H World Group Ltd

BMV:HTHTN

Earnings Call Transcript 2019-Q2

[Operator]

Ladies and gentlemen, thank you for standing by. Welcome to the Huazhu Group Limited Q2 2019 Earnings Conference Call. [Operator Instructions] Please be advised today's conference call is being recorded.

I would now like to hand the conference to your first speaker today, Ms. Ida Yu. Thank you. Please go ahead, ma'am.

[Yu Ida, executive]

Thank you, AJ. Good morning, everyone, and thanks to all of you for dialing in today. Welcome to Huazhu Second Quarter 2019 Earnings Conference Call. Joining us today is Mr. Ji Qi, our Founder and Executive Chairman; Ms. Jenny Zhang, our CEO; and Mr. Teo Nee Chuan, our CFO. Jenny and Teo will present the strategy review and Q2 results. Following their prepared remarks, management will be available to answer your questions.

Before we continue, please note that the discussion today will include forward-looking statements made under the safe harbor provisions of the United States Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the views expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. Huazhu Group does not undertake any obligation to update any forward-looking statements except as required under applicable law.

On the call today, we will also mention adjusted financial measures during the discussion of our performance. Reconciliations of those measures to comparable GAAP information can be found in our earnings release that was distributed earlier today. As a reminder, this conference call is being recorded. The webcast of this conference call as well as supplementary slide presentation is available in the Investor Relations section of Huazhu Group's website at ir.huazhu.com.

Now, I would like to turn the call over to Jenny Zhang, our CEO. Jenny, please.

[Min Zhang, executive]

Hello, and thank you to everyone for joining us today.

We are excited to report our second quarter results with double-digit growth in our number of hotels, net revenues, adjusted EBITDA. As shown on Slide 2, at the end of Q2 this year, we had a total number of 4,665 hotels, an increase of 20% from the end of Q2 2018. Our total turnover at a hotel level reached RMB 8.8 billion, an increase of 18% from a year ago. Our net revenues increased by 13% from RMB 2.5 billion to RMB 2.9 billion in Q2 2019. Our adjusted EBITDA stood at RMB 1.07 billion for Q2 2019 as compared to RMB 965 million in the Q2 last year. The pro forma adjusted EBITDA would have been RMB 1.15 billion or 40.4% of net revenue if excluding the impact of our significant investments in development teams, upscale brand hotels and IT capabilities during this quarter. We believe such investments will help fuel our sustained future growth.

Due to the weak macroeconomics and a general slowdown in business activity and the leisure travel, our same-hotel RevPAR and occupancy has softened since the beginning of this year. Nevertheless, our mature hotel occupancy maintained industry leadership and outperformed the industry average by 20 percentage points in Q2 2019. Huazhu's core competencies and resilient business model remains solid during cycles. Along with the more challenging economic situation, more growth opportunities for consolidation become available to us, thanks to our industry leader position.

As we are seeing, we are capturing those opportunities effectively through our well-defined strategic focuses as listed on Slide 4. Firstly, we are continuing the rapid expansion of our hotel network. Secondly, we focused on innovative technology applications to enhance our guest experience and operational efficiency. Thirdly, the strategic deployment in upscale hotel segment. I will walk you through our progress in those 3 areas.

Let's turn to Slide 5. The left part shows strong acceleration of our hotel openings during Q2 2019. With 269 hotels opened or 3 hotels net every day, this is basically tripling the openings in the same period last year. In the first half of 2019, as shown on the right part of this chart, in the first half of the same -- in the first half of 2019, 435 net hotels were added, also close to tripling the same period of last year.

And we expect future hotel expansion to accelerate given our strong growth in our pipeline. As shown on Slide 6, we have a pipeline of 1,553 hotels, equivalent to 33% of our hotels in operation. This ratio has increased from 21% at Q1 last year, indicating a significant acceleration in our growth. The second -- the strong growth is mainly attributable to franchised and manachised hotels, which account for 96.5% of our total pipeline.

Slide 7 shows that -- our fast expansion in the mid and upscale hotel segments, which is well on track. At the end of Q2 this year, 43% of the total number of Huazhu rooms in operation were midscale and upscale, up from 34% in Q2 2018. As shown on the right-hand side of the slide, our unopened pipeline for mid and upscale rooms accounted for approximately 80% of the total number of rooms in pipeline, same as a year ago. Our enriched mid and upscale hotel brand portfolio, with profitable hotel operating models, continues to attract potential franchisees into Huazhu hotel network.

