RLJ Preferred Hit Too Hard By COVID-19

Summary

• RLJ Lodging Trust common and preferred stock have declined rapidly during the COVID-19 scare.
• The risk to the preferred seems minimal.
• The lack of a call provision makes it look good in a declining rate environment.

One memory from the 2007-09 financial crisis is that preferred stocks in cyclical industries got pummeled even though their dividends were rock solid. Kansas City Southern preferred (KSU.P) was one that I bought at the time. By 2012, it was back above par.

Is there some opportunity like that in the COVID-19 scare?

Preferreds exposed to the travel and shipping industries suffered last week. For example, Global Ship Lease preferred B (GSL.PB) fell 20.4%. Looking for something less opaque than international shipping, I hit on the domestic hotel industry.

RLJ Lodging Trust (RLJ) is a real estate investment trust owning 108 hotels in 23 states, tilted toward Hilton's Embassy Suites (HLT), Courtyard by Marriott (MAR), and Residence Inn by Marriott. Northern California is its largest market. The common stock declined 18% last week as hotel stocks got slammed by convention cancellations on the West Coast.

The virus spread to its RLJ $1.95 Series A Convertible Preferred (NYSE:RLJ.PA), which pays 7.8% at par (Quantum description). The preferred ended the week down 10% to $26.11, for a juicy yield of 7.486%.

Yet, it's hard to see a huge risk in the preferred. A bullish SA article on it last November by Rida Morwa called it "seriously mispriced." If mispriced then, it's even more serious now.

Forced Conversion Unlikely

Usually, when one buys a preferred above its $25 redemption value, one is subject to the risk of capital loss in the event of call. However, RLJ.PA cannot be called, but instead is subject to conversion into 0.2806 shares of RLJ common.

According to the 2017 proxy statement/prospectus:

RLJ may exercise its option to redeem the RLJ Series A Preferred Shares, in whole or in part, only if, for 20 trading days within any period of 30 consecutive trading day period, including the last trading day of that period, the closing price of the RLJ Common Shares on the NYSE equals or exceeds the conversion price per share (initially, $89.09 per share, subject to adjustment as described below)."

With the common at less than one-seventh of the conversion price, the chance of redemption in the next decade seems nil.

Ample Dividend Coverage

The REIT reported free funds from operations of $350 million last year. Preferred dividends were $25 million. That's a lot of coverage.

Common dividends totaled $225 million, less than FFO but well in excess of net income of $129 million, so this is less secure. The common now yields almost 10%.

The common has paid a dividend of $1.32 a share for the last five years. GAAP earnings per share have declined over that period but cash flow - the more important number for holders of preferred stock - has risen at an annual rate of 2.9%.

The company reported better-than-expected earnings last week, but that didn't help the stock.

Effect of Virus on Business

In the conference call, CEO Leslie Hale acknowledged the effect of the virus at a time when major conventions are being canceled on the West Coast.

We are seeing some cancellations. Well, keep in mind, we only have sort of 60- to 90-day window of visibility here. We have seen some cancellations on the West Coast. And they are oftentimes when we're having discussions with those individuals about rebooking and utilizing the cancellation provisions as a way to sort of segue into that conversation.

RLJ is not adjusting guidance due to the virus "given the difficulty in quantifying the impact at this time," but acknowledges it will be a drag on RevPAR (revenue per available room).

An immediate question is whether Americans will start canceling pleasure trips domestically as well as internationally. As a CNN article stated, "there's no one-size-fits-all answer."

In general, travelers should always assess the importance of a trip, as well as their personal risk tolerance for health dangers and hassle," said Dr. Henry Wu, director of Emory Healthcare's TravelWell Center."

The threat of a spring-summer slump in business is real, but not permanently injurious since most recent pandemics - if COVID-19 becomes one - last at most a year or two. The REIT seems primed to weather the storm. It ended 2019 with $882 million in cash and cash equivalents, versus current liabilities of $183 million and distributions payable of $64 million.

Conclusion

Income investors could start to build a position in RLJ.PA now. I'll be looking for the next downdraft to get in.

Analyst’s 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.