THEY may be relatively light when it comes to amenities but cleanliness, good service and, of course, the price are helping economy hotel chains in China attract more guests away from the traditional state-owned inns and into their cheap and cheerful rooms.

For many executives in the global hospitality sector, China's growing legion of business and leisure travelers are a tough bunch. Despite their increasing disposable income, travelers are collectively keeping a tight grip on their purse strings.

During the recent Golden Week holiday in October, for example, individual tourists spent an average 459 yuan (US$69) a day, mostly at scenic sites, restaurants and hotels, with the rest on travel via planes, trains and cars, according to the country's National Tourism Administration (NTA).

That's not enough for the fancy, big Western hotel chains to hit their growth targets back at home. But at the other end of the spectrum - in the local budget-hotel segment - executives such as David Sun, CEO of Home Inns & Hotel Management, are smiling, not least because their Chinese customers are hitting the road like never before.

During the weeklong National Day holiday, the NTA counted 254 million visitors to various tourist destinations across the country, up 27 percent from the same period in 2009. Revenue from these tourists reached 116.6 billion yuan, a 32.4 percent year-on-year increase.

Home Inns, in particular, was ahead of the curve in spotting that growth potential back in 2002. Launched by a handful of individual investors and tourism service consolidator Ctrip.com, it was at the forefront of the country's budget-hotel chain concept, offering accommodation at rates from less than 100 yuan a night. Currently the largest of the economy-class chains, Home Inns has grown from operating 10 hotels in four cities in 2003 to 674 hotels in 126 cities today, along with a number of franchised locations.

Sales have also been rising accordingly, reaching 2.6 billion yuan in 2009 from 1.9 billion yuan in 2008. Earnings before interest, tax, depreciation and amortization for the Nasdaq-listed firm nearly doubled over the past two years, to 614.5 million yuan from 323.9 million yuan.

Other firms have had good reason to want to emulate the company's budget concept. Guangzhou-based 7 Days, founded in 2005 and launched on the New York Stock Exchange in 2009, is another major budget hotel chain in China, with 399 hotels and 147 in the pipeline. In the second quarter of this year, revenue rose 25 percent from the previous year to 352 million yuan and its occupancy rate was 93.4 percent. Another major player is China Lodging Group. Founded in 2005, the newly Nasdaq-listed firm operates 324 hotels in 51 cities under Shanghai-based Hanting Inns & Hotels. Its revenue for the second quarter jumped nearly 40 percent to 439 million yuan, with an occupancy rate of 98 percent.

The reason for the growth? "It's not because we're cheap," says Sun of Home Inns, when asked why his economy hotel chain has been steadily wooing customers from China's traditional state-owned inns. He suggests that service rather than price holds the key.

He has a point. Industry experts point out that while China's up-and-coming budget hotel chains like Home Inns are relatively light in terms of amenities - along with a bed, a typical room will have an air conditioner, a television and a washroom - they are known for their cleanliness and service.

"People looking into three- and four-star hotels are willing to trade down for possibly a less nice location because the product is more consistent and reliable," notes Paul Keung, head of investment research at Oppenheimer Investments Asia.

According to Keung, "Home Inns, Hanting (China Lodging) and 7 Days fit a niche that appeals to travelers who are not up for spending between 300 yuan and 400 yuan a night."

The challenge now, however, is figuring out how to enable the niche to evolve. While the expanding market currently gives the three firms and their other rivals plenty of room to maneuver, industry analysts see warning signals ahead.

There has been plenty working in favor of the budget segment. Rising disposable incomes, massive public spending in transportation infrastructure and government policies spurring domestic tourism are the obvious drivers. However, it is first and foremost China's command economy - which essentially left no serious incumbent players in the hospitality sector - that has made the country such a fertile ground for these new chains.

The state-owned hotels, recalls Oppenheimer's Keung, have been "places where if you wanted hot water, it may take 10 minutes and where there may or may not have been working elevators or (where the properties) were in disrepair. Up until about 10 years ago, hotels were not really businesses.

They were state-owned operations, at a local government level." As a result, he says, "it is an unaccommodated demand issue, where (the economy chains) are taking share away from either old guest houses or the inefficient state-owned and operated hotels."

Local savvy

Domestic upstarts have dominated the segment. Super 8 of the United States and Ibis of France are just two of a few non-Chinese firms that have thus far only managed to nibble at the market. According to Sun of Home Inns, this is in part due to the need for local knowledge.

