Hilton Worldwide: Primed To Outperform, But Upside Is Limited Currently (NYSE:HLT)

Investment thesis

Our current investment thesis is:

• Hilton is a fantastic business, with all the hallmarks of a staple in investors’ portfolios. It is low risk and has impressive margins, with a strong runway for advance growth through new developments. We expect macroeconomic conditions to weigh on the company in the near term but the broader trajectory appears positive.
• With distributions being the primary value driver, valuation is critical in our view. With rates elevated, the cash expectations for investors are naturally far higher, which currently prices Hilton out in our view. The stock is likely slightly undervalued, although we would suggest awaiting a clear macro picture and superior yield.

Company description

Hilton Hotels Corporation (NYSE:HLT) is a global hospitality company with a diverse portfolio of 18 world-class brands encompassing more than 7,400 properties and over a million rooms in 119 countries. Headquartered in McLean, Virginia, Hilton is renowned for its commitment to providing exceptional guest experiences and innovative offerings.

Share price

Hilton’s share price has been exceptional, returning over 250% to shareholders and noticeably outperforming the wider market. This is a reflection of its positive financial performance and the development of its business model.

Financial analysis

Presented above are Hilton’s financial results.

Revenue & Commercial Factors

Hilton’s revenue growth is deceiving, as the company has refranchised locations, contributing to revenue and costs being exchanged for franchising fees. Currently, ~80% of total fees are franchising and licensing fees, with this revenue line growing at a CAGR of +10% since 2009.

Business Model

Hilton’s profitability growth (+14% EPS) has been propelled by a strategic shift towards franchising. By franchising its brands, Hilton can enlarge its global footprint rapidly without the need for significant capital investment. advance, this has de-risked the company, reducing its exposure to cost inflation and demand cyclicality. Franchisees pay fees for using Hilton’s brand and benefit from the company’s global reservation and distribution systems. This is the principal reason for its impressive margin improvement during the historical period, as ~1% of RevPAR (“revenue per available room”) equates to ~1% of adj. EBITDA growth.

In addition to franchising, Hilton enters into management contracts. In this model, Hilton manages hotels on behalf of the property owner, earning fees based on the hotel’s performance. This allows Hilton to enlarge its brand presence without significant ownership stakes, again allowing for de-risking.

Hilton has a diverse portfolio of brands catering to various market segments, from luxury to budget-conscious travelers. This diversification allows Hilton to capture a broad range of customers and answer to different market demands. This said, the company is heavily weighted toward the US and the upscale segment (lower with midscale, and higher with upper upscale). This segment is less resilient than the luxury segment to cyclicality but has greater growth potential and runway for rooms due to the larger target segment.

Hilton’s Hilton Honors loyalty program plays a crucial role in customer retention and attracting repeat business,. The program offers members various benefits, including points for stays, exclusive discounts, and access to unique experiences. Loyalty programs benefit from the network effect. If consumers are easily able to access Hilton properties and have the scope and need to do so regularly, it creates loyal customers. Conversely, if access is limited then psychologically, consumers do not see the value proposition. Hilton benefits from its global presence and a vast range of properties in various categories.

Hilton has invested in technology and features to boost and differentiate the guest go through. Examples of such as reflected below, with the first two options in particular being genuinely valuable to its customers. This emphasis on incremental improvements has the ability to create small but compounding brand development.

Hilton competes with the following peers (also represents alternatives for investors):

1. InterContinental Hotels Group (IHG): A global player with a focus on brand differentiation and guest loyalty.
2. Accor (OTCPK:ACRFF): Known for its strong international presence and diverse brand offerings.
3. Marriott International (MAR): A major competitor with a diverse portfolio of brands, particularly focused on the higher-end segment. We have previously covered this stock, rating it a buy.
4. Hyatt (H): Similar profile to Marriott. We have previously covered this stock, rating it a hold.

Margins

Hilton’s margins have meaningfully improved over the last decade and currently sits above its pre-pandemic level, attributable to the shift to franchising. The company has externalized the cost of operations while monetizing its brand, contributing to an asset-light profitability profile.

With the company still ramping up most-pandemic, we see reasonable scope for near-term margin appreciation, although this will be materially impacted by the current macroeconomic environment (discussed in detail next). If demand can remain robust, we believe EBITDA-M can achieve low the 60s, while a refuse will likely leave the company at its current levels. Inflationary conditions have allowed Hilton to aggressively better margins, which would not have been possible in “normal” conditions.

Quarterly results

Hilton’s revenue growth continues to be strong, with top-line growth of +38.1%, +39.7%, +19.2%, and +14.0% in its last four quarters. In conjunction with this, margins have slightly softened, although remain materially above its pre-pandemic level.

