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RLJ Lodging Trust (RLJ) has been making improvements to its balance sheet by selling non-core assets and paying down debt following its 2017 merger with Felcor Lodging Trust. As RLJ looks to complete this portfolio optimization in 2019, growth has slowed in the hotel business. The market seems to have taken this low-growth forecast as a reason to sell shares. As a result, the company's dividend yield is high relative to its peers and its own history.
While a high yield can indicate a lack of confidence in a dividend’s safety, the market’s apparent skepticism is misplaced in this case. Management expects to complete its post-merger portfolio optimization in 2019, which will allow the company to demonstrate improved free cash flow even in an uncertain operating environment. I expect RLJ to remain range-bound for the next 6-12 months as the company completes its portfolio and balance sheet optimization strategy. In the meantime, shareholders are paid to wait with a near-best-in-class yield. Beyond the next year, I expect RLJ's share price to improve as the benefits of optimizing the portfolio fully show up in reported earnings and distributable cash.
Source: Investor Presentation, June 2019 (data as of 5/31/2019)
RLJ’s strategy is to own “focused-service and compact full-service hotels” which have less restaurant and meeting business than larger full-service hotels, and are therefore cheaper to operate. In 2017, RLJ merged with Felcor Lodging Trust in an all-stock transaction. RLJ obtained 37 properties in this transaction, all but 6 of which fit well with its compact full service strategy. The company completed the sale of 3 of these hotels in California, Florida, and Vermont in 2018. It is targeting to sell the remaining 3 properties in 2019. Proceeds from these sales have already been used to reduce debt.
Optimizing the Portfolio, Strengthening the Balance Sheet
RLJ has demonstrated its ability to optimize its portfolio and pay down debt following the Felcor merger, which should give shareholders confidence that the company is improving its free cash flow. Based on a recent presentation to the National Association of REITs (NAREIT), RLJ is executing well on its portfolio optimization strategy, having sold 3 of the full-service legacy Felcor hotels plus 3 smaller properties for total proceeds of $530 million in 2018. So far in 2019, the company has “made significant progress” towards selling the two legacy Felcor full-service hotels in Myrtle Beach, SC. Myrtle Beach is a rapidly growing tourism destination, making these properties attractive to a more tourism-focused owner. RLJ is “following a disciplined sale process” for the final one, the Knickerbocker Hotel in New York. The Knickerbocker is fully updated, with Felcor having spent $240 million on renovations after paying $109 million for it in 2011.
The 2018 asset sales helped pay off $524 million in debt with an interest rate of 5.625%, for $29.5 million per year of interest savings. No additional debt is due until 2021, although asset sales this year could allow the company to pay off early the 6% legacy Felcor notes callable in June 2020. (This is the $475 million maturing in 2025 on the chart below.) Paying off this tranche of debt would produce another $28.5 million annually in interest savings.
Source: Investor Presentation, June 2019
Protection Against Slower Growth
In the model below, I show how RLJ can increase its funds available for distribution and its ability to cover the dividend. This should improve market confidence in the shares despite the low-growth outlook for the industry. Actual data from 2016-2018 are included for comparison. 2019 estimates come from RLJ’s June 2019 NAREIT presentation. The company’s own projections for key metrics in 2019 are conservative, showing little growth from prior years, with only a 0-2% improvement in RevPAR (revenue per available room). This is less optimistic than Deloitte's projection of 2.4% industry RevPAR growth for 2019. RLJ forecasts hotel EBITDA margin down 20-100 basis points from 2018’s 32.8%, and the range of expected 2019 FFO/share brackets 2018’s $2.26. While the company is optimistic about business in Northern California and many markets in the Southeast, other cities are facing challenges. Additionally, demand is temporarily impacted at the hotels that are going through renovations.
Source: Investor Presentation, June 2019
Following a high capex spend in 2018, RLJ is again spending about $100 million in 2019 on improvements to its core properties, such as re-brandings, adding rooms, energy conservation, revenue enhancements and procurement cost savings. The company has a historical track record of delivering attractive returns on these projects.
The spreadsheet below calculates funds from operations available to cover the dividend. 2016-2018 actuals shown are from company reports. Low and high estimates for 2019 come from RLJ’s conservative full-year outlook above. The company has not yet released projections for 2020 and beyond, however other industry watchers predict the slow growth environment will continue. In the chart below, I have developed 2020 and 2021 projections based on conservative key assumptions:
- 2019 FFO low and high estimates come from the $2.18-2.30 in the company slide above, multiplied by the share count of 173.7 million shares.
