Hotels & Lodging Industry Outlook - Oct. 2010 - Industry Outlook

With a gradual recovery of the global economy, the hotels and lodging industry is experiencing an increase in demand. The industry faced extremely tough challenges in the prior year due to the economic turmoil that resulted in weak labor and tight credit markets, resulting in lower discretionary spending.

The recovery in the economy has seen 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 and profits are expected to rise further in 2010, as bookings continue to ramp. We are seeing ample evidence of that in positive estimate revisions.

Since the U.S. market is somewhat saturated, hoteliers are exploring growth opportunities abroad. Hotel companies are seeing higher demand in the international market, as the pace of economic recovery is particularly fast outside the U.S.

U.S.-based companies are targeting fast-growing emerging economies. The Asia-Pacific region specifically promises solid growth, and companies such as Starwood Hotels and Resorts Worldwide Inc. (HOT) and Marriott International Inc. (MAR) are increasing their pipeline in this region.

Major growth markets are China and India. These countries have largely remained unaffected by the global economic turmoil and are experiencing rising economic growth rates. This is expected to considerably increase disposable income and the demand for hotels is expected to considerably outpace supply. The availability of local capital is another positive factor.

Metrics Analysis

In evaluating hotel companies, we will pay close attention to changes in average daily room rates as an indication of how quickly the sector recovers with the improving economy.

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 the average daily room rate (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 is no surprise that hotel occupancy percentages have raised. However, due to decline in occupancy percentages in the last year, some hotel owners started slashing room rates in an attempt to fill beds. In most cases, this tactic will result in material long-term damage to the business for two primary reasons:

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

Second, and more importantly, cuts to ADR are 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 the clients. The ability to benefit from an improving economy will thus be delayed.

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

OPPORTUNITIES

We believe that the recovery of the hotel industry has begun. The trend of positive demand growth is expected to continue in 2010 and beyond driven by economic recovery. According to the data from Smith Travel Research, the leading information and data provider for the lodging industry, the U.S. hotel industry reported mostly positive results on all three key performance measurements – occupancy level, ADR and RevPAR – during the week of 12–18 September 2010.

Comparing the operating metrics with the prior-year period, the industry’s occupancy increased 6.7% to 63.5%. Average daily rate ended the week with a rise of 1.8% to about $100. As a result, RevPAR rose 8.6% to $63.66. Moreover, supply is expected to grow 2.2% during 2010 and demand is projected to increase 6.6%.

Smith Travel Research projects that the hotel industry will end 2011 with increases in all three key metrics. Occupancy is forecast to rise 1.4% to 57.9%, ADR is expected to be up 3.9% to $101.55, and RevPAR is projected to rise 5.3% to $58.75. Supply during 2011 is expected to grow 1.1% and demand is projected to rise 2.5%.

The operating environment in the international market is better, which is driving hoteliers to increase their share of the overseas pie. Hotels in the Asia-Pacific region experienced increases on all three key performance metrics for August 2010, according to data from Smith Travel Research. The Asia-Pacific region’s occupancy rose 5.8% to 67.2%, ADR increased 10.0% to $129.00 and RevPAR jumped 16.5% to $86.74.

The hoteliers are also focused on rebalancing their portfolio by increasing the contribution 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 managing/franchising the property. Additionally, the fee business is less cyclical than owning hotels.

Currently, there are a number of stocks in the hotel industry universe with a Zacks #1 Rank (Strong Buy). These include Home Inns & Hotels Management Inc. (HMIN), Intercontinental Hotels Group plc. (IHG) and Wyndham Worldwide Corporation (WYN). The stocks with a Zacks #2 Rank (Buy) are Marriott and Starwood.

We believe companies such as Wyndham are better positioned as we expect these companies 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 somewhat improved, ADR has yet to show meaningful improvement in the U.S. ADR has started to inch up, but the rate of upside still lags. There is a lack of a significant positive catalyst in room rates. According to data from Smith Travel Research, the U.S. hotel industry reported a decrease of 2.0% in ADR for the first time in 13 consecutive weeks for the week ending Sep 11, 2010. The fall in ADR was due to the Jewish New Year on Sept. 9, 2010 compared to the previous year, when it was on Sep 19. However, in the very next week ADR was positive.

Given the lower levels of room revenue, margins remained constrained in the prior quarters. However, we expect higher room rates by the end of this year, though the pace of improvement is expected to be slow as the economy is projected to improve only sluggishly. Besides, some sort of volatility is noticeable in the hotel industry’s performance metrics. However, we expect stability in the upcoming quarters with an improvement in the operating environment.

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

Additionally, the year-over-year comparison from the fourth quarter of 2009 onwards eased out as the quarter reflected the first anniversary of the abrupt decline in lodging demand.

Financial distress has engulfed all business sectors, including the hotel and lodging industry. Although the industry is showing gradual improvement, a high unemployment rate coupled with an expectation of a prolonged economy in 2010 is expected to restrict margin improvements as room rates are being pushed down. In addition, companies with weak balance sheets – or even limited financial flexibility – will likely have a harder time navigating the challenges created by the recent economic recession.

The competition in the industry is increasing as well. Every hotel company is not only competing with major hotel chains in national and international venues but also with local home-grown hotels in regional markets.

Hotels & Lodging Industry Outlook – Oct. 2010 – Industry Outlook

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