Profit From The Oil Price Crash And Follow Blackstone: Short La Quinta Holdings

Oil Price Crash:

Oil prices (NYSEARCA:USO) have crashed, and so have the stocks of companies directly servicing oil producers (NYSEARCA:OIH). Here is a chart of the price performance of oil, oil producers (NYSEARCA:XOP), and oil service stocks over the past six months:

Opportunity to Profit from the Crash:

Fortunately, not all stocks of companies with disproportionate exposure to the oil industry have crashed yet. So for those of us with broken crystal balls, who did not short oil or oil service stocks before the crash, there is still an opportunity to profit from the crash. Some stocks are even trading at all-time highs. And some have debt of more than 5 times their annual operating cash flow. One of those has experienced substantial insider selling, with one of the biggest and highest performing private equity firms in the world, Blackstone (NYSE:BX), having sold almost 50% of its holdings in the past 8 months.

That company is La Quinta Holdings (NYSE:LQ). To the uninformed observer, La Quinta looks like a potentially good investment. Sometimes IPOs of private equity portfolio companies perform well after the IPO. After all, there was a reason why the private equity firm took the company private, and typically after borrowing money against the company to pay the private equity firm dividends, the company is taken public again, typically at a high earnings multiple and with promises of improved business prospects and growth.

Aggressive Insider Selling:

However, Blackstone is already out of almost half of its ownership of La Quinta, having sold $460 million of stock on November 24th, 7 months after its IPO. And other private equity backed public companies with exposure to the oil industry have done poorly recently. According to Bloomberg, private equity funds lost $11.7 billion on their holdings of 27 oil related public companies from June to December 2014. This includes Blackstone , Carlyle (NASDAQ:CG), Apollo (NYSE:APO) and other well-known private equity funds.

Specific to La Quinta, one of the motivations for Blackstone to exit such a large portion of its position so soon after the IPO is likely that Blackstone was already losing money on other oil-related public companies. La Quinta stock had yet to react to the drop in oil prices, and so aggressive selling of La Quinta was an opportunity for Blackstone to offset losses and reduce exposure to the energy sector.

Blackstone is famous for Steve Schwarzman, its founder and Chairman, sitting in each investment committee's meetings for each of the fund groups. One likely scenario is that he connected the dots from his large, successful energy investment group and conveyed information from them to his real estate group, motivating them to sell down their stake in La Quinta and other energy exposed properties. This may have happened in 2007, when Blackstonepurchased Equity Office in February and resold more than half its properties by August 2007, correctly anticipating the real estate downturn and cutting risk exposure into the midst of a real estate crash.

Risky Geographic Concentration and Energy Exposure:

Incidentally, the prospectus from the secondary offering in which Blackstone sold its shares explicitly mentions some of these risks. In particular, it says:

"Our hotels are geographically concentrated, with 25% of our hotel rooms and 31% of our pipeline properties located in Texas, which exposes our business to the effects of regional events and occurrences."

There are few things that could impact the business environment in Texas as much as a collapse in the price of oil and in drilling activity. It is the equivalent of the effect of the housing crash on the economies of Florida and Arizona, or of the 2008 financial crisis on the economy of New York. This is a link to a more in depth discussion of the impact on the Texas economy from the oil price crash. And this is a link to analysis by JP Morgan's chief economist arguing that Texas may enter into a recession in 2015.

Incidentally, while Blackstone's CEO has said that "[the price drop] has not created a lot of difficulties for us" (possibly because of Blackstone's ability to exit La Quinta at a high price), other CEOs of Blackstone's competitors are saying there is blood in the water and there will be great distressed buying opportunities. Henry Kravis of KKR said "he welcomes the decline as a chance to fund cash-starved producers" and David Rubenstein said "the next five to 10 years stack up 'as one of the greatest times' to invest in energy." This correlates with distress across the energy and energy related space, including lodging providers to the space such as La Quinta.

Lodging For the Energy Industry:

Civeo (NYSE:CVEO), another more direct lodging provider to the energy industry, may be a leading indicator for La Quinta. Civeo stock crashed on December 30th, down 50% after Civeo announced that its occupancy was far lower than expected, due to a slowdown in the oil and gas business. Civeo lodges oil workers on site, while La Quinta lodges energy industry workers and executives across Texas and other active oil producing states like North Dakota. La Quinta doesn't have the same focus that Civeo does, but its disproportionate exposure to Texas and other oil producing states means it will likely be disproportionately affected by lower room occupancy rates and accompanying lower prices.

