Check-In to Profits: Exploring the Hotel Economics

by Sricharan Komateswar

Summary. We delve into the fascinating world of the hotel industry to understand how it mirrors economic prosperity and navigates its unique challenges. From discretionary spending as an economic indicator to exploring the robust employment opportunities in the post-COVID era, this analysis covers the strategic drivers of demand in hospitality. With the hospitality sector being a major employer in India and globally, we examine its contribution to the economy, valued at approximately $24 billion in 2023 with expectations to rise to $29 billion by 2028. This piece also discusses the operational intricacies and customer experience dynamics that define hotel operations, offering a deep dive into how hotels balance innovation with tradition to maintain profitability and allure in a competitive market.

We will explore the analysis of the hospitality sector, more specifically, the hotel industry. How can hotels indicate economic prosperity? Spending on hotel rooms is essentially discretionary spending, where it is not a need - it is rather a demand arising from individual disposable income, i.e., people spend on hotel stays after they have fulfilled their necessities. When more consumers can spend on things other than necessities, the economy is said to be growing. Remember how consumers continued to spend on groceries but stopped traveling during the COVID lockdowns? Let’s dive into this then.

As I write this chapter, hospitality is said to be the strongest employment generator, as other sectors are experiencing a slowdown. The post-COVID travel boom fueled by more destination weddings, business travel and events, and the opening of new airports under the UDAN scheme are all said to be the demand drivers for hotels and hospitality at large.

Hotel Industry in India

• The hospitality sector is arguably one of the largest employers in the world, including India. It employs about 10% of India’s active workforce directly and millions indirectly.

• The housekeeping staff, servers, concierge, etc., are direct hotel employees. Laundry staff, security staff, cab drivers, etc, are indirect employees.

• India’s hospitality sector was valued at approximately $24 billion in 2023 and is expected to reach $29 billion in 2028. Note, that this is a forecast for the entire hospitality sector, not just the hotel industry. Hotels are a large part of the sector, and restaurants are another large part. I plan to cover restaurants separately as they have different economics and key performance metrics.

• International tourist arrivals were just under 11 million in 2019 and over 6 million in 2022, as per the Ministry of Annual Report 2022-23. India Brand Equity Foundation (IBEF) expects this trend to upturn and the number to swell to 31 million in 2028.
  

Features of the sector

Hotels are a service industry and unlike salons, movies, laundry, or plumbing, where a service could take only a few hours, hotels offer a more extended service that could last a day, a few days, or even weeks. Due to this nature of the product, the sector harbors some peculiar features…

People-intensive - on both ends of providing and receiving the service, a hotel stay is manpower-intensive. How customers experience their stay can determine whether they would like to return in the future. Throughout their stay, a customer can interact with valets, security guards, receptionists, concierges, and housekeepers, amongst others. Each of these professionals has different skills and is expected to have great soft skills.

For that, employees have to be adequately trained in their respective responsibilities. Keeping employees motivated in the hotel industry is a challenge. Angry or demanding customers severely hurt employee morale, so training them to handle such situations is imperative.

You would have noticed that these aspects are qualitative; there are ways to measure customer satisfaction, but more is needed. Every hotel or organization will have its way of measuring customer satisfaction. Additionally, two customers can rate the same experience differently since services are most open to something called personalized experiences and rational choices.

The involvement of so many people in delivering a service makes it an operational challenge, thus margins become difficult to maintain. Large hotel chains become large by establishing standard operating procedures and controlling wastage and costs, so changes in their profit margin structure can invisibly hurt the finances of the hotel.

Experience is the product – A hotel stay is an experience like any service industry and experience is an outcome of several elements – the decor, the staff demeanor, the staff’s level of knowledge, bed quality, room cleanliness, goodies or freebies in the room, facilities on the property, etc. The list is exhaustive and that shows that any factor can alter a customer’s experience. 

Again, the effectiveness of all these offerings may be challenging to measure, but they collectively build a customer’s experience. Specific offerings improve customer experience while others may not. The factors that do not improve experience are essential. They are the bare minimum factors. For example, having potable water in the faucets does not enhance your experience, but not having it could seriously annoy you.

