Within this company is a high-quality business model that has removed the need for tying up large amounts of capital while maintaining a large growth potential and generating high and stable cash flows. Changing the structure of an old, British conglomerate was the first step towards the creation of this beauty. In a few years InterContinental Hotels Group, IHG, is expected to have more than one million hotel rooms in its network.
IHG has a network of around 4,800 hotels and almost 830,000 rooms. The beauty of the concept lies in the fact that IHG only owns 12 of these hotels, therefore the growth arises from franchise and management contracts with hotel-property owners. That also means that no capital expenditures are needed to grow earnings. Agreements have already been concluded to open another 270,000 rooms, and this makes IHG’s future growth very predictable.
As a guest, you will see hotel names like Intercontinental, Holiday Inn, Holiday Inn Express, Kimpton, Regent, Avid, Voco and Crowne Plaza – these are all a part of IHG’s global network. For hotel owners, it is hard to achieve more than 10 percent in return on invested capital, but IHG manages returns on invested capital of more than 50 percent. This is due to the fact that IHG does not own the hotel properties – rather, it receives royalty payments that are mainly based on the revenues from the hotels.
This adds a significant degree of stability to IHG’s revenue, as it is mainly the total revenue and the growth of the revenue that has an impact on the level of earnings. For the property owners, the revenue per available room is critical to how profitable they are, as they have to increase efficiency and profitability.
For IHG, the business consists of operating their head quarter from where they can assist franchise holders with back-office systems, marketing and the development of new hotel concepts – and thus, revenue is mainly driven by the expansion of the hotel network. IHG has renewed its focus on increasing growth in number of rooms, and it aims to increase the number of rooms at an industry-leading pace which will require annual growth rates of more than six percent.
Contracts signed on expansions are added to the so-called pipeline which, as mentioned, consists of around 270,000 rooms that they expect to open in the next three to five years. This is an expansion of more than a 33 percent to the number of rooms, and thus results in annual growth of around five percent – which is in addition to the growth from the rooms already opened. In 2018, the pipeline grew at a faster rate than seen in the last decade, as the growth rate of added rooms exceeded 15 percent. We see strong opportunities for IHG to grow its earnings by around 10 percent per year due to very attractive growth in revenue and a disciplined approach to cost management.
For a long time, IHG was part of a large British conglomerate which operated hotels from 1948 onwards, which also included a soft drink manufacturer. The transition towards the current business (without significant property ownership) took place after a split in 2003, and since 2005 IHG has increasingly been a business focusing on the operation and development of hotels via franchise and management contracts and without significant ownership of properties.
The focusing included major property divestitures, and most of the profits from these were distributed to the shareholders. Thus, over the last 16 years IHG has distributed more than 13 billion dollars to the shareholders – which is approximately the market value of the company today. However, dividends have not only been financed from these divestments. IHG also generates significant annual free cash flows exceeding five percent of the market value.
We expect that the number of owned hotels will decrease from the current number of just over ten, as the management (quite sensibly) is not interested in owning all of them. After all, owning them carries greater financial risk than the main franchise model where there are no financial risks from the individual properties. A number of the hotel properties are, however, expected to be kept. They are located on extremely exclusive addresses and are seen as flagships – such as the Intercontinental in London. If this property is sold, IHG would risk not having this historical downtown hotel in its network, as the new owners of the property would be the ones deciding whether this should continue to be an IHG hotel.
Nevertheless, it is a fact that they do not own many hotels which makes the business model so interesting and value creating. When the growth in both hotels and hotel rooms do not require capital investments from IHG, the return on incremental invested capital is almost infinitely high for IHG. This sounds almost too good to be true. The operating margin at IHG on royalty payments are at an impressively high 54 percent of revenue, and it is expected to increase by approximately one percentage point per year, in line with past performance. This increase is mainly driven by economies of scale, which means that revenue growth is key.
But why should the independent hotel owners decide to join IHG’s network and not continue to run their hotels independently? As independent hotels, the owners would, after all, not have to give a percentage of revenue to IHG but would be able to keep this themselves.
True, but there are advantages in terms of economies of scale for the individual hotel owners in being part of IHG – for example, inventory can be purchased at bulk discounts that a single hotel would not be able to negotiate. In addition, it provides access to the world’s second largest loyalty programme which has around 100 million members. When these members travel to a new city, they can use IHG’s mobile app or website to search for available hotels and benefit from membership discounts. On average, hotels that are part of large branded chains have higher occupancy than independent hotels.
For hotel owners, this ratio of booked rooms as a percentage of total available rooms is one of the aspects of generating higher revenue per available room. The average daily rate is the second factor, and IHG also helps to optimise this part of the top line. Through Revenue Management Systems, IHG can use data from all its hotels to help the individual owners identify where and how rooms should be offered. While the hotel owners pay around five to six percent in royalty to IHG, they also pay four percent to a ‘system fund’ that is used to market and develop the entire network. This is another area where scale benefits the members of the IHG network.
