How Extended Stay America’s Bankruptcy Affects Ashford Hospitality

Short Answer: marginally.

Long Answer: There was much sturm und drang over Extended Stay America’s (ESA) Chapter 11 bankruptcy filing on Monday. Of primary concern to this investor is how the filing may affect Ashford Hospitality Trust’s (AHT) $98 million mezzanine loan that was made to ESA last year.

For investors, it’s important not to panic and trade in response to emotion. Instead, first run through a rational evaluation and then make a decision. Here are the important questions each investor should ask:

1) What happened?

2) What are the possible outcomes?

3) How does this affect the company’s balance sheet and/or operations?

4) What does the stock price reflect?

5) Has your opinion of management changed?

6) How is all this actionable?

So, let’s look into each of these. I’ll quote from a few conference calls so there is no ambiguity.

1) What happened?

“In July, we invested $98 million to acquire a mezzanine loan that had a face value of $164 million. The loan was part of a $400 million mezzanine tranche [Note: Tranche 6]” (CC 2Q08). There was $6 billion of first mortgage and mezzanine debt senior to Ashford, $1 billion of mezz debt and $600 million of equity junior to them.

The maturity date of this mezz paper was June 12, 2009, and at that time, Ashford was due to receive the full $164 million payment from ESA. The borrower was likely to have met the requirements to extend the maturity date.

ESA filed for Chapter 11 bankruptcy on Monday, declaring the value of the newly restrucutured entity at $3.3 billion, a 55% reduction from its buyout price. In it’s bankruptcy proposal – and it is only a proposal which will be attacked -- they propose to extinguish all mezzanine notes. In exchange, ESA appears to offer Call Options for equity in the newly reorganized company (NewCo).

So now it all gets worked out in court.

2) What are the possible outcomes?

There are literally too many to even postulate. There are many different players fighting it out in court. Investors have one consolation, which is that Ashford, as one of the few interested parties with hotel operations and financing experience, can bring value to the table. If they can demonstrate that whatever they propose has value, they may be able to recover some of what was lost. And while a complete write-off of the debt is possible, there may be little correlation between what’s actually written off and whether Ashford ultimately attains any value.

3) How does this affect the company’s balance sheet and/or operations?

Ashford paid $98 million for the loan last July. Ashford already spent the money on the note. They will not have to put up any money as a result of ESA’s default. That amount was being amortized up from loan date until maturity. They were receiving $5-6 million annually in interest payments. From an earnings standpoint, they will not book that interest. However, from a cash flow standpoint, the impact is negligible. On a bottom line basis, across the board, from EBITDA to CAD, this only marginally affects the company’s ability to operate, meet preferred dividends payments, and service debt.

Let me repeat this, because it’s one reason why the stock sold off.

The impact on cash flow is negligible.

As for debt covenants, Ashford remains well within the credit facility’s required net debt to asset ratio of 65%, and well below the Security Preferred B’s of 75%. By taking a worst-case scenario impairment charge of $109 million (see the 6/19 8-K filing), and based on Q1’s balance sheet, that ratio would be in the high 50’s. I say “would be” because Ashford has an impairment “bucket” of $150 million for the cash flow, so in fact that ratio will not change at all.

Ashford’s debt covenants are not affected, and required ratios are negligibly increased.

4) What does the stock price reflect?

The stock fell from $4.25 to $2.18 on this news, a decline of 48%. Is this justified?

I suppose a pessimist could look at this and think Ashford’s entire mezz portfolio could go bad. Now I personally do not think that’s going to happen. There is nothing to suggest that will happen, and only two other properties are struggling with mezz payments – one which was due to weather. But still, let’s look at what impact that would have and see if that’s what’s driving the sell-off. We should be conservative in our analysis.

Let’s say we wipe out the full $234 million in notes receivable and Prudential JV investment from Assets, we first look at the debt ratio covenant. If that were to happen, then Ashford would still be nowhere near the 65% ratio.

Q1 income from mezz notes was $6.2 million. That would extrapolate out to $24.8 million annually. Based on Q1’s results, all bottom line numbers remain positive or a hair above break-even. All preferred dividends and interest get paid.

The fixed charge coverage ratio covenant needs to be higher than 1.25. The new ratio would be 1.63, down from 1.75. Not a concern.

So even given the worst case scenario – which means a writedown of the entire mezz porfolio with no evidence to support that such a thing is going to happen – it seems this concern is wildly overblown.

To me, the stock price has overly discounted this worst case scenario. It’s also discounted something else -- a continued deterioration in RevPAR, and an inability to keep pace with cost-cuts. Yet Ashford’s Q1 showed that in the face of a 17% RevPAR decline, they were able to cut operating expenses by 15%. This aggressive cost-cutting is likely to continue should RevPAR continue to decline.

5) Has your opinion of management changed?

Nothing about Ashford has changed, so we have to look at their mezz underwriting as being the item in question. So I ask, “Was Ashford too liberal in their stress-testing of this mezz paper”? Reading back over the 2Q08 and 3Q08 conference calls, I feel that Ashford did their due diligence on this paper. I imagine they stress-tested to account for the enormous but short-lived RevPAR dip after the 9/11 tragedy.

However, I don’t see how anyone could have reasonably been expected to account for the kind of substantial, sustained, RevPAR declines we’ve witnessed. We are experiencing an unprecedented economic crisis that nobody expected to be this bad. So while I don’t blame management here, those folks who fear that the other mezz paper may not be good, can certainly point to this same problem and find their fears to be justified.

Again, however, even that worst-case scenario does not significantly impact the strength of Ashford’s balance sheet or its operations.

6) How is this actionable?

