H World Group: Strong domestic travel and leisure demand outlook (NASDAQ:HTHT)

Summary

I have a positive opinion about H World Group Limited (NASDAQ:HTHT). My summary thesis is that the domestic travel and leisure industry in China remains very strong. Flight volume data has recovered very strongly and shows no signs of weakening, even in July. I consider this to be a strong indicator of hotel demand, which is very positive for HTHT. In addition, HTHT is executing very well on several growth initiatives that should better position it to capture demand. Given my positive outlook, I do not believe HTHT deserves to trade near its five-year low.

Company Overview

HTHT is a leading multi-brand hotel group with over 10,000 hotels under its belt as of Q2 2024. The operating model is both leased and owned. [L&O] and franchised and managed [F&M]In China, 6% of total hotels are owned by L&O and 94% by F&M. In terms of room count (in China), as of 2Q24, HTHT has approximately 974,000 rooms, of which L&O is approximately 84,000. of them and the rest from F&M. The company has operations primarily in China, where it earned 80% of fiscal 2023 revenue. The remaining 20% ​​is split between 15% in Germany and 5% from the rest of the world. Operationally, L&O accounts for 60% of total revenue, with the remainder coming from F&M.

Earnings Results Update

In the last quarter (2Q24) 20 new cases were reported^He In August, HTHT’s total revenue increased 11% to RMB6.15 billion, of which L&O was RMB3.7 billion, F&M was RMB2.3 billion and others was RMB133 million. This was coupled with a healthy gross margin expansion of 230 basis points to 39.3%, and helped HTHT translate revenue growth into stronger EBIT growth of 14% (from RMB1.36 billion in 2Q23 to RMB1.57 billion in 2Q24). In terms of margin, EBIT margin expanded 60 basis points year-on-year to 25.6%. For Adjusted EBITDA (reported), margin improved 120 basis points year-on-year to 33.2%, reaching RMB2.04 billion.

Travel demand remains strong

The prevailing narrative for China is that the consumer spending environment is weak given macroeconomic conditions, and this is leading to a contraction in discretionary spending. This is consistent with several companies that have pointed to weak demand in China. For example: (1) Sephora cuts jobs in China; (2) WPP downgrades sales forecast in China; and many otherNaturally, the expectation is that the travel and leisure industry will also be affected (in line with what The United States is watching).

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However, I disagree, as the domestic travel industry in China has been extremely robust. Above is a chart reported by skytravelAnd from the data we can see that the total volume of flights has already recovered. above 2019 levels with a massive increase in year-on-year terms compared to the first half of 2023 (24%). More notably, if you look at the table on the top right, the entire recovery is driven by domestic travel (international travel down 50% compared to 2019). Even in the last reported month (July), the strength of demand remains extremely strong: 14% year-on-year domestic growth.

The reason I highlight this data is that I consider it a strong indicator of hotel demand. Logically, higher flight volume should translate into higher demand for hotels as travelers need accommodations to stay in during their travel period. In fact, if we look at HTHT’s Q2 2024 results, the underlying operating metrics have painted a similar picture: (1) occupancy rate has improved 80 basis points year-over-year and 560 basis points sequentially to 82.2%, and (2) total room sales grew 19% to 73.2 million in the quarter.

Multiple initiatives to boost growth

First, HTHT is executing very well on the modernization of its existing mid-scale and economy hotels, especially across its three core brands – Hanting, Ji and Orange (which together account for 70% of the domestic hotel count). As of Q2 2024, including those under construction, the number of secured mid- and high-scale hotels accounted for 52% of the total hotel count, which is 400 basis points higher than hotels in operation alone. Doing the math, it suggests that a large mix of hotels under construction are mid- and high-scale hotels – this should result in HTHT enjoying higher ADR (which should boost RevPAR growth). It is important to note that in the upper-midscale segment, HTHT’s brands (Crystal Orange, Intercity and MAXX) have found a solid foundation to capture demand (as evidenced by the increase in occupancy from 81.7% last year to 82.6% this year, which is higher than the improvement in the group’s occupancy rate). Another positive demand indicator (my logic being that franchisees would only want to open hotels that are in demand) that these brands are capturing demand is that HTHT has successfully increased hotels in operation and in portfolio by 8% and 18% sequentially, respectively.

Secondly, following the launch of NiHao 2.0 in Q1 2024, HTHT repositioned another value brand, HI Inn, and redesigned its products with the latest version 6.0 launched in Q2 2024. HI Inn 6.0 is positioned as the best value-for-money brand with an innovative digital operating system that combines guest self-service, digital reception, and mobile staff. I am very positive about this strategy as it should help HTHT better capture demand from: (1) value customers (those who want to try but are on a tight budget) and (2) the increasing popularity of traveling to lower-tier cities. With more offerings available, as seen from the increased city coverage (up 11% YoY) and hotel coverage (21% YoY growth in Tier 3 and below cities), HTHT is definitely well positioned to continue capturing demand.

Finally, HTHT has strengthened its direct B2B sales capabilities, which has resulted in strong growth in terms of hotel nights booked and number of active corporate clients. To put things into perspective, the 3,600+ new active corporate clients contributed over 6 million (~8% of the group total) hotel night bookings through its B2B platform (31% YoY). The most important implication here is that it gives a very early idea of ​​how strong the potential growth is when China enters full macroeconomic recovery mode. With more active corporate clients on board, it also means that HTHT is better positioned to contact/convert sales at the start of a recovery growth situation.

Valuation

I believe HTHT is worth 29% more than the current share price. My target price is based on FY2026 adjusted EBITDA of RMB8.9 billion and a forward EBITDA multiple of 13x.

Earnings Bridge: I believe growth in the coming years will remain strong as consumer preference for travel has proven to be resilient (as shown in the various data points above) and HTHT is stepping up its growth initiatives to capture this demand. Assuming a recovery to HTHT’s pre-COVID (2014-2019) average growth of 12% over the next 2 years, I arrived at about RMB29.7 billion of revenue in FY2026. I then assumed a stable Adjusted EBITDA margin as HTHT is likely to reinvest excess profits back into the business to drive growth. This led me to Adjusted EBITDA of RMB8.9 billion in FY2026.

Valuation rationale: The main bullish driver is the appreciation in multiples. I don’t think HTHT should be trading at the current multiple of ~9x forward EBITDA. For comparison, the current 9x is almost at the lowest point in the past 5 years, even lower than the COVID period, which is meaningless considering the growth outlook (potential for further acceleration when the Chinese economy recovers). Another way to look at this is to compare HTHT to Shangri-La Asia, which is trading at 13x forward EBITDA but is expected to grow slower (expected growth is in the low to mid-single digits) than HTHT. As such, I think HTHT should at least be trading back to 13x forward EBITDA (it was trading at 13x two months ago, for reference).

Investment risk

The Chinese economy could weaken further from here, which could deal a major blow to the domestic travel and leisure industry, impacting HTHT. Moreover, this comes at a time when HTHT is ramping up its offering and various growth initiatives. Lower than expected demand, coupled with rising operating expenses, will deal a double blow to Adjusted EBITDA, further weighing on the valuation.

Conclusion

My positive view on HTHT is driven by the strong domestic travel and leisure demand outlook in China. Based on recent flight volume data, this indicates strong underlying demand for hotels, which benefits HTHT. HTHT is also executing well on growth initiatives such as brand refreshes and B2B sales expansion, further positioning it to capture this demand. While a potential economic slowdown in China poses risks, HTHT’s current valuation is very attractive, near its five-year low (which does not reflect growth prospects).