Description

The entire lodging sector has been killed lately.  While I am reticent to ever invest in a sector at its peak, prices today are already baking in at least a minor recession.  While there are bumps in the economic road lately, mostly these are commodity and industrial related.  Investors are throwing out some babies with the bathwater, namely lodging stocks.  The sector is down 20% in just a month, with most down 40-50% from their peaks last year.

There are some hiccups in the space.  Houston Revpar’s look weak due to the energy bust.  New York and Miami will see sub 1% revpar growth for 2015, mostly due to a strong supply growth there, and a strong dollar curtailing the international traveler.

Earlier this month too, Lasalle Hotels (LHO) cut Q4 guidance from 1-3% revpar growth, to flat revpar growth.  They are focused on 8 major cities, mostly gateway markets particularly impacted by a strong dollar.  There also are specific reasons for problems there.  They terminated a manager of 3 hotels in San Francisco, had a union uprising with their 2 major NYC hotels (claiming health and safety violations), and had to take dozens of rooms out of service to rip out walls and perform testing.  Bad press didn’t help.

In any case, national industry demand is admittedly slowing.  But so far, it appears demand continues to outstrip supply both for 2015 and 2016 and remains positive.  While industry revpar growth in Q4 2015 appears slightly below forecasts at 4.8%, we do not see slowing growth as the end of the cycle yet.  And at current multiples, lodging stocks are near trough valuations.

Here are forecasts from Smith Travel, PwC and PFK Hospitality from last summer.

While consensus appears to be that revpar will be up 4-5% for 2016 now, I deem growth above 3-4% to be still impressive, and probably all the industry needs to trade to better multiples.  If the economy did accelerate though to these type figures, then the sector could trade up substantially.

Here is a pretty good chart from Chesapeake Lodging regarding supply and demand:

It doesn’t appear supply will outstrip demand until it does slightly in 2017.

The CEO at Chatham said this on the last earnings call “At this point, we are 65 months into a cycle, which is longer than the last cycle. But given the fact that new supply is still fairly well contained for the next couple of years, most industry experts believe this will be a longer cycle, similar to the cycle that lasted 111 months which began in the mid-1990s.”

Cap rates last year averaged around 7.5 to 8.0% for select service hotels, and we can see this chart over time on historical valuations, with trough valuations at 10% cap rates roughly in recessionary environments:

So, with public equities now trading at roughly 9% cap rates on 2015 figures, it appears valuations are now cheaper than where individual hotels are trading in the M&A market, and not too far from trough valuations either.  Could be a lot of M&A among public equities.

As for particulars, I looked at a handful of US based lodging REITs in the select service sector (limited food, e.g. Hiltons, Hyatts, Doubletrees) as the full service/luxury hotels could suffer more pain owing to the strong dollar.  I tossed out the ones with too much leverage (Felcor, Summitt, STAY), the ones with too much NYC exposure (Lasalle, Hersha), and focused on the ones with who have outperformed the RMZ index since 2011 (those include Chesapeake, Pebblebrook, RLJ and Chatham).

Chesapeake is somewhat more expensive, Pebblebrook is interesting in that they are 55% West Coast focused and do have quality assets.  They are however quite acquisitive and exposed to the dollar, and PEB trades at a richer valuation.  RLJ is a good pick, buying back shares and selling some assets.  But its revpar growth is weak (up only 2.9%), and it is more expensive.

That left Chatham, a small cap owner of 38 hotels (mostly extended stay).  Today, CLDT is only 4.9x levered, has vowed not to raise capital at these prices, and trades at a very cheap 7x FFO and a 9.3% cap rate.  CEO/founder Jeff Fisher has an excellent track record too, having sold Innkeepers (a public REIT) to Apollo back in 2007, making investors 11.9%/year over some 15 years.

They recently amended their revolver to allow share buybacks of up to $75mm, which is 11% of their market cap today should the board approve such a plan.

On a FCF basis, Chatham trades at a 12% FCF yield on 2016 figures, assuming maintenance capex at 4% of revenue.  Chatham also has better occupancy figures than average hotels by around 10%, and sports the highest industry EBITDA margins (mid 40s vs mid 30s).  Overall Chatham is around 2/3s extended stay hotels, with the rest being Hyatt’s and Hampton Inns.

Interestingly, the lack of food and beverage services, longer term nature of their customer, and higher margins actually make Chatham look a bit like a multi-family type REIT, which trade at high teen FFO multiples.  It should not trade at a discount to its hotel REIT peers in any case, and I would argue a slight premium valuation makes sense.

