Description

Recommendation

We are recommending a short position in the shares of Hyatt Hotels Corporation.  We believe the shares trade at a substantial premium to the hotel peer group (PE of 37.5 vs. 18.7x) despite having a lower quality business mix.  Additionally, we believe the industry is near the peak of the cycle while facing secular headwinds from online travel agencies (price transparency eroding brand power/pricing power and increasing customer acquisition costs) and incremental capacity from sources such as Airbnb.  We value the shares at $36.58/share vs. the 7/8/16 closing price of $49.80 implying upside of ~27%.  Our valuation assumes 18.9x multiple on equity free cash flow (ex joint ventures and SBC) + the book value of the joint venture investments and cash as of Q1 2016.

Business Mix/Comparable Company Analysis:  Hyatt trades at a premium to its peer group based on consensus PE estimates: 37.5x forward vs. a median of 18.7x for the peer group (for comparability we use Capitaliq consensus estimates).  While the shares trade at a modest discount to the peer group on an EV/EBITDA basis, 9.6x vs. a median of 10.4x, we believe PE is a more appropriate measure as it better captures cash flows to equity and reflects the impact of differences in business mix on the capital intensity of each business.  We view Marriott, Starwood, and Hilton as the closest peers, as these companies tend to own/operate/manage similar classes of hotels in similar cities.   

Below we provide additional metrics comparing Hyatt and its closest peers. We note that Hyatt generates a smaller percentage of EBITDA from more profitable, less cyclical, higher margin, and less capital intensive fee businesses (Management contracts/Franchising).  This difference in business mix justifies lower multiples for Hyatt given implications around cyclicality and returns on capital, as well as, less cash flow generation per dollar of revenue and EBITDA for Hyatt.

While business mix is also an important driver of Hyatt’s lower return on assets (2.6% vs. 5% – 13% for peers), we believe Hyatt’s lack of relative scale is another driver.  We do not believe Hyatt has been earning its cost of capital as we calculate ROICs consistently below 5%, and even as the industry operates at cyclically high levels we calculate ROIC at ~4%.  The two charts below highlight some of these challenges both in terms of the strength of the member program, aggregate SG&A spend, and SG&A spend per room.

Industry Operating at Peak Levels:  Virtually all demand metrics in the Lodging sector are at or above peak levels, with room nights sold +17% higher than 2007 and room revenues +31% higher than 2007. Below we provide 2 charts from the Bank of America Merrill Lynch Lodging and Macro checklists which paint a bearish picture as we are in year 7 of what has traditionally been a 5-9 year cycle. Hotel occupancies are 66%, the highest levels in 30+ years, and ADRs are 17% above prior cycle peak.  We note that RevPar growth has been decelerating at the same time, suggesting modest erosion in pricing power. Room demand has traditionally tracked closely with both GDP and S&P 500 earnings growth and both correlations have held tightly in the last few years.

Supply/ Secular Challenges:  While supply growth has been somewhat benign at ~0.6% CAGR over the last few years, we note a few challenges for the industry:  1) long term supply growth 2)  supply growth has been much more aggressive in central business districts and in the upscale segments where Hyatt and the larger chains skew 3)  Airbnb adding shadow capacity focused on most profitable cities 4)  OTAs creating price transparency and increasing in relevance as a channel.  We believe low interest rates, the desire to invest in a hard asset in USD, and the EB-5 visa program are all factors that have been supporting excess supply growth.

1. Long Term Supply Growth:  Supply growth has outpaced population growth and job growth over the last 45 years.  While clearly this growth was reflective of the industry benefiting from a long term secular trend, 45 years is a long time enough time for imbalance to potentially form/accumulate.

2. Central Business District Supply:  While industry level supply growth has been somewhat benign, supply is expected to accelerate in the U.S. to 1.7% and 1.9% in 2016 and 2017 up from the last 5-year average of 0.8%.  Additionally, we believe supply mix has been more adverse than what is suggested by the broader level data:

1. Supply growth has been much higher in central business districts which drives a disproportionate amount of EBITDA for the large chains (H, MAR, HOT, HLT)

2. Supply growth is expected to be much higher in the upscale segment where Hyatt and the large chains skew.  

3. Negative mix shift to limited service hotels in many of those same markets (driven by both new construction and higher transparency via OTAs), will also erode pricing power.

3. Airbnb Shadow Capacity:  One of the broader questions facing the industry is the impact of Airbnb.  We believe Airbnb has the potential to meaningfully add capacity to the sector and impact margins and pricing power over the long term. Instead of the 1.7% hotel room supply growth analysts expect in 2016, this figure may actually look more like 3.3% when Airbnb is included.  Analyst estimates suggest Airbnb will make up 5.4% of total US room supply in 2016. This is meaningful as only five hotel players (Hilton, Marriott, Wyndham, Choice, IHG) have US market shares (as a percent of US rooms) in excess of 5%.  The larger more important issue is that much of Airbnb’s capacity increase is occurring in top markets. In these top cities, Airbnb can often add 5% and 10% to supply, numbers that are absolutely material to the hotel owners and operators in those specific markets.  At present, we believe Airbnb’s impact will be particularly felt in certain urban areas, among longer-stay guests and during peak leisure travel periods. Additionally, Airbnb is rapidly developing corporate tools and alternatives.  It is our understanding that Airbnb has been growing at rates close to 100%, suggesting that its impact on the industry is likely to increase in the coming years.

Summary Financial Model

Catalyst

-  Earnigns pressure from:  Overbuilding by industry in key markets, shadow capacity from Airbnb, F/X headwinds affecting non-us earnings and impacting U.S. travel.