• IHG looks to China for balance

 

InterContinental Hotels Group told a meeting of investors and analysts last month that it was looking to the markets of China, India and the Middle East to make its business more balanced and less skewed towards the US.

The growth will be the fruition of the company's asset-light expansion strategy, which will see it achieve growth around the globe at limited cost to itself through management contracts in the initial stages, with its key concern maintaining the quality and consistency of its brands – its primary assets.

IHG's expansion plan for the next 10 years sees the US will provide one third of its growth, followed by China, the Middle East and India. The group said that it expected total global hotel rooms to reach 20 million by end of this year, rising to 30 million by the end of 2030.

Branded rooms are expected to grow from 40% to 50% of the market, by four million over 10 years and nine million over 20. IHG said that its share of the open branded room stock today was around 5%, with its share of the pipeline around 17%.

The company has seen the number of removals from its system to rise to between two and two and a half times its normal rate because of the Holiday Inn relaunch, but CEO Andy Cosslett said that he was confident it would return to normal once this was complete, with "industry leading" levels of system growth, back to 2007 and 2008 levels when it was seeing between 5% and 6% of net system growth.

Of the three highlighted regions IHG focused in the main on China, which is providing a blueprint for its emerging market growth and which it expects to overtake the US, which is currently its largest market, in 2025 and become twice the current US size by 2039. "The opportunity for growth here is almost unprecedented," said CEO Andy Cosslett.

The group's growth forecasts for China see almost an eightfold increase in its rooms in Greater China, taking it to 360,000 rooms in the next 20 years. IHG estimated that the country's total hotel estate today was 2.3 million rooms, less than 50% of US today, currently mostly mid-scale and economy. The segmentation is expected to shift, with luxury, upper upscale and upscale to grow, midscale to continue and economy to fall off.

Of the existing market, 20% is currently branded (against 70% in the US), with IHG expecting this to grow to 50% by 2030. IHG is the biggest operator in Greater China today, with a 10% share of all branded rooms, with STR putting it at 14% and a 32% share of the pipeline.

The basis of the forecasts was a combination of strong GDP growth, increasing domestic travel and international arrivals, rising foreign direct investment, greater urbanisation, a growing middle class and the lack of brand penetration. Keith Barr, COO for Greater China, said: "Chinese government has identified tourism as a key driver of economic growth and will support it. By 2030 it will have more international visitors than any other country in the world."

The group has so far expanded almost exclusively through management contracts, limiting its capital exposure and allowing it to maintain brand standards. Barr said that, although the group had been approached by existing owners to franchise Holiday Inn Express, it was unwilling to do so currently.

IHG's management contracts in China have as their base fee 2% of gross revenues, with incentive fees at 6% to 8% of gross operating profit. Typical length of contract was 10 to 15 years, with an average of 14 years. Barr said that he was not expecting fees to fall as a result of competition, adding: "In terms of pressure on future profits, we've renewed eight contracts since I've been in China and we've either retained or raised fees so I have no concerns about management fees."

The group said that it was anticipating seeing margins move towards those more typically seen through management contracts, with the evolution seeing a move up to the mid 50% levels by 2015 and 60% plus by 2020, from 23% in 2007 and an estimated 34% for this year. Although the group said that profits have doubled in China since 2004, low revpar has kept margins down.

Profits would expect to move upwards once the group is comfortable enough that it can maintain quality to introduce franchising.

To date the group has had no capital expenditure requirement and no guarantee exposure, although it said that it was planning to make an initial incremental investment of $6m next year. "We're going to be moving costs forward, as you would expect with growth like this, but there will be efficiency to compensate," Cosslett said.

In order to take advantage of the growth potential at the upscale end of the market, the company said it was looking to add another brand, either by acquiring one or developing one themselves. Cosslett pointed to Shanghai, where he said the group was close to saturation in the market, with six hotels under the Intercontinental flag. "But we know that the market can take more and have owners that are asking for more," he said.

The group said it had started the process of looking at new brands and had commitments to expand new and existing brands from its current partners.

Cosslett remains uninterested in the other end of the sector, adding: "We are less interested in competing in the economy end of the market. Here, the branding model doesn't generate the kind of added value we're looking for, as stay decisions are usually made based on price and because of the typically small unit size, the economics of this sector only really work if you own or lease the hotels."

Looking at the scope for success, Barr said: "We believe that the risks to IHG are low, given the government's track record of growth, the increasing importance of tourism and the role of hotels in the development of cities. These combine with the fact that we are not deploying capital to mitigate our business risk.

"I don't think an industry had ever seen this much supply growth and this much demand growth. The unspoken story is demand growth in China, which is going to be the future of the industry over there. There will be imbalances every now and then but overall we're confident."

The chances of the group's plans for China being hit by restrictions in development funding looked limited, at least in the short term. The company has seen the ownership profile in the region mature since its debut 26 years ago, with the initial phase of overseas investors partnering with State-Owned Enterprises being replaced to see the market currently dominated by major SOEs and real estate developers. Barr added: "We expect to see dedicated investment funds being created and Reits formed if government policy allows."

Barr added that efforts taken by the government to prevent a real estate bubble from forming had seen loans restricted to 30% to 35% of the development, but that this had not impeded development, with cash-rich investors in ready supply to provide the balance.

He added: "In terms of government policy for supply growth you're not competing with a domestic SOE, you're aiding employment and aiding economic growth. In terms of government support, they have mapped out in economic development zones where hotels will be – they are in most of the plans. The overheating of the real estate market in China is related to the residential sector."

