The Capital Cycle Podcast - Whitbread

Episode Date: March 31, 2025

The capital cycle in the UK budget hotel industry.Edward Chancellor talks to Tytus Żurawski.For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello, this is Edward Chancellor with another edition of the Capital Cycle podcast, and I've got with me Titus Zaraski, who's an analyst with Marathon Asset Management, and we're going to talk about a UK business that he's excited about. Value investors make a virtue of investing in unglamorous stocks that are trading at attractive valuations, and British domestic stocks would seem to fill the bill. The London Stock Exchange is stuffed with, shall we say, unexciting UK domiciled companies. And in the latest global investment review, Titus, you highlight the attractiveness of the brewer turned hotelier, Whitbread, whose budget premier in-chain is never going to be the chosen location for another series of White Lotus. We can be sure of that.

It's a reliably profitable business with an unchallenging valuation in an industry that you think is quite nicely positioned in the capital cycle. But first, let's discuss a bit about the origins of Whitbread, because it's a, what the Americans would call a storied company. It's probably the oldest listed company on the London Stock Exchange. So tell us a bit about its origins. I will try to do justice today nearly 300 years of history. Wheatbread's history dates back to mid-18th century when its namesake founder Samuel

Wheatbread pioneered mass production brewing and also became an early adopter of steam engines during Industrial Revolution. The company built its brewing empire around one particular type of beer, potter and the urban pub drinking culture. In the 20th century, the industry began shifting. Consumption started moving to off-premise and bottling became essential. Tastes also evolved more towards pale ales and lagers. Wheatbread was slow to respond and eventually started diversifying their business into other areas of hospitality. They launched the Bifitter Steakhouse chain. They founded the budget hotel brand that was initially called Travel Inn, but later matched with other chain

and formed what we are today familiar with Premier Inn. They also acquired Costa Coffee and operated franchises of US brands such as Mario's hotels and Pizza Hut. So having got this mishmash of different businesses, you say that they then had a strategic turnaround at two decades ago. Yes, so around early 2000s, they recognized that their best asset is premier in budget hotel chain, which is vertically integrated and where they have full control over buildings and customer experience. So they decided to streamline the portfolio. They sold off brewery assets, disposed of Costa coffee, and also started scaling down the restaurant operations. So right now, the wheatbread portfolio is mainly the premiering hotel chain.

So tell me from a capital cycle perspective how the UK hotel industry is attractively positioned. The pandemic was crucial. It hit the industry really hard, lockdowns, travel restrictions, the rise of video conferencing. It emptied hotels. And in an industry with high fixed costs and significant amount of financial levels, leverage, you can easily deduct that it was a truly brutal combination. In fact, between 2019 and 2021, the UK hotel supply shrunk by 4% to around 685,000 rooms. This was level last seen in 2013. And you mentioned that this contraction of supply induced by the pandemic, particularly hit the independent hotel sector. Yes, that's right. Smaller independent hotel operators were the main

market share losers. It's a competitive industry and they lack access to capital markets, operational expertise and scale of larger chains. In fact, majority of supply that exited the market over that period is unlikely to return these properties have often been repurposed for residential use. This contributed to the ongoing shift away from independence to branded budget hotels, which we've witnessed since 2010. Independence lost 12 percentage points of their market share, and Premier Inn actually captured almost half of that and expanded their market share steadily from 6% to 12% over that same period.

But Titus, you also mentioned that the largest competitors of wet bread are struggling. Yes, so those players that stayed afloat weren't immune to hardship. For example, travel lodge, they're the second largest hotel chain in the UK. They also play in the budget space like Premier Inn and are basically the main rival. They entered 2020 with a fair amount of leverage around three times their last year's EBDA. And within months when pandemic led to demand collapse, they were forced to. to raise 200 million pounds in a mix of equity and debt. And effectively, this delayed their 10% room expansion plans.

