OceanLink Partners Q1 2019 Letter

OCEANLINK
MANAGEMENT LTD. | [email protected] | (416) 323 -‐ 5095

May 15, 2019

Dear Partners,
The OceanLink Partners Fund’s unaudited gross and net returns for the first quarter of 2019 were
47.34% and 39.15%. This puts our returns since inception (2017/06/01) at 92.62% and 70.61%,
respectively.1
Returns OceanLink, Gross OceanLink, Net MSCI China All Shares MSCI World, Net
2017 (7 months) 30.08% 23.85% 22.85% 11.04%
2018 0.50% -1.00% -23.27% -8.71%
2019 YTD 47.34% 39.15% 22.29% 12.48%
Cumulative 92.62% 70.61% 15.27% 14.02%
Annualized 42.98% 33.83% 8.06% 7.42%
Given your and our long-term focus and the inherent volatility in our investment strategy, what
happens to the quoted value of the portfolio in a month, a quarter, or even a year should be of
little significance to you, and to us. As we have asked all of you to commit to a three year
investment, our preferred KPI for OceanLink is a three-year CAGR, so we encourage you to sit
back and skip the first paragraph of our future investor letters until the Q2 issue of year 2020.
Service Champions
Sometimes the best investment ideas are products of theory crafting. Anyone who has played
with a DCF model knows that the one variable to which intrinsic value has the highest sensitivity
to is the terminal growth rate, which is a simplified way to really describe two key inputs: how
fast is a company going to grow and for how long can the growth be sustained? As such, it can
be said that the companies which grow the fastest and for the longest duration are deserving of
the highest earnings multiples. What are those businesses in China? We have always wondered.
A year ago we set out to find the answer.
We began by identifying sectors that present the longest secular growth prospects. Starting from
the big picture, all of the “Confucius” countries which successfully developed their economies
follow a consistent pattern – their growth models are highly “unbalanced”. In the early stage of
economic development (from an agricultural economy to an industrialized one), they prioritized
building up their capital stock and talent base, which manifested in a high savings rate, rapid
urbanization, and the creation of a robust export economy. During this period, income grew
significantly slower than GDP per capita as productive inputs shifted from labor to capital. The
industries which benefited disproportionally from this stage were either capital intensive (real
estate developers, heavy industries) or those that financed their growth (banks).

1
The performance results for Q4 2018 (period ending December 31st) represent unaudited returns for the Class A Limited
Partnership interests, and the net returns are presented net of management fees, accrued performance allocation and all other
fund-level expenses. Each individual investor’s actual performance may be materially different.
1
OCEANLINK MANAGEMENT LTD. | 2 BLOOR STREET W | SUITE 1902 | TORONTO, ON | M4W 3E2

