Hilton IPO: A Safer Way to Invest in China

NEW YORK (TheStreet) -- The IPO of Blackstone (BX)-owned Hilton Worldwide could create an opportunity for investors looking to gain exposure to the Chinese economy, while minimizing some of the risks that are associated with the country's credit and real estate-fueled economic growth.

Since Blackstone Group bought Hilton Worldwide for $26 billion in a 2007 leveraged buyout that has been used by some as an example of the peak of the pre-crisis bubble, the international hotel and timeshare chain has undergone a significant, if subtle, change to its business. 

Hilton Worldwide took billions of dollars in buyout financing when Blackstone made its 2007 investment, just ahead of a sharp downturn in the global economy and credit markets. Given what seemed like crushing debts, few would have expected Hilton to emerge from the crisis as the fastest growing hotel brand in the world. The company's redoubled commitment to franchisees for hotel growth, however, has allowed Hilton brand to expand rapidly without putting up much money by way of real estate purchases or construction.

In its franchise business, Hilton receives royalty revenue from developers who seek to profit from the company's iconic brand. Franchisees, not Hilton, purchase and develop the real estate.

Under its PE owners, Hilton Worldwide has used third-party franchisees to grow its overall room count by 36% in an over five-year stretch without taking on the financial burdens generally associated developing real estate.

Ninety-nine percent of Hilton's new rooms under its PE-owners have come from third party franchisees, the company advertises in its S-1 IPO documents filed with the Securities and Exchange Commission.

The benefit to Hilton's earnings is striking. It also compares favorably to competitors such as Starwood Hotels (HOT), Marriott Worldwide (MAR), and Hyatt (H).

Hilton's franchise business now contributes over 50% of the company's overall earnings before interest, taxes, depreciation and amortization (EBITDA) according to its S-1, and adjusted franchise EBITDA has grown by 25% from 2007 through 2012. It is Hilton's fastest source of earnings and hotel growth.

So what about China?

Hilton's use of franchised hotels for growth has helped the company map out an international growth strategy that is shielded from many of the risks associated with investing in foreign markets.

Hilton won't be taking on direct credit or real estate exposure to markets in China, Southeast Asia and the Middle East. It means that Hilton is fairly insulated if China's real estate market or its credit system hits a snag, an issue that has generally muted investor interest in the world's second largest economy in recent years.

As a result, Hilton has been happy to increase its presence in international markets, even as post-crisis economic challenges make investing in foreign markets a big risk. According to Hilton's S-1, its pipeline of rooms in development outside of the U.S. now account for 60% of total new rooms in development. Prior to Blackstone's 2007 buyout, the figure stood at just 20%.

In China, Hilton has increased its total hotels from just six as of 2007 to 171 hotels currently open or in development. China, as it turns out, has led the world in revenue per available room (RevPAR), a key metric in the hotel industry.

"In the Americas, RevPAR has increased at a CAGR of 6.9% over the past three years and demand has returned to pre-economic crisis levels. The Asia Pacific region also has experienced high RevPAR growth during the last three years, primarily fueled by China and to a lesser degree Southeast Asia. Weaker economic conditions in Europe dampened RevPAR growth, but recent trends show improvement," Hilton states in its S-1.

Still, Hilton's growth push in the U.S. and internationally through franchise businesses doesn't come completely without risk. Were franchisees to dilute Hilton's brand, it could undermine the company's ability to maintain existing relationships and grow new ones. Such a scenario would impact Hilton's franchise earnings, now the lion's share of the company's overall EBITDA.

Hilton also isn't entirely insulated from deteriorating economic fundamentals such as a fall in real estate prices, a slowdown in credit or a rise in mortgage defaults. If Hilton's franchises in the U.S. or international markets like China are unable to cover the financial burdens of owning and maintaining real estate, they could be forced to terminate management or franchise relationships.

Still, Hilton's financial exposure is relatively minimal compared with a business model that invests and owns hotels directly. For those looking for a way to invest in China's growth without taking all of the risks associated with the country, Hilton could be a compelling IPO.

The company plans to use IPO proceeds to pay down some of its $7.5 billion in outstanding term loan borrowings, the leftover debt from Blackstone's 2007 leveraged buyout.

--Written by Antoine Gara in New York

Follow @antoineGara

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