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Shares of hotel companies soared this week amid a frenzy of top-dollar deals, including Blackstone Group's agreement to pay $26 billion for Hilton Hotels.
Yet there's plenty of reasons for investors to stay away. Consider the sell-off of Marriott International (MAR, news, msgs), which had set a record high earlier this week.
Marriott's second-quarter earnings beat estimates by 7.5%, with sales coming in 1.6% ahead of projections. But there's more to the sell-off than profit-taking.
First of all, investors need to consider that growth in revenue per available room, or RevPAR, may have peaked. Growth in North America was a modest 5.6%, well below the industry norm over the past several years of closer to 8%. Though systemwide growth was 6.4% and management suggests it could edge higher during the next two quarters, the industry is at the top of a multiyear bull run.
One reason RevPAR is likely to trend lower over time is that the hotel industry is adding capacity at a rapid rate. For example, just after announcing its sterling results, Marriott bragged that it has 110,000 rooms worldwide under construction, awaiting conversion or approved for development. That's a considerable increase in supply from just one company.
Given the record profits in the industry over the past few years, other companies are also expanding fast. Room starts are up 64% in the last year, according to The Wall Street Journal.
What's the likely effect of all this building? Occupancy rates will decline, pricing power will falter, and profit margins will erode. We are about to witness a total reversal of fortunes in an industry that has enjoyed near-perfect operating conditions for the past several years.
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At least Marriott isn't standing still. Management is taking steps to grow its business for the long term. Expanding in fast-growing markets such as India, striking a deal with Ian Schrager to build high-end boutique hotels and expanding its relationship with Nickelodeon to build more family-friendly hotel chains are all good ideas that should help drive top-line growth. But they also add supply, compounding the problem facing the company and the industry.
Though it's possible that shares of Marriott and the rest of the hotel industry will press higher over the short term -- buoyed by the prospect of additional deals and more good news on the earnings front -- investors should sell into this strength.
Not only are industry conditions peaking, but valuations are based on the overly optimistic assumption that current conditions will persist for the next few years. They won't, and as such, you shouldn't pay the premium built into stock prices.
Before Blackstone Group's (BX, news, msgs) deal for Hilton Hotels (HLT, news, msgs), stocks in the group were generally going for about 12 to 13 times earnings before interest, taxes depreciation and amortization (EBITDA, a measure of cash flow). Hilton sold for roughly 16 times EBITDA.
Marriott started the day trading at about 14 times EBITDA -- or above the basic valuation of prior deals, which were based on current industry conditions. Take away those conditions, and the valuations will almost certainly contract.
Assuming an historically generous valuation of 11 times EBITDA, Marriott's stock has downside risk of 22%. By contrast, Marriott's potential upside is a relatively modest 13%, based on the bullish Hilton takeover price. I don't know about you, but that's not the kind of risk-reward ratio that makes me want to book any shares of Marriott.
At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.
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