Wyndham Hotels: A Capital-Light Franchisor Trading At A 10% Normalized Free Cash Flow Yield (NYSE:WH)

Via SeekingAlpha.com

Winston Churchill famously said, “Never let a good crisis go to waste.” Rather than say it, Wyndham Hotels’ (WH) management is doing it. While others viewed April’s precipitous drop in RevPAR as a disaster, management viewed it as an opportunity to reset the company’s cost structure. On the May 5th call it explained that it had already slashed 2020’s cash outlays by $255 million and permanently reduced costs by $100 million. The permanent savings are from a reduction in facilities, vendor spend, and 440 positions.

This is a remarkable feat for a company that was lean to begin with. In 2019, Wyndham generated $600 million of adjusted EBITDA on revenues of $2,050 million. But this 30% margin understates Wyndham’s economics. Over half of Wyndham’s revenues are marketing and reservation fees which Wyndham is contractually obligated to spend in support of franchisees. These revenues have no impact on EBITDA or free cash flow. Stripping them out, Wyndham sports a 70% margin.

CFO Michele Allen affirmed that, ceteris paribus, last year’s $600 million of EBITDA would have been $700 million and margins would be 500 basis points higher. Straight from the horse’s mouth:

Analyst: So just to clarify, I mean, are you saying that with these savings last year’s $613 million EBITDA would have been $713 million. I mean, how do I think about that?

Michele Allen: Yes. That’s the right way to think about it.

Normalizing 2019’s earnings and adding the costs savings suggest Wyndham can produce $420 million of free cash flow in a normal environment (i.e., not 2020).

Source: Author, Data from 2019 10-K

Today Wyndham’s stock is worth $4,300M ($46 per share x 93M shares), just about ten times normalized pro forma free cash flow. This seems too cheap considering that Wyndham Hotels is a quintessential capital-light compounder with a fortress balance sheet. It is about as well-positioned as possible in the travel and leisure industry, given current conditions. To boot, Wyndham has a large addressable market for growth and has a history of growing through downturns. Wyndham’s growth is particularly valuable because it requires no capital and sports 75% margins on non-pass-through revenue.

Wyndham’s 10x FCF valuation doesn’t take any of this into account. Partially, that’s because it is in an out-of-favor industry. It’s also because its financial statements are clouded by one-off charges, such as related to its 2018 spinoff and La Quinta acquisition. Finally, the market may not be yet privy to management’s cost savings or is waiting for proof.

Business Model

Wyndham is one of the world’s largest hotel franchisors with 9,280 hotels in 90 countries and 828,000 rooms. 96% of its hotels are franchised, 392 are managed, and 2 are owned.

Warren Buffett described the best business as “a royalty on the growth of others, requiring little capital itself.” That almost perfectly describes Wyndham Hotels, as explained on the April 2019 call:

We generate our earnings from [a] percentage of revenue fees from thousands of hotel owners and our income is not dependent on incentive fees or hotel level profits. We generate substantially all of our EBITDA from hotel franchising activities [and] our margin on non-pass through revenues [is] in excess of 75%.

Wyndham’s strategy has elements of a positive feedback loop. Its well-known and well-received brands drive traffic to hotels. This produces higher returns for hotel owners, which incentivizes new room growth, which drives franchise fee growth.

The wonderful part of Wyndham’s model is that franchisees provide the money for advertising, reservation software, and the loyalty program. Wyndham assesses these fees in addition to its royalty fees. Wyndham not only doesn’t need capital to grow, it doesn’t need to spend its own money to advertise its brands.

Wyndham’s scale allows it to spend its franchisees’ advertising and marketing dollars better than those franchisees could individually. Management discussed one aspect of scale in the May 2018 call:

Approximately 80% of the U.S. population live within a ten-mile radius of one of our hotels, and our roadside signs generate more than 500 billion annual drive-by impressions in the United States alone.

Wyndham Rewards is a key piece of Wyndham’s flywheel and an important differentiator. Revamped in 2015, Wyndham Rewards consistently ranks as one of the simplest and most rewarding loyalty programs in the hotel industry. The Points Guy values Wyndham Rewards 40% higher than peers.

Source: Author, Data from The Points Guy and 10-Ks

Wyndham Rewards dwarfs Choice Hotels, its closest competitor, providing a key competitive advantage. Wyndham’s Rewards members account for 44% of US occupancy and 36% of global occupancy (per February 2020 call). Marriott’s program leads the industry with 50% of bookings and suggests there’s room for further improvement.

