A Way to Go About Hotel REITs

Summary

  1. Hotel REITs have been out of favor, but recent chase for yield has helped to propel share price performance.
  2. Several stocks that failed to approach their fair value present their own catalysts. FelCor Lodging Trust is a great example.
  3. FelCor management is actively engaged in selling non-core hotels and using the proceeds to repurchase stocks.
  4. Moreover, although being an activist target doesn’t necessarily lead to gains, the company has worked cooperatively with activists in an effort to improve governance.
  5. Finally, the company is actively looking to reduce its leverage level and improve its debt profile.
  6. June’s share dip was a great opportunity to buy, but new dip after softer Q2 results presents new opportunity.
Quick Profile (as of 29 July 2016)
Industry Fundamentals: Favorable, but potentially near or at peak

Hotel Portfolio: Luxury and upper upscale, balanced, diversified

Stock Volatility: High

Small Cap (Market Cap: $0.9 billion)

Dividend Yield 3.5% vs Hotel REITs 5.4%

AFFO Payout ratio: 19%

Upside: High (38% below 52-week high)

Risk: High

External catalyst: Fair

Internal catalyst: High (sale of five hotels, repurchase of stocks, decrease of leverage ratio, potential credit rating upgrade)

A Way to Go About Hotel REITs

That hotels, one of 2016’s trailing REIT performers, have been out of favor is not news. Investors have been cautious because many believe hotel REITs have either already reached or are currently reaching their peak in the real estate cycle. Nevertheless, recent chase for yield has helped to propel hotel REIT share price performance. Although share price performance was flat in the first half of the year, July demonstrated to be more promising.

Hotels overall lack a long lasting industry catalyst to convince investors. Although industry figures still demonstrate that supply has yet to surpass demand, supply has been on track to reach the historic growth rate of 2%. Also, supply has seen intensified construction in several hotel categories, especially upscale and upper midscale markets. In a highly competitive industry, this doesn’t come off very encouraging.

To top it off, economy has not helped to make the industry’s case. Rumors of recession have been on and off, the same way Fed’s Janet Yellen has demonstrated to be very sensitive to the swings of labor figures. In addition, a potential appreciation of U.S. dollar will scare international tourists away, especially to gateway locations such New York and Miami.

Weaker industry catalysts don’t imply that individual stocks cannot present their own internal catalysts. A way to go about this situation is to look for undervalued stocks (which is the large majority of hotel REITs) and find those that are creating events that could spur a share price performance. A promising hotel REIT that has failed to realize its value and fits the bill is FelCor Lodging Trust.

Among hotels, FelCor is the REIT with one of highest upsides. FelCor’s share price has been 37% below its 52 week high and 14% below its 2016 high. While hotel REIT shares are up by 9% this year, shares of FelCor are down by 6%. In June, its share dropped by 6%.

The management is focused on propping up shares. They put up for sale 5 of its 41 hotels and plan to use the proceeds to reduce debt, repurchase stocks and redevelop several hotels. Also, the sale of non-core assets will raise FelCor’s portfolio profile, improving hotel metrics, such as RevPAR, Hotel EBITDA per key, and hotel EBITDA margins. The company’s core assets have been in gateway urban markets and resort locations that can be more difficult to break into.

Maybe one of the reasons why the company has been flying under the radar is its debt profile. In April of 2015, Standard & Poor’s upgraded the company from B- to B, which is still two notches below investment grade.

The company is actively looking to reduce its leverage level and improve its debt profile. The company doesn’t have any major debt maturity in the next two years as interest expense has decreased over time and debt metrics have improved.

Diversified Portfolio Not Potentially Affected by Supply Growth

chart01FelCor owns luxury and upper upscale hotels in gateway cities and tourist locations. They own well rated hotels that are ranked very competitively to the hotels in the surroundings.

Gateway urban markets remain to generate a significant portion of revenues. Geographically, they have a balanced distribution of properties on both east and west coast, in cities such as Boston, Los Angeles and San Diego.

What is in the company’s favor is its diversified portfolio composed of suburban, airport, and resorts, which is not one of the subsectors potentially affected by supply growth.