Regarding our network expansion, I'm also very excited to share news about our flagship brand, HanTing. Launched in 2019 -- 2005, HanTing today serves the widest range of business and leisure travelers in China. Last month, we unveiled our first HanTing 3.0 hotel in Shanghai. As shown on Slide 8, HanTing 3.0 is intelligent and affordable, with premium quality. Our guests can enjoy not only the most contemporary design, but also the fast automatic check-in by just easily clicking our display at the front desk. In their rooms, a robot instead of hotel staff can fulfill their delivery orders. What's more exciting is that our guests will also enjoy our artificial intelligence system called Hello Huazhu, which features a voice-activated 2-way communication, plus guests can control in-room light, television, air conditioning, window shades and other features in their rooms through the Hello Huazhu system or our mobile application.

Our previous market research and our initial customer trials are confirming that these technology applications will enhance our guest experience at HanTing Hotels. And the enthusiastic response from our franchisees also make us believe this is going to attract many new franchisees and opening more hotels under the HanTing brand going forward. We look forward to the accelerated growth of the HanTing brand under this exciting new model.

Technology application strategy is essential for Huazhu's sustained growth. It enables us to satisfy our customers' evolving needs. When you launch the Huazhu application, you are one step closer to a seamless stay experience. As shown on Slide 9, we divide the full cycle of each guest booking and stay experience into 16 distinct mobile touch points and are seeing that we improve their experience with us when they use the Huazhu app. [ We are a hotelier ] to digitalize these functions into a single user-friendly application.

In addition to reliability and the fast booking through the Huazhu app, we also facilitate a more carefree hotel stay. For example, guests just use the Huazhu app to control the elevator and to open their room door instead of using a traditional door card. Guests are also able to buy their breakfast in the cafeteria through the Huazhu app instead of having to walk to the front desk. Moreover, we also speed up the checkout process through the Huazhu app. The easy billing function makes an invoice immediately available when each guest checks out via the Huazhu app.

Our innovative technology also drives our corporate direct sales as shown on Slide 10. First, we [ combined ] various corporate booking channels for our corporate clients to access directly to our Huazhu booking app. Huazhu offers the lowest price by booking through our own channels. They can enjoy the membership benefits such as free breakfast and loyalty points. Second, B2B settlements eliminate the back office headaches previously experienced by our corporate clients because our clients now don't need to process expense reports to reimburse their traveling employees for Huazhu Hotel stays. We issue 1 invoice to each corporate client per month. And last but not the least, we also help ensure corporate compliance by documenting authentic hotel stays and invoices, all while meeting the travel guidelines of our corporate customers.

Finally, I want to update you on our progress on the upscale segment. The resolution of our 4 Joya Hotels are well on track. Two of them are located in Shanghai, Lujiazui and Shanghai Gubei SOHO. Both are in central business district or what we call CBD areas. Another 2 are located in Hangzhou, Qianjiang CBD and in Chengdu, Taikoo Li, respectively. Joya will greet Huazhu's guests with its unique brand proposition of oriental elegance and Chinese fine living. We look forward to those grand openings late this year and early next year.

In September 2019, we are going to officially launch 2 new brands, Madison and Grand Madison, to convert the existing 4 and 5 star hotels. When joining Huazhu's network, these hotels will benefit from our operating platforms including IT infrastructure, procurement systems, sales terminals, and et cetera. As of June 30, we have already signed a pipeline of 12 hotels under Madison and Grand Madison.

With that, I will turn the call over to Teo. He will walk you through our operational and financial results in more detail. Teo, please.

[Nee Chuan Teo, executive]

Thank you, Jenny, and good morning, everyone. Please turn to Page 14.

In Q2, our blended RevPAR grew by 1.3%, driven by higher ADR and partially offset by a decrease in occupancy. The ADR increase of 4.4% was contributed by a positive 0.4% increase in our merchant hotel ADR and also by an increasing mix of mid and upscale and upgraded hotels with higher ADR. Our hotel occupancy was at 87% in Q2, 3 percentage points lower compared to 90% a year ago. The lower occupancy was largely attributable to the softer macroeconomic environment as well as a higher base in Q2 2018.

Turn to Page 15. Our same-hotel RevPAR declined by 2.1% in Q2. Our ADR slightly improved by 0.14% (sic) [ 0.4% ] and partially offset by a lower occupancy of 2.3 percentage points, mainly attributed to softness in business travel demand. We observed fewer hotel stays for trip fairs and conference in April compared to last year. In May, the overall travel demand was relatively stronger because of more tourist stays due to a longer holiday. However, the performance in June became softer again. This is consistent with our original forecast earlier this year. However, given the recent escalation in the China-U.S. trade war as well as the uncertainty in the timing of the final resolution of these trade disputes, we need more data to determine the timing of the final recovery in the subsequent quarters.

