Hotel Brands: Undergoing Consolidation with No Industry Winner

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1 The greatest hockey player of all time, Wayne Gretzky once said: A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be. I skate to where the puck is going to be, not where it has been. Success in the hospitality business is no different: developers race to build hotels where they believe the profits will be ahead of industry cycles; hotel chains develop distribution platforms that provide new customer loyalty benefits; and aspiring chefs create new culinary concepts based on local trends. What distinguishes the hospitality industry from the broader travel industry is the hyper fragmentation of the value chain. In order to understand the hospitality industry, we have to analyze the competing relationships between the primary stakeholders: real estate owners, hotel chains, third party managers, restaurant companies and online travel agencies. The lack of alignment between the stakeholders is the primary reason why most hotel brands, largely undifferentiated upon their launch, deteriorate over time, into commodities. Imagine an airline brand opening new routes with each plane owned by an entrepreneur who decided how the plane was configured, what food and beverages to serve its passengers and how seats should be sold. Take it another step further and consider that the fleet owners were motivated by increasing the planes value and reselling it, with or without the current airline brand. How much executive time would be spent managing the individual fleet owners as opposed to improving the customer experience? This is becoming the predicament of the hotel industry where the chains own less than 5% of hotels in their system. Hotel Brands: Undergoing Consolidation with No Industry Winner The U.S. hotel industry delivered record profits the past few years recording an all-time high $73 billion in profits. However, over the past 4-5 years, the share prices of the U.S. based hotel chains recorded only 40% appreciation, compared to over 70% growth in S&P 500.

2 Given record industry profits and great real estate fundamentals, why are lodging stocks underperforming the market? Which brands are capturing the customer and translating this into a larger share of the economic pie? If one looks more broadly at the industry and includes on-line travel agencies, who generate the vast majority of their profits from hotels rather than airlines or car rentals, we see the following truths: 1. The hotel chains are adopting the same business models and similarly valued for the past few decades. Marriott, Hilton and the other majors have historically traded at the same EBITDA multiples. Each chain has its ups and downs but over long periods of time, there is no global industry winner in terms of brand equity or value creation for shareholders;

3 2. The most successful travel companies with the highest return on invested capital are online platforms such as Airbnb, Tujia, Trip Advisor, and Expedia. They have also captured over 40% of the over $100 billion in equity market capitalization created over the past decade. This lack of leadership contrasts sharply with the airline industry, where Southwest Airlines, India s Indigo Airlines and Virgin America have redefined the landscape through innovation. Few if any have Hotel Chains have executed a distinctive corporate strategy that is a rallying cry for employees or investors. If you read their annual reports, it will be a boring and repetitive exercise. What they lack in soul and passion cannot be made up in superficial commitments to environmental sustainability or symbolic charitable causes. It is not surprising that commoditization is leading to a highly publicized wave of global mergers and acquisitions coupled with the divestiture of timeshare and other hard real estate assets. In a few years there will only be a handful major hotel chains left standing and their business models and value propositions will remain strikingly similar.

4 On the surface the consolidators will capture cost synergies such as combining their loyalty programs and reducing corporate overheads. The consolidators may even appear to be the industry winners but their success will be short lived. By selling off their real estate and under investing in technology, incumbents are mortgaging their future. In other words, their brands will remain weak and consumers will not be fooled. The Future of Hospitality Branding With the rise of Asian economies, the globalization of real estate capital flows and the emergence of disruptive technologies, change is in the air. While the hotel chains focus on consolidation and replication, how will the customer experience evolve? Who are the game-changers? Where will future profits reside? What is the future of hospitality? The rise of Airbnb, UBER and alternative travel distribution networks poses the biggest threat to traditional hotel brands. The CEOs of Hilton, Marriott, Starwood and others have recently dismissed this discontinuity as a niche, or different kind of demand. This reminds us of how Ross Perot dismissed Microsoft in 1982: What do thirteen people in Seattle know that we don t? Among industry leaders, only Barry Sternlicht at Starwood Capital appreciates the significance of these new technologies. It s undeniable that these industries are changing the landscape, Sternlicht said. I think hotel companies are working hard now to make their product not just a commodity or they re going to get disintermediated by Airbnb and guys like that. Hotel franchisers are technology companies in disguise. They exist because their loyalty programs, contact centers and platforms including group sales, fill rooms. The success of meta-search engines such as TripAdvisor and Airbnb mark the beginnings of a new industry structure. The rise of these branded travel networks is a low cost disruption that will support a new generation of brands that will capture the customer, provide services and fill rooms at a lower cost. Once these branded travel networks begin working directly with hotel owners and developers, the game will change. The new business model will provide the ability to program assets more dynamically based on demand factors and to sell different classes of rooms and meeting facilities. Developers may borrow or employ different brands for different hotel spaces and will be able to employ 3 rd party managers whose only mission is to maximize performance. Consider the likely response of the incumbent hotel chains who will likely undergo further rounds of consolidation and perhaps go back to their roots and become real estate companies. In the short term they will face a classic innovators dilemma: invest in new business models at the expense of their core business. They will face enormous pressure from owners and lenders to change their rigid and

5 inflexible business model: up to 15% management and brand fees, an average of 500 so called brand standards, and all or nothing inflexible technology platforms. In this new world, brands with compelling content and integration of differentiated design, food and beverage and technology will resonate with consumers and generate the most economic value for real estate owners. The next generation of brands may come from outside the lodging industry. We believe that restaurant, media, entertainment and retail brands will be significant players and reshape hospitality into a living space industry. We are already witnessing supporting trends with the growing success of brands such as Hard Rock, Nobu Hospitality, Virgin hotels, Armani, Baccarat and the entrance of retailers such as IKEA into hotels. Global residential brands such as Frasier Residences and timeshare networks are also interesting game-changer candidates whose brand equity and could be parlayed into a broader living space play.

6 At CACHET Hotel Group, we believe that living space brands are the future of travel, not a niche segment. The winning hospitality brands will participate in all aspects of the living space: apartments, homes, timeshare, membership, leisure and business hotel, banquet and meeting space rentals and others. The winning brands will be engaged in creating the new generation of travel networks that provide value for money.