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Urbem's 'Wonderful Business' Series: Choice Hotels International

As one of the largest hotel franchisors in the world, Choice Hotels International (NYSE:CHH) owns a portfolio of proprietary "Choice brands," including Comfort Inn & Suites, Quality Inn, Econo Lodge, Rodeway Inn, Sleep Inn and Clarion Pointe. As of fiscal 2018, the company had 7,021 hotels (or 569,108 rooms) opened and an additional 1,082 hotels (or 87,061 rooms) under construction, awaiting conversion or approved for development. Choice Hotels operates in over 40 markets around the world.

Approximately 99% of the company's business is franchise-based, charging license fees, royalty fees, marketing and reservation system fees and procurement services fees. At Urbem, we particularly favor the franchise model, which often generates reliable, repeatable and predictable cash flow, and leverages others' money free of charge to grow the business.

Unlike hotel giants like Marriott (NASDAQ:MAR), Hyatt (NYSE:H), Hilton (NYSE:HLT), and Best Western, Choice Hotels is much smaller in size, as it targets the lucrative niche market of business and leisure travelers with a conservative budget. According to our calculations, the company's revenue per employee is roughly five times more than Marriott and 17 times more than Hyatt, indicating higher operational efficiency.

As Choice Hotels positions itself mainly toward the midscale and economy market, its revenue per available room would be less impacted than the upscale or luxury market by economic cycles. During the financial crisis, Choice's revenue was down 12% year over year and operating income declined 15%. At the same time, revenue and operating income were down 15% and 39% for Marriott, 13% and 87% for Hyatt, 17% and 63% for InterContinental (NYSE:IHG).

Per the chart below, Choice Hotels maintained its annual return on tangible assets (referred to as "ROTA") above 15% over the past 10 years. The current reading of ROTA is well above the likes of its peers, including Wyndham (NYSE:WH). Quantitatively, we strongly feel the existence of a durable competitive advantage at Choice Hotels.

Source: GuruFocus; data as of Nov. 24, 2019.

The growing brand awareness, economies of scale and high switching costs build and widen the moat around Choice's highly profitable franchising business.

The diversified portfolio of well-known brand offerings (from the economy to the upscale level) positions the company well within the lodging industry. For instance, Cambria is named by Business Travel News as one of the top upscale brands due to its strong performance in guest satisfaction. Additionally, according to the American Customer Satisfaction Index, Comfort Inn & Suites earns one of the highest ACSI scores in the upper midscale category.

Utilizing the significant number of hotels and loyalty program members, Choice Hotels also concentrates on reducing costs and increasing returns for franchisees. As of 2018, Choice Privileges has approximately 40 million members, compared to 36 million at Best Western. Also, according to Statista, as of last June, there were over 7,000 properties in the system of Choice Hotels - one of the largest networks globally and only second to Wyndham (with 9,157 properties). Taking advantage of its scale, Choice Hotels creates premium relationships with qualified vendors to negotiate lower supply costs for its franchisees and streamlines the purchasing process.

Last but not least, the majority of Choice's franchise partnerships are over a decade in duration and embedded with so-called "Liquidated Damages Provisions," which "protect" the franchisor from early terminations and, therefore, drive a durable switching cost advantage.

To fuel healthy growth moving forward, Choice Hotels reinvests its earnings to mainly supporting a robust pipeline (more than 1,000 hotels pending opening at the moment), ongoing overseas expansion and the recent development into the high-end category. We see enough room for further market penetration at least for the medium term, comparing the expected 1.8 billion international tourist arrivals by 2030 and the less than 0.6 million available rooms in Choice's global network.

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.