WOLF Great Wolf Resorts, Inc. (MM)

The year 2012 started on a positive note for the hotel & lodging industry, with lodging performance indicators witnessing considerable improvement in most regions of the world. However, global economic and political issues like sovereign debt, currency fluctuation and sustained economic instability in various countries will likely take their toll on lodging companies in the second half of 2012.

Notwithstanding the hurdles expected in the second half of 2012, the lodging sector is expected to continue its recovery trail this year. International travel and tourism volumes are anticipated to increase on the back of the rapidly growing BRIC economies.

Furthermore, mega events in Europe and South America scheduled from 2012 through 2016 will boost tourism. As owners and operators strive to enhance value and competitiveness, industry-best practices like sustainability and brand refreshment, will remain priorities this year.

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 helped hoteliers grab a bigger share of the overseas pie.

A number of U.S.-based hoteliers are targeting the fast-growing emerging economies, including India, Brazil, China, Russia and Africa. Major players in the industry like Starwood Hotels and Resorts Worldwide Inc. (HOT) and Marriott International Inc. (MAR) are primarily eyeing the Asia-Pacific, Africa 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 1.8%, 5.4% and 7.3% to 66.2%, $136.87 and $90.66 in June 2012.

China is set to fuel a recovery in global tourism, and is expected to emerge as the world's most popular travel destination by 2020. 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 and is growing in prominence 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.

The prospects for Latin America, particularly Brazil, remain outstanding. Brazil is the largest country in South America and is the fastest-growing travel and tourism economy in Latin America. For tourists, particularly domestic travelers, the region is becoming one of the hottest destinations. Brazil primarily attracts domestic tourists, who are enjoying an economic resurgence in recent times.

Moreover, with major events like the FIFA World Cup in 2014 and the Summer Olympics in 2016, 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 come up in the country to cash in on the FIFA World Cup and the Olympics.

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 with ADR over that same period. Changes in either occupancy or ADR will impact RevPAR, but with different implications for bottom-line profitability.

With lower supply in the U.S. economy, the hotel occupancy percentage is stepping up based on strong demand coupled 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 these 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 from the economic revival.

OPPORTUNITIES

The hotel industry continues to witness upside and remains on track for improved performance. According to statistics released by the US Department of Commerce in May, total annual spending of international tourists visiting United States has reached $14 billion, up 8% year over year. We expect the positive demand growth trend to continue in 2012 and beyond.

The US government has released a new National Travel and Tourism Strategy whose main objective is to attract more than 100 million international visitors by 2021, thus generating $250 billion annually in visitor spending by 2012. The government believes that this will provide significant growth stimulus for the local economy, which is currently hurt by the global economic crisis. If government succeeds, it will also create huge growth opportunities for the hoteliers.

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 second quarter of 2012 as well as for the fourth week of July.

Comparing the operating metrics on a year-over-year basis, the industry's occupancy, average daily rate and RevPAR at the end of the second quarter jumped 3.1%, 4.7% and 7.9% to 65.1%, US$106.41 and US$69.32, respectively.

PwC expects the US lodging industry to enjoy increased pricing in 2012, driven by improved occupancy levels, particularly in the higher-priced segments of the industry and a recovery in travel. PwC forecasts RevPAR growth of 6.5% in 2012, benefiting heavily from a 5.1% increase in ADR.

Demand Exceeds Supply

In the U.S., Smith Travel Research noticed growth of 3.5% in demand and an upside of 0.4% in supply during the second quarter of 2012. The firm expects the same trend to continue in the second half of 2012, but at a slower pace. In the U.S., PwC expects supply in 2012 to inch up 0.5% but demand to increase 1.8%.

Room rates are on the rise 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 June, the total active U.S. hotel development pipeline comprises 2,741 projects totaling 296,333 rooms, down 6.7% year over year. Among the chain scale segments, Luxury reported the largest increase in rooms in the total active pipeline, with 6,358 rooms (up 54.4%). Among the rooms under construction, the upscale segment reported the maximum increase of 52.9% with 18,692 rooms.

Shift Toward Asset-Light Model

Since late 2010, transition to an "asset light" business model has gained prominence in the hotels and REIT industries. Asset sales remains a long-term strategy to strengthen financial flexibility, which help 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.

