How to do Business Analysis of Hotels

The current article aims to highlight the key aspects of the business of hotels. After reading this article, an investor would understand the factors that impact the business of hotels and the characteristics that differentiate a fundamentally strong hotel from a weak one.

Key factors influencing the business performance of hotels

1) Highly fragmented industry with intense competition and a low pricing power:

The hotel industry is highly fragmented as almost every city has numerous branded as well as unbranded, family-owned hotels. The industry has many hotels comprising international and Indian hotel chains as well as numerous standalone hotels.

Rating methodology – hotels by ICRA, July 2021, page 1:

The hotel industry in India is highly fragmented across numerous players—independent hotels, home-grown hotel chains and global hotel majors.

Within India, in the past, most of the supply of branded hotels was concentrated in the higher luxury/premium segment. This was primarily because, in the past, tourism spending was dominated primarily by foreign tourists. However, in recent decades, domestic tourists have increased significantly.

Rating methodology – hotels by ICRA, July 2021, page 1:

From a predominantly foreign tourist market, the Indian market over the past decade has slowly matured into a much larger domestic tourist market, with higher incidence of leisure trips. Compared to the volatility witnessed in foreign tourist arrivals (FTAs), domestic tourist visits (DTVs) have witnessed a linear growth over the past decade.

As a result, most of the hotel brands have entered the midrange hotels as well, which has increased intense competition among branded hotels in the midrange segment as well.

Rating methodology – hotels by ICRA, July 2021, page 1:

As against a scenario where a bulk of the industry’s branded supply was concentrated in the higher price points, over the last few years, several branded mid-scale properties have been launched — either through conversion of non-branded properties or construction of new hotels, thereby increasing the supply and competition in the mid-scale branded segment.

In addition, many new-age start-ups like Oyo have been spending money on unbranded hotels in order to create a new segment in the low-cost economy hotels.

As a result, the Indian hotel industry has turned into a crowded place where many hotels are now competing for customer footfall.

Rating methodology – hotels by ICRA, July 2021, page 4:

Despite the sizeable capital requirements and the barriers to entry, competition in the Indian hotel industry is high with numerous players, both home-grown and global majors vying for a foothold in growing markets across the country.

The intense competition within the fragmented hotel industry takes away the pricing power from hotels because a customer now has many options to choose from.

Rating methodology – hotels by ICRA, July 2021, page 4:

This intense competition from existing rooms, coupled with new inventory being constantly added, often caps pricing power, constraining margins.

This trend has been increased by online hotel aggregators, which provide a platform where customers can easily compare the prices and see the availability in different hotels instantaneously. This is unlike the past when once a traveller walked into the hotel, then the hotel staff could quote any price and the customer had no easy way to check whether it was a competitive price.

Therefore, currently, the hotel industry is faced with intense competition and eroding pricing power.

Further advised reading: How to do Business Analysis of a Company

2) Demand for hotels is cyclical and seasonal:

Demand for hotel services comes primarily from business travel and leisure travel. Both these activities are highly dependent on the stage of general economic activity. During the boom phase of the economic cycle, companies increase spending on travel to grow businesses. During the same period, individuals also have spare money to spend on leisure travel. Therefore, the demand for hotels increases sharply during upcycle of the economic growth.

On the contrary, during the down cycle, companies reduce travel spending to cut costs. Simultaneously, individuals reduce their leisure travel as the growth prospects are reduced.

Therefore, the demand for hotel services increases and decreases in alternate periods bringing in a cyclicity in their performance.

Rating methodology – hotels by ICRA, July 2021, page 2:

A highly cyclical and seasonal industry with strong linkages to the underlying and global economy, the hotel industry is prone to sharp upcycles and a deep downcycle. A favourable geo-political and economic environment encourages discretionary travel spending. However, travel advisories by countries and weakness in the global economy slows down travel.

The cyclicity in the demand for hotel services leads to a similar variability in the financial performance of hotel companies. It brings significant volatility in the revenues and profits of hotels, which increases the underlying risk in the business model. The credit rating agency, CARE, states that the risk represented in the hotel industry is high.

Rating methodology – hotel industry by CARE, August 2022, page 1:

The risk profile associated with the hotel industry is high given the fact that the industry is highly seasonal as well as cyclical in nature and exhibits high volatility in its revenue and profitability depending on the economic cycle.

