Over the past few months, we have become increasingly concerned about the lodging industry's vulnerability to the issue of room supply growth. Therefore, we have reduced our group weighting to "average."
Lodging stocks outperformed the market by 18 percentage points in 1996 and are slightly ahead to date in 1997 as well. We believe concern about room supply will grow, and cause investors to become much more selective in their picks, favoring chains with mainly upscale exposure.
The chart below shows that supply growth has experienced an almost uninterrupted acceleration over the past year or so from 1.5 percent in January 1996 to 2.8 percent in January 1997. With construction activity at record levels, there is little chance that supply growth will ease anytime soon.
The evidence is very strong that many of the public companies focused in the upper upscale segments will remain relatively isolated from the effects of overbuilding for the next two to three years, and we feel comfortable that their fundamentals will remain solid through 1997 and 1998. We would include companies such as Doubletree, Hilton and Host Marriott in that grouping. But others with exposure in the midscale or lower-price tiers of the market will likely face increased pressure on numerous fronts, including occupancy, room rate increases, labor costs and margins in general. Combining these concerns with valuation issues, we have reduced our ratings on both Bristol Hotels and Promus Hotels from 2 to 3.
In addition to oversupply concerns, another issue that likely will influence hotel stocks in 1997 is industry consolidation. Within the past three months, announcements regarding Hilton and ITT, Marriott and Renaissance, and Extended Stay America and StudioPlus have focused investors' attention on potential mergers and acquisitions, both friendly and unfriendly. A strong case can be made as to why further consolidation in the industry makes sense, including:
1. The number of hotel companies far exceeds those in comparable travel categories such as airline, car rental and cruise.
2. The hotel business is becoming more global, and international acquisitions make strategic sense.
3. There has been a sharp increase in the number of alliances within the industry, from which a merger is but a short step.
4. Capital costs to fund a purchase are historically low, and many firms may feel at risk of being left behind if they aren't an active participant in industry consolidation.
The theme of consolidation is consistent with our sense of an underlying shift in the hotel business. In the next few years, we anticipate a pattern similar to what has been seen in the gaming business in the past two to three years, wherein the strongest companies have pulled away from the pack. While the analogy cannot be taken too far because of the numerous differences between the two businesses, we think that there are good reasons why the top five hotel chains will wield more control over the business in 2002 than they do today. In addition to the items noted above, other factors supporting an increasing concentration of power would include economies of scale, marketing and distribution clout, financial muscle and a rising premium on the best management talent as competition intensifies.
Upscale chains are compensating for minimal or no development activity by buying. They continue to buy individual hotels-which on average could be acquired in 1996 for 65 to 80 percent of replacement value-and have found that the supply of good product to purchase has remained high. While prices climbed in 1996 and will continue to do so this year, we do not think any major chains will run out of product to buy. Moreover, many of them have shifted their sights to entire chains as a way to grow their asset base and their earnings. Examples are Marriott outbidding Doubletree for Renaissance and Hilton seeking ITT with its well-positioned Sheraton hotel unit. We expect to see more upscale chains (e.g., Westin, Inter-Continental) in the news in 1997 via public offerings or acquisitions.
In fact, the upper upscale and upscale segments of the hotel market (based on the new Smith Travel Research segment definitions) remain in excellent shape from both a supply and a demand perspective, and are expected to stay so through our 1997-1998 forecast period, enhancing participants' pricing flexibility and profit margin expansion potential.
Other sectors are expected to begin to feel the effects of an industry shifting from an excess of demand to an excess of supply. For the first time in five years, the industry is expected to see the growth in the supply of rooms outpace the increase in demand for them, causing occupancy rates to ease slightly and the pace of growth in ADR to ebb from its impressive 1996 level. Certain sectors are particularly exposed to supply concerns: The upper economy and the midscale without food and beverage categories accounted for 63 percent of net industry room additions in 1996 and 83 percent over the 1993-1996 period (see chart, top of page).
