2 for Tuesday: A Star Among Hotels

For those willing to hang in there, Starwood may have an upside of 55% after the recent downturn.
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The stock market has made a nice bounce from its post-Sept. 11 low, and the travel-related sector has been no exception. Lodging stocks are up 17%. But that's still a long way from where they were before the terrorist attack -- and it's hard to imagine that before Dec. 31 they'll recoup much of the 25% loss that they've experienced so far this year.

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But for those who have a time horizon of at least a year or two, this could be another one of those rare opportunities -- as was 1990 when the lodging industry lost $5.7 billion -- to pick up some high-quality companies at literally bargain prices. Of course, with U.S. military action underway, there is tremendous near-term uncertainty surrounding this sector. More terrorist incidents could deal another blow to the stocks.

Last

week I wrote about a small-cap name called

Orient-Express Hotels

(OEH)

, an ultra-luxury hotelier with a heavy international exposure. Another high-end name, but with a much bigger market capitalization of $4.6 billion, is

Starwood Hotels

(HOT)

.

Starwood controls very strong brands, including Sheraton and Westin, as well as exceptional luxury properties such as the St. Regis, the Phoenician Resort in Arizona and the Hotel Gritti Palace in Venice. Its fast-growing brand, W, is a trendy upscale boutique hotel chain that has been the rage of the hotel industry for the last several years.

Like Orient-Express Hotels, Starwood owns most of its properties (owned hotels operations account for 75% of cash flow.) And although the environment was deteriorating for lodging stocks because of the weakening economy even before this tragedy, Starwood still was expected to earn roughly $1.5 billion in EBITDA -- earnings before interest taxes, depreciation and amortization -- this year, or a 35% margin.

Now, all bets are off.

There's Still Hope

But that doesn't mean Starwood is in dire trouble -- yet. On the contrary, the company has moved swiftly to manage its business to cope with the fall-off in demand. On a Sept. 24 conference call with the investment community, Starwood's management laid out plans for reducing costs and conserving cash. On the cost side -- about 35% of which is variable, according to analysts -- management said it was reducing staffing through the remainder of this year by 23%, closing floors or wings in hotels to preserve energy, and curtailing hours of operation at its restaurants.

In terms of spending, Starwood has slashed its capital expenditure budget for next year to $100 million, delaying or deferring any project over $3 million, such as the construction of the St. Regis and Towers Hotel in San Francisco. The company has $800 million in cash available, including unused debt capacity, and also may consider cutting the dividend, which would save $160 million a year.

Not only that, Starwood has advantages unique to it. First of all, it doesn't need to spend much cash to maintain its biggest chain, Sheraton. According to Bryan Maher, the lodging and gaming analyst at Credit Lynonnais Securities, Starwood already has invested heavily to renovate and reposition the Sheraton brand at a much higher level of quality. He thinks any cutback on spending won't be noticed by customers.

Secondly, the company is trying to sell its Chiga Hotels, a portfolio of 25 hotels in Europe, many of which are extremely high end and irreplaceable, like the Hotel Deniali in Venice. Although this sale will be more difficult to achieve in these uncertain times, Maher believes a transaction could reap $1.2 billion to $1.4 billion in proceeds for Starwood, which could then be used to pay down debt or buy back shares.

Nevertheless, it's important to recognize that the near term is going to be pretty rough. Hotel-occupancy rates in the U.S. for the week ending Sept. 29 were 55.8%, according to Smith Travel Research. This was a slight improvement from the prior week's level of 52.3%, which bore the brunt of the post-Sept. 11 tragedy. Industry revenue per available room, or RevPAR -- an industry benchmark because it factors in rates as well as occupancy -- declined 24.3% year over year. On the conference call, Starwood's CFO Ron Brown claimed that the company is EBITDA break-even at occupancy rates of just 40% and EBITDA-plus-debt-service break-even at 50%. If RevPAR declines 35%, Brown said Starwood can still earn EBITDA margins of 15 to 20%. Starwood has annual interest expense of roughly $330 million on $5.5 billion in long-term debt.

Most analysts are hopeful that the mid-50% occupancy rates and double-digit RevPAAR declines are over soon. In fact, since the second week of September, RevPAR declines have mitigated. Maher -- who incidentally had downgraded the group in early August due to the deteriorating economy but turned positive again on Sept. 20 -- thinks RevPAR will post a 10% decline in the fourth quarter, then a 5% decline in the first half of next year, and then flatten out in the second half. Then in 2003, he sees growth of 2% to 3%. Maher says lodging demand correlates extremely tightly with U.S. GDP growth, with about a two-quarter lag -- meaning it's late to enter the recession, and late to recover.

The outlook for the supply side of the equation -- industry capacity -- has, if anything, improved as a result of recent events. Maher says new room supply growth had been decelerating since the peak of 150,000 rooms in 1998. He now expects just 115,000 rooms to be added this year, then a sharp drop to 75,000 to 80,000 in 2002 and just 60,000 to 65,000 in 2003.

"If they haven't dug the holes and put the pilings in the ground, forget about getting financing," says Maher, about the prospects for new construction.

The big question is what do you pay for Starwood when the earnings picture is so risky? One measure to use is the replacement cost of the underlying assets. Joseph Greff, the lodging analyst at ABN Amro, provided me with his analysis. You start with the number of rooms at each hotel and apply an average cost of each room. Starwood has a total of 56,614 rooms, and the average cost Greff uses is roughly $188,000, although the company says it's more like $250,000.

Using Greff's more conservative estimate yields a total value for Starwood's properties of $10.6 billion. Greff then added in the EBITDA from Starwood's other businesses, like time shares and various management and franchise fees, and applied a multiple of between 4 and 8 to those. He then deducted net debt -- long-term debt of $5.5 billion less cash of about $221 million. That gave him a total equity value of between $7.1 billion and $8.9 billion, or $34 to $43 per share.

That's the upside -- 55% back to $34 alone. The downside? That's certainly tougher, but the Sept. 11 low of $17 is probably a good starting point, which would be 22% down from here. Not the greatest risk/reward, but certainly one worth considering, particularly if military actions drive the stock back below $20.

Odette Galli writes daily for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to

Odette Galli.