As a karate expert, I will not talk about anyone up here, because our children cannot afford to live anywhere. Nowhere, there's nowhere to go. Once again, why? You said it, 'cause the rent is too damn high. (Jimmy McMillan)
TravelCenters of America (NYSE:TA) is a publicly traded special situation. The company is one of the largest operators of truck stops along the US interstate highway system and formerly owned most of the sites it operated. TA and a smaller, similar chain (Petro Stopping Centers) were purchased by Hospitality Properties Trust (NYSE:HPT) a few years back.
Shortly thereafter, HPT entered into a sale/leaseback whereby it retained the real estate from both transactions, and entered into a long-term lease and operating agreement with the combined TA+Petro (I'll just call this "TA" going forward). TA was then spun-off to HPT shareholders, as REITs are limited in the operating assets they can own. Note that HPT basically negotiated the lease rate on the TA properties with itself before spinning off the TA operating company encumbered by this new lease agreement.
This was all completed in early 2007 and post-spinoff TA traded up into the high 40s. When the bottom eventually fell out, TA traded below 2 per share by late 2009. The sell-off was understandable: TA had no debt, but was a highly leveraged business due to its huge fixed lease obligations to HPT. On the operating side, TA's income statement was directly exposed to the decline in economic activity, and revenue and gross profit dropped alongside falling trucking activity during the depths of the recession (revenue also varies due to fuel prices, but this is mostly a pass-through... only fuel gallons and the margin/gallon really matter).
Here is where it gets interesting. As the largest tenant of HPT, TA could no longer afford to pay the enormous lease expense that was due. When negotiating the lease with itself in late 2006/early 2007, HPT was probably more interested in comparable cap rates and rental costs (at the height of the market) to derive the maximum cash flow it could squeeze from the several billion it paid for TA and Petro. Creating a sustainable economic model for an independent TA evidently wasn't management's highest priority.
I've summarized the company's income statements over the past several years (and detail for the YTD quarters) below:
So as TA swung to a deepening operating loss during the recession, what could be done? Almost immediately, HPT began allowing TA to defer $5 million per month in rental expense.
The table below breaks out this deferral so you can look at EBITDA with the $5 million either above-the-line or below-the-line. In addition, I've detailed out the other components of rent expense that are non-cash (GAAP required certain amounts to be classified as capitalized leases, including the tenant improvement allowance). This gives you a better idea of what the required cash payments to HPT look like.
As shown in the table above, the rent deferral let TA stay EBITDA positive to the tune of about $20 million in 2009 (it would have been $40 million negative without the benefit of the $60 million in deferrals). So far in 2010, EBITDA has been $49 million gross of deferrals and $4 million net.
Using Q3 as a proxy for Q4 performance, full year 2010 EBITDA should be $82 million gross and $22 million net of the deferral amount. The current market capitalization is approximately 0.75x gross 2010 EBITDA and 3x net EBITDA. These figures do not give the company any credit for a potentially better EV/EBITDA multiple based on the net cash and other assets on the balance sheet, nor do they take capital expenditures into account.
TA's balance sheet is fairly simple (click to enlarge):
However, the PP&E shown on TA's balance sheet is intermingled by GAAP with assets actually owned by HPT (with offsetting capitalized liabilities). The detail of these properties in the 2009 10-K is as follows:
These amounts need to be adjusted out to assess the standalone book value of TA. The balance sheet analysis below also nets out the deferred rental debt from the corporate cash balance, and places haircuts on the intangible and illiquid assets on the company's balance sheet (details are footnoted, click to enlarge):
Based on the analysis above, TA's current price implies an approximately 60% discount to the adjusted book value over $9 shown above. Coupled with the very low EBITDA multiples discussed above, TA is clearly trading in deep value range.
With the financial detail discussed above as a backdrop, I'll lay out why I'm long TA common and why I believe that a sale of the company would benefits all parties and could be completed at a substantial multiple to the current share price:
The Investment Case
The current wide discount to tangible value offers a decent margin of safety, as summarized below and supported by the fact that TA benefits from the implicit backstop of HPT.
- Valuation supported by assets: At ~$3.80 per share, TA is trading at a discount of over 75% to GAAP book value and almost 60% to the more conservative adjusted/tangible book value calculated above.
- Recent results: The company generated $20 million of EBITDA in the latest quarter, even after expensing the rent which is being deferred. While results will be volatile due to gas price margins, the company has clearly benefited, and should continue to benefit, from the economic rebound.
- "Parent" backstop: The lifeline that HPT cut TA during the recession wasn't just a gift: A healthy TA is absolutely crucial to HPT. TA contributes an enomous portion of HPT's cash flow, and as a REIT HPT's shareholders value a predictable, steady income stream. The rent deferred couldn't be recognized as income by HPT under GAAP, and that type of low-quality, volatile earnings stream from such a large part of your portfolio won't be valued very highly by Wall Street. On the other hand, this situation was of HPT's own making by the lease agreement it negotiated with itself and put upon TA. While the lease rate is clearly too high in light of what has transpired, HPT can never just let TA go bankrupt either. It would decimate HPT's earnings and they would have no hope of replacing TA with another tenant at better rates. It should also be noted that for TA to service its lease obligations to TA, it must transact literally billions in sales of diesel fuel each year. The oil companies likewise require that HPT maintain TA as a credit-worthy enterprise.
