H World Group Limited (HTHT) Q2 2016 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the China Lodging Group’s Second Quarter 2016 Earnings Conference Call. [Operator Instructions] Please note, this call is being recorded today, August 15, 2016 and I would like to turn the call over to your first speaker today, Ms. Ida Yu. Please go ahead, ma’am.

Thank you, operator. Hello, everyone. Thanks to all of you for dialing in and welcome to our second quarter 2016 earnings conference call. Joining us today is Mr. Ji Qi, our Founder and Executive Chairman; Ms. Jenny Zhang, our CEO; and Mr. Teo Nee Chuan, our CFO. Jenny and Teo will present the company highlights and the Q2 results. Following their prepared remarks, management will be available to answer your questions. Before we continue, please note that the discussion today will include forward-looking statements made under the Safe Harbor provisions of the United States Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the views expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. China Lodging Group does not undertake any obligation to update any forward-looking statements, except as required under applicable laws. On the call today, we will also mention adjusted financial measures during the discussion of our performance. Reconciliations of those measures to comparable GAAP information can be found in the earnings release that was distributed earlier today. As a reminder, this conference call is being recorded. The webcast of this conference call as well as supplementary slide presentation is available on the Investor Relations section of China Lodging Group’s website at ir.huazhu.com. Now, I would like to turn the call over to Jenny. Jenny, please?

Hello, everyone. Thank you for joining our call today. We continue on a solid growth and achieved record high net profit in Q2, thanks to the strong operational results and other income from investment activities. On Page 2, at the end of Q2 2016, we had a network of 3,114 hotels or 314,811 rooms in operation, covering 357 cities in China. With 12 brands under management, China Lodging is able to satisfy needs of a wide range of guests whether it be economy, mid-scale or upscale hotels. As shown on Page 3, our Q2 net revenues grew 13.7% year-over-year, in line with our guidance. We are excited with the year-over-year revenue growth for mid-scale and upscale hotels, which was 46% in Q2. As a result, the revenue contribution from mid-scale and upscale hotels was 29% of total net revenue in Q2 2016, an increase of 7 percentage points from 22% a year ago. In Q2, our blended RevPAR for all hotels continued to grow at 1.1% year-over-year. This is the second quarter for us to show a RevPAR growth. As shown on Page 4, we are positive that this trend will sustain as driven by our operating hotel quality and hotel brand mix. On Page 5, I would like to reiterate our three strategic focus for this year and update you on the progress. The first one is to strengthen and differentiate HanTing, our flagship brand in economy sector. Since the beginning of 2015, we have rolled out a redesign and upgrade for HanTing brand. Page 6 shows you the new model of our HanTing 2.0. The new product includes an all-in bathroom model and the new high-quality bedding. The new bathroom model is designed for smart use of space and improvement on operational efficiency. The new bedding is to guarantee our guests a sounder sleep that makes a big difference for frequent travelers. The new HanTing is very much favored by customers. Not only did the HanTing 2.0 achieve higher RevPAR than the older version, it also showed positive same hotel RevPAR growth year-over-year. As shown on Page 7, HanTing’s blended RevPAR trends also showed improvement since the first quarter of 2015. And in the most two recent quarters, our client has almost been stopped. At the end of Q2, about 24% of HanTing rooms were under HanTing 2.0 model, increasing from 17% at the end of 2015. With those efforts, we aim to bring HanTing’s RevPAR back to growth mode in 2017. Our second strategic focus is to continue fast expansion. As shown on Page 8, in the second quarter, we added a total of 125 new net hotels, including 174 openings and 49 closures. The number of closure compared with previous quarters has increased. That demonstrated our determination to remove low-quality properties to strengthen our brands. Among the net new openings in Q2, mid-scale and upscale hotels accounted for 33%. Manachised and franchised hotels accounted for 80% of our hotels in operation today. Meanwhile, we had a pipeline of 586 hotels, with 23 leased hotels and 563 manachised and franchised hotels. Among these hotels in the pipeline, mid-scale and upscale hotels accounted for 36%. We will continue to grow our network fast, fast with an upgrade in product quality and a higher portion of mid-scale and upscale hotels. Our third focus is to further boost our direct sales capabilities. On Page 9, you will find in Q2 about 89% of room nights sold were through our direct channels. The total number of members reached a new record high of 61 million as a result of our most favorable loyalty program. With that, I would like to turn the call over to Teo, who will walk you through more details in operational and financial results in Q2. Teo, please.

