In my recent article on Host Hotels & Resorts (HST), I argued that despite a heavily depressed sector, there are some hidden gems, which are capable of surviving the crisis and provide exceptional returns once the COVID-19 abates.
However, while screening the lodging REIT sector, I found some very risky companies, which are unlikely to survive the crisis. Ashford Hospitality Trust (NYSE:AHT) is one of them; and, perhaps, the riskiest of them all.
To increase the probability of weathering this storm successfully, companies (REITs) have to possess the following characteristics:
AHT has none of the above as elaborated below.
My argument is to sell or at least not to buy AHT in order to avoid permanent capital loses.
As you can see in the graph above, AHT has suffered tremendously. There is about 40% gap between the AHT and HST (i.e. the lodging REIT for which I have a strong buy). Compared to the broader REIT index, Vanguard Real Estate ETF (VNQ), AHT's share price has diverged by 55%.
We all know that the REITs and especially lodging companies have suffered way more than the S&P 500. AHT has considerably underperformed even compared to the VNQ and HST, which are already trading in a depressed territory.
The market seems to be discounting a bankruptcy. It happens rarely, but this time I agree with the market. Have a look below why I think a chapter 11 is the case for AHT.
As alluded to earlier, it is critical to have a sufficient room left to take additional borrowings. For some companies taking more debt is the only option to survive this crisis. Through these debt proceeds, the companies would be able to service their trade payables, cover the fixed costs and meet the debt expenses to the existing lenders.
Source: Ashford Hospitality Trust
Unfortunately, AHT's leverage profile is brought to an extreme, indicating a limited capacity to draw the necessary liquidity.
For instance, let's have a look at the net debt to EBITDA. The average ratio for the whole lodging REIT sector is 6.6x. This level of net debt to EBITDA of 6.6x could already be considered too risky (in terms of the underlying financial risk). However, AHT exceeds it by ~ 30%.
Think this way, all things equal, AHT has to sacrifice 9 years of its EBITDA to pay off the currently outstanding debt. Just to remind you - EBITDA is before interest expense, which is at sky-high levels for AHT, and before any depreciation / amortization.
Moreover, the assumption of "all things equal" is too aggressive when it comes to evaluating this particular metric. The EBITDA will inevitably fall for AHT, and it will not be a move of just a couple of percentage points. To be prudent, one has to factor in at least 80% drop in revenues. Let's assume that a similar drop will translate to the EBITDA. In that case, the net debt to EBITDA would increase to 45x, which is obviously out of any allowable covenant amplitudes.
To support the argument above, let's look at the debt to total assets as it shifts the focus from the cash flows to the AHT's balance sheet.
According to NAREIT, AHT has the largest amount of debt relative to the company's assets among all of the ~15 lodging peers. Approximately, 95% of the total assets are covered with some form of borrowings indicating a very small cushion for the equity part to cover the potential losses. To put things into perspective, the sector's average debt to total assets is 47%.
It should be clear by now that AHT possesses a limited capacity to borrow. The balance sheet is already heavily indebted, and compared to other lodging REITs it carries almost 2x greater financial risk.
However, one could argue that AHT will be able to borrow more and cover the debt expenses until the COVID-19 abates. To answer this, one has to look at the current debt covenants as they provide an estimation of the potential upper bound of the total borrowing capacity (that would be acceptable by the existing lenders).
The SEC 10-k filing says the following:
We are required to maintain certain financial ratios under various debt and derivative agreements. If we violate covenants in any debt or derivative agreement, we could be required to repay all or a portion of our indebtedness before maturity at a time when we might be unable to arrange financing for such repayment on attractive terms, if at all. Presently, our existing financial debt covenants primarily relate to maintaining minimum net worth and leverage ratios and liquidity. As of September 30, 2019, we were in compliance in all material respects with all covenants or other requirements set forth in our debt and related agreements.
Unfortunately, AHT does not provide a more detailed explanation of its debt covenants than in the text above. This is a clear warning signal. Most of the REITs, which I have analyzed introduce a separate section or table to elaborate on the current fulfillment of the debt covenants. AHT has it in neither investor presentations nor in the 10-k.
The key takeaway from this is that (a) AHT has a rather minimal capacity to borrow, and (b) the fulfillment of the existing debt covenants is extremely tight (implied by the massive leverage).
The most likely implications from the COVID-19 on the AHT's cash flows are the following:
All these points impose massive headwinds for the lodging sector. To survive such crisis, these companies will have to rely on their balance sheets to warrant an access to sufficient liquidity.
To determine how many quarters AHT can survive, I will consider an 80% drop in the revenues for next two quarters.
So, AHT is a pure lodging REIT with no fixed and long-term contracts that could provide some cash flows while the bookings reach 0%. This just confirms my assumption that the AHT's revenue sources are risky and do not protect from a significant downside.
If we assume that there is an 80% revenue drop in the coming two quarters, it would imply a $750 million top-line reduction. Some of the lost revenues would be offset by the corresponding decrease in COGS and OPEX. Excluding depreciation and amortization, which is a non-cash item, and assuming that 50% of the costs are variable, the costs could go down by $500 million (given that the interest expense remains flat).
This approximation implies a ~ $200 million cash flow gap during the subsequent two quarters. However, if the depreciation and amortization gets factored in, the loss on a PnL level would amount to ~ $350 million.
In the context of the total equity amount as of year-end 2019, ~ $350 million is a catastrophe. The latest reported figures by AHT show that the equity amount stood at $ 269 million.
Now, if you agree with my reasoning and view it as rather conservative (which I do), AHT could see its equity to turn negative in the coming quarters.
There are very few lenders, which are ready to lend knowing that there is a negative margin safety. Even if AHT found some lenders, the terms in such scenario would be drastic and unfavorable to the shareholders.
AHT operates in a cyclical industry, which is suffering major headwinds because of the COVID-19.
Unfortunately, the Company's balance sheet was extremely indebted before the outbreak of COVID-19. There is a very limited room for additional borrowings that makes it harder to access fresh liquidity to close the negative cash flow gaps. Furthermore, AHT's equity amount is also at a very low level. If in the next two quarters AHT gets only 20% of the RevPAR which it generated before the COVID-19, the equity would turn negative. This would magnify the hardships of accessing the much needed cash.
Finally, as it is stated in the AHT's investor presentation - leverage enhances returns. However, there is the other side of the coin - it also renders the whole organization more unstable, and in such moments as this might result in deadly consequences.
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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.