No Gimmicks At Two Hiltons - Investment Outlook - December 2002

Hilton Hotels Corp.’s Stephen Bollenbach and Hilton Group’s David Michels have shelved sexy deals and turned their focus back to basics: Making more money.

By Staff -- HOTELS Magazine, 12/1/2002

David Michels and Stephen Bollenbach will be spending more time at their respective conference tables than negotiating tables if they hope to optimize profits in the uncertainty of 2003. Faced with a thin deal market and a healthy fear of increased debt, Michel’s Hilton International (HI), London, and Bollenbach’s Hilton Hotels Corp. (HHC), Beverly Hills, California, have little choice but to concentrate on more efficient financing and improved operations. Michels and Bollenbach will have to find ways to make organic growth, debt reduction and margin gains look exciting if they hope to remain at or near the top of an underperforming sector until the turnaround arrives.

As for the ongoing speculation that the two Hiltons could or should merge, though HI and HHC have created seamless branding and their CEOs now sit on each other’s boards, full corporate integration remains unlikely.

“It would be hard to have a merger where stock is the currency. There is a different investor tradition in the UK and the USA,” says Bollenbach. While UK investors look for healthy dividend payouts, U.S. investors want growth and reinvestment of cash flow.

For Michels and Bollenbach, the synergies already realized go far enough for now. Both say they are “extremely happy” with the relationship as it is. Hilton Honors is one reason. Another is an increasingly productive web site. With HHC’s more than 1,950 hotels and HI’s presence of more than 380 hotels, the core Hilton and former Promus brands can cross-sell most of the world.

What HHC Needs To Do

For both HI and HHC, it is a case of so far, so good. “The key to managing in this kind of market is not to do anything stupid while you wait for recovery,” says Bollenbach. Neither he nor Michels has.

Lehman Brothers’ Joyce Minor, based in New York City, cites “impressive” flow through from HHC’s third quarter RevPAR improvement of 2.5x, a 3% increase in EBITDA. “Hilton’s compelling story this year has been margins,” says Minor. “Through belt tightening and productivity improvements, the company has done an excellent job of squeezing incremental operating income from depressed revenues.”

What bodes well for continuation of solid margins is the fact that HHC’s gains are attributable to sustainable managerial efficiencies from organizational and technological refinements rather than easy cutbacks. HHC is finally realizing the payoff for a multi-year effort that now has 90% of its properties on the same technological operating platform. Technological standardization is especially beneficial to the bottom line coming at a time when “controlling costs is a commitment throughout the organization,” in Minor’s view.

The next 12 months will test how far HHC can expand this skill set. Minor and other analysts believe 2003 poses the challenge of more difficult year-over-year cost comparisons, coupled with increasing employee benefits expenses and rising wages. With typical optimism, Bollenbach says, “The 2003-04 race is already run and won.” HHC estimates improvements in processes and systems would require only a modest 1%-2% rise in same-store RevPAR to cover expense increases. Lowered distribution costs generated by a forecasted 50% growth in HHC’s own web site reservations should also help reduce the pressure on cost controls.

Hilton Honors will continue to be an important revenue and occupancy driver. Bollenbach credits HHC’s loyalty program with delivering more than 30% of systemwide occupancy and playing a key role in market share gains across the board. “Hilton Honors’ contribution is not subject to yield analysis at this point. We are looking more at what it means in terms of filling up our hotels every night,” stresses Bollenbach. Analysts would like to see Hilton Honors and other sales/marketing strategies give even more of a lift to Doubletree—the only Hilton brand with less than fair-share market penetration.

The other brands acquired from Promus in 1999 have made a strong showing in both market share and RevPAR. Homewood Suites and Hampton Inn gained market share of 5.3% and 4.7% respectively. Ever-popular Embassy Suites was the group’s RevPAR star, with its third quarter 2.9% increase. With its broad portfolio of brands expected to continue gaining market share, HHC should be able to generate impressive cash flows Bear Stearns forecasts will reach US$466 million this year and US$473 million in 2003.