And servicing that increased dead load became the key priority for them. But you also mentioned that Whitbread at the time turned to the capital markets. Yes, Whitbread also tapped into equity market to raise cash. However, the move was fundamentally different. It wasn't defensive. While travel lodges leverage ratio was skyrocketing, Whitbread had a net cash position, effectively having more cash than debt on their books. And they could invest countries quickly while profits were still recovering from pandemic's effects.

So between 2019 and 2023, Premier Inn grew room capacity by 10% of a larger base, whereas travel lodges' growth was around 3% of, that period. Furthermore, Withbrecht's planning to expand the capacity further by another 13% by 2030. And going back to the capital cycle, one of the things we look at as capital cycle analysts is how long new supply takes to come on and the visibility of that supply. Can you talk a bit about that from the perspective of the hotel market? While Whitbread's pipeline remains robust, the same cannot be said about the rest of the industry. First of all, the lead times are long.

The process of finding suitable location, getting all the necessary permits and renovating a building takes a few years. And if we think about new builds, that process is even longer between five to six years altogether. Then we had COVID which led to deferred capital investments. Subsequently, we had inflation pushing project costs up and rising in. interest rates which make securing funding really difficult. All in all, the supply isn't expected to recover to 2019 levels until at least 2028. We think this capital cycle dynamic will play in Woodbred's favor, helping it capture market share and gain pricing power. I have to ask you whether Airbnb, which has obviously been around for a while, represents a supply

disruption to the UK hotel industry and whipbread? Actually, the competitive overlap is very limited. Premier Inn is split 50-50 between business and leisure travel, and the average stay is only 1.2 night. Their clientele doesn't really want to waste time coordinating with a host where and when they can pick up keys to an apartment. And similarly, Airbnb hosts do not really want to tidy up and change sheets every day. We think Airbnb caters more to leisure travelers that look for longer stays or unique properties.

Also, I would like to mention that Airbnbs are getting increasingly regulated. In many countries, they require permits and hosts must report guest details to police like hotels do. And there's also another problem in very touristy cities. Those Airbnb properties are pricing out locals out of the real estate market. Probably the most radical example is Barcelona, where the city plans to get rid of all short-term rentals by 2029. So actually that could turn out to be a positive supply shock for the hotel industry if the regulatory cycle turns against Airbnb or internet room leasing. That's probably still a bit far-reaching case to underpin the whole investment,

but definitely it undermines the view many people heard that Airbnb supply is very elastic and can fill the hotels gaps more easily. That's a good point. What about the story of demand for UK hotels? as you mentioned earlier, how during the lockdowns, people obviously weren't going to hotels and that was a demand shock. Tell us what you see about the demand side for UK hotels. Sure. Let me start with explaining first why we are mainly focused on the supply side, we also remain attentive to demand dynamics. As long-term investors, we're not typically

concerned with temporary cyclical demand downturns. Actually, these are often sources of opportunities for contrarian capital allocators. Instead, what we really scrutinize is whether long-term demand is structurally impaired or not. I suppose the newspaper industry is a classic example when reduced competition might not always be enough. But going back to the question about demand in the UK and the travel industry, we've actually witnessed very promising recovery path. Travel is back to pretty much pre-pandemic levels in real terms, with stronger bounce back on the leisure side

and more subdued recovery on the business side, as one would expect due to enduring impacts of video conferencing and hybrid working. Whitbread also operates hotels in Germany, which I gather to be less profitable than the UK operations. Can you discuss a bit about the, German business. The German hotel market is 40% bigger than the UK, but structurally it is where the UK market was a couple of decades ago. It's very fragmented. Independent hotels account for nearly 70% of the market and there's no clear market leader. ACO is the largest player with only 2%

market share. Premier Inn is developing their presence on the ground almost one hotel at the time. Despite entering the market in 2014, the segment is still nascent. They only have 56 hotels, which compares with over 800 in the UK. As you mentioned, the segment is not contributing to profits. In fact, it's generating losses, but it is expected to turn profitable in the current financial year. What's very promising for us is that the mature hotels in Germany, are generating returns on par with the UK hotels, and we believe this opportunity really extends with Brett's growth runway. Interesting.