Positioning

Wyndham is as well-positioned as a hotel company could be in a pandemic. It owns 20 brands focused on the economy and mid-scale segments. Lower price points at these properties will likely attract trade-downs as travelers become more budget-conscious.

Source: May 2020 Presentation

Wyndham’s hotels primarily serve leisure travelers in drive-to markets. These travelers will be among the first to return. Bill Ackman cited anecdotal evidence on last week’s Pershing Square call that some east coast hotels sold out over Memorial Day weekend.

Source: May 2020 Presentation

Wyndham has about 5,700 franchisees for its 9,300 hotels (per Form 10). The average Wyndham franchisee owns 1.6 hotels, which is to say it is a small business owner. That’s allowed 80% of franchisees to get a PPP loan. Without any aid, Wyndham estimates its hotels break even at 30% occupancy in the US and at 40% internationally. (per May 2020 call). Wyndham’s U.S. hotels bottomed out at 23% occupancy in mid-April and have since recovered to just above 30%, which means they’re at break-even already.

Source: May 2020 Presentation

Government aid has significantly reduced breakevens. 90% of franchisees are financed by local and regional banks offering forbearance, with further enhancing franchisees’ staying power (per May 2020 call).

Growth Strategy

Wyndham’s revenue is driven by the number of rooms and the revenue per available room (RevPAR). Growth is driven by New Unit Growth (NUG) and RevPAR Growth.

Wyndham has more control over NUG than RevPAR because franchisees set prices. The bane of the hotel industry is that pricing is local. Wyndham estimates that it owns 30% of the global branded hotel industry (per its Form 10), but hotels in Tokyo have no bearing on hotels in Cleveland. Managers price relative to local supply, and no brand monopolizes meaningful geography.

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Hotels have large fixed costs and huge operating leverage which tempt owners to reduce price to increase occupancy in a downturn. This dynamic could pressure average daily rate (ADR) in oversupplied markets this year.

Over the long term, RevPAR tends to trend higher at a nominal-GDP-like rate. Wyndham’s franchisee fees have over 75% margins, allowing Wyndham to benefit from inflation and/or nominal GDP growth. I’d expect RevPAR to grow at about 2% in a normalized environment.

Since Wyndham’s exposure is to revenue, not hotel profits, NUG can blunt RevPAR weakness. Wyndham has much more control over NUG, which is a function of three strategies:

  1. Conversions
  2. New Construction
  3. International

Wyndham currently has 189,000 rooms in its development pipeline, which is 23% of existing rooms. Wyndham’s retention has been improving and now sits around 95%. Assuming that 5% of rooms churn off annually and the existing pipeline is brought online over 24 months, rooms could grow by 6% annually the next two years.

That might be optimistic considering the current environment, but room count will almost surely increase. During the financial crisis, when hotel financing completely shut down, rooms grew 1.6% annually.

Source: May 2020 Presentation

Today the U.S. pipeline is 52% conversion and 48% new construction. New construction tends to comprise a larger share during the good times while conversions make up the larger share during the bad.

Hotels are long-lived assets with long lead times, so owners think in 20-30 year time frames. They expect bumps along the way. 40% of Wyndham’s pipeline is currently under construction and management expects those rooms to come online in 12-24 months (per May 2020 call). Some owners with newly finished hotels are waiting for more certainty before opening. This will only delay, not cancel, openings.

When uncertainty recedes, Wyndham’s value proposition to hotel developers will once again shine through. Wyndham’s hotels tend to be smaller, less complex, and less costly than higher-tier hotels. This means Wyndham’s hotels can be built faster and cheaper, which increases developer’s returns.

Source: May 2018 Presentation

Nevertheless, the new construction pipeline will likely shrink for the next few years. It took 3-4 years for new construction to pick up after the financial crisis. Fortunately, conversions pick up when new construction drops off, which is what allows NUG to continue through down cycles.

Source: May 2020 Presentation

During the financial crisis conversions peaked at 86% of NUG. Management’s already pivoted most of their new construction sales people towards conversions. This has increased conversion coverage 3x (per May 2020 call).

Conversions increase during down cycles because that’s when Wyndham’s ability to drive traffic and occupancy becomes even more valuable.

According to Wyndham, the typical independent hotel gets 50-100% of its revenue through OTAs (online travel agents). These OTAs take 20-25% of revenue as a booking fee. Wyndham’s fees, all-in, run about 12%. About half of this 12% accounts for a reservation system and advertising that the independent would otherwise have to spend itself. Only about half of Wyndham’s fees are comparable to the OTAs.

