Innkeepers Trust KPA
December 22, 2003 - 8:29pm EST by
gumpster335
2003 2004
Price: 8.40 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 325 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Summary
Innkeepers Trust appears like a terrific way to play an economic recovery leading to improved performance in the hotel industry. It controls nice properties with a primary focus on high-end extended stay hotels, resulting in much greater exposure to business travel (the most depressed area). Eight properties in the Silicon Valley region increase the importance of business travel on the company’s bottom line. While the emphasis on business travel has pummeled results over the past three years, the improving economy could result in an inflection point in reported results.

Many other hotel ownership companies are already trading at premiums to their historical valuations due to the expectation of improved results in ‘04, but the poor performance of the company’s Silicon Valley properties over the past two years has created caution among most sell-side analysts (analyst are only looking for 12% ’04 FFO improvement vs. 20%-35% for most of its peers). Innkeepers is still trading at fairly normal multiples of about 10x FFO and 10x EBITDA on relatively conservative ’04 projections, whereas many competitors are trading at premiums to more aggressive ’04 projections. There are some preliminary signs that a business turn is starting to occur – Innkeepers Trust had positive RevPAR in October and industry data suggest that the hotel business has continued improving.

Looking to the future, it looks like Innkeepers Trust could reach $12-$15 per share in an economic recovery if it were to achieve the FFO and EBITDA it earned around 1997-1998 and maintained current multiples. This time frame is selected to represent a normalized peak, which is about 80% of the absolute peak achieved in 2000. The stock price improvement in an upturn would likely be supported by increase in the company’s dividend, which has been slashed throughout the downturn. Of course, a higher yield would boost total return.

While Innkeepers is well positioned to benefit from economic improvement, the stock is also relatively well positioned if the economy doesn’t improve because it has one of the least levered balance sheets of any public traded hotel REIT and expectations for ’04 do not already incorporate dramatically improved results.

Overview
Innkeepers USA Trust (KPA) is the largest REIT owner of upscale extended-stay hotels in the United States and is the only publicly traded REIT whose primary focus is the multi-brand ownership of upscale extended-stay hotels. The company owns 67 hotels totaling 8,311 suites or rooms in 22 states. 52 hotels are positioned in the upscale, extended-stay market under the Residence Inn by Marriott and Summerfield Suites by Wyndham brand names. Innkeepers seeks to acquire hotel properties in markets with high barriers to entry and with strong underlying demand growth. About 70% of the company’s properties are in major markets like Chicago, Philadelphia, and San Francisco.

Innkeepers has suffered more than the hotel industry overall. Upscale extended-stay hotel properties were among the hardest hit among all hotel properties by the economic downturn, as much of their business is dependent on corporate travel. Two of the more prevalent uses for extended stay properties are to house consultants and new hires that are on training. In an economic downturn, these two categories are ripe for a dramatic cutback as companies reduce their use of consultants and cut back on hiring. Companies like Innkeepers have tried to keep guests in their hotels by switching to government, group, and leisure travelers, but this business is much lower-rated than their typical business traveler.

Innkeepers was hit even harder by the downturn because eight of its properties are located in Silicon Valley. As the technology boom took hold, these properties grew to represent 28% of 2000 lease revenue as they experienced terrific results. In the technology bust, the company suffered more than peers – management indicated that RevPAR (Revenue per available room) at the Silicon Valley properties had dropped over 50% from the technology peak to the most recent quarter. This has brought these eight properties down to about 16% of trailing twelve months lease revenue at the end of the third quarter.

Recent Results
Analysts currently estimate that Innkeepers will earn FFO of 0.77/share, down from $1.10 in ’02, $1.52 in ’01, and $1.92 in ’00. This terrible performance is the result of the awful RevPAR performance of its properties (see chart below). As a hotel owner, Innkeepers will feel the full brunt of the negative leverage inherent in the high-fixed-cost lodging business.

