Sunstone Hotel Investors Will Weather The Storm Thanks To Its Robust Balance Sheet

Summary

• Sunstone Hotels saw its share price slide as the new COVID variant seems to be spreading fast.
• I still like the preferred shares thanks to the superior asset coverage ratio.
• I would consider going long the common shares as well. Perhaps I will write some out of the money put options.
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Introduction to Sunstone Hotel Investors

It’s been about six months since I last looked at Sunstone Hotel Investors (NYSE:SHO), and in that article I was mainly interested in checking out the REIT’s preferred shares. The hotel industry was still pretty weak in the first quarter of the year and despite Sunstone running a very clean balance sheet, I wasn’t sure I wanted to have exposure to the common shares. I still have a small long position in a series of the preferred shares, but the recent share price decrease of the common shares (which are now trading more than 10% lower than in the May article) has kindled my interest in those common shares as well.

Data by YCharts

Sunstone reported a positive FFO

As the US economy was gradually reopening during the year and tourism levels seemed to have picked up during the summer months, Sunstone Hotel actually had a pretty decent quarter and although the REIT still reported a net loss, its adjusted FFO was actually positive. That’s encouraging, but we’re obviously still a long way from a normal situation.

Before discussing the FFO result, which is a more important metric than the net income, I did want to take a minute to discuss the income statement as there are a few important parameters there that need to be discussed.

During the third quarter, Sunstone reported a total revenue of just over $167M, which is as much as in the entire first semester. The margins were also getting a bit healthier as the margins on the hotel rooms, which is obviously by far the most important operating division, were pretty strong as Sunstone reported a revenue of in excess of $118M on the rooms while the operating expenses were just over $32M. As you can see in the image below, the REIT pretty much was breaking even on the food and beverage portion of its revenue.

Source: financial statements

The total operating expenses exceeded the total revenue, but keep in mind this includes about $32.6M in depreciation and amortization expenses. This also means that the net loss of about $22.1M would have been a net profit if it wasn’t for those depreciation expenses. You also see the REIT’s net loss attributable to the common shareholders was actually even more negative as there still was a (small) income attributable to non-controlling interests and on top of that, the preferred dividends were costing the company about $6.3M. The bottom line shows a net loss of $29.3M.

That’s bad, but as mentioned before, the FFO is a more important metric as the depreciation and amortization expenses are obviously a non-cash expense. These weigh on the reported net income, but have no impact on the FFO of the REIT.

We can clearly see that in the following FFO calculation. The reported FFO in the third quarter was a positive $2.9M but after including some additional adjustments, the adjusted FFO in the third quarter was approximately $21.3M.

Source: financial statements

As there are just under 220M shares outstanding, the adjusted FFO/share was approximately $0.10. Keep in mind the adjusted FFO of $21.3M includes the preferred dividend payments, which means that those dividend payments still have a very healthy coverage ratio of about 400% in the third quarter. The coverage ratio in the first nine months of the year wasn’t even nearly as good, but that’s where the strong balance sheet comes in as an additional reason to trust the quality of the preferred shares.

The balance sheet remains strong, but I still like the preferred shares

The strong balance sheet was indeed one of the main reasons why I wasn’t worried about the preferred shares. Although the preferred dividend coverage ratio remains weak, the simple fact the preferred shares rank senior to the common equity adds another layer of safety.

As you can see below, the total asset side of the portfolio has a value of $3.03B. This includes about $220M in cash and restricted cash. The total amount of liabilities is just over $930M, of which less than $750M is actually financial debt. After taking the cash into account, the net financial debt of Sunstone Hotel is just over $500M.

Source: financial statements

This means the LTV ratio is just under 20% based on the $2.67B book value of the hotel properties. But keep in mind this book value already includes almost $1.2B in accumulated depreciation.

Source: financial statements

So I’m not worried about the balance sheet at all, especially considering the equity portion of the balance sheet contains about $1.7B in equity junior to the preferred shares.

Of course, the balance sheet size and debt ratio will continue to fluctuate as Sunstone continues to work on its asset portfolio. In October, the company posted a deposit in connection with the acquisition of an 85 room Four Seasons resort in Napa Valley for almost $180M and the acquisition will be funded by drawing cash from the existing credit facility.

Source: company presentation

Investment thesis for SHO

Sunstone Hotel Investors runs a very clean balance sheet and that allows the REIT to take advantage of opportunities that pop up. The REIT obviously focuses on higher end properties and although the market for these properties is much smaller in case Sunstone would have to offload a property, but exactly because these luxury properties are so rare, they will likely continue to be valuable further down the road.

I still own some preferred shares in Sunstone Hotel Investors and I feel very comfortable being a preferred shareholder even though the preferred dividends aren’t always fully covered as the balance sheet remains very strong. I currently do not have a position in the common shares of the REIT but after the recent drop I may consider writing some out of the money put options as I can see the value of owning some irreplaceable assets.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SHO.PH either through stock ownership, options, or other derivatives. 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.

Comments

[Hanger]

The SHO.PR.I prefs below $23 is great value right now.

[tensei]

@Hanger its below $20 now...

[The Investment Doctor]

@tensei Both prefs are now indeed yielding over 7%. I didn't expect to see that level!

[Hanger]

@The Investment Doctor SHO has among the lowest debt for hotel REITs. Its balance sheet is excellent. Hotel Reits survived covid when their hotels were shut, so they'll survive anything. I'm adding more now that the yields are 8% with 25% upside to par value. It will get back to par, may just take a agile for inflation to roll over.

[JrMastermind]

Sunstone (SHO) and Chatham (CLDT) were two prospects that I identified during the early days of the pandemic downturn. I liked them for much the same reason, I saw their balance sheet and cash position as key to both their survival, and the opportunity for growth through acquisition at a time when the valuations were depressed.The thing is, neither stock tanked far enough for me to pull the trigger. I recall looking at the dividend history and thinking IF there is no further dilution, and IF they are able to return to paying the pre-covid divy, then I MIGHT see a ~5% YoB in 2-3 years. By comparison, the companies/funds that I either bought, or tried to buy, are already delivering eye popping returns one year later.I still like them, but I think the market is treating them more like reliable, blue chip stocks rather than the vulnerable hospitality stocks that they are.

[JrMastermind]

What does SA have against paragraphs?!

[The Investment Doctor]

@JrMastermind I don't think there's an issue with paragraphs. Let me try this out.

See, this is how I move seamlessly to a new paragraph. Still about the same subject though: paragraphs.

This final paragraph is just to figure out if it comes through when I hit the 'publish' button. Fingers crossed!