hilton - fairly valued

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Levent Yilmaz, 3 January, 2017

Hilton Fully valued

12 Month Share Price target: $26.74; Current Share Price: $27.2

Hilton is a leading global hospitality company, spanning the lodging sector from luxury and full-service

hotels and resorts to extended-stay suites and focused service hotels. The company’s portfolio includes

thirteen world-class global brands, 789,000 rooms1, 4,820 Hotels2 in 104 Countries and Territories.

Hilton is a high quality lodging company with leading brands and healthy growth rates.

Hilton has a resilient fee driven model and it is diversified across geographies and chain scales.

1 Figures include timeshare properties. 2 Figures include timeshare properties.

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Its balance sheet and cash flow profile is improving.

But a slowing international RevPAR3 growth environment could hurt Hilton’s earnings growth.

3 RevPAR (Revenue Per Available Room) is the total guest room revenue divided by the total number of available rooms.

RevPAR differs from ADR because RevPAR is affected by the amount of unoccupied available rooms, while ADR shows only the average rate of rooms actually sold. Occupancy x ADR = RevPAR –– A RevPAR (Yield) Index measures a hotel’s fair market share of their segment’s (competitive set, market, submarket, etc.) revenue per available room. If a hotel is capturing its fair market share, the index will be 100; if capturing less than its fair market share, a hotel’s index will be less than 100; and if capturing more than its fair market share, a hotel’s index will be greater than 100. RevPAR Index is calculated: (Hotel RevPAR / Segment RevPAR) x 100 = RevPAR Index; Fair share can be thought of as the subject hotel’s “piece of the pie” in the market. For example, if the subject hotel’s RevPAR is $50 and the RevPAR of its competitive set is $50, the subject hotel’s index would total 100. If the subject hotel’s RevPAR totaled $60, its index would be 120, which indicates that the subject hotel has captured more than its fair share. Occupancy (Occ) is the percentage of available rooms that were sold during a specified period of time. Occupancy = Rooms Sold / Rooms Available; (Average Daily Rate) ADR = Room Revenue / Rooms Sold

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Economic slowdown and security threats are impacting its business in Europe. Increased supply growth

in the upscale and upper midscale chain scales could impact fee growth.

The US business is picking up in anticipation of tax cuts, reduction of regulatory burden and

infrastructure spending. Multiples in the sector have therefore expanded. But one needs to wait for

actual implementation of policies.

If we assume multiples for Park Hotels, Hilton Grand Vacations and Hilton "RemainCo" at the top of their

respective peer groups, Hilton could reach a value per share of $26.74.

Hilton Sum-of-the-Parts Valuation ($ in millions, except per share data)

2018E Multiple (x) Value

Ownership EBITDA $1,033 10.5 $10,847

Management and Franchise Fees EBITDA $2,073 11 $22,803

Timeshare EBITDA $415 7.5 $3,113

Corporate and Other -$261 10.4 -$2,714

Total EBITDA $3,260 10.4 $34,048

Less: 2018E Net Debt -$7,549

Equity Value $26,499

Shares outstanding (mm) 991

Equity Value Per Share 26.74

While Hilton’s share price has outperformed S&P 500 in the 2H 2016, the S&P 500 is not cheap

currently and a likely price correction is likely to hurt Hilton’s share price as well.

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Average revenue per available room (RevPAR) of the US hotel industry in USD

Average revenue per available room (RevPAR) of the US hotel industry in USD

Change revenue per available room in the US lodging industry, PWC

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The forward 12-month P/E ratio for the S&P 500 is 17.0. This P/E ratio is based on today’s price (2254)

and forward 12-month EPS estimate ($132.79), according to Factset. 10-year average S&P 500 forward

12-month P/E ratio is 14.4. The forward 12-month P/E ratio for the S&P 500 Consumer Discretionary is

18.4 and the 10-year average 16.5, respectively. Hilton is trading at a multiple of 23.9x.

While it deserves a premium vs the peer group due to its financials and leading position, it is already

priced in.

On top of the current 300,000 rooms in the pipeline, Hilton can boost revenue growth in the future

through new brands e.g. a three-four star collection brand and the gradual increase in franchise fee

rates. The expected rise in cash returns to shareholders ($1bn to $1.5bn p.a. from around $278mn in

2016E) is an additional positive.