"Most of the players in the budget hotel sector lease properties, so you do need strong local expertise to understand the market," he says. In addition, "about 99 percent of our customers are domestic, so you also need local knowledge to understand their needs. Foreign companies know their strength is their global customer base and is in high-end service, and their product is designed for that end of the market."

It also helps that domestic consumers now have more disposable income than in the past. "When people earn more than US$3,000 (a month), it is a sign that they will have more leisure and travel time," Sun notes. "China's economy is growing very strongly and we expect the same momentum for the next three to five years. If we look at small to mid-sized enterprises and the regional economic development, we're seeing more and more strength. That is giving a lot of people incentive to travel

for business, especially now that the economy is moving from the south and east coast areas to the middle and north of China."

Oppenheimer's Keung says the development of second- and third-tier cities makes the budget hotel segment a sweet spot for investment. "One way to appreciate the hotel business here is to look at GDP per capita per city and by region. GDP per capita in the second- and third-tier cities is hitting levels where cities like Shanghai and Beijing were just over a decade ago," he points out. "The growth in these cities over the next 10 years, which will be growth in discretionary income, says to me that you not only have an economy that's growing more strongly than the rest of the world, but there will also be a growing propensity to travel, whether it's because these smaller cities are growing or because people are more likely to travel as they make more money."

What's more, support from the government - both direct and indirect - has been strong. The country's two Golden Week holidays - a weeklong break for Chinese Lunar New Year in January or February as well as the one in autumn - were initiated in 1999 by the State Council to boost domestic consumption in the wake of the Asian financial crisis. In addition, there are plenty of other national holidays to encourage traveling and tourism.

Also fueling the trend are government-funded infrastructure projects, such as a number of new or upgraded airports. The Civil Aviation Administration of China says the number of travelers and the number of flights in the National Day holiday week this year were up about 24 percent and 5.3 percent, respectively, from the same period last year, with the total passenger load for the period reaching 5.75 million.

There is also growth in the high-speed rail lines. In July, China's Ministry of Railways announced that it is investing US$120 billion in railways over the next two years, increasing track length by 6,000 kilometers to bring the total high-speed network to 13,000 kilometers by 2012.

"In terms of high-speed trains, that will raise travel demand, especially into the second- and third-tier cities," says Wendy Huang, a Hong Kong-based RBS analyst. "This is a very good project for the long-term growth of the travel industry." The results are already notable. During the October holiday, state media reported that the railway system carried a record number of passengers, surpassing 8 million passengers in a single day.

Growing pains

Nigel Summers, the consultancy Horwath HTL's Hong Kong-based director, also cites the segment's solid prospects. "The (budget-hotel segment) is the bulk of the travel market and that still has a long way to grow," he notes. But that can be both an advantage and a disadvantage in the sector, where competition can intensify rapidly because there are relatively low barriers to entry. On the one hand, start-up costs are low since the no-frills hotels do not need to provide extras, such as haute cuisine restaurants and concierge services, and overheads are lower than at their high-end counterparts. On the other hand, there could be a shakeout as some players struggle to compete on tight margins and go bust or consolidate.

"There will be a lot of brands that come out, and some will come and go, because the barriers to entry are not that big," Summers says. "But the prospects for that sector are still very promising."

Sun of Home Inns agrees. "So far, we haven't seen anything like (price wars or capacity concerns) because demand is still huge in the market," he states. "If you look at the performance of all the players (in the budget sector), they are still maintaining a very high level of occupancy rates over the past couple of years."

Despite the promising prospects, however, Oppenheimer's Keung says budget hotel businesses will be subject to periodic downturns and the recent impressive earnings are not likely to be repeated soon. "From a cyclical standpoint, you probably aren't going to see as good numbers as you have had this year. We've had the full-year stimulus, a lot of policies to spur domestic consumption (and) you had the Expo (Shanghai) and a number of events that drove up tourism significantly," he points out. "From a short-term standpoint, 2009 and 2010 are special years for the travel industry."

Additionally, Keung notes that the rapid expansion of the chains - all of which have significant plans to grow their networks over the next year or so - could put pressure on revenue per available room (revPAR), a key measure of hotel profitability. In the second quarter of 2010, revPAR at Home Inns was 171 yuan, compared with 148 yuan in the same period in 2009 and 144 yuan in the previous quarter.



(Reproduced with permission from Knowledge@Wharton, http://knowledgeatwharton.com.cn. All rights reserved.)