By Lorna Pappas

Host Marriott Lodges Potential as Travel/Leisure Market Recovers

Despite a tough year for the travel and leisure industry, Host Marriott Corporation (NYSE: HMT) has exceeded analysts' estimates in 2002, performing surprisingly well on a relative basis, given the industry's vulnerability to a slowed economy and effects of September 11. This year, Host Marriott, the nation's largest hotel REIT, experienced some of the lowest performance declines in its segment, and is expected by analysts to start a run of stellar annual results beginning in 2003.

"The economic and travel recovery expected to start in early to mid 2003, along with a reduction in new supply across the board, should position Host Marriott for some of the greatest upside potential of any U.S. lodging company," says William Crow, vice president, lodging and REIT analyst for Raymond James & Associates.

Holding the Trophy

Bethesda, MD-based Host Marriott was formed in 1993 when hotel management company Marriott International—Host Marriott's largest manager—broke away from Marriott Corporation. In 1999, Host Marriott adopted REIT tax status, spinning out its leaseholds and remaining property operations to Crestline Capital (with the leases reacquired in 2001).

Host Marriott Corporation Headquarters 6903 Rockledge Drive Suite 1,500 Bethesda, MD 20817 240-744-1000 President and CEO Christopher J. Nassetta Core Markets Mainly urban markets— New York, Washington D.C., Atlanta, Northern California and Southern California Founded 1927 Went Public 1968 (listed on NYSE) Ticker Symbol HMT (NYSE) 52-Week High $13.48 52-Week low $6.22

Since its formation, the company has been very active, accumulating more than $6 billion in hotel properties. As of August 2002, the firm owns or controls 123 luxury and upscale hotels located in downtown locations in major metro areas, as well as select airport and resort locations. The company's high-end, full-service brands include Marriott, Ritz- Carlton, Hyatt, Four Seasons and Swissotel.

Host Marriott's key business strategy is to own or control trophy hotels in urban markets with high barriers to entry, an approach that has helped it perform relatively well during recent hard times. This particular business strategy was implemented when current Host Marriott president and chief executive officer Christopher Nassetta came on board in the mid-1990s.

"When I joined the firm, the majority of our assets were in limited-service hotels, which we then sold off and reinvested in full-service, upper-end properties. This strategy has and will continue to allow Host Marriott's portfolio to outperform the industry in terms of growth rate in revenue and cash flow, which it has done over the past 15 years by more than 34 percent," Nassetta says.

Host Marriott's disproportionate exposure to upscale urban and convention hotels—an advantageous strategy in a normally robust travel and leisure market—pressured the company this year as corporate and vacation travel dropped off considerably and is still a major piece missing from the business mix. However, the Host Marriott properties affected by this drop-off—all featuring large group meeting spaces—also are favorably equipped to serve the strong group business sector, which has picked up much of the lost demand.

"The type of physical asset we own gives us a multi-dimensional way of selling our business," Nassetta says. "We can flow to either segment, group or corporate, when one sector is down, because the facilities are already in place."

Nassetta adds that the group sector today is relatively strong—roughly equivalent to where it was last year in terms of rate and volume. With weaker corporate transient demand, the company has focused on its group base (about 42 percent of EBITDA in its first quarter this year), and lower-rated transient group businesses like government and AAA. Though rates are lower, occupancy levels are being maintained, which resulted in declines in RevPAR (revenues per available room) growth generated largely by the replacement of higher corporate pricing with lower-rated business. Host Marriott will have more significant pricing power across the board as corporate America starts traveling again, replacing portions of the group and lower-rated transient sectors with higher-rated demand.

Ritz-Carlton, Naples, FL

Reclaiming Its Pricing Power

Why should investors look to the hotel REIT segment at this time, rather than wait on the sidelines until it rebounds? "Because the segment is at, or just coming away from, its low point in terms of operations, while industry fundamentals are getting much stronger," Nassetta says. On the supply side, he says, the number of new hotels being added is already below the 30-year average, and by the end of next year and into 2004 will decline further to below 1 percent growth. At the same time, the economy continues to improve, with an expectation of moderate GDP growth.

"A positive economic growth rate matched with little or no supply of new hotels is very good for our segment and ultimately will result in our industry's ability to regain our pricing power and thus drive greater revenue and NOI growth," Nassetta says. "This positive fundamental scenario should last for several years because there is a long lead time in delivering new hotels at the high end of this business."

"The industry has evolved from a business with passive hotel owners to one with large, public, professionally run owners like Host Marriott that are aggressive in how they manage their assets."

Compared to other hotel REITs, Nassetta says Host Marriott is in a better position to benefit from an economic recovery due to the "trophy" quality of its assets (in terms of location as well as the physical asset), its high barrier to entry markets, history of outperforming the category's average results and its scale and liquidity. "With this scale comes a significant amount of liquidity in our stock," he adds.

Financial flexibility has been enhanced with recent steps to bolster liquidity (the company had approximately $240 million in cash at the end of June) and completing the syndication of a new bank credit facility which replaced its prior credit line. The new credit facility, led by Deutsche Bank Trust Company Americas and Bank of America N.A., provides an aggregate revolving loan commitment amount of up to $400 million, with an initial maturity of June 2005.

Ritz-Carlton, Naples, FL

Surpassing Analysts' Expectations

Host Marriott's reported results in 2002 of FFO, EBITDA (earnings before interest, tax, depreciation and amortization), operating profit margins and RevPAR have exceeded analysts' estimates, with stronger-than-expected second quarter results largely attributable to better-than-anticipated property operating margins. "This excellent margin control in the current market is a testament to top-notch brand affiliation, impressive expense control, Marriott's national sales platform and Host's top-tier quality portfolio," Crow says.

