Investment Thesis

The earnings metric – FFO and EBITDA - typically used by investors systematically overstate true earnings by ignoring maintenance capex.  As such, DiamondRock Hospitality (DRH) is a compelling short as it is trading at a high multiple of true earnings that cannot be justified by any measure.

Company Overview

DiamondRock Hospitality is a self-advised hotel REIT that owns upscale hotel in urban and destination resort locations.

Portfolio Summary

DRH owns 26 hotels with 11,121 rooms and most are operated by hotel operators such as Marriott, Starwood or HIlton.  It also owns a mortgage loan secured by a 443 room hotel in Chicago and the right to acquire a Hilton Garden Inn in Times Square (42^nd and Broadway) under construction at an attractive pre-negotiated price.

The portfolio is heavily exposed to major metropolitan areas and destination resort locations.  Over 85% of 2013 portfolio EBITDA was derived from NYC, Chicago, Boston, LA and the resort hotels.  In 2013 the portfolio achieved $184 average daily rate (ADR), 75% occupancy and $138 revenue per available room (Revpar).

Industry Overview

A hotel main source of revenue is rental income, followed by food and beverage, and ancillary services such as parking, spa, telephone, dry-cleaning etc.  Revpar is driven by either ADR or occupancy.  Revpar growth driven by higher ADR is preferable to occupancy gains because of operating leverage – the higher room rate falls directly to the bottom line with no additional cost.

Hotel properties typically trade at EBITDA multiples and the hotel REITs are valued on EBITDA and FFO basis.

Lodging demand is highly correlated with corporate earnings, job growth, GDP, consumer sentiment and airline enplanements.  It is usually classified as 2 types: group business (more than 10 travelers) and transient demand (group with less than 10 travelers).  Group business is relatively stable and predictable as it is driven by conventions.  Transient demand is less predictable as travelers tend to book within the 3 months before arrival date.  Historically, for upscale hotels, transient represents 2/3 of demand with group making up the rest.

Long-term supply growth, according to Smith Travel Research (STR), is about 2% (1988 – 2014).  Supply has been very limited since 2009 due to lack of financing and risk-adverse investors.  Nonetheless, after growing only 0.6% and 0.5% in 2011 and 2012 respectively, the current up cycle has attracted investors and supply is expected to increase considerably until the next inevitable crisis.

Due to high operating leverage, volatile demand, short lease term, and inelastic supply, hotel earnings are extremely volatile.  Additionally, owing to the mismatch of demand (rooms have to be sold daily) and supply (development takes 2 – 4 years), the hotel industry is fairly cyclical.  For the past 25 years, according to STR,  the industry has suffered 3 downturns that averaged roughly 17 months ; 1990 – 91 (14 months), 2001 – 02 (17 months), and 2008 – 10 (21 months).  It is reasonable to expect another downturn anytime in 2018 – 20.

Because of earnings volatility and the lodging industry cyclical nature, I believe, it is foolish to value hotel REITs based on 2014E /2015E EBITDA or FFO.  I prefer rolling 7 year average numbers to adjust for volatility.

Reported Earnings and Valuation

At $12, DRH has a market cap of $2,364mm and EV of $3,530mm.  This implies 14.7x 2014E EBITDA and 13.5x 2014E FFO.  On the surface this seems inexpensive given EBITDA is expected to grow 16% and 10% and FFO/share to grow 25% and 12% in 2014 and 2015 respectively.

To give some historic context, below are numbers reported by DRH.

Source: company report

I picked FY 2009 as the start to illustrate a point.  2009 is the trough of the last cycle and the recovery started in 2010.  The numbers above represent only the “Boom” part of the cycle. During the current up cycle, Revpar CAGR is 7.2%.  Given the high operating leverage, high Revpar growth, limited supply and financial leverage, one would expect DRH to have explosive earnings growth.  Instead, on a per share basis, despite the favorable starting point of the data, DRH had NEGATIVE growth on all but one metric.

Investment or Maintenance Capex?