Moving on to final results on Slide 16, our net revenues grew by 13.4% in Q2 in line with our guidance of 13% to 15%. As we look at revenue components, net revenues from our leased and operated hotels improved by 5% year-over-year, and net revenues from our manachised and franchised hotels were up 30% compared to last year. In Q2 revenue that was attributable by our asset-light manachise and franchise business models contributed 28.1% of our total revenue, up by 3.7 percentage points from last year. We expect that the contribution from our franchise segment will continue to increase going forward.

As Jenny mentioned, we have made progress in our midscale hotel segment. The revenue contribution from our mid and upscale hotels continued to increase. As shown on Slide 17, in Q2, the revenue from mid and upscale hotels increased by 27% to CNY 1.6 billion, accounting for 56% of the total revenue, up from 44% a year ago.

Let's now turn to Slide 18 on operating income and margin. The reported income from operations was CNY 657 million compared to CNY 671 million last year. The reported operating margin was 23%, 3.6 percentage points lower compared to 2018. The lower operating profit and margin was mainly due to our investment in hotel development teams, upscale hotels and IT capabilities. Excluding this investment which we mentioned in our Q1 presentation, the pro forma income from our operation would have been CNY 748 million compared to CNY 671 million last year. The pro forma operating margin would be 26.1% compared to 26.6% in Q2 last year. These investments do not bring in revenue at the current stage, but they will generate revenue in the future.

As we updated in our last quarterly earnings call, we have increased the head count of our development team. The result has been positive. We have seen our unopened pipeline hotels increase by 85% to 1,553 at the end of Q2 as compared to 839 at the end of Q2 last year. The faster hotel network expansion will bring in revenue and operating profit when they are open.

Another area where we have invested in our -- is our IT capability. As Jenny mentioned in her presentation earlier, our technology capability allows us to drive both operational efficiencies and better customer experience. Our technology team is also working on a good number of other projects, which we will incorporate into our hotel operations. We will share these developments with you at a later time.

We also made a strategic deployment into the upscale hotel segment by expanding our team and securing a number of strategically located properties in Shanghai, Beijing, Hangzhou and Chengdu for our upscale brands. This has caused our payroll costs and pre-opening expenses to increase as compared to last year. And we will not see any revenue contribution from these pipeline hotels until they open for business at the late of 2019 and beginning of 2020. We believe this investment will bring in additional revenue and drive margin expansion in the coming years. In this quarter, we also recorded a lower other operating income of approximately CNY 37 million. This is mainly due to a one-off compensation received totaling CNY 35 million related to the -- an acquisition in Q2 2018. This has also partially contributed to a lower operating margin in this quarter.

Moving on -- sorry, moving on to the cash flow status on Page 19. In Q2 2019, we recorded a net cash flows from operation of CNY 1.2 billion. After deducting the CapEx for maintenance and new developments of CNY 301 million, the free cash flow generated in Q2 was CNY 860 million. We used this cash to partly pay off approximately 1 billion of our offshore syndication loan and provide partial financing to select strategic franchisees for hotel development. At the end of Q2, our cash and cash equivalents and restricted cash balance came in at approximately CNY 4.1 billion.

On Page 20, our guidance, we maintain our full year gross opening target of 1,100 to 1,200 hotels. And we estimate to close about 200 and 250 hotels in 2019. Given the slowdown in economic growth and the opacity as to the timing of the final resolution of the China-U.S. trade dispute, we expect our Q3 net revenues to grow 9% to 11% year-over-year. We also adjust our full year revenue growth range to 10% to 12%.

Finally, please turn to Slide 21. Our Board of Directors has approved a share purchase program of up to $750 million effective for 5 years. Under this program, Huazhu is authorized to repurchase in the open market or privately negotiated transactions its outstanding American Depositary Shares with an aggregate value of up to USD 750 million, depending on the market conditions and other factors as well as in accordance with the relevant rules under the United States securities regulations. The repurchase program does not oblige Huazhu to make any repurchase at any specific time.

With that, let's open the floor for questions. Operator?

[Operator]

[Operator Instructions] And the first question comes from the line of Justin Kwok from Goldman Sachs.