Thank you, Jenny. Hello, everyone. I am pleased to report our operational results for Q2 2016. As shown on Page 11, in Q2, our group’s blended occupancy rate was 85%, a decrease of 0.6 percentage point year-over-year. The slight year-over-year decrease was mainly due to lower occupancy rate in the lower tier cities. The blended ADR was RMB184, an increase of 1.8% year-over-year as a result of a more favorable brand mix. Mid-scale and upscale hotel rooms accounted for 16.4% of our total number of rooms in Q2 2016, up from 12.8% in Q2 2015. At the end of Q2 2016, about 76% of our hotel rooms were in the first and second tier cities. In summary, for Q2, the blended RevPAR was RMB157, an increase of 1.1% year-over-year. Page 12 provides a detailed view of the growth trend of our same hotel RevPAR for hotels in operation for at least 18 months. In Q2, our same-hotel RevPAR decreased by 1.2%, with a 0.7% decrease in same-hotel ADR and 0.4 percentage points decrease in occupancy. As Jenny mentioned earlier, we accelerated our HanTing upgrade in Q2. So the mature hotels performance has been negatively impacted during the upgrade process. If excluding the rooms under renovations and upgrades, our normalized same-hotel RevPAR decreased by 0.1% year-over-year. We think that the overall trend has been stabilized. Meanwhile, the RevPAR for mid-scale and up-scale hotels continued a high single-digit growth on a like-for-like basis, the same-hotel RevPAR improved by 8.6% in Q2. Shanghai Disney was officially opened to the public on June 16. This has helped to bring additional leisure travelers to Shanghai. At end of Q2, we had 13% of our hotels and rooms in Shanghai. Approximately 11% of our hotel pipeline is in Shanghai. Move on to the financial results, on Page 13, our net revenue increased by 13.7% for Q2 from a year ago, hitting the midpoint of our second quarter guidance. Revenues from leased hotels grew by 5% while revenues from manachised and franchised hotels grew by 29% from Q2 last year. In Q2, revenue contribution from manachised and franchised hotels accounted for 20.8% of our total revenue, an increase of 3.1 percentage points from the prior year. On Page 14, our adjusted operating margin came in at 16.9% for Q2 2016, increased by 2.3 percentage points from Q2 2015. The adjusted hotel operating costs and other operating costs as a percentage of net revenue decreased by 1 percentage point year-over-year. This is mainly due to our improved blended RevPAR and a favorable VAT impact on certain of our operating costs such as rentals. The pre-opening expenses as a percentage of net revenue decreased by 1.4 percentage points from a year ago, this mainly results from fewer leased hotels under construction. The adjusted SG&A expenses and other operating income as a percentage of net revenue increased marginally by 0.1 percentage points, this is mainly due to provisions for franchise fee to be refunded to certain franchisees and partially offset by lower selling expenses mainly contributed by lower membership points costs. In addition, we recorded in other income one-time gains of RMB56 million from our disposal of Home Inns ADS and also a gain of RMB49 million from selling our stakes in our apartment businesses to a venture textile firm. Move on to cash flow status as shown on Page 15. In Q2 2016, our net cash from operations reached RMB660 million, while CapEx for maintenance and new developments stood at RMB107 million. As a result, the free cash flows in Q2 totaled RMB553 million. In Q2, you we sold the remaining of our Home Inns ADS for RMB451 million. Also, in Q2, we made strategic investments totaling RMB52 million in the apartment businesses. As of June 30, 2016, we had term loan balances of RMB617 million related to the purchase of Home Inn ADS in 2015 and dividend payment made in early 2016. Our total credit facility available to the company was RMB549 million. Finally on Page 16, we reaffirm our full year net revenue to grow by 12% to 15% year-over-year and we expect to achieve a Q3 net revenue growth of 10% to 12.5% year-over-year. With that, let’s open the floor for questions.

