La Quinta Holdings: Spin-Off For The Better
- Interesting spin-off opportunity.
- Working at reestablishing brand.
- Valuation looks promising.
After reading about La Quinta's (NYSE:LQ) upcoming spin-off of its 319 hotels, I decided to try and learn a bit about the hotel industry in order to see if I could better understand if this special event was going to be a good investment opportunity. When I first sat down to think about the economics of the industry, nothing exciting really jumped out at me. All I could imagine was the many run-down or abandoned motels I used to see on drives up into Northern Ontario or on a vacation to the Florida Keys six years ago. Luckily, I didn't let these limited data points skew my analysis. To my surprise, many of La Quinta's competitors have done reasonably well in the past decade.
Marriott International (MAR) has appreciated from a pre-2008 crash price in the low $70/share to $120/share today (Google Finance). During the financial crisis, you could have purchased the stock for even lower at $14/share (Google Finance). Choice Hotels International (CHH) had a pre-2008 price of around $50/share to $70/share today (Google Finance). However, during the financial crisis, you could have purchased it in the low $20s (Google Finance).
Comparing all these companies to each other equally would be a mistake, though. Some operate under a franchise model, some operate and own 100% of their hotels, and some have a mixture of both. LQ currently falls into the bucket of having a mixture of both owned and franchised hotels. As of September 30, 2017, it had 891 system-wide hotels of which it owns 315, with the remaining being operated through franchise or licensing agreements (LQ Q3 10-Q). LQ's current spin-off proposal is to separate the ownership of the remaining hotels it owns and limit itself to managing the marketing/branding of the La Quinta which in return collects 4.5-5% royalty depending how long the franchise has operated (LQ Q3 10-Q). It will also earn a 5% hotel management fee (Applied against revenue) on the 315 hotels it is spinning off in a 20-year service agreement (LQ Q3 10Q). LQ management is selling this spin-off as an opportunity to create an asset-light business, which can produce significant growth and optimal cash flow for its investors. So, let's go through the strength opportunities of this transaction.
Currently, LQ has 252 hotels in the pipeline for growth, which represents 28% more hotels than it has right now (Investor Presentation). These 252 hotels would equate to 23,700 rooms on top of the existing 87,800 (+26%). This growth should translate to a significant increase in earnings for LQ with its revenue and earnings stream directly related to the number of hotels paying it a franchise fee based on revenue. As a respectable franchiser, though, you should always be concerned with the business economics of your franchisees and not continually selling franchises to novice entrepreneurs who don't understand what they are getting into. I am not necessarily saying this is what LQ is doing, but generally speaking, if economics of owning a hotel were better than franchising it, you wouldn't see a company spin it off. Assume on the conservative side this pipeline translates to 10% growth in earnings in the next two years, as these hotels may take up to two years to get built, their utilization will may take time to develop, and its overall % impact on earnings will be less than the room growth because LQ will only earn the 4.5% royalty from them initially compared to its current earnings being a mix of hotels paying up to 10% (management fees and royalty) and 4.5-5% (Just royalty).
While renovating hotels comes at a great cost, it is a necessity in this industry that should already be accounted for through its annual depreciation charges overtime. Often, this investment gets forgotten about in an effort to preserve cash flows until earnings and the brand start to suffer significantly. LQ's brand seems to have been neglected for a while, and its existing CEO seems dedicated to reestablish it. This should translate to an overall better Average Daily Rate (ADR) for LQ branded hotels, which would result in more revenue for the new LQ as well. Currently, there is a 5% gap between Comfort Inn's ADR - $93.83 and LQ's - $88.73 (Investor Presentation). There is a 28% gap between Holiday Inn's ADR and LQ's, so while these re-branding efforts may not translate to completely narrowing these gaps, you might be able to assume that it could increase its earnings 2-3%.
Current Market Valuation
Currently, LQ is trading slightly under $2B for the entire company, including the 319 hotels it still owns. The company predicts earnings for LQ (post spin-off) will be between $38 million and $41 million (Investor Presentation). CHH, which has a similar business model but has 6,553 hotels and 792 under construction (CHH Q2 10-Q), trades at a PE of 25x right now, and if you apply that same multiple to the new LQ, it would be worth $1B. If you want to be really conservative, you can only apply a 15x multiple to the business, which would value it at $600 million. Now that we have attached a value to the future LQ, we just have to evaluate the portion to be spun off, CorePoint Lodging business. LQ predicts CorePoint's net loss will be $9 million, but that is with a huge depreciation charge of $146 million. If you add the depreciation charge back in, you are at an operating cash flow of $137 million, which is a bit closer to LQ's combined four-year average free cash flow of $158 million per year (Google Finance). The economics of the CorePoint business are not quite as good as LQ, so you might expect it to trade at a conservatively lower multiple anywhere from 10x to 15x FCF, which could equate to a value of around $1.5-2B. So, if you had both numbers up, you can expect a combined LQ should be trading around the level it is today, $2B or up to as high $3B. The true number is likely somewhere in between, so you could expect up to a 50% return in a short amount of time if all goes well.
At the end of the day, LQ does not have a moat, so I would not want to own this indefinitely. I do, however, think this could be a mispriced security with little downside risk if the analysis turns out to be wrong. It's definitely worth considering if you like investing in special situations.
This article was written by
Analyst’s Disclosure: I am/we are long LQ. 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.
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