Focus on Acquisitions

According to Jones Lang LaSalle, hotel operators are becoming proactive on the acquisition front, a trend which emerged last year and gaining momentum in 2012. Hotel operators are presently focusing on purchasing assets, mainly to aid brand development, in a small number of key cities. Consistent with this trend, industry behemoth Marriott has inked a definitive acquisition agreement with Gaylord Entertainment Co for an upfront payment of $210 million in cash by October 2012.

Increased Capital Expenditure on 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 position 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 tread 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.

WEAKNESSES

Tough Comparisons in 2012

The U.S. hotel industry is expected to witness fragmented growth across all the three metrics in 2012 due to the persisting global economic uncertainty, tougher year-over-year comparisons, upcoming presidential election and fiscal cliff in the U.S.

IMF projections for 2012 indicate global growth of 3.5%, down from the forecast of 3.6% in April. Financial turmoil and the deepening Eurozone crisis are responsible for sluggish global growth outlook and IMF warned that the outlook could dim further if policymakers in Europe and the US fail to act. For 2013, IMF has trimmed its global growth forecast from 4.1% to 3.9%.

IMF anticipates the U.S. economy to recover at a slow pace in 2012 and 2013—at about 2% and 2¼%, respectively. As per the World Trade Organization (WEO), U.S GDP could decline more than 4% in 2013, if policymakers fail to deal with the "fiscal cliff."

Tension in the 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, the tourism industry in Europe will remain challenged.

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, the Olympic Games in London brought more visitors in Europe, resulting in improved business for the hoteliers in the third quarter.

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 economic crisis is not uniform across the region.

As per the IMF's July 2012 projection, Eurozone economic growth is expected to shrink 0.3% in 2012 and inch up 0.7% in 2013. The IMF has sharply revised down its growth projections for the United Kingdom as the Eurozone crisis weighs on the recovery. The IMF now projects growth of only 0.2% in 2012 and 1.4% in 2013 for the United Kingdom. In April, the fund expected the UK economy to expand 0.8% in 2012 and 2.0% in 2013.

Slowdown in Emerging Markets

As per IMF, the emerging markets have started to witness a slowdown owing to weaker external environment and a sharp deceleration in domestic demand in response to capacity constraints and policy tightening, which could possibly hurt the performance of the lodging sector in the near term.

IMF has trimmed its July forecast for emerging economies, projecting an expansion of 5.6% in 2012 and 5.9% in 2013. Both figures are 0.1% lower than the April projection. Growth has slowed in a number of major emerging economies, especially Brazil, China and India.

The growth prospects for China remain lackluster as in the second quarter of 2012, the country recorded growth of 7.6%, which marks the slowest three-month annual growth in three years. As per IMF’s July forecast, China is expected to grow by 8.0% in 2012, down from its earlier April forecast of 8.2%.

The IMF has warned that the worsening debt crisis in the Eurozone will pose a "key risk" to China's growth. For 2013, growth in China is now expected to be 8.5% as compared to earlier projection of 8.8%.

The agency estimates weakening growth for India in 2012 and 2013. In its July projection, the agency cut down its growth forecast for India from 6.8% and 7.2% to 6.1% and 6.5%, respectively. For Brazil, the agency reduced its growth forecast from 3.1% to 2.5% in 2012.

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 gains.

Lags RevPAR Benchmark

Though RevPAR has fairly picked up since the recover of the industry in 2009, it has yet to reach the industry’s peak level seen in 2007 in U.S. As a result of economic uncertainty, it is now estimated that industry’s peak level will not be achieved before 2013.

Moreover, surging commodity prices and an unfavorable currency impact raise concerns about the ability of hoteliers 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 Starwood, Marriott, China Lodging Group Limited (HTHT) Great Wolf Resort, Wyndham Worldwide Corporation (WYN), Morgans Hotel Group and Hyatt Hotels Corp. (H).

We also remain concerned about the prospects of Home Inns & Hotels Management Inc. (HMIN), which currently retains a Zacks #4 Rank (Sell), and Orient-Express Hotels Ltd. (OEH), which holds a Zacks #5 Rank (Strong Sell).

Currently, Intercontinental Hotels Group plc (IHG) holds a Zacks #2 Rank (short-term Buy rating) and The Marcus Corporation (MCS) holds a Zacks #1 Rank (short-term Strong Buy rating).
 
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