Apart from cyclicity in the performance, which follows the boom and bust phases of the economy over many years, the hotel industry also witnessed seasonality within a year. Hotel services are usually low in demand during the first half of the financial year whereas the demand picks up in the second half when the festivals and tourist season starts.

Rating methodology – hotels by ICRA, July 2021, page 8:

ICRA also factors in the inherent seasonality in the hotel industry, which witnesses subdued performance in the first two quarters and subsequent pick-up in demand over the second half of the fiscal as the peak travel season starts.

The seasonality in the demand for hotels adds to the risk in the business model because the hotels need to maintain staff and facilities throughout the year, which are their major expenses; however, they earn most of the revenue in the second half of the year. As a result, within a year, hotels see a large fluctuation in their financial performance over different quarters.

Rating methodology – hotel industry by CARE, August 2022, page 3:

Revenue and profitability in the sector are seasonal as well as cyclical in nature…While revenue is skewed towards the second half of a year, expenses are spread more evenly impacting the profitability.

Large variations in the financial performance increase the importance of careful cash flow planning because the hotel may face a liquidity crunch during the off-season and down cycle of the economy, which increases the risk in their business model.

Further advised reading: How to analyse New Companies in Unknown Industries?

3) Highly capital-intensive business with a long gestation period:

The hotel industry is highly capital intensive because the location is one of the prime attractions for any hotel and the price of land at an attractive location is usually very high. Despite the high cost of land at premium locations; still, hotels need to build properties at premium locations because a good location is one of the most important factors that drive the business of a hotel and puts it at a competitive advantage over its peers.

Rating methodology – corporate sector – leisure Industry by Pefindo, November 2021, page 1:

Having an asset or service in favorable markets or near a place of interest with high visitation base will likely perform better and are less volatile as it helps attracts more and repeat customers compared to markets that are far from place of interest with lower visitation base.

In addition, constructing a hotel building with all the safety measures, good construction quality and impressive interiors with furnishing involve a significant amount of cost as well as time.

Rating methodology – hotel industry by CARE, August 2022, page 1:

industry is characterized by high capital cost, coupled with a long gestation period

As a result, the owners have to invest a lot of resources both in terms of time and money to build a hotel. In addition, obtaining various govt. approvals for construction and commencement of the hotel may take more time, which if delayed may lead to cost escalations as well. Overall, it may take about 4 to 6 years to build a good hotel.

Rating methodology – hotels by ICRA, July 2021, page 7:

A typical greenfield project takes four-six years for execution and runs the risk of facing delays in commencing operations because of delays in receipt of regulatory approvals and consequent cost escalations.

As it takes many years to build and make a hotel ready for operations; therefore, the industry faces an additional problem. New hotels are planned during boom phases when the demand is high. However, by the time the hotel is ready, after a few years, then the economic cycle may have turned and entered a bust phase.

Therefore, it usually happens that the new hotel projects announced during the economic upcycle get completed during the downcycle and add an additional supply of room when the industry is already suffering from long demand.

Rating methodology – hotels by ICRA, July 2021, page 4:

Demand dynamics tend to be cyclical and a function of the underlying economic cycle….Further, the sector also witnesses risks arising from lumpy supply additions undertaken in response to market-specific demand dynamics.

Therefore, any plans for the construction of new hotels demand careful consideration, otherwise, the company may face a double-whammy of increased expenses of a new hotel property during the phase of weak demand leading to a cash-flow crunch.

Rating methodology – hotel industry by CARE, August 2022, page 4:

The hotel industry is cyclical, and projects have a long gestation period; hence, the timing of setting up a new hotel or expansion is of critical importance.

Even after the hotel is complete and ready for operations, it takes a long time for the hotel to pick up its operations and reach optimal utilization levels, called the gestation period. It takes time for the owners to put the management team in place, and do advertising and promotions to create awareness among potential customers. It is only after many years of operations that the hotel is able to build good brand awareness via online reviews, word-of-mouth appreciation etc. As a result, the gestation period of a hotel may extend up to 5 – 10 years.

Rating methodology – hotels by ICRA, July 2021, page 7:

The gestation period of a new hotel — depending on its launch period (during the industry cycle), could widely range from five to ten years.

Moreover, even after a hotel is complete, its capital requirement does not reduce. This is because hotels require regular maintenance and major renovations after a few years of operation to upkeep the property and bring it in line with the latest consumer preferences.

