• Blackstone bid shows value in fee model

Blackstone’s bid for Hilton is a dramatic endorsement of the value embedded in fee income hotel companies.

While Hilton retains a substantial property estate, the $26bn enterprise value placed on the company can only be justified by a firm belief in the management and franchise business model as well.

Further supporting the notion that Blackstone is after an integrated hotel company was the explicit statement in the release announcing the deal that: “no significant divestitures are envisaged as a result of this transactions”.

Blackstone currently owns more than 100,000 hotel rooms, including the limited service La Quinta chain and the upscale collection LXR Luxury Resorts and Hotels. And Blackstone is keen to stress its passion to hold and build rather than flip.

LXR has absorbed around $1bn in development capital over the last three years while La Quinta has been expanded by 45% since its acquisition in January 2006.

Blackstone’s filing for its IPO last month said that over the last 15 years, Blackstone has bought 1,422 hotels with 209,500 rooms worth a $27.5bn.

The document said: “We believe that a substantial portion of our success in the [hotel] sector can be attributed to the operating platform that we have created to manage our hotel acquisitions.”

Among the recent big hospitality deals was the purchase of Center Parcs in the UK for $2bn, MeriStar Hospitality for $2.3bn, and La Quinta for $3.8bn, all in 2006. Wyndham International (from where 14 of the current 21 LXR’s hotels hail) was bought in 2005 for $3.4bn, and Boca Resorts, Prime Hospitality and Extended Stay were bought in 2004 for $1.3bn, $705m and $3.9bn respectively.

The deal that dwarfs all others, including Hilton, was the $38.6bn acquisition of Equity Office Properties Trust in February this year.

The driver behind the office acquisition is similar to the driver for Hilton: rising income. Last week, the Wall Street Journal had a front page lead detailing what it described as “soaring” office rents across the US. Similarly, revpar in the US hotel industry is expected to keep climbing – albeit at a reduced rate – well into 2010.

The typical chant at US hotel investment conferences is “we’re fine through 09”. Not so fine, however, is the outlook for capital value increases in hotels or any other commercial property segment.

This picture is repeated across the Atlantic. If the typical hotel cycle is between 10 and 11 years – as has historically proved the case for at least the last couple of cycles – then the UK and continental Europe will not see a downturn until beyond 2011.

But capital values are already coming under pressure. There has been a sell-off of listed commercial property companies and fears that values have peaked was at least one factor behind the failure of Vector’s flotation.

According to figures from Investment Property Databank, UK commercial property enjoyed an annualised return of 18.5% over the last three years to 2006. This broke the historical trend by being ahead of equities, which averaged 17.2% each year from 2004 to 2006.

In the 26 years worth of data since 1980, equities have averaged 14.0% and commercial property 11.2%. This data therefore shows clearly that property has historically delivered a slightly lower return than equities for what is usually perceived a long-term lower risk profile. The current anomalous situation of property outperforming equities must surely soon run its course.

In particular, it is hard to see how capital growth can continue for property. And this has been by far the biggest contributor to the growth in total returns. In 2006, commercial property in the UK saw income grow by 4.9% but capital growth was 12.6%.

If stagnation in capital growth is looking increasingly certain, then Blackstone must be eyeing the opportunity to exploit the expected continuation in income growth.

And this – together with the substantial tax hit were it to sell anything immediately – would explain why Blackstone seems to be publicly committing itself to retaining the Hilton portfolio.

This is in contrast to its actions following the acquisition of Equity Office Properties where it moved quickly to sell-off chunks of the portfolio.

It is buying Hilton with three or four years of the current trading cycle still to come. This improving cashflow can finance the necessary debt.

In addition, holding Hilton together with Blackstone’s other hotel assets, will enable Blackstone to enjoy a steady stream of fee income from its own investors for looking after these assets on their behalf. In its new public guise, Blackstone will benefit from less lumpy income just as much as any other public company.

Blackstone has pounced when its own currency, private equity, has the biggest advantage over public equity. Despite Hilton’s share price tripling since the depths of the downturn in 2002, there remains a vast valuation gap between what public equity investors and what the private markets are prepared to pay.

In the case of this latest deal, the gap is 40%. This is the gap between the Blackstone offer, which is all cash, and the share price of Hilton on July 3, the day before the deal was announced.

According to Citigroup estimates, the 2007 EBITDA multiple is 15.1 times and for 2008 it is 13.5 times. The 2007 multiple breaks down as 13.5 times owned hotels, 16.0 times for the management and franchise business, and 8.5 times for timeshare and leased hotels.

These all look full multiples, but not out of kilter with other recent transactions. With the size of the valuation gap as big as it is, other publicly listed groups look extremely vulnerable. Of the other members of the big five – Accor, Marriott, Starwood and InterContinental – it is the latter two who must be the favourites to be taken private.

It is a sign of the times, however, that even Marriott’s share price enjoyed a 7% boost in the first full trading day after the Hilton announcement as even that company was put into the frame as a possible target.

Citigroup reckoned that Marriott’s share price should be $56 (up 20% from the current $46.50) and Starwood’s $80 (up 8% from the current $74) if the Hilton multiple applied.

There have been widespread industry predictions that the big five would shrink to four or even three in the coming years. But most scenarios have one business taking out another.

It now seems far more probable that this will occur only after an acquiring company has been privatised first and uses its non-public status to leverage up. In this scenario, a group of investors might take out InterContinental and join with Blackstone to create a franchising and management behemoth. Or perhaps Colony Capital will take Accor private and, with other investors, swoop on a US major.

If such activity is to take place, the best time will be over the next few months. Rising interest rates and consequent tighter debt markets, coupled with increased political scrutiny possibly resulting in higher tax levels, means the high water mark of the current private equity flood is here.

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