Hello everyone, I am Dolphin Analyst!

In the first part of the hotel overview article, "Surging 75%, how did Huazhu build its faith? (Part 1)", we analyzed the current revenue elasticity and future development direction of Huazhu $H World(HTHT.US) (HKEX: 1179), the domestic hotel leader. In this article, we will continue to dissect the company's financial model.

Since its IPO, Huazhu has received high market attention and enjoys a relatively high valuation level. Looking back at the past three years, the company's stock price was still up 10% as of the end of 2019, and even soared nearly 60% at the market’s highest point. Currently, investors may have three questions:

Has Huazhu's store opening trend reached its peak? With the improvement of industry chain rate compared to an annual net addition of 1,300 in 2019, the net addition of stores per year may decline. To what extent could it fall?
As the company gradually transitions from a growth-oriented company to a mature one, it is possible that the center of valuation needs to move down, causing limited upside for the stock price. Is the high valuation given in 2019 a thing of the past?
More realistic question: Huazhu has already rebounded to $43. How much of the fundamental repairing has been priced in and how much upside is left? What is the investment risk?

Regarding these three questions, here's what I think: I have analyzed the first question in the previous article. Even if we only target properties with more than 70 rooms for chain operation, by increasing the chain-operation rate from the current 50% to 80% in the next five to seven years (this type of property has standard designs, so the chain-operation rate increases quickly), Huazhu can achieve an addition of 4,000 stores by maintaining its current market share (market share can be increased to 15%, industry market share is 6%). Based on the logic of the increasing concentration of the market share of hotel leaders, it is possible for Huazhu to achieve an addition of 6,000 stores (market share can be increased to 18%, industry market share can be increased to 7%). Moreover, in the next few years of development, it is entirely possible to explore feasible ways for properties with 40-70 rooms, which will double the effective industry space (currently, there are very few leading brands operating such properties, and they are not profitable).

As for the second question, although Huazhu's store opening speed has slowed down compared to 2019, after considering the first question, we find that this slowdown may not be due to the impact of the epidemic alone, but rather a normal situation resulting from the large base. However, Huazhu's revenue structure is improving, the proportion of franchisees is increasing, and the hotel's performance is becoming more stable. The impact of high fixed costs on direct-operating businesses will become smaller and smaller. The transformation from growth to maturity is not a bad thing. In the US and Hong Kong stock markets, the valuation of mature hotels has always been expensive (the EV/EBITDA of mature hotels is between 10 and 20 times). At this stage, what investors need to do is to wait patiently for the right entry price.

So, the answer to the third question is also clear. At the current price, you can either wait for the stock price to retreat to obtain higher security (though hotel operations may improve as the pandemic eases, so this retreat may not happen), or consider entering in the current price range. For Huazhu, faith is difficult to collapse, and the worst result is to digest the valuation and hold it for a longer time.

If you are interested in interpreting Hong Kong stock company research reports, please add the WeChat account "dolphinR123" to join the investment research group, obtain Dolphin Analyst's in-depth research report, and discuss investment opportunities with investment veterans in real time.

IV. What is the future space?

Regarding future performance, the Dolphin Analyst thinks that it should be judged in two stages. One is whether the recent performance can pass the market test and whether there are significant deviations from the company's previous guidance and the market's consensus expectations. The other is the company's long-term business development direction, which determines the future of the company's core.

1. No short-term breakthrough

At the end of the year, there is almost no difference in market expectations for Huazhu's full-year performance this year. Thanks to the performance improvement in the first three quarters of the year (specific performance reviews can refer to "Growing in the Cracks of the Pandemic, We Have the Power to Dream Big and Catch Up: Analysis of the 3Q 2022 Financial Report of Huazhu"), combined with the performance guidance given by the company in the financial performance report for the third quarter of 2022, it is estimated that Huazhu's revenue in the fourth quarter of this year will be around RMB 3.6 billion, and the full-year revenue will be around RMB 13.8 billion. Some investors may think that the company's performance guidance at that time looked relatively cautious. Although the RevPAR in the third quarter of the company had recovered to about 90% of the same period in 2019, according to the estimation of the fourth quarter, it would only be at the level of 70-80% of 2019. In mid-to-late November, various places in the country adjusted their epidemic prevention policies, especially the cancellation of travel codes and nucleic acid testing, which will accelerate the recovery of industries such as business hotels, and there should be better results.

