Choice Hotels International

Moat: 2/5

Understandability: 1/5

Balance Sheet Health: 4/5

Choice Hotels International is a hotel franchisor with a focus on the midscale and extended-stay lodging segments. Its business model involves licensing its brand names and providing services to independent hotel owners, rather than directly owning and operating hotels.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Choice Hotels operates in the hotel industry as a franchisor, meaning it licenses its brand names to hotel owners and operators. The company does not own the hotels themselves. Instead, they generate revenue through franchise fees, royalties, and marketing and reservation services. This business model allows them to expand without significant capital investments, creating a relatively stable and recurring revenue stream.

  • Revenue Distribution: The primary source of revenue for Choice Hotels comes from franchise fees which are divided into Initial franchise fees (paid once at the time of agreement) and Recurring franchise fees (or royalty fees paid every month by the franchisee).
  • Industry Trends: The global hotel industry has seen growth in both leisure and business travel, which could benefit Choice Hotels due to its diverse brand portfolio. However, it’s also facing headwinds from:
    • Inflation and Rising Costs: Higher input costs and wages may put pressure on franchisee’s margins, potentially leading to less profitability for franchisees.
    • Competition: The hotel industry is highly competitive with various players ranging from large global chains to smaller, independent operators. New entrants and alternative accommodation options (like short-term rentals) can pose a threat.
    • Technology: The industry has been changing with the increase in online travel agencies and platforms that allows hotels to get direct bookings online. This requires hotel brands to invest more in their tech infrastructure to increase their revenues, as travelers now tend to avoid booking hotels though travel agents.
    • Economic Conditions: The macro conditions play a huge part in determining the travel industry’s revenues. A poor economy can lead to less travel (both business and leisure), and cause a drop in revenues for hotel brands. This is an important point to watch out for.
  • Margins: Choice Hotels operates on a pretty high margin. Over the past year, it’s gross profit margins have hovered around 70%. However, these margins are often high for franchise based companies, because they generate revenue without incurring the operating costs.
  • Competitive Landscape: The hotel industry is highly competitive with other established players like Marriott, Hilton, Hyatt, and Wyndham, each with many brands. These are primarily in the upscale and luxury space. Choice Hotels focus primarily on the midscale and extended-stay segment, which makes it unique and better insulated from competition. However, some large global hotel brands are extending their reach to this lower segment as well, which may increase competition. The company also faces competition from smaller and regional players in its geographic markets.

It’s important to realize that while the company is a hotel brand, they don’t own the hotels. This implies low maintenance cost, but does mean that they have little control over the underlying hotels as it is the responsibility of individual franchise operators. This will show in lower margins as the brand can’t extract as much profit as a hotel chain that owns its own locations.

  • What Makes Choice Different:
    • Focus on Midscale and Extended-Stay: Choice Hotels is primarily focused on these lodging segments, while other players focus on upscale. This provides the company with a competitive advantage in these segments that are less competitive.
    • Brand Portfolio: They have a wide range of brands with different price points, which will benefit them from the different customer bases.
    • Strong Franchisee Network: They have a history of maintaining strong relationships with their franchise operators, which improves both revenues and profitability. They have 6800 hotels around the world, 6,100 of which are franchised.
  • Other Relevant Factors
    • The company’s international operations are focused on several areas such as Europe and Asia Pacific.

Financials

The company has demonstrated stable revenue growth over the past few years, which are primarily driven by increase in franchise contracts (the number of locations keeps increasing by around 2% per year). Choice Hotels has generated pretty high return on capital, with the most recent number around 20%. The financial health seems to be pretty strong and stable.

  • Profitability: The company has a very high profit margin, around 70% gross margins and 30% net income margins.
  • Cash Flow: The company generates consistent positive operating cash flows, and is able to cover it’s financial needs.
  • Debt: Choice has a decent amount of debt in its balance sheet. As of 2022, the company’s long-term debt was around $1.2 billion. This needs to be monitored as a high debt burden can cause problems if the company fails to generate enough cash to meet its debt requirements, specially if there is an increase in interest rates.
  • Capital Expenditure: The company does have low CAPEX and maintenance requirements because they do not own hotels.

Overall, Choice Hotels shows pretty good financials, and is showing stable growth, which will be a great sign for investors.

Moat Analysis

The moat rating for Choice Hotels is rated 2 / 5. The company has a narrow moat built upon a strong brand reputation, franchise network, and some switching costs. But the competition is significant and the company’s ability to extract as much value from franchisees as other hotel chains is questionable.