OCEANLINK MANAGEMENT LTD. | [email protected] | (416) 323 -‐ 5095

As these economies crossed the middle-income mark, a reversal took place. GDP growth
moderated as capital formation slowed. Slowing urbanization brought an end to the
“demographic dividend”, causing a shortage in labor supply and rapid wage growth that
outpaced GDP. This resulted in labor’s share of GDP increasing at the expense of capital, and
rising domestic consumption. Within consumption categories, service industries enjoyed growth
that meaningfully outpaced retail goods, as new demand emerged for services that previously
didn’t exist when living standards were lower.
With China at the cusp of breaking the middle income boundary, the economic rebalancing is
likely to usher in an era of sustained high growth in services. At the same time, the low barriers
to entry in most service industries make them highly fragmented, even in verticals ripe for
consolidation. This gives the best quality operators an unique opportunity to consistently expand
their market share while riding the wave of double digit industry growth year after year, all the
while a multi-decade growth runway lies ahead of them.
Compared to another popular “compounder” theme - Chinese Internet companies, these “Service
Champions” offer a few notable advantages:
First, they tend to operate in industries that are less susceptible to technological disruption.
At the same time, they face weaker rivals, the majority of which consist of mom and pop
operators as opposed to another Internet giant.
In addition, the labor intensive nature of these industries necessitate that the skills required in
building a winning model, culture and operating procedures require years of trial and error to
master, unlike in Internet where skills tend to be more transferable and a successful platform in
one vertical can easily invade into another to compete for dominance.
Lastly, the optimal growth model of a successful Service Champion is fundamentally different
from that of an Internet monopoly. The nature of the network effect mandates that Internet
platforms are highly capital intensive in the early stages of development, as they must spend
aggressively to outgrow their competitors. A typical Internet company can burn cash for many
years before turning profitable, at which point new technology has often already emerged to
disrupt its business model. The service industry is quite the opposite. Service Champions rarely
use aggressive discounting to gain market share because discounts cheapen the brand and attract
the wrong type of customers. They also face growth bottlenecks from a talent development
perspective, so the objective is not to compete on volume, but to grow sustainably without
compromising on quality. As a result, all Service Champions are profitable from the early days,
and tend to be far more profitable than smaller competitors. Instead of relying on VC money to
fund aggressive growth, they finance expansion with internally generated cash, often with free
cash flow left over to be allocated elsewhere.
We have spent the past eight months exploring the “Service Champion” theme, in the process
studying several companies in depth. All four of this year’s letters will be devoted to our findings
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on this subject. In these, we will detail not only the companies we invested in, but also those we
studied and passed. We believe these summaries should give you a good insight into how we
evaluate moats and management teams and how we approach decision making. Five years from
now they will make interesting case studies when we look back at our decisions.
To start, what are some of the key characteristics of industries that are suitable for creating
Service Champions in China? In our experience, they tend to follow these patterns:
1) The industry is extremely fragmented where even the top players only make up single
digit % market share; more often than not the majority of players in the industry are
single location operators (mom and pops). This ensures the leading player will have a
multi-decade runway to compounding its market share.
2) The provision of the service is relatively complex and requires multiple skill sets and
capabilities. A large number of business processes are typically required to render the
service. Here we use the “instruction manual” test: if all the business procedures are
written into an instruction manual, how many pages would it be? The thicker the manual,
the harder it is to standardize service quality, and the more valuable standardization
becomes as a competitive advantage.
3) The ultimate goal of creating a “Service Champion” is to create a brand that conveys
consistency. For consistency to be meaningful, the service must have returning customers
and involve a sufficient level of information asymmetry that standardization can be used
to reduce search cost and create loyalty. This is not possible if the customer life cycle is
too short (like wedding planning) or if there is no meaningful room for “unbranded”
players to cut corners (like massage clinics).
4) There must be sufficient rationale for consolidation in the industry. Perhaps scale leads to
procurement and supply chain advantages. Perhaps increasing regulatory burdens are
making small competitors unviable. Perhaps the service is so critical to the customer that
they naturally gravitate to only the most reputable providers. If scale doesn’t lead to real
advantages, the industry will forever stay fragmented.
5) Finally, for consolidation to take sufficient speed to drive an attractive long-term growth
rate, we are only interested in industries where single-location operations are uneconomic
(not profitable when not evading taxes and when accounting for owners’ salaries). This is
important because industries with low profitability tend to incentivize small operators to
cut corners, which hastens the consumers’ switch to more trusted brands. Over time, the
lack of returns will also accelerate the exit of weak players from the industry, leaving
more room for the leading players to expand.
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A great example that meets all of the above criteria is retail pharmacies. It’s an extremely
fragmented industry in China where half of the industry consists of single store operators. It’s a
relatively complex business that involves a retail component (choosing the right drugs to sell and
procuring them at favorable prices), a supply chain component (handling logistics and working