[Justin Kwok, analyst]

Perhaps 2 questions to start with. The first one is on the share buyback program. So I think it's interesting to see you have initiated a quite a sizable amount of this program. I want to get a sense on the rationale and the logic in terms of why you're initiating it today. And in terms of the [ quantum, why ] you think this USD 750 million will come up? And how do you look at this in the kind of context of balancing, as Jenny mentioned at the beginning of the call, that you actually see opportunities for M&A, onshore. How do you balance the use of cash on this [ both ] side.

The second question is on the HanTing 3.0. So I remember a few years back when you rolled out the HanTing 2.0, there was a massive wave of upgrade within your franchisees, which at the end bring in RevPAR growth before and after. So for this HanTing 3.0, would you mind to give a bit more guidance for the potential ROI or the CapEx for this upgrade and any time frame for the rollout of this program throughout your system?

[Min Zhang, executive]

Teo will help respond the first one and I will address the second one.

[Nee Chuan Teo, executive]

Justin. We put in place a share buyback program considering a couple of factors. Number one, we believe that the current situation, the current economic environment and turbulence may cause some turbulence in our share price which will cause the share price to fall below the -- I feel the long-term valuation of the company. So having said that, we believe that China Lodging's -- Huazhu's is that we have a long-term view of the company and we have been consistently invested in some of the long-term growth of the company which will bring back the revenue and as well as the revenue growth in the longer-term. So we believe that the valuation will recover in the longer term, so we expect that -- we would like to put in place a longer-term kind of share buyback program to enable us to actually buy back some of the shares when the share price is far below our long-term value. It's number one.

Number 2 is that the cash that we have put in place in terms of the M&A as well as the -- our share buyback is that we have, actually have some cash balance offshore to facilitate this share buyback. In addition to that, you said for the -- is there any M&A opportunities within China, we have also had some cash balance as well as the credit facilities within China to execute the M&A activities.

[Min Zhang, executive]

On your second question on the HanTing upgrade, by now we have already got more than 55% of our HanTing Hotels are 2.0 or above. And this launch of the new 3.0 model has brought a lot of excitement to the market. So we have decided to accelerate the renovation and upgrade of the existing HanTing portfolio. Our internal, what we call struggle, is to increase the 2.0-up version of the product to 65% by the end of this year and 80% by the end of next year. That will be driven by 3 components. One is the accelerated growth of new openings of the HanTing Hotels, and the second is the upgrade of the existing old HanTing Hotels. And thirdly, we will also [ off load ] some assets. And also some of that will be natural expiration of franchise agreements for some of the oldest hotels. We believe those efforts are going to continuously strengthen our HanTing brand. And our goal is to make HanTing the largest single-brand hotel in the world in the next 18 to 24 months.

[Operator]

The next question comes from the line of Billy Ng from Bank of America.

[Billy Ng, analyst]

I have 2 questions. The first one is can you provide a little bit more color on the current quarter in terms of the demand or the RevPAR trend. And in particular, in different segments, if you can provide some, shed some light, that would be appreciated.

[Nee Chuan Teo, executive]

What we have observed in Q2 was that the -- if you break it down to the different tiers of cities, is that the tier 1, I would say that, that is pretty mix where we see a continued growth in Beijing as well as Hangzhou overall. On the other hand, we do see some weakness in Shanghai and Shenzhen. On the other hand is that overall in the Tier 1 cities, the RevPAR has been holding up. On the other hand is that in Tier 2 cities, we see that the RevPAR has experienced a quite significant, I would say, drop in Tier 2 cities. Mainly we speculate that this is mainly because the business activity in these areas has been slowing down without competitive activities and other commercial activities as well as the leisure. And in the lower-tier cities like Tier 3, we're happy to see that the RevPAR continues to go up in the lower-tier cities.

[Billy Ng, analyst]

Would you mind to tell us for July and August, you see similar trend as well? And overall pattern for July and August?

[Nee Chuan Teo, executive]

Okay. August, it's still too early to call. But having said that, in July, we see a softness in the overall demand as well. And I will say that in August, the first week was pretty good, but except that in the -- starting from the August 10, you saw there was a typhoon that was hitting the Shanghai and a good part of the Eastern Coast. Which also affected the -- I would say that the peak period of our demand. But having said that, it's too early to call. We need to -- we need a couple more weeks to see where the numbers will fall.

[Billy Ng, analyst]

And my second question actually is related to your Madison plan. Can you tell us how many of your Madison pipeline to be leased and operated [ ourselves? ] And if so whether there will be any impact on your -- the [ operating ] expense for the next few quarters?

