Description

Hilton sells at 75% my estimate of private market value and has a 7% discretionary (after maintenance capital expenditures) cash yield on my 2006 projections. Business trends are likely to continue very strong, as net new room increases for the industry will remain subdiued through at least 2007. The company is in the midst of a major asset sale program--taking advantage of the prevaling low cap rates--and since November has been a significant buyer of its own stock. Fee income should rise disproportionately quickly as Hilton leads the industry in new rooms under construction (owned and financed by others). Over time the combination of asset sales and growing fee income will produce higher financial returns and less earnings volatility--a formula for multiple enhancement.

The company has three segments: Ownership (47% of operating income and close to 60% of cash flow in 2004); Managing and Franchising (41% of operating income), and Timeshare (12%). Management’s goal is to make ownership and franchising each contribute 40-45% of EBITDA and they have stated that timeshare, alhthough it has been growing rapidly, should be no more than 12-13% of EBITDA in 5 years.

As noted above, HLT recently has been an active seller of hotels. Twelve hotels, including the Chicago Palmer House, have been sold so far in 2005 for approximately $650MM. Most of the gains have been shielded through the use of 1031 exchanges for land in Hawaii that had previously been on a long-term lease. On trailing operating income and adjusted for the buyers’ capital commitments, the cap rate is roughly 6%. On forward income (2006), the package sold for 10-11X cash flow. Eight additional non-core hotels are currently on the market, which should yield over $600MM in gross proceeds. Almost all of these hotels will remain within the Hilton system, so the company will continue to earn fee income from them. Assuming sale of the eight hotels, owned hotels should decline to about 50% of 2006 EBITDA, or within shouting distance of the contribution target. Hilton will continue to own many ”crown jewel” properties, including the Waldorf-Astoria, New York Hilton, Hilton Hawaiian Village, San Francisco Hilton, and the Washington Hilton. Although it is highly unlikely that Hilton would sell these hotels, I think it is reasonable to assume that they would trade at an even higher multiple than those that have been sold and will be sold this year. I put an 11.5 multiple on 2006 cash flow of $625MM for owned hotels and believe that to be conservative. Note that this represents EBITDA margins of 30% for this segment--still under the 34% reached at the peak in 2000.

With the acquisiton of Promus Hotels in late 1999, Hilton both became a multibrand company with exposure to more segments of the lodging business and also more of a franchisor/manager. Typical fees are 5% of revenues. Today, Hilton has three rapidly growing brands: Hampton Inn, Hilton Garden Inn, and Homewood Suites by Hilton. Athough there are 1300 Hamptons, management believes that there remain several more years of good growth. The other two are much smaller and should be able to sustain rapid growth for a long time to come. Each of these are ranked first in their category by J. D. Power and each scores over 120 on a category REVPAR index, a characteristic prized by franchisees, as it indicates that their investment in a Hilton property will produce higher returns. Overall, Hilton has a significantly larger development pipeline in the US than any competitor. Management and franchise fees grew 18% in the first half; 60% from RevPAR gains and 40% from unit expansion. As was stated on the 1st quarter conference call, “We get inflationary growth plus real expanding market share." This year, Hilton franchisees will open over 160 new hotels with over 20,000 rooms. Analysts don’t usually look at it this way, but at current RevPAR levels at maturity these hotels should produce over $30MM in operating income for HLT with no investment required. I value the management business at 15X 2006 operating income. That may seem high but this business really has very unique characteristics. If this segment were a standalone business I am confident that the P/E would be over 20 given its combination of high returns on capital, unit growth opportunites, and pricing power.

Timeshare is the smallest operating segment but has been growing very quickly. This is a concentrated business in three markets: Orlando, Las Vegas, and Hawaii. Margins are in the mid-20’s. Hilton finances many of the buyers and earns handsome interest income as well. I don’t think it’s worth a lot of attention here; I value it at 8X2006 EBITDA.

The combination of recession, 9/11, and travel fears around the beginning of the war in Iraq depressed operating results until late 2003. Accordingly, the company focused on cost control and balance sheet strengthening. The corporate goal is to have investment grade ratings and debt less than 3.75X EBITDA. This level was achieved in 2004 and the company began to buy back stock last November. Through the end of Q2, they have bought back 14.6MM shares at an average price of $21.85. I believe that the pace of buybacks will accelerate given continued free cash generation and the proceeds from the asset sales. Additionally, the dividend was doubled at the end of Q2, but is still only $0.16/year. By the end of 2006, HLT should generate a net additional $750MM from the asset sales described above and another $350MM in excess cash from operations after dividends and all capital spending. Hence, the company could reduce its share base by 10%+ and still improve its financial ratios.

Risks:

1. A terrorist incident crimps US travel.

2. Recession.

3. Stupid use of free cash. (I think this is highly unlikely.)

Catalyst

Completion of the second tranche of asset sales and continued aggressive share repurchase cause the Street to look at Hilton differently.