- LQ has a model that provides extremely high levels of top-line growth.
- LQ has been able to deleverage during the first half of 2014 in the face of opening 24 new locations.
- LQ is at a level of maturation that should begin to allow it to realize economies of scale and margin expansion from its size alone.
There's a growing force in the hotel space that is slowly, actually rather quickly, becoming the market leader in the select service niche - this force is La Quinta Holdings, Inc. (NYSE:LQ). La Quinta just put on a smoke show of a quarter after being given the benefit of the doubt for the last three months with nothing but high expectations and momentum being priced into the stock as analyst upgrades rolled in and the share price stair-stepped its way higher and higher. The company did not disappoint. After reporting one of the most impressive quarters you're ever going to see from a semi-mature hotel chain the shares look well positioned to continue to make higher highs on all durations. This continuing coverage article will breakdown the recent quarterly announcements and make the argument that based on a well-oiled systematic schedule of hotel openings, excellent cash flow management that is actually allowing the company to deleverage while growing, and based on the high visibility of key metric growth that La Quinta remains one of the most attractive real estate derivatives available.
The Quarter that was
To be clear, when I initiated coverage of LQ my expectations were for this type of share performance by year-end not by the end of the first half. What has happened has been a surprise to say the least and I think that's well evidenced by the chart above. Everybody has been surprised - not by the execution but by the speed with which LQ was able to do it. That's going to be big going forward because the ability to hit home runs changes the way that the stock will trade on a technical basis. The stock has moved from one of the "show me" variety to one of the front-run kind. From here going forward you're going to have to own the shares in advance of the earnings periods instead of after. The company's ability to hit the long ball also should keep short interest low which will allow the shares to develop a natural trading slope like the one shown above. If the company can perform, so will the shares. Uninterrupted and free of artificial selling. That matters. Shares are up 18.3% for a laundry list of reasons that we'll go over but just know that this company, despite the technical performance, is not overvalued. I'll try to make that point clear.
The analyst community is very bullish LQ:
- Evercore: Overweight - $21.50
- Credit Suisse: Outperform - $22
- JMP Securities: Buy - $23
- Stifel Nicolaus: Buy - $21
The average of the four PT's listed is $21.87 which implies another 10% price appreciation, using today's information, before the analysts above believe the shares are at fair value. By the time that shares hit that mark the company should be at or near another earnings announcement and if LQ can just hold steady the trend line growth that it showed during 1H/14 I would expect shares to continue to move upward and to the right on a chart. I myself have adjusted my models and have a slightly higher PT than the average listed by Q3/14 earnings.
The financials from Q2/14 are more than slightly skewed from a net income standpoint and a percentage performance standpoint when not looking at them adjusted for a one-time, non-cash tax expense that occurred as a result of LQ transitioning to a C-Corp structure at IPO. This conversion caused LQ to record a net deferred tax liability of ~$321 million. Now, this tax expense is real but again it was non-cash based and will have no effect on LQ's actual cash flow until 2016 when it should begin to have a ~$26 million cash expense. The actual cash impact and any further income statement impacts being so far away I'm going to choose not to discuss this event further or to recognize it in the financials from this quarter. The tax expense is essentially irrelevant until 2016 and the share prices since the earnings announcement have confirmed that. Just know that the tax expense is an annoyance when reading the financials from this quarter.
We'll start with operations and finish with the key metric performances. I'm only discussing the income statement because it will be a comparison point for future continuing coverage articles but this particular income statement has been skewed beyond recognition at the bottom line so bear with me:
Top-line growth was excellent, coming in at 9.7% on the half year and 11.7% on the quarter Y/Y. The majority of this growth was external based as LQ expanded its overall location growth by 12 hotels in Q2 and by 12 hotels in Q1 - bringing the total hotel growth for the 1H to 24. With new builds and location growth being a key growth initiative now and going forward I would expect new location growth to continue to drive growth. This part of the growth discussion is deserving of further granularity.
Strong Pipeline and High Visibility of New Location Growth
In regards to growth there are several consistencies with which the LQ investor has come to know. First, is that the company realizes the building of between 25-30% of its outstanding pipeline of fully committed franchise locations annually. Currently, LQ's pipeline consists of 190 hotels with a small percentage of the pipeline being international based. In regards to the locations and the concentration of where the current pipeline is located, the company has been able to position most of its pipeline in areas of high economic activity - speaking primarily of Texas and California. 29% of the current pipeline locations are located in Texas.