with suppliers to create private label products), an advisory component (the pharmacist taking
the role of a family doctor and recommending drugs to patients), and deals with insurance and a
long list of government regulations. The business involves high degrees of information
asymmetry where small operators cutting corners often lead to drug safety and misuse issues, so
standardization accrues mindshare to the most trusted brands. Consolidation is inevitable, as
government regulations have tightened to make life impossible for mom and pops and scale leads
to significant procurement savings. Additionally, very few small operators make a profit when
adjusted for the owners’ salary, so the pace of consolidation will be swift, allowing the leading
players to take share at high rates for years to come.
On the other end of the spectrum are barber shops. While also extremely fragmented, barbers are
very simple businesses that involve very few processes (it’s just a guy cutting hair). Information
asymmetry is not particularly problematic – the worst outcome is a bad haircut. Standardization
is also not highly valued because people inherently seek different hairstyles to express their
individuality – the most popular barbers are often ones that deviate the most from “industry
conventions”. There is also no strong industrial logic in consolidation, since scale benefits are
nonexistent and government intervention is minimal. Being a relationship business (customers
are often friends with their barbers), customers are highly sticky and rarely switch for “branded”
providers. Consequently, this is not an industry suitable for producing Service Champions.
This brings up our next question - what qualifies one as a Service Champion? We think they all
have the following characteristics in common:
1) The company has developed a robust management system designed to make every
business process replicable across its entire footprint, coupled with proper incentives to
encourage compliance with the system.
2) There is clear evidence of a culture and a value system that self-selects the right
employees and motivates them to satisfy customers.
3) The company manages all of its own locations to ensure service quality. The traditional
franchise model of outsourcing manager duties to a third party does not work in China.
4) The brand is highly recognized and the company ranks within top five of the industry in
terms of scale, while the business model has demonstrated an ability to appeal across
different provinces with diverse cultures.
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5) The company should possess unit economics far superior to small players, typically
reflected in higher revenue per location, higher margins at mature stores and higher
average revenue per employee.
6) The company should deliver organic growth consistently in excess of the industry (the
rule of thumb is the best operators should grow 3x industry average), and should be
taking share locally, reflected in best-in-class same store sales growth.
7) The management team is able to deliberately prioritize quality consistency over the
growth rate.
Below we discuss two companies that we have studied which are representative of these
characteristics.
Haidilao
Haidilao is perhaps one of the best examples of a Service Champion in China. Some of you may
recall that we first mentioned Haidilao in the Q4 letter of 2017 as part of a discussion on our
investment in Yihai (Haidilao’s condiment business). Lo and behold, just six months after our
write-up, Haidilao went public and has since surpassed Yum China to become the most valuable
restaurant chain in China.
What’s responsible for the success of Haidilao? In the original letter, we described the
company’s customer service philosophy guided by a familial culture that seeks to maximize the
potential of its migrant worker employees. However, that was only part of the picture. Just
having loyal and hardworking employees is not a sufficient condition for creating a highly
standardized service culture, yet Haidilao is famous for the consistency in its quality, so much so
that on the top restaurant review sites, almost every Haidilao location has a customer rating that
ranks it within the top 100 restaurants in its city. This is quite an outlier outcome considering that
most cities in China have at least thousands of restaurants. The result is even more extreme if we
consider the fact that in many markets, as many as half of the top 20 rated restaurants in the
entire city are Haidilaos. Haidilao is not only consistent, it is in fact consistently the best.
Creating and maintaining standardization in the full service restaurant business is an extremely
delicate task. In the US, almost every casual dining concept that had once been viewed as
destined to succeed has flamed out once they reached a certain size. The operational complexity
of casual dining chains means that it is simply too difficult to reach national scale without
diluting service quality. In fact, scaling has proven so difficult that only one casual dining
company in the US, Darden, has ever reached a market value higher than $10 billion, and that
was achieved with the help of 8 separate concepts, which pales in comparison with Haidilao’s
achievement with just a single brand. The relationship between scale and standardization is a
conflicting one – while standardization is a pre-requisite to creating scale, growing scale also
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makes maintaining standards increasingly hard. Once a full-service restaurant concept surpasses
a few hundred locations, the growing complexity almost always overwhelms the operator’s
ability to manage it. Scale benefits also work both ways – on the way up, a growing presence can
help a brand quickly establish mindshare, so every new store added actually benefits the existing
store network under the same brand. On the other hand, the moment the concept outgrows its
ability to maintain a certain level of quality, just a minority of underperforming locations can
create enough negative reputation to undermine the entire franchise.
How Haidilao created a system of standardization to maintain high quality across all of its stores
in a period of rapid expansion is instructive for those looking to invest in the Service Champion
theme. In essence, we believe Haidilao owes its success to a management system consisting of
four components: training, incentives, promotions and supply chain.