- No increase in same-hotel income except for benefits from 2019 renovation projects. Base FFO before renovation projects for 2020 is the same as the midpoint of 2019 low and high estimates. Other changes for 2020 and 2021 on the FFO line in the table below include:
- Three remaining legacy Felcor properties are sold in 2019. Proceeds are used to exercise the early call provision on $475 million of 6% notes due in 2025. This can be done on 6/30/2020.
- Lost income from hotels sold was estimated from hotel-specific TTM EBITDA disclosed in the 1Q 2019 earnings release, with estimated depreciation added back to get the FFO impact.
- 10% return on $100 million of 2019 renovation capex is achieved in 2020-21 ($10 million/year incremental income)
- On the capex line, $60 million per year of maintenance capex is assumed, based on RLJ’s guideline of 4% of revenue.
- For 2019, the company plans between $90 million and $110 million of renovation capex. This is added to the $60 million of maintenance capex to get the low and high capex estimates on the table below.
- In 2020 and 2021, I estimate renovation capex is dialed back to $50 million/year, or about half of 2018-19 levels, as properties are brought up to date after the Felcor merger.
- No additional buybacks of common or preferred shares.
As you can see from the actuals, distributions were not fully covered in 2017 and 2018, largely because of acquisition costs of the Felcor merger in 2017 and unusually high capex in 2018, which included renovations at the company’s largest property, the Louisville Marriott. In 2019, the dividend may still not be fully covered as RLJ continues its high spend on renovations and wraps up its legacy Felcor sales. These recent results, combined with the low-growth outlook, may be the source of skepticism the market seems to have about the company. In 2020 and beyond, however, we will begin to see the benefits of debt interest cost reduction and more disciplined capex, even with the loss of income from the 3 Felcor properties the company expects to sell.
With these changes, funds available for distribution would increase, and the current $0.33 quarterly distribution would be fully covered by ongoing cash flow with a margin of safety.
In the base case, RLJ has a clear path back towards increasing free cash flow and ensuring the safety of the dividend. In a recession case, this will prove more difficult. However, the moves the company has already made should allow it to weather a 1-2 year downturn using capex and balance sheet moves. Given the lateness of the current economic cycle, it is worth analyzing how much a recession would impact the conclusion that RLJ’s dividend is safely covered in 2020 and beyond. Recall that the base case already assumes anemic RevPAR growth of 0-2% in 2019 and less than that in 2020-21, driven only by incremental renovation benefits, not the overall economy. Starting from the base case presented here, a 7-10% drop in FFO in 2020-21 would reduce the dividend coverage ratio to a breakeven of 1.0. Given typical margins, this translates to a revenue drop of 2-3% with no corresponding drop in costs.
The bad news is that prior recessions have seen larger revenue downturns. The last two recessions in 2002 and 2008 were particularly severe. Hotel News Now has analyzed how these recessions impacted hotel revenue. The good news is that RLJ’s focused tier of Upper Midscale is the most recession-resistant of all segments:
(Source: Hotel News Now)
2009 was such a severe recession that we can probably set it aside when forecasting the next one. 2002, with its post September 11th, 2001, curtailment of travel, is already a big downturn. The table below looks at the impact a 6.4% revenue reduction would have in 2020 and 2021, assuming the worst case of no corresponding cut in costs. The FFO reduction shown in the table below assumes a FFO margin (FFO/revenue) of 24%. In this way, FFO can be projected to fall 0.064 x 0.24 = 26.7%.
If renovation capex were temporarily put on hold during the recession, you can see that the dividend would still be about 90% covered. In reality, management has other levers, such as targeted cost cuts and temporarily drawing on cash or revolving debt to cover the remaining 10% of the dividend in the event of a recession. Even if the dividend were cut to match free cash flow, the shares would still yield around 6.9%, which is still in the top half of its peer group, which might be struggling even more given their more recession-sensitive mix of properties.
RLJ Lodging Trust is accomplishing what it set out to do with the Felcor merger, upgrading its portfolio and selling off non-strategic assets to improve the balance sheet. The company has made considerable progress so far and expects to largely wrap up this post-merger portfolio optimization in 2019. While cash flow has been impacted during this process, it is expected to improve in 2020 and beyond, even with slow growth in the operating environment. This is achieved through asset sales in 2019 freeing up cash to pay off high-interest debt and returning to a more normal level of renovation capital spending. A recession in 2020 or 2021 would delay achieving full dividend coverage but would not be catastrophic.
RLJ shares may be range-bound until the post-merger optimization is reflected in its results. After that, I expect the market to value RLJ more in line with its peers, based on dividend yield and coverage (through increasing share price at a constant dividend amount). Until then, the downside appears limited because the balance sheet has already been improved since the time of the merger, making the company more resilient to a downturn. Shareholders will be paid to wait in the meantime.
Disclosure: I am/we are long RLJ. 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.