From Dan Ferris in the S&A Digest:

Hotels saw big declines in group bookings [last year]. Business groups tend to book large blocks of rooms, sometimes years in advance. The drop in group reservations makes it harder to know if they're going to make any money or not. Ed Walter, CEO of Host Hotels & Resorts, says, "Our portfolios saw unprecedented group declines. That's one thing that we used to prop up our performance."

When the one thing that props up your performance goes away, look out below. Host Hotels, like most hotel stocks, has soared off its March 2009 bottom, up more than 250%. It sells for more than 35 times trailing free cash flow. That has to be an even higher multiple of 2010 free cash flow, given the main support under its revenues continues to weaken.

When business groups stop booking rooms, the industry stops building new hotels. The U.S. lodging industry built a record 154,667 new rooms in 2008 and nearly as many (146,929) in 2009, flooding the market with rooms it doesn't need. Industry analysts at Lodging Econometrics estimate about 82,000 new rooms will be built this year and less than 64,000 next year.

The setup is looking good. Hotel pricing continues to decline. The supply of new hotels is falling dramatically and expected to do so for another year or two. If this keeps up, we would expect the sentiment to show up in hotel stocks at some point, pushing prices down to depressed levels.

For now, the opportunity in hotel stocks appears to be a better short than long... The Dow Jones U.S. Hotel & Lodging Industry Index is more than 220% off its March 2009 bottom.

If the hotel stocks get cheap enough, it could set you up for years of compounding in some of the better hotel stocks. My all-time favorite lodging industry stock, one I've coveted for years, is Choice Hotels. Choice Hotels is essentially a royalty on several well-known hotel/motel franchises, including Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, and Econo Lodge.

Choice doesn't own hotels. It franchises them. Without having the enormous operating and capital expense involved in owning hotels, Choice's business requires little capital to sustain and grow.

Today, Choice gets a piece of the action from more than 450,000 hotel rooms worldwide, with more than 90% of revenue from U.S. properties. The company is one of the all-time world champion share repurchasers, too. It has reduced its share count from 84 million in 2001 to less than 60 million shares outstanding today. It continues to buy back shares with much of its ample free cash flow.

Free cash flow peaked in 2006 at more than $146 million. Over the last 12 months, it has fallen to $80 million. Right now, the stock sells for about 27 times trailing free cash flow and about 15 times peak free cash flow. That's not quite cheap enough. I'd like to see it get closer to 10 times peak and much less than 20 times trailing. I have a feeling we might just see that happen if the hotel industry has another bad year in 2010.

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