Rating methodology – hotels by ICRA, July 2021, page 7:

it is important for hotels to invest in regular renovations/upgradations to keep the property in line with evolving customer expectations and competition

Therefore, constructing a hotel, and running and maintaining it is a highly capital-demanding activity. This is especially true for the owner-operator model where the same entity owns and operates the hotel. In such cases, the expansion of hotels into a chain becomes very challenging due to significantly large capital requirements.

Rating methodology – hotels by ICRA, July 2019, page 4:

An owner-operator model…Considering the large funding requirements and management bandwidth, the ability to scale up under this model is constrained

As a result, hotels under the owner-operator model usually restrict themselves to a few properties clustered within a close geographical area.

Rating methodology – hotels by ICRA, December 2014, page 2:

An Owner-operator model…Typically, such companies have between one to eight hotels spread across a few cities but mostly contained within one to two states

Hotel operators try to reduce the risk associated with large capital investments in their business model by separating the ownership of the hotel from the management of the hotel by entering into lease arrangements to use the hotel property.

Rating methodology – hotels by ICRA, July 2021, page 5:

several entities, to avoid the sizeable upfront construction cost, resort to taking properties on long-term leases.

Another model used by hotel companies to reduce funding costs is the management contract model where a large brand operates the hotel owned by someone else for a share in revenue or profits.

Rating methodology – hotels by ICRA, July 2021, page 5:

The owner invests funds to build the hotel and enters into a management contract with a major operator….In such an arrangement, the manager-operator typically appoints the key management at the hotels, oversees the day-to-day operations and decides the overall strategy, in return earning a share of the revenues and the gross operating profit (GOP) as incentive fees.

The arrangements of lease or management contract divide the overall risk of “owner-operator” among different entities. However, please note that as a rule, risk can always be transferred from one entity to another; it cannot be overall reduced or eliminated.

Therefore, these arrangements divide the overall risk of owning and managing the hotel among different entities; however, the hotel industry still stays a risky business due to large investments, and the long time needed to earn a return on capital due to intense competition and cyclical as well as seasonal demand.

Rating methodology – hotel industry by CARE, June 2019, page 1:

In CARE’s view, the risk profile associated with the hotel industry is relatively higher as compared with other industries primarily on account of high capital cost, coupled with long gestation period, highly cyclical nature of the hotel industry and high degree of competition in the industry.

An investor should keep these aspects of the hotel industry in her mind while doing her analysis.

Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors

4) Cash flow management is very important for hotels:

Hotels require a large investment for initial construction as well as for regular maintenance and renovation. However, their business is highly cyclical and seasonal with periods of good demand alternating with periods of poor demand. As a result, hotels get most of their revenue during peak seasons whereas they have to incur expenses all around the year for running and maintaining it.

Rating methodology – hotels by ICRA, July 2021, page 8:

Operating in a highly cyclical industry and exposed to discretionary spends, hotels witness significant variation in profit margins through an economic cycle. Hotel revenues are highly cyclical, in view of the demand-driven price-elastic business model as well as the lumpy supply side dynamics.

Therefore, hotel operations consist of consistently large fixed expenses whereas their revenues are very volatile, which makes their profit margins and cash generation highly fluctuating.

Rating methodology – hotels by ICRA, July 2021, page 2:

High capital intensity and relatively high fixed costs lead to significant volatility in profitability and cash flows during downcycles. A marginal decline in revenues can lead to a sharp contraction in profits and cash flows available for debt servicing.

There are three different aspects from which cash flow management becomes very important for hotels.

First, within a year, during peak season, hotels get a lot of revenue with a high-profit margin within a few months whereas, during the rest of the year, the lack of business may result in cash burn. Therefore, within a single financial year, hotels need to cautiously manage their cash flows so that they may use the cash from surplus months to meet the expenses during deficit months.

Second, over an economic cycle of boom and bust phases spread over a few years, hotels earn good revenue and profit margins during the boom phase and may have to spend cash to keep the hotel running during the bust phase. Therefore, over an economic cycle, hotels need to cautiously manage their cash flows to use surplus cash from the boom phase to meet the cash deficit during the bust phase.

Third, over its entire useful economic life, the hotel involves a significant cash outflow during the construction and initial gestation period; however, if it becomes successful, then it may earn a surplus once the hotel stabilizes into a seasoned-mature property. Therefore, the hotel company needs to manage its cash flow over its life very carefully by taking debt during the construction period with a moratorium during the gestation period and ballooning repayments during the later phase when the property is seasoned and earns surplus cash.