Training: To start, unlike chains in the US, Haidilao does not use part-time workers. Working at
Haidilao is a serious 80 hour per week job no matter what your role is. This ensures that every
employee is able to complete the full training regimen. The training system at Haidilao is
extremely comprehensive. Instead of starting the job at the store, all new trainees are sent to a
centralized facility for initial training - a type of military drill to set expectations and instill
discipline. They are then given clear instructions on just about every aspect of their job down to
the most minute details. For instance, servers must be present at the table within five seconds of
the guests arriving. Hot towels must be handed out exactly two minutes after the guests sit down,
with strict temperature control (80 degrees). The towel then needs to be replaced at least four
times for every guest during their meal. Food runners not allowed to return empty handed after
serving food and must clean at least one table on their way back to the kitchen. Employees are
required to memorize and adhere to countless other standards and policies, and are regularly
tested to ensure compliance. Going beyond just following instructions, trainees are also taught
how to converse with customers and how to anticipate their needs, so they can fulfill those needs
before the customers even ask for them.
Performing up to Haidilao’s expectations is exceptionally difficult – very few trainees make it to
a regular employee. In exchange, the company treats them generously, providing them with free
housing, free meals, an above-market salary and an opportunity to eventually become a
millionaire if they are ever promoted to store manager. The training doesn’t stop even as
employees advance through their careers: store managers must go to Haidilao University to take
courses every year, and regional managers are sent to Renmin University to complete an EMBA
program to broaden their horizons.
Incentives: To create the best customer experience possible, Haidilao’s training is paired with an
incentive system that provide both positive and negative reinforcement. Lower level employees
derive a large portion of their income from bonuses which are awarded on the basis of
performance and customer feedback. Top employees’ parents receive stipends and free meals
from the company, and are promoted quickly – the most outstanding ones rose from dish washers
to store managers in just 18 months. On the other hand, employees are fined for “light”
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misconduct (such as being late) and face termination for a variety of behaviors that are
inconsistent with the company’s values: arguing with the customer, lying, gambling, taking
kickbacks, not taking care of one’s parents, and so on.
Haidilao’s restaurant manager incentives are highly innovative: new store managers receive 2.8%
of the store’s profit. Managers who have successfully cultivated “apprentices” that are approved
to run new restaurants instead receive 0.4% of profits at their own stores and 2.8% of store
profits from every “apprentice” under them. If the apprentices have produced apprentices of their
own, their teachers receive a further 1.5% of profits from the stores run by the 2nd generation
apprentices. On the other hand, the store manager is terminated if he doesn’t produce at least one
reserve manager within three years. This system creates a strong incentive for managers to
develop new talent which can be used to fuel expansion – some of the most successful “teachers”
can potentially receive profits from dozens of stores amounting to millions of RMB each year.
A unique evaluation system is used as a quality check on the apprentice model. All new manager
candidates must pass an exam at Haidilao University to get “certified”. Every quarter, Haidilao
sends 15 “secret guests” (consisting mostly of long-time customers) to each restaurant to dine
and rate the service. At the end of the quarter, the company averages these ratings (A = excellent,
B = average, C = fail) to assign an overall grade to each manager. Only A rated managers are
allowed to train apprentices and share in their profits. C rated managers are given a warning and
six months to turn around their performance (with help from coaches), while getting three Cs in a
row results in a demotion back to a regular store employee. In the scenario in which an A rated
restaurant sees its rating slide, the manager automatically loses all profit sharing including those
from his apprentices. As a redundancy, the company also employs two separate teams to
internally audit the stores’ performance and search for potential misconduct. These practices
have allowed Haidilao to create a culture of checks and balances, which align incentives between
the store manager, the customer and the company.
Promotions: The promotion system at Haidilao also sets itself apart from the rest of the industry.
With the exception of engineering and finance personnel, all employees at Haidilao must start
from the most basic role – the dish washer. Unlike other restaurants which treat servers as the
lowest denominator, Haidilao designates servers as an intermediate position at the store level –
one must successfully advance from dish washer to food runner, and from food runner to server.
This ensures that every employee is experienced before they step into a customer facing role.
The best servers are then promoted to provide manicure and shoeshine services in the waiting
area before they are considered for more senior responsibilities. All promotions are self-
requested, and the employee must both be popular among customers and other co-workers to
advance. In addition, the employee’s boss’s boss is responsible for approving the promotion,
rather than his immediate superior. This ensures that merit, rather than politics, is the primary
determinant of who gets promoted and who doesn’t. In order to become a store manager, the
employee must rotate between and excel at every single position in the store – accountant, head
of staff, lobby manager, and so on. Only those considered “all rounded” are allowed to advance,
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so that by the time an apprentice is elevated to the manager role, he/she is already intricately
familiar with every aspect of running the business. The best store managers are then promoted to
regional managers, who then will have a chance at being considered for VP positions at
headquarters. High level employees are still required to work at a restaurant a couple of times
