A long night’s Journey

Hit by a slowing economy and now terrorist destruction in New York and Washington, hoteliers worry that Americans will avoid traveling.

Hit by a slowing economy and now terrorist destruction in New York and Washington, hoteliers worry that Americans will avoid traveling.

By Howard Rudnitsky
November 2001
Institutional Investor Magazine

Is that a buy signal?

The Ritz-Carlton Laguna Niguel resort in Dana Point, California, sits on a cliff with a panoramic view of the Pacific Ocean. With its Italian marble lobby, posh restaurants and such fancy accoutrements as saunas, fitness centers, spas and a golf course, the resort’s 394 well-appointed rooms run a hefty $400 to $500 a night.

It’s a steep price, but one that that well-heeled visitors and top corporate executives didn’t blink at paying in the summer of 2000. Then, Laguna Niguel had an occupancy rate of more than 90 percent - about as full as hotels get. But 2001 has been another story: A slowing economy, coupled with the terrorist attacks on New York and Washington, sent occupancy plunging to the low 40 percent range, says Steven Kisielica, senior vice president for development at Chicago-based Strategic Hotel Capital, which owns 28 luxury hotels, including the Laguna Niguel resort. By late October occupancy had recovered to 60 percent. Full service hotels break even at about 55 percent.

Terrorists destroyed more than New York’s famed World Trade Center twin towers on September 11. They damaged consumer confidence and inflamed a wound that was already festering within the travel industry. Less than a week before the attacks, Arne Sorenson, CFO of Washington, D.C.-based hotel industry giant Marriott International, surprised investors when he announced that “business in August was even worse than in July.” Sorenson went on to disclose that Marriott’s revenue per available room, or revpar, would decline by 7 to 10 percent in the third quarter, instead of the 5 to 6 percent decline the company had projected just two months earlier. As a result of September 11, Sorenson says, “That would have looked pretty good. We now expect revpar in the fourth quarter to decline by 25 to 30 percent.”

Most hotel analysts had long contended that revpar would never decline for an entire year. But according to accounting firm PricewaterhouseCoopers, a stunning 7.3 percent decline in revenue per available room, the first ever recorded, now appears likely for the industry in 2001. Worse, revpar in the “upper upscale,” or luxury, hotel segment is now expected to decline 12.8 percent this year, says Pricewaterhouse’s Bjorn Hanson, who heads the company’s hospitality and leisure practice.

In a special report issued a week after the attacks, Hendersonville, Tenneseee-based Smith Travel Research issued a very gloomy projection for the year, predicting that overall hotel occupancy, which began the year at 63.7 percent, would fall to an anemic 60.7 percent by year-end. The situation in New York is, understandably, much worse. According to a late September Pricewaterhouse lodging report on the Manhattan market, occupancy there is projected to fall from 84 percent in 2000 to 70 percent this year, the worst one-year decline since analysts began publishing data on the industry in 1927. The report also warned that there could be as many as ten hotel bankruptcies in New York.

Despite the gloomy forecasts, most major chains will still make handsome profits this year. There will just be some nettles amidst the clover.

But at the moment, the luxury segment is being hammered. This is the part of the industry that caters mainly to business travelers and includes the largest hotel companies - Starwood Hotels & Resorts Worldwide, Hilton Hotel Corp., Host Marriott Corp. and Four Seasons Hotels and Resorts. Although occupancy for this upper-crust hotel group was expected to decline, revpar is projected to be down far more. That’s because there is heavy discounting of room rates in key markets like New York, Boston and San Francisco to encourage travel.

“The full-service, upscale hotel brands have been hit harder, since they rely more on air travel than the midprice and economy brands that rely more on ‘drive-to’ business,” says Lehman Brothers lodging & gaming analyst Joyce Minor. Hotel chains like Hilton, Host Marriott and Starwood, with operations in ‘destination’ cities like Orlando, New York, San Francisco and Washington will be hit especially badly, she says.

As in other high-fixed-cost industries, including the airline industry, the leverage of increased - or decreased - revenue is enormous. Once the fixed costs of things like mortgage payments, real estate taxes, maintenance, salaries and utilities on are met, almost all the rest goes straight to the bottom line. A typical upscale hotel breaks even at an occupancy rate of 55 percent. Beyond that, the main variable costs are things like additional laundry and food. So a resort like Laguna Niguel was raking in money at 90 percent occupancy. By the same token, a hotel hurts badly as soon as it drops below breakeven.