Rating methodology – hotels by ICRA, July 2021, page 7:

projects burdened with high leverage and hence interest expenses struggle to service their debt in the initial years of operation, given the gradual ramp up in operational performance. A judicious mix of debt and equity is required to tide over the initial stabilisation period… A debt amortisation structure, which provides for ballooning repayments, could help match cash flows generated by the project with debt servicing requirements, given the long gestation period of the new hotels.

If any hotel company is not able to manage its cash flow position on any of these three fronts: between peak and off-peak period within a financial year, between boom and bust phases during an economic cycle and between initial construction & gestation period and later on seasoned operational period, then it may face serious liquidity crunch impacting its solvency.

Rating methodology – hotels by ICRA, July 2021, page 7:

The entity’s ability to capitalise on periods of healthy profitability to generate adequate cash flows and fund expansions without affecting the capital structure, could help the company tide over down cycles comfortably.

If any hotel company is not able to manage its cash flow over these periods properly i.e. if it splurges the excess cash during the peak season/boom phase, then it would not be able to stay financially healthy during the down phase and may even face bankruptcy.

Advised reading: Understanding Cash Flow from Operating Activities (CFO)

5) Financially strong parentage is a big advantage:

If a hotel company belongs to a well-established and financially strong hotel chain or promoter group, then it provides a very big advantage to the company. On an initial level, the well-established parent company can provide the hotel company with all the management expertise, software and system solutions, access to its customer base etc., which puts a new hotel in a competitively advantageous position over its peers.

Moreover, a financially strong parent group can help the hotel company with cash infusion whenever it faces a cash flow crunch during operations or debt servicing or capital expenditure like major renovations etc.

Rating methodology – hotel industry by CARE, August 2022, page 1:

Considering the capital-intensive nature of the hotel business, a company with financially strong promoters enjoys an advantage over others as its ability to infuse and/or raise funds in a timely manner is better. Moreover, given the long gestation of the hotel industry, active involvement of promoters in the operations of the company and ability to support by way of infusion of funds in the initial stages operations becomes important

A new hotel may take about 4 to 6 years for its construction and commencement. In addition, it may take up to 5 to 10 years in gestation. Therefore, it may take more than 10-15 years from the start of the construction phase to the final phase of optimal operations when it may start generating surplus cash sufficient to repay its debt and meet its renovation capital expenditure requirements.

However, this period is very long from the perspective of any lender because a lender may not be comfortable giving a loan with a maturity of 15 or more years. As a result, the debt repayments may start even before the hotel has reached its optimal operational stage. This makes it critical for the hotel company to either refinance its debt or raise additional money to repay the debt.

Rating methodology – hotels by ICRA, July 2021, page 13:

Considering the troughs, the hotel industry faces and the relatively long gestation cycle for new properties, promoters with strong financial resources can provide a significant credit uplift. This is critical, more so, in the Indian context where the tenure of borrowing could fall short of the much longer gestation period and life of a typical hotel asset

In such cases, a financially strong parent group may make the difference between survival and bankruptcy.

Advised reading: How to do Management Analysis of Companies?

6) Large-scale operations are a big advantage:

The hotel industry faces a very tough business environment with intense competition from a fragmented industry with very low pricing power, which coupled with highly cyclical and season business puts them at significant risk.

In such a situation, a large scale of operations of any hotel helps in achieving economies of scale i.e. its fixed costs are spread over large size of operations. In addition, due to its large size, it becomes a large purchaser of goods and services and gets a higher bargaining power over its suppliers.

Due to its large operations, the hotel can also exercise a little higher bargaining power over its customers as it can accept large-sized orders like big events, which many hotels of smaller size may not accommodate. In addition, a large-sized hotel can ensure a higher probability of room reservation even during peak season and can entertain repeat business even during peak season without turning away customers.

Rating methodology – hotel industry by CARE, July 2020, page 3:

In CARE’s view, the scale of operations is an important rating consideration as it provides the entity with competitive advantages such as economies of scale with better absorption of fixed cost and better bargaining power with suppliers as well as its customers.

A large-scale of business brings in additional advantages like influence on the market, better operational efficiency as well as the financial power to withstand down phases.

Rating methodology – hotels by ICRA, July 2021, pages 4 & 5:

An entity’s scale in relation to its competitors can determine its ability to influence pricing within the industry. A large scale is often a reflection of a strong market position, operating and financial flexibility and staying power, and is also a driver of operational efficiency. It also determines the entity’s ability to withstand downcycle pressures.

