Description

Short FS at US$72

Summary
FS is viewed as an asset-light hotel management company with an exceptionally strong brand that enables the company to grow substantially and generate high returns on capital. Also, like other companies in the lodging space, FS’ stock has benefited from investors seeking exposure to the lodging up-cycle. In FS’ case, this has lead to a valuation in the stratosphere at 45x EV / ltm EBITDA. I believe that FS investors will ultimately be disappointed as 1) FS’ value proposition in a market plagued by overcapacity is thinner than commonly believed, 2) FS has had to put up much more capital in order to grow and to protect existing earnings and 3) Profitability has been vastly overstated by the exclusion of repeated write downs of capitalized expenses, the exclusion of stock options expenses and the generosities of Canadian GAAP. These three items accounted for 70% of operating profit over the last 10 years. While reported average ROIC (defined as NOPAT/invested capital) over the last 10 years before the items above was 9%, adjusted ROIC over that time frame was less than 3%. FS plans to grow the hotels under management by around 10% annually and with such low returns on capital this means they will destroy shareholder value. In my mind, this warrants a discount, not a premium valuation.

Catalyst
The above has been the case for a while and timing this short has been difficult given FS’ ability to fake earnings over a fairly long time and the positive momentum related to the lodging up-cycle. I don’t claim to be able to predict the slope or the duration of the lodging cycle, which is largely driven by macro economic factors. However, FS missed consensus EBITDA estimates for the 2 most recent quarters by one half and one third respectively and the stock is down 15% from its peak. I believe momentum may finally have been broken, the company may have run out of accounting tricks and investors’ tolerance for excuses may be running thinner as we approach a lodging peak.

Business
FS is the largest hotel management company in the luxury segment. The company enters long-term contracts (typically 70 yrs) with hotel owners to manage their hotels. Hotel revenues and direct expenses are passed through to owners and FS is compensated for its services and brand through base fees, approx. 3% of hotel revenues, and incentive fees, a percentage of hotel gross profits beyond certain thresholds. While less cyclical than hotel owners, the Street expects a substantial recovery in profits for hotel managers like FS and Marriott (MAR), primarily through a recovery of incentive fees. I believe FS’ value proposition is fairly thin since they don’t own the real estate and the hotel manager could be replaced by another high end manager/brand. In recent years, there have been many signs that the terms in existing management contracts are too favorable for hotel managers, as several owners have sued to exit long-term management contracts (and in some cases succeeded, e.g. against FS in Seattle).

There are also signs of overcapacity in the luxury lodging segment. 2004 demand for luxury rooms was estimated to already be 8% above the peak 2000 level (2005 demand 12% above 2000) according to Goldman Sachs’ Biannual Lodging Outlook report from May 2004. (Actual 2004 demand was likely even higher.) However, 2004 supply has grown 13% since 2000 and supply already outgrew demand in the late 90ies despite a strong demand environment at that time. FS is now targeting to grow its 63 hotels (as of end of 04) by 5-7 hotels per year into this environment, primarily through new construction.

FS also has a few hotels for which it leases the real estate itself (“owned hotels/operations”). All of these have been unprofitable because of overcapacity in the local markets and/or expensive unionized labor. FS has been trying to exit these hotels to prevent further losses. In 2004, FS made use of a contract clause that limited its lease payments on the FS Berlin to the cash generated by that hotel and the lease was subsequently terminated by the owner. FS does not manage the hotel anymore. Unfortunately for FS, the remaining 2 “owned” hotels (which have generated ltm EBITDA losses of US$5.1m vs. total ltm EBITDA of $63.6m) do not have such clauses in their leases: The lease for the Pierre in New York expires in 2012 and the lease for the FS Vancouver expires in 2020. Recently, there has been a lot of excitement amongst sell side analysts about speculation that FS would be able to exit the Pierre. My expectation is that FS would pay to get out of the lease, write it off as one-time and avoid the future ongoing losses. (The sell side then looks at historic multiples that reflected the owned losses and applies them to forward earnings that exclude the owned losses). In any event, it’s not big enough to really change the valuation meaningfully. Also, FS lumps Owned losses together with corporate losses in its P&L and I suspect that many analysts mistakenly assume corporate expenses would disappear too if owned operations were exited

Use of balance sheet to produce earnings
Over the last 10 years, FS has increased the amount of capital it puts up to secure the revenues and earnings related to its management contracts. This capital is used in various ways: As of 1Q05, FS had US$80m in receivables (DSO of 114 days despite IR’s claims that receivables from hotels are typically collected within 30 days. As the hotel manager, FS controls that cash itself.), long-term receivables of US$198m, equity investments in hotels of US$130m, “investments in management contracts” (advances and other capitalized costs associated with winning contracts that can be capitalized under Canadian GAAP) of US$178m. If FS’ brand and value proposition was so strong, it shouldn’t have to provide the hotels - its customers - all this capital in order to secure their business.

