Hotel Stocks We Like

Hotel investors needed steely resolve to brave the lodging industry's ups and downs over the last five years. From 2000 to 2003 occupancy plummeted by more than 4 percentage points while nightly rates fell 2.5% over the same period. Since then, hotels have rebounded: Occupancy and rate levels are quickly approaching the industry's mid-1990s peak. Stock performance has mimicked these travel trends; bellwether  Marriott International (MAR) lost 40% of its value from August 2001 to February 2003, but has since appreciated by more than 200%. We think growing demand and a limited supply of new rooms should keep the hotel industry healthy, presenting investors with several exciting investment opportunities.

The 9/11 Effect
Travel plummeted after the 9/11 attacks, leaving hotels half empty. The industry's troubles were compounded by high fixed costs--costs that don't fall despite unoccupied rooms. Several companies that were teetering on the edge--like  Lodgian --were pushed into bankruptcy. At the time there was concern that terrorism fears and expanded use of video conferencing would create a permanently depressed travel market.

The doom-and-gloom scenario did not come to pass. Beginning in 2004, travelers came rushing back as fat corporate profits led to more business travelers, convention-goers re-established their importance, and more-confident consumers took longer and more-expensive vacations.

Additionally, very few new hotels have opened since 2000. Developers were not willing to risk building new properties when there was so much fear and uncertainty surrounding the travel market. Even the brave who tried to build new hotels found several substantial barriers. First, there was a limited amount of land in major business centers where the demand for hotel rooms is highest. Second, construction and permit costs rose dramatically as residential construction and international development sucked up scarce resources.

We think the outlook for hotels is bright. Demand among all travelers remains high, and bookings for conferences and meetings continue to show strength. We are seeing rising new-hotel supply primarily in low-barrier-to-entry suburban markets. However, we are not that concerned because suburbia is much less important to the lodging industry than large urban centers, where the pace of new construction is tepid.

Our Approach
How can investors take advantage of this rosy scenario? There are two major investment avenues: the owners of the actual bricks and mortar, and hotel managers.

Hotel managers derive their profits from brand licensing and managing hotels' day-to-day operations. Managers receive a base fee--typically around 3% of the hotel's revenue--and an incentive fee when the hotel meets certain profit targets. Management contracts tend to be long term, up to 30 years in some cases. These contracts provide a stable source of revenue, as even during low times, hotels still have guests paying for rooms and ordering food. Managers are not burdened by fixed costs the way owners are, so managers are less affected by drops in occupancy. Management is a high-margin business; there are no expensive capital expenditures required, just hourly workers who can be let go when times get tough again. The downside to this model is that management companies miss out on the potentially large returns that owners see when their hotels are full. Additionally, management firms are responsible for advertising and building brands over time, which can be a daunting task.

But what if you want to invest in the actual properties? Hotel real estate investment trusts provide the opportunity. Hotel REITs experience the highs and lows of the lodging cycle. In a strong market, like today's, they do quite well, but they are exposed to the dangers of a sudden downturn. REIT regulations prohibit these companies from managing the operations of their properties, forcing them to bring in a third-party manager--either brand affiliated like Marriott or independent like  Interstate Hotels & Resorts . By ceding direct control of their assets, hotel REITs have very low corporate overhead, often just a few dozen employees.

In addition to the difference between owners and managers, there are also important divisions between hotel tiers. At the high end are the luxury hotels such as Ritz-Carlton or Mandarin Oriental. We think returns from luxury properties are highly lucrative in a good market; they are also the most sensitive to macroeconomic trends because it is relatively easy to trade down to upscale chains like Marriott, Hilton, and Westin. We believe that the sweet spot both for growth and profitability is in these upscale properties and business hotels like Courtyard by Marriott and Hilton Garden Inn. The upscale segment is increasing market share, as travelers prefer them to midscale brands like Holiday Inn and Best Western. Upscale hotels can effectively target both business and leisure travelers, charge a decent rate, and have much lower overhead than their more-luxurious brethren.