Specifically, FFO in the first quarter of 2002 was $.25 per diluted share, $0.06 above the Street's consensus of $0.19. Host Marriott's hotel operating profit margin decline (22bps) was the lowest of any lodging company in the quarter, while comparable RevPAR was also down (declining 12.3 percent in the first quarter of 2002)—still better than industry estimates.

FFO for the second quarter was $0.36 per diluted share, $0.01 above the Street's consensus of $0.35. Citing a delayed economic recovery, Host Marriott has reduced guidance for the remainder of 2002 and expressed a more cautious near-term outlook. Such caution is in keeping with the most recent industry data, which indicate that the travel recovery has leveled off after an impressive run early in the year, Crow says.

Notes Jason Ader, senior managing director of Bear Stearns in New York, "We believe Host Marriott is well-positioned to realize significant profitability inherent in real estate ownership as hotel fundamentals become more favorable and pricing leverage returns, which we anticipate will develop early in 2003 into 2004. A very favorable supply backdrop and leaner cost structure will also be a complement."

Marriott's Harbor Beach Resort Fort Lauderdale, FL

Accelerated Cost Control

Lean, mean, accelerated cost controls helped mitigate the effect on Host Marriott's operations from the industry's recent downturn. Key cost containment efforts included suspending less essential brand standards, eliminating costs not apparent to guests and further reducing labor cost.

"Necessity is the mother of invention," Nassetta says. "After September 11, when occupancy dropped 30 percent to 40 percent, we and our hotel operators were forced to identify specific efficiencies in order to lower break-even levels so we wouldn't lose money keeping the properties open. This allowed us to get more creative with the business model of how the hotels typically are run. Now as the economy improves, we are going forward with a much more efficient, streamlined model." One of the primary elements of this model is expense savings related to labor, such as a meaningful reduction in management level positions.

Additional cost savings and other economic benefits are being pursued by Host Marriott in its efforts to renegotiate its contracts with Marriott International. At press time, these negotiations were close to completion, but not yet final, according to Nassetta. The more significant changes expected to be made include: increased control over budgets and capital spending at Host Marriott's properties; reductions in incentive management fees paid to Marriott International; reductions in the amount of working capital the company must provide to the hotels; reductions in hotel-level allocated expenses; and flexibility to sell a group of assets without management or franchise agreements, among other issues.

"Raymond James views Host Marriott's contract modifications as a positive, one which could push up estimates later this year and, more significantly, in 2003 and 2004 when more of the company's properties would be paying incentive management fees," Crow says.

Nassetta's view is this: "The industry has evolved from a business with passive hotel owners to one with large, public, professionally run owners like Host Marriott that are aggressive in how they manage their assets. While evolving from passive to active, certain issues naturally will arise between owners and operators, some related to contracts that govern those relationships. The proposed contractual changes stem from our efforts to resolve outstanding issues arising from that evolution," he says.

Making Deals and Moving Forward

Early in 2002, many analysts were predicting that Host Marriott would use its available capital to make some acquisitions later in the year. That prediction transpired several months early when on June 18, Host Marriott acquired the 1,139-room Boston Marriott Copley Place hotel, located in the famous Back Bay district of the city (another high barrier-to-entry market), for $214 million.

While analysts expect other deals are on the horizon, Nassetta says the Copley deal is a unique situation in Host Marriott's market segment, where acquisition activity is light today due to the significant difference between bid and asking prices. "We're driven by investing in assets that meet our criteria of very high quality properties in the strongest markets with the best operators and where we can generate a yield that is meaningfully in excess of our cost to capital. Trying to make it through that screen isn't easy." Host Marriott continues to work on selected deals that the company hopes to complete within the next 12 to 24 months.

Of the Copley deal, Nassetta says the purchase will create significant value for Host Marriott shareholders. He says the Boston hotel market has been hard hit, with the cash flow on this particular property off over 35 percent over the last 18 months. Boston Marriott Copley Place will be repositioned by improving the rooms and public spaces, reports Nassetta, providing significant upside opportunities for investors.

Traveling Ahead

Looking forward, Host Marriott hopes to reinstate the distribution of its common share dividends later this year—which it suspended in the fourth quarter of 2001 to preserve capital during uncertain economic times—but at significantly lower levels than the prior run rate. The company's policy is to distribute the minimum necessary to maintain REIT status. "We expect a healthy rate of dividend growth beginning in early 2003 and continuing for at least a couple of years," Crow says.

Crow remarks that while 2002 will not be a year to celebrate, he believes 2003 will be a remarkable period for Host Marriott, one that could mark the start of a run of stellar annual results. Lodging stocks in general are positioned for further outperformance in 2002, he claims, as equity prices continue to reflect expectations for robust earnings growth in 2003 and 2004.

"We've put a ‘Buy' rating on Host Marriott, an investment thesis focused on the likelihood that the company will experience a strong recovery in RevPAR, impressive margin expansion, and EBITDA and FFO per share growth due to the anticipated economic and travel recovery expected to start in 2003 and extend through at least 2004. This will be coupled with the substantial slowdown in new supply growth," Crow says.

As owner of some of the most outstanding lodging assets in the U.S., Host Marriott will continue to benefit from its portfolio of top-notch assets, which possesses some of the greatest upside of any lodging company, Crow says. And in a market shrouded with questions, upside might be an investor's best asset.