Extended Stay Hotels, which owns a chain of 680 hotel properties throughout the United States and Canada, filed for Chapter 11 bankruptcy protection this morning. The move is yet another sign of the ongoing deterioration in the lodging industry.

The privately-held chain reported assets of $7.1 billion and debts of $7.6 billion at the end of 2008. Given that operating fundamentals in the hotel sector have weakened substantially in 2009, we would expect that the company’s financial position has deteriorated further since year-end.

The current owners of Extended Stay Hotels acquired the chain in June of 2007, near the peak of the market for hotel assets, for $8 billion. The deal was highly leveraged, reportedly consisting of $7 billion in debt and only $1 billion in cash. With this amount of leverage, a firm can quickly experience a crisis if operating results turn lower.

While the leverage levels of most publicly-held hotel companies are substantially lower than some private firms in the industry, the downturn has nevertheless taken a significant toll.

Both occupancy levels and room rates are down dramatically in 2009, and the sharp reductions in room revenues are resulting in significant margin pressure. The outlook for the industry remains challenging, and we believe that many investors in the sector remain too optimistic regarding the chances of a meaningful improvement in operating fundamentals during the second half of the year.

Despite these clear challenges, hotel company stocks have generally rallied over the last three months along with the broad market. We believe that this rally has been unwarranted, and that the stocks are due for a correction. The more companies cut room rates in an attempt to boost occupancy, the more likely it becomes that the downturn will last well into 2010, in our opinion.

Given our negative outlook on the group, we reiterate our Sell rating on Marriott (MAR) and Starwood (HOT) at this time.
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