Description

Investment Summary

The recent market pullback has opened an opportunity to invest in this exceptional business at a very reasonable price offering a very low-risk – double-digit compounding reward for long-term investors at a time when IHG’s business is accelerating.

Brief Background

IHG is one of the largest asset-light hotel groups. Franchised and managed rooms drive ~80% of IHG’s revenue and close to 100% of profits. These are derived from fees paid by owners of its 19 hotel brands which span across the full spectrum of price categories with a total of >950k rooms globally as of H1 2024. Major brands include Intercontinental and Kimpton in the Luxury & Lifestyle category, Crowne Plaza in the premium segment and Holiday Inn and Candlewood in the lower priced segments. Its One Rewards loyalty program has over 130 million members, which is 50% more than pre-pandemic. 60% of room nights are currently booked by loyalty members. The business has good geographic exposure with lower exposure to Europe (just 13% of rooms) and higher exposure to the Americas and China.

High Quality Business

IHG shares have compounded at mid-teens % over the past 10,15- and 20-year periods and are highly likely to continue doing so for a very long time. The key to this is the combination of underlying demand growth for travel and the franchised business model which drives high operating leverage with virtually zero capex requirements.

• Travel demand growth: International travel has grown 4% CAGR since 1995 while domestic travel has grown 7-8%. This trend is expected to continue for the foreseeable future driven by secular tailwinds of population growth (1-2% annually), growing wealth in developing countries, the aging population meaning more wealthy retired consumers (population aged 65+ will double by 2050), and a general cultural demand shift from ‘things’ to ‘experiences’.
• Hotel RevPar inflation: pricing is expected to grow 2-3% per annum (we think it will be higher) going forward driven by 2 key factors:

1. Total hotel room supply growth is expected to grow at just 1% per year, significantly lagging the above-mentioned demand growth for travel
2. Unlike the asset-light franchisors, hotel owners operate with narrow margins so cost inflation drives industry wide increases in nightly rates

• Volume (unit) growth: While overall hotel room supply will grow 1% or less, branded hotels are taking share and will grow 3-4% per annum with IHG growing 4-5% annually. This is being achieved through a combination of more new hotel builds than industry average and conversions of independents to brands. Both of those are the result of the superior economics for hotel owners operating under a branded group over independents. The top 5 branded hotel groups today account for just 10% of total room supply so they have a multi-decade runway of above industry growth rates.

• IHG specific unit growth: IHG currently has one of the strongest pipelines in the industry at 35% of its total system size with particularly strong growth in China (34% of pipeline vs 19% of current rooms) and several emerging brands that will drive growth as the more established brands slow. Conversions account for >40% of openings.

• Margin expansion: Unit and RevPar growth at the hotel level comes at virtually no incremental cost to IHG as the costs of building and operating the hotels are borne fully by the hotel owner. IHG’s opex has been roughly flat for the past decade+. This has driven significant operating leverage. The company’s EBIT margin has increased by 120bps per annum over the past decade. This is expected to continue with IHG targeting 100-150 bps annual margin expansion. IHG’s EBIT margin will soon exceed 50%.
• Double-digit earnings growth: the combination of 4-5% unit growth, 2-3% RevPar increases and 100-150bps annual margin expansion drive double-digit growth in profits.
• Triple digit returns in invested capital

• 100%+ FCF conversion: Given the low capital requirements more than 100% of profits are converted into free cash flow annually which enables large cash returns to shareholders through dividends and buybacks. Over the past 10 years, IHG has returned approximately 100% of its (2013) market cap to shareholders
• Limited cyclicality: While RevPar declines during economic downturns obviously do impact IHG, its impact tends to be merely slower growth, no major declines or losses. The business was resilient even during the covid lockdowns, generating positive free cash flow in 2020.

A couple of upside drivers

• Co-branded credit cards: Co-branded credit cards: Hilton and Marriott currently generate 10-20 times the credit fees that IHG earns. Even after adjusting for scale and segment mix, Hilton and Marriott still generate up to 10 times more. This discrepancy presents a significant growth opportunity for IHG's EBITDA in the coming years as the company focuses on closing this gap. Last year, Hilton earned $345 million and Marriott $600 million in credit card fees, compared to IHG's $35 million. On a per-room basis, this represents an 8-10x difference. IHG has only recently begun tapping into this opportunity through a realignment with its hotel owners. The agreement with Chase expires next year (after 10 years), providing an opportunity to renegotiate terms, especially given IHG's 10x growth in rewards members over the past decade. Currently, Marriott and Hilton derive 12-13% of their EBITDA from credit card fees, while IHG only achieves 3%.
• China RevPar recovery: RevPar in China is still 10% below 2019 levels while developed markets RevPar is already 20-25% above 2019 levels. IHG has the largest China exposure among the big hotel groups so whilst a massive recovery in China isn’t currently apparent in the very near-term, when RevPar in the region eventually catches up it will boost IHG’s overall RevPar by a mid-single digit %.  

Unjustified underperformance and valuation discount relative to Hilton and Marriott

IHG shares have lagged US peers since the end of 2019, and in particular Hilton which has risen 87% vs IHG just 36% in this period. On a forward P/E basis, IHG is now at a nearly 30% discount to Hilton and 15% discount to Marriott. We believe this discount is unwarranted and the result of anchoring to past differences in performance between the groups that aren’t a reflection of the future. IHG’s unit growth has lagged Hilton and Marriott over the past decade. However, this was a combination of exceptional growth (for Hilton in particular) and some idiosyncratic headwinds faced by IHG. Currently, IHG’s pipeline relative to its system size is similar to Hilton’s at ~35% with a RevPar mix that is slightly better than Hilton’s (i.e. the pipeline is more skewed to higher RevPar segments vs Hilton), implying IHG’s revenue growth should be similar to Hilton and Marriott in the coming years.  Geographic mix is also similar (low Europe/high US exposure) and IHG has the incremental upside drivers mentioned above from its low penetration in co-branded credit cards and a RevPar recovery in China.

Valuation and prospective IRR

IHG currently trades on <18x forward P/E, which is below its own historical average and below US peers Marriott and Hilton. Without re-rating we expect the shares to compound at >15% per annum, slightly faster than the rate of compounding achieved over the past 10,15- and 20-year periods. However, with a re-rating to 22x and some earnings upside from the various levers discussed above, the shares should compound at >20% for the next 2-3 years.

Catalyst

• Delivering on unit growth and RevPar
• Continued cash returns to shareholders
• Chase credit card agreement renegotiation in 2025
• RevPar recovery in China