Description

Pitch:

Hilton Worldwide Holdings (HLT) is a fantastic business trading at a reasonable valuation with a very long runway to compound FCF per share at 15 to 20% per annum through a combination of organic growth, operating leverage, and continual share repurchases.  Specifically, through the cycle revpar can likely grow at 2%, room night unit growth at 5-6%, EBITDA at HSD + growth, with MSD to HSD annual share count reduction through the use of financial leverage at a constant 3 to 3.5x ND/EBITDA ratio. At 17x 2019E FCF with a defensive & asset light business model, strong competitive advantages, secular growth tailwinds, small share in a large global TAM, and a best in class management team this strikes me as a 10 year buy and hold kind of investment.  HLT could be trading at 14.5x 2020 FCF per share in a base case and as low as 13.3x FCF 2020 in an upside case. It should trade for higher multiples in everything but a severe recession.

The near term risk/reward profile is attractive with 25-30% upside to YE19 in a base case assuming $5.00 in 2020 FCF per share at an 18.5x forward multiple plus dividend.  In an upside case, with realistic assumptions, there is 50% upside to shareholders assuming $5.50 in 2020 FCF per share and a 20x forward multiple at YE19. In a bear case there could be 15% downside assuming $4.40 in 2020 FCF per share and using a 14x multiple, which I would argue is too low for any sustainable time frame as I believe this business should be a 3-4x multiple turn premium to the market and buybacks help serve as a backstop for valuation given the accretion.  In 2018, the company plans to buy-in 1.65B of stock, which at the current market cap would be almost 8% of the float.

Why now?  The stock has been flat to down over the last 12 months, is off 17% from its recent highs, and has sold off with other “cyclicals” on the potential for a down business cycle.  This is among the cheapest valuation levels it has been since the asset separation. It doesn't screen great given fcf is higher than reported earnings.  Meanwhile, fundamentals have been strong with recent results and 2019 guidance being solid. If we do go through a business cycle I believe the market will be surprised at how resilient this business has actually become.  The RemainCo has not be tested in a cycle as a standalone entity (see prior write-ups). As such, the market could be overreacting to fears of a downturn and how HLT will perform. Investors also get a few “free” growth options that will help grow FCF per share in all but a severe downturn. First, the company has a significant development pipeline of room nights that could translate into 30% + EBITDA growth over time when this comes online and secondly they have 6.5% EBITDA growth from franchise fee contract renewals - these two factors create high quality embedded growth for many years.  In addition, the capital light model frees up significant cash generation for buybacks each year. 

Great business, great management:

This is a great business with the best performing portfolio of brands in the business.  Since 2007 HLT has had the leading room night growth in the industry and currently has one of the largest development pipelines.  You have to dig into the business model and history to understand just how strong this business has become but once you do it’s easy to see how Hilton can have such an advantage over the independent market.  They also have 50B of developer capital committed to their pipeline with HLT only putting up 219MM, which is outstanding. The company continues to create new brands organically and has shown significant strength in being able to execute in all major price points of the industry, which bodes well for their ability to take a significant amount of market share in the long-run and adapt to changing market conditions as needed.  Given so much of a hotel is experience vs. price, I think their track record of creating leading brands is an important point to drive home. They are a great incubator of new brands and great steward of old.

HLT is an asset / capital light franchisor with 90% of adj EBITDA coming from franchise/ management fees.  Franchise contracts are 10-20 years (19 years in the pipeline) with 20 year contracts for hotel management.   Their scale, global presence of leading brands at multiple price points and Hilton Honors loyalty program creates strong network effects.  These factors create a strong experience for customers who want to increasingly keep their hotel spend “in-network” to gain rewards and better economics for developers who join the Hilton portfolio of brands.  Developers of Hilton brands typically get a 14% global RevPAR premium versus alternatives leading to far superior ROICs. Booked room nights are now ~60% loyalty program members versus less than 50% before the GFC and continues to trend up suggesting the network effect is growing stronger.  Hilton also has the highest rated travel app according to the company with innovative features like Digital Key available in 4,000 out of the 5,500 properties by YE18. They continue to roll-out new features such as mobile connected rooms for HVAC, lighting, and entertainment. Room selection and digital check-in are already available through the app at the majority of properties.  Technology has transformed many industries over the last decade and it will further widen the gap in branded versus independent operators in the hotel space as well.

The management at HLT is fantastic and committed to superior shareholder returns.  It’s my impression that the CEO would welcome a modest downturn so he could buy-in an even larger percent of the float.  It’s not hard to see how they could buy in a significant % of the company over the next 10 years.

