Why We Recently Bought Hilton — Eagle Point Capital

Overview

Hilton is a global brand that needs no introduction. As a brief overview, the company operates nearly 20 leading hotel and hospitality brands across 119 countries and more than 6,000 locations.

Revenue and profitability have international exposure but are driven primarily by the US market, with 73% of EBITDA derived from U.S. operations. Europe and Asia Pacific both account for roughly 10% of EBITDA and represent significant growth opportunities.

While Hilton is a well-known global franchise, the quality of its business is not as widely publicized.

Capital-Light Business Model and Moat

Building and owning hotels is a capital-intensive business that requires significant upfront investment and a high level of fixed costs, not exactly the ideal model. Fortunately for Hilton shareholders, the company owns virtually none of its properties (they own 65 out of 6,000+ properties) and instead operate as a franchise and management company with a largely variable cost structure. Hotel owners who wish to utilize any of Hilton’s brands pay Hilton a percentage of gross revenue (or operating profit occasionally) and receive several benefits in return, resulting in a two-sided network for hotel owners and customers.

Competitive Position

Hilton enjoys a self-reinforcing value proposition whereby both hotel owners and customers benefit from Hilton’s global brands.

Hotel owners that operate under one of Hilton’s brand immediately gain access to over 100 million Hilton Honors loyalty members that serve as a reliable and growing customer base that generates repeat business. Additionally, owners benefit from Hilton’s broad marketing campaigns, IT and reservation systems, and supply chain purchasing power. Further, the variable nature of Hilton’s fees mean that Hilton only does well when the hotel owners do well and makes paying for each of these benefits a compelling value proposition.

Customers, on the other hand, also benefit from the award-winning loyalty program and can redeem points for free nights at Hilton, or with over 70 other partners such as airlines, rental car companies, and Amazon. Rewards members have access to hotels across the globe at an array of price-points and know they will receive consistent and quality service backed by Hilton.

Consumers are clearly buying into this network, as loyalty members have grown at a 16% CAGR since 2012 and grew 20% last year alone. The growth in loyalty members attracts more hotel owners into the Hilton brand which offers consumers more hotel options, which allows Hilton to invest back into its reward programs which grows its membership which…you get the point. The company lays it out clearly in the graphic below.

Plenty of businesses do not require significant capital to maintain their core business, but less common are companies that can sustainably grow at above-average rates without employing any capital, otherwise known as capital-light compounders. Hilton fits this bill and should grow earnings, on a normalized basis, around 15% annually for many years without committing significant capital back into the business. Next I’ll look at how this growth should materialize.

Growth

Hilton’s earnings growth is a function of new unit growth (NUG), revenue per available room (RevPAR) growth, and to a lesser extent, franchise fee increases.

New unit growth is the primary driver of growth and should contribute ~7% annually for many years. New units are comprised of new hotel constructions (about 80%) and existing hotels that convert to a Hilton brand (about 20%). This growth avenue has high visibility due to the length it takes to build a hotel. The company currently has the equivalent of nearly 50% of existing properties in its pipeline to be completed in the coming years. On the May 7th earnings call, the leadership team commented that it didn’t expect to see any material cancellations of the backlog due to COVID. There will be a delay in some due to construction stoppages during the shutdown, but no adverse impact over the long-term. Additionally, these contracts run an average length of 19 years, providing a recurring source of earnings for years.

RevPAR, the hotel industry analogue to same-store sales growth, should grow around 1% annually in a normalized environment. This is largely driven by average daily rates and occupancy levels of hotels and will fluctuate around the low single digits to slightly negative based on different conditions in markets across the world, but overall should provide growth over time.

Finally, margins on franchise agreements will expand as the company rolls over franchise contracts at 5.6% of revenue from the 4.9% current rate.

As the company outlined in February, there is plenty of room to continue replicating this model. Despite being one of the largest hospitality brands in the world, they still have meaningful opportunity to grow market share. As you can see to the right, the company has more than three times as many rooms under construction globally as its current share.

