Business Strategy and Outlook
We expect Hyatt to expand room and revenue share in the hotel industry over the next decade, driven by a favorable next-generation traveler position supported by its newer House and Place brands (28% of 2018 total rooms), resulting in an intangible brand advantage. We see the company’s room growth averaging in the midsingle digits over the next decade (above the U.S. industry long-term supply growth average of 2%).
In addition to an intangible brand advantage, Hyatt has switching cost barriers through its managed or franchised rooms, which was 53% of total EBITDA (excluding corporate expense) in 2018. These asset-light rooms not only offer high returns on invested capital, but also provide contract lengths of 20-30 years that are costly to terminate.
We expect Hyatt's intangible brand advantage to strengthen, driven by new hotel brands (since 2006, Hyatt has grown from five to 17 brands) that target the next-generation traveler. Hyatt's growing brand advantage is witnessed by its managed and franchised unit growth that has averaged more than 11% annually the past five years (2014-18), well above long-term U.S. industry supply growth of 2%.
The higher ownership exposure presents increase exposure to fluctuations in economic growth and is the main risk to prospective shareholders. An additional risk is the Pritzker family having over 90% voting interest of the shares outstanding. Although the Pritzker family is required to vote based on the board of director recommendations, the family controls board seat elections. This structure significantly reduces the ability of minority shareholders to dictate change in the operations of the business. Further, the Pritzker family is allowed to sell up to 25% of its shares in a given year, which present an overhanging risk to shares.
Our long-held view of Hyatt’s evolving moat has continued to develop, and we forecast ROIC including goodwill to surpass its cost of capital in 2020, as third-party hoteliers are gaining increased confidence in joining the company’s brand portfolio (evidencing an intangible asset). As a result, we award Hyatt a narrow moat rating, driven by both intangible asset and switching cost advantages.
Hyatt’s intangible asset advantage is supported by robust third-party unit growth, demonstrating other firms’ desire to join the company’s brands, supporting its narrow moat. To illustrate, Hyatt’s managed and franchised unit growth has averaged over 11% annual growth the past five years, well above the long-term U.S. industry supply growth of 2%.
More recently, Hyatt’s intangible asset advantage is evident by the increasing mix of third-party development funding, which shows growing confidence in the company’s portfolio of brands. Historically, Hyatt has relied on self-funding to support growth of its brands, leading to a high exposure of owned assets. This dependence on an ownership-driven model is not uncommon for a hotelier earlier in its life cycle like Hyatt (in 2018, Hyatt’s 211,018 rooms represented around 15% of narrow-moat company Marriott). This is because hoteliers often need to prove that their concepts can perform before third parties gain enough confidence to join the company’s portfolio. We believe that Hyatt’s self-funding efforts have successfully built attractive brands that third parties have increasing confidence in, supporting a narrow moat rating. This is witnessed by the company’s comments regarding its ability to obtain higher levels of third-party capital funding for development projects, leading to our expectation that Hyatt can drive its capital expenditure as a percentage of sales to 4.2% in 2028 from 6.7% in 2018.
In addition to Hyatt’s managed and franchised momentum, the scale of the company’s managed properties also points to an intangible asset advantage. Third-party owners that choose to outsource management responsibilities seek a strong brand and management team with both scale and expertise in reservation, advertising, marketing, and labor management, which leads to strong revenue per available room, or revPAR, occupancy, and profitability. Worldwide, there are hundreds of lodging management companies but only a few of those currently manage more than 100 properties with Hyatt one of them, making it a prime partner for third-party owners looking to outsource management responsibilities.
As a result of increasing third-party confidence in Hyatt’s brands, the company's asset-light business became the majority of adjusted EBITDA (before corporate) in 2018, and we estimate it will exceed 69% in 2028. We also see Hyatt’s adjusted ROIC including goodwill averaging 11% the next five years and reaching over 15% in 2023, above our 8.3% WACC estimate, which would add quantitative support for our narrow moat rating.
In addition to an intangible asset advantage, we believe Hyatt’s increasing asset-light exposure generates a switching cost advantage, as managed and franchised contracts are typically for 20-30 years (depending on the region and hotel). Termination of these contracts requires significant expenditures to renovate and rebrand a property to meet the new brand specifications, which results in 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). Hyatt’s growing brand and management expertise, along with these meaningful switching costs, result in low attrition of its managed and franchised customer base. In fact, Hyatt’s termination rate is sub-2%, which is near Marriott's 1%-2%.
Travelers continue to return to Hyatt, as evidenced by its World of Hyatt loyalty program, where members represented 41% of total room nights at the end of second-quarter 2019, up 460 basis points from the prior-year period. Hyatt has outsize exposure to convention groups (near 50% of U.S. room nights), where loyalty use could be lower--one books where the event is taking place. Hyatt notes that its select-service hotels (not tied to conventions) generate around 50% of bookings through loyalty members, which is near Marriott's percentage.
