Corporate Trade Creating Value in the Lodging & Travel Industry
Corporate Trade Creating Value in the Lodging & Travel Industry he concept that business strategies shouldT be judged by the economic value they create iscommonly accepted in the business community. The How Does Corporate Trade Work? A corporate trade strategy involves selling the under- performing assets, unoccupied rooms, at their prevailinglodging industry, in the ordinary course of business, cash values instead of liquidation value, to a corporatesimply by the imbalance of supply and demand, creates trading company such as Active Internationalan excess of rooms during the year. These excesses (“Active”). Active purchases these assets utilizing itsmay also be referred to as “underperforming assets” “currency” known as trade credits. Instead of payingand represent a perishable asset or inventory which, 100% cash, the hotel company uses the trade credits,when unsold, becomes a lost revenue or value coupled with cash, to purchase media, sponsorship,opportunity. As a result, these unutilized rooms are printing, travel or other goods and services throughoften sub-optimized. Active at the equivalent independently determined pricing the hotel company would normally pay. Thus,Corporate trade is a strategy to create maximum value corporate trade creates value through cash savings. Afrom these underperforming assets, usually in the form corporate trade strategy may also create incrementalof cash savings, which, in the lodging industry may be business through ancillary occupancy revenues, suchcoupled with incremental ancillary business in the as food and beverage, which would have been lost hadform of additional revenues. the rooms been unoccupied.In an effort to regain some value, hotel companies In the case of a media purchase, Active operates in thetypically dispose of a portion of their excess rooms same capacity as the media-buying department of anthrough liquidation channels, including the Internet and advertising agency. The price of the media purchasedconsolidators. However, in doing so, they receive lower through Active is benchmarked at what the hotelroom rates and potentially tarnish their brand image company would have paid, except that when suchby advertising what would otherwise be unacceptable services are purchased through Active, they are paid forpricing. This practice, in turn, may lower the related with a combination of cash and trade credits (i.e.,returns of their properties over the long term. cash/trade credit blend), at prices established by the hotel company and its suppliers. No media order is everIn addition, these liquidation practices usually carry placed without the hotel company and its ad agency’srelatively high commissions and fees to the distribution approval and as a result, the services purchased willchannel or agent. Importantly, from a cash perspective, always meet all of the hotel company’s specifications.hotel properties may only be realizing 20-30% of theirnormal corporate rates through liquidation, rather than Active charges no fees or commissions and, in therealizing the other 80-90% of economic value by case of media, Active bills the media net of an industryutilizing a corporate trade strategy. This extra 80-90% standard commission of 15% so as not to interfere withof economic value created by corporate trade is huge in the hotel company/advertising agency relationship.and of itself, without considering the other ancillary Further, Active provides full proof of performance sorevenue streams, which may be realized once occupancy the hotel company can easily ascertain that what wasis increased. ordered was, in fact, delivered. With respect to non- media goods and services, the process works similarly.
Accounting and Financial Statement Treatment transaction are quite dramatic. Consider the cost of theAuthoritative accounting guidance in the United rooms traded, which would otherwise have beenStates for corporate trading or barter is set forth in absorbed. Industry cost averages1 as a percent of cashFinancial Accounting Standards Board Accounting revenues for luxury and upscale full service businessStandards Codification, Topic 845, Non-monetary class hotels are 26.4% and 27.6%, respectively.Transactions, including Topics 845-30-17 to 20, Leveraging and utilizing this cost basis through corporate trade, enables the hotel company to realizeBarter Transactions and Transfers of Operating leases the other approximately 73% of economic benefit thatfor Barter Credits hereinafter referred to as “ASC would otherwise be lost.845.” Industry practice and suggested accountingtreatment is summarized in the Ninth Revised Edition Since the valuation process is somewhat subjective inof the Uniform System of Accounts for the Lodging nature in assessing values under ASC 845, theIndustry (USAL) as published by the Educational accounting treatment of a corporate tradeInstitute of the American Hotel and Motel transaction may vary from company to company.Association. Accordingly, interested parties should consult with their respective outside accountants to determine theASC 845 set forth that in reporting the exchange of a appropriateness of the suggested accountingnonmonetary asset for barter or trade credits, it is treatment. The example below illustrates a common orpresumed that the fair value of the nonmonetary asset typical arrangement relative to the points describedexchanged (unoccupied rooms, real estate or capital above. Other structures and arrangements may begoods) is more clearly evident than the fair value of designed by the trading company to meet the hotels’the