Hotels and Lodging Industry Outlook - Feb. 2011 - Industry Outlook

The hotels and lodging industry seems to be back in demand, thanks to the gradual global economic recovery. The industry has been witnessing a return of business travelers, with a rising demand for leisure. However, the rate of improvement in room rates still lags.

Riding on the back of improvement in the U.S. economy and the consequent rise in operating metrics, most of the hoteliers have started reporting positive quarterly results. Profits are expected to rise further in 2011 as bookings continue to improve. Positive estimate revisions give us ample evidence of this growth momentum.

Since the U.S. market is somewhat saturated, hoteliers are exploring growth opportunities abroad. International markets offer greater potential based on the higher pace of economic growth that they currently enjoy.

The U.S. based companies are targeting fast-growing emerging economies. Industry stalwarts such as Starwood Hotels and Resorts Worldwide Inc. (HOT) and Marriott International Inc. (MAR) are specifically eyeing the Asia-Pacific region and Latin America as they promise solid growth going forward.

The Asia-Pacific region gave a stellar performance during 2010. It was the only region to report double-digit RevPAR growth at year end. Major growth markets in Asia-Pacific, China and India, remained more or less unaffected by the global economic turmoil and are enjoying rising economic growth rates. The availability of local capital is another positive factor.

China is all set to bring about a recovery in global tourism, and by 2020, is expected to be the world's largest travel destination. Both Starwood and Marriott derive their second largest revenue chunks from that country.

While in the past, hotels in China were mainly occupied by Western travelers, today, more than 50% of the guests are Chinese. This is indicative of China's fast growing domestic travel market. Moreover, according to an analysis on the enrollment and travel trends of Starwood Preferred Guest members, China is expected to have 100 million outbound travelers by 2015.

Metrics Analysis

In evaluating hotel companies, we pay close attention to changes in average daily room rate (ADR) to figure out the likely pace of improvement in the sector.

A key operating metric in the lodging industry is RevPAR (revenue per available room), which is derived by multiplying the occupancy percentage of a hotel over a given period by ADR over that same period. Changes in either occupancy or ADR will impact RevPAR, but with different implications for bottom-line profitability.

Given the recovery in the U.S. economy, it isn't surprising that hotel occupancy percentages have stepped up. However, declining occupancy percentages last year, compelled some hotel owners to slash room rates in an effort to fill beds. In most cases, this tactic will result in material long-term damage to the business primarily for two reasons:

First, increase in occupancy is accompanied by escalating operating expenses. For every room that is filled, there are additional costs such as housekeeping, laundry and utilities that must be borne. Margins are compressed when room rates decline and variable operating expenses increase. Changes in ADR, however, affect almost entirely the bottom line.

Second, and more importantly, cuts in ADR will be difficult to recoup when the operating environment eventually improves. After slashing room rates in an effort to fill a hotel, attempts to restore these to previous levels are likely to be met with significant resistance from clients. The ability to benefit from an improving economy will thus be delayed.

Finally, the ability of the lodging companies to sustain room rates should have a significant impact on their capability to weather the downturn. Lowering room tariffs should be an absolute last-ditch effort to survive. By keeping an eye on changes in ADR, investors can gain some insight into companies that are best poised to benefit when the economy rebounds.

OPPORTUNITIES

We believe the hotel industry has begun to turn around. We expect this trend of positive demand growth to continue in 2011 and beyond. According to data from Smith Travel Research, the leading information and data provider for the lodging industry, the U.S. hotel industry reported single-digit increases on all three key performance measurements -- occupancy level, ADR and RevPAR -- during the week of January 16-22, 2011.

Comparing the operating metrics with the prior-year period, the industry's occupancy increased 6.5% to 49.8%. As a result, RevPAR rose 9.3% to $47.99. The week ended with a 2.6% rise in RevPar to reach $47.99 at the end of the week. Moreover, supply and demand are likely to have grown 2.2% and 6.6%, respectively, in 2010.

Smith Travel Research projects that the hotel industry will end 2011 with increases in all three key metrics. The expected growth is 1.4% for Occupancy to 57.9%, 3.9% for ADR to $101.55 and 5.3% for RevPar to $58.75. Both supply and demand are projected to rise 1.1% and 2.5%, respectively.

The operating environment in the international market is better, propelling hoteliers to grab bigger shares of the overseas pie. Hotels in the Asia-Pacific region experienced increases on all three key performance metrics for year-end 2010, according to data from Smith Travel Research. The region's Occupancy, ADR and RevPar increased a respective 8.9%, 11.4% and 21.3% to 66.0%, $132.80 and $87.69.

The hoteliers are also focused on rebalancing their portfolios by increasing contributions from managed and franchised hotels. This fee-based business is attractive as growth is powered by multiple sources-RevPAR growth, unit additions and incentive fee escalation. The business is also capital efficient as the owner/developer partners provide the capital and the company then earns a fee by managing/franchising the property.

Currently, there are a number of stocks in the hotel industry universe with a Zacks #2 Rank (Buy). These include Intercontinental Hotels Group plc (IHG) and Morgans Hotel Group Co. (MHGC). The stock with Zacks #1 Rank (Strong Buy) is 7 Days Group Holdings Ltd. (SVN).

We believe companies such as Wyndham (WYN) are better positioned as they are likely to benefit from their repositioning as a more fee-for-service based business. Marriott and Starwood should also benefit from their global pipeline.

WEAKNESSES

Though occupancy levels have fairly picked up, ADR is yet to show meaningful improvement in the U.S. We believe the rate of upside in ADR continues to lag due to the lack of a significant positive catalyst. According to data from Smith Travel Research, the U.S. hotel industry reported a meager rise of 0.6% in ADR accompanied with a 5.6% increase in occupancy for year-end 2010.

Notably, visibility on booking and overall pricing continues to be low and demand recovery is fragile. The booking window, though longer than it was in the time of recession, is still shorter than the normal level.

Given the lower levels of room revenue, margin expansion remained depressed. However, we expect higher room rates in 2011, though the pace of improvement will remain tardy in tandem with sluggish economic growth.

According to data from Smith Travel Research, the U.S. hotel industry is expected to have ended 2010 with an increase of 4.4% in occupancy and 4.3% in RevPAR, but ADR will remain flat with the prior-year period.

The competition is also building up across the sector. Every hotel company is not only competing with major hotel chains in national and international venues but also with home-grown hotels in regional markets. Heightened competition and potential addition of new supply will restrict market share.

By the look of things, we currently refrain from being too enthusiastic on a number of stocks in our universe, which continue to have a Zacks #3 Rank (Hold). These include Wynn Resorts Limited (WYNN), Hyatt Hotels Corporation (H), Choice Hotels International Inc. (CHH), Great Wolf Resorts Inc. (WOLF), Red Lion Hotels Corporation (RLH) and Orient-Express Hotels Ltd. (OEH).

We also remain concerned about the prospects of The Marcus Corporation (MCS), which currently has a Zacks #4 Rank (Sell), and Home Inns & Hotels Management Inc. (HMIN), with a Zacks #5 Rank (Strong Sell).
 
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