A typical instance of the swoon in occupancy had already occurred in the 1,900-room Hilton San Francisco, in the heart of the city’s business district. In the summer of 2000, its lobby bustled and the hotel enjoyed an occupancy rate in the mid-80 percent range. By last August, however, stung by the tech meltdown, occupancy at the hotel had fallen to the mid-70s. And that was before the terrorist attacks.

Roiled by the attacks, hotel stocks fell sharply when the stock market resumed trading on September 17. Marriott International fell 21 percent; Starwood plummeted 28 percent; Hilton declined by 24 percent; and Host Marriott plunged nearly 25 percent. A dozen large, publicly traded hotel operating companies and REITs saw nearly $10 billion of market value erased in five days. The panic selling encouraged Marriott International and Starwood, both of which have considerable borrowing capacity, to buy in an additional 1 million shares each. Through late October the non-REIT lodging stocks had at least regained some of the lost ground.

The environment is proving to be especially brutal for most hotel REITs. Since May, Irving, Texas-based hotel REIT FelCor Lodging Trust had been seeking to merge with Washington-based MeriStar Hospitality Corp. in a $2.6 billion deal that had been projected to close in October. When completed, it would have made FelCor the second-largest hotel owner in the U.S., with 299 mostly full-service hotels, such as Crowne Plaza Hotels and Resorts, Doubletree, Embassy Suites Hotels, Hilton, Radisson Hotels & Resorts, Sheraton Hotels & Resorts and Westin Hotels & Resorts. FelCor’s president and CEO Thomas Corcoran said in August that he expected “a challenging operating environment for the remainder of 2001 and early 2002.” But by late September, after the devastating impact of the terrorist attacks on travel, it had become apparent that the proposed deal with MeriStar was no longer feasible. Citing “adverse changes in the financial markets,” the two companies announced that they were terminating their merger agreement. “The events that have occurred over the past few weeks have made the capital financial markets very unkind to any transactions,” said Corcoran in the press release announcing the cancellation of the merger.

Bethesda, Maryland-based Host Marriott Corp., an upscale luxury hotel REIT that owns 125 hotels, including Four Seasons, Hilton, Hyatt Hotels & Resorts, Marriott and Ritz-Carlton brands, also warned in July that the second half of the year would be worse than the first. It has proved to be tougher than president and CEO Christopher Nassetta had dreamed. “The tragic events of the past week, coupled with the already weak environment, will impact our fourth-quarter and full-year results and will need to be taken into account before establishing our fourth-quarter dividend,” he warned on September 19.

That same day Stephen Bollenbach, president and CEO of Beverly Hills-based Hilton Hotels, held a conference call to discuss the impact of the attacks on Hilton. “The next eight to 12 weeks could be the worst times ever seen in business travel,” Bollenbach said. “We’re running a business that’s going to have some short-term problems.” Bollenbach added that cancellations had been substantial since the attacks and occupancy levels at the company’s hotels “are really low,” and he predicted that earnings in the third and fourth quarter would fall short of Wall Street earnings projections. By next year, however, Bollenbach expects revenue and cash flow to return to 1999 levels.

In September, Lehman’s Minor wasn’t buying Bollenbach’s sanguine “short-term problem” hypothesis. “We are concerned that additional [terrorist] events could prolong or renew travel fears,” she warned. But a few weeks later, as occupancy rates picked up, Minor became more optimistic.

There is no question that the attacks have made matters more uncertain. Take, for example, the 1,400-room Hyatt Regency hotel in New Orleans. Adjacent to the Superdome, the hotel, with its towering atrium, is often used for conventions and large meetings. At the start of September, occupancy had dropped to about 70 percent because of the weakening economy. After the attacks, with so many people afraid, or unable, to fly, occupancy plunged. “We were lucky to be at 20 percent,” says Strategic Hotel Capital’s Kisielica. The company bought the hotel in 1997 at the same time it bought the Ritz-Carlton Laguna Niguel resort. At one point this fall, it seemed that New Orleans might lose the 2002 Super Bowl because of the delayed start of the football season. That would have been a catastrophe for the Hyatt. But the Super Bowl will remain in New Orleans, and occupancy has picked back up to almost 70 percent as travelers have resumed flying. “We’re seeing a substantial pickup in new business in October,” says a relieved Kisielica. “Companies are starting to book for next year.” Still, many of Strategic’s other hotels lag the recovery experienced by the New Orleans Hyatt.

Bollenbach remains surprisingly optimistic about next year, averring that business travel and the hotel business will start to rebound by January 2002. “The American people are not going to live in little holes in the ground,” he said in a conference call. “They’ll be back traveling.” That’s why, Bollenbach now says, “Hilton’s revenues and ebitda will roughly be about where they were in 1999, which was a good year.”