[Min Zhang, executive]

Also the existing pipeline of Madison and Grand Madison, there are 3 leased hotels and the rest are all manachised or franchised hotels. This is our upscale soft brands. We expected to become an innovator in how we manage the upscale hotels, especially the full service ones. [ The mid scale and economy ] we'll be able to consolidate [indiscernible].

[Billy Ng, analyst]

Okay. And just to follow-up on that because I -- we understand in the last few quarters, the Joya brand actually contributed most of the increase of the opening expense. Just want to clarify whether we will see a significant increase of the opening expense due to the pushing of this new brand.

[Nee Chuan Teo, executive]

Well, the fact that -- although there will be some lease and operators on the Madison brand, but for this brand is that -- the whole objective is that we try to retain as much as possible the existing structures and renovations of the existing hotels, which is normally in a good quality. So the investment is putting expenditure into this -- the even the leased hotel is [ actively ] minimum. But the objective -- the purpose of this brand is actually consolidate the 3 to 4 star hotels, existing hotels, using the manachised models.

[Operator]

The next question comes from the line of Dylan Chu from CLSA.

[Dylan Chu, analyst]

This is Dylan from CLSA. I have very quick 2 questions and ask them one by one. Number one is on your updated revenue guidance for 3Q and full year. Could you please also help us update the same hotel RevPAR assumptions that you have behind the updated revenue guidance? And still related to that, just any thoughts or color on the margins, particularly for 3Q, which is a few quarters, that would be very helpful.

[Nee Chuan Teo, executive]

Okay. Under the revised revenue guidance is that we expect that the same hotel RevPAR will actually will be slightly -- I would say that in the lower single-digit in the negative territory. We have -- we feel a little bit uncertain because of the -- I would say that the events happening in the China and U.S. trade disputes, which were, one time in June, it seems to be recovered. Then subsequently in July and August particularly even like 2 days ago, turns the event [ deteriorated ] badly and the trade dispute appears to escalate again. So -- and because we see that due to these uncertainties, so we were not very sure that the original expectation that the overall demand as well as the business activities were recovered in the second half or even in Q4. So as a result, we decided to lower down our revenue guidance as well as RevPAR expectations. As to the -- your question on the margin is that we have been -- one good thing about our growth model is through the asset-light business model. So because the majority of our openings are the asset light model, so we expect that the revenue that's been coming in from the franchised -- manachised model is that will help to actually post the decline in our leased hotel operating margins.

[Dylan Chu, analyst]

Okay. Great. Second question just in terms of costs, mainly about next year. In addition to preopening and development team investments, which should normalize, do we see any further areas where we can achieve more cost efficiency if operating environment continue to be quite subdued? Just any areas which are identified and sort of anything we could quantify would be very helpful.

[Nee Chuan Teo, executive]

Okay. You may in fact -- this year in 2019, we may make significant investment in a couple of areas. Number one is the development team areas as well as our IT resources as well as our sales teams. This has put -- I would say that those are additional investment of approximately CNY 30 million of the people costs every quarter, okay? And we currently that we do not expect this quantity, the number of head count, to increase much further or significantly much further. So we expect that this cost will retain and will remain in this year as well as next year. But on the other hand, the pre-operating expenses that are related to our investment in our upscale hotels, the additional preopening expenses of CNY 200 million is that up until this moment is that we have not made any new, I would say, the investment in the high-end hotels, which will require such a high capital expenditure as well as preopening expenses in 2020. So we expect that the preopening expenses in 2020 will be lower compared to 2019.

[Dylan Chu, analyst]

Okay. Yes, okay. Final question, just the buyback program. So you just mentioned that we also had a view in terms of our long-term value. Just curious, it's obviously no obligation, it's highly discretionary, but what kind of price range would you be interested in terms of buying back? Would there be any sort of ceiling price about which you wouldn't consider? Just any color around that would be helpful. And sort of related to your capital allocation obviously there could be compelling M&A opportunities [ spoken ] out. Sort of what kind of maximum leverage would you consider if you do see a compelling candidate? That would be helpful. And also would you consider potentially using equity to fund any future acquisitions?