Bollenbach is looking to deliver RevPAR gains “in the low single digits” in 2003. If HHC is to realize these targets, it must fine tune the business mix at large, owned assets in major cities which provide a substantial portion of owned EBITDA. Individual corporate travelers will not be rushing to raise occupancy or yield over the next 12 months, so HHC, like it peers, is looking for more group business. Minor says the challenge will be to complement flat rates generated by corporate volume accounts with group business booked on shorter notice and better rates. It also will have to turn a 15% increase in tentative bookings into room nights and banquet sales.

“HHC has been successful in attracting groups to back-fill rooms left vacant by slow corporate transient demand,” says Bear Stearns’ Jason Ader. “However, the group market is becoming increasingly competitive and we expect to see HHC give back some of its market share in the coming quarters.”

The Bright Spots

Where HHC will not give anything back is in growth, particularly on the management/franchise side. Bollenbach says flatly that, on the owned side, “There is no place we need to be.” Although bravura deal making made Bollenbach a household word during the high-speed early and mid 1990s, he says this “structurally complete” company plans no further acquisitions unless the deal is clearly a financial bargain. Any deal also would have to have “a significant impact on earnings.” “We do not have to pay a premium to get into any given market. I do not think we will be buying much for the foreseeable future,” he says.

Nor does he see emerging new capital sources that will fuel deal activity. “There is no vibrant new capital market for hotels,” says Bollenbach. “We are comfortable that we will recognize it when it comes. But, at this point, I just do not know when it will emerge or from what sector it would come. In the meantime, we have the benefit of owning and controlling a class of assets that are in short supply. Five years from now, anyone who owns hotels will be very happy he or she invested in the hotel industry.”

Currently, owned hotels contribute roughly 65% of HHC’s profits. That has served HHC well in the current economy. It enables HHC to maintain a steady income stream while remaining leveraged for recovery through ownership interests. Bollenbach sees the profit ratio changing as management/franchising’s contribution gradually moves toward 50-50. He estimates HHC and Marriott International “will do about half the projects in the United States” this year.

Ader credits HHC with a strong franchising system “thanks to its acquisition of Promus.” Brand recognition for extended stay Homewood Suites, and mid-tier Hampton Inn and Hilton Garden Inn opens up solid growth opportunities. “Competition among flags is increasing and, to HHC’s benefit, it has been able to grow without making a significant number of loan guarantees, equity loans or mezzanine financing to keep up its expansion pace,” says Ader. Others in the industry add that Marriott’s much-publicized legal problems with owners have not hurt HHC’s franchising prospects.

An estimated 30% of HHC’s 2003 cap ex budget will be devoted to the timeshare sector, which increased HHC’s EBITDA 7% in the third quarter. Hilton Grand Vacations will test the urban waters with a new project in New York City. “If this is a big success,” says Bollenbach, “we might take it to other cities. It would offer an interesting alternative for stabilizing what is essentially still a young business. It also would draw developer interest in different locations.”

In Ader’s view, the growing timeshare component “will provide HHC with solid earnings growth.” Minor also likes timeshare, but cautions that EBITDA growth may moderate because of increased construction costs in Hawaii and additional start-up costs in New York.

Generally, excess cash flow will continue to be used for debt reduction. Assuming HHC resolves the mold problems that have plagued the reopening of the Kalia Tower at Hilton Hawaiian Village and added a US$10 million charge in both the second and third quarters of this year, the company is expected to perform in line with the industry.

In 2004, a better story should be in store for shareholders. “HHC is one of the best positioned stocks in our coverage universe,” says Ader. “It has steady earnings from management/franchise fees. Timeshare and ownership of 60% of its rooms should provide good leverage when the recovery takes hold.”

Where Hilton International Is Headed

The challenges for Hilton Group’s Hilton International, which operates in 70 countries, are clearly different. “It is impossible to forecast for 70 countries,” says Michels. “We can forecast that there will be a big turnaround, which there will, but we cannot say when. Shareholders will have to guess when Americans will begin to travel and whether there will be a war. We are not doing badly now. Our numbers are good, but they should be better. We have a good brand, in which we invested US$600 million from 1999 through 2001. So, we should outperform in our sector.”

Realizing gains on its investments will be HI’s immediate challenge. HI will need to show good returns on its expenditures for the acquisition of Stakis in 1999, Scandic in 2001 and substantial renovations. Some analysts have charged that ROI on Stakis has been weak. Scandic’s performance is also a question mark, given some experts’ view that HI paid “full price” for the Scandinavian chain and set post-acquisition targets too high.