Altogether, in a normalized environment (i.e. 2020 is already out the window due to COVID), the company should see free cash flow expand at 8%-10% annually for many years. Per share results, which are what ultimately matter to investors, are even more attractive as we will see next. It is worth repeating that this high-visibility growth should materialize without significant capital investment from Hilton because of their franchise model. Below is a summary of each growth lever.

Valuation and Returns

Normally capital-light compounders do not go on sale, and rightfully so. Investors are willing to pay a premium for businesses that can grow for years without deploying capital and instead direct earnings to attractive shareholder return programs via dividends and buybacks. Since 2017, when Hilton spun off Park Hotels and Resorts and Hilton Grand Vacations, the company has garnered an average valuation of roughly 24x free cash flow. Here you can see average valuations for Hilton and its closest peer, Marriott.

Marriott, also a great business, has garnered a slight premium likely to due to a longer history of operating under this capital-light structure as they spun-off their real estate holdings in the ‘90s. Over time I wouldn’t expect a material difference in valuations as each business operates a strong, growing brand under an attractive franchise structure. Hilton currently offers a better value proposition in my opinion because of the lower valuation and correspondingly higher margin of safety.

Because the company requires nominal capital to grow, they can return almost all of their earnings to shareholders by way of dividends and buybacks. Before the pandemic, Hilton was on track to return between $1.6 - $2.0B to shareholders in 2020, or 8-10% of the current market cap. Buybacks are the largest contributor and share count has been reduced 8% annually since 2017. Combining the ~8% growth in free cash flow with another 4-8% shareholder yield, per share free cash flow (my proxy for intrinsic value growth) should grow at 12-15% annually for a long period of time.

So essentially we have a clearly above-average business trading for a below-average price, something not common for such a high-quality business. Of course, this opportunity exists for one reason and with a catch. Hilton’s short-term results have been and will continue to be decimated by the travel halt resulting from the COVID-19 pandemic. On a 2020 basis, the company looks extraordinarily expensive given they will earn only a fraction of what they earned in 2019. Fortunately, this is of little importance to the long-term investor.

In my view, investors only need to answer two questions when considering Hilton:

- Will the company survive the travel halt from the pandemic?

- Will the company return to 2019s performance within a reasonable amount of time?

If the answer is yes to each of these questions, which I believe it is, investors should do very well buying a high-quality business at a significant historical discount. I’ll discuss the first question in more detail under the risks section below, but in short, I don’t see a scenario where Hilton fails due to the pandemic, liquidity simply isn’t an issue for them.

The second question of when the company can return to 2019’s performance level is more subjective. However, it appears there is enough margin of safety in the current quotation where great accuracy in predicting a rebound in travel and hospitality is not required. Consider the following scenarios:

- Scenario A: performance does not return to 2019 levels for three years (end of 2022), no capital return (buybacks or dividends) until 2022, and a return to historical growth and valuation levels thereafter with a buyback program reduced by 30% compared to recent levels.

- Scenario B: performance does not return to 2019 levels for five years (end of 2024), no capital return until 2025, historical growth and valuation levels thereafter.

I think even scenario A is on the conservative side, and in the event the business takes five years to recover and employs a conservative capital return plan, investors should still be looking at respectable annual returns. They key is at the end of whatever the recovery timeline is, investors still own a great business poised to grow around 15% annually for years, allowing for a long compounding period. In any scenario, it’s quite difficult to see this investment actually losing money over the long term. There’s additional upside on a few fronts, including the possibility that:

- At the first sign of sustained recovery in travel the business re-rates quickly to historical valuation levels

- Operating margins will likely improve from historical levels given the company may not ramp back to 2019 SG&A levels after recent layoffs

- Pent up travel demand could increase growth rates once a vaccine or herd immunity diminishes risks of the Coronavirus

Regarding his opinion on a recovery timeline during the May 7th earnings call, CEO Chris Nassetta commented:

“I think the business, when you get two or three years out, will look a lot more like it did 90 days ago than it looks right now. I think it will look very, very similar... It's going to depend on what happens with how we fight COVID-19. It's going to depend on things that are unknowns today, which is where we end up with vaccines and therapeutics. I'm super optimistic based on the people I'm talking to about those things.”