The potential, but not guaranteed, loss of this mezz investment is unfortunate. But it will have negligible impact on Ashford. As Q1 demonstrated, Ashford meets all cash flow needs –and more – even under an 17% RevPAR decline. Their balance sheet remains strong, with $240 million of unrestricted cash. Unless RevPAR declines substantially further from here, I see upside. The market valued it at $4.30 before the ESA bankruptcy. Since impact is negligible, a 100% return from these levels seems very achievable.

Now, let’s go one step further. Let’s say Ashford returns to the same levels of 2007’s NOI by 2014 – a full five years out – and the market rewards it with the same EBITDA multiple of 13, as it did before. Buying at $2.30 will yield a 40% IRR.

Where else can you find that return?

Meanwhile, the Preferred D trades at $11 – 55% below par, and paying a $2.11 annual dividend (almost a 20% yield).

I purchased more common this past week.

Full Disclosure: Long AHT, and AHT Preferred D.

Comments

[SeattleGold...:]

In a macro sense I agree with your "theme." There is no rationality to a 50% decline in AHT's stock as a function of the ESA Chapter 11 filing. However, in a micro sense I disagree with several of your "leanings."
1.) I don't think AHT will salvage one penny in the ESA Chapter 11. I know Chapter 11 very well and if their position, that far down in the stack is thrown any bone at all, it will be one that will not have any future value (i.e. an out of the money warrant for the Newco equity that would only have value if/when Newco's valuation made everyone else in the stack above them 100% whole...not likely.)
2.) I think that the RevPar numbers will continue to be horrendous for a protracted period of time (see USA Today for teleconference article) with implications for permanent change to property valuations in line with reduced property-based cash flows.
3.) AHT has done a sensational job of funds management and has performed extraordinarily well for shareholders. Its average cost of 3.37% due to its "hedges" and its pull down of its credit line and use of liquidity to shrink its common and preferred share base will allow it to salvage more value as a % of former value than any other lodging REIT. That said, one can be very concerned about what the share price might move to in the future. EBITDA in 2014 may not at all come close to the level it was at in 2007 even if Revpar begins to move up again. The reasons for this would be:
a.) A rational person will assume that the current enormous impact (and it IS enormous) of the hedging strategy will wear out after the hedges expire and that without a great crystal ball, a benign scenario would be "normal" cost of funds.
b.) That "normal" cost of funds is going to be higher than it is today for AHT both in nominal and relative terms as we are witnessing bank hardball on refis and new financings with terms way above what AHT is running. The clock starts ticking again for refi in 2011 for AHT.
c.) A permanently lower level of Revpar could also be part of the scenario with very muted recovery for both consumption expenditures and corporate marketing events.
Larry, if you have the expertise, or know someone who does, and can model what the cash flows look like through 2014 restoring "normal" average funding interest levels, assuming refis will ratchet up a bit with less leverage available, and then put a variety of Revpar and cash flow retention assumptions through that meat grinder (assuming current Preferred and Common share counts as I think most of the buybacks are over) then you can begin to assess what ranges of values are and which variables create the greatest EPS changes over that set of scenarios. I am sure the good folks at AHT try to have this kind of perspective, although I would hazard a guess that even they have not modeled this in as "tight" a way as an investor should.

Jun 24 06:04 AM

[zorro6204:]

What was a hotel company doing buying notes in the first place? In spite of the discount, surely the monies would have been better spent on capital for the operating business. It didn't matter that the note was bought in another era, it didn't fit.

Jun 24 09:06 AM

[Rhino Realty:]

Larry.....you stated that AHT has good senior management and you stated that they made a mezz loan to debt heavy ESA. AHT stock should have dropped more than 50% as they are plain and simply STUPID for making this Mezz loan when they knew they ESA ship was sinking !! Starting over, the short answer is STUPID !!!!!!!!!

Jun 24 08:42 PM

[Larry Meyers:]

SeattleGold:
Yours is really the first substantive comment i've had on AHT. My thoughts are that AHT probably won't see a penny from the default, but I didn't say that they would, either -- only that they bring more to the table than most.

We both know that there is no predicting the future. How and when RevPAR recovers depends on too many variables, but to declare *permanent* damage to RevPAR, cash flows and property values? I think that's going too far.

When the hedges expire, yes, the cost of funds could very well increase, esp. with the spectre of inflation out there. But 2011 is two years away, so it's wait-and-see, isn't it?

What you project is, wisely, a doomsday scenario. All of this could certainly come to pass and the most conservative of investors might examine this and question upside potential. That, of course, depends on individual risk tolerance.

I suspect management has, in fact, modeled out this variety of possibilities. They have also proven to be extremely deft with respect to debt structure. I also do not foresee a permanent change to RevPAR and consumer expenditures. So, backing off from the doomsday scenario but not factoring in a rosy picture, either, I believe the stock remains cheap looking out several years and provides an attractive IRR scenario.

Thank you for your excellent thoughts.

Zorro: It is easy to look at AHT's mezz strategy in hindsight as being a bad move. Of course I would prefer the liquidity right now as well. However, their IPO prospectus made it clear that this was a portion of the market that they felt offered attractive returns during down economic cycles that few other entities serviced. It's easy now to say it was a mistake, but as I pointed out in the article, management stress-tested RevPAR declines beyond what was seen after 9/11 -- which at the time was unprecedented. I don't fault them for failing to foresee the global meltdown. Certainly, few others did.

Rhino -- What gives you the impression that AHT made the loan "knowing" that ESA was sinking, especially with 3 one-year extensions built in? Did you see ESA's financials? Did you observe AHT"s underwriting? No. So perhaps you should clarify your statement.

Jun 24 09:14 PM