Struggling European Unit Tramples On H World's Post-Covid Rebound

The latest quarterly report from leading Chinese hotel operator H World Group Ltd. (HTHT, 1197.HK) contains a few noteworthy elements, many related to China's post-Covid travel rebound. The operator of the Hanting budget chain and more upscale Ji brand of hotels in China reported its first profit in nearly two years, as the Chinese took to the road in a post-Covid wave of "revenge travel."

But one of the most noteworthy elements, in our view, is the continued underperformance of the company's European operation, which it acquired in 2019 when it purchased Germany's Deutsche Hospitality for 720 million euros ($771 million). That deal was part of a broader trend for globally-minded Chinese companies to make overseas acquisitions in a bid to extend their success at home.

Such Chinese acquirers often set their sights on financially troubled acquisition targets, believing they have the know-how to turn them around. But too often the problems are far too-entrenched for these relatively inexperienced Chinese companies to tackle. What's more, the issues are often more difficult to resolve due to unfamiliarity with such a different market as Europe, where, for example, union politics play a big part in managing a company.

One of the few similar examples of such difficulties in the travel sector comes from Fosun Group, which found itself in a mess when it ended up investing in and later taking over Thomas Cook, the former big-name British travel agent that later imploded.

We don't want to rain too much on H World's post-Covid comeback parade, as the numbers in its latest report released Monday really do look quite good. But the drag it is feeling from its European operation, which accounted for about a fifth of its revenue in the latest quarter, is something the Chinese company will have to reckon with sooner or later.

The underperformance of H World's Deutsche Hospitality asset, listed in the report as "DH," is evident throughout the latest earnings report. The business actually did pretty well revenue-wise, with the figure rising 118% to 886 million yuan ($125 million) year-on-year in the first quarter. That reflects the fact that Europe began reopening in February 2022, meaning the year-ago figure was quite depressed.

More noteworthy was the fact that the DH business opened just two new hotels in the quarter and closed six, meaning the unit is actually contracting in terms of total hotels. And despite its rebound, the DH business is losing money - a sharp contrast to H World's China business which was quite profitable before the pandemic and returned to profitability in the latest quarter.

Specifically, the DH part of the business reported a loss from operations of 158 million yuan in the latest quarter, though that was an improvement from the 292 million loss it posted a year earlier when it was still feeling the effects of the pandemic. The DH asset also had a negative effect on H World's net income, dragging the figure down by about 200 million yuan in the first quarter.

Set for offload?

Granted, it's only four years since H World made the Deutsche Hospitality purchase, and three of those years included the difficult pandemic period. So perhaps it's too soon to judge the success of this acquisition. But H World's obvious reluctance to put more resources into the asset, plus DH's continued struggles even during the post-pandemic travel boom, lead us to wonder if perhaps H World might not be better off selling this underperformer.

H World's Hong Kong-listed shares fell by 1% in Tuesday morning trade after the publication of the results, indicating investors weren't too impressed. The stock is down 11% this year - and has lost 28% of its value from a February peak, indicating the market was already expecting this kind of post-Covid rebound.

Even after that selloff, investors still seem to still quite like H World for its core China business, as well as its strategic tie-up with French hotel giant Accor (OTCPK:ACRFF) (OTCPK:ACCYY). The company currently trades at a price-to-earnings (P/E) ratio of 32, based on its forecast earnings for 2023. That's higher than the 27 for higher-end Chinese hotel operator Atour (ATAT), and also quite a bit higher than the P/E of 20 for global giants Accor and Marriott (MAR).

That leads nicely into H World's latest results, which were dominated by its 67% year-on-year revenue growth in the first quarter to 4.5 billion yuan. The growth for the company's China business was actually a bit lower at 58%, but the overall figure was boosted by the previously mentioned 118% growth for the European business.

Notably, H World forecast the European DH business will start to drag on revenue again starting in the second quarter. It forecast overall revenue growth for the entire company would range between 51% and 55% in the second quarter, but added that growth for the China business would be quite a bit higher at between 64% and 68%.

Like most of the major global operators, H World is increasingly focusing on hotel management and franchising, which typically carry higher margins and lower costs than hotel ownership. Its portfolio included 8,592 hotels at the end of March, up 7.6% year-on-year, with 92% of those as managed or franchised properties.

RevPAR, a widely watched metric for the hotel industry, reached 210 yuan for H World's Chinese hotels during the first quarter, up 59% from a year earlier, and also notably ahead of the 178 yuan figure from the first quarter of 2019 before the pandemic. The company pointed out that business peaked in February before starting to settle down in March, though business for both months was still ahead of pre-pandemic levels. Still, that seems to indicate the post-pandemic rush is likely to quickly vanish.

The bottom line was that H World reported a 990 million yuan profit for the quarter, representing its first profit in nearly two years. But as we noted earlier, the profit was dragged down by the European properties. Excluding the loss from those properties, the company would have recorded a 1.2 billion yuan profit for the quarter.

We'll probably need to wait another few quarters to see if the European portfolio can finally show some significant improvement as it heads into its second post-pandemic year. If it continues to struggle, we wouldn't be surprised if H World puts it up for sale, perhaps as soon as late this year.

Disclosure: None

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