Small, but fastest growing share of a large global market:

Domestically, HLT has 11% share of the US Hotel market, but 25% of the new room night development pipeline for a ~2x ratio.  Globally, the company has about 5% share of the existing room supply, but 20% of the rooms under construction for a 4x ratio.  Travel and lodging grows globally at a GDP plus type rate and HLT is taking a disproportionate share of the growth which bodes well for the long-haul.  The two closest peers Marriott and IHG are also well run, but only account for around 2.5x global rooms under construction versus existing rooms.

Resilient earnings stream + safe balance sheet should perform ok in a downturn:

Given the franchise fee nature of the business the company’s guidance is for a 1% revpar change to change adjusted EBITDA by 1%.  If we go through a business cycle revpar will decline, but should be offset by room night growth and share repurchases. At 3.4x ND/EBITDA in the MRQ, minimal maintenance capex needs, and a 6 year average maturity with 75% fixed debt there is significant room for aggressive balance sheet usage should we go through a downturn.  I don’t have good stats on how levered their franchisees are, but rooms under management grew nicely even through the GFC, suggesting prudently run franchisees.

Room pipeline + franchise rate changes creates embedded growth:

HLT has 895K rooms in operation and 371K rooms in the development pipeline with 50B of third party investment committed versus 219MM of HLT investment.   This is an incredible statistic and reinforces the notion that hotel owners are happy and committed with 75% of the pipeline coming from existing brands overall and 25% from organically developed new brands.  As of Q318 > 50% of the 371K rooms in the pipeline were already under construction. At a stabilized adjusted EBITDA once these hotels are completed HLT will have an incremental 740MM in EBITDA versus 2018E guidance of ~2.1B.  The pipeline has been resilient historically given how much is under construction and the nature of these projects / approvals, so it’s safe to assume that 80% or more of this will likely convert even if we go into a severe recession.  If that math proves accurate HLT has embedded ~30% growth EBITDA once these rooms come online before factoring in pipeline growth. Pipeline growth is not slowing down with 11% growth expected this year and similar levels next. Room growth should continue for a long-time as Hilton penetrates more of the international market where a significant amount of properties are managed by independent operators.  

For anyone concerned with APAC due to China this region only constitutes ~22% of the room nights in the pipeline.  While RevPar will ebb and flow with the economy investors are likely to get at least a 3-4% room night growth CAGR over the next 4 years for the company overall.  In the event we do go through a sustained downtown, or a higher interest rate environment the company’s development team would shift their focus into conversion opportunities, tapping existing developments for conversion to HLT brands.  The ratio of conversion versus new build has expanded during downturns to 40% +, was 22% recently, so there is some flexibility in the model to be semi-capital light to the hotel developers as well if the environment changed materially.   

The in-place rate vs. Published rate for the franchisees is 4.9% vs. 5.6%, which results in 140MM adjusted EBITDA increase once it flows through.  This is another 6.5% increase to the 2018 EBITDA guidance of 2.1B.

Conclusion:

We’re 9 years into a business recovery so a recession or business cycle is going to occur at some point in the not too distant future but HLT is a high quality, resilient business that may be able to grow its FCF per a share in a modest downturn given the room pipeline under construction, franchise rate increases already contracted, and the significant amount of capital it can deploy into share count reduction.  It appears to trade for 17x 2019 FCF and 14.5x 2020 FCF under reasonable assumptions and it may have a decade or longer run-way to grow it’s FCF per share at a high teens rate.

Risks:

Recession with RevPar coming under pressure.

AirBnB will likely continue taking some share from traditional hotels over time, but at a manageable pace.  

Hotel developers could sour to Hilton properties over time if returns diminish, but they also continue to create new brands and so far seem to be gaining steam not losing it with loyalty members growing faster than room nights and members booking a larger share of their overall hotel budget with Hilton.  This makes sense as their portfolio of options, locations, and rewards increases to reinforce the network effect.

The big three hotel brands with loyalty programs will become a bigger share of the market overtime and could reduce the RevPar premium to the market overall these businesses enjoy.  However, at MSD to HSD overall global market share for Hilton we’re still a long ways off from that point and even then developers will still likely choose one of the large branded operators who have scale benefits and customers will choose networks with most options.   

Disclosure:

We and our affiliates are long Hilton (HLT) and may buy additional shares or sell some or all of our

securities, at any time. We have no obligation to inform anybody of any changes in our views of HLT. This

is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please

conduct your own research and reach your own conclusion.

Catalyst

Earnings.  Economy holding up.  Passage of time.  Larger than expected float reduction over time if valuation gets even cheaper.