Tuesday, July 11, 2006

Why We See More Upside for Starwood Hotels

With the US hotel industry currently hitting on all cylinders (in 2005, it showed a healthy 8.8 % rise in total revenue and an impressive 15.5 % increase in profits, according to PKF Hospitality Research), it's no wonder that investors are adding hotel stocks to their holdings in the 1H of 2006. We think the hotel industry will continue to exceed expectations, thanks in part to the millions of Baby Boomers who're fervently looking for upscale experiences on which they can unload their disposable income.

However, if investors settle for a Hilton (HLT) or a Marriott (MAR), we think they'll only get the shell. If they want the oyster, we suggest they take a good, hard look at Starwood Hotels (HOT), a hotel and leisure company with approximately 850 properties in more than 95 countries.

Description Starwood operates two business segments: Hotel and Vacation. Hotel ops include a global hospitality network of full-service hotels. Vacation covers the operation of vacation ownership resorts, marketing and the financing to customers who purchase such interests. Starwood's brands include the St. Regis, The Luxury Collection, Sheraton, Westin, W, and Four Points. Starwood, which generated $6 billion in sales last year through more than 145,000 employees, currently holds a market cap north of $13.1B and is followed by 11 analysts, 11 of which have a strong buy on the stock.

Positive Considerations We believe Starwood's brands -- like the impeccable W Hotel chain -- are invaluable. The firm has done a 180 and is now focused on hotel management rather than ownership. By repositioning assets, Starwood has been able to weather hotel cyclicality; it has also cashed in on non-core properties through sales and raised occupancy rates through heavy renovation. We believe that going forward, Starwood will go light on the acquisition trigger and focus again on integrating its portfolio in order to deliver a valued-added experience to its end market. Additionally, we believe that Starwood will be a large buyer of its stock in the coming months: In 1Q06, Starwood bought $447M worth of its stock; management has approved, in total, $1B dollars worth of stock repurchases and it's possible that Starwood will have bought back 15-20% of its market cap when all is said and done.

Risks/Valuation 2005 marked the second consecutive year of double-digit profit growth for US hotels -- simply stated, we remain bullish, but note that 2 central risks remain at play. Terrorism fears, as well as eroding economic conditions, could adversely affect Starwood's prospects. With the stock already trading at a sharp premium to the S & P (32 x 06 EPS vs. broad market's 20 x; HOT also trades at 17 x cash flow/share vs. S & P's 14 x), investors would most likely take profits off the table should Starwood release negative news. We assign HOT a premium multiple due to the company's cash flow generation, management's renewed focus on brand reach, and its variegated, multi price point portfolio of hotels. Assuming a 11% WACC and a terminal value of 3%, we land at our DCF-based $70 price target. Forecasting HOT's cash flow is difficult, we think, because the company's labor costs, as well as the possibility of terrorist attacks, which would clearly depress consumer travel and impact shares to the downside, are unpredictable. We wouldn't say we are aggressive buyers of hotel stocks in general, but for the reasons listed above, Starwood has our attention. On a light volume pullback, we'd take great delight in amassing shares.

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