Risk The travel industry is cyclical and the main risk for prospective shareholders. In a downturn, consumers and businesses look to cut back on expenses like travel. Hilton has outsize exposure to business travel, as corporate represents 75% of its room nights with 80% of that coming from transient and the other 20% from group. 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 had a meaningful impact on the top line for both ownership and recurring fee-based models.

In addition, overbuilding can lead to lower occupancy and room rates, which would then have an impact on growth and profitability. The last two lodging cycles peaked in the late 1990s and in 2008 once supply was comfortably above 2%. We currently believe that supply will approach these levels in late 2017.

Asia-Pacific offers great demand but has been met with great supply in countries like China, which could damp the positive impact on financials. Additionally, economic growth in China is slowing after many years of rapid growth. The Asia-Pacific region is currently 10% of total adjusted EBITDA for the company.

Terrorism can occur anywhere and can often lead to temporary delays or cancellations in trips to the affected region. 2015 saw attacks concentrated in France; Hilton has 12% of its adjusted EBITDA derived from Europe. Additionally, global disease epidemics can reduce travel in the affected areas.

Finally, we expect competition from other hoteliers and alternative lodging options such as home, apartment, and vacation rentals to remain.

Hilton’s spin-offs of owned assets at the beginning of 2017 has left the company with 90% of its adjusted EBITDA derived from fees versus just 52% previously. Given the lower capital-intensive nature of franchise and managed assets relative to owned ones, free cash flow as a percentage of sales and the cash flow cushion are now higher, which increases our comfort with management’s stated leverage target of 3.0-3.5 times. Hilton’s financial health is improving, although still trails its key peers on many metrics.