With a gradual recovery of the global economy, the hotels and lodging industry is experiencing an increase in demand. The operating metrics are looking up, and year-over-year comparisons are becoming easier as the operating environment was significantly stressed in the prior year.

Though businesses are still cost-conscious, the recovery in the economy has seen a return of business travelers, with leisure demand increasing as well. However, the rate of improvement is still sluggish, in keeping with the slow pace of the economic revival.

Since the U.S. market is somewhat saturated, hoteliers are exploring growth opportunities abroad. Hotel companies are seeing higher demand in the international market, as the pace of economic recovery is particularly fast outside the U.S.

U.S.-based companies are targeting the fast-growing emerging economies. The Asia-Pacific region specifically promises solid growth, and companies such as Starwood Hotels and Resorts Worldwide Inc. ( HOT - Analyst Report ) and Marriott International Inc. ( MAR - Analyst Report ) are increasing their pipeline in this region.

Countries that are of specific interest include China and India. In these countries, where a potential increase in gross domestic product (GDP) within the next few years will considerably increase disposable income, the demand for hotels is expected to considerably outpace supply. Additionally, the availability of local capital is another positive factor.

Metrics Analysis

In evaluating hotel companies, we will be paying close attention to changes in average daily room rates as an indication of how quickly the sector recovers with the improvement in the economy.

A key operating metric in the lodging industry is RevPAR (revenue per available room). This metric is derived by multiplying the occupancy percentage of a hotel over a given period by the average daily room rate (ADR) over that same period. Changes in either occupancy or ADR will impact RevPAR, but with different implications for bottom-line profitability.

The downturn in the U.S. economy was hard on hotel occupancy rates. In response, some hotel owners initiated price cuts to fill beds. In most cases, this tactic has caused material long-term damage to the business for two primary reasons:

• First, increases in occupancy are accompanied by increases in operating expenses. For every room that is filled, there are additional costs such as housekeeping, laundry and utilities that must be borne. When room rates decline while variable operating expenses increase, margins are compressed. Changes in ADR, however, fall almost entirely to the bottom line.
• Second, and more importantly, cuts to ADR are difficult to recoup when the operating environment eventually improves. After slashing room rates in an effort to fill a hotel, attempts to restore these to previous levels are likely to be met with significant resistance from the clients. The ability to benefit from an improving economy will thus be delayed.

Ultimately, the ability of lodging companies to maintain room rates proved to be critical to their ability to weather the downturn. Cutting rates meaningfully should be an absolute last-ditch effort to survive. By keeping an eye on changes in ADR, investors can gain some insight to the companies that are the best poised to benefit when economic growth rebounds.

OPPORTUNITIES

We believe that the recovery of the hotel industry has begun. The trend of positive demand growth is expected to continue in 2010 and beyond driven by economic recovery. According to the data from Smith Travel Research, the leading information and data provider for the lodging industry, the U.S. hotel industry reported mostly positive results in all three key performance measurements -- occupancy level, ADR and RevPAR -- in recent weeks.

The operating environment in the international market is however better, which in turn is driving hoteliers to increase their share of the pie. Hotels in the Asia/Pacific region experienced increases in all three key performance metrics in recent months, according to data from Smith Travel Research. In April, the Asia-Pacific region’s occupancy rose 11.7% to 65.3%, ADR increased 13.1% to $130.06 and RevPAR jumped 26.4% to $84.96.

Currently, there are a number of stocks in the hotel industry universe with a Zacks #2 Rank (“Buy”). These include Marriott, Starwood, Home Inns & Hotels Management Inc. ( HMIN - Snapshot Report ) , Hyatt Hotels Corporation ( H - Snapshot Report ) , Intercontinental Hotels Group plc. ( IHG - Snapshot Report ) and Wyndham Worldwide Corporation ( WYN - Analyst Report ) .

We believe companies such as Marriott and Starwood are better positioned to benefit from their global pipeline. Also, the availability of local capital frees the U.S. companies from invest much -- or even any -- capital in this region.

WEAKNESSES

While the occupancy levels are showing positive trends, it is noticeable that the ADR has yet to show meaningful improvements in the U.S. Though the rate of decline in ADR has moderated and is currently flat compared with the prior-year period, there is a lack of any significant positive catalyst in the room rates.

Given the lower levels of room revenue, margin gains have remained restricted in recent quarters. However, we expect higher room rates by the end of this year, though the pace of improvement is expected to be slow as the economy is projected to improve only sluggishly. Besides, some sort of volatility is not unusual in the hotel industry performance metrics. However, we expect stability in the upcoming quarters with an improvement in the operating environment.

Currently, the high rate of unemployment coupled with an expectation of a protracted labor market recovery is expected to restrict margin improvements as these are pushing room rates down. In addition, companies with weak balance sheets -- or even limited financial flexibility -- will likely have a harder time navigating the challenges created by the recent economic recession.

Hence at this moment, it is difficult to become enthusiastic on a number of stocks in our universe, which continue to have a Zacks #3 Rank (Hold). These include Choice Hotels International Inc. ( CHH - Snapshot Report ) , The Marcus Corporation ( MCS - Snapshot Report ) , Morgans Hotel Group Co. ( MHGC - Snapshot Report ) , Orient-Express Hotels Ltd. ( OEH - Snapshot Report ) and Red Lion Hotels Corporation (RLH). We also remain concerned about the prospects of Great Wolf Resorts Inc. ( ) , which currently has Zacks #4 Rank (Sell).