“We knew that we were investing for the medium term with deals such as Scandic, our hotel in Sydney and our new hotel in São Paulo,” says Michels. “You have to be brave—or foolhardy—to invest US$90 million into a hotel in Brazil knowing there will be an election. But, you also have to ask yourself, will a stunning hotel in a market like Brazil deliver good ROI over 10 years? The answer is, ‘no doubt.’”

Scandic’s potential may be nearer term. Michels terms the Scandinavian market “somewhat resilient”going into 2003. However, it still trails HI’s strength in the solid UK market and its surprisingly good performance in the soft Caribbean market.

Hilton Group has more leeway than most of its hospitality sector competitors in waiting for its hotels to recover, given its betting and gaming group’s 63% contribution to revenues in 2001 and prospects for further growth of the US$600 million channeled through Internet betting.

Growth Prospects

For the next 12 months, growth will take a back seat to concerns about safeguarding HI’s gearing. Like analysts, Michels wants to see controlled spending at a time when earnings growth is expected to be neutral. “Cap ex for the entire company will be US$238 million. That is all we intend to spend,” states Michels.

That leaves room for growth through innovative deals such as Coral by Hilton, the first effort by a major international chain to create an all-inclusive brand. It may also produce movement on HI’s long considered intention to go into the midscale segment. Though Michels “is unable to comment on market speculation,” sources suggest that HI may be looking at a franchise deal with UK-based Queens Moat Houses (QMH). The majority QMH’s franchise agreements with Six Continents Hotels’ Holiday Inn branded hotels in Germany are nearing expiration. A decision is expected this month as to whether HI or companies such as France’s Accor or U.S.-based Westmont Hospitality, which has a 10% stake in QMH, will get the nod.

Winning the deal would provide HI with access to the mid-tier and give it entry to the German market. It could also offer a boost to Scandic. “The Scandic brand, which is strong in the Nordic region, could realistically spread to northern Europe and Germany,” says Bear Stearns’ Mark Abramson, London. It will be far more difficult to build a mid-term presence in France (already dominated by Accor) and the fragmented markets of Spain and Italy—a lesson that has dashed many mid-tier chains’ hopes. Still, organic growth remains HI’s number one priority, and the City will be watching closely to what extent that translates into a replenished development pipeline and new management contracts.

Balanced Portfolio

It is on the financial side that HI has shone in recent years. “What Hilton Group and HI are doing really well is recycling capital. They have set the mark,” says Mark Wynne Smith, executive vice president, Jones Lang LaSalle Hotels, London. Wynne Smith adds that, in addition to the success of the sales/leasbacks, HI’s liquidity and its “sensible mix” of owned and managed hotels should offer good leverage going forward. UK gaming deregulation, which seems all but assured, would give the group’s hotel side “a major boost” as some of its UK resort/conference hotels could cost effectively add business-broadening casinos for US$50 million to US$75 million per hotel.

Michels says the sales/leasebacks will continue as HI looks to aggressively manage its portfolio. The issue will be accomplishing these kinds of transactions without allowing them to become little more than incremental debt. “We will continue to buy and sell. It may be sales and leasebacks; it may be sales and management backs,” Michels says. “I would be surprised if we do not do a deal of more than US$500 million. I have told shareholders that, if they invest in us, they are investing in real estate. But, over time, it may be different real estate.”

These kinds of advantages, plus Michels’ almost obsessive transparency, should keep shareholders and owners in the fold. Michels’ recent decision to suspend the dividend, even with returns at 5 1/2%, was typical of his management style. “I have a responsibility to keep the company stable. In this environment, increasing the dividend would indicate an optimism that is not justifiable,” he says.

Maintaining strong cash reserves fulfills two key aims: helping to protect Hilton Group’s investment grade rating and keeping it positioned to take advantage of opportunistic deals before recovery is full blown. “When the U.S. business cycle turns, Hilton Group will be in an excellent position to benefit. This is what attracts most investors to the stock now—a pure trading call based on an expected upturn in the U.S. economy,” says Abramson.