Therefore, in the hotel industry, a large size puts the existing hotels in an advantageous position and at times promotes the phenomenon of big getting bigger in the industry.

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

7) Strong brands matter in the hotel industry:

Association with large well-known brands puts a hotel in an advantageous position. Tie up with brands ensures that the hotel gets access to a large customer base immediately upon becoming operational. The association with the brand communicates to the customers about a high service quality, which also provides a better pricing power to the hotel.

Rating methodology – hotels by ICRA, July 2021, page 5:

An established brand, on the other hand, ensures visibility among travellers – both domestic and foreign. Therefore, tie-up with reputed brands provides hotels the access to a wider set of customers and helps with occupancy. Further, hotels under the umbrella of established brands have higher pricing power stemming from various factors including their service quality

Due to a tie-up with established brands, the hotel gets bookings from customers loyal to the brand and it helps in increasing the occupancy levels.

Moreover, risk-averse first-time travellers can take comfort in the brand name in anticipation of a good experience at the hotel even without any previous experience at the hotel. This also helps in increasing occupancy rates at the hotel.

Rating methodology – hotels by ICRA, December 2014, page 3:

Brand: This lends comfort to first-time travellers who are doing their bookings using online modes, assuring them of a value for money proposition

Rating methodology – hotels by ICRA, July 2019, page 4:

A brand indicates a minimum standard of quality, irrespective of location.

Moreover, depending upon the type of tie-up with the brand like a soft brand association or a management contract, the hotel may benefit from the operational experience of the brand as well, which would help in smooth operations of the hotel while improving the customer experience.

However, an association with the brands come at an increased cost due to royalty, incentive fees etc. In addition, a brand tie-up also increases the cost of hotel construction because the brands mandate higher safety standards at the hotel, which increases the hotel costs.

Rating methodology – hotels by ICRA, July 2021, page 7:

role of the future hotel operator is also critical to project costs, as they mandate certain minimum safety standards and designs which have a bearing on the cost per key

Advised reading: Operating Performance Analysis: A Simple & Complete Guide

8) Other sources of competitive advantages:

Apart from premium location and strong brands, the hotel also creates a competitive advantage using factors like a long vintage (mature and stabilized properties), loyalty programs (reward points), wide distribution network (i.e. tie-up with many aggregator platforms) etc.

Rating methodology – hotels by ICRA, July 2021, pages 5-6:

sources of competitive advantages, which can enable a company to differentiate itself, such as operational track record and vintage of operational properties, locational advantage…Stabilised properties could have advantages in the form of repeat customers while those with  locational advantages will be able to generate higher ARRs.

Operational synergies arise from a wider portfolio of hotels, strong loyalty programmes which draw demand and a wide distribution network.

Having strong and efficient software systems, which can help in capturing the maximum paying ability of the customers by pricing the services appropriately according to real-time demand may help the company in generating the maximum possible margin during all phases of cycles and seasons.

Rating methodology – hotels by ICRA, July 2021, page 6:

Access to sophisticated product pricing software enables dynamic management of RevPAR through occupancies or ARR depending on demand.

Having a tie-up with a well-established hotel operator/brand helps a hotel get access to many of these resources.

9) Diversification helps:

The business of a hotel is exposed to many factors, which bring volatility in its performance like an economic cycle, economic factors like currency movements, natural events like cyclones, earthquakes, floods, disease breakouts etc., manmade events like terrorist attacks, law & order situation etc., and country advisories about travel to a certain destination, and geo-political circumstances. All of them have a bearing on the performance of the hotel industry.

In such situations, having diversification in the sources of revenue with significant contributions from different segments helps the hotels in lowering the probability of severe impact from any single adverse event.

9.1) Diversification in guest profile:

Guests at hotels are from many different backgrounds like business travellers, leisure/holiday travellers, corporate vs individual travellers, religious vs medical travellers, international vs domestic travellers, long-term tie-up vs walk-in travellers etc.

The demand from different segments of these customers is impacted by different factors. At the same time, a single factor may influence each of these segments differently. For example, a depreciation of the Indian Rupee (INR) makes travel to India cheaper for foreign tourists whereas it makes it costlier for Indians to travel abroad. An appreciation of INR will have the opposite impact making international travel cheaper for Indians and a trip to India costlier for foreign tourists.

Rating methodology – hotels by ICRA, July 2021, page 4:

a depreciated Indian currency may make India attractive for inbound travellers and limit outbound leisure travel, encouraging domestic holidays

Therefore, if any hotel is able to attract different kinds of guests, then it would be able to maintain its performance even when some adverse factors impact the hotel industry.

