Stuck in the middle

20 January 2003 by
Stuck in the middle

If some observers' predictions in the late 1990s had proved correct, there should now be only a handful of midmarket hotels left in the UK hotel industry.

The received wisdom was that midmarket hotel operators would be squeezed out by the emerging budget sector and the upscale, four-star sector. The reasoning was that in a downturn, budget hoteliers would be expected to attract guests looking to save money, while upscale hotels would lower rates to fill rooms with those guests still willing to pay midmarket rates.

Peter Eyles, executive chairman of the Hanover International chain, says such fears have meant that "there has been a lot of scrambling for everyone", as companies have attempted to reposition their properties out of this unloved segment.

Declining numbers

Indeed, there has certainly been a decline in the number of UK midscale hotel bedrooms, as figures from the hospitality research unit at the University of Huddersfield reveal.

In 1998 there were 112,906 bedrooms classified as midscale in the university's database of group hotels. Four years later there are 101,733. In contrast, upscale bedrooms run by groups increased in number during the period, from 69,414 to 87,471. And the dynamic budget sector grew even faster, from 50,915 to 77,209 bedrooms.

If the current pattern continues, the midmarket will soon no longer be the dominant segment in the UK hotel industry. But, although unfashionable in certain circles, including among most financiers, midscale hotels are not likely to disappear.

If there was to be a mass exodus from the segment, it would be happening now. As Simon Johnson, analyst at UBS Warburg, says: "Companies are not in financial distress. Their balance sheets are significantly stronger than they were in 1991 and 1992."

Richard Thomason, chief executive of mainly midmarket group Jarvis Hotels, says that fears for the segment have proved unfounded. "If something was going to happen, it would have happened in the past year," he says.

The sector has certainly had a trying time of late. There has been a series of difficult circumstances over recent months, starting with petrol shortages, then foot-and-mouth, and culminating in the 11 September attacks. "It was shock upon shock, but we have shown terrific resilience," says Thomason.

He adds that the strength of midmarket hotels lies in their flexibility. "You can mix markets," he says, pointing to how Jarvis has shifted into UK leisure business in the past year.

The stability of the midmarket might be explained by the fact that it has learnt from tough times in the past. The combined effects of the recession and the Gulf War in the early 1990s caused widespread distress in the hotel industry. Despite similar challenges more recently, there have been no hotel company collapses. "Hotels have got themselves exceptionally fit this time around," explains Thomason.

Hoteliers are surviving rather than thriving, though, as a glance at current share prices indicates. In the case of Jarvis, its share price remains at about 30% below its 1996 flotation price of 175p.

The stock market is not a friendly place for any hotelier, midmarket or otherwise. In fact, for the past couple of years, the stock market has seen hotel companies return funds to shareholders rather than raising money for expansion. Two giants of the sector, Six Continents and Whitbread, have either given substantial sums back or are proposing to. The heady days of 1996, when six hotel groups were listed, are long gone.

The fact that midmarket, mid-sized hotel groups are out of fashion has made it particularly difficult for them to raise money. The stock market is largely closed to them, and debt financiers are cautious, given the current trading environment.

With little money, the chains are struggling to expand. And no expansion means no or slow profits growth, which in turn only reinforces the slump in share price, as investors look elsewhere for a return on their money.

Bricks and mortar

Making growth even more difficult is the fact that prices for hotel property have not fallen in line with share prices. Share prices may have halved in some cases, but the value of the buildings has stayed broadly the same. Even with cash, buying properties at a reasonable price is difficult for operators.

The growing gap between share price and net asset value has been spotted by at least one activist shareholder - Jack Petchey. He has used his Isle of Man-registered vehicle, Trefick, to snap up substantial holdings in a number of hoteliers, including Jarvis, Hanover and Queens Moat Houses (QMH).

At Jarvis Petchey has built a 23.45% holding, while he holds almost 29% of Hanover and just over 17% of Queens Moat Houses.

Petchey has not revealed his plans, but in previous corporate raiding he has built up a stake in a company to force activity by its management and then sold out as the share price rises. He usually maintains that he has no wish to seize control of any of the companies he buys into.

Managements have been, not surprisingly, wary of Petchey, and are reluctant to discuss the issue openly. One executive claims: "He is just another shareholder." But having somebody with that size of holding in your business cannot be comfortable.

QMH did go on the record back in March, describing Petchey's tender offer for a stake of just over 25% as "opportunistic". In other words, the QMH board thought he was attempting to buy a chunk of the company on the cheap.

The response of listed hotel company managements to the growth conundrum (and pressure from the likes of Petchey) has been to devise ways of realising value. In the case of Jarvis, it has chosen the sale-and-leaseback route. In October it announced it was raising £150m by selling nine hotels to investors grouped together as Ireland-based Lioncourt. It will then lease them back for almost 35 years.

The move has enabled Jarvis to hand back up to £85m to shareholders and leaves it more focused on managing hotel operations rather than owning hotel property (although it still owns 45 hotels). But this has not made it clear how Jarvis intends to grow.

Thomason says the company is looking at all opportunities, and hints that there are deals in the pipeline. These will not be outright acquisitions but transactions in which the company can add operating leases and management contracts. For the time being, despite wanting to be a focused management-services company, there are no plans for further sales of hotel property.

A particular problem for the midmarket hotel is finding its place in the broader accommodation market. Thomason believes branding is part of the solution. It drove Jarvis to adopt the Ramada badge - operated by Marriott International outside North America - despite more than a decade of pushing the Jarvis moniker.

Derek Gammage, managing director of Insignia Hotels, a company which has advised on many key sale-and-leaseback deals in the UK, including Jarvis's, says: "Those midmarket hotels that have secured a niche will trade well, but those pretending to be something they're not will fail."

He cites as examples of successful niche operators Village Leisure Hotels, the De Vere Group-owned brand that has a strong appeal to local markets through its health and fitness facilities, and Hanover, which is now a four-star hotel and conference centre operation.

The midmarket may not be about to disappear, but the successful companies are becoming radically different operations. That fabled flexibility is being truly tested.

Market-level distribution of UK hotel groups

\ \
>NUMBER OF BEDROOMS
MARKET LEVEL\* 199820002002
Budget (one and two-star) 50,915 61,912 77,209
Midmarket (three-star) 112,906 110,435 101,733
Upscale (four-star) 69,414 80,568 87,471
De luxe (five-star) 8,825 11,556 9,848
\\* Based on AA gradings

Source: Hospitality Research Centre, University of Huddersfield

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