The strong growth is representative of a continuation of its ramp-up post-pandemic, with travel progressively improving following the end of lockdown restrictions and the holiday season across key Western geographies.

With growth falling to low single-digits in Q3’23, we suspect the business is quickly approaching a normalized level, particularly as macroeconomic conditions act as a partially offsetting factor. With elevated interest rates and inflation, consumers have experienced soaring living costs, contributing to softening discretionary spending. This will likely continue into most of FY24, as the outlook for a return to expansionary policy remains uncertain. We expect growth to refuse to MSDs in FY24, although is highly dependent on the US’ economic performance.

Key takeaways from its most recent quarter are:

• System-wide comparable RevPAR increased by +6.8%, an impressive achievement in our view which reflects the underlying demand for its services currently. Importantly, consumers are willing to pay the increased prices sufficiently to drive revenue forward.
• 35.5k new rooms were approved for development, increasing its pipeline to a record 473.3k, which is 10% of rooms compared to Sep22. This is a substantial pipeline relative to its existing footprint and should allow the company to grow at MSD/HSDs in the coming years (Management estimating 5-6% in FY24).
• Management believes “an inflection point” has been reached, with a meaningful number of new opinions expected going forward. 14.3k additional rooms were opened in the current quarter.

Balance sheet & Cash Flows

Following the transition to a franchise/fee model, Management has been aggressive with capital allocation. Debt has been laddered up with profitability, currently sitting at 3.4x EBITDA. This is financially manageable due to its low-risk profitability profile, with interest coverage of 5.7x.

Management has utilized this cash to distribute to shareholders, favoring share buybacks alongside small dividends. The cash yield from this is impressive, particularly when considering the consistency of its profitability.

These represent an ROIC of ~9%, which we consider to be an attractive level given the low cyclicality of the company.

Outlook

Presented above is Wall Street’s consensus view on the coming years.

Analysts are forecasting healthy growth in the coming years, with a CAGR of +9% into FY27F. In addition to this, margins are expected to sequentially better.

We consider these assumptions to be reasonable. With an aggressive pipeline of new rooms, and future approvals, a strong growth trajectory is likely. advance, underpinning this will be economic development globally and growing incomes.

Industry analysis

Presented above is a comparison of Hilton’s growth and profitability to the average of its industry, as defined by Seeking Alpha (28 companies).

Hilton performs exceptionally well relative to its discretionary peers. The peer group has been materially impacted from a growth perspective, contributing to messy financial results as many have bounced back from a refuse in revenue. Importantly, its forecast revenue growth is superior to the 5Y revenue average of its peers, while its profitability growth has been strong and is primed to outperform. We expect this to be deliverable given the room growth achieved relative to its peers in recent years.

Margins are the company’s key strength, with its superior business model allowing for substantial returns. Only three of its peers have a superior EBITDA-M, and only one has revenue in excess of $1b (Marriott).

Valuation

Hilton is currently trading at 20x LTM EBITDA and 16x NTM EBITDA. This is a premium to its historical average.

Despite the significant disruption in recent years and the macroeconomic outlook, we do believe a premium is justifiable. The company is substantially more profitable and less cyclical, positioned to be a cash machine in perpetuity. At a ~10% discount on an EBITDA basis, we believe there is small upside with Hilton (Our fair value would be a premium of ~15-20%).

advance, Hilton is trading at a LTM EBITDA premium of ~9% and NTM P/E premium of ~20%. A premium is justifiable in our view, and noticeably so, owing to its impressive margins and comparable growth on a normalized basis. It is positioned well to exceed its peers while broadly performing in line with the wider industry. We would suggest a premium of ~20-30%, which again suggests upside of ~10%.

Based on this, we believe Hilton is slightly undervalued but not materially so. We lean toward not sufficiently so for a buy rating, owing to its FCF yield of ~4.6%, which is below its historical average. We admire to acquire companies at a cash discount preferably, unless a noticeable acceleration is possible (which is not the case here). advance, as this is a cash vehicle in the most simplistic sense, we would seek a yield exceeding the RfR, which has noticeably increased.

Key risks with our thesis

The risks to our current thesis are:

• [Upside] Economic downturn avoided and an early return to expansionary policy (without the re-emergence of inflation).
• [Downside] Economic downturns
• [Downside] Price competition if demand softens.

Final thoughts

Hilton is a high-quality business following the transition to a franchise model. It is significantly de-risked from market factors, while boasting impressive margins and a steady growth trajectory. We expect its strong brands, international presence, impressive pipeline, and incremental improvements to its service to drive revenue growth of ~5-10%.

Given this is an investment motivated by cash returns, entry valuation is critical. At a FCF yield of ~5% following a share price expansion in 2023, we do not think the company is attractively priced any longer.