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Industry Outlook

The hotels and lodging industry seems to be back in demand, thanks to the gradual global economic recovery. The industry has been witnessing a return of business travelers and a growing demand for leisure.

Riding on the back of improvement in the U.S. economy and the consequent rise in operating metrics, most of the hoteliers have started reporting strong quarterly results. Profits are expected to rise further in 2011 as bookings continue to improve. Positive estimate revisions give us ample evidence of this growth momentum.

International Growth

Since the U.S. market is somewhat saturated, hoteliers are exploring growth opportunities abroad. International markets offer greater potential based on the higher pace of economic growth that they currently enjoy.
 
The U.S.-based companies are targeting fast-growing emerging economies. With lackluster U.S. GDP growth of 1.8% in the first quarter of 2011, industry stalwarts such as Starwood Hotels and Resorts Worldwide Inc. ([url=http://www.zacks.com/stock/quote/hot]HOT[/url]) and Marriott International Inc. ([url=http://www.zacks.com/stock/quote/mar]MAR[/url]) are eyeing the Asia-Pacific region and Latin America as they promise solid growth going forward.

The stellar performance that the Asia-Pacific region gave during 2010 is expected to continue in the near future. This was the only region to report double-digit RevPAR growth at year end. Major growth markets within Asia-Pacific, China and India remained more or less unaffected by the global economic turmoil and are enjoying rising economic growth rates. The availability of local capital is another positive factor.

China is set to bring about a recovery in global tourism, and by 2020, is expected to be the world's largest travel destination. Both Starwood and Marriott derive their second largest revenue chunks from that country.

In the past, hotels in China were mainly occupied by western travelers, but today, more than 50% of the guests are Chinese. This is indicative of China's fast growing domestic travel market. Moreover, according to an analysis on the enrollment and travel trends of Starwood Preferred Guest members, China is expected to have 100 million outbound travelers by 2015.

Apart from China, India is another hot spot for the western hoteliers. India has a compelling investment proposition with its rising importance as a global business hub, where the demand for moderate-tier as well as upscale branded hotels will considerably outpace the supply for the next three to four years. Moreover, western hoteliers also find the built-cost to operating returns favorable. All these factors testify to the longest development pipeline that the hotel companies have in India .
 
Metrics Analysis
 
In evaluating hotel companies, we pay close attention to changes in average daily room rate (ADR) to figure out the likely pace of improvement in the sector.
 
A key operating metric in the lodging industry is RevPAR (revenue per available room), which is derived by multiplying the occupancy percentage of a hotel over a given period by ADR over that same period. Changes in either occupancy or ADR will impact RevPAR, but with different implications for bottom-line profitability.
 
Given the recovery in the U.S. economy, it isn't surprising that hotel occupancy percentages have stepped up. However, declining occupancy percentages during the recession compelled some hotel owners to slash room rates in an effort to woo visitors. In most cases, this tactic will result in material long-term damage to the business primarily for some reasons:
 
First, an increase in occupancy is accompanied by escalating operating expenses. For every room that is filled, there are additional costs such as housekeeping, laundry and utilities that must be borne. Margins are compressed when room rates decline and variable operating expenses increase. Changes in ADR, however, affect almost entirely the bottom line.
 
Second, and more importantly, cuts in ADR will be difficult to recoup when the operating environment eventually improves. After slashing room rates in an effort to fill up rooms, attempts to restore these to previous levels are likely to be met with significant resistance from clients. The ability to benefit from an improving economy will thus be delayed.
 
Finally, the ability of lodging companies to sustain room rates should have a significant impact on their capability to weather any kind of economic uncertainty. By keeping an eye on changes in ADR, investors can gain some insight into companies that are best poised to benefit with the economic revival.

OPPORTUNITIES

The hotel industry has begun to show signs of a turnaround. We expect the trend of positive demand growth to continue in 2011 and beyond. According to Smith Travel Research, the leading information and data provider for the lodging industry, the U.S. hotel industry reported increases in all three key performance measures -- occupancy level, ADR and RevPAR -- during the first week of May.

Comparing the operating metrics with the prior-year period, the industry's occupancy increased from 60.0% to 60.3%. Average daily rate ended the week with a 4.8% growth to US$101.73. The week also ended with an 11.1% rise in RevPar to reach $61.31.

Positive Changes Across the Board

RevPAR in the Luxury and Upper Upscale markets was up 13.1% and 12.0%, respectively, during the week of May 1-7, 2011.

Occupancy increases across the board were 5.5% for Luxury, 5.5% for Upper Upscale, 5.5% for Upscale, 7.3% for Upper Midscale, 5.8% for Midscale and 6.1% for Economy.

Rate increases across the board were 7.2% for Luxury, 6.1% for Upper Upscale, 4.4% for Upscale, 3.8% for Upper Midscale, 0.6% for Midscale and 2.0% for Economy.

Strong Projection for 2011 and 2012: Demand Exceeds Supply

Smith Travel Research projects that the hotel industry will end 2011 with increases in all three key metrics. The expected growth is 1.8% for Occupancy to 58.5%, 4.2% for ADR to $102.21 and 6.1% for RevPar to $59.78. While supply is projected to inch up 0.7%, demand growth is estimated at 2.5%.

Smith Travel Research also anticipates increases in all three key performance metrics during 2012. Occupancy is expected to rise 1.7% to 59.5%, ADR will increase 6.8% to US$109.16, and RevPAR is projected to end the year with an 8.6% increase to US$64.93.