  • Intangible Assets (Brand):
    • Choice has a large portfolio of recognized brands, which is a plus but it’s not at the level of the brands used by bigger hotel chains such as Hilton or Marriott.
    • Brands like Comfort, Quality, and Sleep Inn are all successful names, but they do not have the brand pull or pricing power that some luxury brands have. This allows them to be highly profitable and have pricing power, but doesn’t fully shield them from competitors.
  • Switching Costs:
    • There are moderately high switching costs for franchise operators who invest in the Choice Hotel brand and systems. But, this is a lower barrier for the company to raise prices as many franchisees may switch brands if they face a significantly lower price, especially in an economic downturn.
    • There are also some switching costs present in the loyalty program, with over 50 million members using it, but the membership is not exclusive to Choice Hotels and other brands are starting to increase the reach of their loyalty programs.
    • These advantages combined creates a narrow economic moat as compared to other franchise/hotel companies, but is certainly not enough to give a strong long-term edge to Choice.
  • Cost Advantages: The cost structure is efficient for franchise operations as the company is not responsible for funding hotel construction or operations.
  • Network Economics: The network effect is somewhat applicable due to the large franchise base.

Risks to the Moat

Several factors could negatively affect Choice Hotels’ competitive advantages:

  • Increased competition: Expansion from larger companies into the midscale and extended-stay segments, and new players in hospitality such as online rentals can create pressure on margins.
  • Technological disruption: Changes in booking platforms and the emergence of new technologies (AI, etc.) can make existing technology systems irrelevant. The company has been investing in technology, and their focus on providing high-quality and affordable technologies to franchisees is a positive sign.
  • Macroeconomic downturn: This can significantly decrease the demand for hotels, and can reduce the company’s profitability.
  • Changes in Regulations: The lodging industry is subject to a range of government regulations, and any change to these regulations may affect the company’s financial standing and profitability.
  • Franchise Disputes: Because the company doesn’t directly own or operate hotels, it has less control over the standards or their operation. Any conflict with the franchisee can cause damage to the brand.

Business Resilience

While the hotel industry is inherently cyclical, Choice Hotels’ franchise model offers a measure of resilience in the face of market fluctuations because they primarily earn through the franchising revenue (royalty fees) which are more stable than other operating revenues for hotel operators. Also, if there is a bad market downturn, they can just reduce their new hotel opening goals without affecting revenues much. They are also less affected by interest rates because they do not own hotel properties, hence are more insulated against any rate hikes that can drastically cut into the operating profits of other hotel businesses.

Understandability Rating: 1 / 5

Choice Hotels’ business model is very straightforward and easy to understand. They mostly operate through franchise based revenues, and operate mainly in stable and low to mid tier hotel segment. The company operates several brands each offering specific value propositions, and the management team is focused on driving the business forward by capitalizing on the demand for mid-tier hotel services. The business model itself is well understandable, but there are specific requirements needed to value the company and the management needs to have the right plans in place to keep this machine growing forward, without any major disruption, especially in the face of growing competition. Overall, it has low business complexities, hence a score of 1 / 5 is provided for understandability.

Balance Sheet Health: 4 / 5

  • The company has a relatively stable capital structure with debt that is lower than its total assets.
  • Their free cash flow is increasing year-over-year, allowing the company to easily cover any debt obligations they have
  • The company has a high level of current assets, and can quickly and comfortably pay off their current liabilities, making it financially secure.
  • Overall, I would give the company a score of 4 / 5, because while it is generally healthy, a decrease in long-term debt might be better for investors.

Recent Concerns, Controversies, and Problems

There are a few key points to be noted:

  • COVID-19 Impact: The hotel industry was significantly affected by the Covid-19 pandemic. Though recovery has been quite good, the company will be facing issues such as high occupancy rates, wage inflation, and increase in supply chain costs. This will need to be looked at over the next few quarters, but the management seemed positive on the growth and revenue increases for the company.
  • Acquisition of Radisson Hotels Americas: This is not a recent development as it closed in mid-2022, but the market might be wary of the company taking on a large acquisition. Management’s view is that the acquisition was completely accretive and that it expanded the company’s presence to the upper-mid scale and upscale segment. The integration of the Radisson portfolio is still going on. They have 90 hotels integrated in Q1 2023 and more expected in Q2. The company is currently focused on growing and refining the Radisson brand, while trying to improve the performance of the existing franchise locations. They want to use their technology and management skills to turn the company profitable.

Overall, while it has a strong franchise, it’s still exposed to some external factors such as inflation, increase in operating costs, and changes in consumer spending. Also, the competition within the hotel industry is always on the rise, and Choice needs to consistently improve itself to get an edge against other competitors.