Rating methodology – hotels by ICRA, July 2021, page 6:

ICRA analyses the guest profile mix (foreign, domestic, business, leisure, walk-ins, FITs (free and independent traveller), airline crews, and government business) to determine concentration on a particular set of guests.

Many hotels enter into tie-ups with corporates etc., which provide them with an assured long-term business like airlines for their crews or corporates for their employee travels. A significant portion of such business helps in the occupancy levels of the hotel; however, hotels have to offer discounted rates for such business, which lowers the revenue per available room (RevPAR) for the hotel. Nevertheless, such arrangements help the hotels in generating revenue during down cycles.

Rating methodology – hotels by ICRA, July 2021, page 6:

While the airline crew tie-ups and long-stay guests ensure base occupancies, low rates often compromise ARR. However, during downcycles, base occupancies allow the operator to manage daily ARR to maximise RevPAR.

At the same time, hotels with a high proportion of domestic tourists perform better during down cycles with reduced seasonality as compared to hotels relying mainly on foreign tourists. However, the average revenue earned from domestic tourists is lower than foreign tourists.

Rating methodology – hotels by ICRA, July 2021, page 3:

domestic tourist visits (DTVs) have witnessed a linear growth over the past decade. While this reduces the impact of seasonality the hotels typically face, the revenue-per-guest statistics has also witnessed pressure. In upper-scale hotels, per foreign-tourist spend on room and allied services is usually higher than the per domestic-tourist spend.

Further advised reading: How to analyse New Companies in Unknown Industries?

9.2) Diversification in leisure vs business travel:

Leisure vs business travel is another dimension in which hotels may achieve diversification because these two segments behave differently under different circumstances. Leisure travel is highly seasonal and peaks in holidays and festive seasons whereas business travel is more stable in its demand. Therefore, hotels with a mix of leisure and business customers can reduce the impact of seasonality on their performance.

Rating methodology – hotels by ICRA, July 2021, page 4:

While leisure travel is purely discretionary and a function of disposable income and consumer confidence, business travel is generally more stable, but is prone to witnessing pruning by corporates during periods of downturn.

Rating methodology – hotel industry by CARE, August 2022, page 3:

Properties located in leisure destinations are likely to have significant seasonality in occupancies and ARR and high gestation period

This trend of high seasonality in leisure travel is true for almost all markets. For example, the Indonesian credit rating agency, Pefindo, has also highlighted the high seasonality in leisure travel in its rating guidelines for the leisure industry.

Rating methodology – corporate sector – leisure Industry by Pefindo, November 2021, page 1:

Given the demand dynamics are relatively different between the two segments, assets located in leisure destinations are likely to have significant seasonality in occupancies and room rates.

9.3) Geographical diversification:

Those hotels, which contain a chain of properties spread across different geographical markets are protected from events, which impact tourism and demand in any one geography. These hotels also get the benefit of access to a different profile of customers in different markets, which reduces the volatility in their performance.

Rating methodology – hotels by ICRA, July 2021, page 6:

The geographic diversification…insulates the company from any city-specific event risks. It also helps to capitalise on a wider range of consumers. Further, an entity with presence across different locations which cover both business and leisure, will be better diversified compared to those with hotels only in business or leisure destinations.

Presence in different geographical markets also protects the diversified hotel companies from natural disasters, which may seriously impact the business of single location-based hotels.

Rating methodology – hotels by ICRA, July 2021, page 12:

Hotel entities are exposed to natural disasters (such as hurricanes and floods) and extreme weather conditions, which could interrupt operations or damage properties. However, the availability of insurance for most hotels mitigates the adverse effects of these circumstances and may not be a material driver of credit, especially when there is property diversification.

9.4) Diversification of revenue sources:

Hotels bring in the diversification of their revenue from different segments by focusing on revenue from food & beverages (F&B), meetings, incentives, conferences and events (MICE) etc. Walk-in customers in the restaurant may bring resilience to the revenue across seasons and cycles.

Rating methodology – hotel industry by CARE, July 2018, pages 3-4:

CARE also evaluates the mix of revenue from rooms vis-à-vis food and beverage (F&B) /banqueting and their interdependence… Contribution, stability and dependability of revenues from F&B, business-related services, banquets, spa, gym and recreational activities are considered in business evaluation. Furthermore, the ability of the property to attract walk-in customers for F&B outlets/Clubs/Spa and other services offered are also taken into account.