trade credits received. specific needs.The trade credits should generally be reported at the fair Example, Facts and Assumptionsmarket value of the asset exchanged or given up. The Assume that a business class, luxury, full service hotelUSAL provides that exchanges of accommodations and chain is averaging 72% occupancy and has a prevailingother lodging services for external services, such corporate rate of $200 per night. Further assume theas media (trade credits) should be recognized as hotel chain has ten properties each with 300 rooms.executory contracts and need not be reflected in the Utilizing these facts, and assuming the industry averagefinancial statements until services are provided or room cost (payroll plus other direct costs) as a percentreceived. In essence, the USAL suggests the hotel’s of cash revenues of 26.4%1, the chain is incurring anrecords reflect the exchange by recording an asset and average cost of $44,352 per night on unoccupieddeferred credit (liability) at the time the corporate trade rooms which, when unsold over a year, aggregate antransaction is negotiated in equal and offsetting annual burden of $16.2 million. Assume further thatamounts in order to properly track the transaction. For on average, the hotel realizes an additional 10% offinancial reporting purposes, the asset and deferred revenue in the form of ancillary services, such as food,credit at the balance sheet date may offset each other beverage, pay per view television services, etc., for itsand may be reflected on a gross, or alternatively, net occupied rooms. If the hotel chain were able to morebasis as a current asset or liability. The hotel company effectively utilize this “perishable asset” or at least amay wish to consult with its outside accountants to portion of it, the hotel chain would be able to createdetermine, based on its facts and circumstances, the a substantial benefit on a dollar-for dollar basis bypreferable manner to present and account for such taking advantage of this otherwise overhead charge ortransactions for internal and external reporting burden. The key here is to use an underperformingpurposes. The fair value assigned to the transaction, asset to create value in the form of lower expendituresassuming the sale of otherwise unsold rooms, should for goods and services to be purchased, incrementalgenerally reflect the prevailing corporate market or revenues, or both.cash equivalent rate of the unoccupied rooms, ratherthan the “rack rate.” Interpretations of value may vary, Now let’s assume that the hotel wanted to sellbut since the room would have been unoccupied, the $10 million of the unoccupied room nights for $10lower-end range of value appears appropriate. million in trade credits, which are redeemable over three years (the assumed contract term) at a fixed rateWhen room nights are consumed, revenues are reflected or blend of 75/25 (cash/trade credit) ratio. This meansand recognized by the hotel; when services such that $40 million of cumulative purchases of media,as advertising, are received by the hotel, an expense is printing, sponsorships, promotional merchandise orrecognized and the prepaid asset is amortized or reduced. other goods and services would fully utilize the tradeThe economic consequences of a corporate trade credits. To simplify, assume the trade credits will be 2
used in the purchase of media and that the average occu- trading company bills its clients and vendors on apancy rate is 72%, rooms are available and restrictions non-disclosed cost basis utilizing a combination of cashdo not apply. In addition, the hotel company has annual and trade credits at the prevailing market rate, the tradingmedia expenditures totaling $20 million and the trade company preserves the hotel’s pricing in the market-credits will be utilized equally over three years against place. Clearly, the compelling reason to utilize corporatefuture media purchases and the traded rooms will be con- trade rather than the liquidation strategy is to create realsumed equally over the first two years. economic value in the form of incremental revenues, coupled with reduced future cash expenditures, whileGiven these facts, a great opportunity exists for the hotel preserving the brand image in the marketplace.company to utilize corporate trade. In accounting forcorporate trade transactions, it is necessary to apply the The Economic Benefits of Corporate Trade Comparedconcept of reasonable assurance2 in order to properly with Liquidationevaluate the feasibility of a corporate trade transaction. (Figure 2) Corporate Trade LiquidationSince reasonable assurance exists that the trade credits Strategy Strategywill be utilized at the outset of the transaction, a prepaid Alternative 1: Liquidationmarketing expense of $10 million and a deferred credit of Revenues assuming liquidation of$10 million are established in accordance with industry $10 million of rooms at 50% $5,000,000practices (USAL). In summary, the hotel company has Distribution fees and services (15% x $5 million) (750,000)exchanged a portion of its unoccupied rooms to pay for Alternative 2: Corporate Tradefuture media purchases. The figure below summarizes thefinancial aspects of the corporate trade transaction over a Cost of goods and other services to be acquired at benchmark prices $40,000,000three-year contract period. Consideration given up for goods and services:Financial Impact of Trade ($ In Thousands) Cash component 30,000,000(Figure 1) Allocated cost of rooms At Contract Year 1 Year 2 Year 3 Cumulative (26.4%1 x $10 million) 2,640,000 (2,640,000) Signing Date Totals Total