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] The first question comes from the line of Justin Kwok from Goldman Sachs. Please ask your question.

Hello. Thanks for taking my questions. Perhaps I would have two housekeeping questions and then one on – in more medium-term trends, I guess the first one is that do you mind just talk a little bit more on what’s the disposal gains, the RMB46 million sales of your Home Inn business that you talked about and why are you selling it, I thought the company is trying to expand into more business lines along the value chain. And the other housekeeping question is about the rental expense, I saw that there is actually a Q-over-Q decline in your rental expense, can you also walk through as well?

I am sorry, Justin. Can you repeat the first question?

The first question is that I heard from your call that you have a disposal gain of RMB46 million related to the apartment business, so I just wanted to get a sense on why you are selling it and why you are not really investing into the new business line?

Okay. Hi Justin, actually I would like to clarify. This is not disposal gain per se. This is because we originally invested in apartment business and we actually have an investment by a venture capital firm into our business. So we actually – we are actually diluting our share our – in this apartment business. So we are not selling out per se, but we are actually, as what we mentioned in the call during last quarter is that we would like to go into this business together with some venture capital funds. So this is an accounting gain from realizing part of our – for inviting the investments from this private equity funds because they provide a higher valuation than our original costs.

I see. Thanks for the clarification. So the other one is about the rental expense quarter-over-quarter decline?

Okay. Now you see for rental – for the rental costs, we actually get some benefits from VAT reforms in China. So previously you received, for example, rental costs of RMB100, which is – 6% of which is that we need to capture that as our costs. But following the VAT reforms in China, the VAT portion of the rental costs can be used to offset against our VAT debt on invoices that we issue to our customers. So effectively, our rental costs have been reduced.

I see. Thanks for this clarification. I guess more likely strategic and medium-term question I had was to ask is that when we look at your pipeline, it seems that there has been two consecutive quarters of decline already, so could I check and what’s the management thinking about the growth in terms of number of hotels that you open into next year or the year after, are you thinking roughly 500 hotels, 600 hotels is a normal level or do you think that is actually going to be going down even further as I think Jenny also mentioned in the call that you guys are more focused on the quality of the projects now? Thank you.

Our new openings this year is still on track to target 700 hotels to 800 hotels. However, we have accelerated the closure of some of the lower quality hotels. So currently, our forecast is the net opening this year, which is the new opening minus the closure, will be somewhere around 600 hotels to 700 hotels, which is still fairly close to what we indicated at the beginning of the year. As for the coming years, we are considering a mix adjustment that we are going to further increase the portion of mid-scale hotel opening and likely to reduce some of the lower and brand new openings to improve the overall quality of our portfolio.

Okay, thank you.

You are welcome, Justin.

The next question comes from the line of Yaoxin Huang from CICC. Please ask your question.

Hi, thank you for taking my questions. I have two questions here. First, clear information that some hotels or some rooms are closed for renovation and upgrading, can I ask for how many rooms – how many percentage of rooms are closed for renovation and upgrading? And what’s the renovation plan going forward in the second half? My second question is I see there is other income, which is RMB110 million in second quarter I realized that part of the other income comes from the disposal of Home Inn and what else as other income improved?

Okay. Now, regarding your first question is that we are actually accelerating the number of rooms under the renovations for product upgrade purposes. So, in fact, we had – as we have mentioned in the earlier calls in the last quarter is that we have actually showcased our HanTing 2.0 to our franchisees last year and they started to buy in since the Q4 in 2015 and they had gradually put their rooms into – under the renovations for the product upgrades. So, we expect that this process will be moving on for a number of periods even going forward for next couple of years, because our plan is not to close down the entire hotels for renovations, but rather is that we are going to renovate – actually suggest our franchisees and our own renovations to be done through stages even in by floors in each hotels. So, I do not have the exact numbers as to what – how many rooms are under renovations right now, but it is undergoing a very hectic process. And the speed of renovation all depends on the seasonality, because we would accelerate renovations on products, which is like in the lower seasons versus the higher seasons. This is number one. Number two is that as I explained to Justin Kwok earlier is that the RMB110 million of other income is comprised of two parts. The first part is the RMB56 million related to disposal of the Home Inn ADS. The second is actually accounting gain from deconsolidation of our investments in one of our apartment businesses. This is because we – previously, we invest 100% in that apartment service – in apartment business, but with the investment of private venture – private equity firm into our apartment business, we have realized a portion of the gain. This actually gives rise to approximately RMB49 million that recorded in Q2.