However, the Dolphin Analyst wants to further explain here that although the guidance was given by Huazhu to the market before the adjustment of domestic epidemic prevention policies, it is indeed closer to the current market situation. On the one hand, due to the rapid relaxation of policies, there is a surge in virus carriers in the short term, which will stimulate residents to improve their willingness to "stay at home". On the other hand, the Spring Festival next year will come earlier than in previous years, and many regions in China will enter the Spring Festival travel season immediately after New Year's Day. Therefore, in December, the probability of enterprises considering increasing business or other activities due to the relaxation of epidemic prevention policies is not very high. That is to say, in the short term, the most likely situation is that the occupancy rate and other operating data will not immediately rise with the policy adjustment, but will slowly fall back to a medium level compared with the third quarter, due to entering the industry's off-season.Although the stock prices of the overall social service sector have already risen as expected by everyone.

2. Long-term expectations

（1）Compared with peers, the fastest recovery

Although the relaxation of epidemic prevention policies has limited short-term impact on the company's recovery, it is definitely a huge benefit in the medium and long term, especially for Huazhu, which has continuously improved its competitiveness by using its lean management capabilities. In the past two years, Huazhu has had the fastest recovery rate in the industry. The domestic RevPAR level in the third quarter of 2022 has already recovered to about 90% of the same period in 2019, while the average domestic level is still less than 75%, and the recovery of the other two listed companies is respectively 80% and 70% of the same period in 2019.

It is also necessary to note that the ADR of the hotel industry is currently close to or exceeds the level of the same period in 2019. The occupancy rate that has the greatest impact on recovery is still around 60-80% of that in 2019. As mentioned in our previous post, in the medium to long term, it is not difficult for the RevPAR of head companies to exceed the level of the same period in 2019 with the recovery of occupancy and the continuous improvement of ADR.

(2) Expanding against the trend

In the past three years, the market share of head hotel groups has continued to increase, especially Huazhu and Jinjiang, with an average net increase of more than 1,000 hotels per year in the past three years. Combining Huazhu's current number of hotels to be opened, the situation of opening and closing in the past few years, and the increase in chain rate mentioned in the previous post as incremental space for head companies (reference: "Rising by 75%, how did Huazhu develop its faith? (Part 1)"), it is expected that Huazhu can achieve a net increase of 800-1,000 hotels per year in the next few years.

3. Neutral expectations

Based on the above, we make the following assumptions:

(1) Number of hotels: Net increase expected to be 4,200Assuming that in the next five years (2022-2026), Huazhu will benefit from lean expansion and structural upgrades, maintain its existing market share, and expect to add a net 4,200 hotels over five years. At the same time, according to the trend of the ratio of direct-operated and franchised stores in the past few years, it is expected that this trend can be maintained, and the proportion of franchised hotels can increase at a rate of 0.5% per year (increased by 1.3% in 2022 according to the trend in the first three quarters). The number of direct-operated and franchised stores in corresponding years is shown in the following figure: DH is mainly used for the opening of direct-operated stores, while Huazhu is mainly used for the opening of franchised stores in China.

Refer to the historical trend and the concept of lean management of Huazhu to understand that the number of single hotel rooms in direct-operated hotels in China is expected to increase by one room per year, while the number of direct-operated hotels overseas will remain at the current level in the next few years. As for franchise stores, the number of single hotel rooms of Huazhu and DH will remain unchanged in the future. Therefore, it is expected that the total number of rooms of Huazhu can still maintain a certain degree of growth.

(2) Single store operation: Recover to pre-epidemic levels in two years

a. Domestic: In terms of self-operated stores, according to a neutral assumption, it is expected that Occ will gradually recover to the 2019 level through two years (2023-2024) and remain stable. At the same time, referring to the actual situation in the first three quarters of this year and the degree of domestic epidemic opening in the fourth quarter, this year's ADR level is estimated and adjusted upward by 4% year by year based on this. The same is true for franchise businesses in China.

b. Overseas: In terms of self-operated stores, considering that overseas hotels have continued to raise prices in the past two years, and RevPAR is close to the level of the same period in 2019. Currently, the main damage is Occ, and it is expected that the occupancy rate will gradually recover to the pre-epidemic level in the next two years, and the ADR will increase by 2% year by year. The same is true for franchise businesses overseas.

(3) Franchise ratio steadily increases

On the basis of this assumption, the proportion of income from Huazhu's franchised stores will further increase, and the CAGR of direct-operated business income in the next five years can reach 15%, while franchise business can reach 17%.

(4) Costs will further decrease to pre-epidemic levelsHotel's total cost is mainly concentrated in the direct business, and from 2020 to 2022, the unit room cost has not changed much, but the rigid cost rate such as rent amortization suddenly jumped due to the impact of insufficient occupancy rate. Based on the performance of the first three quarters of this year, we predict that various cost rates will decrease to a certain extent this year, but they have not yet covered direct sales revenue. It is expected that they will gradually recover to the pre-epidemic level of 2019 in the next two years.