Here is a chart of Civeo stock, versus oil prices and La Quinta stock. Due to high levels of debt, even though La Quinta is more diversified than Civeo, its stock may follow Civeo's down:

Substantial Indebtedness:

La Quinta's high debt levels increase risk to equity holders and make a decline in the stock likely to be more pronounced. This is what La Quinta discloses in its November prospectus:

"As of September 30, 2014, our total indebtedness was approximately $1.9 billion. Our substantial indebtedness could adversely affect our financial condition, our ability to raise additional capital to fund our operations, our ability to operate our business, our ability to react to changes in the economy or our industry and our ability to pay our debts. Our substantial indebtedness could also expose us to interest rate risk to the extent of our variable debt anddivert our cash flow from operations to make debt payments."

Considering La Quinta's disproportionate exposure to the oil-driven Texas economy, the recent crash in the price of oil and La Quinta's "substantial indebtedness", it should be little surprise Blackstone is running for the exit.

Further Insider Selling Could "Depress" The Stock Price:

La Quinta further warns in its prospectus that "availability for resale of shares held by our pre-IPO owners may depress the price of our common stock." To see how this could play out, it makes sense to look at an example, Memorial Development (NASDAQ:MRD). MRD's private equity sponsor, NGP (which is partially owned by the Carlyle Group) wanted out, sold stock at a discount, and the stock fell another 20% after that.

This could easily happen to La Quinta's stock. Blackstone likely considers itself lucky that it was able to sell down a large portion of its La Quinta holdings before investors were able to connect the dots to La Quinta's exposure to the crashing oil price and distressed energy economy. As investors make this connection and as La Quinta's operating results are affected by reduced demand, LQ could fall precipitously.

Risk to Operating Results from Oil Crash:

The oil price crash hurts La Quinta in many ways. Most directly, hotels in places like Midland, Texas and Minot, North Dakota will see lower utilization and lower daily rates in the near term as fewer oil rigs are operated in nearby fields. La Quinta has an unusual concentration of hotels in close proximity to oil fields, and these will be the first to be affected. For a company with 5.5x trailing Debt to EBITDA, the effect of this downturn will be magnified.

Next, places with less field-specific energy industry related travel will be impacted, such as Houston, Texas and Denver, Colorado. This will happen as energy companies lay off employees, service providers lay off employees, and service businesses slow down. La Quinta also has an unusual concentration of hotels in these cities, and they will be the next to be affected. Numerous companies with headquarters in Houston and Denver have already announced layoffs, affecting business and leisure travel.

And next, the wealth effect from lower oil prices will start to flow through the economies of those areas, as well as affecting the millions of people who own mineral rights and collect monthly royalties from oil production on family land and ranches. This will affect their investment and travel decisions, leading to lower personal and business demand for hotels in these areas. Ownership of these royalty interests is disproportionately concentrated in areas in proximity to oil fields, including the major cities in Texas and cities like Denver, Colorado. Depending on the duration and severity of the oil price downturn, this effect could be pronounced.

Economist View:

JP Morgan's Chief Economist put out research in December talking about the effect of the drop in oil prices on the economy of Texas. Titled "Houston: You Have an Oil Problem", it argues that Texas is as energy intensive as it was in the 1980s by some measures. In the late 1980s, there was a wave of property loan defaults in Texas that led to the Savings and Loan collapse. Hotel loans defaulted along with residential loans.

I had the opportunity to run the La Quinta short thesis by a member of the JP Morgan Chief Economist team, without specifying the name of the hotel chain. They confirmed JP Morgan's prediction of a recession in Texas in 2015, and agreed that if a hotel chain had disproportionate exposure to Texas, it would likely see disappointing operating results in 2015 and potentially beyond.

Incidentally, in a potentially conflicted sell side research report discussed below, another investment bank cited Texas's positive economic performance in 2008/2009 as a reason for bullishness on the Texas economy despite a crash in oil prices. They point out that the price of oil crashed then, but Texas's economy continued to grow. However, Texas's oil production grew from 1 million barrels per day in 2009 to over 3 million barrels per day in 2014. Obviously the state's economy is much more highly levered to oil prices now. This is a point JP Morgan makes, as it argues that Texas's current economy is similar in crucial respects to its economy in the 1980s, which suffered a severe recession in the midst of falling oil prices.

