We are initiating coverage of Choice Hotels (CHH) with a narrow moat rating and $60 fair value estimate. The shares currently look slightly undervalued.
Our fair value estimate is based on our forecast for 7% annual revenue growth over the next 10 years, driven by 4% and 3% annual growth in units and revenue per available room, respectively. We model Choice to leverage top-line growth, leading to operating margins expanding to 30% in 2025 from 26% in 2015.
Choice’s narrow moat is driven by an intangible brand and switching cost advantage in its asset-light business model (99% of revenue from franchised hotels), which we believe will continue to support strong returns on invested capital (123% on average the next five years, including goodwill), well above its 7.9% cost of capital. The brand advantage is evident by its 8% share of existing hotel rooms in the U.S. and sustainable unit growth demand from third-party owners (averaging 2.5% the past five years, excluding Comfort brands, versus the U.S. industry’s long-term average of 2% growth), supported by a solid loyalty and online presence. Choice’s focus on a franchised structure drives a lasting switching cost advantage, given its 20-year contracts with high termination costs.
We believe Choice’s advantages will remain intact the next several years, driven by the successful completion of the Comfort (45% of total rooms in 2015) rejuvenation and demand for its newer Ascend and Cambia (4%) brands, offset by high franchisee terminations. The revitalized Comfort brands have led to recent improved pipeline and revPAR growth. The Comfort brands experienced 20%-30% average annual drops in rooms under construction during 2009-11, but pipeline growth resumed in 2013 and accelerated through 2014 and 2015, showing 30% growth last year. We have also seen an improvement in Comfort Inn’s revPAR, which underperformed the overall U.S. industry in 2012 and 2013 but has outperformed it since.
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