Okay, got it. Thank you.

The next question comes from the line of Billy Ng from Bank of America. Please ask your question.

Hi, good evening. I have a question from the recent plan. Can you share with us what you see so far in July and August about the RevPAR trends? And also the recent improvement in RevPAR, will you be able to quantify how much is due to the upgrade of our rooms, how much is due to the middle end brands contribution and how much is due to maybe if Shanghai Disney is a factor?

Let me try to confirm that I understand your question. So, you are asking about the RevPAR trends and you would like to understand what are the main factors contributing to that, is that the question?

Right, right, right. The recent pickup in RevPAR trend like this year so far, we saw RevPAR trends been turn positive, yes.

Yes. In the past two quarters, we have shown a positive blended RevPAR growth. It’s 1.1% for Q2 this quarter. The main drivers are the following: number one, our mid-scale hotels performed very strongly. As you can see on a same hotel basis, it has been increasing at 8.6% for Q2. You also showed a very strong number in Q1. So, that’s the first one. And then secondly, our economy hotel brands such as HanTing 2.0 as well as Hi Inn also showed positive same hotel RevPAR growth. So, they also made a contribution to this improvement. And on a blended basis, the portion of our mid-scale hotels as well as the HanTing 2.0 also gradually account for a higher portion of the overall portfolio. So, those are the main contributors of the trend we have seen in this quarter. The Disney impact is negligible in the Q2, because there is only 2 weeks and the visitors in the first 2 weeks were mainly locals. So, they didn’t really contribute much to the room consumption.

Thanks. And how about the recent trend so far in summer?

We have seen the travelers start to pickup and – especially the eastern parts of the Shanghai, the RevPAR trend is very strong. And for July, we have on a whole country basis we have already seen some positive same hotel RevPAR number. So, we are quite confident that we are going to have a very strong summer.

I see. Thanks. And then you mentioned Shanghai particularly strong was that related to Disney or it’s just seasonality and how strong was that, would you mind to share?

Shanghai, the Disney definitely had some contribution in this, but I think it’s still in the warm up phase. I don’t think the Disney impact has already fully shown in our numbers in July. We expect it to gradually climb up as more visitors come in the next few months.

Okay, thank you. Thanks a lot.

You are welcome.

The next question comes from the line of Timothy Lam from Macquarie. Please ask your question.

Hi, thank you for taking my questions. I have a few questions here. The first question is about HanTing 2.0 upgrade just want to confirm with management that target is still at 35% by year end or is it – has been going a bit tighter by the year end? And then the second related to that is was the depreciation expense as the company would expect going forward on a quarterly basis? And second question I have is regarding to the company’s strategic alliance with Accor, just want to see if somebody can give us some color on the long-term about Hua Zhu’s alliance versus other hotel operators in China? Thank you.

Okay, hi. Let me address your questions on the target – on HanTing 2.0, we still maintain our target of 35% of the rooms that are upgraded at the end of this year. Having said that, it’s that because we have to depend on the seasonality and the occupancies on each area so to determine to fine tune the number of rooms that we are going – putting into renovations or upgrades. This is number one. And number two is that the depreciation cost is that in Q2, our depreciation cost is approximately RMB117 million. We expect that the – although with HanTing 2.0 upgrades, it is actually part of the – our heavier path that we expect it to happen with the – so, we expect that the depreciation costs will be maintained approximately with marginal increase on our current level. This is number two. And number three is can you keep your question number three?

Yes. The third question was about strategic alliance with Accor, just wanted to see if somebody can share some highlights on the long-term strategy with China Lodging’s alliance versus other hotel operators in China that China work in the same – with the same group?