Upscale hotels (not referring to Motel 6 here), the sort that DRH owns, typically require major renovation once every 7 – 8 years.  A typical renovation would include new carpets, new furniture, lobby, flat screen tv, new bedding, etc.  Hotel owners generally do not have a choice because the hotel manager (i.e. Marriot) requires these expenditures to maintain brand integrity and experience.

The accounting treatment is to capitalize these costs as real estate asset.  Hotel REITs portray these cash expenditures as “investment” and exclude the item from adjusted EBITDA or AFFO.  Interestingly, depreciation and amortization is conveniently added back as well.

The logic in treating major renovation as “investments” goes something like this:

1. The hotel will earn a higher EBITDA after-renovation compared to pre-renovation.  Hence, the incremental EBITDA is the “return on investment” with investment being the renovation cost.
2. If the hotel is sold immediately post renovation, the purchase price will be higher than if it is sold without renovation.  So the renovation cost is recouped and therefore this is an investment.

Superficially both points are right.  However, the logic is flawed from the perspective of a hotel owner.  If a brand new 5 star hotel was purchased in 1995 and no renovations were done to the property, it would have depreciated into a 2 or 3 star hotel by now.  There is tangible erosion of earnings power with the passage of time; the hotel will look tired and out of touch with modern designs.  DRH is in the upscale hotel business, hence its properties need to stay competitive.  Renovations are not an investment program although it is portrayed as such but an expenditure required to “maintain” the appeal and competitiveness of the hotel.

Due to limited disclosure, the infrequent occurrence of renovations, and hotel acquisition/dispositions made by DRH, it is impossible to calculate an exact maintenance capex number.  I examined the relationship between capex and revenue, # of rooms and the gross book value of real estate, excluding land and use rolling 7 year average to eliminate the effects of cyclicality and changes in the hotel portfolio.  Paraphrasing Buffett, the result should be “approximately right” enough.

The following table are pro-forma numbers with capex subtracted.  The underlying assumption is that maintenance capex is equal to 7.7% of revenue.

The adjusted EBITDA and AFFO numbers provided by DRH is a poor proxy for true earnings.  Non-cash expense with real economic impact (i.e. real estate depreciation, acquisition costs, impairment losses) are excluded. 

I use a more conservative approach.  I define FCF as cash from operations – maintenance capex – cash financing expense; operating FCF is defined as FCF + interest expense + financing cost.  Under my approach cumulative FCF/share from 2009 – 13 is 20% lowered than DRH defined AFFO.

Why short now?

Last time when DRH was trading at $12 was in Jan 2011.  The P/after capex AFFO is 33.6x, and now it is at 30.2x. 

On an after maintenance capex basis, DRH is trading at 26x 2013 Adjusted EBITDA and 21.1x 2014 Adjusted EBITDA using the mid-point of guidance.

Remember, DRH is a hotel REIT subject to high competition; it does not deserve its current trading multiple.  I believe shorting DRH now will provide 25% upside with limited downside.

Going forward, with great luck and competent management, DRH may be able to sustain earnings growth of 3 – 4%.  This may sound too skeptical as management is guiding 9 – 11% Revpar growth in 2014.  Please be cautioned that lodging is a mature and cyclical business with volatile demand and high operating leverage so one year number is meaningless.  Long-term Revpar growth according to STR is 3%.  Despite favorable tailwinds amid strong demand and limited new supply in the last few years and cherry-picking 2009 as a starting point, DRH is still earning less than it did 5 years ago.

Risks

• I can be too early
• The market continues to overlook the issue of maintenance capex.  Without adjusting for capex, P/AFFO is 16x and EV/EBITDA is 14.5x.
• Strong headline numbers or increase in guidance could push the stock higher
• Demand drivers such as job growth, corporate earnings, GDP are trending positively and may continue to do so, thus hurting my thesis

Catalyst

Supply is accelerating.  4 of DRH’s submarket are expected to have above-average supply with NYC leading the way at 12.4%, Denver 4.8%, DC and Boston at 3.5 – 4%.  A small drop in revenue would affect the bottom line dispoportionately due to operating leverage.