Description

Wyndham Hotels (WH) was the franchise hotel asset-light that was spun out of Wyndham Worldwide Corporation (WYN) in June 2018.  This spin transaction separated the asset heavy, more cyclical vacation ownership (timeshare) business, renamed Wyndham Destinations and since rebranded as Travel & Leisure (TNL), from the more recurring, fee-based brand franchise business.  The idea behind the transaction was sound strategically, as Wyndham (WH, the subject of this writeup) was and remains the largest hotel franchising company in the world by number of hotels, a huge loyalty member program/database with 108 million members, and an important scale advantages over independent operators and smaller chains given $375m annual marketing budget and international footprint. 

On paper, the WH spin should have been a success story.  On paper, Wyndham is an exceptionally high quality business: ~85% EBITDA margins on royalties, franchise and license fee revenue, minimal capital intensity (capex % of EBITDA of about ~7%), trusted brands and dominant market share in the economy to upper-midscale segments (largest brands: Days Inn, Super 8, Ramada, La Quinta and Howard Johnson), and a sales machine that consistently builds a pipeline of capital-light room growth – using third-party developer capital – for many years while returning ample FCF back to shareholders. Several similar publicly traded hotel FranchiseCo/AssetCo corporate breakups have done quite well for shareholders, namely MAR’s separation in 2011 and HLT’s three-way breakup in 2016. 

In June as Wyndham commemorated its sixth anniversary, the look back on its experience as a standalone company has been disappointing.  WH has underperformed all public peers since its spin record date. Cumulative returns since May 18, 2018:

Wyndham +25%

Choice +62%

IHG +77%

Marriott +82%

Hyatt +93%

Hilton +165%

**S&P 500 +128%

A discussion of the factors responsible for the poor performance is somewhat relevant for background.  The company has had a franchisee retention problem ever since the spinoff (and prior to it).  Franchisee churn was a big drag on organic room growth, which is a hugely important driver of earnings and cash flow growth considering the incremental room comes at near-100% incremental margins and near-0% incremental capital requirements.  In the first couple years post-spin WH couldn’t get its room growth to accelerate due to persistently high franchisee attrition. Then Covid hit in 2020, causing all sorts of problems.  To their credit management has put a lot of focus on improving franchisee retention and this metric has improved consistently every year since the pandemic reaching an all-time best of nearly 96% last year, up from 94% in 2017.  Like in any mature business model, customer retention is a huge lever as it is much less expensive to retain existing customers than to attract and acquire new ones.  This is an area of great potential for WH as it appears they have become much more capable and confident in driving further improvement in retention. 

Another area of angst for investors is the relative inadequacy of pricing power in the economy scale segment where the business is heavily leisure-transient (as opposed to business travel and groups) and consumers are price sensitive due to lack of differentiation among brands and chains.  Since 2019, economy and mid-scale RevPAR is up just 10-20% cumulatively compared to luxury chain RevPAR increasing over 100% and upscale segment RevPAR increasing nearly 100%.  This might be the worst thing about Wyndham’s business and not something to ignore, especially as competition has been heating up somewhat from the likes of Hilton with its Spark budget brand or MAR’s Moxy chain. It’s at once alarming and interesting that global franchisors like HLT and MAR are cautiously expanding into the select service space, which WH more or less dominates.  One supposition is that the big players are acknowledging the relevance of select service (economy plus midscale), which accounts for about one-quarter of all US hotel rooms.  Irrespective of its muted pricing power, the select service franchise business, like franchised quick service restaurants, can be a nice money maker.  It tends to be less cyclical, and for developers less risky, than the premium end segments which are more dependent on international tourists and corporate T&E, and are significantly costlier to develop.  