each year to maintain a deep understanding of customers.
Supply Chain: Finally, running a restaurant chain with a national footprint requires a modern
supply chain that can service each region at an acceptable cost. This is a much bigger challenge
in China than the US because raw material suppliers in China are far more fragmented and
highly regional. Quality control is a significant issue, as producers and wholesalers often cut
corners and slow shipping can result in high loss rates of fresh ingredients. The lack of price
transparency and changing prices every day create room for corruption, as restaurant purchasing
managers are known for colluding with wholesalers in exchange for kickbacks. Not having
access to high quality supply chain infrastructure has thus become the biggest bottleneck for
growth for many restaurant chains in China.
Haidilao solved the supply chain problem the old school way by creating its own suppliers in-
house – Yihai to provide condiments and Shuhai to procure and distribute fresh ingredients.
These units were instructed to adhere to the highest quality standards, and were later turned into
profit centers when Haidilao opened their services to third parties. Today Yihai is the largest hot
pot condiment brand and Shuhai is the largest restaurant supply distributor in China. Both derive
the majority of sales from third party customers. In addition, Haidilao created a comprehensive
monitoring system designed to dissuade corruption, by paying purchasing managers far above
market and setting up an internal monitoring organization to periodically audit procurement
practices. Purchasing managers are rotated frequently to ensure that they can’t build personal
relationships with suppliers, and are immediately terminated even for receiving the smallest
benefits (ex. a pack of cigarettes).
What’s admirable about Haidilao’s management system is that within each component, the rules
and practices are consistent about the set of values that Haidilao wants to uphold among its
employees: integrity, customer centricity, meritocracy, respect for each other and hard work. It is
these values that set Haidilao apart from the competition and keep customers coming back. It
should also be noted that none of these systems work in isolation: no one can endure the high-
intensity training without proper incentives that reward hard work; no amount of monetary
incentives alone is enough to keep the top employees satisfied without any prospect of advancing
to positions of higher responsibility; no store manager can ever get an A grade without the proper
supply chain to guarantee food quality. These systems all reinforce each other and just getting
one of them right is not enough for a competitor to replicate Haidilao’s success without
mastering the rest.
Haidilao’s plan is to eventually scale the concept to 3,000 stores in China alone (from fewer than
300 when we wrote the original letter), opening 200 – 300 new locations each year. This makes
it one of the fastest growing casual dining concepts globally, and one of the very few that we
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suspect can truly achieve its “TAM” without compromising on quality. If we are so confident in
Haidilao’s future success, why did we pass? The way we see it, our ownership in Yihai
effectively gives us a royalty on future Haidilao expansion, while Yihai’s downside is more
limited since its third party business involves fewer variables that can go wrong (selling
condiments through supermarkets is a much easier business to run than restaurants). Meanwhile,
Yihai has traded at a considerable discount to Haidilao because of its low profile. As such, we
ultimately concluded that Yihai remains the better investment on the Haidilao thesis.
Huazhu Group
We chose to feature Huazhu as a case study because we believe its success provides valuable
insights on how the perfect service business is created when great people, culture and business
model intersect. Huazhu is the second largest, and by far the best managed hotel franchise in
China, with a footprint mainly in the economy (corresponds to 1 & 2 stars) and mid-scale (3 & 4
stars) segments. Huazhu was an early pioneer of the limited service hotel (LSH) model, a
relatively new concept which started taking off in the mid-2000s. After 15 years of consistent
market share gains, today LSHs command a 30% penetration of total hotel expenditures.
Huazhu’s success was built on creating a culture of service and innovation that perfect the LSH
value proposition.
The key tenant of Huazhu’s culture is extreme customer centricity. It is this ability to deeply
empathize with the guest that allowed Huazhu to do away with the excesses of the traditional full
service (or “starred”) hotel model and pioneer the LSH concept, which offers an equivalent level
of comfort and convenience with better customer experience at a much lower cost. For instance,
most of the amenities (gym, convenience store, conference rooms, swimming pool, business
center, lobby bar, a second restaurant, etc) provided by “starred” hotels are rarely used by
Chinese travelers. The hotel can maximize its utilization by building hotel rooms in their space
instead. Concierge service incurs unnecessary labor cost and is privacy-unfriendly, so it’s not
included in Huazhu’s services either. Most hotels in China charge for Wi-Fi – a huge pain point
in a mobile-first society, so Huazhu makes Wi-Fi free and easy to access. Traditional hotels litter
guests’ work desks with pointless items, such as the traveler’s guide, magazines, room service
menus and TV guides; few people ever use them and re-arranging these items is unnecessary
workload for cleaners. Instead, desks in Huazhu hotels only have a phone (with only one button
to contact the front desk) and some simple decorations. Carpets are comfortable, but also very
difficult to clean and represent a health risk due to the accumulation of bacteria, so Huazhu uses
hardwood floors in their place. Travelers rarely have the time to take baths, so the bathtub is a
waste of space and money; Huazhu eliminates them and reinvests the savings into high quality
shower equipment. There are countless other examples where the company has found ways to
create a better guest experience by doing less: mini fridges are rarely used, and create noises at
bedtime that often wake guests in their sleep. Hotel alarms have very unfriendly UIs, and are
unnecessary in the era of mobile phones. Safes serve no useful purpose since nobody carries cash
9


