Fight Shrinking Profit Margins with "Attribute-Based Selling" - Del Ross, McKinsey & Company

Josiah: 0:00

Our guest today led sales and marketing for one of the biggest hotel companies in the world, advises the top global strategy consulting firm, and invests in hotels personally. From all of this experience, one opportunity for a hotelier stands out above all others.

Josiah:Del Ross is a longtime industry expert, innovator, and leader who currently serves as senior advisor with McKinsey & Company, the top global strategy consulting firm. Before that, he led sales and marketing for IHG in the Americas, delivering $12 billion in annual revenue for IHG worldwide, drawing from his earlier experiences at IHG leading e-commerce and distribution. On top of that, he's investing in hotels personally now, so he understands the industry from so many perspectives. So that opportunity I mentioned earlier? It's fighting shrinking profit margins with something called attribute-based selling. In this episode, Del explains how we got to where we are today and what the path forward to healthier profit margins can look like.

Josiah: What have you seen play out that sets the stage for the environment we're in today?

Del: 1:34

This is one of the oldest industries. As long as people have had a need to travel to other places far enough where they can't come home at night, there's been a need for someone to put them up for the night in a safe, warm, comfortable place to stay. That's our industry. It's been that way for 5,000 years. The reason that I mentioned that context is because old, long-standing industries don't change very quickly. We've actually seen more change in the last 70 years in the industry than the entire 5,000 years that preceded it. It's all basically driven by technology. It started off with the central reservation systems that enabled the creation of centralized call centers and travel agency support If you have loyalty programs that were copied from airlines and adapted for hotels and then, all of a sudden, the internet blew up everything. In the last 25 years, we've seen dramatic changes in the way that people buy hotels, make reservations, how they search, how they explore and how they're guided into the lodging choices that they make. Even other disruptors like alternative lodging, Airbnb, which initially weren't much of a threat and now are taking big chunks of business in major markets every single day these are all things that have forced change. Big, slow, profitable business like ours, with an ancient lineage, doesn't change unless it has to. We're rapidly getting into an environment where we have to change.

Josiah: 3:08

Why do we have to change? You answered this a little bit. With disruptors entering the market, could it be taking away business that you used to just count on? For those that are listening, they're saying, hey, I have a fine business, I should just let it run as is. I don't really need to think about change. What are the motivating factors that require to think about this?