Basics

History

Chatham was written up in VIC in August 2013 at roughly the same price it is today ($18/share), a year in which it generated $1.49 in FFO/share.  This year they should do $2.50-2.60, meaning the stock’s current year FFO multiple has dropped from 12x to 7x.

The write up has a good history of Jeff Fisher and how Chatham got started (2009), acquiring a few hotels around 11x EBITDA.  Today they operate 38 hotels with 5675 rooms.  50% of their hotels are based on the West Coast, with some 7% exposure to Houston.  

Fortunately, Houston revpar was actually positive last Q3 (up 1% vs Houston overall down 6%), as 2 of their 4 extended stay hotels there are next door to a large medical complex, and not tied to the energy industry.  The other 2 are in the West University section of Houston, and also less tied to energy.

The company went public in April 2010, and since has done 9 secondary equity raises.  They have grown FFO/share by 27%/year since, and I consider the company smart acquirers.  Their Innkeeper JV with Cerberus was a home run, and after its sale in 2014, they realized a tax free $80mm gain on a $37mm investment in 3 years.  They also cherry picked 4 of the best hotels out of this JV to purchase outright.  These are 4 Silicon Valley extended stay hotels, which the company is just beginning to renovate and expand.

It is worth reading their recent transcript to see how well the company’s hotels are performing on the West Coast and in Denver, with many double digit Revpar gainers.  In Q4, Chatham has guided to 5.0-5.5% revpar growth, but I suspect the market has priced in a miss already.

Overall Chatham will spend $80mm renovating their 4 Silicon Valley hotels and management believes that EBITDA should improve by 12-13mm once complete.  This will mostly impact 2017, and provides a nice 20c uplift to FFO once complete.  My conservative model generally runs in the $2.45 range for FFO / share for 2016.  This is below where the street is at $2.60, as I exclude equity from their JV’s which adds 5c in FFO/share and a few cents of stock based comp.  I assume a ramp up to $2.70 in 2017 with the Silicon Valley hotel renovations complete, with very small revpar gains overall.

The company is also underlevered with some capacity for perhaps $100mm of acquisitions and or buybacks (should the board move on that).  That could add $4mm of FFO too (at an 8% cap rate financed at 4.5%).  That is 10c in incremental FFO/share.

That could get Chatham up to $2.80 or higher in 2017 without much in the way of revpar growth.

Comps

Chatham is 10% undervalued compared to its peers today.  If we use a $2.70 FFO figure for next year, and a range of multiples between 8 and 12 (its historical trading range), with dividends I get this kind of upside range in a year.  There is a nice 6.7% dividend so investors get paid nicely to wait, and should provide some kind of floor to the equity.

On the downside, I assume trough multiples and trough EBITDA.  In 2009 hotel REITs got as low as 8-10x EBITDA, and EBITDA fell 15% generally across the board.

Taking EBITDA from $121 this year, to $109 next year (15% decline vs 2015, but adding in $12mm of EBITDA from added rooms in Silicon Valley) gets this:

I ignore the JVs here, which are on the books at $25mm, so probably worth another 50c after tax.

Here is a summary of my model:

Risks / Other Notes

The lodging industry could fall apart this year. Comps are difficult, and supply will start to catch up to demand in late 2016/early 2017.  I think airBnB is a non-event for Chatham, whose customer base is 75% from corporate travelers.

The hotels also are managed by a JV between the CEO and Island Hospitality. SOme point to conflicts with the CEO owning a piece of the managment company.

They have an at the money share issuance program, with $29mm of stock issuable as of September 2015.

RLJ has a few of its non-core hotels for sale.  A bad print could add to already poor sentiment among these names.

The company did a secondary in January 2015 at just under $30 net.  There is always the risk of another deal.  I point to this from their last earnings call:

Dennis Craven - EVP and COO

Hey, Gaurav. Good morning. This is Dennis. No, I think certainly at this point in time were pretty comfortable with our portfolio. I don't think, as far as from an acquisition standpoint, certainly we always would have our eyes open and be certainly looking for some opportunistic deals. But I think at this point, certainly given kind of where we are with the equity price and -- although we do have some capacity on our balance sheet, we certainly aren't targeting new acquisitions at this point in time. But we're just going to be optimistic. As we alluded to we may be opportunistic on the sales side, looking at one or two assets to sell, which would be a means of recycling some capital at that point in time.

Jeff Fisher - Chairman, President and CEO

Of course, we would always look at our own stock and the implied yield there. It goes without saying, we'll measure that against what returns we may find in the market to buy a hotel. And we, given where the world is today, would think our own stock would be a better investment, to be clear, than buying an asset.

Catalyst

Dividend increase likely happens soon

Potential for share buybacks