The year 2012 is expected to end with a virtually flat to a modest 0.5% increase in supply, and demand is projected to rise 2.2%. An environment marked with higher demand in the face of lower supply leads to our anticipation that the room rate will gradually swing back to profits leading to RevPAR growth in 2011 and 2012. According to data published by Smith Travel Research in April, the total active U.S. hotel development pipeline comprises 3,053 projects totaling 322,423 rooms, down 12.2% year over year.

The operating environment in the international market has shown a marked improvement, propelling hoteliers to grab bigger shares of the overseas pie. Hotels in the Asia-Pacific region have been registering rises on all three key performance metrics, according to Smith Travel Research. The region's Occupancy, ADR and RevPar increased a respective 8.9%, 11.4% and 21.3% to 66.0%, $132.80 and $87.69 in 2010.

Shift Toward Asset-light Model


Since late 2010, transition to an “asset light” business model has gained momentum in the hotels and REIT industry. Asset sale remains a long-term strategy to strengthen financial flexibility, which would help the companies grow through management and licensing arrangements instead of direct ownership of real estate. A higher concentration of management and franchise fees reduces earnings volatility and provides a more stable growth profile.

According to a recent research report by Jones Lang LaSalle, a financial and professional services company specializing in real estate, hotel sales and acquisitions as well as new deals will increase to 25% in 2011 in the Americas. Jones Lang further projected that Hotel transaction volume would total approximately $13.0 billion in 2011.

Hence, the hoteliers are focused on rebalancing their portfolios by increasing contributions from managed and franchised hotels. This fee-based business is attractive as growth is powered by multiple sources-RevPAR growth, unit additions and incentive fee escalation. The business is also capital efficient as owner/developer partners provide the capital and the company earns a fee by managing/franchising the property.

Following the industry trend, many industry players like Morgans Hotel Group Co. ([url=http://www.zacks.com/stock/quote/mhgc]MHGC[/url]), Red Lion Hotels Corporation ([url=http://www.zacks.com/stock/quote/rlh]RLH[/url]), Great Wolf Resorts Inc. ([url=http://www.zacks.com/stock/quote/wolf]WOLF[/url]) and Starwood embarked on an asset disposition strategy.

Currently, the stock with a Zacks #2 Rank (Buy) in the hotel universe is Intercontinental Hotels Group plc ([url=http://www.zacks.com/stock/quote/ihg]IHG[/url]). The stocks with Zacks #1 Rank (Strong Buy) are Wynn Resorts Ltd. ([url=http://www.zacks.com/stock/quote/wynn]WYNN[/url]) and Wyndham Worldwide Corporation ([url=http://www.zacks.com/stock/quote/wyn]WYN[/url]).

We believe companies such as Wyndham are better positioned as they are likely to benefit from their fee-for-service based business shift. Marriott and Starwood should also benefit from their global pipeline.

WEAKNESSES

Comparatively Slower Growth in ADR


Though occupancy levels have fairly picked up, ADR has yet to show meaningful improvement in the U.S. We believe the rate of upside in ADR will likely remain tardy due to the sluggish economic revival. Additionally, surging commodity prices raised concerns about the ability of hotel companies to control costs.

Disruption in North Africa and Earthquake in Japan

Unrest in Middle East and Africa and the March 11 earthquake in Japan remain causes of near-term concern. In North Africa, the political upheaval seems relentless. Starwood management expects lesser management fees in 2011 from 24 hotels across the affected North African countries, with no incentive fees earned, and base fees sharply down.

In fact, Starwood expects a $20 million to $25 million EBITDA shortfall in Japan for the year. Marriott also expects RevPAR to remain weak for their 31 hotels in the Middle East and 10 hotels in Japan, although a modest improvement is anticipated over the current level later this year.

Tough Comparison in China

Another near-term international apprehension will come from China where the companies will see tough comparisons in the second and third quarters of 2011 as as the country laps some one-time profits from revenues, owing to World Expo in Shanghai, China. The Expo was a third quarter of 2010 event.

Stiff Competition

Competition is also building up across the sector. Every hotel company is not only competing with major hotel chains in national and international venues but also with home-grown hotels in regional markets. Heightened competition and potential addition of new supply will restrict market share.

A number of companies in our coverage lack near-term catalysts that can push their stocks up. These Zacks #3 Ranked stocks include Wynn Resorts Limited, Hyatt Hotels Corporation ([url=http://www.zacks.com/stock/quote/h]H[/url]), Morgans Hotel Group, The Marcus Corporation ([url=http://www.zacks.com/stock/quote/mcs]MCS[/url]), Home Inns & Hotels Management Inc. ([url=http://www.zacks.com/stock/quote/hmin]HMIN[/url]), Marriott, Starwood, Great Wolf Resorts and Orient-Express Hotels Ltd. ([url=http://www.zacks.com/stock/quote/oeh]OEH[/url]).
 
We also remain concerned about the prospects of Choice Hotels International Inc. ([url=http://www.zacks.com/stock/quote/chh]CHH[/url]), 7 Days Group Holdings Ltd. ([url=http://www.zacks.com/stock/quote/svn]SVN[/url]), Red Lion Hotels, which currently have a Zacks #4 Rank (Sell), and China Lodging Group Limited ([url=http://www.zacks.com/stock/quote/htht]HTHT[/url]) which currently retains  a Zacks #5 Rank (Strong Sell). The weak prospects of these companies are reflected in the declining trends of their earnings estimates.

Conclusion

We anticipate continued positive RevPAR growth for the near future owing to decelerating growth in supply. The U.S. market will likely experience easy comparison and modest economic improvement that will drive occupancy as well as pricing.

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