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Do Bargain Hotel Rooms Mean Bargain Stocks?

Hotels are in for a bumpy ride, but certain firms look undervalued to us.

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The hotel industry has been riding high for years as tail winds such as limited new supply, growing demand, and low interest rates pushed up occupancies, nightly rates, and asset prices. However, as the economy has begun to falter, these tail winds have become head winds, and the fortunes of hotels are declining. Occupancy and nightly rates have deteriorated, and we expect things to get much worse before they get any better. So should investors steer clear of the entire sector, in the face of declining fundamentals? We believe that investors should exercise caution, but that a few high-quality names are trading at attractive prices.

Demand for hotel rooms is tightly correlated with the broader economic picture. When times are good, business travelers hit the road to meet with clients or to attend conferences. Leisure travelers feel flush with cash and are willing to spend big on family vacations. However, these trends quickly reverse when the economy starts to wobble. Businesses look to cut costs, and the travel budget is often the first thing to go. Families worried about job losses or shrinking investment portfolios choose to scale back their vacations or scrap them altogether. These dynamics have started to play out in the second half of this year, with hotel revenue and profitability taking a hit across the United States.

Hotels have been particularly hard-hit because of several travel impediments. Although gas prices have come down off their highs, consumers are thinking twice before filling up the tank and hitting the road. Flying hasn't been much easier; airlines concerned about high oil prices have slashed flight capacity, making it more difficult and expensive to fly the friendly skies. Hotel markets that depend on the airlines, such as Hawaii, have already seen dramatic drops in revenue because guests are simply unable to get there. For example, in the third quarter of 2008,  Host Hotels(HST) Hawaiian properties experienced a 28% year-over-year decline in revenue per available room (RevPAR), a key measure of hotel performance.

Making matters worse is that new hotel supply, planned during the last upturn, is just now starting to come on line in earnest. Construction of new hotels is at a 15-year high as measured as a percentage of gross domestic product, which we've illustrated in the graph below. These new rooms will flood the marketplace over the coming years. At first the supply was limited to economy hotels in low-barrier-to-entry suburban markets, but increasingly the new hotels are upscale and located in urban centers like New York City, Chicago, Philadelphia, and Washington, D.C. Fortunately, many projects that are currently in the planning stage will probably be shelved due to lack of financing and the deteriorating fundamentals in the industry. Still, we believe that enough projects are far enough along that they will get off the ground and create a meaningful increase in the supply of hotel rooms at the worst possible time.

With supply and demand so out of balance, the outlook for hotel industry fundamentals is bleak. But how much of this has been priced into the stocks already? There are two main ways to invest in the hotel sector: buying hotel owners or buying hotel managers.

Hotel Owners
Buying hotel owners allows investors to gain direct exposure to lodging real estate. Most of the owners that we cover are organized as real estate investment trusts (REITs) and generally own upscale hotels in major and secondary urban and resort markets. These assets are generally attractive, but they are subject to the same supply/demand imbalance issues that are touching the entire industry. We expect that most owners will experience double-digit declines in RevPAR in 2009. Hotels are unable to radically shrink their cost structures in the face of declining revenue, because fixed costs remain high even if many of the hotel's rooms are empty. This dynamic means that most owners are likely to be sharply less profitable in the near term.

Our favorite hotel owners at the moment are Host Hotels,  DiamondRock Hospitality (DRH), and  Sunstone Hotel Investors (SHO). While this select group is not immune to current trends, their relatively conservative balance sheets and premier locations mean that they will be able to weather the storm and emerge ready to take advantage of weak competitors when the market turns around. On the other hand, highly levered owners like  Ashford Hospitality Trust  (AHT) and  FelCor Lodging Trust (FCH) may face severe financial distress or even bankruptcy as reduced cash flow makes it hard for them to cover their fixed costs.

For both the strong and weak hotel owners, dividend security is a major issue. Even though some names currently have eye-popping yields (Ashford's recently surpassed 60%) the payout is not sustainable. FelCor has already cut its dividend, and DiamondRock has indicated that it will follow suit. We expect most owners to cut dividends in the coming quarters, as declining cash flows make payouts unsustainable.

Hotel Managers
Rather than directly owning properties, hotel managers make most of their profits by licensing their brand names and expertise to third parties in exchange for a percentage of revenue brought in by the hotel. Although franchise and management contract fees are tied to the health of the hotel industry, they tend to be less volatile than owners' earnings, because profit declines more than revenue during a downturn due to a hotel's operating leverage. This stability should help managers make it through a downturn with more ease than hotel owners, but it will be a rocky road nevertheless. In addition, while supply growth is driving down industry fundamentals for hotel owners, it can actually help mitigate some of the downside for managers, because they earn initial franchise fees and face little incremental cost when they add another property to the system.

Timeshare sales have been a big growth driver for several managers in the past few years. Timeshare sales have made up a substantial portion of earnings for stalwarts such as  Marriott International (MAR),  Starwood Hotels & Resorts (HOT), and  Wyndham Worldwide (WYN). However, sales are already slipping, and we believe that further declines are in the cards. Travelers are unwilling or unable to put down large initial payments for future vacations when the economic outlook is so cloudy. Complicating matters is that the credit crisis has made it very hard for consumers to get loans to buy timeshare weeks. Few potential buyers can afford to pay cash for the entire purchase price, so without financing the product becomes unattainable. Managers are already starting to scale back their marketing budgets and construction of new timeshare resorts. Timeshares will remain an important part of their businesses, but much less so than in the past.

The hotel industry is in for a rough couple of years, but we believe the players with the strongest balance sheets, best properties, and more compelling brands will emerge ready to grow again. We list a few examples of such firms below.

 Host Hotels & Resorts (HST)
Moat: Narrow | Fair Value Uncertainty Rating: Very High | Star Rating: Four Stars
From the Analyst Report: "Host Hotels & Resorts has carved out a narrow moat by building an impressive collection of upscale, urban hotels and smartly selling off older assets to pay down debt. However, even with its high-quality hotels, Host may suffer significantly in the short term as the economic slowdown reduces travel. Nevertheless, we think the company's efforts to prepare for the downturn will allow it to ride out the storm better than other, more-leveraged hotel owners."

 DiamondRock Hospitality (DRH)
Moat: None | Fair Value Uncertainty Rating: Very High | Star Rating: Four Stars
From the Analyst Report: "DiamondRock's portfolio of upscale hotels has produced outstanding results on the back of a strong travel market. However, a slowing economy and an uptick in the supply of new hotel rooms will temper growth. Although the firm owns some excellent properties, we do not think that it has built the scale to earn an economic moat."

 Wyndham Worldwide (WYN)
Moat: Narrow | Fair Value Uncertainty Rating: High | Star Rating: Four Stars
From the Analyst Report: "Wyndham Worldwide has its work cut out as it polishes rusty hotel brands, rebrands time-share resorts, and attempts to integrate diverse business units in the face of a slowing economy. Despite these challenges, the firm has carved out a narrow economic moat because of the stickiness of the franchise agreements for its well-known hotel brands and the network effect of its vacation-exchange business."

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Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.