Travel recovery had been researched as early as September 2020, just six months after the World Health Organisation declared Covid-19 to be a pandemic. After nearly three years, the sector still remains in the shadow of pre-Covid numbers. As gloomy as that sounds, there have been forecasts that the sector is well poised to surpass its pre-pandemic performance. For investors, this means that more opportunities are awaiting to be captured.
Travel and tourism is a huge umbrella, encapsulating multiple smaller industries. For simplicity, the industry can be broken down into two categories, namely air transport and accommodation. Yet the advent of technology means that digitalisation radically transformed the sector, giving rise to a third category formed by online travel agents (OTAs). These three categories have vastly different business models and characteristics. In this piece, we attempt to evaluate which of them is the most attractive from an investor’s standpoint.
Based on the World Tourism Organization, tourism recovery is most evidently witnessed among internet companies specialising in hotel searches and bookings. Apart from posting the strongest resurgence, there is a host of other reasons why internet companies could be preferred over traditional aviation and hospitality enterprises.
We start by dissecting why airlines might look less favourable. To begin, airlines generally serve the passenger and air cargo markets. The air passenger market looks sanguine as global passenger traffic increases but the demand for air cargo has trended downwards due to lower inventory pressures and restored belly capacities of passenger aircrafts.
On the financial front, players continue to be battered by mounting costs mostly in the form of rising fuel prices. As such, profitability could be dampened, with some regions even struggling to break even. Add to that the high capital expenditure required to meet passenger demand, infrastructure maintenance and achieve sustainable development goals, airlines may find it challenging to meet the required returns of investors.
To elucidate, the return on invested capital (ROIC) barely sits above 0% due to substantial invested capital which goes into the denominator of ROIC. Meanwhile, slim margins reduce the numerator which when paired with a large denominator, compresses ROIC. With rising interest rates, the cost of capital has increased which makes it more onerous for investors to achieve yields above and beyond their desired returns.
We turn our sights to accommodation which commonly includes hotel chains, private rental properties, and hostels. The global lodging industry is governed by operational metrics such as occupancy rate, average daily rate (ADR), and revenue per available room (RevPAR). The resilience of the industry is demonstrated by recovering occupancy rates, improvement in RevPAR across various geographical regions, and ADRs staying ahead of high inflation rates. Nevertheless, the industry has its own set of obstacles.
One of the more prominent issue lies in labour shortage caused by large scale furloughing or retrenching of hospitality workers during the pandemic. Recruitment of personnel to fill the gap has become less straightforward as candidates progressively demand more flexible work arrangements, an expectation that lodging firms possibly find difficult to satisfy given the in-person nature of the job. Employees also look beyond salary, evaluating other aspects including fulfilment, meaning, personal and professional development, and even environmental, social, and corporate governance (ESG) levels of hospitality establishments. Besides labour shortage, supply chain disruptions may also stymie the day-to-day operations of delivering products and services to lodging guests. However, the single largest obstacle that faced by the accommodation segment is arguably competition. This is attributable to the trinity forces of change.
The first is technological improvements that invited new digital entrants. Secondly, Covid-19 catalysed people’s redefinition of what they yearn for in a travel experience, mostly expressed by millennials and Gen Z. Finally, this younger demographic comprises about half the world population, making their collective voices more impactful. Together, the confluence of these three factors gave rise to new accommodation alternatives such as serviced apartments, co-living, branded residences etc. The implication is that traditional hoteliers are forced to invest in this space or risk gradual obsolescence.
For example, Marriott International, Inc. (NASDAQ: MAR) introduced Apartments by Marriott Bonvoy late last year in response to shifts in customer demand. Even though the uptick in cross-border investment activities should flush companies with funds, full-service and traditional hotels may become even more capital intensive as they are bogged down by new assets on top of existing property portfolios. Since alternative accommodation appeals to global investors partially because of their leaner operating models with higher profit margins, a meaningful pivot of conventional hotel brands may run contrary to some financiers’ investment case. Furthermore, it also causes accommodation to face a similar problem to the airline segment where being asset-heavy can be detrimental to returns.
Online travel agents
It appears the above two business models suffer from the same downside of eroding shareholder returns due to bloated balance sheets. Indeed, having an asset-light business model has become more popular among companies from all sectors beyond travel and tourism. Businesses must become agile, flexible, and nimble to meet volatile customer needs.
OTAs such as Booking Holdings Inc. (NASDAQ: BKNG) and Expedia Group Inc. (NASDAQ: EXPE) are paradigmatic of an asset-light business. Both have similar businesses split into three models, namely the merchant, agency, and advertising models. Under the merchant model, travellers pay the OTA the fee incurred from booking transportation and/or accommodation. Subsequently, the OTA pays the service provider the amount the customer paid, net of commission for facilitating the payment. Under the agency model, OTAs do not facilitate payment and instead act as an agent by passing the reservation to the travel provider. The difference here is that the traveller pays the travel provider directly, and the OTA earns a commission for acting as the booking intermediary. Lastly, the advertising model generates revenue through advertising placements and offerings that direct more traffic to various travel providers.
Being asset-light confers various advantages to OTAs. To start, they do not bear inventory risk, the mismanagement of which can adversely affect a business. An asset-light business model positively influences investment cash flow sensitivities so during times of weaker capital market activities such as that in the near term, companies with fewer fixed assets can more flexibly respond to investment opportunities.
What this means for investors is that efficiency measures such as ROIC may be enhanced. To illustrate, the respective returns on asset, capital, and equity are higher for online booking platforms than in the airline or accommodation segments. As a testament to the merits of less capital-intensive businesses, some of the top international hoteliers have embarked on shedding excess fat, including the likes of Accor S.A. (ENXTPA: AC) and Hyatt Hotels Corporation (NYSE: H).
More crucially, as the service offerings of OTAs are less dependent on fixed assets, they can afford to provide extremely broad and wide-ranging options to customers. This allows them to respond quickly to changing market needs and be better positioned to ride on fluctuating tourism trends. Examples include the abovementioned rise of alternative accommodation, the waxing and waning between domestic and international tourism demand, and varying recovery rates of tourism across different regions.
Next, we examine the margins, growth, and trading multiples of these three segments. Despite all the positives of OTAs, it is noteworthy to highlight that the lodging segment still remained as the most profitable on a net income basis, with both OTAs and airlines registering slightly negative margins. OTAs incur significant marketing expenses as they capitalize on the strong demand environment to firm up future bookings. Moving onto growth, OTAs posted the highest growth rates across most financial metrics pre- (i.e., 2016 to 2019) and post-Covid (i.e., 2020-2023). Companies with faster growth rates tend to command premium valuations. It is no surprise that OTAs trade at the highest multiples, whether on the basis of revenue, operating income, net income, or book value.
The fifth perspective
Investing in a richly valued company implies a conviction that the market has yet to bake in the full potential of the company into its price today. This may present a risk as further upsides could be more dependent on positive surprises. Whether faster growth rates are worth the incremental price one pays to own a slice of the company is a conclusion that should be drawn after thorough due diligence. Investors should bear in mind that the market is everchanging, resulting in the conclusion to frequently be in a state of flux.