Seasoned Leadership More in Touch with Shareholders

FelCor, although they encompass two entities, is a de facto internally managed REIT. The management is seasoned and composed of executives who worked for other companies in the industry. Key people in the senior team have been with the company for about ten years.

The board has accumulated an equivalent average tenure, although the company has taken recent measures to reduce the board term from 3 to 1 year. The desired effect is to reduce the average tenure and promote renewal that better reflects shareholders’ concerns. It is one of the actions to improve corporate governance.

Choppy Dividend Record, But Who Doesn’t?

chart02Although the company has been around since 1994, the company’s dividend record has been choppy. Notably, the REIT hasn’t distributed dividends for almost six years, between 2008 and 2014. The management interrupted dividends because they had predicted a sharp drop in FFO in the following years in function of the great recession, which actually forced the company into negative territory in 2010.

In January of 2014, the company resumed distributions, but management has clearly been cautious as they only distribute equivalent to 19% of the adjusted funds from operations. The company is concentrating its efforts on internal growth. For that reason, the dividend has been well covered, but yield is one of the lowest among hotel REITs.

The truth is that there’s nothing to be ashamed of this record. In fact, very few hotel REITs have dividend records that date back before the great recession in 2008. The sector has not produced a premier, long lasting dividend payer yet.

Activists Made Compelling Case

The company has been the target of activist Land and Buildings, which has almost doubled down on its position and now owns approximately 4% of the shares. Although being an activist target doesn’t necessarily lead to future gains, they did make the management improve its governance by including two independent directors. In the end, the company seems to be working cooperatively with the activist, something that is positive in itself.

In late January, Land and Buildings cited an upside of 60% to NAV and made a series of proposals to accomplish the target price. In February and March, FelCor shares were on a roll, rallying by more than 30%. However, weeks later, the stock lost steam and went back down.

Latest Results

chart03Following its Q2 announcement late July, the stock began trading with a significant drop. The management was treading lightly after seeing business travel getting soft in Q2. The weakening of corporate demand in transient travel forced the company to lower expectations for some of the metrics, including the full-year 2016 guidance for AFFO per share. The corporate transient segment accounts for 30% of overnight stays.

Despite the market’s negative reaction, the firm owns an overall portfolio that has the potential to deliver positive results. Also, the management has resources to partially mitigate the softness.

On Track for a Credit Rating Upgrade

chart04Highly levered, the company has been making a systematic push to reduce its debt level. By the time the company finalizes the planned sale of some hotels, the leverage ratio will be below the peer average. Moreover, the company has one of the best maturity profiles among hotel REITs and the majority of its debt is fixed rate interest (79%).

Following its corporate credit rating upgrade from B- to B by Standard&Poor’s April last year, the company improved its debt profile. Although it is two notches below becoming investment grade, the company managed to expand its borrowing capacity. Also, the company was able to replace its outstanding 6.75% senior secured notes due 2019 to 6.00% senior unsecured notes due 2025.

Valuation

The company is clearly undervalued. While hotels’ average multiple has been around 10 times AFFO, FelCor’s multiple is around 7 times.

Conclusion

If you buy FelCor, you’re buying it for long term appreciation, not for dividend.

In summary, with the recent dip, FelCor demonstrates to be a good opportunity, but I’d limit its exposure in the portfolio because FelCor performance has been conditioned to the successful hotel sales.

Source: FelCor Lodging Trust Incorporated (NYSE:FCH)

Written on 29 July 2016

Disclaimer: This is not a recommendation to buy or sell stocks. The highest-yield stocks are not necessarily the best portfolio investment choice. The purpose of this report — which is essentially a snapshot of information available on July 29, 2016 — is to reduce your stock analysis by enabling you to compare stock and sector performance. Please do your own due diligence before making any investment decision.

This report is not engaged in rendering tax, accounting, or other professional advice through this publication. No statement in this issue is to be construed as a recommendation to buy or sell any security or other investment. Some information presented in this publication has been obtained from third-party sources considered to be reliable. Sources are not required to make representations as to the accuracy of the information, however, and consequently the publisher cannot guarantee accuracy.

Disclosure: The author is long FCH, XHR, CLDT, PEB.

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