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    The Call @ Hedgeye Plus

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Trading opportunities aside, the trend for hotel stocks won’t be positive until occupancy turns. The good news is that occupancy will move into positive territory before average daily rate. The bad news is that we are probably still a long way from a sustained up move in occupancy rates.

We are not breaking any new ground by revealing that lodging is a highly cyclical business. The demand cycle is generally driven by economic growth. Fortunately, supply growth looks tame for years to come which should limit this lodging downturn to the duration of the economic downturn.

The stock market is a discounting mechanism and the same applies to lodging stocks. While ADR is the more important metric for profitability, occupancy is the optimal leading indicator of sustained moves in lodging stocks. Since the flow through on room rates is so high, hotels hold rate as long as possible. Typically, occupancies drop long before rates and so while revenues and profitability will continue to accelerate, this is a signal that the industry is on the back side of the cycle.

Similarly, and more germane to the current environment, a positive turn in occupancies signals the beginning of the cycle and usually rates will follow. The following chart clearly shows the relationship between the stocks and occupancy. In the supply led downturn in the mid-90s, occupancy declined well before rate and the stocks soon followed. After the supply situation worked its way out, occupancy and the stocks began a short-lived ascent, cut short by the 00/01 recession and 9/11 attacks. Occupancy recovered in mid-2002 and the stocks commenced a four year bull market in early 2003. Finally, occupancy again began its current descent in mid-2006 and the stocks peaked in May of 2007, no doubt kept afloat by the hope of private equity involvement.

So what are the takeaways for the current environment? We are currently at an occupancy rate around 60% which leaves about 2-3% downside to the post 9/11 low. It could take 9-12 months to get there which probably means we are still a long way from a sustained recovery in lodging stocks. We had gotten more positive on lodging into the New Year, particularly MAR, due to the winding down of timeshare (more cash flow) and unprecedented bearishness. There will be other trading opportunities but for those investors looking for a sustained rally, watch occupancy levels. We don’t appear to be there yet.