The various forms of investments into customers have lead to a bloated balance sheet with invested capital growing almost 3 fold since 1995 (in US$) despite rooms only growing by 29% over that time frame. FS now has US$38k in invested capital per hotel room. Accordingly, FCF was almost non-existent (an average of C$14m per year over the last 10 yrs for a company with a market cap of US$2,746m. FCF was only C$2m in 2004, despite CFFO and FCF being higher under Canadian GAAP than US GAAP). The accounting for these capitalized items appears aggressive, as indicated not just by their growth far in excess of the business growth but also by the fact that most of the adjustments to book value over time have been negative (losses on sale, write-downs of management contracts etc)

Earnings quality
FS’ financial statements are quite complex. The earnings releases are so long and convoluted that after an earnings call, different analysts often simultaneously exclaim that FS either beat, met or missed consensus. FS uses Canadian GAAP, has just switched the reporting currency from the Canadian $ to US$ in 1Q05 and has frequently restated results for changes in accounting policies. This has helped FS mask the weak profitability of the business, with analysts focusing on RevPAR gains and house margins (which confirm their cyclical recovery story) and not on profits (or, God forbid, FCF or the balance sheet). However, a close inspection of the financials is very rewarding; especially the footnotes at the end of the annual reports, which reconcile reported Canadian GAAP results with US GAAP. (FS started disclosing this in the 2001 report.)

While a 10 year, across the cycle, average ROIC of 9.4% is not impressive, this metric is overstated in various ways. Analysts typically exclude the write-offs associated with customer investments gone wrong. However, while lumpy, these write-offs are a cost of winning new business and maintaining existing management contracts. Over the last 10 yrs, net losses on disposal, write offs and legal expenses for defending management contracts have totaled C$104m and the 10 year ROIC has been 1.4 pts less after these items

Also, reported Canadian GAAP operating profits have excluded C$45m in expenses over the last 5 yrs that would have been reflected in US GAAP income statements. This includes C$25m in losses from equity investments that are accounted for under the equity method under US GAAP with FS picking up their share of net losses, but are reported at cost under Canadian GAAP, so the losses disappear. This has helped 2004 pretax profits by C$9.0m or C$0.18 in EPS out of a total of C$1.59. Under US GAAP, the book value of these investments would be C$90m lower, indicating that cumulatively earnings have been overstated by C$2.83/sh. Similarly, Canadian GAAP allows FS to capitalize expenditures associated with “negotiating, structuring and executing” new management contracts, such as travel, legal advice etc. Under US GAAP, this would have to be expensed. This helped FS by another C$20m pre-tax over the last 5 yrs, C$4.8m in 2004 (C$0.10/sh) and C$36m cumulatively (C$0.73/sh). In total, the use of US GAAP would have shaved another point off the ROIC over the last 5 yrs (and presumably a similar amount over the previous 5 years)

Finally, FS has been granting lots of stock options to employees, which by and large haven’t been expensed. FS started expensing stock options under Canadian GAAP in 2003, but only for options granted after 2003. Even the Canadian GAAP footnotes included in earnings releases don’t reflect the full pro-forma stock options expense, since they only reflect options granted in 2002. Only the footnote to the Canadian GAAP – US GAAP reconciliation in the annual report discloses the full pro forma stock option expense, which has been running at C$0.66/sh in 2004 and C$0.86/sh in 2003 (of which 6c/2c has been expensed under Canadian GAAP). Over the last 5 years, the failure to expense stock options has helped operating profits by C$142m and overstated ROIC by 4.1 pts.

In total, adjusting operating profits for not so one-time expenses, stock options and Canadian GAAP, 10 yr average ROIC has only been 2.8% vs. the reported 9.4%. Even in the peak of 2000, adjusted ROIC has only been 12.8%. This is not a good business.

Valuation and target
With the stock at US$72 and with 38.1m fully diluted shares, FS has a market cap of US$2,746m. As of 1Q05, there was US$198m in cash and US$296m in debt, so net debt was US$97m and EV is US$2,844m. The debt is mostly from a convert, which is shown on the balance sheet in 2 pieces: in long-term obligations and in equity - another peculiarity of Canadian GAAP. The conversion price is US$71.64 and conversion is contingent on the stock trading above 130% of the conversion price. The dilution has not yet been reflected in the fully diluted share count. Ltm EBITDA has been US$64m or US$69m if you prefer to exclude the Owned losses and Firstcall projects 05 and 06 EBITDA at US$93m and US$121m. Applying the 10 year average unadjusted ROIC of 9.4% to 2004 invested capital to get a sense for normal EBITDA would yield US$88m in 05 EBITDA. So even if you believed the accounting, 05 estimates are probably already close to “normal” and not depressed and 06 estimates are significantly above normal. FS is trading at 32x that 05 estimate of normal EBITDA. My best estimate of true underlying earnings power would be derived using the adjusted average ROIC of 2.8%, which would yield US$35m in normal 2005 EBITDA and FS is trading at a whopping 82x that.

How much is it worth? I struggle to estimate FS’ intrinsic value given its unprofitable growth. How much would you pay for a company with an overstated book value that is destroying value by growing aggressively despite sub par returns on capital? I wouldn’t even pay book value, which is US$14/sh vs. the current stock price of $72. Needless to say the current valuation is also miles away from any comparable lodging companies. While this has been the case for a while, the recent substantial misses in combination with still aggressive estimates make me believe that valuation may become more relevant over the next few quarters.

Catalyst

The above has been the case for a while and timing this short has been difficult given FS’ ability to fake earnings over a fairly long time and the positive momentum related to the lodging up-cycle. I don’t claim to be able to predict the slope or the duration of the lodging cycle, which is largely driven by macro economic factors. However, FS missed consensus EBITDA estimates for the 2 most recent quarters by one half and one third respectively and the stock is down 15% from its peak. I believe momentum may finally have been broken, the company may have run out of accounting tricks and investors’ tolerance for excuses may be running thinner as we approach a lodging peak.