On a positive note, the company’s Q3 RevPAR shows a lessening of the terrible results from the past two and a half years. In fact, excluding the Silicon Valley Properties -22% Q3 RevPAR, the other properties had a negative 0.3% RevPAR. More encouraging, the company said it had a positive 1.5% RevPAR in October. As the economy continues to improve, Innkeepers should benefit from increased business travel and spending. Needless to say, the company is facing fairly easy comparisons in the upcoming year. While the peak earnings from these properties are unlikely to be attained in the near-term, the company should be well positioned to enjoy some stabilization and a modest rebound in these properties. Of course, the company could benefit even more if the tech rebound is sustained and helps the Silicon Valley properties.

RevPAR Trends

Q1 Q2 Q3 Q4 Year
1999 0.0 0.5 2.7 3.4 1.7
2000 3.7 8.5 8.7 8.6 7.4 (18.4% Silicon Valley, 4.3% ex-SV)
2001 4.7 -7.4 -17.1 -22.7 -10.8 (-21.0% Silicon Valley)
2002 -22.3 -11.9 -6.9 -4.3 -12.0 (-24.4% Silicon Valley)
2003 -6.9 -11.8 -4.3 (9MOS:03: -23.0 Silicon Valley)

Balance sheet
Innkeepers has maintained one of the least levered balance sheets in the hotel ownership business, a strategy that proved extremely valuable during the downturn. At the end of 2001, debt/capital was 35%. (For comparison sakes, REITs Host Marriott and Felcor were at 77% and 49%, respectively, while owner/operators like Hilton and Starwood were at 74% and 58%).

Just as important, the company has fairly distant debt maturities, providing flexibility if a business travel spending recovery takes longer than expected. The company’s debt maturity schedule shows $5MM due in 2004, $6MM in ’05, $6MM in ’06, $28MM in ’07, and $177MM thereafter.

The company recently announced an offering of 5.2MM shares 8% Series C cumulative preferred stock, which was priced on December 18th and is expected to close on January 20th. The overallotment option is for another 600K shares. Proceeds of this offering will be used to redeem all 4.6MM shares of 8.625% convertible preferred stock (convertible at $16.88/share) and general corporate purposes.

Dividend
Innkeepers dividend has been slashed as performance has deteriorated. Assuming results are beginning to stabilize and improve, the company could increase its payout in 2004. The company’s declared dividends of $1.12 per share in ’98, ’99, and ’00. That number fell to $0.91 in ’01, 0.40 in ’02, and 0.17 in ’03. The current quarterly payout is 0.03/share, resulting in an implied yield of 1.3%. Assuming the dividend just goes back to what was declared in ’02 (which is only 35% of the ’98-’00 declaration), the yield would increase to 4.7%. While that may be an aggressive expectation for ’04, it doesn’t strike me as far-fetched for ’05 or ’06 assuming the economy experiences a modest sustained recovery.

Conflict, Litigation, Taxable REIT Sub
Another problem Innkeepers has had is that the hotels are leased and managed by a separate organization (Innkeepers Hospitality) that is controlled by Innkeepers Trust CEO Jeff Fisher. Such an arrangement was fairly typical under old REIT rules, but has become increasingly rare due to investor concern about this arrangement, as well as the REIT modernization act that allowed REITs to create taxable REIT subsidiaries that could lease properties (effective Jan. 1, 2001). Innkeepers Trust is finally in the process of buying the leases back from Innkeepers Hospitality for $5.25MM, about 4x trailing EBITDA. Some of the leases have already been bought-in (23 out of 60) with the remainder expected to be completed next quarter. This pace is due to the requirement that Innkeepers Hospitality have some more business not related to Innkeepers Trust so that Hospitality will qualify as an “eligible independent contractor”

The completion of the lease buy-ins next quarter will accomplish several tasks, but will not eliminate all conflicts. Financially, the deal will mean that Innkeepers Trust will not eliminate profit “leakage” to Hospitality on leases (when the hotels are profitable). The closing of the first tranche of lease buy-ins also completed the settlement of a lawsuit against Innkeepers and CEO Jeff Fisher by former COO Fred Shaw, who alleged wrongful termination and breach of fiduciary duty. Finishing the deal should also free up management time to focus on other strategic opportunities the company can pursue.