nowadays, and people often forget to take the belongings they deposit in them. None of these
items is on the menu of the Huazhu experience. The company instead takes the money that it
saves from these useless accessories and reinvests it in the essentials, such as a bigger and more
comfortable bed, better furniture and higher quality bathroom supplies. What’s left over is
passed to the consumer in lower prices. As a result, Huazhu hotels command some of the highest
customer ratings on review sites and are often priced at a 20 - 30% discount to their “starred”
equivalents.
In addition, Huazhu has invested heavily in automation technology that both improve experience
and save on cost. For example, card keys are often unreliable and are easily left in the room
locking the guest out, so Huazhu built a system where guests can use their smartphones to open
room doors. The biggest time waster for travelers is the hotel check-in process, which usually
takes at least 20 minutes and consume most of the work hours of front desk employees, so
Huazhu created technology to enable automated check-ins using the Huazhu app.
Huazhu’s automated hotel check-in system is partly responsible for creating what is arguably the
most successful hotel loyalty program in the world. Because the front desk employees no longer
need to waste their time helping customers with check-ins, they can now focus most of their time
signing up customers for the loyalty program (the number of new sign-ups is their most
important KPI). The program offers customers substantial benefits for booking hotel rooms
within Huazhu’s portfolio, such as automatic discounts ranging from 5 to 15% (depending on the
membership tier), reward points to pay for future bookings, free breakfast and preferential check-
out times. Aggressive front desk promotions have helped Huazhu accumulate an astounding 120
million members, nearly 10% of China’s population, in the process creating a loyal group of
users, with nearly 90% of bookings generated through organic channels (the app or walk-ins).
As a result, Huazhu hotels have the lowest customer acquisition cost in the industry, while
enjoying the highest occupancy rates – 89% on average. This compares favorably to the industry
standard of 60 – 70%. High demand has helped the company realize steadily improving
economics, with same-hotel revenue per average room night (RevPAR) rising double digits in
recent year.
While Huazhu uses the franchise system, it retains strong control over service quality at its
franchisees by forcing them to use Huazhu-employed managers, all of which have gone through
Huazhu’s rigorous 3-year training program. Huazhu owns roughly 20% of its system-wide hotels;
all the managers at these 700 locations are bound to the KPI of producing 1 to 2 qualified new
managers each year. This “talent assembly line” produces a steady supply of over a thousand
new managers every year to staff Huazhu’s new properties. As part of Huazhu’s agreement with
its franchisees, Huazhu managers have full discretion in the operations of their hotels, creating a
high level of standardization across its properties. At the same time, Huazhu also manages the
construction and furnishing of franchisee hotels to the same standard under each of its 17 sub-
brands, ensuring that the experience is always consistent when staying at a Huazhu property. In
an industry where independent operators have a reputation for cutting corners, Huazhu’s
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consistency has made it one of the most trusted consumer brands. Many travelers (such as
ourselves) default to the Huazhu app to book travel accommodations without even checking the
OTAs for alternatives.
Huazhu’s higher-sales-at-a-lower-cost model translates into an attractive value proposition for
franchisees. In China, LSH brands have historically focused on growth through converting
existing independent hotels into franchisees as opposed to new builds. Converting existing
capacity requires less capital expenditures, time and allows for a faster rate of expansion. A
secondary benefit of this approach is that hotel conversions limit the amount of new capacity
being released into the market, which helps maintain pricing. The unit economics of franchising
with Huazhu is extremely attractive: when an independent hotel converts into a franchisee, it
typically experiences a 10%+ uplift in occupancy rate and a 15%+ increase in average daily
room rate (ADR). Customer acquisition cost is dramatically curtailed, with bookings from the
OTA channel reduced from 40 – 50% of total to just over 10% post-conversion. In addition,
Huazhu’s automation and superior management system help the franchisee reduce its employee
headcount from the industry average of 35 to just 18 per 100 rooms, shaving off another 5 to 10%
of sales in personnel costs. In return, the franchisee only pays a 5% royalty to Huazhu
(sometimes another 2.5% for use of the centralized booking system). The end result is that new
franchisees enjoy an extremely short payback period – on average 1 to 1.5 years on their
conversion Capex.
As an increasing number of independent hoteliers join the Huazhu brand, they help increase the
