An In-Depth Look At Morgans Hotel Group's IPO (MHGC)

Morgans Hotel Group (MHGC) plans on offering 20.7 million shares (assuming over-allotment) at a range of $19- $21. Insiders are selling 3 million shares in the offering. Morgan Stanley and Merrill Lynch are lead underwriting the offering. Post- offering MHGC will have 34.5 million shares outstanding for a market cap of $690 mid-range. 75% of IPO proceeds are being utilized to pay down various debts, while 1/4 is going to insiders. $200 million of debt is being paid off on offering, MHGC will continue to be heavily leveraged post-offering with $446 million in debt.

Note that this another deal with a myriad of insider transactions leading up to and on the IPO. The result is that it appears insiders have essentially free shares post-offering. An entity entitled MHG Subsidiary LLC will own 28% of outstanding stock and voting control of MHGC post-offering. The ownership chart of the public MHGC and hotels is quite complicated-- whenever something is set- up this convoluted it is assumed that it will not be to the direct benefit of new public shareholders.

From the S-1:

We are a fully integrated hospitality company that operates, owns, acquires and redevelops boutique hotels in gateway cities and select resort markets in the United States and Europe. We own or partially own and manage a portfolio of nine luxury hotel properties in New York, Miami, Los Angeles, San Francisco and London comprising over 2,500 rooms.

MHGC credits themselves with inventing the 'boutique hotel' concept and will be the only public 'boutique hotel' pure play. Boutique hotels characterized by a 'distinctive hotel experience' are usually a bit smaller than the large urban hotel chains and feature modern, sophisticated design with uniquely styled public spaces. Also boutique hotels depend on their 'hip' bars and restaurants to bring in additional revenues from guests/ non-guests.

Properties include Morgans, Royalton and Hudson in New York; Delano in Miami; Mondrian in Los Angeles; Clift in San Francisco; St. Martins Lane, Sanderson, and Shore Club in London. In addition MHGC has entered into a 50/50 arrangement to build 2 hotels in Las Vegas as well as acquire 100% of The James Hotel in Scottsdale AZ. The Las Vegas 50/50 arrangement is with Boyd Gaming for two hotels ( Delano Las Vegas and Mondrian Las Vegas ) as part of the Echelon Resort planned for the property on which The Stardust now sits. MHGC expects to contribute $97 million in cash to the deal over the next 2 years. Note that MHGC will not own any portion of the Echelon Palace and Casino nor the Shangri- La Hotel. Both are scheduled to be constructed on the property. MHGC will not be in the 'casino business' rather they will own 50% of the 2 boutique hotels on the property. Manhattan represents 45% of MHGC's guest rooms and revenue base.

Rates for their 2500 rooms run in the $216 to $482 per night range. In 2005 overall occupancy was 77% with an average daily rate of $290. Revenue per available room per day was $206, a big improvement over 2004s $205, 2003's $171 and 2002s $155. The trends here are strong as MHGC has recovered from the 2001/ 2002 economic downturn and the post 9/11 travel swoon.

Financials

Debt at $446 million is the concern here. This is too much debt for me on the general principle that these debt levels lower the bar greatly for future default risk.

Revenues have been growing slowly but steadily the past 4 years although the company does note that daily rates and revenue per available room are still below 1999/ 2000 levels. As mentioned above by all measurements 2005 was MHGC's best year of the past four and yet they still are not profitable. The debt here is hampering them a great deal: Even taking into account debt paid off on offering, debt servicing is still eating up 20% of total revenue. In the capital intensive hotel business, that is a near impossible debt service % to overcome and book a profit. It is too much.

Revenue was up 10% in 2005 to roughly $260 million. Operating margins roughly 19% up from 2004's 16%. Net losses appear to be 7-10 cents per share for 2005, taking into account debt paid on offering. This is a much smaller loss than MHGC has posted each of the previous 4 years. Note though that even in 2000 when occupancy was running 80% and average rates were $300+ MHGC was still posting a net loss. I think a case can be made that as currently constructed MHGC would need occupancy rates of 85% and average room rates of $350 to post a profit. That is a tall order and something that has yet to occur.

The bottom line: This is a hotel chain that is paying off $200 million in debt on offering, is booking very strong daily revenue per room of $206 a day and still cannot make a profit. The debt just remains too robust for the margins of the hotel business, even for a chain with nearly $300 average room rates.

Risks
The hotel business is extraordinarily capital intensive with high fixed costs. Factor in a debt servicing load eating up 20% of revenue in the good travel environment of 2005 and what you've got is an operation that is very susceptible to economic downturns. In fact The Clift, MHGC's San Francisco hotel filed for bankruptcy after the last downturn a few years ago. This was in an environment in which 4 star boutique hotels in San Francisco could be found in 2002 for $50 a night. MHGC is so leveraged that they need $200+ average room rates at 70%+ occupancy rates simply to survive. This is a company with massive economic downturn risk, it would not take much of a business travel drop-off to put MHGC at debt default risk.

The hope here is that the 2 Las Vegas 50/50 joint ventures will be so successful that it drives future cash flow and allows the company to begin to pay down the debt load. These hotels will be cash intensive in their own right requiring nearly $100 million from MHGC over the next year or so. Should be noted that MHGC will not be in the casino business itself simply will have 50% ownership of two upscale boutique hotels on a gaming property.

This is not akin to The Wynn, a destination gaming hotel from arguably the most successful gaming developer in modern Las Vegas history. Boyd Gaming (BYD) the other 50% owner of the 2 future Vegas properties may be the much better bet here as BYD will also be constructing 4,500 more rooms on the Stardust site along with a full service casino. I do think the Las Vegas venture is what has opened the window for MHGC to come public here and may be what allows it to get out the door in decent shape.

Conclusion
With the current debt load and the lack of profitability in an improving travel environment, there is much too much risk in this one in range or above for me. I don't expect much in the way of earnings from MHGC in 2006 or 2007 and any economic slowdown in their hotel cities could easily bring about major financial troubles for MHGC. 20% of annual revenue to debt servicing is much too much for me. I avoid companies devoting this large a chunk of revenue to debt servicing and therefore have to 'pass'. By all accounts MHGC appears to have wonderful properties in great locations. Also the trends have been improving greatly the past few years, specifically in 2005. There is also hope that the Las Vegas operations will drive future cash flows. However it just would not take much of a negative event at all to push the public MHGC into debt default...and we know what that would mean for common shareholders.

Comments

[tom p:]

you are dead on about the mhg. i live at the hudson in new york. there are about 80 s.r.o.'s living there. the guests paying big prices, for way sub par rooms. don't realize that the hotel is falling apart. the piping is 80 years old. and are busting all over the place. even forced a supermarket at street level to close down. do to the constant flooding. and they are callig the hotel the worst hotel ever. some people from england - have labled the hotel as the "MINUS FIVE STAR HOTEL". BEWARE - BEWARE

2008 Jan 19 04:12 AM