Checkout Time for Hotel Stocks?

After a great multiyear runup, it looks like now might be time for investors to pack their bags

by Charles DuBow

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Today there are more expensive hotels and resorts offering exotic pampering, fawning service, fantastic food, and eye-popping prices than at any time in the history of the world. Islands once barely habitable are now clogged with private yachts and belly-button-revealing beauties temporarily in search of paradise. City blocks that had formerly housed factories have become home to hedonistic high-rises that welcome American Express' favorite customers on a regular basis. If you're willing to pay for it, it's almost impossible to travel far without being able to find a luxury hotel that offers beds swathed in Egyptian cotton, aromatherapy spas, or four-star restaurants serving French premier crus and caviar.

Beginning in 2003, the hospitality industry began what turned out to be a four-year surge. Share prices of hotel chains with significant luxury holdings have soared. Last year alone, nine luxury chain-affiliated hotels were built in the U.S., adding more than 2,000 rooms to an increasingly crowded field. Overseas, construction is equally aggressive, especially in burgeoning markets such as China and India.

But are there too many hotel rooms? Some analysts are beginning to think so.

The reason is that there soon could be more luxury hotel rooms than guests to fill them on a regular basis. While the potential of a glut would be spread across the entire hospitality industry, it could be even more worrisome for large operators such as Marriott (MAR), Starwood (HOT), InterContinental (IHG), and Fairmont (FHG) that have a strong presence in the luxury sector.

Downward Turn?

While they make up only 2.6% of the overall market room supply, luxury hotels account for 5.5% of room revenue. According to Smith Travel Research in Hendersonville, Tenn., rates for all U.S. hotels rose 7.1% in 2006, but luxury hotels increased 9%. For the most part, luxury hotels don't generate higher returns cash on cash but will often generate higher returns based on appreciation of the cost. A decline in revenue from their luxury subsidiaries would have an equally disproportionate impact on the parent companies' bottom lines.

"The U.S.-wide slowdown in room demand and ADR growth is evident across all sectors of the hotel industry," says Bjorn Hanson of PriceWaterhouseCoopers. (ADR is an acronym for Average Daily Rate, a metric that determines a hotel's pricing scale by dividing actual daily revenue by the total number of available rooms.) "This is a cyclical industry, you see, and we could be coming to the top of the cycle."

But Hanson believes the luxury sector will be reasonably well buffered, even if it won't see the same kind of gains it has enjoyed recently. He predicts that for the luxury lodging segment, revenue per available room (RevPAR) will only grow by 7.3% on the strength of a 7.4% increase in ADR as occupancy declines by 0.1%. By contrast, in 2006 RevPAR was up 11.6% on a 9.1% rise in ADR and an occupancy growth rate of 1.6%. And don't look for any rapid rebound. Hanson further forecasts that the numbers will continue their downward trend over the next few years.

That doesn't mean the sector is in trouble, however. It just means that shareholders won't witness the kind of growth they've become accustomed to seeing.

Deals Still Brewing

The warning signs have been out there for a while. Last October, analyst Steven Kent at Goldman Sachs (GS) was one of the first to raise concerns about the industry's near-term future when he downgraded the lodging sector overall to neutral from attractive. He admits he was a little early, because rumors of private equity takeovers and better-than-expected top-line guidance for 2007 continued to buoy share price.