network’s geographical coverage. This completes the positive feedback loop inherent in
Huazhu’s business model – higher coverage translates into more loyal customers and higher
booking frequency, which lead to better economics for franchisees, which result in more
franchisees joining the network and even higher coverage. The outcome is a growing number of
“Huazhu-only” travelers who never need to stay at another hotel (similar to shoppers who only
use Amazon to buy everything).
Who are the people behind this amazing culture and business model? Huazhu’s founder is one of
the most impressive entrepreneurs we have studied in China, and the only one to have created
three NASDAQ-listed public companies in succession. Before Qi Ji founded Huazhu, he was a
co-founder of Ctrip and Home Inns (later sold to Huazhu’s largest competitor). We admire Qi
Ji’s focus – in a country where new opportunities seem to pop up every day in many industries,
Qi has stubbornly and singularly focused his attention on the hotel industry for the past twenty
years. This has allowed Huazhu to develop deep expertise in its field, while many others have
seen their competitive advantages eroded by making inroads into new businesses.
Qi Ji’s contribution to the hotel industry was partly rooted in his ability to bring a technology
executive’s perspective to a traditional industry, which has allowed the company to think
differently than its peers and be the pioneer on innovations. At its root, the hotel business is
about efficiency - how to provide the best possible customer experience at the lowest cost. Every
innovation that Huazhu brings to its business evolves around optimizing these two variables.
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Doing so requires a deep understanding of the needs and pain points of the consumer, and a
founder obsessed with customer experience.
Furthermore, Qi Ji’s data-driven mentality was instrumental in creating a system of meritocracy
and accountability. At Huazhu, every employee’s output is carefully measured and compared
against the appropriate KPIs; everyone’s pay also has a large variable component tied to those
KPIs. Every outlier success in every industry that we have studied in China is managed this way.
There is no better way to build a great business than creating a proper alignment of incentives.
What initially attracted us to Huazhu as an investment candidate is the company’s long-term
growth potential. Despite its industry leadership, Huazhu currently only has a 20% market share
in the LSH segment and just over 6% market share in the overall hotel industry. The tailwinds
behind the company are powerful: We believe it is virtually certain that LSH penetration will
continue to increase (eventually approaching 100% of economy and midscale segments). At the
same time, hotel chain penetration rate in China is just over 20%. Our research indicates that the
vast majority of independent hotels are unprofitable on a standalone basis (when excluding the
owners’ salaries or counting rent for owned locations), so the pace of consolidation will be swift
– what took 30 to 40 years for the US to accomplish may well take China only 10 years. Best
positioned to benefit from consolidation, Huazhu has the ability to sustain a 10%+ growth rate in
hotel rooms for a long time. In addition, Huazhu’s hotel mix is improving markedly. While the
economy segment in China is already mature, with almost 90% LSH penetration, the midscale
segment is growing rapidly from Consumption Upgrade and LSH penetration of 30% is still
quite low. The result of this is that midscale hotels represent only a third of Huazhu’s current
portfolio but is expected to consist of 80%+ of Huazhu’s incremental hotel growth every year.
Since midscale properties have almost double the RevPAR of economy ones, this mix shift can
add to Huazhu’s bookings growth meaningfully. Combined with a low-to-mid single digit
expansion in RevPAR, we believe Huazhu should sustain a 20%+ growth rate in its bookings
and even faster growth in earnings power.
Another appeal of Huazhu is its competitive landscape. In China, the LSH segment is dominated
by three domestic hotel chains which control a combined 60% market share; no other player
comes close in scale. The three are comparable in size and each has gained market share in the
past five years. What gives Huazhu a unique competitive advantage is the fact the both of its
main competitors, Jinjiang and BTG, are state-owned. As a result, they are less well-managed
(with much lower occupancy and margins) and far less aggressive with expansion. Since no
other player in China has the critical mass to compete with the Big Three (scale is required to
build out the membership network which creates the necessary low customer acquisition cost to
complete the virtuous cycle), Huazhu’s competitive advantages appear to only widen over time,
with no serious threat in sight.
Looking at the big picture, we think LSHs are a decent quality business in China. While
somewhat sensitive to the economy, hotel expenditures benefit from the secular growth of travel
and should continue to grow at a good clip for a long time. Industry capacity growth is rationally
12


