Condor Hospitality: Decision Time For Upcoming Exchange Tender Offer

by: The Owl

Summary

Recent announcements about tendering Preferred Series A and B Shares seems to have unnerved holders of these securities, with values sinking since the tender announcement.

As in past quarters, the face value of the A and B Shares continue to be backed $1 per $1 of assets net of liabilities (almost).

Now the Question is: "What is the best approach for holders of Condor Hospitality A and B shares (CDORO & CDORP) to maximize the value of the shares?".

Full Disclosure: I am a holder of a significant number of both the A and B Shares (SPPRP/CDORP and SPPRO/CDORO). In addition, these shares represent a significant percentage of my equity holdings.

(Share prices are taken from Yahoo Finance as of the close of trading on August 28th, 2015: $18.95/share CDORO and $7.00/share CDORP)

Introduction:

This is the fifth in a series of reviews of the Condor/Supertel Hospitality quarterly earnings statements. This series of articles has focused on the balance sheet and assets of the company. Specifically, these reports have tracked the underlying assets of the company and how they compare to the value of the Preferred A and B Shares, in order to monitor whether there are still assets that can stand behind the face value of these preferred shares (and whether they can continue to be purchased, even as their large discount suggests a high degree of risk).

Given the upcoming tender offer, the latest quarter's results will be covered in brief to enable an updated assessment on the offer from the company to exchange Preferred Shares A and B for common shares. This offer will expire on September 9th, so holders of the Preferred A and B shares will need to be making their decisions in the next two weeks about whether they plan to tender their shares. In addition, there is a more immediate vote by the Preferred B holders to determine whether some of the protective covenants related to the B Shares should be moderated to enable the tender to move forward as planned by the company.

This article will both review the previous quarter, and over the previous 5 quarters, to provide some input for holders of the A and B Shares to consider prior to their final decision on both the upcoming vote on the protective covenants on Sept. 3rd and a second decision on whether to tender their shares by Sept. 9th. A third section, as indicated above, will reflect on why this step needs to be taken soon, given the direction of net assets and on the inexorable buildup of accrued dividends (as well as interest on those accrued dividends for the A Shares).

2Q'15 Balance Sheet Analysis & Net Tangible Assets Summary:

Consistent with the practice of earlier articles, the balance sheet for the 2Q'14 is rearranged to clarify the net tangible assets available to support the value of the preferred shares and the ability to pay the accrued dividends. Simultaneously, this analysis also highlights the degree to which assets exist to support the value of the common shares as well.

The chart below shows the tangible assets net of all liabilities, excluding the derivative liabilities:

The $45MM value represents the tangible assets that exist, net of debt and any liabilities senior to the preferred shares, to back the face value of the three Preferred Share Series A (CDORP), B (CDORO) and C (not listed & not traded as privately held by RES, an affiliate of IRSA).

Compare these net assets to the face value of the three preferred share series here:

and we see that the tangible assets net of liability nearly equals the face value of the three preferred shares series, but not quite. In fact, the net assets covers about 97 cents of every dollar of face value of the sum of the three preferred shares series. However, there is not enough assets to back fully the face value of the preferred shares; as a consequence, there are no assets available on which the common shares can call as backing for their investment.

In addition, this implies that the sum of the net assets is insufficient to cover the accruing dividends (which are not included as a liability in the balance sheet), as we see in a continuation of the last chart:

{Please Note: Accrued Interest and Dividends shown in this chart are current at the end of June 2015. Currently, the Accrued Interest and Dividends as of month-end August 2015 is $5,895K, $435K higher than at the end of the 2Q.}

Of course, if the net assets are insufficient to cover even the face value of the preferred shares, then it is obvious that the accrued dividends and interest are not covered as well. Between the shortfall of the coverage of face value and the accrued dividends, there is a shortfall of $6.8MM of assets (as of month-end Aug., the shortfall would be $7.2MM) to secure the face value and the accruing dividend (plus interest) "pile" of obligations.