At the same time, Innkeepers Hospitality will continue to manage the properties, leaving some real and perceived conflicts of interest. The management agreement terms between the Trust and Hospitality are certainly advantageous to Hospitality, but they don’t look completely absurd. Hospitality is to be paid a base management fee of 3% of gross revenues, an accounting services fee of $750/hotel/month, and 50% of available hotel cash flow (basically hotel-level operating profit). To put this in comparison, when Host Marriott renegotiated its previously-egregious contracts with Marriott International, it agreed to pay base management fees of 3% and incentive fees equal to 20%-50% of operating profit.

Valuation
Innkeepers is currently projected to post FFO of $0.77 in 2003 and $0.86 in 2004 (up 12% y/y), resulting in an estimated ‘04 FFO multiple of 9.8x. This compares to ‘04 FFO multiples of 14x for Host Marriott (’04E FFO up 29%, high quality properties, lots of operating leverage), 11x for Hospitality Properties Trust (‘04E FFO up 1%, very conservative lease structure, limited to no operating leverage), and 13x for Felcor Lodging (‘04E FFO up 35%; mediocre properties; lots of operating leverage; high financial leverage, but paying down debt).

Innkeepers “normalized” FFO multiple appears to be a range of 8x-10x estimates. It traded at lower multiples during the Silicon Valley boom times of ’98-’00 and traded at higher multiples as FFO plunged in ’02. Due to this fact, I really don’t look at Innkeepers as a multiple expansion story – it’s more a stock that will see its price increase as underlying performance improves. I suspect that in a sustained reasonable economic environment, the company could achieve FFO of $1.50/share – that’s slightly below the average for the company in 1997 and 1998 and just a hair below 80% of the company’s peak ’00 FFO earnings. Putting an 8x-10x multiple on that number results in a price target of $12-$15, a pretty nice increase from the current price of $8.40 – particularly if the dividend increases nicely on the way to that price target.

From an EBITDA perspective, Innkeepers is expected to earn $65MM during ’03, with current estimates calling for a slight increase to $67MM in ’04. At the end of the third quarter, the company had 38.7MM shares outstanding from an FFO perspective, $233MM in debt, and $116MM in convertible preferred (yes, this number will increase to $145MM after the new issue, assuming the shoe is exercised, but this will also increase cash by the difference of the value of the two issues, less fees, so I’ll ignore it). The total enterprise value is about $675MM, or 10.1x ’04 estimates. Broadly speaking, this is a reasonable valuation for a lodging company. Again, valuation increases will likely be driven by improved performance, not expanded multiples. In 1998, the company was able to post EBITDA of about $85MM. If this were to again be attained (this isn’t trying to be overly aggressive… the ’98 number is 77% of the ’00 peak) and investors still gave the stock a 10x multiple, KPA would be worth $13/share. You can play with the numbers however you want. Each $1MM increase in EBITDA at a 10x multiple is worth about $0.26 per share of Innkeepers Trust.

Catalyst

• Stabilization and possible upturn in business travel, a key driver of extended stay hotel occupancy. Improvement in Silicon Valley performance would be particularly beneficial to KPA given its substantial exposure to that market.
• Gravitation of investors to depressed, cyclically-sensitive hotel owners rather than more-defensive hotel management companies.
• Relatively low-leveraged balance sheet provides security if economic recovery is choppy
• Increase in common stock dividend as taxable income and cash flow increases.
• Resumption of acquisitions/property upgrades with cycle apparently having hit bottom.
• Increased management focus on operations and company opportunities now that company has worked out plan for bringing leases in-house and has resolved litigation with prior management
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