WOLF Great Wolf Resorts, Inc. (MM)

The hotel and lodging industry is progressing quite well in the first half of 2012, based on strong global travel demand and sustainable U.S economic growth. With the global economy gradually recovering, leading to turnaround in business, higher leisure travelers and decelerating supply growth, pricing power is expected to remain stable for the year.

Moreover, easing U.S. visa procedures, European Soccer championships in Poland and the Ukraine, followed by the Olympic Games in London will further boost tourism in 2012 in the US and Europe, respectively.

Recovery in the U.S. economy and the consequent rise in operating metrics helped most of the hoteliers report strong quarterly results. Group bookings appear to be gaining momentum and the companies registered strong advance bookings and pricing for 2012 and beyond.

However, the sovereign debt crisis in Europe and slowdown in emerging markets will restrain industry growth in 2012. Overall, the long-term outlook of the sector remains promising.

International Growth

Owing to the saturation in the U.S market, major hoteliers are exploring growth opportunities abroad. Some international markets offer greater potential based on the prevailing higher pace of economic growth. The operating environment in those markets enabled hoteliers to grab a bigger share of the overseas pie.

A number of U.S.-based companies are targeting the fast-growing emerging economies. Major players in the industry like Starwood Hotels and Resorts Worldwide Inc. (HOT) and Marriott International Inc. (MAR) are eyeing the Asia-Pacific and Latin American regions.

The stellar performance of the Asia-Pacific region is expected to continue. Hotels in the Asia-Pacific region have been registering significant upside across all three key performance metrics, according to Smith Travel Research. The region's Occupancy, ADR and RevPAR increased a respective 4.4%, 4.8% and 9.4% to 69.4%, $145.64 and $101.01 in March 2012.

Major growth markets within Asia-Pacific, China and India remained more or less unaffected by the global economic turmoil and long-term growth prospects remain strong. The availability of local capital is another positive factor.

China is set to fuel a recovery in global tourism, and by 2020 is expected to be the world's most popular travel destination. Both Starwood and Marriott generate their second largest revenue chunk from China.

Apart from China, India is another hot spot for the western hoteliers. India possesses a compelling investment proposition with its rising importance as a global business hub, where the demand for moderate-tier as well as upscale branded hotels is expected to considerably outpace the supply over the next three to four years.

Moreover, western hoteliers also find the built-cost to operating returns favorable. According to the latest Tourism Satellite Accounting (TSA) research published by the World Travel and Tourism Council (WTTC), the demand for travel and tourism in India is expected to grow by 8.2% between 2010 and 2019.

The prospects for Latin America, particularly Brazil, remain outstanding. Brazil is the largest country in South America and is Latin America's fastest-growing travel and tourism economy. For tourists, particularly domestic travelers, the region is becoming one of the hottest destinations. Brazil primarily attracts domestic tourists, owing to the resurgence of the middle class.

Moreover, with major events like FIFA World Cup in 2014 and Olympics in 2016 coming up, the Brazilian government has turned its focus to improving the infrastructure of the country as demand for hotel rooms will shoot up and the events will significantly increase tourism in the country.

According to Jones Lang LaSalle, hotel investment in Brazil will be around $2.4 billion by 2014. The real estate consulting company predicts that a large number of hotels will be constructed in the country to cash in on the FIFA World Cup scheduled in 2014 and the Olympics in 2016. Business Monetary International forecasts 21.5% growth in tourist arrivals in Brazil through 2015, totaling over 6.73 million tourists.

Metrics Analysis

In evaluating hotel companies, we pay close attention to changes in average daily room rate (ADR) to figure out the likely pace of improvement in the sector.

A key operating metric in the lodging industry is RevPAR (revenue per available room), which is derived by multiplying the occupancy percentage of a hotel over a given period by ADR over that same period. Changes in either occupancy or ADR will impact RevPAR, but with different implications for bottom-line profitability.