[Nee Chuan Teo, executive]

Okay. Number one, relating to the pricing -- the pricing question, I'm afraid that I'm not able to answer your questions because it's actually totally up to the management and it's not appropriate to answer it, to provide answer to the public. As to the capital allocation, we say we are pretty open. The reason why we put in place a share buyback is because we have existing shares, the existing cash as well as the credit facilities in place. In fact, we said that we will also -- due to our bank credibilities that we are able to increase our credit facility further in -- at the end -- by the end of this year. So we do have the cash resources to deploy. So the first and most important thing is that we would like to grow this company. So it is attractive, M&A opportunities. We will first utilize the cash to pay for the M&A activities. But having said that is that we also believe that what we have been doing in [ 2 0 1 ] in the last few years, particularly in 2019, is that they will have a bearing on -- there will be a pressure on our profitability, which some of our investors may not appreciate because of the low operating margins. But we believe that by doing this investment, our profit margin and growth potential will accelerate in the coming years. So we will think that we would use some of our cash to buy back these shares when the market, I would say, that did not react well in some of the [ profit ] situations. And then that we will consider to reissue the stock in the future.

[Operator]

The next question comes from the line of Lina Yan from HSBC.

[Hau-Yee Yan, analyst]

I have 2 questions. So first question is regarding your guidance revenue growth in 3Q. It's like a 3 percentage point deceleration versus 13% revenue growth in 2Q. You just mentioned you're expecting like a low single-digit negative same hotel RevPAR in the second half of the year. So I'm wondering if you're going to have more temporary closure of owned and leased stores like in 3Q or second half for upgrades, while we have so much like macro uncertainties.

[Nee Chuan Teo, executive]

I would say that the -- our upgrading -- okay, I will say that our upgrading our -- sorry, we closed some of our hotels for upgrading. It is actually part of our long-term plan to actually upgrade our hotels. You see is that in a good time, is that there is -- the opportunity cost to upgrade is bigger because you actually lost the opportunity to make the revenue. But having said that, in the slow economy, it's actually good timing. Particularly, we also consider that there'll be a number of activities coming up, for example, the Beijing Olympics is going forward in the next couple of years. And you actually see that some of the government meetings who actually [ expect ] the timing of the renovations. So we need to seize the opportunities to do some upgrades of our leased and operated hotels so that when after the cloud and mist and dust has been cleared, we are in a better position to actually attract more market share into our hotels.

[Hau-Yee Yan, analyst]

Is there a target for upgrades like for owned and leased and specifically to HanTing 3.0?

[Nee Chuan Teo, executive]

Okay. We -- at least that we do have -- we do have some service specialty target in doing that by step. Our plan, our upgrading and the maintenance plan was anchored into our original plan that we said [ last time would happen ] at the beginning of 2019.

[Hau-Yee Yan, analyst]

And my second question is regarding the expenses. So as I understand, your investment into the IT development team and the preopening are reflected in the SG&A and preopening expense. But when I looked at the other expense under hotel operating expense, actually, the [ worldwide ] growth in the first half was still quite, like, significant. So may I know what's the reason for that?

[Nee Chuan Teo, executive]

Okay. The other operating income, the other operating expenses is reflective of a couple of things. Number one is that we do have an IT company, which we call [ Mingguang ] , which generate revenue from our affluent customers. So the cost is actually the cost in servicing those customers actually reflected in that. And of course, the revenue for [ Mingguang ] was also reflected in the other revenue in the revenue line.

[Operator]

The next question comes from the line of Tian Hou from T.H. Capital.

[Tian Hou, analyst]

So the question is related to your expansion. So in your press release, you mentioned that you have about more than 1,000 hotels in the pipeline for you guys to put on board. So I wonder where those hotels are in terms of the tier 1, tier 2, the region. And also that is one metric, one angle to look at it. The other angle to look at it is the -- what's the portion of the hotels are much more are like a higher tier [ and ] what are the middle tier or lower tier? So that's the clarification of your pipeline. And another question is related to China hotel market. So if I look at 2019, we have, like, almost 300 million room nights already. And for those with 300 million room nights, and I wonder is that already penetrated and saturated? So when you expand, is that consolidating the existing or is the market expansion? What exactly it is?

[Nee Chuan Teo, executive]

Okay. Let's first answer the question regarding the tier cities, is that approximately the 3% of pipeline are between Tier 1, and then it's that in Tier 2, we have approximately 36% and the balance in the lower-tier cities, okay?

Regarding that -- we see that the [indiscernible] that we -- no. We said Huazhu is that there'll be our -- the number of hotels that we have, that we currently have as a percentage of the total market is actually pretty small. We are talking about like 2 point -- 2.5% to 3%. It's very, very, very small. What we have been seeing is that our -- our expansion is we would like to expand in the market where the penetration is low. And then we would like to convert the existing hotels into our own brands because we think that we can operate the hotels in a better way, at appropriate pricing and at appropriate quality to our customers. So we see that our opportunity is still very, very small. To give you an example is that even the total penetrations of the other branded hotels include not only us but also other like the bigger brands like BTG, or is it Lijiang, in the Marriott, Hilton, everyone, those brand of hotels is that they own approximate 20% in the market. So if you look into the U.S., it's 70 odd percent. Assuming that because of the fragmented nature in China is that we can grow up to 50%, we still need to grow a bit, 2.5x more at least. So what we were seeing is that the opportunity to do that is much bigger. So that's the reason why we have been putting in place appropriate brands, including introduction of the Madison brand to further consolidate this market in the good locations.