As the price point inches up, the minimum expectation level also moves up. As more hotels offer added services, those services will soon become the standard norm or bare minimum. Therefore, hotels charging a high price must keep innovating to augment and differentiate customer experience. Offering differentiated experiences comes at a cost. Employee training also has to be more frequent and regular. Experiences can drive revenues as well as cost and in doing so, an efficient business can balance profits. 

New daily inventory – Suppose your local fruit vendor intends to sell 50 kilos of fruit every day. But today, he could sell only 40 kilos. He can try to sell the remaining 10 kilos the next day on top of the daily target of 50 kilos. He might even succeed. Can the same happen with a hotel? If a hotel with 50 rooms could sell only 40 rooms daily, it cannot sell 60 total rooms the next day. The next day’s inventory will again be 50 rooms only. This is similar to airlines – unsold seats cannot be carried forward to the next flight.

However, only the room inventory is reset every day. A daily inventory is open to the other things and services a hotel sells. Restaurants can sell more food than their tables can accommodate by offering deliveries and room service.

Seasonal business – Children’s vacations, wedding season, monsoons, festivals, etc., are significant determinants of the level of business a hotel will get. For example, school teachers often plan their holidays according to student’s vacation timings. Hotel properties in tourist destinations frequently see many customers around vacations. Naturally, room rates also surge correspondingly.

Most weddings in India take place between November and April, and destination weddings have also become popular. Therefore, apart from driving the demand and prices of banquet halls and party lawns, weddings also boost the demand for hotel stays. Increasingly, most large hotels are now offering wedding venues as part of their offerings.

Many tourist destinations are open only for a few months during the year. Ladakh, Kedarnath, Badrinath, and Doodhsagar are some examples. Hotels in such places only have business due to seasonal fluctuations in demand. Seasonality may often be reflected in the quarterly revenues of the most affected businesses. To mitigate this, hotels offer special discounts on room stays. The idea is to offer cheaper rooms and get customers to spend on food and beverages. Price competition is usually high in a dull season.

Some businesses enlarge their target market by altering their offerings and marketing efforts (I am talking about Airbnb here). By popularizing homestays, Airbnb practically created this working class of people who call themselves “digital nomads.” They travel places for weeks and months and work out of Airbnb’s homestays. The use of new-working-age lingo like, “staycation” and “work-cation” came up.

This new category of travelers inspired conventional hotels to offer similar arrangements. Boutique and business hotels started offering weekly and monthly plans. Lemon Tree is now offering “day-cation” or day rooms between 7am and 5pm These innovations in room plans, price points, and overall offerings are meant to improve the return on asset ratio. The next point discusses this in further detail.

Capital-intensive – Picture this: there is a wedding in your family. You will probably be buying clothes, gifts, and jewelry worth thousands, if not lakhs. A few family members and you would spend a few hours choosing and purchasing these things at each store. 

It is going to be a destination wedding so the hotel stay and wedding venue will also cost lakhs. The hotel stay would be for a few days, thus you will need rooms for your guests and venues for all rituals and functions.

The hotel will need more space to deliver its offerings. This space, or real estate, is often a fixed cost. Space requirements for a store are relatively more minor.

Therefore, return on assets, or return on fixed assets, is an important metric for hotels. Hotels will always maximize their revenue per square foot to improve their return on asset ratio. To get their customers to spend more, they offer many add-on services. Salons, spas, fitness classes, drawing classes for kids, bicycle rentals, gaming centers, etc., are a few such services I can think of. There can be many more.

Hotels also often have a long gestation period as they are a fixed-cost business. Return on assets, or return on fixed investments, is an essential metric for hotels.  If you want to develop a new resort, it could take a few years to buy a land parcel, begin construction, and serve customers. The money you employ will yield no returns for these years. Ratios such as return on equity and assets are impacted.

Many hotel chains run a mix of owned, managed, and franchised properties in various combinations. Let's look at a few examples to understand these types of properties…

• IHCL owns and operates the Taj Mahal Palace & Tower in Mumbai, and EIH owns The Trident Nariman Point in Mumbai.

• IHCL does not own but manages the Umaid Bhawan Palace in Jodhpur. 

• Chalet and SAMHI own and operate hotel properties, but they also acquire brand franchises from Marriott and IHG.

• Club Mahindra may own or lease its properties under its brand name. It also has short-term inventory arrangements with the local players at many destinations. 

• Lemon Tree has a mix of owned, leased, managed, and franchised properties under its brand name.