Let me confirm if I get your question right. Do you want to understand more about the Accor-China Lodging alliance or you want to get comments on other hotels collaboration with other international companies?

More on China Lodging, please? Thank you.

Okay. As we explained earlier of course, China Lodging’s collaboration with Accor is exclusive in the greater China area. We have currently been exclusively managing three brands Mercure, Ibis Styles and Ibis. And we are having co-development agreement with Accor on Novotel and at Grand Mercure and we also have a JV with Accor for Sofitel, Pullman as well as the Novotel and Grand Mercure that has widely been opened in the past, so it’s a full range collaboration with Accor across China. Does that answer your question?

Sorry. And finally, just one – there is cleanup question just to understand the full year CapEx at this stage, I am wondering if the companies are still – any changes on that? Thank you.

Can you repeat that again? Sorry.

Just trying to understand company’s full year capital expenditures plans at this moment after including all these upgrades and your own hotels investments?

Okay. We budgeted – as we mentioned earlier, we budgeted approximately RMB650 million for our maintenance as well as upgrade CapEx for this current year.

Including new hotels.

Sorry?

Including new hotels.

Including new hotels.

The next question comes from the line of Leon Chik from JPMorgan. Please ask your question.

Hey, hi guys. Just one quick one on the RMB109 million gain does that just include the RMB49 million from the apartment sale and the rest from the Home Inn stock?

Can you repeat your questions again?

The RMB109 million gain, right, in the second quarter, is that just the apartment sale and the Home Inn shares, is there anything else in there?

There is nothing else in that. I just want to reiterate that, this is not the sales of our apartment business. It is actually a gain from – it’s a gain that had been realized from our investments because there are additional investments by a venture capitalist firm in our apartment business.

Okay, that’s fine.

So this is not disposal.

And the RMB109 million is there is no tax on that, right, it’s already after tax?

Yes. Only these two, RMB56 million and RMB49 million.

No tax, okay. One last question, I think you closed 49 hotels this quarter, I can’t really get a lot from the previous quarters, I don’t think sometimes you don’t disclose, but is normal level very low, I mean like what I am trying to get at is you probably don’t have that many really bad hotels, right, so if you continue to close at such a high rate, eventually you will go back down to like a very low rate, right, is that correct?

No. These – I will say that, I mean on a totality basis that we expect that the closure to be in the range of 150. So yes, this quarter is a bit high and then it’s at – we may continue the closure in Q3 then you may have slowed after that. Once we cleanup the hotels that are not meeting our standards, then there will be less to close going forward.

Okay, that’s great. But I think that the number is like from last year would be much lower than 150, right?

Correct.

Okay, good. Thank you.

Yes. If you went back – sorry, let me add just one word on that. If you went back two quarters in the earnings release, you will notice that we have indicated that we are going to improve the quality of our portfolio and then we are going to take more proactive actions to remove some of the lower quality properties from the portfolio. So what you have seen in the closure of Q2 is the successful execution of that strategy.

Thank you. The next question comes from the line of Lin He from Morgan Stanley. Please ask your question.

Thanks for taking my question and congratulations on very strong quarter. Two questions from me, one is – the first one is for Zhang. [Foreign Language]. Hi, Teo. My second question from me is the impact of VAT reform, if I look at the business tax and the related surcharges and that line actually only accounts for around 2% of gross revenue this quarter, so it’s much lower than before. And also I believe the margin uplift seems to be bigger than we discussed last time and you also commented that it also has an additional impact on the expense side as well, for example, the rental expense you talk about, so it will be very helpful if you can give us a little more color on how to quantify the VAT impact going forward? Thank you.

The first question is – this question is for Mr. Ji Qi is about franchisee business. First, she wants an update with our discussion with franchisees, which has brought in a lot of attention in Q2, that’s number one. The second is she wants to know Mr. Ji Qi’s idea about franchise business future in China.