Although his 30-year career in the hotel industry lends credibility to his assessments of the ups and downs of the travel industry, Bollenbach’s optimism is not universally shared. From his foxhole across the country in White Plains, New York, Barry Sternlicht, CEO of Starwood Hotels & Resorts (which owns the Sheraton, Westin and other brands), has a more pessimistic take on the near-term outlook. Sternlicht - who knew absolutely nothing about the hotel business until 1997, when he made his opportunistic grab for ITT Corp. - labeled the attacks “a 1,000-year flood for hotels.” He promptly began slashing Starwood’s North American workforce by 23 percent and announced plans to gut capital expenditures from a planned $650 million to under $100 million in 2002. Recently, as it became clear he had been overly pessimistic, Sternlicht announced he would cut capital expenditure plans only to a little more than $200 million. Still, he said, “We’ve closed floors in many hotels and in many cases closed wings.”

As occupancy rates slide, the hotel industry faces tough room-rate negotiations with its corporate customers. Many companies and travel agencies negotiate the price and guarantee a minimum number of rooms for industry meetings and business travel with the hotel chains for the following year. “Corporate travel managers, eager to reduce expenses, have put further downward pressure on hotel rates,” says Pricewaterhouse’s Hanson.

“The major hotel brands already find themselves engaged in a rate war,” says John Arabia, hotel analyst for Newport Beach, California-based Green Street Advisors. By late September every one of the 25 largest hotel markets had experienced declines in average daily rates, according to data compiled by Smith Travel Research.

When the outlook seems bleakest, however, is when investment opportunities arise. James Ryan, a principal at Atlanta-based Lend Lease Real Estate Investments, whose Value Enhancement Fund IV has acquired three downtown city hotels over the past 18 months for a total of $175 million, says recession fears and softening rates are providing some buying opportunities, as “finite-life institutional funds that have owned hotels for a good number of years have to cash out,” to deploy the funds differently.

Despite extremely weak room demand this year - estimated to be down 3.5 percent, compared with up 3.8 percent in 2000 - this year’s profit outlook isn’t all that bleak. True, Pricewaterhouse’s Hanson now estimates earnings in 2001 will drop 21 percent from 2000, rather than his preattack estimate of 8.6 percent. But the hotel industry had a record profit of $23.4 billion in 2000. And though some hotel REITs will see earnings hit far harder than 21 percent, most will be profitable. “The lodging industry will make as much money this year as we did in 1998,” says Hilton’s Bollenbach. “Even $18 billion in profits ain’t chicken feed.” Meanwhile, the airlines are awash in red ink - requiring a $15 billion government bailout.

The hotel industry was much worse off in 1990-'91, when it lost $8.5 billion as a result of the recession induced by the Persian Gulf War, excessive construction, high operating costs and crushing debt. During that period investors shunned highly leveraged hotel debt, which for some companies reached 85 percent of total capital. The financial delinquency rate hit 17 percent, and lodging stocks fell by some 50 percent in a little more than two months.

Even Marriott Corp. became financially shaky, reeling from its enormous debt load. In a controversial transaction in October 1993, it split itself in two. It spun off most of its owned hotels to Host Marriott, to which it also transferred most of its debt. Marriott International kept the lucrative management contracts and franchising operations.

Marriott International’s leverage today is an extremely low 31 percent of total capital, in good part because it only owns about ten of its 2,225 brand-name hotels and is basically a hotel management and franchising company. It also has fast-growing hotel time-sharing and senior living operations, which are capital-intensive until they’re sold. In contrast, Host Marriott has $6 billion in debt, 76 percent of its capital.

“We have about $1.7 billion in net debt [after cash] today, but we look at our debt coverage and it is several times that,” boasts Marriott International’s Sorenson. That’s a far cry from the wobbly early 1990s.

The industry enters this slowdown in far better financial shape than in 1990. “Debt structures and interest rates are much lower today,” says FelCor’s Corcoran. “Breakeven back then was over 65 percent; today it’s around ten percentage points lower. There had been far too much [room] supply, companies were heavily leveraged, and a number of them faced bankruptcy.”

Still, Pricewaterhouse’s Hanson projects a 5 to 10 percent financial delinquency rate next year, up from 1 percent at the start of this year.

The impact on earnings would have been worse but for several factors that helped support lodging company earnings through the first seven months of this year. Consumer travel spending stayed strong through much of the summer. The largest hotel chains got a boost from being able to offer a variety of rooms at different price points and in different geographic locations to business travelers. “Some businessmen shifted from a five-star to a four-star hotel,” says Marriott International’s Sorenson. “And we’ve also been able to hold on to customers because we have hotel products in the suburbs, where the markets are healthier.”

