Background
Strategic Hotels & Resorts, Inc. (BEE) is a Hotel REIT that owns and manages luxury hotels in the United States, Europe and Mexico. Having purchased 9/16 of those hotels in the sizzling commercial real estate market of 2005 - 2007, and refinanced others in those years, the company has struggled with its overleveraged balance sheet in the post-2008 era. The company’s shares took a precipitous dive during the financial crisis from a 2007 high above $23.00/share to a 2009 low of under $0.70. After selling some properties, issuing stock and paying down recourse debt, the company has successfully survived bankruptcy fears and now trades at $6.30/share with 170M shares outstanding, commanding an equity valuation of just over $1.0B.
Thesis
Trading At 16X 2011 EV/EBITDA, 90X 2011 FFO per share, and 25X 2011 EV/EBITDA-capex,* Strategic Hotels is overvalued in all but the most optimistic of recovery scenarios and should be sold short, either outright or to hedge one’s other real estate investments. While operations have improved somewhat, cash flow continues to be swallowed by interest payments and capital expenditures, putting BEE in a precarious position as it faces over $700M/1.1B (63%) in mortgage maturations in the next 2 years. With two hotels deeply underwater, BEE will lose additional properties and/or have to dilute shareholders again. As preferred dividends accumulate arrears while BEE restructures its balance sheet, a common dividend remains a hope and dream for this REIT. Being owners of the first-loss tranche in a capital structure weighed down by debt and preferred, shareholders are unlikely to enjoy their stay in this hospitality stock.
*Guidance is from most recent earnings release
Capital Structure & Asset Breakdown: Bear & Bull Case
The table above is a simplified snapshot of Strategic Hotels’ capital structure. For a more in depth understanding of the company and its valuation, it is necessary to break the company into three parts: Unencumbered Properties, Encumbered Properties and Leaseholds/JV's.
Unencumbered Properties
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Strategic owns four properties secured by its $350M credit facility, which will have no borrowings after the close of a recent transaction. Therefore these hotels are owned outright by the preferred and common shareholders. Recently, BEE issued stock and purchased the Four Seasons Jackson Hole and The Four Seasons Silicon Valley from the Thomson Family of Thomson-Reuters fame. The borrowing base properties are valued using trailing EBITDA multiple (12X and 16X), whereas the Thomson hotels are valued at the recent transaction price and transaction X 1.33.*
*Property by Property EBITDA can be found in the supplemental financial info released 2/23/2010
Encumbered Properties
Most of Strategic’s owned hotels are encumbered by non-recourse mortgage debt in which default leads to seizure of the individual property. Note that two of the properties (Fairmont Scottsdale + Hyatt LaJolla) have debt yields below 5% and are at risk of being lost/restructured; Strategic projected in its conference call today that Fairmont Scottsdale will be lost this fall when its loan matures.
Other Assets: Leaseholds & Hotel Del Coronado JV
Strategic also manages two leaseholds on European properties. Recently the leasehold on the Marriott Paris Champs Elysees was sold for around $50M to pay down debt while the Marriott Hamburg leasehold remains in the company’s hands. Although the leasehold produced very little EBITDA (+$109K) in 2010, it is valued at $50M in our bear and bull case for the sake of conservatism. After a tough refinancing on the storied Hotel Del Coronado in which Strategic saw its equity stake reduced from 45% to 35%, the company’s stake is valued at $56M (transaction price) in the bear case and 1.33X in the bull case. Combining these assets in a sum-of-the parts valuation gives us a share price 20-70% below the current market price.
The huge variance is testimony to the impact of changes in assumptions have on the valuation of BEE’s leveraged portfolio. Is the valuation adequately bullish for our short case? I believe so. 16X 2010 EBITDA implies a cap rate of 6.25%, which seems right for high quality real estate. Nevertheless, it is important to also take into consideration forward earnings/cash flow projections, since hotels are arguably in a recovery stage, lest the short case be based on depressed operating data.
Cash Flow Projections
In its most recent conference call, Strategic Hotels projected $135-150M in EBITDA, $75M of cash interest expense and $70M of capital expenditures, $22M of which is for a full renovation of the InterContinental Miami. This projection assumes a 7-8% growth in RevPar. Even taking this into account, cash flow will not be enough to make the preferred dividend current, much less pay down over $60M in arrearages. Therefore a common dividend remains far out in the future.
While it is difficult to project beyond 2011 without the company’s own guidance, it is fair to say that several years of uninterrupted economic recovery are necessary for the stock to be fairly or undervalued on an EV/EBITDA-capex basis. In the meantime preferred arrearages accumulate at $30M per year (3% of Common's Market Cap).
To illustrate that recovery is more than priced in the stock, if we assume EBITDA improves further to $200M, interest expense of 80M, maintainance capex of 50M, there is only $70M of cash flow left, $32M of which belongs to the preferred. $40M of cash flow gives common shareholders a measly 4% yield at today's valuations, without discounting for time or the risk that said recovery does not happen.
Debt Refinancings : Higher Interest Costs Likely to Come
It is also important to note that Strategic Hotels currently pays a weighted average interest rate in the neighborhood of 4% because of a combination of loans made at the height of the credit bubble at low LIBOR spreads and interest rate swaps made in today’s rate environment. The company’s latest refinancing was at a more realistic fixed rate above 6%. If BEE’s operations do not recover dramatically, refinancing may come at a higher cost.
Risks to Shorting
A prolonged economic recovery along with an increase in real estate values will benefit BEE in a pronounced way given its financial and operational leverage. These are high quality assets for which there is enduring demand from asset managers. Also, inflation should benefit real assets to a point, but higher interest rates would increase the cost of BEE’s debt capital as well. Putting this trade on requires a bit of arrogance as well considering you are betting against a company whose largest shareholders are Bill Gates, the Thomson Family, and John Paulson, one of the best hedge fund managers in the world. Also if the company can continue to use its overpriced stock (16X Forward EV/EBITDA) to purchase hotels at 11X Forward EV/EBITDA like in the Thomson transaction, this is an accretive and effective method of deleveraging.
Conclusion & Possible Catalysts
All things considered, Strategic Hotels appears overvalued and is pricing in a dramatic economic recovery. Its enterprise value of $2.5B is exactly the gross book value of its assets, most of which were purchased at the top of the real estate bubble, implying that the economic downturn never happened and that those properties are worth what they paid. They are not.
Possible catalysts include the loss of the Fairmont Scottsdale and Hyatt LaJolla, increased difficulties with loan maturations, and the company continuing to use stock as currency to pay down its obligations. REITs exist to produce income for stockholders, and this will not happen within the near future without significant restructuring and/or dilution.
Disclosure: Author short BEE.
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