Morgans Hotel: Clouds Ahead for Boutique Hotel Operator?

Feb.22.11 | About: Morgans Hotel (MHGC)
Business Profile
Morgans Hotel Group (NASDAQ:MHGC) is the original “boutique” hotel operator, with about 4,950 rooms at its 15 properties. With designs by the famous duo of Philippe Starck and Ian Schrager, its flagship hotels help to attract a celebrity following and enhance a glamorous image throughout the system.
MHGC has grown from a portfolio of just nine hotels to today’s 15, located primarily in gateway cities. Beginning with the purchase of the Las Vegas Hard Rock in early 2007, the company’s aggressive growth at the end of the most recent lodging cycle has provided management a huge challenge: improve operational results, while keeping lenders at bay.
Investment Thesis
Although I like Morgans for its one of a kind, well-located assets, at recent levels, the stock’s valuation leaves little room for any bad news. As I outline below, there is potential for adverse events at a number of its properties, which are failing to meet their capital costs and seeing only faint signs of a rebound. With its best quarterly period (Q4) behind it, and considerable uncertainty ahead, MHGC should be available at levels over the short term (3-6 months) some 20-25% below recent trading (of around $9.85).
Working With Lenders
The joint venture that owns the Las Vegas Hard Rock, managed by Morgans, is likely in default of its EBITDA hurdle covenant. A recently announced standstill agreement with its lenders, set to expire by late Feb. 2011, bought the JV a little time to work things out. I believe Morgans will continue to manage this key property indefinitely, given the JV’s huge investment, the property’s significant cash flow potential and a relatively favorable relationship with its key creditor.
Its joint venture partner at Hard Rock (DLJ Merchant Banking) has committed $424 M of its own cash (next to MHGC’s $76 M), and is inclined to make a return on its investments – both the initial purchase and its recent expansion. A project to more than double the property’s room count was completed (in two stages) in 2009 is further indication of the partner’s ongoing commitment. At that time, the principal lender’s CEO, also chairman of the Board at Morgans, agreed to extend the facility’s loans to 2014, from early 2011.
Results at Hard Rock have begun to improve, though slowly. And while Las Vegas works through significant hotel room supply, results from peers, including Wynn Resorts (NASDAQ:WYNN) and MGM Mirage (NYSE:MGM) - the largest property owner in the city - suggests room demand is improving in 2011. A sustained improvement would have important implications for MHGC’s 12.8% equity investment in Hard Rock, which has been written down to zero. Under a favorable scenario, the $4 million in yearly EBITDA currently generated by the property’s management could easily become $8-10 million.
Less Than a Year’s Visibility at Some Hotels
Ames and Shore Club, like Hard Rock, are joint ventures where existing liquidity problems could result in a loss of those lucrative management contracts. Based on management’s recent rhetoric, though, it seems likely MHGC will continue to manage the Ames property (Boston) until at least late 2011, when a one-year extension clause in its lending agreement expires. Meanwhile, operating results at Shore Club (Miami) are beginning to stabilize, making it less likely this JV’s mortgage lender will seek foreclosure in state court, after failing at the federal level.
At Mondrian South Beach, a joint venture hotel/condominium project, the company is making the best of a difficult situation. Unit closings there remain slow – even at reduced asking prices – but cash flows from rentals of hotel units are helping mitigating losses, which I expect at around $2 million in 2010 and 2011, versus more than $4 million in 2009. Its non-recourse financing was recently restructured (April ‘10) to extend the debt’s maturity (up to 7 yrs), even though another impairment of the property is possible.
Clift, a San Francisco property operated under a 99-year lease, has had its rent reduced by the lenders (a Morgans subsidiary). The lower amount will save the company slightly more than $1 M this year, before rising to the prior level ($6 M) in early 2012. Although room rates continue to slide at Clift, overall RevPAR and EBITDA are trending solidly upward.
Morgans Property List
Net
Debt
%
Consol-
Off-BS/
Rooms
Owned
Idated
JV
Status
Royalton
168
100%
Collateral for reduced credit facility.
Morgans
114
100%
Loan recently restructured.
Delano
194
100%
Hudson
831
100%
250
Mondrian LA
237
100%
121
Loan recently restructured.
Clift
372
100%
85
Rent temporarily reduced.
Mondrian South Beach
328
50%
62
Miami condos tough sell.
Ames
114
31%
14
Working through default.
Mondrian SOHO
270
20%
39
Opened Feb ’11.
St. Martins Lane
204
50%
79
Interest rates reduced.
Sanderson
150
50%
Interest rates reduced.
Hard Rock Hotel & Casino
1,510
13%
Cash flows < debt svc.
