Starwood Hotels & Resorts: Fairly Valued At Current Price

The following article by Cornell University School of Hotel Administration student Jeffrey Valane was originally submitted as a paper for a class entitled "Investment Analysis and Portfolio Management," in which students wrote a 'mock' analyst note about a publicly traded company. In no way should its contents be construed as conveying professional investment advice.

Starwood Hotels & Resorts Worldwide, Inc. (HOT) manages approximately 850 properties in more than 95 countries and includes such renowned brands as: St. Regis®, The Luxury Collection®, Sheraton®, Westin®, and Four Points®, W®, St. Regis®, Le Méridien®, and aloft®. While its core business revolves primarily around luxury and upscale hotels, Starwood Hotels also owns Starwood Vacation Ownership which focuses on the marketing and selling of private ownership interests in resorts. Starwood Hotels was founded in 1969 and is based in White Plains, New York. As of December 31, 2006 Starwood Hotels owned, leased, managed, and franchised 871 hotels.

Synopsis
Starwood Hotels has successfully managed to break away from the cyclical nature of the real-estate industry into a brand company, and has become substantially more efficient as a result. It has managed to climb to the top with the best Average Daily Rate [ADR] of $199.48 in its class. Although its cash reserves have dropped from $1,192,000 to $512,000 (xxx), it has managed to reduce its long-term debt by 37.66%. Recently, the company has been able to successfully integrate the Le Méridien brand and introduce the Aloft and Element brands. However, despite its performance, I feel that Starwood is fairly valued at its current price and based on discounted future cash flows and peer replication, I have set a price target of $64.00.

Lodging Industry Outlook
The hotel industry follows a cyclical pattern of growth followed by stability, each lasting 7-9 years. The current growth cycle is expected to last until 2010 with moderate Revenue per Available Room (RevPAR) growth in 2007. InterContinental Hotels Group’s (IHG’s) senior vice president of brand management foresees 2007 as “not as good as 2006, but still good by any standard.” As the cycle begins to wind down more attention will need to be paid to guest satisfaction through amenities and entertainment. Indeed, the expected driver of performance in 2007 is luxury. Demand is expected to be transient from the United States to Asia Pacific and group business is expected to curb the effect of these fluctuations.

The challenge facing the hotel industry in 2007 is the ability to deliver a customized package to each guest as hotels will be competing over the same clientele. In 2007 it is imperative that hotels establish a brand identity for the traveler to identify as worthy of a premium. This is not only true for the top-market hotels. Business-class hotels will also see a leveling off of growth and hotels looking to over-achieve their markets must cater to the needs of their clientele. As companies continue to compete over the leveling number of guests there is expected to be increase of M&A activity as industry giants look to diversify their holdings and establish a clear brand name.

Starwood Hotels Analysis
I feel the Starwood Hotels has a good grasp of the challenges it will face in 2007 and has already initiated a successful strategy of diversifying their hotel portfolio to include a balance between Managed & Franchised Hotels and Owned Hotels. Furthermore, Starwood increased the role of Starwood Vacation Ownership [SVO] from 12% to 18% of its portfolio, helping reduce Starwood’s risk profile. Lastly, Starwood reduced their number of Joint Ventures, helping increase brand name recognition. This is in-line with their 2007 philosophy where they expect to increase revenue not only from the increased ADR associated with a better brand name, but also through the additional management fees they can charge through their SVO business.

To address the shift of the hotel industry towards luxury and personalization Starwood has oriented their hotels to exist in the top three tiers of the hotel market: Luxury, Upper Upscale, and Select Service.

As a result of their portfolio realignment, Starwood expects RevPAR growth between 7% and 9% (significantly higher than the 1.1% RevPAR increase expected in 2007), EBITDA growth between 13% and 15%, and EPS growth between 20% and 23%.

In 2006 Starwood Hotel’s cash decreased from $1.192 million to $512,000 as it paid down its long-term debt 37.6% from 2.93 million to 1.827 million. Starwood Hotel’s intent is to increase its Gross Debt / EBITDA to enhance its borrowing capacity while increasing dividend payouts and stock buyback as it begins to behave defensively as growing demand slows.

Risks
Although Starwood has successfully shifted their portfolio to be less cyclical, the nature of the industry as a whole is undeniably cyclical and as such any negative impact to the real-estate industry will impact the value of their assets. Likewise, any downturn in the hotel industry will reduce expected earnings and decrease Starwood’s value.

Starwood is currently highly geared towards the high-end hotel market. If a major recession were to hit than with their current profile, they won’t have time to react to their changing customer demographic.

