The operating environment in the hotels and lodging sector has continued to deteriorate in the last few quarters, and we expect hotel industry operating metrics to remain stretched in the near term. As the recession continues, both business and leisure travelers are cutting back on their trips.
However, with some early signs of economic recovery, we believe that hotel occupancy will improve in the fourth quarter of 2009 and in 2010. Though occupancy levels are expected to pick up, pricing pressures will continue as hotels will carry on offering heavily discounted rates to draw in travelers. As such, profits will remain cagey in this environment.
In evaluating hotel companies such as
Starwood Hotels and Resorts Worldwide Inc. (
HOT) and
Marriott International Inc. (
MAR) during this down cycle, we will be paying close attention to changes in average daily room rates as an indication of how quickly the sector may recover once the economy improves.
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.
Given the current state of the U.S. economy, it is no surprise that hotel occupancy percentages have been down. Some hotel owners have initiated to slash room rates in an attempt to fill beds. In most cases, this tactic will result in 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 paid. When room rates decline while variable operating expenses remain stable, 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 those rates to previous levels are likely to be met with significant resistance. As such, the ability to benefit from an improving economy will be delayed.
Ultimately, the ability of lodging companies to maintain room rates as much as possible should have a significant impact on their ability to weather the downturn. Cutting rates meaningfully should be an absolute last-ditch effort to survive, because changes in rate have the biggest impact on the bottom line and are the hardest to recoup when the operating environment improves. By keeping an eye on changes in ADR, investors can gain some insight to the companies that are best poised to benefit when economic growth rebounds.
OPPORTUNITIES
The beginning of the recovery for hotels is expected to be primarily demand driven as the economic recovery gains momentum. Also, with a stressed credit market, we expect a deceleration of lodging supply growth. Hence, with some early signs of economic recovery, we expect occupancy levels to increase in the rest of 2009 and 2010, driven by increasing demand and slowing supply growth. Though we expect RevPAR to decline modestly in the fourth quarter, we expect stability in 2010.
We also note that the year-over-year comparison in the fourth quarter of 2009 will be easier as the fourth quarter reflects the one-year anniversary of the abrupt decline in lodging demand that occurred during the fourth quarter of 2008.
When researching potential investments in the sector, however, we would advise investors to pay close attention to the ADR reported by lodging companies. We expect that companies that are best able to maintain room rates through the downturn will be the best positioned to capitalize once economic conditions do improve.
We have a Neutral recommendation on Marriott. The company has benefited from the implementation of the cost reduction initiatives. We believe that Marriott is better positioned to command a premium room rate relative to the overall lodging industry. We are also positive about the prospects of
Marcus Corp. (
MCS),
Choice Hotels International Inc. (
CHH) and
Wyndham Worldwide Corp. (
WYN).
WEAKNESSES
According to data from Smith Travel Research, the U.S. hotel industry reported declines in all three key performance measurements during the first week of November. The industry’s occupancy decreased 3.6% year-over-year, while the average daily rate fell 8.5%. These declines resulted in an 11.8% drop in RevPAR.
We expect RevPAR to decline through the remainder of 2009. To this point, the majority of the declines have stemmed from occupancy losses. Nevertheless, while occupancy declines have somewhat stabilized, the rate of decline in ADR has continued to increase. Given the lower levels of room revenue, we expect margins to tighten materially during 2009, resulting in substantial year-over-year earnings declines.
We expect hotels in the Luxury and Upper Upscale Chain Scale segments to experience greater declines in RevPAR due to continued pricing pressure primarily from both larger corporate accounts and meetings. We noticed that Starwood, which operates mostly luxury and other top-tier properties, has been particularly sensitive to the decline in business travel and corporate cost-cutting. Though we have a Neutral recommendation on Starwood, we note that its margins remained compressed in the third quarter. We are also concerned about the prospects of
Morgans Hotel Group Co. (
MHGC).
In addition, companies with weak balance sheets -- or even limited financial flexibility -- will likely have a harder time navigating the challenges created by the economic recession.
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