Domestically Wyndham’s central reservation system drives 70% of bookings, and 56% globally. Participating properties saw a 13% average increase in ADR (per February 2020 call). OTAs account for less than 20% of bookings at Wyndham properties, and walk-ins account for the balance. Wyndham offers independents more traffic at higher margins, which is tough to argue with during a travel apocalypse.

This value proposition gives management confidence that Wyndham will still manage 2-4% NUG in the present environment (per May 2020 call). Longer-term, Wyndham hopes to drive NUG into the 3-5% range.

Wyndham has a long runway for conversion growth. The U.S., which is the most heavily branded hotel market in the world, still has 15,000 independents. That’s 2.5x Wyndham’s domestic hotel count.

Source: May 2020 Presentation

Internationally, Wyndham is positioned to benefit from a rising middle class able to travel for the first time. New travelers begin by staying in economy hotels, meaning Wyndham will be the first to benefit. International hotel franchising has not penetrated as deep as in the U.S. despite an equally strong value proposition. Wyndham has an even larger addressable market overseas than in the U.S.

Wyndham’s international growth strategy is to introduce its brands to new countries via master franchise agreements. This has led to some problems in China where franchisees weren’t meeting Wyndham’s quality standards. Wyndham has been removing these rooms, which has been a headwind to NUG but hasn’t materially affected free cash flow. As a result of the master franchise structure, Wyndham’s international royalties are lower than domestically (2.2% vs. 4.5%). International RevPAR is also lower ($32 vs. $46). Still, 40% of Wyndham’s rooms are abroad (in 90 countries), so international is a meaningful segment.

The bottom line on growth is that it requires little capital and carries high margins, making it very valuable. Wyndham has three complementary levers to pull to generate NUG, which allow it to grow through down cycles. A large addressable market provides a long runway for growth. RevPAR is less predictable than NUG, but likely to track nominal GDP. Wyndham’s high margins and capital-light model make it a possible beneficiary from inflation. I’d expect Wyndham’s NUG to increase 2-4% annually and RevPAR to grow 1-3% annually. Altogether, that’s 3-7%.

Fortress Balance Sheet

In March, Wyndham drew down its revolving credit facility as a precaution and pre-emptively amended its credit agreement. The amendment suspended the quarterly leverage test until Q2 2021. The leverage calculation was also modified for the second, third and fourth quarters of 2021 to use annualized EBITDA rather than the last 12-months EBITDA. In turn, Wyndham agreed to maintain $200M of liquidity ($300M to pay a dividend), increase interest rates 25 basis points, and restrict share repurchases.

At quarter-end, Wyndham had $750 of cash against $2,850 of debt. Subsequently, Wyndham declared a $0.08 dividend (cut from $0.32) payable to shareholders of record on June 15th. This will only cost $7.5M ($30M annually).

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Wyndham has no meaningful debt maturities until 2023. Until 2023, it needs to only pay $21M against its term loan.

Source: Author, Data from March 31, 2020 10-Q

In the truly worst-case scenario of absolutely zero franchise fee revenue, Wyndham has 36 months of fixed charge coverage. That ought to give it ample time to wait for a recovery.

Source: May 2020 Presentation

Valuation

It’s futile to speculate what Wyndham might earn this year or even next. Therefore, my valuation centers on what Wyndham might earn when things return to normal. The million-dollar question is when that occurs. Wyndham’s fortress balance sheet virtually guarantees it can stick around until travel picks back up, so investors don’t need to have a strong opinion on when travel resumes, so long as they believe it someday will.

The majority of Wyndham’s non-pass-through revenue is from royalty and franchise fees. Based on its current room count and royalty rates, it looks capable of earning $472M. Wyndham reported $480M of royalty and franchise fee revenue in 2019. I’m chalking the difference up to a rounding error. These fees have no associated costs (besides general corporate overhead) and convert almost entirely to EBITDA.

Source: Author, Data from 2019 10-K

Last year Wyndham earned $130M in license fees. When Wyndham Hotels spun off from Wyndham Destinations in 2018, Wyndham Destinations agreed to pay Wyndham Hotels a license fee. The minimum payments under the agreement are $70M per year. Like royalty and franchise fees, licensing fees convert almost entirely to EBITDA.

The last revenue segment is hotel management, which is a capital-light but labor-intensive business. Wyndham earns franchisee fees from these hotels plus a management fee, which is an additional percentage of revenue. Wyndham’s management fees are heavily skewed towards a percentage of revenue, versus a percentage of operating profit or an incentive fee structure. This makes its management business relatively predictable. Last year hotel management produced $65M of EBITDA.

Putting it all together, normalized EBITDA should run about $600 million.