Del: 3:26

Well, I mentioned earlier that, as an investor, the attractiveness of the industry is that you can generate very high returns if you do it well. But it's very risky. High risk, high reward that's really good. The challenge that we're facing today is that the ability to generate those above-market returns is being threatened. It's actually eroding every single day and has been eroding for quite some time. We used to see gross operating profit margins depending on the business model 40%, 50%, higher in some cases. Those are steadily eroding. Some of that erosion has been masked by some short-term demand changes, but in general, the operating profit margins for hotels have been shrinking pretty steadily. This is caused by a few key factors distribution costs what we mentioned earlier about how much the internet changed distribution. Well, we have these new entrants, these online travel agencies that charge an awful lot more than traditional travel agencies for bookings. They commanded bigger share. They're actually seeking to get loyal travelers and have a successful loyalty program. In exchange for that, they're selling the rooms to hotels at a much higher price over time. Now that price went down for a while and then it's on its way back up. It's also a bigger and bigger portion of hotel reservations. Distribution costs are really high. Direct distribution costs also go up for the same reason. Because you're competing with these very lucrative third parties with a lot of cash for that demand, your direct booking costs go up. Then the underlying technology to support that all drives booking costs really high. They're really big, which erodes your margin. In the last five years, labor costs that's your biggest operating line item after distribution. Actually, technically, it's bigger than that because we're a people-powered business that has exploded. This is a combination of a couple of things. Weigh rates huge. In 2018, the average housekeeper was making about $18.50 an hour in the US. Today, that same housekeeper is making over $18 an hour. It's still one of the hardest jobs to fill. You can't get people because they can make $18 an hour doing a lot of other things that sometimes are easier jobs or less strenuous than the housekeeping job, less lonely than the housekeeping job. In addition, we let go of almost the entire industry. 75% of hotel workers were let go at the beginning of COVID. Most of those workers did not come back to the industry. So since 2020, we've been going through new workers. People have never worked in the industry before. They have no experience. They don't know what they're getting into. A lot of them quit. Nutrition rates are incredibly high. They've always been high, but they've been higher than ever in the last several years, even those that like it. They have to learn the job and there's a ramp up process. So productivity is a lot lower. And the combination of high attrition, which drives an individual cost and position up 30%, and low productivity until they're ramped up, until they've gotten that, that drives up overall labor costs. It also forces us to use a lot more overtime and a lot more contract labor. That's a roading margin. So that's a really big deal. We get into a couple of the other costs that are out there. I could get into the supply chain, like linens and things, because we saw that there was a bit of a spike there. That's attenuated a bit since the supply chain problem was more or less fixed over the last year or so. It was a warning call to say we've got some exposure there. But more importantly, energy. We've relied on cheap energy in just about every industry for a very long time and energy costs have been rising steadily and progressively over the last several years. We don't think this is going to go down. In my home state of Georgia there was a lot of hope that the new nuclear plant would reduce our energy costs, when in fact the difficulty of building that plant has caused the cost of that plant to be a lot higher than ever, dramatically higher than it was. And as the plant comes aligned, our energy costs are going up in Georgia because we have to pay for that plant. So this purported source of cheap energy is actually going to drive up our energy costs. That's devastating. Can't run a hotel without electricity and those costs keep going up. And fixing that, addressing that with more efficient HVAC units, smart temperature controls and other energy management solutions that's capital intensive, it's expensive and the payoff is slow, so you can't do a lot about that. Financing costs this is a below the line cost, a lot of time. But financing costs we practically had free money for a long time. Interest rates were so low. We've seen what's happened with interest rates in the last year and a half and we have uncertainty about whether that's going to keep on going up. We don't know from the Fed their latest thing if they're going to keep raising rates or not. Kind of left the door open there, but in any case it's higher than it's been in a long time. All this means is there's less money to go around once you've paid all your bills. And when you're comparing your returns on a high-risk investment like a hotel against other, less risky investments, you've got to consider that return. If your profit margins are eroded by 10%, 15%, 20% or even percentage points, that suddenly makes this a very unattractive investment, especially for institutional investors or lenders who are doing hybrid loan. Inequity and capital stacks yeah Thanks for walking through that, del.

Josiah: 9:03

On this show, I make the case for people thinking about investing because I would like to see more participants, more people have an ownership stake in the outcome of what we're collectively building and help us all do well for ourselves, for our families, for our communities, and so I make the case for that. But I also want to recognize people who may be skeptical and say, hey, this is all well and good, but why should I care? There are profit margins for investors are eroding. I don't invest, I don't really care too. I wonder if we talk a little bit about why this matters and some things that I'm thinking about, is it seems that profitability and attractiveness as an investment fund a lot of the things that we enjoy, even as travelers right, the beautiful spaces we enjoy are funded by investment dollars. If we think about operationally within these businesses programs, the ways that we can attract talented, caring people into our organizations, the benefits that we can offer, everything comes from its attractiveness as an investment and its profitability as a business. Right, you're an investor. Is that a fair summary of why everyone should think about profitability, even if they're not investing? Or is there anything else that comes to mind for you there?

Del: 10:12

I think it is important to keep that in mind. It certainly is an investor. Profitability is everything and an investor also considers the underlying value of the asset, which is linked to profitability but also has a lot to do with what else. Where are they? Very often a city-center hotel. It's very hard to make the economics work on a daily basis because the operating costs are so high, but the underlying dirt is so valuable and just goes up. So you may make your returns by the long-term value the terminal value of the asset when you've decided to sell it, versus the operating profits that are starting to cash flows. It really depends. In my case, I don't invest in those kinds of hotels. The typical hotel, yeah, you've got to care about the profits because it is about not just the underlying asset, it's about the cash flows, it's about the net operating income, and even the value is tied to the net operating income. So you need to pay attention to that. If you don't understand what are the fundamentals of that business, what drives profitability, it's probably something you need to research before you make that investment, because it's too challenging of a market and too hard of an industry to just go in blindly.