EV/EBITDA P/E Ratio PEG Ratio 5 Yr EPS Price/book Price/Cash flow Efficiency Gross margin Net profit interest Total debt to

23-Dec-16 2017E next year next year Growth % MRQ TTM ROI (TTM) (TTM) margin (TTM) coverage (TTM) capital (MRQ)

Hilton Worldwide Holdings 12.3 27.45 2.01 23.63 4.16 12.07 6.69 62.08 13.47 3.31 0.6157

Marriott International 12.7 21.06 1.81 23.88 5.62 37.87 6.58 14.84 4.82 9.64 0.6017

Wyndham Worldwide 12.06 1.37 17.54 10.5 9.92 7.56 50.94 10.55 7.92 0.8724

Hyatt Hotels Corporation 36.6 -6 21.82 1.89 13.65 2.98 21.7 4.49 37.63 0.2723

InterContinental Hotels 12.3 7.45

Choice Hotels International (CHH)14.2 4.76

China Lodging Group 25.68 3.47 31.41

Extended Stay America Inc STAY9.5 35.81

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Executing on the China growth strategy is important. China is the largest outbound market in the world

and it is growing strongly. Hilton thinks it is on a good path, particularly with its Plateno relationship as

well as some others and its new relationship that they're building with HNA.

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India offers also a lot of potential given low hotel penetration and healthy growth rates. Hilton is well

positioned to profit from its strong brand, technology and management. But Trump’s protection/trade

war policies, if implemented, could impact growth ambitions in China.

Hilton introduced a three year outlook for the company in December. If we assume RevPar growth of 1%

to 3% and annual unit growth of 6%, Hilton estimates it can generate annual EBITDA growth of 5% to 8%

and annual EPS growth of 14% to 23% from 2017-2019.

Hilton could return $3.0bn to $4.5bn to shareholders over the three years, with dividends representing

15%-20% of payouts and repurchases representing 80%-85%.

SAME STORE NET UNIT FEE RATE

GROWTH IN RevPAR Net Unit Growth Effective Franchise

(CAGR) (+1 to 3%) (+6%) Rate

Adj. EBITDA Sensitivity 1 Pt. = around $20.25MM 10K rooms = 5 bps = around $8-10MM

around 20MM

steady-state

Corporate & Other around 3% CAGR

Adj. EBITDA 5 to 8% CAGR

Free cash flow 12 to 15% CAGR

Reduction of shares 4 to 8% CAGR

Three year model summary

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Franchise fee rate step-up could add $125mn annual EBITDA. Hilton’s current realized franchise rate is

4.8% and is gradually moving up to the published 5.5%. As Hilton’s system grows, franchise rates could

continue to move higher.

The new Hilton is a market-leading, resilient, fee-based business. Lower volatility with 90% of adj.

EBITDA from fees, 90% revenue driven. 70% of total fees franchise driven. Capital efficient growth. 6.5%

managed and franchised net unit growth (2016E).

Operating upside in a simplified model: 1% of system-wide RevPAR growth likely to lead to $20mm -

$25mm annual Adj. EBITDA.

Meaningful, growing and resilient pipeline – 300k room pipeline – round $640mm annual adj. EBITDA.

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Increasing franchise fees as contracts roll over at higher published rates: 4.8% in-place vs. 5.5%

published rate -> $125mm annual adj. EBITDA.

Meaningful capital return potential: $3.0 billion to $4.5 billion of potential capital return 2017E-19E, 13%

to 21% shares outstanding repurchased.

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Hilton has the 13 best brands in the business, because they've got the highest average market share in

the business with a 14% RevPAR premium. Every one of their brands is a leader in its segment.

The value drivers to generate free cash flow are:

1. Same store growth. One point in system wide RevPAR growth is $20mn to $25mn in EBITDA growth.

2. New unit growth. The 300,000 room pipeline is worth $640mn, and every 10,000 room means $20

million more EBITDA growth.

3. Opportunity to increase franchise fees moving from the current 4.8 to a published rate of 5.5. This

would mean $125mn. Every five basis points is another $8mn to $10mn.