Bull Thesis / Conflict of Interest:

Goldman Sachs (NYSE:GS) put out a report on January 2 recommending La Quinta as a "buy" and raising its price target to $25 per share. In the report, Goldman dismisses claims that La Quinta is exposed to economic malaise because of the oil price crash. Goldman argues that "only" 8% of La Quinta's hotels are in proximity to oil fields, and that "only" 25% of the hotels are in Texas.

In conversations with hedge fund managers who do not have a position in La Quinta, they said that the report read like a sales pitch to Blackstone. Despite the Spitzer settlement after the Dot Com crash, investors say investment banks orient their research to securities issuers to garner business. The hope here may have been for Blackstone to pick Goldman as the lead broker for Blackstone's next secondary offering of La Quinta shares (which will further cut Blackstone's exposure to La Quinta). The report is dismissive of risks, understates La Quinta's exposure to lower oil prices, and argues that there is upside to converting La Quinta into a REIT structure.

Goldman's arguments are particularly weak because, with 5.5x Debt to EBITDA, La Quinta is so levered that if there were no spillover effects and "only" 8% of La Quinta's hotels were affected with lower utilization and pricing, there would be a material impact to La Quinta's financial results and stock price. This is particularly because those 8% of hotels have been earning a disproportionate share of the whole company's profits, further impacting credit metrics, as discussed below. Goldman points out that La Quinta is one of the most levered C corp hotel companies, which could be a factor in a stock price decline.

The Goldman report is also unrealistic because Blackstone is the master at realizing maximum value from its private equity investments. If the highest value exit was to turn La Quinta into a REIT or to monetize its properties, Blackstone would have done so before aggressively selling down its position. There are 2 most likely explanations for why this did not happen. Either 1) Blackstone saw the risk from the collapse in oil price and exited sooner than planned or 2) the optimal structure for La Quinta is as a publicly traded C corp (or possibly both). There could be tax related issues converting to a REIT - Blackstone is expert in monetizing real estate. Regardless, it is highly unlikely that Blackstone left "low hanging fruit" at La Quinta before aggressively selling down its stake.

Reason Market Has Missed This Mis-Pricing:

It is worth considering the above when thinking about why the market hasn't yet priced in the risk of the oil crash to La Quinta's stock price. Sell side reports have competed to be as bullish as possible, in what investors are saying looks like a competition to be used as the primary broker for the next divestiture tranche of La Quinta stock by Blackstone. These reports had successfully stemmed the tide of concern by investors, but as the utilization rate in affected areas declines and revenue and profits start to fall, investors will notice and the stock will likely start to price in this risk. Rigs are actively being cut right now and there may be a lag of up to a few months for utilization to drop off, room rates to drop off along with them, and revenue and profits to follow suit. At that point, La Quinta stock will likely be far lower than the current price and it may be too late to sell or short for those investors lulled into a false sense of security by potentially conflicted sell side research reports.

Other Positive Factors for La Quinta:

Beyond Goldman's sales brochure, the risk to shorting La Quinta is that, prior to the oil price crash, La Quinta was successfully implementing its business plan. It was growing its franchise locations and improving its metrics. However, so was Civeo and so were numerous other companies that directly and indirectly serviced the oil industry such as components of the ETF OIH. That has not stopped CVEO, OIH and others from trading down significantly. And despite good operating performance until now, the 30% of La Quinta's growth projects that are in Texas may underperform in the new economic environment, as may the 25% of La Quinta's existing properties in Texas and additional 5-10% of properties in other oil-heavy economic areas like North Dakota, Colorado and Louisiana.

Oil Area Hotels Previously Had High Comparable Room Rates:

Part of why La Quinta will be substantially impacted is the huge difference in room rates between La Quinta rooms in oilfield exposed places like Midland, Texas and in similar sized cities not exposed to the oilfield, like Little Rock, Arkansas. In the absence of comprehensive data on this, it makes sense to look at real time examples. The first two La Quinta's that show up on Kayak for January 13th-15th 2015 show Midland per night room rates of $175 and $296, respectively. And for those same dates on Kayak in Little Rock, they show $59 and $82. This is obviously a huge disparity. There is no reason to expect that the economy in Midland in an oil crash will be any better than in a city like Little Rock, and there are certainly more hotel rooms per capita in Midland and more being built right now. If rates simply converged, room rates at La Quinta hotels in Midland would go down by 70%.