We believe a wide moat rating is not prudent, given the sustainable competition from both independent hoteliers and alternative lodging (narrow-moat Airbnb and apartment hotels). International markets have a higher mix of independent hotels (60%) than developed markets (30%). For example, the top five hotel brands control one third of all rooms in the U.S. but only 10% of international rooms. We believe this independent presence will remain in international markets, as many international travelers prefer the experience that boutique hotels offer. Additionally, we believe that alternative lodging, such as apartment and home rentals, will continue to increase. Airbnb offered near 6 million rooms on its website at the end of 2018, up from 300,000 rooms in February 2014; this compares with Hyatt’s room count of 211,000 units at the end of 2018.
Fair Value and Profit Drivers
After reviewing Hyatt's second-quarter results, we are maintaining our fair value estimate of $78 per share. Our fair value estimate represents a 12 times 2020 enterprise value/EBITDA multiple.
The key drivers of our financial model are revPAR, managed and franchised room growth, and owned room growth and margins.
We forecast total room averaging annual growth of 5.3% over the next decade, driven by our managed and franchised 10-year annual forecast of 5.8% growth. Our unit growth forecast is supported by a favorable position with the growing next-generation traveler, new brand growth, and a pipeline that equates to an industry leasing 40% plus of existing units. Our revPAR annual growth forecast for asset-light properties the next 10 years is 3.5%. We continue to model the current U.S. hotel cycle to extend through 2019, lasting 10 years versus a typical cycle of 7-9 years, as industry supply potential peaks at 2% this year (versus near 3% in prior cycles) and global growth in the middle-income class supports demand. Our revPAR annual growth forecast for owned assets the next 10 years is 3.4%. Additionally, we model reimbursement revenue to average around 3.6 times the level of management and franchised sales. The result is annual revenue growth of 6.8% over the next 10 years.
We estimate margins on owned properties to reach 26.7% in 2028 from 24.6% in 2018 as Hyatt continues to leverage the top line and see operational improvement in a recycled owned-asset portfolio that is higher in quality. This results in operating margins (unadjusted for cost reimbursement) averaging nearly 8% over the next five years.
We assume a 9% cost of equity, which is in line with the 9% rate of return we expect investors will demand of a diversified equity portfolio.
Risk and Uncertainty
The travel industry is cyclical and the main risk for prospective shareholders. In a downturn, consumers and business look to cut back on expenses like travel. Industry revPAR was down 17.1% in 2009, while U.S. GDP growth was down 2.8% that year. This drop in revPAR meaningful affected the top line for both ownership and recurring fee-based models. Hyatt’s ownership-based model, which has higher fixed costs than managed and franchised properties, makes its operating income more exposed to fluctuations in economic growth. In 2009, Hyatt’s sales and operating profit were down 13% and 84%, respectively.
In addition to cyclical demand, Hyatt is exposed to a few other risks. Excessive supply 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 2008 once supply growth eclipsed 2%. We believe that supply growth will surpass 2% in 2019. Any specific changes affecting convention growth would likely affect Hyatt (near 50% of U.S. rooms group) more than others in the industry, and present an additional risk. Finally, we expect competition from boutique hotels predominantly found in international markets (around 30% of Hyatt’s room base) and alternative lodging options such as home, apartment, and vacation rentals to remain.
Hyatt, founded by Jay Pritzker in 1957, is still under significant influence from the Pritzker family. CEO Mark Hoplamazian has been at the helm since 2006 and also serves as vice president of the Pritzker Organization, an advisory firm run by the founding family. Thomas Pritzker is chairman and his son Jason Pritzker is a board member. Even though the roles of CEO and chairman are split, we view the two as effectively one entity, because Hoplamazian and Thomas Pritzker are closely linked. There are two classes of common stock, with Class B shares representing 10 times the voting power of Class A shares. The Pritzker family controls over 90% of total voting power, so minority shareholders have a small voice in decision-making. Even in the event that the Pritzkers' economic ownership declines to less than 50%, the family will still have majority voting power due to the dual-class structure. Directors serve staggered three-year terms, which slows the ability to make changes relative to annual terms. We would prefer to see variable pay based on long-term, value-enhancing metrics such as return on invested capital versus EBITDA. We also frown upon various related-party transactions involving the company conducting business with entities in which the Pritzkers have an interest. We rate management stewardship at Hyatt as Poor.
Hyatt is an operator of 881 owned (8% of total rooms) and managed and franchise (92%) properties across 17 upscale luxury brands, which includes two vacationl brands (Hyatt Ziva and Hyatt Zilara, the recently launched full-service lifestyle brand Hyatt Centric, the soft lifestyle brand Unbound, and the wellness brand Miraval. Hyatt acquired Two Roads in November 2018. The regional breakdown as a percentage of total rooms is 68% Americas, 19% Asia-Pacific, and 13% rest of world.