Josiah: 11:24

Yeah, I want to talk a little bit about the path moving forward. You talked about the challenges that we're facing, the headwinds. Where do we go from here? I think I've seen a lot of conversation recently about resort fees. Some people call them junk fees as a way to augment the money coming in the door. You've written about attribute-based selling. I guess for people who are uninitiated, how would you describe the difference between these resort fees and attribute-based selling?

Del: 11:49

Attribute-based selling is very different than things like resort fees. Resort fees are a way of padding your ADR, your room rate, without calling it room rate. Consumers understand that, but they do tend to look at the face rate, the base rate, before the fees. But they get really upset. It's actually a major dissatisfy in the long run. That's problematic for us, especially when you have an industry. You have providers like Airbnb that give you all the fees up front. You see everything, you're going to be charged, you're not going to show up and they suddenly throw another $30 a night on the bill. You see it all and you agree to pay it. I think that's creating expectations and I think in the long term it's challenging to rely on those kinds of fees for your sustained profitability. Hotels used to be able to use that to avoid paying ruin taxes or royalties. The brands have totally changed that. They charge your royalties on it, the local municipalities and taxing authorities. They charge you tax through occupancy tax based on it, so that dodges out. It's really just the consumers now and in the long run we have to be careful about relying on it now. Attribute-based selling is a whole other ballgame. We can look at the history of the travel industry, not the hotel industry, for good examples of this. Airlines began to unbundle the flying experience almost 20 years ago when they started to charge for where do you sit on the plane? Not just front of the plane, back in the plane, but there are good seats. They're bad seats. There's preferred seats. They created these comfort zones. They started adding amenities in there, in some cases the boarding order. When do you get to get on the plane? How do you get around on there? There are all these things that they can do now. They're limited because yet today a plane's like a bus, right, there's just only so much you can do in that experience, Especially with competitors. But they did their best to deconstruct the experience. They used to give everybody free check bags. Everyone did and not everybody brought free check bags. So you could argue people were paying for baggage fees without using them. Well, now they make it. So you only pay for what you value and what you're willing to pay. That's really good. They've proven that model works. They've captured what economists refer to as consumer surplus right the most that people are willing to spend for a given good or service and that is a lesson that we can learn and apply to hotels.

Josiah: 14:19

We haven't really done that, yet there's so much more opportunity in hotels. Right, I like the plane is like a bus analogy. Hotels are so much more dynamic, there's so much more to work with. But, as you outlined in your article, attribute-based selling is not actually a super new concept. I think around was it 2010? There's a lot of conversation, maybe even hype, around this. What happened then and kind of what's happened since then, as you've looked at kind of the hype cycle and people thinking about this, yeah, reality rarely catches up to the hype cycle, and it certainly didn't.

Del: 14:49

Then we heard an awful lot about attribute-based selling, like you said, about 10, 15 years ago. In fact, it drove a lot of investment by some of the brands and a lot of buzz To the tune of hundreds of millions of dollars in new CRSs, etc. But we still haven't seen it and I think, like everybody else, you don't see something. You just kind of give up on it, right? Well, guess we'll never see that. Well, that's what I'm suggesting now we revisit the reason we want to revisit it and it will be revisited by the smart operators, the smart brands, the smart owners is because we have to, because we need to assure our profitability back up and because we leave so much money on the table Each booking that we sell with every customer we really just do, and that's not a sustainable Scenario. So the environment's there. More of the pieces to fall into place and we need intention and there is little work to do. When we do this, we could be looking at a massive increase in the actual paid rates of customers and the underlying profitability of those sales.

Josiah: 15:57

If we could, let's talk a little bit about what happened when the potential of attribute-based selling wasn't fully realized 10 or 15 years ago. I think sometimes we learn more from failure than success stories. And so what happened then? You said there's a lot of investment into technology. Was it a technology capacity or capability issue, or process issue? Or what did you see because you were on a commercial leader at that time right, what were you kind of seeing in the industry?