90% of Hilton’s EBITDA is going to be fee driven, and of that, 90% is going to be driven by top line base

management and incentive fees. Incentive fees are 10% of its fee segment and 85% of that 10% is from

international style management agreements. All of its management agreements outside of the US work

in this way and its agreements with Park are going to work in this way too.

Same store RevPAR growth, combined with new unit growth combined with growth in their effective fee

rates and some of the other fees that they charge out of the enterprise is the top line algorithm.

Combined with re-levering to its target leverage should yield significant amounts of capital to return to

shareholders.

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Hilton has $1.25bn in liquidity available between its undrawn revolver and its unrestricted cash position

which they think is more than sufficient to run the business. It intends to maintain its dividend and

targets a payout ratio of 20% to 25% of recurring free cash flow.

Hilton expects to maintain net leverage in the range of 3 to 3.5 times net debt to adjusted EBITDA. Any

cash flow it generates in excess of that, Hilton intends to return to shareholders, likely though a

combination of programmatic and opportunistic stock buybacks.

Hilton is assuming net unit growth of 6% p.a. with about 160,000 net room additions over the course of

the three-year modeling period. Its cash taxes for 2017 is modelled at 25% of adjusted EBITDA. They are

keeping the weighted average cost of debt at 4.2%. Investment spending is modeled at $185mn p.a. for

this year and at $175mn to $185mn p.a. afterwards.

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The free cash flow is modelled by the company at $2.6bn to $2.8bn p.a. and 3x to 3.5x leverage. That

would produce incremental issuance of net debt of between $400mn and $1.7bn over the three-year

period. That would mean a total of $3 billion to $4.5 billion of cash available to return to shareholders. If

you break that down between dividends, assuming its 20% to 25% of free cash flow target, 15% to 20%

of the return of capital would come in the form of dividends and 80% to 85% of the return of capital will

come in the form of programmatic and opportunistic stock buybacks.

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Spin-Off

Hilton is spinning off the bulk of its owned real estate business (Park Hotels and Resorts) and its

timeshare business (Hilton Grand Vacations) to it shareholders. The record date for the spins is

December 15, 2016 and the distribution date for the spins is January 3, 2017. Hilton anticipates Park will

trade with the ticker “PK” while Hilton Grand Vacations will trade with the ticker “HGV.” Current Hilton

shareholders will receive 1 share of PK for every 5 shares of HLT and 1 share of HGV for every 10 shares

of HLT. Following the spin-offs, HLT will complete a 1-for-3 reverse stock split.

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Park Hotels and Resorts (the REIT spin-off)

Park sees its current portfolio as well defended with a high discount to replacement value. Based on

EBITDA contribution, Park’s largest assets are in Hawaii, San Francisco, Orlando, New York, Chicago and

New Orleans. Many of these markets face limited supply growth. Park thinks that it faces competitive

supply growth of 2.2%, which is 50bps below its peer average. On top of that, many of these Hotels are

large Hotels in great locations Park estimates its discount to replacement cost in the range of 46% to

57%.

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It is targeting large deals in luxury⁄upper upscale. Park is focusing on acquisitions over $250mn.

Park believes its Hotels are well capitalized. The portfolio spent an average of 9.4% of revenues on

capital expenditures over the past five years. It expects to spend 6% of revenues on capex going

forward.

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Park has a target of 65% revenue flow through on gradual revenue throughout its portfolio. It is

targeting a payout ratio of 65% to 70% of FFO⁄Share, which compares to an average of 55% for the

REITS.

Hilton Grand Vacation (the timeshare spin-off)

Market share gains are driven new customers and timely additions of inventory. HGV has increased its

market share of vacation ownership interest sales from 5% to 12% since 2007. It has generated an 8%

sales growth during this time period while the industry have not yet recovered all of the sales lost during

the recession.

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Its growth is due to a focus on adding new owners to its customer base and also adding well-time

attractive inventory.

HGV has focused its efforts on scale in key locations in the USA and Japan. HGV thinks this focus allows

them to efficiently allocate sales and take advantage of tourists to these markets. HGV has increased its

fee for service business to 58%. This compares with its nearest competitor at 8%. The fee for service

model allows it to secure inventory without using its balance sheet. Going forward, HGV aims to keep its

fee for service mix in the low 50% range.

hilton - fairly valued

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