[Foreign Language]

Okay. So, yes, I personally – together with Jenny, I personally met almost 10 franchisees, who suffered the most from the business loss. And I also tan out with the top 20 best performing franchisees to understand another side of the story. I even – I assigned every district manager to meet 10 franchisees by themselves to really understand their needs and their diversified needs, but basically they want to cut franchise fees. You can all imagine and people trying to complain all kinds of issues, but I think that fundamental root causes because their business is not performing as good as they expected, especially in slowing down economy and this problem mainly concentrates in Tier 3, 4, 5 tier cities. The macro economy is not something we can change. We don’t have the magic stick. So what we can do is that really help our franchisee doing better than they used to be before and doing better than the competitors’ franchisees. So, we want to pick the franchisees who share the same value system with us, not just looking at the new opening store numbers. We care more about the franchisees behind them. And as our culture emphasized, we are a bunch of people who share the same mission and vision and accomplishes great things altogether and have to be. As the next step, we will form a franchisee committee, which will channel back franchisees’ feedback regularly to us. And back to the big question about my view about hotel franchisee business, first of all, I think China Lodging is the best brand in economy and mid-scale segment. We are the top choice for our franchisees. And second is that we think the branded chain penetration in the economy and mid-scale market is still very low. So there is plenty room of growth and consolidation. So I am very confident about the franchisee business. Third is that compared with other investment channels, which is quite limited in China nowadays, I think the franchisee business is still has a lot of merit and the return itself is quite handsome. So I think it’s still quite attractive business. And fourthly – lastly, but not least, is that although we are prepared that the economy growth is slowing down and this phenomenon is going to continue for a while, but we think in such a market circumstance, those companies who have very strong brand and very strong IT or other operating systems support can really stand out among other hotel companies. So I am very confident in our franchisee business and our hotels. Thank you.

Hi Lin. Hello, I am answering in response to the questions relating to the VAT reform. Number one is that this line will disappear going forward, because there is – a portion of the revenue that is collected from our customers will be directly paid to the textile parties. And this amount will be reduced by the VAT that or the invoices that we received from our vendors such as our lease landlord, such as utilities, such as consumables and even from the purchases of our capital expenditures that we spend. So effectively is that our net – our revenue line will only shows what – our total revenue line will be similar to our net revenue line going forward and similarly is that our operating costs – hotel operating costs will be reduced by the portion of the VAT that we can use – the VAT that we receive from our customer and payables to the tax authorities. Does that answer your question?

So we can move to the next question. The next question comes from the line of [indiscernible] from Brean Capital. Please ask your question.

Hi. This is [indiscernible] from Brean Capital. First, congratulations on your strong quarter and we are up to a very [indiscernible]. This question is regarding the guidance for the third quarter, do you expect net revenue to grow 10% to 12% in the third quarter, but normally speaking, the third quarter is the peak season for leisure and travel, I just wondered why China Lodging guide a little bit lower? Thanks.

Hi. In responding to your question, at the beginning of the year we guided in the range of – to grow net revenue by approximately 12% to 15%. And this is in light of – to consider the comparison to the trend in the year 2015. Back in Q1 2015, the Q1 revenue was pretty low. It was impacted by the downturn that was [indiscernible] back in 2014. So Q1 in 2015 was very low. So in Q1 2016 is that it was reflected as a higher growth compared to what we have expected because the trend in 2016 was actually a recovery from what has happened back in 2015. So but in Q2, you said we continue to guide in the range of 12% to 15% and it is similar to what we have explained earlier because like last year, in 2015 Q2, it was also in recovery stage. But going forward, in Q3 in 2015, the net revenue has grown more healthily. So we expect that the growth in 2016 compared to 2015 will be more moderate is one. And number two is that as we mentioned is that we are also cleaning up our portfolios by actually removing hotels that are not meeting our quality standards, so that will actually impact our revenue growth for the second half of 2016. But having said that is that we are still pretty confident in terms of meeting our revenue growth for the entire 2016 and we also expect that we will continue to record margin expansion because by removing those hotels with the lesser qualities, it actually help us improve our profitability.

Okay, thank you.

Thank you. There are no questions. I would like to hand over the call to the speakers. Thank you.

Thank you all for your time today. Our management is looking forward to talking to you next quarter. Thank you. Bye.

Thank you.