China as an engine for future growth
In 2018, IHG – in collaboration with the Spanish software developer, Amadeus – launched a new Revenue Management System that has already been rolled out to almost all hotels. This system will help increase the profitability of the individual hotels and thus make it even more appealing to be part of IHG. The project was funded by the ‘system fund’ that the hotel owners, as mentioned, contribute to.
More and more hotels are choosing to join the large branded hotel chains such as IHG, Marriott and Hilton. Today, hotel chains make up just over half of all hotel rooms, and this proportion is growing steadily. Among other things, the growth is coming from the rapidly growing Asian market, and China is particularly interesting in this context due to continually increasing industrialisation and a rapidly growing middle class. Today, the American market represents approximately 80 percent of the operating income in IHG and China a mere 10 percent. However, China is expected to become a major source of growth.
The opportunities in China are not unique to IHG, but the model through which IHG operates on the market is different from its main western competitors. While the competitors have typically signed Master Franchise agreements with local operators, IHG runs its Chinese business itself. This leads to more direct control and larger gains from growth.
The control is in part showcased by a requirement from IHG that the Chinese hotels employ a manager who has gone through a fundamental training in operating hotels, and this helps ensure the quality of the service. China is about 15 percent of the open rooms, but almost a third of the rooms in the pipeline. We are extremely optimistic about the future value creation from the Middle Kingdom.
The approach IHG is taking in China, where they have maintained control of the process, is an expression of the company’s strong management and disciplined focus on profitable growth. In general, the management have long tenures with the company and acts in a long-term manner. Keith Barr assumed the role of CEO in the summer of 2017, and already by the time of his first annual report in 2018 he had left his mark via an acceleration in growth of earnings and the free cash flows. Previously, Keith Barr was responsible for overseeing the loyalty club and the development of new hotel brands – two factors that will play a key role in the years to come. Together with CFO Paul Edgecliffe-Johnson, he will be deciding on which initiatives are most worth pursuing. They have both been at IHG for more than 15 years.
As a starting point, new initiatives must be expected to add around 50 million dollars in revenue in a three-year period after they are launched. In 2018, IHG had revenues of 1.9 billion dollars, and during the last year initiatives have been launched that will amount to around 200 million dollars based on this math. These are significant growth initiatives which all indicates that IHG is on an exciting journey.
Online travel agents are not a problem for IHG
One of the questions that we are often asked when we speak about our ownership of IHG, is on the perceived threat from online travel agents such as Hotels.com and Booking.com. However, we do not view these travel agents as a threat to IHG’s business model as it does not matter to IHG whether a reservation comes from these or other sources. It does, however, matter to the individual hotel owners, and therefore IHG helps them to optimise where the reservations are coming from.
Online travel agents take up to 30 percent of the room price, and this has an important impact on earnings for the individual hotel. Thus, the hotels need more reservations from such websites in order to achieve the same earnings – and therefore a hotel can earn the same from three reservations via IHG’s homepage as from four reservations made from Hotels.com. At the same time, the terms and conditions for hotels are typically worse from such sites, as the guest can cancel their booking up to 24 hours before check-in without paying while they generally need to do so three days before if making a direct reservation.
In order to increase the share of direct bookings, IHG continually tries to make it more attractive to be a member of the large loyalty programme. This includes keeping track of how the individual guests’ preferences can continually be saved and used in the future – e.g. if the guest prefers a hard or a soft pillow, if they prefer a room on the top or lower floors etc. The experiments even go one step further and try to determine which of these extra requests the customers might be willing to pay for – and how much. All this serves to increase the interest surrounding IHG’s network and thus also helps to increase IHG’s earnings.
Significant potential for dividends
In 2018, IHG expanded the portfolio of hotel names to include the luxurious Regent which was acquired for 39 million dollars. IHG, with Holiday Inn and Holiday Inn Express, is the market leader in the “Upper Mid-Scale” market where the focus is primarily on business travellers booking two- or three-night stays, and without the need for a lot of service. By increasing the range of names and degrees of luxury, IHG can serve the needs of more customer segments and thereby take advantage of more opportunities for growth – and more growth results in higher earnings and more free cash flows. For every additional dollar earned, IHG is capable of distributing three dollars. This is due to a financial strategy where the debt amounts to 2-2.5 years of earnings before interest, tax, depreciation and amortization. This is in the high end compared to the majority of our companies, but due to the extremely stable and steadily growing free cash flows, we do not see any significant risks in this regard.
IHG is disciplined about allocating excess capital to shareholders, and it has the potential to allocate around six to seven percent of the market value to its co-owners annually. We find it extremely appealing to be co-owners of a company that can grow its earnings and free cash flows by ten percent a year while at the same time being able to distribute such significant dividends. Due to the significant exposure to the US market (which currently represents 80 percent of earnings), we have also benefitted from the US tax reforms. This alone has increased the earnings per share by 15 percent and growth in earnings per share exceeded 20 percent in 2018.
IHG is just the kind of company we like to invest in. We therefore look forward to being along for the ride during the rapidly increasing value creation – and of course, we have no doubt about which hotels we will be staying at when we travel and visit our companies around the world.