In most markets, the price of a good is dictated by supply and demand. When supply outstrips demand, prices fall; when demand outstrips supply, prices can rise rapidly. The latter scenario currently exists in the lodging industry and is likely to persist for many years to come. Companies in this industry will likely experience large increases in profitability over the next few years as a result of the growing shortage of hotel rooms throughout the country.
High profits resuming
Most hotels and resorts are faring much better in the post-recession years than they did during the depths of the crisis. In fact, many hotel chains did not experience a sustained downturn in profitability as a result of the economic slowdown. Instead, most hotels bounced back relatively quickly.
For instance, Marriott International Inc (NYSE:MAR) experienced one year in the red before returning to profitability in 2010 (free cash flow remained positive throughout the recession). The company’s fee-based business model spared it from the heavy losses that more asset-heavy firms experienced.
The fee-based model works well for several reasons. For one, it takes much less capital to generate profits than if the company owned its land and hotels. Instead, Marriott International Inc (NYSE:MAR) uses its brand and know-how to manage hotels owned by others. This capital-light model enables it to grow revenue and profits with hardly any additional investment, allowing the company to return more capital to shareholders.
Marriott International Inc (NYSE:MAR) also exited its timeshare business, as it was unable to earn outsized profits due to heavy competition with Wyndham Worldwide Corporation (NYSE:WYN) and others. Wyndham Worldwide Corporation (NYSE:WYN) is perhaps the most profitable firm in the timeshare business because it has made the market a key component of its strategy. As a result, the company earns higher margins than most other companies in the timeshare business.
But Wyndham Worldwide Corporation (NYSE:WYN)’s real strength is its attention to shareholder return. The company has repurchased a significant number of shares over the last few years and management recently increased the dividend. Shareholder-friendly management is one of the key reasons why Wyndham Worldwide Corporation (NYSE:WYN) could be a good investment over the next decade.
Another hotel chain, Starwood Hotels & Resorts Worldwide, Inc (NYSE:HOT), has a different strategy than Marriott International Inc (NYSE:MAR) and Wyndham Worldwide Corporation (NYSE:WYN). Instead of managing other companies’ hotels like Marriott International Inc (NYSE:MAR), Starwood owns most of its properties. As a result, the company was hit hard during the recession and had to close over 50 of its hotels.
However, Starwood Hotels & Resorts Worldwide, Inc (NYSE:HOT)’s concentration in upscale brands enables it to earn higher margins than many of its peers — including Marriott.
Investment case
Each of the three chains is faring much better in the current environment than they were just a few years ago, and their future prospects look brighter still due to low investment in new hotels.
Each of the three stocks trades for 20 to 22 times earnings. If an investor were to buy each company in its entirety — and if each company were to stop growing altogether — the investor would earn a roughly 5% annual return on investment.
However, each of these companies has grown at least as quickly as inflation over the last decade, and Starwood has grown much faster. Combined with the shortage in hotel rooms, it is not improbable that these companies could experience 4% to 5% annual growth over the next few years.
If you add 5% annual growth to a 5% initial yield, you get an expected annual return of 10%. That’s a pretty good return in a low interest rate environment, so investors with extra cash may want to take a closer look at these stocks.
Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Lodging Industry Set to Reap Huge Profits originally appeared on Fool.com and is written by Ted Cooper.
Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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