A key implication is that there are no assets which are backing the common shares; rather, the value that the common shares exhibit are an estimate of value, based on how the current leadership can overcome the current state and grow the business into a more profitable enterprise with a growing asset base (admittedly not a bad bet, if this is your style of investing, given the strength and capability of the new CEO, Mr. William "Bill" Blackham, who has been added to the leadership team). If you also include the impact of the derivative liability, which estimates the negative impact of a significant share dilution at an issuing price below market (at the time the liability was calculated) and the assets standing behind each share is a large, negative number, implying a large, negative book value. The common shares may be a great investment, but common shareholders will be starting in a "deep investment hole" before starting their journey to positive returns.

The company has indicated that, with all Preferred Shares from all series being tendered, there would exist about 36 Million Shares. In that case, given that there are about $45MM in assets net of liabilities, then the book value per share of the common should equal (setting aside the remaining derivative liability) about $1.20/share. The market appears to be reflecting this reality, given the market price on the Aug. 28th closing was $1.35/share, just a bit above the nominal book value. Again, depending upon what the derivative liability looks like post exchange, this could be significantly reduced as there will still be a large potential for common share dilution post exchange as well. This will be discussed again in the discussion about options for "monetization" of the A and B Shares.

Discussion about the Recent Trend of Assets Backing Preferred Shares over the Previous Year:

Without wanting to create a sense of panic, which would be against the interests of all holders, including myself, there does seem to be good reason to be moving along briskly towards a balance sheet restructuring, as can be illustrated by the trends in balance sheet strength over the preceding year (since this series of articles began).

Asset coverage for the face value of the three series of preferred shares, and for the additional coverage of the accruing dividends (and interest on the dividends in arrears for the A shares) is provided below:

Asset Coverage of Preferred Face Value, Accrued Dividends & Interest
Quarter Net Assets ($K) (1) Asset Coverage of Face Value (2) AD & I ($K) (3)

Asset Coverage

FV plus AD&I

3Q'14 $49,766 + $3,421 $2,921 +$ 500
4Q'14 $47,091 + $ 746 $3,764 - $3,018
1Q'15 $46,113 - $ 232 $4,610 - $4,842
2Q'15 $44,998 - $1,347 $5,460 - $6,807

(1) Net Tangible Assets: Tangible Assets minus All Liabilities excluding the Derivative Liabilities.

(2) Net Tangible Assets minus Face Value of the Three Preferred Shares: Assets Available for Liquidation.

(3) Accrued Dividends for the Three Preferred Shares Series plus the Interest Accrued on the Dividends in Arrears for the A Shares.

(4) Assets Coverage for the Face Value plus the Accrued Dividends and Interest: A Measure of the Assets Available to Cover the Preferred Shares in a Hypothetical Liquidation.

As one can see clearly, at the time of this first report (3Q'14), there were sufficient assets to cover both the face value of the preferred shares and the smaller "pile" of accruing dividends and interest in arrears at that time; in fact, this was the key element that supported the recommendation(s) to purchase the A and B Shares, both at that time and in the intervening periods. In spite of the great work by the company's management team to restructure debt, reduce financing costs, sell non-core hotels and generally tune-up the performance of the company, the company seems to be losing ground against their obligations to their preferred shareholders. Of special concern is that, at the end of the 2Q which is typically a stronger quarter, that the decline of net assets continued, instead of rebounding with a higher asset value, as one might expect after what is typically one of their stronger quarters.

Ninety-seven cents of every dollar of all of the preferred series are backed by assets, which implies that there should be stronger market pricing than exists currently (although some readers may argue with that assertion) as opposed to the 70-76 cents on the dollar valuation being implied by the current market prices of the A and B Shares. Having said that, the decline of the net assets below the sum of the face value of the preferred shares is a concern. The inexorable trend of declining asset value versus the face value does provide significant motivation for the board and the company leadership to drive decisively to address the "top-heavy, unbalanced" Balance Sheet (pardon the expression). There is a need to generate create more common equity and reduce the preferred equity, which is acting less like equity and more like a liability, as a practical matter, for financing this enterprise.

It is also clear that the company is losing ground against the rising tide of dividends and interest in arrears to the holders of the A, B and C Shares. This gap is growing at an ever-increasing rate, by virtue of the interest accruing on the unpaid dividends of the A shares, and will grow by another $1.3MM by year-end. While there is still time to act and while the leadership is acting aggressively to address this situation, time is not on the side of the company.

