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), owner of Expedia, and Priceline.com ( PCLN) 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) -- 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.

Four Seasons ( FS), which issued bullish guidance when it released second-quarter earnings last week, has seen shares drop 10.4% since July 16, while earnings estimates for both 2004 and 2005 continue to rise. As the table shows, Hilton Hotels ( HLT) and Marriott International ( MAR) have seen the same thing happen.

Many investors are overlooking the underlying strength of the industry -- peaking occupancy rates are just half the story. As occupancy rates approach 75% and plateau, hotels begin boosting room rates to capitalize on strong demand, especially from business travelers. And rising room rates, not occupancy levels, are what really drive hotel earnings.

"Let's say you have a hotel with 100 rooms and you can either sell 100 rooms at $50, or you can sell 50 rooms at $100," said Freitag. "The outcome is the same, but when in doubt you'd want to choose the higher rate -- because if you have a full hotel, you'll need more staff, more linens. With a half-full hotel, you have higher margins. And if you look at second-quarter earnings, a lot of analysts are saying expect to margins to grow healthily in third and fourth quarters."

Indeed, UBS analyst William Truelove upgraded Marriott and Fairmont Hotels and Resorts ( FHR) to buy from neutral last week, citing this very phenomenon, telling investors that "about 90 cents or every $1 increase in room rates reaches house profits. By comparison, about 33 cents of every $1 increase in revenue from higher occupancy reaches the house profit." (UBS does and seeks to do business with the companies covered in research reports.)

Keep an eye out on industry fundamentals. Each Wednesday afternoon, Wall Street pores over weekly data from Smith Travel Research that shows the latest revpar (or revenue per available room) trends, along with data on room rates and occupancy. With comparisons getting harder, hotel stocks could sell off again if numbers fail to impress -- presenting investors with another chance to buy.
Estimates Up, Stocks Down
Over the last month, hotel stocks have dropped, outpacing the 2% fall in the S&P 500. But while stocks slump, fundamentals remain strong and estimates are rising.
Company % Change in Stock* 2004 EPS Est. Change* 2005 EPS Est. Change*
Hilton -10.7 +2 cents +3 cents
Four Seasons -10.4 +5 cents +8 cents
Starwood -9.5 +16 cents +21 cents
Marriott -7.0 +7 cents +8 cents
*Since July 16.Source: Bloomberg.

"The good news is that the recovery continues apace -- third-quarter lodging company earnings expectations are likely to be met or exceeded, and fourth-quarter guidance appears conservative from most of the companies," said William Crow, analyst at Raymond James, noting later. "The recent selloff in lodging stocks has driven stock valuations to what is likely their lowest level in the past three years." (Raymond James does and seeks to do business with the companies covered in research reports.)

On the basis of Monday's closing stock price, Starwood was trading at 22.9 times 2005 earnings expectations -- lower than its five-year historical average of 28.3, according to Baseline. Marriott's price-to-2005 earnings ratio was 16.7 against its five-year average of 21.5, while Four Seasons' price-to-2005-earnings ratio was 31.9 against its five-year average of 46.2.

Not everyone, however, is convinced that hotel stocks are worth a buy. Jeremy Cogan, an analyst at Banc of America Securities, rates the sector at neutral because of the sector's big run in 2003, when the Dow Jones Hotel Index rose 50%. In his view, the huge gains have left stocks with limited upside potential, even now, and with the economic recovery once again appearing shaky, the risks and rewards are balanced.

"The lodging industry is very mature and tends to follow the lead of the broader U.S. economy," said Cogan. "Continued downward expectations of job growth, consumer spending and GDP could weigh on future earnings forecasts, and stocks we view as 'not exactly cheap' today could begin to look 'expensive.'" (Banc of America does and seeks to do business with the companies covered in research reports.)

With expectations on the rise and bullishness the de facto sector call, surprising the already optimistic mindset could become more difficult -- one reason why better-than-expected guidance and earnings have failed to inspire sector rallies. But with shares down more than 10% in some cases and fundamentals like occupancy and room rates moving in the right direction, even Cogan said the sector may be worth a second look -- if stocks continue to fall and the economic sluggishness abates.

"Should concerns about the economy prove to be short-lived, we could get more constructive on the shares, especially if they show a bit more weakness," he said.

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