And now hotels are buildings, their long-dated capital assets. I wanted to ask you a bit about how the shift in interest rates, from the lowest levels in history to more normal levels, has affected the hotel industry. I imagine that higher rates might in part explain why the independent hotel sector has contracted somewhat. Yes, so during COVID, of course, many players exited the market, but those that are still around aren't having the best of times. Interest rates push up the debt servicing costs for them. And then when you have aging hotels and you cannot even renovate them because you have to service your debt,

really just decreases your competitiveness. So that's why independent sector really is suffering right now, and we see that continued shift to budget branded hotels. Also, higher interest rates make it harder for new supply to enter the market. Those hotels are often mortgage finance, higher interest rates just make obtaining such financing more difficult. Yeah, so it creates a barrier to entry. But you also mention, and this goes back to,

what we discussed a few minutes ago, that whipped bread is under leveraged, having raised a lot of capital in 2020 when it had very little debt. Yes, wheat bread is more conservatively run than competitors. They had net cash position after the capital race we alluded to and now they want to return to around 110 of EBDA over time. But that level compares very favorably with other players running between three to even eight times EBDA leverage ratios. And apart from that, they own significant share of the hotel estate. In the UK, they own around 50% of hotels. So that's an attractive asset that can serve as collateral and also appreciates in value over time.

Whereas travel lodge, the main competitor here is owned by private equity. and doesn't own the assets? That's right. They didn't want to put up too much capital up front and in fact they lease virtually all their hotels. The high exposure to lease properties makes those players more vulnerable to higher interest rate environment. Now, I want to turn to WIPPred's value proposition

because the firm argues naturally that it delivers very good value, for money for its guess compared to the competitors. Not only the firm argues that the third party customer satisfaction metrics also put Premier Inn hotels in the Goldilocks position of great quality and value. One gets a room and food and beverage offering comparable to mid-market hotel at a fraction of a price in the UK, average price is around £80 per night. And when we compare the proposition to other budget hotels,

Premier's Inn hot breakfast is a real differentiator. Most budget hotels offer cold continental breakfasts if you're lucky and vending machine if you're not. We think travellers would really take a Premier Inn's full English overdose any day. Interesting. So let's talk about profitability. Premier Inn generates around 10% plus written on capital,

which compares favorably with the average written of around 3% for independent operators and typically between mid to high single digit returns for other branded competition. I think there are two key factors behind it. Premier In's brand is really strong in the UK and the greatest testament of that is the fact that virtually all bookings in the UK are direct and majority of them come from repeat guests. This allows wheatbread to generate higher margins by circumventing commissions of online travel agencies such as booking.com, which typically take between 10 and 15% of the booking value as their cut.

Second factor is operational efficiency and while it sounds like a cliche, it actually shows up in many ways at Premier in hotels. When you walk in, you will see innovative kiosks that automate checking experience. The personnel will be cross-trained to handle multiple roles, ranging from receptionist tasks to administrative tasks and cleaning responsibilities. Then you have also standardized room layouts so that rooms could be turned over more quickly. And a few minutes per room lead to significant cost-saving, when you have over 80,000 rooms to clean each day. Let's talk finally about valuation why you think this stock is attractive. We think wheat bread's market valuation is in similar position to the value proposition,

a good asset at attractive price. The share price is in fact below pre-COVID levels. The multiple is undemanding around mid-teens, P.Multipal, despite more conducive supply. eyesight, healthy demand recovery and the significant progress the company has been making in Germany. Thank you very much, Titus. As I said earlier, whipbreads premier inns may not be white lotus type venues, but from what you're saying, they appear to be an attractive business and the stock attractively priced. It's been very interesting conversation,

and I look forward to having another one with you in the near future. Thank you. Thank you for your time today. I hope you will listen to the next edition of the capital cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.