Shore Club
309
7%
No longer in foreclosure.
Water and Beach Club Hotel
78
0%
Hotel Las Palapas
75
0%
4,954
455
194
Other debt
163
Convertible notes
50
Liability to subsidiary trust
11
Promissory note
24
Revolving credit
702
896
Total Balance Sheet
Click to enlarge
High Debt Pressures Spending and Discretionary Cash
MHGC is approaching breakeven on a free cash flow basis, before interest costs (as seen in the table below). But its weighty debt service is pushing up the company’s borrowing needs, in a vicious circle, forcing a more economical spending program.
2008
2009
2010E
2011E
EBITDA
42
(4)
22
35
Capital expenditures, net
(54)
(13)
(16)
(16)
(Investment) distributions from JV's
9
(24)
(12)
(15)
Free Cash Flow
(3)
(40)
(6)
4
Share (repurchases), net
(49)
-
-
-
Proceeds discontinued operations
17
Proceeds preferred stock and warrants
-
60
Interest expense
(45)
(50)
(41)
(39)
Stock based compensation
16
12
13
14
(Increase)/decrease in net debt
(82)
(19)
(16)
(21)
Net debt
649
670
702
723
Click to enlarge
Management pegs maintenance capex at $6 to $8 M, but that estimate (about $1,400 per room) seems insufficient relative to its own depreciation (of $30-35 M). Nor does it look realistic against the maintenance levels of comparable upscale hotel chains. As an example, Orient-Express Hotels (OEH), with some 30% fewer rooms in its system, must put $25-30 million annually toward maintenance outlays.
On the expected spending level, and assuming EBITDA increases solidly in 2011, the company may need to make further drawings on a revolving credit facility secured by its three wholly owned, unencumbered properties (Royalton, Morgans and Delano), or dispose of certain assets altogether.
Potential Sales of Key Properties
Royalton and Morgans, both located in Manhattan, have been rumored as possible sale candidates. After undergoing significant room renovations and a recent restaurant overhaul at the Forty Four (Royalton), these two hotels have only begun to see room rate increases, the key driver of property leverage. Sale at this time can and should be avoided.
At this early stage in the lodging upcycle, cash flows remain near trough levels: I expect 2010 EBITDA for Royalton of around $3 M, and $2 M for Morgans, putting this past year’s property cash flows at less than half the levels each averaged from 2005-08.
Based on recent appraisals, of $155 million ($920k/key) and $60 million ($525k), respectively, these properties are being valued at discounts ranging from 25-35% of their values from two or three years ago. The flood of commercial debt coming due throughout the industry in 2011 and 2012 only helps ensure a buyer’s market.
Finally, although Asset-Light might work for the majority of hotel operators, the concept has little value at Morgans, where design and ambiance are integral to the image. Though terms of any sale would ensure continuation of management at the properties, the forfeiture of ownership would severely limit property control, potentially jeopardizing a hotel’s standards.
Management Agreements Announced
The most viable alternative for generating (free) cash flows is through property management contracts, given MHGC’s heavily leveraged balance sheet. As such, the company has recently announced four separate property management agreements. Each of the agreements would be to operate a property currently under construction or in planning. Since none of these properties is set to open before 2013, it’s difficult to place any real value in these contracts.
Valuation
Even under favorable assumptions – a rebound in EBITDA and/or the exclusion of in the money warrants – the stock is expensive, as seen in the table below. Adjusted EBITDA potentially provides a more robust view of the company’s valuation, theoretically. However, as a practical matter, investors have tended to value the company based on reported EBITDA (generally applying a multiple in the high teens). The gap between adjusted and reported EBITDA has always been wide – even in better times – undermining the value of the adjusted figure. For instance, in 2007, Morgans best year as a public company, its adjusted EBITDA of $110 million was 60% above the actual EBITDA of $68 million.
Balance Sheet - As Reported (9/30)
All in Balance Sheet
Market capitalization
299
422
Includes ITM warrants
Net debt
702
896
Includes OBS debt
Preferred stock
50
50
Minority interest
11
11
Enterprise value
1,062
1,378
EBITDA (2011E)
35
35
EV/EBITDA
30.3x
39.4x
EBITDA (2010E)
22
EV/EBITDA
47.9x
EBITDA (2010E adj.)
55
55
Ex mkt val adj warrants
EV/EBITDA (adj.)
19.3x
25.5x
and JV losses
Click to enlarge
I estimate normalized EBITDA for MHGC at between $50 - 60 million, which could be achieved as early as 2012. Given the near term uncertainty around key assets, and the company’s broader liquidity issues, an EBITDA multiple of 20 - 22x these projected levels is appropriate, resulting in a target price of between $7 and $8 a share.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.