Shares of Hilton Worldwide (NYSE:HLT) have been a strong performer over the past year, rising about 18%. Even with recent market weakness, they have stayed within 5% of their all-time high. While at 25x forward consensus earnings, shares do not appear cheap, Hilton’s cash flow generative business model and long-term growth potential makes for a compelling long-term investment opportunity even at this valuation.
Hilton is one of the world’s largest hospitality companies. It has about 7,300 properties and over 1.1 million rooms, so chances are you have stayed at one of their hotels at some point. As you can see below, about three-quarters of its business is in the United States, with Europe its next biggest market. Hilton is also diversified across price points, but in aggregate, it generates 15% higher RevPAR (revenue per available room) than the industry average, pointing to a modest upscale bias.
Hilton has also dramatically increased its loyalty program, Hilton Honors, over the past decade. It has grown its loyalty members over four-fold since 2012 to 166 million, and they account for 63% of guests. Generally speaking, it is more expensive to convert and acquire new customers than to retain existing ones, and this buildout of its loyalty program has helped to boost growth and support margins.
It is essential to note that Hilton is an asset-light business because it does not actually own many of its hotels at all. Rather, outside investors own the hotels, and Hilton franchises and licenses out its brand to the location, helping to manage the hotel, but it has limited real estate exposure. Hilton is to hotels what McDonald’s (MCD) or Domino’s Pizza (DPZ) are to restaurants—franchise companies, not owners.
Hilton generates 95% of its adjusted EBITDA through fees, creating a recurring contractual cash flow. Franchise and licensing fees accounts for 80% of fee revenue. As contracts reset, Hilton sees about 5-5.6% steady-state growth from its existing footprint.
In a testament to how capital-light its model is, Hilton’s pipeline of hotels under construction encompassing 441,000 rooms—representing about 30% potential growth for the company. Hilton is committing $325 million to these projects, whereas 3rd party investment is $50 billion. Management expects the pipeline to generate $900 million of EBITDA. About half of its pipeline is already under contract for a term of 19 years.
These franchise agreements are long-term, creating a stable base of recurring cash flow. 3rd party investors bring the capital for the real estate, while Hilton brings the brand and the management know-how. This is also why the growth of the Hilton Honors program is so important for its franchising program. Rather than opening a hotel and trying to build a brand or find customers, Hilton brings 166 million customers they have data on, can market to, and who will earn benefits by going to that location. This is what has made Hilton a compelling partner for outside real-estate investors. Importantly, this business model not only sounds good on paper; it is working in practice.
In the company’s second quarter, it earned $1.63 in adjusted EPS, up from $1.29 last year, as it generated $811 million in adjusted EBITDA. RevPAR was up 12.1% from last year, and it is up 9.3% from Q2 2019 (2.25% annual growth). As you can see below, the company is enjoying occupancy gains across all market. Asia Pacific has been the strongest as China was still facing some lockdowns in 2022, making it among the last markets to recover.
.
Thanks to these strong results, Hilton executed on $510 million in capital returns, buying back 3.3 million shares. It has returned $1.1 billion in H1, with about $1.4 billion planned for H2. It has generated nearly $1.8 billion in free cash flow the past twelve months, providing ample support for the capital return program.
Thanks to these buybacks, its share count is down 5% from last year. When we consider its company-wide unit growth is 5%, Hilton is generating about 10% per-share unit growth.
Management also raised guidance following the strong growth in Q2. It expects diluted EPS of $5.93-$6.06 with adjusted EBITDA of $3 billion. That represents ~23% earnings growth from last year’s $4.89. Hilton guided for about $5.55 in EPS this year, meaning it will top that initial estimate by about 8% thanks to the health of the travel & leisure customer.
During the depths of COVID, Hilton borrowed over $2.5 billion to maintain liquidity as travel all but ceased. It has repaid $1.8 billion of that. The company has $7.9 billion of net debt for debt to EBITDA of 2.7x, a conservative level given the recurring nature of its cash flow. Importantly, 88% of its debt is fixed, and it has no maturities until 2025, meaning it does not have to refinance for some time, reducing its exposure to interest rates.
Now, some investors may be concerned that after the “revenge travel” of the past two years following COVID, Hilton may not be able to sustain growth. I would caution against this thought. Travel & leisure accounts for 11.1% of personal spending, slightly below the 11.2% pre-pandemic level. Growth was dramatic, coming off of such a low level, but on an absolute share of wallet, we have not overshot to the upside. We are just back to where we were.
Conservatively, this would argue for spending on travel that tracks overall growth levels. However, I would note that since 2000, travel spending as a share of spending had been in secular growth, steadily rising. Just getting us back to where we were still leaves spending below trend. As such, I would expect travel spending to growth somewhat more quickly than GDP. Additionally, while Hilton is predominately a US business, it does have overseas exposure, and the Asian markets in particular have not fully recovered.
Despite recession worries, we are also not seeing signs consumers have stopped travelling. TSA passenger flows have stayed stronger than last year (January was flattered by Omicron reducing travel in early 2022). While this series can be volatile, it has ticked up lately, and travel is clearly still rising by ~10%.
Earlier, I noted that Hilton was to hotels what McDonald’s and Domino’s were to restaurants. Well, McDonald’s has a forward P/E of 22x while Domino’s Pizza is 27x. I would look for Hilton to earn about $6.30 over the next year, assuming 10% growth in 2024, slower than this year’s 23% growth as comps get tougher for a 23.8x forward multiple.
With its large pipeline and travel likely to gain share of the wallet, I think Hilton operates in a superior market to fast-food/fast-casual restaurants, making it relatively attractive at a similar multiple.
I would view the current business as one that should trade 20x earnings, or a 5% earnings yield, given the recurring nature of the cash flows, and the average 5% annual growth in franchise fees, which combine to create a 10% return profile. That is worth $126.
We also have not fully recovered in Asia, Africa, and Latin America. Closing the gap in occupancy in these markets should provide another ~$0.15 in earnings power, or about $3 of value.
It’s announced pipeline, which will contribute $900 million in EBITDA will provide another ~$2.40 in earnings for about $48 of future value, using a 20x multiple. Discounting this back at 10%, and assuming a 7-year average time to get these projects operating and running in a steady-state fashion, that is worth $24 today
Combined, this would argue that at $153, investors in Hilton should see about 10% long-term returns, based on earnings being generated and ~5% growth in fees per year. Shares trade just below that level today at around $150, so they may not offer 20% or 20% upside, they do offer long-term double-digit return potential, which I think is attractive.
Moreover, this valuation assigns no value potential for growth beyond its announced pipeline. As we can see from the chart above of US spending on travel related activities over the past 60 years, as an economy develops, consumers spend more on travel. With so much of the emerging world developing a middle class, there is ample opportunity for growth beyond announced projects. At $153, you get this potential growth for free, which in my view more than offsets near term uncertainties about recession.
It is because of this additional extra growth that I suspect investors today would be conservative in expecting long-term 10% returns, and likely to see appreciation over the long-term approaching 13-15%. At its current level, Hilton is a great business trading at a fair price, and over the next 3–5 years, that should result in a very good return profile for investors.
Read the full article here