Discussion of the Options Facing Holders of the Preferred A and B Shares Series:

In my last article discussing the merits of the company's tender offer, I recommended a "sell or exit" decision, but tried to nuance this recommendation by tailoring the recommended approach to investors based upon their investing style. My comment was intended to spur a decision to determine how to "monetize" the investment in the A and B Shares, but also commented explicitly that these shares ought not be dumped as there is still value to be had and these decisions should be made consistent with the investors style. My caution to investors is that it appeared, and still appears, that the company will make it difficult for the A and B holders to realize the full value of these shares and, as such, each investor needed to determine for themselves how much incremental risk could be taken to capture incremental value.

There appear to be three options for holders of the A and B shares:

  • Sell
  • Tender
  • Hold

In addition, there is exist three possible outcomes if the holders chose to hold the shares:

  • Shares Exist in Unlisted Form (but will receive dividends once dividends are to be resumed on the common) as the company has indicated an intent or desire to de-list them.
  • Shares become redeemed at Face Value plus Dividends (& Interest) Accrued at the time of redemption.
  • Shares are restructured in a Chapter 11 reorganization and a restructuring of the balance sheet

I have recommended that holders of the A and B Shares monetize their holdings, but the appropriate path to do this may be different for different investing styles. In my view, one size definitely does not fit all and I have tried to offer more nuanced views of what this means.

In order to provide some input into this decision, please find one analysis for the financial consequences of "sell, tender or hold".

Four Most Likely "Liquidation or Exit" Scenarios
  A Shares B Shares
Sell $ 7.00 $18.95
Tender/Exchange $ 7.36 $18.61
Hold to Redemption

$11.50

$29.38
Hold to Restructuring $ 9.98 $26.30

Sell: The simplest and most direct approach to "monetizing" the investment is to sell. It yields the lowest return, but it realizes cash the quickest. Even at lower returns, securing cash has its own advantages, especially in this market environment. It will generate the lowest returns, however, for the A shares.

Tender/Exchange: This approach, based upon the existing market pricing, delivers a small increment of additional value to the A share investor (and lower return for the B Share owner), but that increased value does not come in the form of cash; rather, it comes in the form of common shares. Given the significant dilution and the ability of long-suffering preferred shareholders to have finally an instrument which can be liquidated, however, this value may be very short-lived and actual value realized may well be at values below $1.35/share. As indicated, the "book value" (excluding the derivative liability) will be about $1.20/share if all of the preferred shares are exchanged; given that this price would result in less value for the A shares ($1.20/share * 5.38 shares = $6.46/share) and for the B Shares ($1.20/share * 13.71 shares = $16.45/share), this may not provide an incrementally improved return. In my opinion, tendering or exchanging for the common really implies an investing premise that the company will indeed be successful both at the financial restructuring and at growing the company accretively through sales of non-core hotels and economical acquisition of the target upper-tier, select service hotels. Using the tender to provide a more liquid investment to sell immediately after the exchange would not be an approach that I would recommend as I believe that the price short-term will be driven down before a recovery.

One other note: for those investors who are planning to tender, ensure that your Condor preferred shares are not included in your margin capital. The Condor preferred shares were marginable, but the common shares, being less than $3/share, are not marginable. Ensure that you are not using margin or that your Condor preferred shares are not included in your "margin equity" or you could have forced selling and a margin call that you are not expecting.

Hold: This implies a significantly higher return, but will also represent the longest-term, continued commitment with the least certain end-point. In addition it will require holding a very illiquid security which may still not offer any yield for a significant time period. In addition, this will be a difficult road for those investors not accustomed to distressed investing or investment in illiquid investments for which updated pricing may only come once or twice a month, if that.

In addition, investors holding the A or B Shares post-exchange will face the widest spread of possible outcomes. There are three that represent the most probable outcomes:

a. De-listed and continued as a de-listed entity: In this case, the preferred shares will be "exiled to the pink sheets" as I indicated in my previous article on this subject. As such, they will not be traded on a recognized exchange, although private transactions and some dealers may continue to buy and sell these securities. At some point, however, when there is an intent to pay dividends to the common shareholders, the company will need to bring current the dividends and interest in arrears and pay the dividend on these shares. This will enable immediate cash payments of 20-25% of the current value and will drive the value to near-face value (even if it is still traded in illiquid markets) due to the 11.5% yields for the A shares (based upon the current market price) and a 13.2% yield on the B shares (based upon the current market price). Please keep in mind that, even if unlisted, the units will still be accruing dividends which will need to be made current prior to any payouts to the common shareholders at very high yields.