These locations continue to add to the new locations of LQ's portfolio, speaking of actual hotel age (new is defined as less than 5 years of age), and continue to keep LQ at the top of the list of major chains when it comes to average age of hotel. Having a portfolio of younger hotels has obvious aesthetic and structural benefits (up to date building design, realization of up to date efficiencies such as having energy efficient lighting structures, heating and A/C flow structures, technology based infrastructures on hotel by hotel basis, etc.) but also advantages that come from not having legacy locations in areas that were once profitable but are not now post 2008 financial crisis. Finally, being a younger hotel and having a young portfolio in aggregate (owned hotels have an average age of 26 years and franchise locations have an average age of 13 years) means that LQ has been able to DCA its and its franchise owners build costs across more relevant durations. What this means is that as LQ has had a majority of its locations being opened "recently" (on a hotel age scale) it has a lower cost of maintenance on locations (SOURCE: Smith Travel Research, LQ IR) and has been able to acquire the actual properties at lower underlying land costs (financial crisis included). This will matter more for the longer term investor than a mid-term investor but it matters none the less.
Second, is that LQ is almost exclusively opening new locations via the franchise owned channel. LQ has a long term strategy to drive the composition of its portfolio to 80% franchise owned locations and 20% owned locations. As a part of this strategy and a way to further create shareholder value, post-IPO LQ has restructured its existing and new agreements away from an older agreement that only charged 2% in aggregate fees to a new one that charges 6.5%. LQ has not noticed any resistance to the new agreement and notes that all of the financial data presented so far, and including the Q2/14 numbers, is using the legacy agreement. This should be looked at as the second largest driver of topline growth for LQ on all durations but especially in the short term. Again, this is a high visibility revenue and margin expansion driver that forces the investment community to expand the multiples used to value the company. Please do not overlook this subtle but huge share price catalyst. This will be further evidenced in graphics to follow.
Third, the growth strategy at LQ can flex forward and accelerate as economic conditions improve or as accretive opportunities present themselves. LQ is extremely under represented, when compared to its direct competitors, as it is only participating in 67% of the markets with existing select service hotels domestically (SOURCE: Smith Travel Research). LQ's footprint remains less than half of that of its defined direct competitor domestically however with the full realization of its existing pipeline LQ will enter into 31 new markets as defined by Smith Travel Research. This lack of representation presents itself as an opportunity, the third high visibility driver, for new investors as LQ should not experience any material level of cannibalism of sales with its new builds. This becomes important from several obvious avenues but also from the less obvious avenues of helping expand the LQ brand, helping LQ realize economies of scale from a supply and delivery logistical infrastructure standpoint, and helping LQ realize economies of scale from other OPEX channels. To be specific, the overall growth of the company and the growth into newer and more diversified markets has allowed (and this is just so far) the company to renegotiate contracts for toilet paper, trash cans, and trash bags. While lower visibility than any factor listed above the potential improvements to fixed costs down the line are not a stretch of the imagination by any means and with one or two more quarters on the books I feel some basis point improvement in margins could be modeled in with a decent level of confidence. This final part of the strategy is something to watch long term.
Getting back to the income statement, with expansion comes increased expenses. LQ saw operating income fall from ~$77 million to ~$60 million Y/Y for 1H/14 as a result of greatly increased G&A (up from ~$36 million to ~$69 million) and direct lodging expenses (up ~$12 million). This lower operating income figure (also factoring in a one-time $5 million impairment charge), which is not a point of concern based on where the drop is coming from, was not greater than the other fixed costs at LQ (comprised mostly of ~$73 million in interest expense on debt but also a one-time $2 million loss on the extinguishment of debt) and lead to a swing from a net operating income to a net operating loss. The total swing was ~$19 million but factoring in the above listed one-time expenses as well. This is where using the income statement becomes less relevant as the company had to recognize a one-time tax expense of ~$321 million leading to a massive net loss on the quarter and on the half year.
Overall, the income statement looked healthy when considering the sources of losses and the nature of the degradation of performance. A more accurate look at company health and future prospects can be had by viewing individual performance metric growth.
First, a quick look at two important segments indicative of growth. Notice the bars highlighted in green don't vary from the top to bottom of the graphic. There is no adjustments needed within the graphic for the franchise and management additions to revenues when adjusting EBITDA. This is the segment in the growth section we discussed should see marked improvements because of the changes outlined red. Look for this to be a material driver of overall topline and margins going forward. This should also slowly help to negate seasonality of performances. Both important long term. Second, notice that although operating income and net income fell dramatically (but not unhealthily) during 1H/14 that the Adjusted EBITDA (removing one-time items) increased on the Q and on the half year, increasing 14% Q/Q and 11.3% H/H. For this particular company during this particular transition period I think the Adjusted results are more correlative to growth.
Next, as a result of the improvements outlined in the first half of the article LQ noticed a substantial outperformance of metrics particular to its business and comparable to other competitors. LQ' s expansion efforts are illustrated in the ownership composition section of the graphic showing the marked growth of its franchise channel. Remember, with a footprint size half the size of its competitors the growth of its locations has historically equaled revenue growth - cannibalism is not a concern. That said, this metric is important to watch and will be a number that getting right Q/Q/Q can help an investor front run revenue growth and share price growth. It should also be noted that LQ has expressed that it plans to realize franchise location growth and has done so thus far at an 80% new build 20% conversion of existing build rate. LQ is very selective with its conversion properties but with a recent trend of other chains in this space looking to get leaner there may be conversion opportunity available. If LQ can bring on board any increases in locations via conversion this would accelerate overall opens and margins. This is not something I will be modeling in but is an unknown variable that should keep shorting of the shares at reasonable levels.