Source: Author, Data from 10-Ks

As a double check, last year Wyndham earned $613M of EBITDA. Since then, management announced $100M of permanent cost savings. Those savings must be related to hotel management and corporate SG&A.

Source: May 2020 Presentation

Historically, Wyndham has spent about $50M on capex and $100M on interest. Incidentally, though Wyndham’s debt has increased and its interest rate rose 25bps, its interest expense is still running about $100M a year because of the benefit of lower rates.

Source: Author, Data from 10-Ks

All told, Wyndham should now produce about $420M of free cash flow in a normalized environment. At a $4,300M valuation, Wyndham is only trading for 10x free cash flow. That strikes me as a bargain price given Wyndham’s highly probable, high margin growth.

A 10x multiple is the fair terminal multiple for a business that neither grows nor shrinks using a 10% discount rate. Wyndham, in my opinion, looks virtually certain to grow over the coming years if for no other reason than a pickup in inflation. I estimate Wyndham can grow 3-7% for the foreseeable future. That would imply a fair multiple in the range of 15-35x. I wouldn’t bet on 7% perpetual growth or anticipate a 35x multiple, however.

Pre-pandemic, Wyndham traded at a 17x multiple. Choice Hotels, which is Wyndham’s closest peer and has a longer trading history, traded at a 21x median P/E the last 10 years (per Value Line).

I summarized some potential returns given three terminal multiples 10x (i.e. no re-rating), 17x and 21x. Making some assumptions about NUG and changes in RevPAR, Wyndham looks poised to earn 9-26% annual returns over the next five years, in a recovered, normalized environment.

Normalized Earnings

One reasonable criticism of my valuation is that Wyndham’s GAAP net income and free cash flows have never come anywhere near my estimate of normalized earnings. Historically, net income and FCF have averaged just half of their normalized value.

Source: Author, Data from 2019 10-K

There are a variety of reasons for this. The table below bridges GAAP net income to normalized earnings.

Source: Author, Data from 10-Ks

Wyndham’s D&A charge has consistently overstated actual capex primarily because of amortization of intangibles.

Source: Author, Data from 2019 10-K

GAAP requires Wyndham to amortize its franchise agreements, management contracts, and trademarks. These are non-cash costs and, in my opinion, not reflective of economic reality. Wyndham’s contracts last for multiple decades and are renewed at a 95% rate. Wyndham’s retention rate suggests a contract amortized to zero is not worth zero since it provides a meaningful incumbent advantage. Wyndham’s trademarks actually appreciate in value over the years as Wyndham spends on advertising.

The impairments and contract termination charges relate to hotel management contracts Wyndham initiated in 2012 and 2013 which guaranteed the owner a minimum operating profit. The agreements collectively covered 30 hotels and proved unprofitable. In 2019, Wyndham took a contract termination charge to exit them and wrote off their associated receivables (out of pocket incurred but not reimbursed by the owner). In 2017, Wyndham took a $41M non-cash impairment to write down hotel guarantees and management agreements.

These charges are unlikely to reoccur because Wyndham only has one hotel contract remaining and does not expect to enter into new guarantees. The remaining contract expires in four years and limits total payments to $20M and $5M in any given year.

The last costs are related to Wyndham’s spinoff and acquisition of La Quinta. Wyndham certainly won’t be spinning anything off anytime soon, nor does management expect to make a large strategic acquisition like La Quinta. It is limiting itself to smaller bolt-on acquisitions, if any.

Capital Allocation

Wyndham’s management have been good stewards of shareholder capital in the past. The current management team’s track record is limited because of the spinoff, however. Over the past 20-30 years Wyndham has acquired a new brand once every 18 months, on average (per July 2019 call). Most of those were small, tuck-in acquisitions. The recent La Quinta acquisition was strategic and much larger than average. Notably, the La Quinta acquisition and integration came in on-schedule and with greater synergies than forecast. This wasn’t management’s first integration.

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Management laid out its capital allocation framework on its Form 10 and reiterated it on the February 2019 call:

Our capital allocation framework is unchanged. We remain focused on growing our business organically and we will deploy a modest portion of our free cash flow for development advances and similar opportunities. We will also keep using free cash to pay dividends. Beyond that we will allocate cash flow to bolt on acquisitions that are both strategic and accretive and to share purchases with the amount going to each depending largely on the acquisition opportunities that are available.

Management expects to return most free cash flow to shareholders. The first priority is the dividend, which was $0.32 per share but cut to $0.08. Getting it back to $0.32 is a priority once there’s more economic certainty.