The presentation was more an overview of its aspirations for the long-term rather than specific targets for anything past five years. The growth is reliant on forecasts of increased travel and a shift away from today's domestic, business-sector focus to add leisure travel by both domestic and international consumers. Barr said that such were levels of enthusiasm that, in any year he had the luxury of turning down 100 to 150 projects, because they weren't the right partners, locations or fit.

Outside China, the group is also looking to the Middle East and India. In the Middle East the company has been able to benefit from large hotel sizes, the highest revpar levels in the world and the advantages of expansion through management contracts. It has also enjoyed regional quirks, with strong income from f&b through hotels selling alcohol.

The group said that it expected to see ongoing growth coming through midscale brands, including Staybridge Suites and Hotel Indigo. It added that it was getting considerable interest in Iraq as well as growth in Lybia and Syria, with a significant amount of pipeline being repeat business. The high proportion of owners who were high net worth individuals because of the oil business meant that attrition rates were low, at 8% for 2010.

IHG aims to open 38 new hotels across the region in the next four to five years and in 10 years time expects its portfolio to be two and a half times what it is today.

India, which has around 100,000 branded hotels, has been a more problematic market for the company, with Richard Solomons, CFO and head of commercial development, commenting: "It is a tough place to do business. Going forward we will see quite an increase in our market share, but we don't have as good a feel for the growth there."

Solomons admitted that the company had made "early mistakes" with partners and locations in India and was in the final stages of eliminating seven hotels from its estate as a result. Of its pipeline – the second largest for an international brand – over 50% were under construction. It has the second largest international branded pipeline in the country and aims to treble its size in the next three years, opening 150 new hotels by 2020.

The group is looking to the midscale for its growth, with 70% of hotels open and in its pipeline in the segment. Solomons said it was also doing more portfolio deals, which will speed up expansion. It is also working to cut the time taken to open hotels, which has been a past issue.

The issues that the company had in India are indicative of the issues that come with expansion into growing markets such as China and the Middle East. There are a lot of ‘ifs' and ‘whens' in the group's hopes for the future and it is hoping that the knowledge it has picked up expanding its brands and most recently conducting the worldwide relaunch of Holiday Inn will allow it to meet its expectations.

Cosslett said that the group was continuing to see growth in established markets such as Europe and the Americas, which would give it the firepower to invest, attract owners and make the most of opportunities around the world.

He said that the hotel companies needed to "anticipate trends at least 10 to 20 years ahead" adding "we know the world is going to be on the move like never before".

In this Cosslett seems to be betting on a sure thing. Even shocks such as terrorist attacks have failed to have anything but a short-term impact on travel, with the truth looking to be that, once people have tasted travel, they never look back. This was something Barr touched on when saying that, despite the amount of supply going into China, demand was expected to meet it. What the shape of this travel will look like, is less clear.

Cosslett said that, looking to China, they were already seeing the evolution from tour travel to individual travel. He added that, with the 10% richest people in China having an average age of 38, the future looked bright.

 

HA Perspective: Analysts at Morgan Stanley estimate that China could generate 25% of IHG's EBIT within three to five years. Currently, the country generates 14%. The forecast does not look unreasonable given that existing pipeline should take it to this point.

Further out, in 10 to 15 years, it was speculated that China could be as large as the US is today for IHG in EBIT terms. This looks more of a stretch.

At face value, the figures are beguiling. The World Tourism Organisation reckons China is comfortably on course to be the fourth largest tourism arrivals market in the world by 2020. And it is already at least 5th placed globally in terms of what it spends outbound.

And according to IHG, China has 1.5 million hotel rooms for a population of 1.3 billion and under 20% are branded, creating 20 branded rooms per 100,000 people. In the US, the number of branded rooms per 100,000 of population is 1,000. So the US is 50 times bigger.

This means there is huge potential in China. Or does it? The reality is that while rising, per capita income is much lower than the US. The potential is definitely big but not quite as big as some of the wilder numbers bandied around by BRIC (Brazil, Russia, India and China) boosters would have you believe.

The challenge for international operators inside China is undoubtedly margins and delivering profits. IHG was right to highlight this in its presentation. IHG pointed to the growing number of wealthy consumers in Chinese cities, with wealthy being defined as citizens with an income over $25,000 or so. By 2025 it is projected that there will be more wealthy – by this definition – consumers in China than in the US.

And so these wealth figures suggest that the market will soon sustain a hotel sector as large as that of the US. But there are a number of reasons to be cautious about making this assumption.

Firstly, it is a very big bet that China will continue with its current breakneck pace of growth. As its citizens become richer, the competitive advantage that drives the growth – cheap wages – disappears. Yes, growth can continue as the country develops internal demand and diversifies away from manufacturing but it is a fair bet that there will be some bumps along the way and that growth will slow.

Secondly, the pact of the Chinese government with its people is that it delivers growth as long as they let it get on with the job without interfering via democracy. The problem is that as citizens grow richer, they grow more demanding and this will be at a time when in all probability growth will be slowing. There is therefore significant political and social risk.

China is, like the other BRICs and rapidly emerging nations, a fantastic opportunity that will accelerate growth in the international hotel business.

But it is as well to remember the project management truism that a badly planned project will take three times as long and a well planned one twice as long. IHG does at least seem to have planned well.

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