Do Not Disturb: Why Marriott and Hilton's Franchise Model Works

By Bradley Seth McNew Markets Fool.com

Franchising in the hotel space has been growing in recent years. Hotel brands, or "flags" as they are referred to by industry insiders, are lending their name and likeness to third party owners, while the building and operations are run by the franchisee (or often a third party hotel management company). For the popular-name hotel companies like Marriott International (NASDAQ: MAR) and HiltonWorldwide(NYSE: HLT) thatare doing this well, this could lead to consistent earnings growth.

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Image source: Getty Images.

A look inside hotel franchising

Hotels area capital intensive business that take a lot of time and resources to open each new property. However, if the flag can be licensed out to an existing property, or another group will put up the investment for building development, then the larger hotel brands can benefit from receiving a percent of revenue from the franchisee, with far less risk or upfront costs.

Larry Speltsis a VP of the hotel management company CharlestowneHotels, whichhas no owned properties but manages nearly 50 properties including the top hotel in the U.S. as voted byTravel + Leisuremagazine this year.In an interview, Speltssaid that most of his company's managed properties are private hotels without a major flag, but the company does also manage franchised properties under brands likeHiltonWorldwide,among others.

Many of the properties they manage are owned by real estate investment trusts (REITs), or by other property companies that are in the business of hotel building, not branding. These real estate companies benefit from having the major brand to use with their property while a separate company manages operations, such as Charlestowne Hotels or sometimes the hotel parent brand itself. Having a recognizable name brand can also help the developers get investors on board with the project, according to Spelts, meaning that more projects can get completed this way.

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A Hilton hotel in China. Image source: Hilton.

Hotel brands increasingly going asset-lite

As for the big hotel brands like Marriott and Hilton, this is a pretty good deal. Spelts says that "The risk that's inherent in owning an asset like a hotel is high, but the risk of owning a franchise contract is fairly low. The costs of getting a new franchise are minuscule and the brand is still going to get between 8%-12% of sales, and that's gross not net, so there's really no risk."

The major hotel brands are increasingly asset lite as a result, relying on franchise agreements to grow their footprint worldwide rather than owning physical properties. This helps the brands to grow faster, especially internationally or in tier two or three sized markets where local developers might want to put a hotel that a big brand otherwise might not consider. This strategy also helps these hotel brands to grow in the burgeoning boutique hotel space. Marriott and Hilton have multiple smaller brands in the "lifestyle" space that they can lease out to smaller properties that fit into the boutique hotel market without building out such small properties on their own.

Another major benefit of this franchise model, both for the franchisee and the hotel flags, is that it allows the big name brands to focus more on their digital strategy and customer loyalty program, giving the hotel owner access to those systems and rewards, while also getting more members to join the programs and keep tighter control over the customer's experience and data.

Image source: Marriott, from the company's most recent quarterly earnings SEC filing.

Hotel stock growth in focus

Marriott and Hilton now franchise or manage nearly all of their hotels, with only a very small percentage still owned by the parent companies. Instead, they are relying on their distinct brands to drive growth.

Following the acquisition of Starwood Hotels this year, Marriott now has 30 brands, an arsenal of names that can be turned into residual revenue with little work by licensing the flag out. Hilton has 13 brands, including the more recently launched brand called Tru, a digitally focused concept that tries to appeal to younger travelers. In Hilton's most recent earnings call, management said that franchisee deals for the Tru brand have been ahead of expectations and helped to drive the 7% increase year over year in franchise fee revenue.

The hotel industry faces some serious challenges ahead. Slower economic growth in the U.S. and China, uncertainty in many important markets such as Latin America, and increasing security challenges with political turmoil and terrorism in key markets all could put a damper on hotels ability to continue growing aggressively. However, the asset-lite strategy many of the top hotel brands have made in recent years to sell their brand name to franchisee hotel owners and operators could continue to pay off in a big way in the years ahead.

This strategy includes its own risks, such as lack of control over brand image if franchisees don't follow brand guidelines or the risk of falling franchise fees among great competition from other big hotel brands. Marriott and Hilton, among other big names in this industry, are still going more aggressively toward this franchising model than ever before. For investors -- the winners in the hotel industry look like the ones with the best brand portfolio to bring even more franchisees on going forward.

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Seth McNew owns shares of Marriott International. The Motley Fool owns shares of and recommends Marriott International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.