Why Problems at U.S. Franchise Could Spell Trouble for 'Choice' Competitors

Mondayne:

Hotel hit parade: The 68% slide in U.S. Franchise Systems (USFS Quote) stock in the past four weeks can be attributed, in part, to problems specific to U.S. Franchise. But according to industry observers, the numbers also reflect trouble in lodging land.

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"The lodging franchise business is no longer profitable for franchisees," says one hedge fund manager and longtime industry observer. He notes that U.S. Franchise said its franchisees could no longer profitably build hotels because of slower lease-up times relating to oversupply. "As a result," he says, "the franchisees are pulling back projects. The lodging franchise business -- as opposed to the hotel ownership business -- is a unit growth business."

What's more, U.S. Franchise told analysts that such brands as Red Roof Inns (owned by Accor (ACRFY Quote)), Comfort Inn (owned by Choice Hotels International (CHH Quote)), Sleep Inn (also owned by Choice) and Wingate Inn (owned by Cendant (CD Quote)) were offering incentives of as much as $100,000 per hotel for franchisees to build their brands. U.S. Franchise, in response, said it would not hold back development and instead would match the incentives.

"Their theory is that by spending now, they will build their brand for years to come and crush the newer upstarts," our hedge fund source says, quickly adding: "Who do these guys think they are, Amazon.com (AMZN Quote)? As a result, margins should be crushed along with revenue for everyone." (And that doesn't even take into account rising labor costs; hotels compete with the likes of McDonald's (MCD Quote) for employees -- and look how they're being forced to raise prices to get quality help.)

The result, according to our hedge fund source: The U.S. Franchise fracas is merely the first warning "of deterioration in the limited service franchised lodging sector." Why then haven't any other franchisees been warned? Because, according to our source, U.S. Franchise CEO Mike Leven "is notoriously communicative with his franchisees, and he's probably just ahead of the curve."

Most vulnerable, our source believes, are Choice Hotels, Promus Hotel (PRH Quote), Cendant and Accor. But Accor and Cendant are well-diversified companies, and Promus is in the process of being bought by Hilton Hotels (HLT Quote). That leaves Choice as the only pure play among public companies in the low-end, budget and midpriced hotels. In other words, a direct competitor to U.S. Franchise.

Choice officials didn't return several calls. But one Choice competitor said that, unlike U.S. Franchise, which is in the process of building its chain, Choice already has 4,000 units. "Ninety-seven percent of its revenues come from stable properties," compared with U.S. Franchise, which gets very little of its revenue from existing properties.

Even our short-selling source doesn't argue with that. But the way he sees it is that any slowdown in growth, combined with the general industry slowdown and other margin pressures, won't help -- especially for a stock, such as Choice's, that assumes the growth will continue.

For more Herb, see today's second installment of Herb on TheStreet.