Threatening to exacerbate that situation is a spate of 20 new brand introductions in the past two years, most of which are in the midscale or lower-priced categories, a condition reminiscent of the early to mid-80s. The top tiers of the market, however, have seen a dearth of new room development (although we expect to see it get under way this year and accelerate in 1998), and the two- to four-year lead time necessary to build an upscale facility suggests that the supply balance should remain positive into 1999.
One of the scariest indicators in regard to supply growth is the sharp escalation in room construction activity that took place in 1996, with a record $11.2 billion put in place, up 56 percent from the prior year. While on a constant-dollar (1992) basis, the construction index remains below the crazy peaks of 1984-1987, it is not far enough below to escape concern.
A major cause for the ebullient times in the lodging business is the consistent, solid pace of aggregate economic growth in the past several years. Demand will remain closely aligned with overall economic growth as in years past (a correlation of 0.95 since 1990), and the consensus prediction for a modestly slowing rate of real GDP gain in 1997 and 1998 indicates that an ebbing in hotel room demand can be expected both this year and next.
The number of hotel real estate transactions, their total value and, of course, the price per room all are moving ahead smartly. This is true generally, and certainly so for the over-$10 million properties, which tend to be those the public chains trade in. Availability of financing for these transactions, for refurbishments and for acquisitions has loosened up considerably over the past year, but funding of new development projects remains very limited above the midscale price point. Capital is abundant for mid- and lower-priced hotels, although this has generally been the case to varying degrees for the past several years. A major change in financing of the industry over the past two-plus years is the public markets, which have contributed a total of $10.3 billion in debt (46 percent of the total) and equity (54 percent) capital to C-corps (71 percent of the proceeds) and REITs (29 percent) from 1995 through early 1997.
Our forecasts for key barometers in 1997 include:
<UL TYPE=DISC> <LI>Room supply should rise 2.9 percent.
<LI>Room demand should increase 2.2 percent.
<LI>Occupancy is estimated to fall 0.5 p.p. to 64.7 percent.
<LI>ADR is projected to gain 5.9 percent.
<LI>RevPAR should grow 5.1 percent.
<LI>Industry pre-tax profits are estimated to rise 21 percent to $13.5 billion.
<LI>We believe that the key issues in 1997 will be:
<LI>The pace of room supply growth
<LI>Activity in the aggregate economy and the resultant impact on room demand growth
<LI>When and how rapidly the rate of ADR increase slows
<LI>The pace of industry consolidation (i.e., mergers and acquisitions) and how that influences capital allocations
<LI>Our preliminary thoughts on the 1998 outlook are:
<LI>Room supply should continue to accelerate, rising 3 percent.
<LI>Room demand is expected to gain 2.1 percent.
<LI>Occupancy is anticipated to fall another 0.6 p.p.
<LI>ADR will increase 5.5 percent.
<LI>RevPAR is estimated to move up 4.6 percent.
<LI>Industry profits are forecast to rise 15 percent to $15.5 billion.
<LI>Our favorite stocks among the large caps are:
<LI>Hilton. Among the shapers of the industry's future, Hilton has been pummeled since its hostile bid for ITT. We think the stock can get to the low $30s, win or lose on ITT.
<LI>La Quinta. A contrarian bet given its segment: We believe the Gold Medal Program will work, and that LQI takes share from others. We forecast a $24-$25 stock price target in a year.
<LI>Host Marriott. Few are better positioned in terms of segment or have done a better job of beating Wall Street expectations for the past two years. Not dirt cheap, but we like the story.
<LI>Doubletree. Another "activist" industry shaper and a leader in consolidation. Stock is not inexpensive, but it beats estimates, and is well positioned and managed.
</UL>Among smaller caps, we like U.S. Franchise Systems and Candlewood, both led by top-quality people and both with dynamic 50 percent-plus growth stories for several years to come.
<I>John Rohs is managing director at Schroder Wertheim & Co. Inc., New York.