[Operator]

The next question comes from the line of Praveen Choudhary from Morgan Stanley.

[Praveen Choudhary, analyst]

A couple of questions for me. One, you mentioned that the IT investment upscale and business development, [ look ], 3% of your margin in this quarter. I'm just wondering that in 2020, when these investments will go away, how should I think about the pressure on your margin? Will that 3% completely go away to 0% or will there always be some pressure on adding upscale hotels, maybe 1% lower than what it could be?

[Nee Chuan Teo, executive]

Okay. I will say that the pressure -- I won't characterize the investment as a pressure. But I would say that it is actually a fit for growth okay. So the investment that we put in place for development team, it will bring growth to our company through increasing, especially the manachised hotel to hotel expansions on -- particularly on asset-light franchise models. So this revenue will come in. But having said that, we said we do not expect the team to grow much bigger as compared to, like -- as well we have added the results in 2019 compared to 2018. So we see that in 2020 is that our resources in this area will actually remain approximately the same number. So in other words, that the revenue that this team will be bringing in to the [ network ] hotel will be more than offset in the years coming forward. The IT team is the same thing as well. As far as the -- our pre-operating expenses, as I mentioned earlier, is that we have not secured any more major strategic hotels in [ Tier 1 ] good location where they be -- with a very high rental cost at this moment. So we don't -- we expect that the preoperating expenses will be coming down in the year to come in 2020.

[Praveen Choudhary, analyst]

I understand, Mr. Teo, I think you have explained that. My question was particularly on 3% margin that you have shown in your presentation very clearly that in Q2, your margin could have been 3% higher. My question is that 3% goes to 1% or 0% when I look in 2020?

[Nee Chuan Teo, executive]

Okay. We have not provided the revenue guidance for 2020 yet. But we do expect it -- because the sort -- as for the absolute amount for the expenses will deliver approximately what the current stage is so we expect the percentage of this expenses will be coming down going forward.

[Praveen Choudhary, analyst]

Okay. That's helpful. Quickly on the second question is related to your pipeline, you mentioned -- your pipeline has grown over time, which is good news. It has also grown as a percentage of your installed number of rooms. But your net opening guidance has remained same. So what I wanted to understand is why? And the second is, how much of these net openings in second half '19 and in 2020 would be from Huazhu or as well as H Hotel?

[Nee Chuan Teo, executive]

I will say that the -- all our pipelines are only related to the hotel that is listed in our disclosure. And H Hotel is not within -- it's not within our consolidation scope and is not included in our premier hotels. Zero, okay.

Number two is that we expect that normally that for our pipeline hotels is that we are opening it up in -- within the next 12 months. As you may see that with our pipeline of hotels in the beginning of the year, and now what we are -- our target opening is approximately the same. And the reason why we have not been increasing the pipeline hotel is the opening target is that you never know. Because especially in the [ facilities ] at the end of the year, coming to the third and fourth quarter of the year, there may be some meetings and maybe some timing of issuance of the fire safety secured license that may actually alter [ the ] deviation of the timing of openings. So this is -- we prefer to stick to our current target, and we see how it goes. If the opening target were to be -- if the actual openings would be higher than what we expected, we revise that in Q3.

[Praveen Choudhary, analyst]

Okay. Great. And then on upscale hotel, if I may ask the question, are you seeing RevPAR trend in upscale hotel to be similar to what you have seen in your own hotel, meaning business travelers are traveling less, RevPAR is declining? And if that's the case, your entry into this segment, is it, like, good thing or a bad thing for your business?

[Min Zhang, executive]

The upscale segment this year has seen or bore some RevPAR decline. And currently, we have a very tiny [ weight ] in the upscale segment in China. Given our main business model is to do management and the franchise, I think it's the perfect opportunity for us to enter into this segment. As a newcomer, we come into this segment with more efficiency tools that will help this segment to improve their profitability. We're in the current [ suffering ] point across the industry. And because of the significant revenue base, each upscale hotel is going to contribute more management fee than the small economy hotels. Therefore, we believe, number one, there is a demand for our capabilities. And number two, there is a good profit base for us to expand into. We think this is the perfect timing.