All of this is to say: this business has good bones. It’s in a decent industry, and while competition is intense the competitors are big public franchisors that aren’t in business to blow up the economics.  At the same time, the management at WH has taken some important steps to put the company on better footing:  as noted above it has and continues to improve franchisee retention; it has divested its owned hotels and management business for $260mm a couple years ago; and it has stayed away from large scale M&A while returning over $1.0bn in dividends and share repos over 2022-2023 (nearly 20% of the current market cap).  The company has been generating about $350-$400m of annual FCF over the last few years (2020 excluded), which on this year’s ending share count is about $4.50 to $5.25 per share in free cash flow. At the current pace of buybacks we estimate FCF/share of around $5.60 next year - a yield approaching 8% while FCF (pre buybacks) should grow perhaps +6-7% annually.  Reasonably speaking an algorithm of 6-7% EBIT growth plus 7-8% FCF yield (manifesting via buybacks and dividends) should yield a +13-15% total return – if not tantalizing than at least interesting against a backdrop of an expensive cap weighted S&P 500 and, if I may be so presumptuous, with below-average risks of business model disruption or multiple compression. 

The presence of good bones and long term value might be attested to by Choice Hotels (CHH) trying, unsuccessfully, to buy the company last year.  CHH, Wyndham’s key select-service competitor and a smart family-controlled operator, was willing to pay about $90/share to take over Wyndham, and would have likely paid more had it possessed the resources (CHH being the slightly smaller of the two in terms of enterprise value and earnings).  WH fought Choice’s hostile bid tooth and nail over the course of the past several months, but it has never refuted the industrial logic of consolidation.  

In recent conversations, management has in fact touted the synergies and scale economies inherent in industry consolidation.  The hang up was price and regulatory risk protections.  $90 was probably a reasonable price were it offered in cash and by private equity (with mgmt keeping their jobs).  Blackstone and Starwood paid about 14x EBITDA for Extended Stay a few years ago, a multiple that implies $90/share on WH today.  But as it were, WH’s management was not interested in giving up the company (and pretty sweet comp packages) to a strategic acquirer while the uncertain/volatile stock currency and antitrust risk gave the board the out it needed to reject the deal.  In any event, it is conceivable that consolidation efforts could resume if and when a new administration occupies the White House next year (as could be said for many industries).  

The $90 Choice was willing to pay is 23% above the current price and we think it’s a pretty good approximation for what some might call “private market value”.  It might be reasonable to assume that this private market value should accrete at around 13-15% a year including dividends, so long as as the business is stable and capital allocation does not go off the rails.  In two years, WH could be trading at around $113 ($90 compounded at 12% for two years) – about 57% upside with dividends. At that valuation the stock would trade around 5.5% FCF yield on 2025/26 estimates – aspirational, maybe, and dependent on interest rates for sure – but not unreasonable.  

As a kicker, this idea also has an activism angle which i am more loath to discuss in gory detail.  We think that organizationally this company is a rather fat one, with cost cutting of the low hanging fruit kind available.  The corporate campus is large and a bit too nice (and the rent too high) for a company of this size, and management’s compensation is on the rich side. The Board is stale, with the majority of Directors in place since the spin and, despite having overseen a period of underwhelming public market performance, are handsomely paid upwards of $500k retainers.  This is a discussion for the message board perhaps.  Corporate governance and incentives (geared toward growth without regard to ROIC) are two areas for improvement that a credible activist could address.  

To sum it up: a decently high quality business at a 7% FCF yield with an organic EBIT growth profile of about 6-7% (driven by 3-4% room growth, 1-2% RevPAR growth, and very modest operating leverage) and levered per-share FCF growth profile of 13-15%, maybe even better with more aggressive capital allocation.  A well informed buyer thinks the stock is worth at least $90.  A balance sheet in good shape for a highly cash flowing business. A cheap valuation.  Relatively subdued investor expectations given well documented historical issues discussed above.  Slack in the business due to high expense base (in our opinion).  And prospects of consolidation/takeout reemerging at some point.  

Catalyst

Improved execution (higher room growth and stable Revpar) resultion in multiple expansion 

Time - buybacks shrink share count 6-7% per year

CHH or PE come back to bid on asset