b. Redeemed at face value plus dividends and interest accrued to that time in the future: As I have indicated earlier, borrowing at 10% to secure an 8% yield on hotels is not a recipe for business success. I believe that the company will be forced to redeem the B shares (if not the A shares) as the B shares are very expensive financing. In that case, the B shares will be redeemed at $30/share (after Sept. 22nd, after the dividend date for the 3Q) and will accrue dividends at a 13.2% yield rate until redemption thereafter. The A shares may or may not be redeemed, but even borrowing at 8% to make 8% does not appear to be a good deal, but it is possible that the company may chose to just pay the dividend rather than use precious cash to buy back those shares (or do it well after redeeming the B shares).

In the case that the company does not garner the 2/3 plus 1 vote supporting the change in covenants protecting the B shares (specifically, a change in control would require the company to buy back the B Shares at face value plus accrued dividends or prevent the current restructuring from taking place), then the company will need a Plan B (pardon the pun) or simply need to buy back the B shares to enable the restructuring to move ahead.

c. Decision is made by the board to employ a court-supervised, "restructuring process" (a Chapter 11 "reorganization" bankruptcy): If the company cannot secure enough exchange of the preferred shares and decide that they cannot move forward in another way to re-capitalize the company, then they might resort to a Chapter 11 reorganization. This would, compared to many such restructurings, likely move very quickly with the following representing the most likely scenario: preferred shareholders will become the common shareholders of the company, owing a share of the company determined by the face value of the shares that they own plus the accrued dividends and interest owed to them at the point where the restructuring is initiated. Common shareholders would be wiped out or reduced severely, as there are only enough assets at this point to satisfy the senior claims of the three preferred share series. The current state of the preferred shares are used below as illustration:

Value of Current Shares at Liquidation
  Shares Face Value + Dividends Valuation
A 803,270 $11.50 $ 9,237,605
B 332,500 $29.375 $ 9,767,188
C 3,000,000 $10.9375 $32,812,500

Again, this reflects the state of affairs at month-end August 2015. As time passes, the A and B shares would gain incrementally greater percentages of the ownership of the company. Also, please note that the total valuation of $51.8MM exceeds the total assets of the company and, as such, leaves no remaining assets for the common shares in principle. In practice, to facilitate the on-going execution of the process, each common share may be accorded some residual value (like $0.01-0.05 of value per share) to secure their rapid co-operation and make sure that the process occurs in days rather than months or years, but the preferred shareholders will own the company moving forward.

Assuming that no value is accorded common shareholders, then the following distribution of assets would take place:

Liquidation Analysis: Distribution of Existing Assets to 3 Share Classes
Share Series Value of Series % Assets New Per-Share Value
A $ 9,237,605 17.83 $ 9.98
B $ 9,767,188 18.85 $26.30
C $32,812,500 63.32 $ 9.50

As you can see, the recovery in such a "hypothetical" reorganization, while not securing 100% recovery, does capture much more value than an immediate exchange or sale would secure.

RES, while having lost the value of 1.42MM shares would still end up with control of the company and a super-majority control, so their loss would be limited. In addition, once this restructuring would have taken place, the balance sheet would be very clean and growing the balance sheet would be much easier as the top-heavy structure which currently exists would have been eliminated. At the same time, the preferred shareholders would be more secure moving forward as their would not be residual senior preferred shareholders remaining.

What to Do Moving Forward?:

The Owl has always struggled with offering recommendations to others as this depends heavily on the kind of investing style with which each investor works. Rather than providing very directive advice, much of which is misplaced if it is in contradiction to the investors investing style, I have tried to provide options to each investor to help each think though the options and decide what the best course of action is, given their own investing approach. Growth investors would react very differently than value or distressed investors.

Perhaps I can best help others to think through their next steps by reflecting on what I have done and plan to do, providing the reasons why those decisions have been made.

