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Check-In Time at Four Seasons?

By William Mack Luxury lodging outfit Four Seasons Hotels (FS

; recent price, $67) has benefited from its leadership position at the high end of the hospitality industry. However, its recent results have been less than stellar, in Standard & Poor's view, as weakness at properties in the key European region has been compounded by softness within important customer categories, such as group business and certain leisure-travel market segments.

Nonetheless, we think Four Seasons has one of the most recognizable brand names in the hotel industry. Even though its relative valuation has moderated lately because of sluggish recent results, we think the company deserves a significant valuation premium to its peers. Given a steady pipeline of oncoming management contracts and the long average duration of existing management agreements, Four Seasons' long-term growth potential is quite compelling, in our view. The stock carries S&P's highest investment recommendation of 5 STARS, or strong buy.

Four Seasons is one of the world's leading managers of luxury lodgings, with 64 hotel and resort properties and three residence clubs, containing about 16,400 guest rooms and units. Properties are operated mainly under the Four Seasons and Regent brand names in principal cities and resort destinations in 28 countries in North America, Europe, Asia, the Middle East, Australia, the Caribbean, and South America.

CUTTING LOOSE. In the early 1990s, Four Seasons shifted its focus from hotel ownership to hotel-management services, as it aimed to combine premium returns with manageable risk for its shareholders. Currently, Four Seasons has a majority ownership position in only 2 of the 64 hotels and resorts in its portfolio.

Four Seasons has continued to pare its hotel investments. It has divested its leasehold interests in properties such as the Hotel Berlin and the Pierre Hotel in New York City, reduced its direct investments in properties in Whistler, B.C., and Amman, Jordan. It continues to actively pursue similar outcomes for certain of its other significant investments.

Under its management agreements, Four Seasons supervises all aspects of a project's operations on behalf of its owner, including sales and marketing; reservations; accounting; purchasing; budgeting; and the hiring, training, and supervision of staff. In exchange, Four Seasons receives a base fee calculated as a percentage of gross revenues of the property. In addition, it may receive incentive fees based on properties' operating performance. These management agreements are generally long-term, with an average remaining term of about 52 years as of December, 2004.

CONTINENTAL ADVANTAGE. With average daily rates in excess of $500, Four Seasons' hotels in Europe were its most profitable for much of the past few years on a per-room basis, in our estimation. But with occupancy levels at less than 60% in each of the past two quarters, we think these units haven't contributed their proportionate share of incentive fees since this past fall.

Nevertheless, we think recent booking patterns suggest an upturn in overall demand throughout the European region. An improving economy and more favorable business environment should help bolster demand for Four Seasons' European hotels, in our view, especially among its fixed-rate or group guests on the Continent. As for U.S and Asian leisure travelers to these properties, we expect moderately strengthened home currencies to bolster their perceived spending power.

We think these trends will support a low-single-digit percentage increase in Four Seasons' average European room rates in 2005, after currency effects, and result in year-over-year occupancy increases ranging from two to five percentage points in the last three quarters of this year.

NEW GROWTH. And we expect the North America region, easily Four Seasons' largest profit contributor, to see room-rate increases of about 10%. Extensive recent renovations at select properties should support heady room-rate hikes at these locations and should easily offset more modest price increases in locations where demand is likely to be relatively sluggish, such as its two managed properties in Chicago. Four Seasons recently eliminated what had been a significant drag on profitability when it assigned the leasehold interest on the Pierre Hotel in New York City at the end of June.

In addition, we expect the addition of four to six new service contracts by yearend 2005 to offset this and up to two other contract terminations. By the beginning of 2006, we look for the total number of hotel-management contracts to rise to about 67, from 64 as of Mar. 31, 2005.

These new contracts are likely to bolster penetration in each of its regions, as properties in the Americas (Silicon Valley), Europe (Switzerland, Britain), Asia/Pacific (Malaysia, Hong Kong), and Middle East/Africa (Qatar) are either already open or are accepting reservations for later this year. Through decade's end, we project that Four Seasons will add 25 to 35 net new management contracts, suggesting mid-single-digit annual growth and resulting in a total of approximately 100 of these long-term agreements by 2010.

CASH ON HAND. While virtually all of the new contracts we forecast are likely to be for third-party-owned properties, in the cases where Four Seasons makes a direct investment -- whether at the development stage or at existing properties -- we think those investments will be minimal. Moreover, we think it will time these new contracts so as to maximize its returns on investment, keeping the period of time between cash outlays and the inception of related cash flows as short as possible.

We expect that new and enhanced management agreements will be funded from cash generated by operations, and we believe management makes it a top priorities to maintain an investment-grade balance sheet. As of Mar. 31, 2005, Four Seasons' cash position nearly equaled its debt obligations. And with less than a 2% yield on its debt -- mostly convertible -- this obligation was more than paid for by its returns on cash and periodic payments on previous advances to hotel owners.

With a majority of its revenues, assets, and debt obligations denominated in U.S. currency, Four Seasons' greatest ongoing currency exposure continues to be to the U.S. dollar. Losses related to past weakness in the dollar are likely to moderate, if not reverse, in our opinion.

CONFIDENCE BOOST. Our S&P Core Earnings per share forecasts of $1.37 for 2005 and $1.60 for 2006 are the same as our operating estimates for these years, as we don't expect operating results to materially deviate from reported results. We note that the estimated impact of stock-option issuances has been reflected in Four Seasons' reported results since 2003 and were in fact mandated by Canadian accounting regulatory bodies to take effect at the beginning of the following year (2004). (Four Seasons in incorporated in Ontario.)

We have a favorable view of the company's long-term growth prospects, based on the average remaining lives of its management contracts (in excess of 50 years) and the continued benefits of its strong brand name. We believe that over the course of this year, Four Seasons will have mostly restored investor confidence in its long-term profit potential, which has been shaken by successive quarters of profit growth that we consider below trend.

In arriving at our 12-month target price of $85, based on our

discounted cash-flow analysis, we assume free cash flow growth of 12% for the next five years, slowing to 4% for the longer term.

VALUATION RISKS. We view Four Seasons' corporate governance standards to be about average compared to peers. Within its board of directors, the company has a committee set up to regularly review issues of corporate governance, a point in its favor. However, certain other board committees, including those responsible for nominating directors and for compensating executives, comprise affiliated outsiders. On balance, we have confidence in the board's ability to maintain its independence and to avoid potentially significant conflicts of interest.

Risks to our recommendation and target price include the possibility that Four Seasons will lose a material number of contracts, as well as the possibility that it may fail to add new management agreements fast enough to support the stock's current valuation, which is among the industry's highest. In addition, because Four Seasons invests in some of the properties that it manages, it has ongoing exposure to the credit risk of its ownership or development partners, along with a potential conflict of interest. Analyst Mack follows shares of lodging companies for Standard & Poor's Equity Research Services

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