Our Hotel Manager Picks
Our most attractively priced hotel stock is  Wyndham Worldwide (WYN). Created from the breakup of Cendant Corporation, Wyndham makes money from brand-licensing fees as well as a booming timeshare business. Licensing fees have even higher margins than management fees, as Wyndham is not responsible for any of the day-to-day operations. Timeshares have surged in popularity as they gain greater acceptance in the broader travel community. Wyndham has taken advantage by opening its own resorts and providing services that allow timeshare owners to trade with each other.

Though we like Marriott International's business, we think the stock is pricey. Marriott was the early leader in recognizing that the management business could be extremely lucrative. The company spun off or sold most of its real estate in the early 1990s, turning itself essentially into a pure-play manager. The firm has consistently nurtured some of the best-known brands including the eponymous Marriott, Courtyard, Residence Inn, and Ritz-Carlton. Marriott already controls nearly 10% of the United States hotel market, and it is now focusing on international expansion. Management expects to increase the number of international rooms by 10% per year through 2009. Although the international market is a lucrative opportunity, we think the market is expecting too much from the firm--it is now trading nearly 40% above our fair value estimate. Pursuing a similar strategy is  Hilton Hotels , which repurchased its international arm that it had spun off in the 1960s. We believe this deal was a triumph for Hilton as it will allow the company to execute a consistent worldwide brand strategy.

Taking a different direction is  Starwood Hotels & Resorts , which has focused on branding by launching new concepts such as W and reinventing older brands like Sheraton and Westin. Starwood is also looking to its "aloft" concept, which will compete in the upscale segment against Courtyard and Hilton Garden Inn. Starwood has done a good job targeting travelers in their 20s and early 30s who are starting to hit the road in large numbers. We think that when this generation overtakes the baby boomers as the primary guests, Starwood will be well positioned with amenities and decor that younger patrons expect.  InterContinental Group (IHG) is also concentrating on branding as it tries to fix its aging Holiday Inn brand to make it more relevant to today's travelers.

Our Hotel Owner Picks
One of our favorite REITs is  Strategic Hotels & Resorts , which is currently trading below our fair value estimate. Strategic buys undervalued upscale and luxury properties and then redevelops them to realize their full potential. This can be as simple as new mattresses and TVs in guestrooms to complete overhauls of meeting spaces, restaurants, and lobbies. This active strategy is risky because it adds to the already-formidable capital expenditures that hotels need. But we think Strategic does a good job of managing this risk.  Ashford Hospitality Trust (AHT) follows a similar strategy for slightly lower-end hotels, but the company's short track record and concerns about the independence of one of its major managers gives us pause.

Other owners look for the best properties in the best locations, regardless of the redevelopment opportunities.  Host Hotels & Resorts (HST)--formerly Host Marriott--owns several marquee hotels in the most-attractive markets. Host recently expanded by purchasing most of the hotels still owned by Starwood earlier this year. This deal helped further establish the firm in prime markets such as New York City.  DiamondRock Hospitality (DRH) is a much smaller and younger company, but it has built an impressive collection of urban upscale hotels that have been performing well.  Sunstone Hotel Investors (SHO) has a portfolio of upscale hotels concentrated in California. Recently the company intensified its bet on the luxury sector by selling off a portfolio of midscale hotels, mostly Holiday Inns, to focus on big-spending travelers.

 Hospitality Properties Trust (HPT) leases out its properties, giving up the full profit and loss potential that its REIT peers experience. Instead, the company extracts a minimum rent payment from its third-party managers plus additional rent when hotels meet certain profitability and revenue targets. This creates a steady stream of guaranteed rents, which allowed HPT to remain profitable throughout the downturn. A recently announced deal to acquire truck-stop operator TravelCenters of America concerns us because it is such a departure from the firm's hotel business.

Concluding Thoughts
We think hotel management firms make the most-attractive investments. They have dug narrow moats around their businesses by creating recognizable brands. Their long-term management contracts guarantee a slice of hotel revenue without direct exposure to the rising costs of hotel ownership. Hotel owners are more attractive to investors looking for larger dividend yields, but several owners have been forced to cut or suspend dividend payments during lean times. Both types of firms are far from risk-free. Travel disruptions, long-term threats of overbuilding, and price pressure from Internet wholesalers like  Expedia (EXPE) pose serious concerns. Notwithstanding the potential pitfalls, we believe that investors buying firms with competitive advantages at a discount to our fair value estimates should rack up hotel rewards.