However, a focus on the F&B revenue comes at a cost because the margins in this segment are lower than room rates.

Rating methodology – hotels by ICRA, July 2021, page 2:

Room revenues usually tend to have higher margins compared to F&B.

Another dimension where hotel companies are able to diversify their revenue streams is by focusing on mixed-use properties where apart from the hotel, the premises also owns commercial/retail space/office space and residences etc. These diversified revenue sources help the hotel company reduce the impact of cyclicity and seasonality and better management of cash flows.

Rating methodology – hotels by ICRA, July 2021, page 6:

Further, mixed use properties which earn revenues not only from the hotel but also from leased out commercial space, office space and residences are often viewed favourably as they diversify the revenue base and are relatively stable earnings-wise compared to hotels.

9.5) Diversification in different economic segments and brands:

Hotels also focus on customers from different economic segments to bring in diversification benefits because the demand from these segments responds differently to different factors. Usually, the economy segment hotels provide stability in the occupancy rates; however, at a lower profit margin. Whereas the luxury/premium segment customers bring in higher profit margins during boom phases.

Rating methodology – hotels by ICRA, July 2021, pages 6-7:

Segment diversification…across various segments: Luxury, Upscale, Upper-Upscale, Midscale and Economy. This segment diversification helps capture a wider traveller base and any down-trading in traffic during economic downturns, thereby helping the entities to maintain occupancies. This enables better absorption of fixed costs and prevents a sharp deterioration in profitability and cash flows during downturns, which is viewed as a credit positive. While the upscale brands generate higher margins during up-cycles, the economy brands exhibit relatively better stability in performance across cycles.

Therefore, most of the established hotel chains cater to different economic customer segments by launching branded hotels providing services at different price points. It helps in reducing the impact of cyclicity on performance.

Rating methodology – hotels by ICRA, July 2019, page 4:

The presence across multiple and strong brands with distinct product offerings is a credit positive as it lends stability to revenues. Access to a wider set of potential customers can help branded hotels in achieving higher base occupancies and consequently greater pricing power and higher stability in revenues and cash flows.

Advised reading: How Companies Manipulate Cash Flow from Operating Activities (CFO)

10) Risks:

The business of hotels has a high risk, primarily due to a high cyclicity, seasonality, exposure to natural calamities, adverse travel advisories etc. However, apart from these external factors, hotels also face significant risks due to internal factors, which are primarily the decisions of the owner/management.

10.1) High leverage:

Many times, hotel companies decide to go for high debt funding for hotel construction/capital expenditure under the assumption that due to a lower equity investment, the return on equity will be high, especially during good times.

Rating methodology – hotels by ICRA, July 2019, page 9:

While high leverage may mean high risk from a credit perspective, it is an often-adopted course by shareholder-oriented managements, given that high leverage, in good times, leads to high returns on equity capital.

However, a high debt acts as a double-edged sword and in case of any slip-up in the performance of the hotel, it can lead to bankruptcy. As a result, a conservative capital structure with a low debt helps the hotel in surviving the down cycles.

Rating methodology – hotels by ICRA, July 2019, page 9:

An entity with lower leverage is better equipped to withstand volatility in cash flow generation

Having a low debt is essential because hotels undergo very volatile periods in their performance, where situations become very difficult due to high capital needs for running and maintaining the hotel including significant renovation expenditure every few years to keep the hotel relevant to customers’ changing preferences.

Therefore, many times, a hotel cannot defer a major capital expenditure especially major renovations because otherwise, customers would switch to nearby competitors.

At such times, low leverage helps the hotel immensely because it can raise money from debt for the renovation even if the business is going through a down cycle.

Advised reading: How to do Financial Analysis of a Company

10.2) Project risks: time and cost overruns:

Constructing a hotel is a long-term project, which usually takes about 4 to 6 years. During this period, the company may face many challenges like delays in getting approvals for construction/commencement, labour unrest, difficulty in getting construction material etc., which may lead to significant cost overruns.

At the same time, the hotel company may decide to spend a significantly higher amount on the hotel like higher interior design and furnishing costs, which may be much more than warranted for a particular star segment of the hotel. In such cases, it may be difficult to recover the money and earn a good return on the investment done in the hotel property.

To assess whether any hotel property has overspent in construction, an investor may compare the per-room investment of the hotel with its peers.