Buybacks are currently restricted until Q2 2021. When that restriction lapses, Wyndham will likely get aggressive about buybacks. In the first 18 months since its spinoff, it bought back 7% of shares outstanding.

Incentives

Management receives a base salary, annual incentive compensation, and a long-term incentive compensation. Annual incentives are 75% weighted towards adjusted EBITDA and 25% weighted towards global net room growth. Long-term incentives are a function of EBIT per share. These incentives seem reasonable. There’s no capital charge, but that makes sense given that the business doesn’t require capital. Management and the Board collectively own 1.8% of the stock, per the most recent Proxy. That’s better than nothing, but nothing to hang your hat on.

Why Does This Situation Exist?

Wyndham looks clearly mis-priced, which begs the question, why? The mis-pricing looks like a confluence of factors:

  1. Travel and leisure are out of favor. Hotels face unprecedented uncertainty, so many investors are giving them a wide berth. Wyndham’s stock price has recovered much, but not all, of its March plunge, which may dissuade value investors from studying its latest result.
  2. Investors haven’t noticed management’s announced cost savings or are taking a “wait and see” approach. I’m giving management credit for it because it said the costs have been cut. The savings are not forecasted or projected. They already happened.
  3. Wyndham’s historical financials don’t show anything close to $300-400M of free cash flow or net income because of lots of one-off payments, impairments, charges, and adjustments related to the spinoff. 2020 should have been the year for Wyndham’s earnings power to shine through, but that will be delayed.

Risks

The biggest risk to my thesis is that the cost savings don’t materialize. I’m willing to trust management because it has been forthright. I’m not reading between the lines or interpreting tea leaves. Management flat out said $100M of savings were in the bag and would have turned 2019’s $600M of EBITDA into $700M.

In the same vein, Wyndham’s normalized earnings power has yet to shine through its GAAP financials, so there’s a risk it never does. Some companies are serial restructurers. That’s possible, but not likely, here, since there shouldn’t be much acquisition activity.

The macro economy is probably the greatest risk to Wyndham. There is unprecedented uncertainty here, so I won’t speculate on what might happen. Sustained lockdowns or additional lockdowns would clearly hurt Wyndham’s earnings. Wyndham can cover its fixed charges for 36 months even if it earns zero franchise fees, which should give it plenty of runway.

The worst-case scenario would be a coronavirus outbreak tied back to one of Wyndham’s hotels. This could permanently impair the brand. Wyndham is increasing its sanitation practices to prevent this, but there’s no way to fully rule this out.

Bigger picture, Wyndham’s brands are not aspirational. People don’t prefer to stay at a Super 8; they do it out of convenience and economic necessity. Similarly, people don’t prefer McDonald’s burgers (no one thinks it makes the absolute best burger). But people still eat plenty of McDonald’s burgers: they’re decent, reasonably priced, and available. Wyndham’s brands are the same way: not the best, but good enough. This reduces Wyndham’s potential pricing power, relative to Hilton or Marriott who do have aspirational brands. Wyndham’s pricing power is probably limited to the rate of inflation.

Airbnb (AIRB) is also a risk, though not one I consider substantial. Hilton’s management discussed its Airbnb studies (in-house and independently commissioned) in its October 2015 call. It concluded that Airbnb demand was largely incremental and didn’t meaningfully interfere with Hilton’s properties. Airbnb demand is centered on high-occupancy urban centers and tends to be leisure-oriented and more extended-stay. Wyndham’s properties tend to be suburban and short leisure stays. Though Airbnb’s and Wyndham’s customers overlap, Airbnb isn’t necessarily taking demand from Wyndham. It’s creating incremental demand. Post-pandemic, Airbnb supply may be more limited as well.

Finally, there’s a risk that normalization takes longer than expected. The sooner RevPAR picks up, the better. Hilton believes a return turn normal will take 2-3 years, which seems about right. Even if it takes 5 years, Wyndham has the balance sheet to wait. And even if it takes five years for Wyndham to re-rate from 10x to 17x, the stock will appreciate 11% annually – before any capital return or growth.

Summary

They say necessity is the mother of invention and Wyndham’s management looks to be proving them right. In response to the crisis, management has reset Wyndham’s cost structure which increased normalized EBITDA from $600M to $700M. Wyndham is a high-margin capital-light compounder and about 60% of EBITDA converts to free cash flow. Today, the stock trades at just 10x normalized free cash flow. This valuation doesn’t give Wyndham any credit for its highly probable and highly accretive growth prospects. If drive-to leisure travel normalizes over the next five years, Wyndham’s stock will do well.

Disclosure: I am/we are long HLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.