I have sold 1/3 of my position of A shares. I didn't want to, but I had to, given my margin position. Given the structure of the company's offer, to swap (marginable) preferred shares for (un-marginable) common shares, I needed to reduce my holdings to avoid a margin call and the unforeseen impact of forced sales (which may not be my Condor holdings). You will have seen my sales on August 26th, during which the market sales on that date, other than 55 shares, were my shares. I am now in a position to pursue all paths, as margin considerations will no longer be a factor.

I have made a decision to hold all of my A Shares and my B Shares going forward. As such, I have already voted my B Shares against the "change in control" provision, which would allow the company to avoid the need to buy back the B shares as RES will take effective control of the company. In addition, I voted against the adjournment provision.

Key factors to this decision to hold the shares are as follows:

a) This will maximize my returns, even if it requires 4 years to monetize these holdings (initiate payment of dividends, accrued and current). I honestly don't think that it will take this long as there is a need for speed to restructure the company. The return from current market value to the expected face value plus accrued dividends, even without considering future accrued dividends, would deliver about 13-15% returns per year if it is resolved in four years (higher if resolved more quickly); in addition, the shares will continue to accrue dividends (and interest on the A Shares dividends in arrears) at a rate of 11.4% ($0.8 per year on $7/share market price) and 13.2% on the B Shares ($2.5/year on $18.95/share market price), so a total of 25-30% returns going forward are expected, unless the company needs to resort to a re-organization.

b) I believe that borrowing 10% to buy hotels yielding 8% is not a recipe for business success and, as such, the company will move to redeem (or buy back in the market) any remaining B Shares not otherwise sold to them or tendered. In the meantime, I am content to accrue dividends and am even more content to earn the coupon. I have always believed and argued that the B Shares will be money-good and still believe that.

c) The A shares may become an illiquid but high-yielding security which will still deliver $0.8 on a $10/share face value. Prior to the common shareholders receiving a penny, the A shares holders will receive $1.5/share in accrued dividends and interest on each $7 share that they own (21.4% of face value) and will receive $0.8/share on-going (again a 11.4% yield in a very low-yield world).

d) Even if unlisted, the preferred shares will still stand senior to the common shares. They will be the predominant recipient of common shares, if the company needs to resort to Chapter 11. Listed or not, the A and B shares are senior to the common shares and "pari passu" to the C Shares owned by RES. Seniority will be very important as we pass through this uncertain phase.

e) The A and B shares holders will be receiving a substantial cash payment for the dividends in arrears and strong on-going dividend payments once the dividends are resumed for the common shares.

f) I understand that there is a strong growth scenario for the common shares, but it is by no means guaranteed.

Holding the preferred shares post exchange is not a path for every investor and I can understand if an investor may want to throw in the towel and "monetize" now by selling (or exchanging and selling the common shares, as they will be more liquid). I understand that the company will make it as hard as possible to secure the real value of the preferred shares as this makes their job easier and retains more value for the existing common shareholders. However, I believe that the path to maximum value for the A and B Shares owners is by holding the shares. I recommended an "exit" strategy in my last article as holding these may not be the best approach for many investors, not accustomed to the strains of owning a very illiquid security. For those who can handle those stresses and strains, the best "exit" or "monetization" strategy is to hold the shares post exchange.

Conclusion and Next Key Milestones:

Each investor will need to determine for him or herself the best path to maximize the returns from holding the Condor Hospitality A and/or B Shares, consistent with their investing style and risk tolerance. I have proposed holding the shares, but as I suggested in both my last and the current article, this may well not be for everyone. The maximum returns will be obtained from holding the shares post exchange rather than either selling or tendering the shares.

The next key milestone will be the results from the B share owners vote on the "change of control" provision. If that passes, the tender will likely be continued and, at that point, the following key milestone will be to understand the percentage of A and B Shareholders that have tendered their shares. If the "change in control" provision does not pass, this may derail the tender offer entirely.

Every A and/or B Shareholder has a tough decision to make and I wish them good luck in making a decision which is right for them.

Full Disclosure: I am a holder of a significant number of both the A and B Shares (SPPRP/CDORP and SPPRO/CDORO). In addition, these shares represent a significant percentage of my equity holdings.

No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult an investment advisor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have substantial positions in both the Condor Hospitality A and B shares (CDORP and CDORO, respectively). Given the recent shift in ticker symbols, the system did not pick up the ticker for these securities in the disclosure section.