subdued - since most independent hotel chains are uneconomic, the only players who get a
satisfactory ROI from adding capacity are the largest chains. As a result, the Big Three account
for 15% of total capacity but have been responsible for more than 55% of hotel room additions
from 2013 to 2017. Furthermore, the industry faces no real prospect of technological disruption
and very limited substitution risk. The Airbnb concept has low appeal in China because hotels
are very cheap (a 4 star can cost less than $70 in a tier 1 city) but apartments are quite expensive
and don’t come with a lot of rooms to spare.
So why did we pass on Huazhu? While we like the business and admire the management team,
so does the stock market. Investors have rewarded Huazhu’s impressive track record with a
premium valuation – 24x our estimate of this year’s EBIT. While the stock traded down to a
more reasonable 16x late last year, we failed to capture the opportunity as it rebounded 60%+ in
the period it took us to study the company. Though we think Huazhu investors can still fare well
at today’s price, 24x is higher than any Chinese stock that we own, and Huazhu’s expected
earnings growth of 25 – 30% per annum puts it on the low end of our portfolio. We ultimately
concluded that this is one that we should follow until a more attractive entry point presents itself.

We thank you for your trust and support, allowing us to invest for the long-term,
Steven & Richard

13


DISCLOSURES: This document contains highly confidential information regarding the portfolio, strategy and organization of
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monitor investments in the Fund managed by OceanLink, (iii) not use the Confidential Information for purposes of trading any
security, (iv) not copy this document without the prior consent of OceanLink, and (v) promptly return this document and any
copies hereof to OceanLink upon OceanLink’s request.

This document is for informational purposes only and nothing herein should be viewed as an offer, solicitation of an offer or
recommendation to buy or sell an interest in the OceanLink Partners Fund, L.P. (the “Fund”). Any offer of an interest in the
OceanLink Fund will only be made by means of an offering memorandum as it may be amended, supplemented or restated
from time to time (the “Offering Memorandum”), which would contain material information (including certain risks of investing
in the Fund) not contained in this document and which would supersede and qualify in its entirety the information set forth
herein. Any decision to invest in the Fund should be made after reviewing the Offering Memorandum, conducting such
investigations as the investor deems necessary and consulting the investor’s own legal, accounting and tax advisors in order to
make an independent determination of the suitability and consequences of an investment in the Fund. None of the Fund or
their affiliates makes any representation or warranty, express or implied, as to the accuracy or completeness of the information
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past or future performance of the Fund.

The analyses and conclusions of OceanLink contained in this presentation are based on publicly available information.
OceanLink recognizes that there may be confidential or otherwise non-‐public information in the possession of the companies
discussed in the presentation and others that could lead these companies to disagree with OceanLink's conclusions. The
analyses provided include certain statements, assumptions, estimates and projections prepared with respect to, among other
things, the historical and anticipated operating performance of the companies. Such statements, assumptions, estimates, and
projections reflect various assumptions by OceanLink concerning anticipated results that are inherently subject to significant
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Prospective investors should be aware that an investment in the Fund is speculative and involves a high degree of risk. There
can be no assurance that the Fund’s objectives will be achieved or that an investor will receive any return on its investment in
the Fund. The Fund’s performance may be volatile. An investment should only be considered by persons who can afford a loss
of their entire investment. The Fund expects to invest substantially in equity securities. The value of these securities generally
will vary with the performance of the issuer and movements in the equity markets. In the event of the death, disability or
departure of any of principals or other key members, the business and the performance of the Fund may be adversely affected.
There is no organized secondary market for investors’ interests in the Fund, and none is expected to develop.
The specific security identified and discussed in this presentation represents a current holding of the Fund. The specific security
does not represent all of the securities purchased, sold or shorted by the Fund. The audience should not assume that
investments in the security identified and discussed were or will be profitable. The purchase of this security only will not create
a diversified portfolio. It should not be assumed that purchases, sales or shorts made by the Fund in the future will be profitable.

This presentation contains forward-‐looking statements that relate to certain securities owned by the Fund. These forward
looking statements may be identifiable by words such as, among others, “anticipate”, “estimate”, “expect”, “hope, “believe”
and similar expressions, and are located throughout this presentation. Prospective investors should be aware that these
statements are estimates, reflecting only the judgment of OceanLink and prospective investors should not place reliance on any
forward looking statements. Actual results and events could differ materially from those contemplated by these forward
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presentation or to reflect the occurrence of unanticipated events
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May 15, 2019

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May 15, 2019

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