Portsmouth Square Is Way Too Cheap

Sep. 28, 2021 7:27 AM ETPortsmouth Square, Inc. (PRSI)INTG17 Comments1 Like

Summary

  • Portsmouth Square owns the Hilton hotel in San Francisco's Financial District.
  • The hotel has performed poorly since pandemic restrictions were imposed; Portsmouth Square is burning cash and looks terrible from an operational perspective.
  • The Hilton's occupancy rates are recovering slowly but steadily; a return to profitability could be on the horizon.
  • The value of the Hilton hotel is grossly understated on the balance sheet; recent hotel sales in the area imply the hotel is worth up to 10x its stated book value.
  • Portsmouth Square is a rare low-risk, high upside opportunity.

Hilton Hotels Reports Better Than Expected Quarterly Earnings
Justin Sullivan/Getty Images News

Portsmouth Square Inc. (OTCPK:PRSI) owns the 544-room Hilton hotel in San Francisco's Financial District. The hotel has performed poorly since the outbreak of Coronavirus; PRSI is burning cash and looks terrible from an operational perspective. While operations are already turning around, I'm much more interested in the asset value of the hotel. A comparable hotel sold this summer at a rate of $615,000 per room. If PRSI were able to sell the Hilton hotel at the same rate, they would net $132mm after taxes and paying off the remainder of the mortgage on the property. PRSI trades at a market cap of $25mm. This is an exceptionally cheap price to pay for the company, relative to the value of its assets. Even using less generous comps, PRSI is an appealing investment at the current share price.

Company Overview

PRSI owns the Hilton hotel located in San Francisco's financial district at 750 Kearny St. The hotel has 544 rooms, a five-story underground parking ramp, and is rated as a four-star hotel. Occupancy rates and average room prices fell off a cliff as Coronavirus restrictions were instituted in March of 2020:

(Source: Company 10-K)

PRSI makes money when guests stay at the hotel, buy food, and park in the ramp; low occupancy rates cost the company a lot of money. In fiscal year 2021 (which ended in June), PRSI's revenue was down 75% compared to 2019 and the company burned over $10mm in cash. The company had just $2.3mm in unrestricted cash at the end of June. In the graphic above you can see that the hotel reached occupancy rates above 70% in May and June of 2021. This is a good sign that the business is improving, but normal occupancy rates are above 90%; there is still a long way to go before PRSI stabilizes. In a "normal" year the hotel generates roughly $55mm in revenue and $7mm in free cash flow.

It is important to note that PRSI is 75% owned by The InterGroup Corporation (INTG), and INTG is majority-owned by CEO John V. Winfield. Winfield is the CEO of both PRSI and INTG and has been CEO of INTG since 1987. Both entities are firmly under his direct control. This has pluses and minuses. On the positive side, it means he has a large amount of skin in the game and is highly incentivized to make PRSI successful. On the other hand, there is little direct accountability to individual shareholders. For example, Winfield has decided to use $3.5mm of PRSI's cash to build a stock portfolio of individual equities and put 38% of that portfolio into ViacomCBS (VIACP). Don't like it? Well, there isn't anything you can do about it because Winfield owns over 65% of the company. For what it is worth, the equity portfolio appreciated 54% in fiscal year 2021, far better than what the cash would have made sitting in a money market account. A quick look back shows that INTG stock has compounded at 8% a year since Winfield took over in 1987.

Investment Thesis

Given poor operational performance and an ownership structure unfavorable to individuals shareholders, why should investors consider investing in PRSI? There are two compelling investment theses:

A Return to Normalcy

If PRSI can survive long enough to get back to regular occupancy rates, I expect them to generate positive annual free cash flow. The company averaged 7mm in FCF from 2016-2019; at even a 5x FCF multiple the stock would trade at a 40% premium to the current share price. PRSI traded in a range of between $50/share and $90/share during that time, so a 5x FCF multiple is reasonable.