(5) Adjusted EBITDA recovers quickly

Due to the large amount of depreciation and amortization in the hotel industry every year, as well as Huazhu's holding of Accor's equity for a long time, which is around 6%, the fair value gains and losses of the company are very unstable, which will affect net profit, but will not affect the company's actual cash flow. Therefore, in general, investors in the hotel industry are more concerned about adjusted EBITDA. Based on the above model, the future net profit situation and adjusted EBITDA situation of Huazhu are expected as follows. The profit elasticity in the next 2 years mainly comes from direct sales business, while the long-term performance elasticity still comes from joining business.

(6) DCF valuation

Based on the assumption of WACC=10.68%, g=3.0%, the DCF valuation result is $44.65 per share, corresponding to the net profit in 2024, implying a PE of 27x and an EV/EBITDA of 15 times (overseas hotel EV/EBITDA is generally between 10-20 times), which is currently approaching the reasonable market value. The above is based on a model of recovery to the pre-epidemic level in two years, simulating the most conservative recovery scenario.

4. Optimistic Expectations

The neutral expectations in the third part are based on the recovery of occupancy rates to the level of 2019 in two years, while ADR is adjusted reasonably based on inflation and occupancy rates. However, if the economic recovery next year exceeds expectations, based on the demand for business travel, the hotel industry may be able to recover to the level of 2019 in only one year, and the number of new hotels will also consider the industry's fast recovery speed.Therefore, we make an optimistic assumption that the number of hotels will increase by a net of 6,000 over the next five years while the occupancy rate in 2023 instantly recovers to the same level as the same period in 2019. Adjusting ADR reasonably based on prices and occupancy rates will give us:

1) Number of hotels: Expected net increase of 6,000

2) Single-hotel operation: One-year recovery to 2019 level

3) The composite annual growth rate of franchise revenue reaches 19%.

Based on the optimistic assumption that the pre-epidemic levels of 2019 will be immediately restored in the coming years, the CAGR of direct revenue in the next five years can reach 17%, and the CAGR of franchise business can reach 19%, with its proportion of total revenue continuously rising. Correspondingly, all costs and expenses will also be restored to the level of 2019 immediately.

4) Greater EBITDA elasticity

Under this assumption, the expected EBITDA adjusted by 2023 will be approximately ¥3 billion more than the neutral expectation. Furthermore, since there will be more new hotels opened, Occ will recover more quickly, and both direct business and franchise business will positively impact the performance.

5) DCF valuation

Assuming WACC=10.68% and g=3.0%, the optimistic estimate of DCF valuation is USD 56.10 per share, corresponding to the net profit in 2024, with an implied PE of 28x and EV/EBITDA of 17 times and potential upside of 30%.

In summary, we can see that under the assumption of neutral expectations, Huazhu's space is relatively limited, but the two-year recovery is also based on the most conservative scenario. Although from the current situation in China, the recovery next year is likely to be a process of first suppression and then rise, it seems difficult to achieve the optimistic expectation at one time.

The actual recovery may be that in the initial stage of the epidemic's release, people will also reduce commercial activities or actively stay at home to reduce the risk of infection. However, after one or two peaks of infection, residents will gradually get used to it and return to normal life. At that time, it is not necessary for Huazhu to immediately recover to the level of optimistic expectations. As long as it can see the development trend of operating data getting better, it can stabilize the valuation. As for the performance recovery, it is just a matter of time. At this time, Huazhu may climb to a market value of $18 billion or more, and there will be more than 30% of space.

Therefore, Huazhu, which is currently priced at less than $43, still has appeal.

[Dolphin Analyst "Huazhu Group-S" historical articles:]

[Earnings Season]

November 29, 2022 Telephone Conference Call "[Cost Reduction and Efficiency Enhancement, Adhering to Business Growth (Huazhu 22Q3 Telephone Conference Call Summary)] (https://longbridgeapp.com/topics/3700768)"

November 29, 2022 "[Striving for Growth against Epidemic Pressure: Huazhu (https://longbridgeapp.com/topics/3699791)]"

March 24, 2022 Telephone Conference Call "Huazhu Group Fourth Quarter Telephone Conference Call Summary: Focusing on Lean Growth"

March 23, 2022 "Huazhu: The Road to Recovery is Long amid the Epidemic Fluctuations"

[In-Depth]

December 14, 2022 "[How did Huazhu's Faith Train for a 75% Surge? (Part One)] (Https://longportapp.cn/topics/3754634)"

October 19, 2021 "Valuation 'Stubborn' and Tall, Is Huazhu Really Reliable?"2021 October 11 "Huazhu Group (Part 1): The Rise of Domestic Brands in the Hotel Industry"

Risk disclosure and statement for this article: Dolphin Analyst Disclaimer and General Disclosure