Managed or franchised properties enable a hotel company to grow its capacity without investing much in fixed capital. If a large chunk of properties are owned, the chances of high debt on the balance sheet are also high.

Large unorganized sector — According to an estimate from November 2022, about 1.5 lakh hotel rooms are in the branded category or organized sector. Compared to that, independent hotels in the unorganized sector collectively had 29 lakh rooms. The unorganized sector may have rooms ranging from economy to luxury. Therefore, the level of competition arising from the unorganized sector may be challenging to ascertain. Nevertheless, the organized sector can attract more customers through its brands.

Having discussed these features, we are all set to examine the hotel industry's key performance indicators. However, for the sake of brevity, I will discuss them in the next chapter.

The aspirational value of hotels — I once talked to someone who was researching the brand position of five-star hotels in India. And it occurred to me that while people may not be able to use or afford to stay at luxury hotels, they are still aware of some names. These names carry aspirational value for them. They might want to visit such five-star hotels with their first salary, on a date, or for some special occasion.

In the previous chapter, I spoke of hotels selling experiences rather than just rooms or food. The price they charge is for the richness of the experience they provide. For most, being able to afford that experience is a matter of pride. Hotels have to live up to the feeling of pride customers expect to have. Studying the industry's key performance indicators can help you judge how well a hotel company is delivering experiences.

The Checklist

Considering the industry’s peculiar features and the existing generally accepted standards, I have collated a checklist for analyzing the industry. The table below shows that I have collated these numbers for different segments of hotels—five-star hotels, operators of five-star hotels, business or boutique hotels, and even vacation sellers. In your analysis, try comparing companies within the same segment. Let me reiterate that this checklist must be used along with fundamental analysis and valuation models for holistic hotel industry research.

Number of properties — This is a good proxy for understanding how geographically distributed a hotel company’s operations are. A large number can help cushion the financial performance against seasonality. Seasonality affects different regions at different times and in different ways. Properties in other regions can compensate for the impact on properties in one region.

If a hotel company offers hotels in various categories, you can break this number down to understand its composition. For example, IHCL offers Taj branded luxury hotels, Vivanta branded premium hotels, Ginger branded business hotels, and SeleQtions branded experiential hotels. Such a hotel portfolio enables IHCL to cater to luxury tourism, business travel, wedding tourism, etc.

Number of keys – This is the number of rooms. So why not call it rooms? A suite or villa having multiple rooms for group travelers cannot be called a room. However, such suites or villas are sold as single units. Hence, to avoid confusion, they are called keys.  Hotel properties with a larger number of rooms (or keys) have certain advantages—they can host conferences or weddings with large numbers of guests. However, too many rooms can also become a fixed cost burden if there is not enough demand. Having a large number of rooms also adds to a hotel's grandeur and aspirational value.

Occupancy rate – If a hotel with 200 available rooms has guests in 150 rooms today, it is said to have a 75% occupancy rate today. The occupancy rates that hotels report are collectively aggregated for the whole year for all properties. Let’s go step-by-step.

• A hotel company has 50 properties.

• It has 2000 rooms across these properties, so it can sell 2000 room nights in a day.

• Throughout the year, it can have 7,30,000 room nights (2000 rooms * 365 days).

• There will be fewer room nights than that. Repairs, maintenance, seasonal shutdowns, etc., can make rooms unsellable. 

• Let’s say 10% of the room inventory is usually unavailable. Therefore, the available room nights will be 6,57,000 (7,30,000 – 10%).

• If the hotel company sells 5,00,000 room nights throughout the year, it will have a 76.1% occupancy rate (5,00,000 / 6,57,000).

A higher occupancy rate is better. Although a 100% occupancy rate might be practically impossible, a hotel with 30-40% occupancy can also be profitable if it can charge a high price and control costs. However, comparing occupancy with peers gives a better perspective on how well a hotel company is doing to attract customers.

Improving occupancy rates year after year could suggest improving brand strength. A declining occupancy rate could also result in deteriorating financial performance.

Average Daily Rate (ADR) is the total room revenues divided by the total number of rooms sold. 

Let’s continue with the occupancy rate example. The hotel company sold 5,00,000 room nights during the year. Assume that it earned ₹315 Cr in room revenues. So, its ADR would be ₹6,300 (₹315 Cr / 5,00,000 room nights).