Falling interest rates have also helped this year. Among the biggest beneficiaries: Starwood Hotels and Hilton Hotels. Starwood has seen its interest costs on $5.5 billion in debt on its balance sheet fall from 9.31 percent at year-end 2000 to about 5.67 percent at the end of September.

In addition, some chains - Marriott and Hilton in particular - benefited this year from their vacation ownership time-sharing revenues and profits. Marriott experienced an 11 percent gain in time-share operating profits, to $39 million, in the June 2001 quarter. It also recorded a $38 million gain on the sale of time-share receivables, compared with just $6 million for the same quarter last year. Hilton’s Grand Vacations Club time-sharing business added an estimated $20 million of incremental profit in this year’s first half. But since the hijackings, with layoffs rapidly mounting, consumer travel spending has slowed.

Most hotel chains had quickly reduced their operating costs as occupancy declined, deferring the replacement of TV sets, cutting back on costly image advertising and reducing bonuses for managers. Hotel industry executives like Hilton’s Bollenbach insist they haven’t done anything on the cost-cutting front that might hurt the customer. “We don’t want the customer to perceive cost controls,” Bollenbach explains. “There are lots of things you can do behind the curtain, like defer information technology spending for a few months. Still, you can’t do these things for long. The easiest things to do may not be the best, like dramatic staff reductions or postponing really needed capital expenditures.”

To get past the travel slump, hotel executives and analysts have mainly been cutting back on the addition of new rooms. In 1998 and 1999 the industry added 4.2 percent a year. That growth rate dropped to about 2.3 percent in 2001 and is expected to fall below 2 percent in 2002. Slowing the rate of growth in rooms will help bolster occupancy and rack rates. “Supply is declining because lenders are more diligent these days,” says Marriott International’s Sorenson. “That’s good for the industry and good for big, well-financed players.” Chains like Marriott, Hilton and Starwood are more able to continue to build because they can borrow more easily.

Slowing room supply growth clearly helps in the long run, but it won’t benefit earnings next year for the big upscale lodging companies because growth in demand is likely to be an anemic 1.5 percent to 2 percent, according to Deutsche Banc Alex. Brown lodging analyst Mark Mutkoski. Since August, demand for upscale urban hotel rooms has dramatically deteriorated. A September 24 PricewaterhouseCoopers report estimates that new room starts for 2002 will be 28 percent below 2001 starts, meaning that net supply growth for 2002 is now estimated at 1.5 percent, the lowest since 1995.

Green Street Advisors’ Arabia continues to believe “earnings are likely to be dramatically impacted through 2002.” In fact, he says, because of substantial operating and financial leverage, the potential “earnings hits are enough that hotel REITs are being forced to address the issue of dividend cuts.” Because of its high operating costs and financial leverage, the hardest impact will be felt by REIT Host Marriott, which, Arabia says, could conceivably see its adjusted funds from operations - which factor in maintenance costs and recurring capital expenditures - “decline by 75 percent in 2002 versus our prior estimate.” He also expects “a smaller but still sizable 50 to 60 percent [adjusted funds from operations] decline in 2002,” for both FelCor Lodging and MeriStar Hospitality. Already in October two hotel REITs, Host Marriott and Innkeepers USA Trust, announced that they were suspending their fourth-quarter dividend payments. Arabia expects all three of the major REITs to rebound sharply in 2003 as occupancy and rates strengthen.

Dividend rate-cut fears kept REIT lodging stocks depressed in October, while other lodging stocks recovered by more than 25 percent after September’s disastrous plunge. Even if substantial 2002 earnings declines hit the upscale REITs and they are forced to cut dividends by as much as 40 or 50 percent, Lehman’s Minor points out that “they would still be yielding 7 to 12 percent.” She notes that lodging stocks were recently “trading at discounts to replacement cost of 15 to 40 percent,” compared with 30 percent at typical market bottoms. Put simply, Minor is saying lodging stocks are oversold.

Although the record years for the industry seem to be over for now, most upscale hotels are still making money, and they should do even better in 2003. It’s unclear how long it will take for people to recover their desire to travel, while the U.S. remains at war. Industry executives and analysts agree that the upscale lodging sector will improve even more, barring any massive new attacks on the U.S. They differ only on the issue of when that will happen.

In that difference of timing lies an investment opportunity.

“Twelve months from now, lodging stocks will be up by about 50 percent from their recent lows as the market anticipates the recovery,” says optimist Mutkowski.

Buy your stocks while they’re down.