Occupancy on the six months increased 150 basis points with average daily rate (ADR) rising 4.8% on the six months. For me, I more closely watch ADR for increases as ADR increasing can drive top and bottom line growth without an increase in expenses. Increased occupancy is always nice to see but obviously comes with increased operating expenses. Both increasing combing to drive Revenue Per Available Room (RevPar) an impressive 7.3%. Again, reiterating this is for a semi-mature company hat has yet to fully realize economies of scale and any recognition of its newest franchise owner fee agreements. All very positive developments. A further breakdown of the segments including ADR and RevPar is included as the final portion of graphic. This section goes on to provide further granularity of segment between owned and franchise owned locations.
All told the growth at LQ is clear, it has excellent forward looking prospects, and based on management's guidance and a history of consistency should continue to develop. I am really excited to see if next quarters financials can confirm the slope of the trend line forming in my models so far.
Cash Flow and Debt
Finally, it's incredibly important to realize that in addition to growing LQ is actually deleveraging as well. I know, that doesn't sound right but it is. Despite the huge "loss" that LQ posted to its income statement the company is more than healthy from a cash flow standpoint, generating big levels of FCF, and has been able to make substantial prepayments to debt. During Q2 LQ made $80 million in prepayments to debt and plans to accelerate this prepayment of debt into the second half of 2014. LQ has guided that it expects debt/EBITDA under 4X by the end of 2015. This is in the face of spending what should be $71-$77 million in full year CAPEX and opening between 45-50 locations in full year 14'. Again, I reiterate that these are not normal operational tendencies. LQ is showing itself to be a rare and very one-time opportunity at this stage of its maturity.
As clearly illustrated in the graphic, LQ has greatly deleveraged over the last six months. While this wasn't listed as a growth strategy of the company in the section above (and it isn't a growth strategy directly) the decreased interest expense as a percentage of revenues will most certainly stretch net income and EPS. Not only that but should LQ see an opportunity to raise a long bond or a some form of managed level of dilutive debt instrument the lower levels of outstanding debt will go a long way into securing cheap financing. There is simply nothing negative to say about the debt situation at LQ.
The greater debt discussion and the discussion of paying debt down isn't complete without a look at the cash flow statements:
For the operations section, when all of the non-cash and one-time non-cash expenses are backed out the operating cash flow grew from ~$110 million to ~$125 million, evidencing the underlying profitability of the business. Also, it's worth noting that LQ was able to generate this cash flow with a build to receivables, no build to payables, and in the top green bar was able to show a lowered net interest expense Y/Y. The only visible drag on cash flows on any duration is the increased tax expense beginning in early 2016. I'm not willing to not own the stock and promote its cash flow generation because of a factor that will take effect 18 months from now. In my opinion the FCF and the debt reduction abilities of LQ is one of the largest if not the largest reason to own this stock.
Looking at the investing activities, which were largely made to look better than normal by a decrease in restricted cash, you can see that CAPEX remains at steady levels and that LQ is clearly continuing with its grow the top-line by growing locations strategy. I like CAPEX here and like it at these levels in the future.
Finally, the cash situation at LQ and the ability to generate cash makes debt and/or dilution a non-concern at this point. With C&CE at over $100 million and no real cash needs that can't be serviced by FCF at this point I look at FCF and what that should do for DCF models as yet another reason to own LQ into year-end window dressing that should be there in size. Cash is king and LQ has a lot of it.
Where's the trade?
I believe La Quinta to be at excellent value even at current pricing. I think the model at LQ should continue to lead to outperformance of peers and to surprises to the upside from a numbers standpoint. I just don't see many ways LQ can miss outside of a complete economic meltdown. Even if that was the case and we see a repeat of 2008 LQ has the cash and the borrowing capacity already in place to take advantage of acquisitions at that point that would be offered at significant discounts.
I think that LQ is a great way to own a REIT in drag that will have excellent beta if the economy and/or the markets continue to improve. I like that it has a good mix of corporate and leisure clientele and that it has high visibility of execution.
Unfortunately, there isn't really an options market for LQ just yet or I would be actively looking to add leaps into January of 2016 which is the first time I'll look to sell my shares that I own - assuming no underperformance of key metrics or major black swan event. I think the long-term trade here is to get long and just watch the shares go higher. I recommend LQ shares for anybody with a mid to long-term beta driven growth position need.
I look forward to providing continuing coverage. Good luck to all.