With the recovery in the U.S. economy, the hotel occupancy percentage is stepping up due to strong demand, along with continued higher pricing. However, declining occupancy percentages during the recession compelled some hoteliers to slash room rates in a bid to woo visitors. Large group hotels are still being impacted by group business booked in 2008-2009, which were recessionary years. In most cases, this tactic results in material long-term damage to the business primarily for some reasons:

• First, increase in occupancy is accompanied by escalating operating expenses. For every room that is occupied, there are additional costs such as housekeeping, laundry and utilities that must be incurred. Margins are compressed when room rates decline and variable operating expenses increase. Changes in ADR, however, affect the bottom line considerably.
• Second and more importantly, cuts in ADR will be difficult to recoup when the operating environment eventually improves. After slashing room rates in an effort to fill up rooms, attempts to restore these to the previous levels are likely to be met with significant resistance from clients. The ability to benefit from an improving economy will thus be delayed.
• Finally, the ability of lodging companies to sustain room rates should have a significant impact on their capability to weather any kind of economic uncertainty. By keeping an eye on changes in ADR, investors can gain some insight into companies that are best poised to benefit with the economic revival.

OPPORTUNITIES

The hotel industry continues to witness upside and remains on track for improved performance. We expect the positive demand growth trend to continue in 2012 and beyond. According to Smith Travel Research, the leading information and data provider for the lodging industry, the U.S. hotel industry reported increased results across all three key performance measures -- occupancy level, ADR and RevPAR for the first quarter of 2012 as well as for the third week of April.

Comparing the operating metrics on a year-over-year basis, the industry's occupancy, average daily rate and RevPAR at the end of the week increased 12.6%, 7.8% and 21.4% to 65.5%, US$106.66 and US$69.91, respectively.

In its April projection, The International Monetary Fund's (IMF) also raised its US growth forecast for 2012 to 2.1% from its previous projection of 1.8% in January.

Demand Exceeds Supply

In the U.S., Smith Travel Research expects supply in 2012 to inch up 0.8% but demand to increase 1.3%. In 2013, supply is estimated to rise 1.4%, but demand is expected to jump 2%.

Room rates swung back to profit in an environment marked with higher demand and lower supply, thus resulting in RevPAR growth in 2012.

According to data published by Smith Travel Research in March, the total active U.S. hotel development pipeline comprises 2,752 projects totaling 293,850 rooms, down 9.5% year over year. Among the chain scale segments, Luxury reported the largest increase in rooms in the total active pipeline, up 17.8% with 16,772 rooms. However, despite reporting maximum upside in both rooms under construction and rooms in the total active pipeline, the Luxury segment still accounts for a small number of actual rooms compared to other segments.

Shift Toward Asset-Light Model

Since late 2010, transition to an "asset light" business model has gained prominence in the hotels and REIT industry. Asset sale remains a long-term strategy to strengthen financial flexibility, which help the companies grow through management and licensing arrangements instead of direct ownership of real estate. A higher concentration of management and franchise fees reduces earnings volatility and provides a more stable growth profile.

Hence, the hoteliers are focused on rebalancing their portfolios by increasing contributions from managed and franchised hotels. This fee-based business is attractive as growth is powered by multiple sources like RevPAR growth, unit additions and incentive fee escalation. The business is also capital efficient as owner/developer partners provide the capital and the company earns a fee by managing/franchising the property.

Following the industry trend, many industry players like Morgans Hotel Group Co. (MHGC), Red Lion Hotels Corporation (RLH), Great Wolf Resorts Inc. (WOLF) and Starwood embarked on an asset disposition strategy.

Increased Capital Expenditure in Renovation

Most of the hoteliers are increasingly investing on property renovations in recent times. Hotel companies are working hard on guest satisfaction to enhance their positions in a cut-throat environment. Brand conversion and remodeling has emerged as a trend for major hoteliers. Many industry biggies like Starwood, Marriott, and others have treaded the same path.

There are several well positioned, older hotels in metro markets, which are good candidates for restructuring. Hence, we believe that 2012 will likely witness further renovations.

Currently, Starwood (HOT), Marriott (MAR), Intercontinental Hotels Group plc (IHG), Orient-Express Hotels Ltd. (OEH) and The Marcus Corporation (MCS) hold Zacks #2 Ranks (short-term Buy rating). Whereas, Wyndham Worldwide Corporation (WYN) holds a Zacks #1 Rank (short-term Strong Buy rating).