Risks and Mitigants
- Why doesn't HPT just bleed the company dry? HPT owns the valuable, "irreplaceable" interstate highway locations, and TA just has a long-term lease to manage and operate these locations. But just keeping TA around as a subsistence farmer on HPT's land really doesn't work in the long-term. The cash flow from the TA leases is very significant to HPT's dividend level. Simply put, over the long-term, HPT requires a healthy TA as a tenant. Even if they could extract a little more cash from the company by repeatedly raising the rent, pushing them to almost file bankruptcy, and bailing them out again and again... what would be the point? The Wall Street analysts will punish your multiple on such a low quality stream of cash more than you will gain in incremental lease cash. In general, if HPT had such a low quality tenant in any other property, they'd probably seek to boot them out and replace them. But this tenant (TA) is effectively of HPT's own making, and nobody else would step up to pay the lease rates that HPT set.
- Economic downturn. Obviously, TA remains an economically sensitive stock. However, I think a rewind over the past several years basically lays out what a downside scenario looks like. Even during the depths of 2009, TA generated over $200 million in EBITDAR, so it has substantial operating cash flow. It's not a bad company, just a bad balance sheet (imputing the leases to HPT). Unlike most companies, TA has its own implicit TARP program from HPT. Just like the Fed really can't afford to let Citi or AIG go bankrupt, HPT really can't afford to let TA go down and would have to step up again.
To summarize, my investment thesis around the stock is centered on the fact that it is trading at a very cheap valuation, and I believe the support from HPT presents a decent margin of safety since letting TA fail would be disastrous to HPT. On the upside, I believe that the upcoming negotiation between TA and HPT on the $150 million in deferred rent coming due in 2011 offers a very real potential catalyst to unlock value at TA via a sale of the company to a third-party, most likely private equity. My arguments for a sale are as follows:
Why should TA be sold (and soon):
- TA is far too small to be public. At a market capitalization of $65 million, it makes no economic sense for TA to be publicly traded. Going private would save several million per year in fees and expenses, and there are no real benefits to being public at this size.
- Timing. TA has shown several quarters of sharply improved results, and the widespread fear of a douple-dip recession seems to be receding. As such, buyers can underwrite current profitability and an improving outlook. There is currently substantial private equity capital available in the enterprise value range where TA would trade, and valuations are currently very aggressive.
- Conflicts of interest. The potential for conflicts of interest in negotiating a suitable, stable long-term economic arrangement between HPT and TA (and RMR, the management company) are huge and unsustainable. Why should all of these parties expose themselves to ongoing charges of self-dealing rather than using the negotiation of deferred rent due as a catalyst to redo the deal and put it on a sustainable footing. HPT is basically being offered a mulligan on the TA transaction, and it would be wise to take the opportunity. Continuing to have such a large exposure to such a shaky tenant is clearly not going to build long-term value and credibility at HPT.
- Adequately capitalized competitor. HPT should remember that TA is still a business, not just a rent-paying tenant. TA's two largest competitors, Pilot and Flying J, recently merged. TA needs financial and strategic flexibility to counter this combined force and remain competitive in the market. HPT can try to be cute on milking TA of all of its cash, but if TA becomes so hamstrung that it begins losing ground to the new goliath in the industry, things get worse. With the current lease structure, HPT has created its own problem in TA. If HPT lets this go on too long and TA begins to lose market share and become less competitive, it will have turned a solvable problem into a potential disaster. TA under private equity ownership with additional capital available for growth and independent (non-conflicted) strategic guidance would be a much more viable competitor.
- Free up HPT cash flow. Even at the current profitability levels of TA, HPT will likely have to continue to have to support capital expenditures going forward unless they restructure the lease to market and get TA independently, adequately capitalized. If they start deferring cap ex, they will only heighten the competitive risks discussed above.
I believe that at $3.80 per share (an approximately $65 million market cap),TA offers a good margin of safety on a valuation basis, and the implicit standby TARP from HPT provides a measure of downside support. However, I believe that the upcoming negotiation on the deferred rent offers a great chance for a redo on the lease agreement that would be a win/win for all sides. A restructuring of the lease in connection with a sale of TA to private equity would let HPT collect its deferred rent due, get off the hook for future cap ex, and create a credit-worthy, stable tenant that would benefit HPT's long-term prospects and let it return its focus to future growth.
I think there are adequate market comparables to show that private equity firms have paid healthy multiples for analogous businesses, such as stadium concessionaires, operators of newstands at airports, hotel operating companies, etc. The adjusted book value discussed above presents a reasonable floor where a sale would be completely supported by tangible asset value. If HPT uses its mulligan opportunity to set the rent at a level that is justifiable to a third-party buyer, I think the resulting TA enterprise could sell in the range of $15-$20 per share. More importantly to HPT, the stable lease stream should be more valuable going forward.
At the very least, HPT should consider a sale process for the company as a realistic market check on what a true third-party rental agreement for the TA properties would look like. I see little harm in that course of action. Other than the time and expense involved in hiring an investment banker (which isn't that much if a sale isn't completed), neither HPT nor TA would really stand to lose. The information on both the lessee and the lessor are already public, so nothing is being compromised by bringing potential third-parties into the mix.