Companies in the lodging and leisure sector have re-thought their business models during the pandemic, but it remains to be seen what changes will be lasting.

The hospitality sector experienced extraordinary stress as mobility ground to a halt during the pandemic. However, the decline provided an opportunity to revisit how companies serve their guests and the costs those services entail. Management teams have touted the experiences as driving fundamental changes to their business models. Below, we explore a number of recent changes, which may create sustainable enhancement to margins and earnings, and the risk these changes may revert back to prior operating models.

One compelling way for hospitality companies to retool their cost structure is through changes to their labor models. At full-service hotels, we estimate labor is about 50% of expenses. Lodging REITs are adjusting everything from food and beverage hours to housekeeping. Brands and franchisors have allowed hotel owners to require guests to “opt-in” to housekeeping, amenities such as room service have been curtailed and many property outlets have been closed altogether.

The adjustments have cushioned the impacts of lower occupancy in a highly fixed cost business. One public lodging REIT, for example, saw 1Q 2021 hotel operating costs rise by only 15% compared to 4Q 2020, despite a roughly 50% increase in total revenues. Likewise, another reached break-even profitability in March at only 32% occupancy.

Hotels are not the only businesses making adjustments to improve margins. Casinos, for example, have reduced low (or negative) margin offerings, such as buffets, spas and giveaways. As demand has rebounded, these changes are proving meaningful to the bottom line. Regional gaming operators have achieved record margins in recent quarters and have even seen profit growth versus 2019.

We agree with companies who say that such an unprecedented experience likely removes decades-old layers of non-essential expenses. Moreover, the adoption of technologies like mobile check-in present, in our view, secular improvements in productivity. In combination, we view it as reasonable that some degree of margin expansion and business model change can be sustained.

Simultaneously, COVID-19 is limiting competition that would otherwise lead managers to incur incremental costs. As competition increases, labor hours to clean rooms and amenities that appeal to guests will grow too. In other words, as the world moves beyond the pandemic, guests are likely to reset their expectations higher. Finally, higher wage rates will pressure costs even if operators reduce labor hours.

Overall, we believe a bottom-up approach will prove critical in identifying issuers who have effected sustainable changes. For example, issuers within the regional gaming industry will likely exit the pandemic with higher-quality balance sheets than they maintained in 2019. For others, we believe it is too early to determine the ultimate impact of such broad changes on corporate credit quality.