Simplified U.S. Visa Process

To boost travel and tourism in the U. S., the government has recently signed an administrative order aimed at simplifying the visa process. The government aims at increasing its share of the international travel market by easing the visa procedure. Hotel companies remain upbeat regarding the government's initiative and expect to enjoy more visitations in the U.S., which remained hampered earlier due to stringent visa policy.

WEAKNESSES

Tough Comparisons in 2012

The U.S. hotel industry is expected to witness fragmented growth across all the three metrics in 2012. Smith Travel Research remains apprehensive regarding the three key performance metrics for 2012, due to the persisting global economic uncertainty and the tougher year-over-year comparisons.

In January 2012, Smith Travel Research slightly raised its forecast for 2012 from its previous projection in November last year. Occupancy is expected to rise 0.5% to 60.4% as compared to the earlier projection of 0.2% to 60.0%, ADR will increase 3.8% to US$105.45 versus 3.7% to US$105.29, while RevPAR is expected to end the year with an upside of 4.3% to US$63.68 compared with an increase of 3.9% to US$63.18.

IMF projections for 2012 indicate a global growth of 3.5%, up slightly from 3.3% forecasted in January, but down from the forecast of 4.1% in September. The financial turmoil and the deepening Eurozone crisis are responsible for sluggish global growth outlook and weak investor projections. Hence, lack of worldwide growth and strong demand last year will make the situation tougher in 2012.

Tension in Eurozone

Hoteliers' expansion plan through management and franchise deals in Europe seem to be under pressure due to the prevailing credit crunch. European banks have curtailed lending to real estate developers in the wake of the Eurozone debt crisis. Until the prevailing economic challenges are not resolved in Europe, customer will continue to remain cautious in visiting Europe.

Hence, hoteliers will likely witness a soft booking trend in the region as most of their European businesses are driven by the leisure segments located specifically in Spain, Italy and Greece. However, European Soccer championships in Poland and the Ukraine, followed by the Olympic Games in London, might drive higher visitors in Europe.

These European countries are significantly exposed to sovereign debt challenges. Some companies anticipate weak performance in the British provinces, arising from the government austerity efforts. However, the effect of crisis is not uniform across the region.

As per the IMF's April 2012 projection Eurozone economic growth is expected to shrink by 0.3% in 2012.

Slowdown in Emerging Markets

The emerging markets have started to witness a slowdown, which could possibly hurt the performance of the lodging sector in the near term. The growth prospects for China remains lackluster as in the first quarter of 2012, the country recorded only 7.2% sequential growth on a seasonally adjusted basis for 2012, below the government's newly-revised 7.5% full-year growth target. In January, the IMF expected China to grow by 8.2% in 2012 and currently reiterated its forecast for the region.

The IMF also estimates slightly weakening growth for India in 2012. In its April 2012 projection, the agency cut down its growth forecast for India from 7.0% to 6.9%.

Stiff Competition

Competition is also growing considerably across the sector. Every hotel company is not only competing with major hotel chains in national and international venues but also with home-grown hotels in regional markets. Heightened competition and potential addition of new supply will restrict market share.

Comparatively Slower Growth in ADR

Though occupancy levels have fairly picked up, ADR is yet to show meaningful improvement in the U.S. We believe that the acceleration in room rates will not reach the peak level, seen in 2007, before the end of 2012. Additionally, the rebound is not uniform as many secondary and tertiary markets are yet to see strong recovery. Moreover, surging commodity prices raise concerns about the ability of hotel companies to control costs.

By the looks of things, we currently refrain from being too enthusiastic on a number of stocks in our universe, which continue to have a Zacks #3 Rank (Hold). These include Great Wolf Resort (WOLF) and Hyatt Hotels Corp. (H).

We also remain concerned about the prospects of Morgans Hotel Group (MHGC) which currently retains a Zacks #4 Rank (Sell) as well as China Lodging Group Limited (HTHT) and Home Inns & Hotels Management Inc. (HMIN) which hold Zacks #5 Ranks (Strong Sell).

 
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