Can PRSI survive until occupancy rates return to normal? I say yes. Occupancy rates were already back above 70% in May and June and trending in the right direction. PRSI burned $10mm in cash in FY 2021, so if things do not improve in 2022 there could be short-term liquidity problems, but I am confident that PRSI could raise additional debt to meet short term obligations. If poor conditions linger, PRSI could sell the hotel to cover their liabilities.

The Hilton Hotel is Worth More than its Book Value

The most significant upside for PRSI investors would come from the sale of the hotel and a wind down of the company. PRSI lists the book value of the hotel as only $31.5mm and has been depreciating the asset over a 40-year useful life. This is a gross understatement of the value of the hotel. Conveniently, there have been three major hotel sales in downtown San Francisco this summer to use as comparable transactions. In July, Park Hotels & Resorts (PK) sold their Le Meridian and Adagio hotels for a combined $303mm (source). Le Meridian is a four-star hotel only two blocks away from the Hilton hotel and sold for a price equating to $615,000/room. Adagio is a smaller 3-star hotel and sold for $480,000/room. Finally, the four-star Sir Francis Drake hotel was sold by Pebblebrook Hotel Trust (PEB) to a private buyer in April for $379,000/room (source).

Given the location and timing, I suggest that the Meridian sale is the closest comparison, but any of the three transactions should be encouraging to PRSI shareholders. As a quick recap, the Hilton hotel is rated at four stars and has 544 rooms. PRSI's current market cap is $25mm, its enterprise value is roughly $150mm, and the company has about $30mm in NOLs that it can use to reduce its tax burden.

If PRSI could sell the hotel for $615,000 per room, they would receive a final price of $335mm and a gain on investment of about $300mm. After utilizing the $30mm in NOLs, PRSI would owe roughly 29% on $270mm in federal and state taxes, resulting in a tax bill of $78mm and net proceeds of $257mm. If the company used the proceeds to pay off the remaining $110mm mortgage balance and all other company net liabilities, then PRSI would end up with $132mm in cash and no debt on their balance sheet. This final amount implies 428% upside from the current market cap of $25mm. Following the same logic, the other scenarios look like this:

$379k/room: Final cash of $40mm, implied upside of 60%

$480k/room: Final cash of $78mm, implied upside of 212%

$615k/room : Final cash of $132mm, implied upside of 428%

Even in the worst comparable scenario, PRSI shareholders would stand to gain 60% on their investment.

Risks

It is hard to see a major risk of ruin here other than a sharp drop in San Francisco real estate prices combined with a prolonged period of operational cash burn. The current implied value of the hotel acts as a substantial margin of safety against operational woes, either via a sale of the asset or the ability to use the company's equity as collateral for a short-term loan. If real estate prices dropped but activity in the city returned to pre-pandemic levels, then the hotel would return to profitability and there would be no need to consider a sale at an unfavorable price.

I will concede that having a CEO with complete control of the company is a bit of a wildcard. Winfield has managed to keep his companies afloat for 35 years and generate a decent compound annual return for minority shareholders; his track record is solid, but an investment in the company requires trust that minority holders will not be cheated or mistreated.

Finally, PRSI is a nano cap company with low float and minimal daily trading volume. Starting or exiting a position could take days, weeks, or even months and the bid/ask spread is substantial. Starting my initial position took over a week and I had to pay a 10% premium over the listed bid price. Investors might consider investing in INTG instead of PRSI; INTG has a higher market cap, more share liquidity, and owns 75% of PRSI. I prefer targeting PRSI directly, but INTG is a suitable alternative.

Conclusion

PRSI investors have two ways to win: either the Hilton hotel returns to profitability and PRSI's share price increases due to free cash flow multiple expansion, or the company sells the hotel at a substantial profit. There are no risk-free investments, but PRSI's risk profile is adequately low when compared to its significant upside potential. I have started a position in PRSI and expect to make at least a 40% return over the next couple of years.

This article was written by

I'm a big believer in the idea that there are "No Called Strikes" in investing. I put a lot of companies in the "too hard" pile, but I swing big when I find a great investment idea
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in INTG over 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: This article is not financial advice, it is only an expression of my own opinions as an individual investor.

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