[Praveen Choudhary, analyst]

Yes. And I like all your IT innovations, those hotels really look great so congratulations and all the best.

[Operator]

The next question comes from the line of Carlton Lai from Daiwa.

[Carlton Lai, analyst]

Just one quick one. Can you just comment a bit about the trends and the take rate and if we're seeing any pressure given the kind of rising competition from a lot of new hotel chains we're seeing right now in China?

[Nee Chuan Teo, executive]

Okay. Now what we have been seeing is that we have been putting a lot of effort in actually increasing our -- how should -- our take rate. However, I would say our take rate, I would say that we've been giving -- putting a lot of pressure as we are putting to increase our centralized reservation systems and the traffic that goes through our centralized reservation systems. And at this moment, is that we will continue to maintain our take rate, our management fees on the base fee. So royalty -- management fees on the management -- on the franchised hotels and through the higher traffic that flows through our central reservation system, we expect that our take rate will creep up a little bit by a little bit. So we have actually experienced a similar pressure before, I would say that, in fact, in 2015, '16. But having said that, is that there will be -- because our franchisee has been seeing value in our management. So at this moment, we have not seen any pressure on our overall base fee take rate yet.

[Min Zhang, executive]

There is an accounting treatment that I want to remind everyone that I think at the beginning of this year, right? The initial franchise fee is amortized into the lifetime of the franchise agreement. This is a significant change because we used to recognize the revenue as a hotel opening. This has caused a significant mismatch when we open a new manachised or franchised hotel because the spending in developments and the service of opening that hotel will be expensed immediately into our books. But the revenue, according to the new U.S. GAAP rules, will need to be amortized in [ many ] years. So when we accelerate the opening of the opening scheme that we will have to absorb more expenses compared as a percentage of revenue compared with previous years. I just want to bring that to your awareness.

[Operator]

The next question comes from the line of [ Lewin Lu ] from SWS Research.

[Unknown Analyst]

Okay. I have 2 questions. First of all, I read our second quarter report on the [indiscernible], we have like an increased bank charge for online payment and higher commission fee to online travel sales, travel agencies. So could you explain like what the increase back in our commission fees to OTA, what kind of a new percentage that we have to pay and about the banking power over [indiscernible]

[Nee Chuan Teo, executive]

I would say that the [indiscernible] as you mentioned, is that there's a part of the increases in expenses was actually due to increase in the commissions, so as bank charges to the bank. This is mainly due to a couple of things. Number one is that we have a bigger number of hotels now. We have a larger number of hotels today. So is that -- as a result is that the -- due to the new openings is that we would need some OTAs to help to fill up our rooms. So as a result, that the OTAs contribution has also increased by 1 percentage point compared to the last quarter. So the commissions payable to the OTAs has increased. But having said that, is that the rates that we paid to the OTAs remain the same. There was no increase in the rate that's been under discussion right now. That's number one. Number two is that because there's an increase in number of our customers also using the credit cards or the online payment versus using cash. So the bank charges related to the transaction has also increased.

[Min Zhang, executive]

Yes. So just to add to Teo's point, we want to confirm, number one, there is a no rate increase in both banking charge and the OTA fees. And actually, we are gradually negotiating the bank charges down, and there we have achieved some success recently. So the increase in expenses you have seen are purely due to volume increase. And in addition to the increase, the number of hotels we are having is driving this various volume growth. This another driver is primarily because there are more and more central booking and attainment through our own central reservation system. And we have been recognizing the revenue of the bank charge we've paid on behalf of the franchisee in the revenue line and the expenses of the -- in the selling expense line. So that has also of course, some volume increase recognized in our book on the other SG&A line.

[Unknown Analyst]

Okay. And I have -- my second question is I also noticed that approximately 84% of our room nights was through our direct channel. So it's a bit lower than last year which is like 86%. So does that mean like we have more like midscale hotels and midscale hotels rely more on the OTA subchannels?

[Nee Chuan Teo, executive]

The increase in the OTA contribution, as mentioned, is that because we are opening a lot more new hotels. Usually in the hotel expansion in new expansion is that we need the help from OTAs to help us to fill up the rooms. So as a result of that is that the percentage has also increased. The main reason is because we need their help to have our hotel rooms at the beginning of the hotel life cycle.

[Operator]

Thank you. Ladies and gentlemen, that does conclude the conference for today. Thank you for participating. You may all disconnect.

Thank you.