Hotel Sector Strong - TheStreet

The rally in hotel stocks has sputtered in recent weeks, but it still may be too early to check out of the sector.

At the very least, the stocks should be able to return to recent highs, market watchers say. The industry's cyclical recovery is far from over, with business travel on the rise and leisure demand remaining strong. Those trends will allow hotels to continue to boost room rates, offsetting potential inflationary pressures such as higher energy costs, factors cited for recent investor skittishness.

"We've seen expense inflation, but we haven't seen inflation in the top line or pricing power," said Asad Kazim, vice president at RReef Funds, a unit of Deutsche Bank Real Estate. "Now we're starting to see pricing power. That ought to mitigate any expense inflation."

Stocks of large hotel companies have retreated recently from 52-week highs. Along with concerns about hotel-expense inflation, worries that higher gas prices might temper travel demand have weighed on the stocks. Some investors also may have worried that multiples were getting too dizzy, as enterprise value reached about 12 times earnings before interest, taxes, depreciation and amortization, or EBITDA. Such multiples are at the high end of the companies' historical ranges.

Nevertheless, Kazim and many analysts contend the recovery is far from over. They point to recent bullish revenue trends. A key metric for the industry is revenue per available room, or revpar. So far this year, it's up almost 10% at upper-upscale hotels, according to Smith Travel Research, an industry research firm. The upper-upscale category includes key brands for

Hilton Hotels

(HLT) - Get Report

,

Marriott International

(MAR) - Get Report

and

Starwood Hotels & Resorts

(HOT)

. The revpar numbers are bullish, according to Kazim, given that Starwood and Marriott forecast first-quarter North American revpar growth of 6% to 8%.

RReef owns shares of Hilton, Starwood,

La Quinta

( LQI),

Host Marriott

( HMT) and

Sunstone Hotel Investors

(SHO) - Get Report

.

Revpar growth comes from two sources: increased occupancy and room rates. Typically, in the early part of a recovery, most revpar growth comes from rising occupancy levels. Later, however, hotels find themselves able to raise rates on strong demand, and those higher rates tend to flow directly down to the bottom line, causing margins and earnings to swell.

Certain U.S. markets, such as New York City, are seeing particularly robust demand, giving hoteliers pricing power, notes Kazim. That situation should continue as businesses beef up travel budgets. Kazim foresees about four percentage points of margin expansion for large hoteliers between now and 2007. "Right now, every dollar of

room rate is probably giving you about 40 to 50 cents after covering your fixed costs," he said. "As we go forward and see rate momentum building, we'll see 70 or 80 cents going through to the bottom line."

Increased pricing power should allow hotels to offset the impact of higher interest rates as the

Fed

continues its tightening cycle, and utility expenses, contends Deutsche Bank analyst Marc Falcone. "Unlike most other classes of real estate (i.e. apartments, office buildings), hotels have the ability to reprice inventory (i.e. raise room rates on a daily basis)," he wrote in a recent research note. "We believe this effectively provides natural insulation against rising interest rates." Deutsche Bank does and seeks to do business with companies covered in its research reports.

Furthermore, Falcone cites a Smith Travel Research study showing energy/utility expenses represent less than 4% of room revenue for full-service hotels and 4.5% to 5% for limited-service hotels. For each occupied room, "utility expenses average less than $8 for full-service hotels and under $4 for limited-service hotels," Falcone wrote. "Accordingly, we do not believe higher energy costs ... should be a significant threat to margins."

With crude oil at historically high levels, some investors may worry that higher prices at the pump could dampen travel plans.

But Matt Quinn, senior lodging and gaming analyst at Zack's Investment Research, says that shouldn't be a factor for the large hotel companies.

"On the demand side, I wouldn't say that higher fuel would hurt these guys, especially the guys in the full-scale luxury market, which is driven by high-end business travelers and upper-end leisure travelers," he said. "They're unlikely to be impacted much by fuel prices."

Zack's neither does nor seeks to do business with companies it covers, and Quinn owns no shares of companies he covers.

Both Falcone and Kazim agree and cite a PricewaterhouseCoopers study showing gas prices need to rise 23% to cause a 1.0 percentage-point decline in hotel occupancy levels.

Quinn believes shares of Starwood, Marriott and Hilton can return to levels around their respective 52-week highs of $61.45, $68 and $23.36, which roughly equate to multiples of about 12 times enterprise value to EBITDA. For now, those multiples will serve as a cap on the stocks' appreciation, he says.

Still, Kazim said positive revpar trends could deliver earnings surprises, allowing stocks to go higher without inflating multiples.