Rally in Hotel Stocks May Come Knocking

Hotel companies are doing everything right -- raising rates, filling rooms and boosting earnings guidance -- and yet shares continue to slide. A combination of economic anxiety and the outsized 2003 sector rally are to blame for recent underperformance, but the underlying fundamental trends are strong, and shares could be worth buying.

At the core of the bullish case is the fact that the hotel industry's recovery is switching gears, leading to higher profit margins and greater earnings growth in the second part of the year. During the first part of a recovery, hotels see occupancy rise as demand increases because of an improving economy. According to Smith Travel Research, an industry tracker, occupancy at all hotel rooms in the U.S. was 60%, with upscale hotels pushing closer to 70% -- the highest levels in two years.

"Fundamentally, the industry is sound. We're looking at seven weeks of double-digit growth in [revenue per available room]," said Jan Frietag, director at Smith Travel Research, noting the high occupancy rates. "What that implies is that hotels are full, and the next step, towards the end of 2004, is that we'll see an increase in room rate growth."

But as occupancy levels rise, filling rooms becomes more difficult and comparisons get tougher. That is happening now. Occupancy at all U.S. hotels during the week ended Aug. 7 rose just 1% year over year. With terror warnings, an uncertain economic outlook and InterActiveCorp (IACI Quote), owner of Expedia, and Priceline.com (PCLN Quote) guiding earnings expectations lower, investors are growing worried that hotel stocks are overvalued and industry fundamentals are peaking.

This is why hotel stocks have fared so poorly over the last month. Since July 16, shares of Starwood Hotels (HOT Quote) -- which has raised guidance for the last three quarters while easily beating analysts' earning estimates -- are off 9.5%. As shares slid recently, Wall Street was raising its earnings expectations, with 18 analysts raising 2004 forecasts by an average of 16 cents. Expectations for 2005 are up an average of 21 cents.