Plenty of room

China Lodging Group (HTHT.NASDAQ) shone in its US initial public offering at the end of March. The company raised a comfortable US$110.25 million to support expansion across China by selling nine million American depository shares at the top of its expected price range; the shares ended their first day up nearly 14%.

Coming after months of disappointing China-related listings on US markets, the China Lodging IPO was a welcome change – and investor interest is understandable. As rising consumer spending and pro-growth government policies help domestic travel to shoot skyward, hotel chains like China Lodging may be on the cusp of a budget boom.

"Budget hotels are a fairly recent product in China," said Karen Tan, vice president at Jones Lang LaSalle (JLL) Hotels in Shanghai. "But it has mushroomed in the last five years or so."

According to data from market research firm Research in China, the number of budget hotels in China grew from around 500 in 2005 to more than 2,800 in January 2009. Their appeal to guests, more than 90% of whom are domestic travellers, is clear. While not offering the range of services of higher-end options, budget hotels – particularly of larger national chains like China Lodging’s HanTing Inns, and competitors Home Inns (HMIN.NASDAQ), 7 Days Inn (SVN.NYSE) and Jin Jiang Group (2006.HK) – provide reasonably clean and well-located accommodation at a low price.

Rooms at HanTing Seasons, China Lodging’s premium budget chain, go for US$44-60 in large cities. On Shanghai’s central Huaihai Lu, the rack rate for a spartan double room in a Jinjiang Inn is about US$40 per night – minutes away from the company’s flagship Jin Jiang Hotel, where the rack rate on a "discount room" is more than US$330 per night.

No supply glut

The rapid growth of budget hotels has led some industry observers to fear a repeat of the capacity glut that has faced China’s luxury hotel segment. So far, it appears that those fears are unfounded. Despite last year’s economic downturn, China’s tourism sector grew by 9% to more than US$184 billion. Growth is widely expected to accelerate in 2010.

"I don’t think the budget sector has seen [overcapacity]," said Parita Chitakasem, research manager at Euromonitor International in Singapore. "Yes, there’s very aggressive competition, but it’s also driven by a growing market. There is high potential for each and every player."

Rapid growth doesn’t mean business has been easy for budget hotel chains. Founded in 2005, China Lodging posted losses in 2007 and 2008 as it poured money into ramping up its hotels across three brands: HanTing Express, aimed at junior-level business travelers and cost-conscious leisure travelers, HanTing Hi Inns, for budget travelers, and HanTing Seasons. It was only in 2009 that the company ended the year in the black, posting a profit of US$7.5 million.

Similarly, 7 Days Group swung from a loss of US$20.4 million in 2008 to a profit of US$10.8 million in 2009.

A question of capital

Recent losses have effectively limited cash-raising options for many budget hotels, said Julie Ke, an analyst at Guotai Jun’an Securities in Hong Kong. Markets in Hong Kong and mainland China require three consecutive profit-making years to qualify for listing; US markets are more flexible, and China Lodging wasn’t willing to wait two more years as rivals continue to strengthen. Competitor 7 Days, which listed in November last year, has grown from five hotels in 2005 to more than 330 today. "For these brands, the faster they get listed the better," said Ke.

There was also the simple matter of money. By opening at a relatively higher offering price in the US market, these firms can raise much more cash per share, noted Euromonitor’s Chitakasem.

Home Inns, which listed in 2006, has used the capital it raised to become China’s largest budget operator. The company had 616 hotels at the end of December, but it’s not stopping there. "We are planning to open 180-200 new hotels this year," a Home Inns spokesman told CHINA ECONOMIC REVIEW. "We don’t have plans for next year, but probably we will open the same amount of new hotels."

Budget chains can only expand in first- and second-tier cities up to a point. The threat of overcapacity aside, budget hotels tend to be converted from existing buildings, rather than built from scratch. As major cities develop, there are fewer appropriate properties available for conversion, says Tan at JLL. Rising real estate prices have also put budget operators in a bind. With low room rates a major selling point, they have little leeway to raise prices to offset more expensive leases.

Going lower

Such pressures, and growing demand for travel accommodation in lower-tier cities, will require budget chains to expand beyond their traditional bases. The potential market is huge, but growth requires heavy investment, and the relatively shallow markets in many lower-tier cities means it may be difficult to repeat the rapid expansion seen in the likes of Beijing, Shanghai and Guangzhou.

Expanding to more destinations will also mark a slight change of focus for budget chains. The bulk of their guests at present are corporate travelers, but much potential growth will come from leisure, rather than business, destinations. Success is not wholly in the hands of the hotels.

"Why is this leisure demand still untapped? It has a lot to do with other factors like setting up rail links, particularly high-speed trains," said JLL’s Tan. "When destinations become more accessible to domestic travelers … that will be a huge stimulus to the budget sector overall."

Ke at Guotai Jun’an says that China Lodging and Home Inns are in the strongest market position to take advantage of the domestic leisure travel market. The firms’ partnerships with Ctrip (CTRP.NASDAQ), which owns 15% of Home Inns and 8% of China Lodging, and cooperation with other third-party booking services help to expand their presence. (China Lodging founder Ji Qi also helped set up Home Inns and Ctrip and remains on the board of the latter.) Hotels operated by 7 Days, in contrast, are held back by relying heavily on an in-house distribution system.

With competition remaining fierce, however, don’t expect 7 Days – or anyone else – to stand still. As the domestic travel market expands, there is still plenty of room for growth and change in the budget hotel sector.

"There are 660 cities in China," said Ke at Guotai Jun’an. "These brands are only focused on big cities right now. So they have ample room to expand in the next three to five years."