consideration 32,640,000 Cash Outlay for Corporate trade incremental value Media Expenditures N/A $10,000 $10,000 $10,000 $30,000 and cash savings created before ancillary incremental occupancy revenues 7,360,000 Income Statement Impact Ancillary incremental occupancy revenues (10% x $10 million) 1,000,000 1,000,000 Revenue N/A $5,000 $5,000 N/A $10,000 Total incremental value created $8,360,000 $2,610,000 Amortization of Prepaid Marketing N/A $3,333 $3,333 $3,334 $10,000 Corporate trade incremental value $5,750,000 Net Profit (Loss) N/A $1,677 $1,667 ($3,334) $0 By increasing the occupancy rate from 72% to 77%, Balance Sheet Impact ancillary revenue streams, such as food, beverage, Prepaid Marketing $10,000 $6,666 $3,334 N/A $10,000 pay-per-view television and other hotel services totaling Deferred Credit $10,000 $5,000 $5,000 N/A $10,000 $1 million have been created by the incremental traffic.The benefits of the transaction for the hotel company Unlike certain liquidation channels, the tradingare: company charges no fees or commissions which, relative to liquidation, provides an immediate benefit. In • Creation of value through cash savings and addition, the trading company charges its clients and preservation of brand image that would otherwise be vendors the prevailing corporate rate expressed in terms lost if an immediate liquidation strategy was of a combination of cash and trade credits and bills followed for this asset its clients on a non-disclosed cost basis, so as not to • Potential creation of further upside by generating undercut the established market rate. Consequently, the traffic and associated ancillary revenue which would hotel brand image and its intrinsic value is preserved in not be realized if the rooms remained unoccupied. the marketplace.Net, net as noted below, at least $8.4 million of value is Intracompany Trade Credit Utilizationcreated in the corporate trade strategy versus$2.6 million through liquidation, for a corporate trade Some hotel companies reflect the acquisition of tradeincremental value of $5.8 million, over three times the credits as a corporate asset. If the trade credits are usedvalue created by liquidation. In addition, since the by different operating properties, the benefit of the uti- 3
lization of the trade credit may be reflected at • Can the trading company provide comprehensive,the corporate level, not at the operating level. In this professional, in-house media staff with agency-manner, control over operating budgets may be trained buyers who have sufficient experience?maintained, however, the downside is that operatingproperty is not sufficiently motivated to utilize the • Are the purchases of goods and services at thetrade credit, as it does not realize any trade credit same quality and at the same price that wouldutilization benefit. otherwise be purchased?To properly motivate those properties, which will in • Are sufficient and appropriate fulfillmentturn accelerate utilization and allow the realization of inventories or capacities maintained to satisfythe full value of the trade credits; the economic benefit anticipated hotel needs?should be shared with the operating property that usesthe trade credits. Planned expenditures, as documented • Does a demonstrated ability to re-marketin corporate and operating property budgets, should unoccupied rooms, real estate and capital goods toreflect the use of trade credits in order to maintain specified end-users exist?budgetary control over those expenditure. Thus the oper-ating unit will be motivated to utilize the tradecredits and, at the same time, maintain budgetary control Notes:over expenditures. 1. Smith Travel Research 2004 Hotel Operating Statistic (the HOST Study) Report for the Year 2003 forConclusion luxury or upscale full service hotels 2. Reasonable Assurance While not specificallyCorporate trading creates value and is easily applied to defined in accounting literature, the concept ofboth individual hotel properties and chains. In the case reasonable assurance generally refers to a probabilityof chains, the corporate trade process should be threshold or standard of "more likely than not" up tocentrally managed at the corporate level between the the threshold of "likely." Reasonable assurance mayhotel company and the corporate trading company; also be viewed as establishing a sufficient basis that can be generally relied upon.issues regarding franchisees and reservations can andhave been addressed easily. This financial solution, asdemonstrated above, will recover substantially greatereconomic benefit in terms of a multiple(s), compared For more information, please contact:to the amounts typically achieved through liquidation. Richard E.VendigKey questions at the outset of a transaction are: Executive Vice President Chief Financial & Administrative Officer, • Does the trading company have the ability to Secretary utilize the traded asset quickly and in a manner that preserves the hotel company’s brand image Active International and pricing? One Blue Hill Plaza Pearl River, NY 10965 • Does the corporate trading company have the Tel: (845) 732-8750 lodging and travel industry expertise and client and vendor base to match the targeted consumer of the Fax: (845) 735-1774 hotel company? email@example.com • Can trade credits be easily retired? www.activeinternational.com • Are you satisfied with the scale and depth of the trading company and does it include a successful track record of retiring trade credits over the last five years? • Is proof-of-performance, accompanied by affidavits and post-buy analysis (in the case of media) routinely provided?