RealMoney Silver - Orient Express' Mystery Is Its Relative Valuation

Orient Express' Mystery Is Its Relative Valuation
By Bill Trent
RealMoney.com Contributor
4/8/2008 2:33 PM EDT

Between the housing bubble bursting, a credit crunch and a slowing economy, it's no wonder that hotel stocks have had a rough year.

In fact, the 20%-30% drops in Starwood (HOT) , Marriott (MAR) and Orient Express Hotels (OEH) over the last year seem in some ways mild, considering the headwinds they face.

The fact that all three have faced similar declines in value is also puzzling, given their great differences in strategy, markets and positions. As long as they trade somewhat as a group, we can find opportunities. Right now, I believe continued underperformance is most likely from Orient Express, while Starwood has the best shot at outperformance.

According to its 10-K, Orient Express is focused on the luxury end of the leisure market. It currently owns or invests in 51 properties (all of which it manages) consisting of 41 deluxe hotels, two restaurants, six tourist trains and two river/canal cruise businesses in 25 countries. The average daily room rate in 2007 was $428, and nearly half of the company's customers were from North America. To me, this sounds like the segment most at risk from a decline in discretionary spending and a weaker dollar.

This hasn't gone unnoticed. Three months ago, the consensus among the analysts covering OEH was that the company would earn $1.61 this year and $1.85 in 2009. Now, estimates stand at $1.40 for 2008 and $1.62 in 2009. A multiple of 27.5 times estimated 2009 earnings in the face of an economic slowdown seems very steep to me.

Starwood has also seen estimates fall, though not quite as steeply. The current consensus expectation calls for the company to earn $2.42 this year and $2.98 in 2009. At 18.5 times the 2009 estimate, Starwood may not be an absolute bargain, but it certainly looks good relative to Orient Express.

That isn't to say that Starwood targets the budget traveler. Its 275,000 rooms worldwide went for an average daily rate of $222 last year. Still, it has a larger and more diversified base, somewhat lower daily rates and proportionately higher emphasis on business travelers rather than leisure travelers, and these factors should help Starwood manage a slowdown more effectively.

Orient Express has been spending heavily over the last few years to grow its business. In 2007, the company generated $52 million in cash flow from operating activity, yet it spent $121 million investing in new capital. In each of the last three years, the company has had to raise as much as $135 million by issuing new debt, issuing more shares or tapping into working capital facilities. If access to financing is curtailed or becomes more expensive, as is likely, the growth efforts may have to take a back seat until the economy mends. That would likely result in additional steep cuts to estimates.

Starwood, meanwhile, can plug along with its expansion plans without needing access to outside financing. Its free cash flow has been positive in each of the last three years, and it amounted to $511 million in 2007. The approximate 5% free cash flow yield is not the best I've seen, but it is nearly twice the current yield on five-year Treasuries. More important, it provides a cushion against any operational slowdown that might rear its head.

With both companies expected to grow their earnings in the mid-20% range next year, I can't see paying a higher multiple for the riskier stock. If Orient Express were to trade at Starwood's P/E multiple on 2009 earnings, it would fall by another 33%, to $30. Meanwhile, I believe Starwood would be justified in maintaining its current free cash flow yield. If free cash flow grows in line with expected earnings, it could rise 23% to $67.50.