Improving ADR year after year implies improving revenue per square foot. How is ADR growth better than revenue growth? Revenues could grow by adding more rooms. Revenues could improve even when ADR is falling. However, this will require using more assets to generate the same level of income, which may not be optimal for the hotel. Let us look at a few examples in this table.

Example 1 is what I used to explain ADR. Let us take that as the base example, and we will build upon that.

• In example 2, revenues did not change, but the hotel had to sell more rooms to maintain the revenues. Therefore, ADR fell. More discounts could be offered.

• In example 3, revenues have grown, but the number of rooms sold has grown faster. As a result, ADR fell. Continuously declining ADR could suggest declining brand strength.

• In example 4, revenues have decreased, and the number of rooms sold has decreased further. The ADR is higher. Such a phenomenon can occur due to an external shock like an economic slowdown, pandemics, or natural calamities. Fewer people are willing to spend on hotels, and those who do spend are little affected by higher prices.

• The best situation is in example 5. Revenues have grown, and the ADR has grown faster. Continuously improving ADR along with increasing revenues could suggest improving brand desirability.

Comparing ADR with peers shows a hotel company’s pricing power. More substantial pricing power is usually an outcome of a strong brand. However, ADR must be analyzed deeper. Lemon Tree offers mid-priced rooms. Its ADR will be lower than that of EIH, which operates in the luxury segment.

ADR can help hotel management make business decisions. A study of ADR across quarters can help identify the impact of seasonality. Accordingly, management can devise promotional or pricing strategies.

Revenue Per Available Room (RevPAR) is the total room revenues divided by the total number of rooms available. To understand RevPAR better, let’s alter the previous example in the following table.

Here again, example 1 is the base, and we will build scenarios on top of it. I have added the occupancy rate in this table to give more context.

• In example 2, the number of rooms sold increased, but ADR decreased. RevPAR did not change because the factors affecting it – room revenue and number of rooms available did not change.

• In example 3, the number of rooms sold and available remained constant, and the occupancy rate did not change. However, due to an increase in room revenues, RevPAR increased, and therefore, ADR was also higher.

• Revenues have decreased in example 4. Available rooms have decreased more. This could be due to external factors. Remember how hotels were ordered to operate at reduced capacity during Covid? The rooms a hotel cannot sell are not included in the available rooms. A higher occupancy rate and higher ADR have resulted in higher RevPAR.

• The number of available rooms in example 5 has increased, and revenues have increased even more. Therefore, RevPAR is higher. A higher ADR negated the effect of a lower occupancy rate.

In simple terms, ADR and occupancy rate positively impact RevPAR.

RevPar will usually be lower than ADR because the occupancy rate is generally less than 100%. The number of rooms available will be more than the number sold.

The Ratio of Room Revenue to other Sources—Hotels charge their customers for the multiple services and experiences they offer. Restaurants, spas, salons, laundry, cabs, etc., are all revenue sources in addition to room revenues. A higher share of revenue from other sources indicates that customers like and are willing to spend on other services and experiences.

In dull seasons, a hotel may offer significant discounts to attract customers. The idea is to earn revenues by getting them to spend on other services and experiences.

EBITDA – EBITDA refers to earnings before interest, Taxes, depreciation, and amortization. We have learned this is Fundamental Analysis. So why am I discussing this here?

We know that hotel companies use various combinations of portfolio ownership. Some properties are owned, and some are leased, managed, or franchised. A company with mostly owned/leased properties will tend to have a higher asset base and, hence, a higher depreciation charge on the P&L. A company using borrowed funds to acquire or develop properties will have a higher interest charge on the P&L.

Let’s look at these two hypothetical companies, A and B.

While both A and B have the same revenue and expense level, B has higher profits because it does not own the properties. A’s profits are lower because it has taken loans to own properties. This is a very simplistic example. B could have higher operating expenses due to the rent it would pay to acquire the property. It could also have a revenue-sharing arrangement with the property owner. The point here is to establish an apple-to-apple comparison between peers and not just to compare their reported profits.

Concluding remarks

Many moving parts work in tandem to deliver service in the hotel industry. Experiences are crucial but difficult to quantify. Differentiated services improve brand strength. Brand strength improves KPIs. Strong KPIs should ideally lead to robust financial performance. This is where management acumen becomes important. As someone studying the industry, your ability to identify quality management will set your analysis apart.