Valuation
1. Discounted Cash Flows
The stock price of Starwood is the Enterprise Value of the firm divided by the number of outstanding shares in the market. The Enterprise Value is equal to the sum of the discounted future free cash flows in perpetuity. The discounted cash flows are based on the free cash flows of the firm discounted by their firm discount rate. The free cash flows were found by taking estimated Earnings Before Interest and Taxes and subtracting out Taxes, Capital Expenditure, and Change in Net Working Capital and then adding in Depreciation and Amortization. A tax rate was settled upon by averaging the tax rate over the past 5 years. The cash flows were forecasted for 5-years since that was the range of initial actual cash flows I started with.

The discount rate was calculated using the CAPM formula, where the risk-free rate was assumed to be the 10-yr treasury, the market return was assumed to be the expected daily market return of the S&P 500 multiplied by the number of trading days in a year, and Beta is assumed to be the correlation between Starwood and the iShares Consumer Services index weighted by their relative standard deviations. An adjusted beta was calculated using the simplified adjusted beta formula utilizing only 67% of the calculated beta. All data was provided by Thomson One Bank and Google Finance.

Lastly I needed to calculate the discounted cash flow of the perpetuity. This was done by taking the final estimated cash flow and holding it in perpetuity at a terminal growth rate. I assumed terminal growth rate to be annual GDP growth rate of 3%. After finding this I was able to come to a fair-value estimate of $64.68.

To calculate the Present Value of the firm without taking growth into account I set my terminal growth to zero and future cash flows equal to 2006 cash flows resulting in $52.39 per share. PVGO was found by subtracting PV (no growth) from my fair-value estimate and is $12.29.

2. Comparables Analysis
The companies I chose to value using replication were Starwood Hotels (HOT), Hilton Hotels (HLT), Marriott Hotels (MAR), Choice Hotels (CHH), and Wyndham Hotels (WYN) due to their all being prominent hotel companies. I performed comparables analysis on Starwood by choosing the 5 characteristics: Price / Book, Price / Expected EPS, P / Inventory Days Held, Price / Average Daily Rate, and Price / Expected EBITDA. When weighting each comparable I decided to heavily value Expected EBITDA (50%) since this is one of the core fundamentals and implies future profitability, and I weighed all other comparables equally (12.5% each). The expected price from comparables analysis is $71.93.

3. Replication Analysis
Using the same companies picked above I performed 3 separate equity replications on Starwood using various ratios and factors to replicate from. The ratios and values that I chose to replicate off of are:

• Price / Book Value: The price to book value should give a good estimate of the premium that the replicating companies are trading at compared to their book value and should give us a good idea of what Starwood should be trading at

• Market Cap: This is a reliable metric of the size of the company and since size has been proven to generate a high-level of descriptive completeness.

• Average Daily Rate [ADR]: Since I am replicating off of hotel companies I thought it would be value to use a key metric in the hotel industry. This measures the average rate that a room is lent for and should prove a reliable metric for how much a premium a company should be trading at.

• Expected EBITDA: Expected Earnings Before Interest, Taxes, Debt, and Amortization, this is an important metric determining how much profit each hotel is expected to make the following year. I expect this should be a reliable indicator of how much a premium a stock should trade relative to its peers.

• Inventory days Held: This is one indication of how efficient a company is and I expect it to generate good descriptive completeness since efficiency is directly linked to profitability and the premium a company trades at relative to its peers.

• Operating Profit Margin: Another indication of how profitable a company is, this should reflect how much of a better brand name one hotel has established over another and thus how much of a premium it deserves to trade at.

4. Technical Analysis
By looking at the 10-day, 20-day, and 50-day Simple Moving Averages [SMA], Bollinger Bands, Relative Strength Index, and the MACD it is apparent that the price of Starwood is about to make a substantial positive or negative price movement. The convergence of the moving averages and the narrowing of the Bollinger Bands show that the price has been stable for a sustained period of time and will soon move. Since the price has reached fair-valuation it is difficult to tell in which direction it will jump, as such I recommend using SMAs to determine which way to trade and to time the trades.

Conclusion
Although Starwood Hotels is properly oriented to face the coming year, the slowing RevPAR of the hotel industry historically shows little upside. The stock price as of March 30, 2007 ($64.85) was very close to its fair value estimate $64.00 and I expect it to fluctuate around this price range in the coming future. I recommend holding on investing in this stock in the long-term unless the stock dips and I recommend trading this stock based on Technical Analysis using Simple Moving Averages, Bollinger Bands, MACD, and RSI.