Obviously, this is just an opinion and I, like the CEO, have no idea what the company’s earnings will look like this year or next. I do have strong conviction that within a reasonable amount of time, say five years or sooner, the company’s franchise, business model, and long-term earnings power will remain intact, people’s desire to travel and interact with each other across the globe will not greatly diminish, and the market will appropriately value this capital-light compounder.

Risks

There are a couple major areas of risk to consider when thinking about Hilton. Obviously, the big one is the fallout from the Coronavirus and the time it will take for the hospitality sector to recover. There was a period in March where Hilton’s survival appeared to be in question based on the values the market was assigning to it. Those moments were brief after the company provided clarity on its liquidity situation.

After bolstering liquidity to $3.8B via drawing down a term loan, furloughing 2/3 of corporate staff, pre-selling American Express rewards, and a new bond offering, the management team has stated the company can last around 24 months with 80-90% RevPAR declines. I was quite surprised and encouraged to learn the company could survive that long with current liquidity levels in such a gloomy scenario. For context, April RevPAR was down around 90%, in-line with China locations early in their lockdown. China has since already returned to “only” 50% declines in RevPAR and there are signs of hope all over the globe. It does not appear that the company is in remote danger of encountering liquidity problems which is the most important question to answer. Further, the company has no debt maturities until 2024 and a well-laddered debt schedule thereafter.

In a scenario where Hilton experiences 80-90% RevPAR declines for more than two years, it seems likely there are much bigger problems across the globe from COVID and virtually any investment other than cash is unlikely to prove successful. This seems like a draconian scenario to me, but maybe I’m just an optimist.

As mentioned earlier, the time to recovery is more ambiguous, but this unknown is more than compensated by the valuation. At 15x 2019 free cash flow (~$73 per share), investors can afford to wait five years for a recovery, which is more than adequate for me. Again, if travel takes more than five years to recover that likely means the broad failure of vaccines and therapeutics, no herd immunity, and trepidation permeating the world economies; a scenario where very few investments turn out favorably.

The executive team has said the existing back logs of new locations will not be diminished because of COVID, and there may be some long-term benefits from this challenging stretch. In a recessionary environment they typically see a higher proportion of conversions to Hilton compared to new builds, which should result in market-share gains. I will make no attempt to predict the timing of a recovery other than to say I feel comfortable that the earnings power of the franchise is not greatly diminished over the 5+ year time frame.

The other risk to consider is disruption from new competitors such as Airbnb in the hospitality sector. These efforts may provide some competition, but Hilton is well insulated from total disruption due to its loyalty program and contribution from corporate travel and events for use of its properties. I think Airbnb poses a larger risk to mom and pop hotels and lower-market properties that don’t compete as heavily with Hilton’s brands, but it is still something to consider.

Also, Airbnb may be significantly impaired by the pandemic as hosts who mortgaged a second or third home to rent out are encountering serious liquidity issues right now as demand evaporates while their debt remains, shaking many of them out of this space permanently.

Conclusion

Investing in Hilton is a time arbitrage opportunity at its core. Hilton is clearly a great business with attractive growth opportunities but will under-earn for the next few years. Most investors do not have an appetite for owning a business that will face certain short-term profitability declines, but therein lies the opportunity.

Waiting for total clarity likely means missing the current attractive valuation. As Buffett has said – “you pay a very high price in the stock market for a cherry consensus”. If you can look past the next several quarters and stomach potentially extreme share-price volatility in the interim as the fight against COVID ebbs and flows, I think shareholders will be rewarded with market-beating returns that should approach 20% annually for many years.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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