Del: 16:23

Well, I was a commercial leader, so with IHG at that time, and we believed that and we still the industry players still believe that this is going to happen. I think we didn't fully anticipate all of the challenges in the hotel. Industry is a people-powered business, always has been an attract people who love people, and that's the beauty and power of the industry. At the same time, it's an industry that cannot run without a lot of technology. Typical hotel has tech stack, that is, dozens of different kinds of technology that all has to work well just to get somebody into the room and have the lights come on and the AC work. There's a lot going on there. Few of those pieces have to be in place for attribute-based selling to work. Central reservation system the bank that says here's where my inventory is, this is what I have available to sell, has to be built to support an unbundled room somebody picking a room type or configuring a room before arrival and being charged for the different attributes that are included in that particular cell. If the system that is storing that data can't support it, you can't sell it. Good news is a couple of the companies already have invested in this. Amadeus built a centralized reservation system for IHG and for Marriott that has this native capability. Not sure how much progress they made in taking advantage of capability, but it's there. It's why they did it, which is good, and there are other companies that have followed suit, so the capability in that back end database is there.

Josiah: 17:52

For me this is really interesting. So there's the CRS you talk about kind of being made there, but that's not all the tech stack, right? What else is in the tech stack that is important for this? Okay?

Del: 18:01

so we have the CRS back end. Everybody has to have a CRS. Now let's go to the other end of spectrum, the property management system on hotel. Right, you got to have a property management system, otherwise you can't run the hotel. And that also has to be configured so it can support an unbundled room of lots of different components other than the sleeping room and the non sleeping room stuff. Things like is there a mini fridge in the room and do I have a bigger screen TV or is a high floor? Am I buying the particular room? Pms has to support that too, and that's not trivial. Then in between there your loyalty program has to understand are there different points for different kinds of things, different packages? Do you create incentives? What's worth the most? You know, because it would be really simple and say all dollars are equal to hotel. Not really true, right? Some things cost money to deliver. Other things make you money. You want to incentivize things that make you money and that's where loyalty program comes in. So you want that configured right. Pricing and yield management, pricing and revenue management how do you price these things right? We've been increasing your line on pricing optimization engines to tell us what should our base Undiscounted rate be for a particular room type on a particular night going forward, and everything else is hinged off of that. Well, now we got to do the same thing for pricing these amenities, these unbundled amenities. How do we do it? So pricing system has to be configured, the yield management system, just like with the room rate. Do we open or close discounts and a given date for a given room type, based on a number of factors predicted future demand, the current occupancy, competing rates. That has to be done for these other amenities to. If there's scarce things like mini fridges and stuff, well, we may want to yield those things out, not all for those things. It's a whole other competency that has to be done. The systems can do this, they just have to be set up to do it and then you get the whole distribution infrastructure. We talked earlier about the dependency on third parties for distribution. They need to be able to sell the stuff the way that we're configuring to sell. Otherwise what's the point is doing forty fifty percent of distribution of all bookings and they can't sell your unbundled configurable room type is gonna hurt the pay off for that now, on the other end, short term it could make your direct channels sharply advantage, which is great. In the long term, they need to be able to sell it the way the customer wants to buy it, and the customer is gonna want to buy it with. That, you're selling right. So that has to happen. Possibly last, what it does need to happen as well, and there's little pieces and parts in between that also need to be put in place All of that stuff is possible today. This isn't pie in the sky. This is stuff that either exist now, just needs to be configured, or it can easily be built on top of what we've already got.

Josiah: 20:54

I love it. So what I'm hearing from you? As you mentioned, the technology is there and probably could be improved a bit, but there's technology that has improved over the past decade. It's not just technology. Is the people in a process, it's a mindset, right? How am I thinking about this? I wonder, before we go, if we can speak a little bit to each of the stakeholders that are piece of this. You mentioned technology making a lot of progress, but I'm curious for the technology folks that are listening, what you would like to see them build towards. Our functionality don't see on the market that you'd like to see the tech industry evolve towards, and then we speak a little bit to the operators out there and then to the brands that might be listening, because I feel like each of these stakeholders have a key role in moving this way of operating forward. Does that sound good? Oh, sure for sure. Maybe let's talk about tech first. For the tech folks listening people building technology. How would you like to see them evolve their platforms to support attribute-based selling better?

