Hilton selling the Waldorf Astoria for $1.95 billion

The day before yesterday, Hilton (HLT) announced it had agreed with Anbang Insurance Group of China to sell the Waldorf, the flagship of the Hilton chain, to the five-year-old mainland financial conglomerate for $1.95 billion.  Hilton will retain an unusually long 100-year management contract to run the hotel (terms not disclosed).  The Hilton will also undergo a substantial facelift “to restore the property to its historic grandeur”  (no details on how much or who’s paying).

When I began following the US hotel industry as an analyst in the early 1980s, US hotel firms were just beginning to transform themselves from owners of hotel properties into managers of hotels owned by others.

Why do so?

–Historically, ownership of hotels has been a low-return enterprise that ties up immense amounts of capital.

–In my experience, hotel management contracts involve the manager taking large slices of the property’s revenues, cash flow and profits–leaving the owner with tax benefits (e.g., depreciation) and the possibility that the property will increase in value.

As I see it, hotel owners fall into one of several categories:

–local businessmen who want the prestige of saying they own the town’s name-brand hotel/motel, and who prize potential tax writeoffs highly

–billionaires who want the same thing, only with iconic properties

–flight capital, where the owner’s interest is less with potential return than with the presumed safety of having “just in case,” non-portable assets located abroad

–national champions, that is, institutions that either officially or semi-officially represent their home governments and who are signalling their country’s rising status.

 

I see Anbang as falling into the last of these categories.  Its justification to itself likely also includes geographical diversification and its perception that real estate investment opportunities on the mainland are not as attractive as the Waldorf.  IN its defense, Anbang can arguably also make more imaginative use of a city block in a prime section of Park Avenue than Hilton has been able to.

All in all, though, recent Chinese deals for Manhattan real estate mostly call to mind the top-of-the-market foray of Japanese firms into Manhattan in 1989 (think:  Rockefeller Center, which turned out pretty badly for Mitsubishi Estate).

hotel stocks: why I think they’re attractive now

not hotels themselves

It’s not that I think owning a hotel is a great investment.  Generally it isn’t.

Like most real estate, hotels can be (and almost always are) leveraged financially using non-recourse debt–meaning that if you can’t repay, the lender can only seize the property, and has no claim on your other assets.  That’s a definite plus.  But office buildings have the same deal and sport much higher and more stable ROIs.

As far as I can see, the typical hotel developer/buyer is an individual or family that views them as symbols of status, signs that they’re “arrived.”

a mature industry in the US

I began covering the hotel industry in the US 30 years ago.  Even then it was a mature industry whose major firms were beginning to develop by:

–segmenting the market by not only offering generic “hotels,” but also resort, luxury, boutique, low-end, extended stay, suites–all the varieties that we have today, and

–selling their hotel properties, while retaining the hotel management contracts that deliver them the bulk of the cash flow the properties generate.

The rest of the developed world has since begun to follow suit.

today’s hotel stocks

The result is that today’s hotel stocks are by and large multi-brand property management companies that control brands and distribution networks (reservation systems and loyalty programs).  Yes, they may own some hotels directly.  But, through their management agreements, their profits are tied to those of all the hotels they manage, even though they don’t have the capital burden of building or maintaining them.

why today?

What makes them interesting to me as investments today is that they’re already comfortably profitable because of the post-recession resumption of business travel.  But they’re also very sensitive to the recovery in leisure travel that I expect will follow the pickup in hiring we’re now seeing in the Bureau of Labor Statistics reports.  (Meetings and conventions are the third big source of income for hotel stocks.  I’m not counting on that getting any better this year.  But it might.  On the other hand, it can’t get any worse, so it’s at least a neutral influence.)

I think the return of leisure travelers (which we’re already beginning to see in results from DIS) will have three aspects:

–a shift from staycation to vacation,

–a move of current Motel 6 stayers to, say, Marriott, and

–gently rising room rates.

According to HotelNewsNow.com, US hotels raised occupancy rates (the percentage of available rooms actually rented) to 60.1% and average daily room rates by 3.7% (to $101.64) last year.  HNN predicts that the combination of rising occupancy and room rates will lift industry revenues by 4.3% in 2012.  I think this is too low.

operating leverage

The key to my positive case for hotel companies is that they have immense operating leverage.  An example:  MAR has achieved an operating margin above 10% only once (in 2007) during the past decade, according to Value Line. 

Consider what happens if room rates rise.  The hotel has almost exactly the same costs if it sells a room at $102.64 as does at $1 lower.  So the margin on that extra dollar is close to 100%, not 10%.  Similarly, if the hotel rents an extra room for one night, its out-of-pocket expense is basically the cost of cleaning it post-stay and putting in new little soaps and shampoos.  That’s about $15.  So the margin on having an extra guest is around 85%.

Let’s say the overall margin on an incremental dollar in revenue is 90%.  If we figure a hypothetical $100 in revenue for a hotel firm at an operating margin of 10% last year, operating profit was $10.  If the extra $4.30 that HNN predicts for 2012 comes in and has a margin of 90%, then it yields operating profit of $3.87.  That’s a 38.7% year on year increase in profit from a 4.3% in revenue.

In reality, no company is going to show that much extra profit.  There’ll always be room refurbishment or other maintenance projects to pay for.  Employees will get raises, new staff will be hired, executives will get bonuses.  But that’s the general idea.

Another, non-fundamental, aspect to the story is that the US stock market has begun to shift its focus from investment ideas that depend only on continuing consumption by the affluent (the major theme since early 2009) to those that are keyed more to recovery of the average consumer.  So the market response to any signs of positive operating leverage of the type I’ve just described may be unusually enthusiastic.

I should point out that this isn’t analysis; it’s the germ of an idea.  That hasn’t stopped me from taking a small position in MAR while I do my homework.  I’ll write more when I finish my work.