Rating methodology – hotels by ICRA, July 2019, page 7:

Per room investment in the hotel (with and without land) forms a key metric to benchmark a property vis-à-vis other upcoming projects and existing hotels in respective star category.

Due to intense competition in the industry, a hotel, which has overspent on the property may not be able to charge a high premium over its competitors within the area. As a result, its return on investment may stay low or negative.

Earning a good return on a hotel property is anyway difficult for companies because of the continuous high capital infusion required to keep the hotel relevant to changing customers’ preferences and to stay ahead of the competition.

Rating methodology – hotels by ICRA, July 2019, page 8:

Given the need for most businesses to invest regularly in physical assets, marketing, and human capital to sustain or improve their competitive position, and the relatively high value of land banks of the properties, the RoCE for the industry has been relatively low even during upcycles in the last ten years.

Therefore, any step from the management to overspend on the hotel either voluntarily or due to cost overruns may prove very detrimental to earning a good return on the investment.

Summary

Overall, the hotel industry is characterised by a volatile business model, which is faced with a very high cyclicity and seasonality in demand. The industry is highly capital intensive with a regular requirement of large capital expenditures for construction, maintenance and renovation of the properties.

Hotels also have a high fixed operating cost, which needs to be spent throughout the year whereas most of the revenue is received in a few months during the peak season. All these factors lead to very sharp volatility in the revenue and profitability of hotels.

One of the foremost challenges faced by hotels is cash flow management where they get surplus cash during peak season and boom phase of the economic cycle. However, they need to conserve it to use it during the off-season and bust phases of the economic cycle. In addition, the long construction and gestation period force the hotels to resort to high debt or equity infusion during the initial period when cash outflows are much more than inflows. Poor cash flow management can lead to the bankruptcy of the hotel.

Due to frequent periods of large cash flow mismatches, hotels with financially strong promoters who are able to infuse cash during liquidity crunch are a big competitive advantage.

The industry is highly competitive with numerous global and Indian hotel chains, single branded, unbranded hotels competing for business at any location. This takes away the pricing power of hotels over customers. The presence of online aggregator platforms allowing for comparison of near real-time pricing and availability with competitors has further pushed down the pricing power of hotels.

Hotels attempt to achieve a large scale and tie up with reputed brands to gain some competitive advantage, customer loyalty and some pricing power.

To withstand the impact of cyclicity and seasonality, hotels attempt to achieve diversification across multiple dimensions like guest profile (foreign/domestic, leisure/business, corporate/individuals, long-term tie-up/free independent walk-in etc.), geographic diversification, multiple brands focused on different economic segments etc. The premium segment provides hotels with high-profit margin business during upcycles whereas the economy segment provides stability in demand at a lower profit margin across cycles.

Nevertheless, despite all these efforts by the hotels to reduce the risk in their business model, still, hotels face a very risky business model where failure rates are high. Most of the time, decisions of the management like high leverage and overspending while constructing the hotel may lead to an inability to survive during the down cycle when the demand is low.

In any case, hotels usually earn a low return on investment even during upcycles due to continuous large capital investments to keep up with changing customers’ preferences and to catch up with the competition.

Therefore, an investor should keep in mind these multiple aspects for hotels to understand the true picture of their business position.

• Highly fragmented industry with intense competition and a low pricing power
• Demand for hotels is highly cyclical and seasonal
• Cash flow management very alternate period of cash surplus and the deficit is very important for hotels
• A financially strong promoter who can infuse capital at the time of need is a big advantage
• A large scale of operations offers a significant competitive advantage
• Strong brands matter a lot in the hotel industry
• Diversification is important to survive down cycles; however, it can only provide a limited protection
• High leverage and overspending (cost overruns) may prove fatal for hotels in down cycles

We believe that if an investor analyses any hotel company by considering the above parameters, then she would be able to assess its business properly.

Regards,

Dr Vijay Malik

P.S.

• Subscribe to Dr Vijay Malik’s Recommended Stocks: Click here
• Mumbai “Peaceful Investing” Workshop, July 27, 2025: Register here
• To learn stock investing through videos, you may subscribe to the Peaceful Investing – Workshop Videos
• 25% savings on buying our Stock Analysis Excel Template and all ebooks together: Analysis Package: Excel Template + All eBooks (25% savings)
• To download our customized Stock Analysis Excel Template for analysing companies: Stock Analysis Excel
• Learn about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
• To learn how to do business analysis of companies: e-book: Business Analysis Guide
• To pre-register/express interest in a “Peaceful Investing” workshop in your city: Click here

Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.