Del: 21:49

As we code this new thing or as we install it and we're setting it up for future years. We need to anticipate this isn't just going to be that room sale with twenty different room types combined with three times. It's going to be configurable rooms. It's going to be people buying a particular room, not just a room. Then they find out when they show up. Assume that that's the case. How would you program it differently? How would you set it up differently? It needs to be seen as a primary goal when developing the feature or function. We need to make sure we're thinking about that. That's the most important thing. The other is interoperability. This is true for any initiative, for any reason in technology, but your system has to talk to other systems. If you haven't built your solution for interoperability, for integration, you need to go back and do it again, because the days of the walled garden, where you just come in and get everything from one source to another, it's kind of gone now and it's never coming back. You see consolidation. You see private equity firms rolling up tech companies in a space every single day, but they're not doing that assuming that they're going to become the one stop shop for everything. They're doing it, because there's a lot of value that needs to be unlocked and hotels need fewer systems that do more stuff, but there's still going to be a lot of vendors and a lot of tech that has to work together. So integration, that's another big thing.

Josiah: 23:15

If I could just ask a follow up to that. I guess you know. For the smaller tech companies out there is it fair to say that interoperability and API connectivity is even more important, because if you're looking to work with some of the largest brands out there, this is not going to be a rip and replace. You need to do some kind of a pilot and you need connectivity to enable that Absolutely.

Del: 23:37

You have to assume that your system is plugging into something else. Hotels don't have time to learn a standalone system. They don't want to. The time that operators spend behind their screen clickety clack is the worst part of their day. They got into the business because they love managing people. They love serving guests. They love managing a complex physical asset. They don't love computers. If they did that, they'd do something else Right, and so they're not going to a standalone. They need it to talk together. It needs to be easy. They need it to be something that doesn't require them to have to take a 10 hour course. It needs to be easy and we can do that. Technologists can build easy tech. We do it every single day. We need to do it here. It needs to talk to everything else.

Josiah: 24:28

What would be your message to the brands that are listening, maybe intrigued by this strategy? They've been maybe testing something for a while. Where would you like to see brands moving as it relates to attribute base selling, the brands have a strong motivation to embrace this.

Del: 24:43

As I mentioned, they've already invested in their underlying capability, which is really important, and they want to be able to capitalize on that investment. They want to do this for a couple of reasons. They get paid on top line revenue, so anything that jins up top line revenue is good for the brands ultimately, especially if it is reflected in their franchise agreement, which it will be. So, number one they have a strong interest. Second, as profitability erodes, that undermines the value proposition they're offering to their licensees. Right, if your asset starts to become like you know, it's going to be a lodging asset. 13 percentage point hit you take because of all the brand fees makes it less attractive financially than going to an alternative lodging provider. A building an all Airbnb hotel. You pay your hotel taxes, pay your all the other stuff, run a leg hotel, but the consumers pay all the fees. It's incredibly cheap as an owner to run a all Airbnb property from a system standpoint, because most of that is borne by others. It's very expensive in other areas, but you need to consider that it's become a viable thing. So brands need to do this. The other thing is they can start offering true differentiators from one brand to another. As brands start to really tailor and hone their offerings around certain kinds of travelers with certain needs, they can have amenities and offerings that are really unique to that. And for brand today wanted to win the work from anywhere stay occasion, something that really took off during COVID and is sticking around for a while. Well, they don't really have a product today to sell there. They're just selling the same room. They're selling to everybody else and saying, hey, why don't you come and say what if there were room configurations that you didn't have to worry about? Hiding the bed that was behind you, right? Or you had a different kind of desk? The lighting in the room was set up for zoom, like? That's pretty amazing, you could do that. And you don't want to sell that to a family or for soccer players. They don't need that, they don't pay for it. But a business traveler who's in town for the week can be working from their hotel room and going out at night. They might pay a lot for that. There's a big interest, I think, for the brands to be able to offer these kinds of things.

Josiah: 27:01

Interesting. And then for operators I know the ecosystem is somewhat convoluted because many organizations wear many of these hats but maybe for pure play operators, third party management companies, what role do they have, if any, in this?

Del: 27:15

Well, they have some of the hardest jobs and actually I think this will make third party operators value proposition even stronger, because everything breaks down at the last mile. I came from outside the industry when I joined it 23 years ago and one of the first lessons I got is about how hard it is to get things done across the entire system because you've got to train people to do it. The first guy that hired me is the late great Eric Pearson from IHG, and we were trying to promote our new website to Booking and I said, well, let's just put a little sign in every room. He just laughed and he said okay, tell me about the sign. I was like you know, put a little tit card that promotes the web. And he said okay, that's fine, how much do you think that'll cost? I'm like I don't know. We could probably do a pretty nice one for a dollar, maybe 50 cents if we get it at scale, or something like that. Okay, that's fine, how many we need? We got 300,000 guest rooms, so we need 300,000. I was like, no, he said they're going to get spilled on, lost, torn, whatever we got to buy several million of these things, are we paying or are we, the hotel's paying for it? Hmm, didn't really think about that. I guess we'll pay for it and maybe the hotel's buying as they need. Okay, they have to be folded or they come folded. No, they have to be folded. Who's going to train the bass keepers to fold them? I didn't really think about that. I guess we needed a training program, and it's like you keep going down and down and down and something as simple as putting a little sign in the room, it becomes so operationally complex and, by the way, the instructions have to be in multiple languages and it's like, okay, this is our. I tell that story because third-party management companies. What they have that very often owner-operators don't have, is they have these training and onboarding programs that they can curate, they can manage, they can deliver more reliably. This becomes a big part of the value proposition is that they know how to do this and they have a pool of employees that isn't just working for that one hotel. They're seeing a career, so they're going through a development process. They can train, they can learn, they've got an incentive to develop. That's a big deal because, as the room product becomes more complicated than it's been for centuries or millennia, you need to have people who can support that and I think this is going to be very, very good for the third-party management companies, at least the ones that embrace it. There will be some that resist it because it's hard, but hard means nobody else can do it. Hard means you have a sustainable advantage. Hard means it's worth paying for and I think that's what we're going to see. We already have seen a lot of consolidation in third-party management. That's going to continue and these large, professionally managed organizations are going to continue to press that advantage.

Josiah: 30:02

I appreciate you walking through that with the story that you used to illustrate it, because it shows the complexity but also the opportunity and attribute. Base selling and the strategy that represents, the financial opportunity that represents, is exciting. But there's something for all of our listeners, regardless of where they're at in the ecosystem, and I guess, of course, the final and a very important piece of this would be the investors, the owners, and back to the earlier part of our conversation. This can be a differentiator right If you're looking at your investment opportunities in terms of what is the commercial strategy here, and this can be a bedrock of that and probably should be a criteria that you use as you look at the operators you're working with, the brands that you're working with, as a key lever in driving the sort of financial returns that you're looking for. So I appreciate you walking through this. Is there anything I did not ask you about this or other things related to this that you're hoping to cover?

Del: 30:52

No, I think. The other thing is that it's tempting to see something like attribute-based selling as a nice to have, and I think right now it's an expensive and challenging source of competitive advantage and rate premium. In the long term, though, it does become a competitive necessity. Do we, as an industry, want to wait for other disruptors to come and do this for us, like the OTAs did? The OTAs mastered web booking well before the brands did, long before independence did. They kind of caught us napping what the same thing to happen with our core offering. Somebody shows up and they have a configurable, perfect offering for every stay that they can accommodate that they're built for. Do we want them to disrupt us again and force us to do this, or do we want to be thoughtful about it now and anticipate it and be part of that? Do we want to enjoy that time of advantage or do we want to wait around for it to become something that's hurting us because we don't have it? But I think that's another thing I mentioned earlier about learning from others' mistakes. We've made some in our past. We tended to become very complacent in our business. We got bitten by the OTAs early and on. Well, let's not set ourselves up to do that again. Let's learn from the fact that change is a part of our business, whether we like it or not, and the wave of change that's been incredibly difficult and incredibly intimidating is not stopping anytime in our lifetimes.

Josiah: 32:22

It's actually a really good time to think about it, with the evolution of artificial intelligence becoming more apparent to more people, almost like attribute-based selling. This has been around a while machine learning, big data but things are starting to click a little bit and it feels we're on the cusp of another big change in terms of what's possible with technology. So this is the time. Well, thanks so much for taking the time to chat. I learned a lot and I know our listeners well as well, so thanks for joining us.

Del: 32:46

You're very welcome. I hope to speak with you again soon.