For thoroughness, I looked at other similar sized or larger cities in other states to further test the validity of the rate comparison. The first two La Quinta hotels in Omaha, Nebraska were listed at $67 per night and $52 per night, for the same nights as above. This is an even larger percentage difference. Other similar cities had similarly low comparable rates, highlighting the absurdly high rates La Quinta has been garnering from its properties in Midland and other oilfield areas. This shows that La Quinta is in fact even more exposed to the collapse in oil prices than is widely known or understood.

Operating Leverage:

Hotels have substantial operating leverage. Many of the costs, such as rent or amortized real estate, staff, utilities and maintenance, are fixed to a large extent. This means that as room utilization goes down, profits go down. And as utilization declines, typically room rates also decline, leading to a double hit to revenue, from fewer rooms being booked and lower prices per room. La Quinta hotels in Midland likely have similar cost structures per room as in Little Rock, with slightly higher land cost and labor, but otherwise similar. This means that a hotel located in Midland may be earning 5 times as much per room as a hotel located in Little Rock. This magnifies the earnings impact to La Quinta of a decline in demand in previously high demand places like Midland, where La Quinta is disproportionately exposed.

Financial Impact of Oil Field Hotel Downturn:

Measuring the precise impact of the crash in oil prices on La Quinta's revenues and profits is challenging. They don't disclose location specific financials. But if just the 8% of La Quinta's total hotels that are based in West Texas and other oilfield areas drop their prices to typical prices for other non-oilfield areas, revenues could drop by 70% in those areas and those areas could go from representing 30%+ of the profits for the whole parent company to 8% of the profits for the company. And that is just assuming a reversion to the mean, not factoring in the full potential impact of an oil bust in those areas. In a bust scenario, occupancy could plummet, driving prices below prices in comparable cities, driving profits down from 30% to possibly 4% instead of 8%.

Goldman is projecting 6% revenue growth for La Quinta in 2015, assuming no impact from the oil price crash and that underlying positive lodging trends continue to benefit La Quinta across its hotel base. If the 65% of hotels outside of Texas, Colorado, North Dakota and parts of Louisiana grow at that 6% rate, and if they earned 65% of the revenue for La Quinta, that would mean 3.9% top line growth for La Quinta from those hotels. That compares unfavorably to the potential 25% revenue hit from just the 8% of La Quinta hotels directly serving oil fields, or a net potential revenue decline of 21.1%.

Considering La Quinta's 5.5x Debt to trailing EBITDA, if EBITDA declined 25%, debt would go to 7.3x Debt to EBITDA, which would get La Quinta close to its 8x debt covenant (see page 49 of the linked prospectus). It could put La Quinta in financial stress and potentially drive stressed sale of properties and a re-rating of the stock from its current 13.7x EV / EBITDA multiple to a lower, financially stressed multiple. Observe what happened at CVEO when occupancy fell. Obviously CVEO became distressed and not simply stressed, but there is the potential for La Quinta to suffer material multiple degradation, on lower EBITDA, which could see the stock price fall 50% or more over time.

Financial Impact of Texas and Indirect Oil State Downturn:

The analysis above focuses entirely on the small percentage of hotels that are within proximity of oilfields, such as hotels in Midland, Texas. These properties are effectively more permenant versions of properties owned by CVEO, and will likely be affected in a similar manner.

Where things get even uglier for La Quinta is the large indirect exposure from the hotels in Texas not in places like Midland. As mentioned above, JP Morgan and others are calling for a recession in Texas in 2015. It would be surprising if North Dakota didn't follow suit, as it is even more levered to oil production than Texas. With 35% of its hotels in Texas and other affected states, La Quinta will likely be impacted in the 27% of its hotels in those states but not in proximity to oilfields. As discussed above, 65% of its hotels may grow revenue, and 8% may see precipitous declines in revenue.

Visualizing the Problem:

Below is a map of La Quinta's hotels, from their S-1 filing. Red circles have been added to indicate "problem areas" in close proximity to active oil fields or oil company headquarters. It is obvious from the number of hotels within these areas that an oil price slowdown will likely materially affect a large number of La Quinta properties:

(click to enlarge)

Hotels in Texas But Not in the Oil Field:

The remaining 27% have not yet been addressed, and will likely see drops in utilization and room rates, albeit to a lesser extent than the oilfield hotels. Lodging is known as a cyclical, highly economically sensitive business. Goldman and others cite US economic growth as a primary driver of their forecast for revenue growth for La Quinta. However, there will likely be GDP contraction in Texas, as the negative wealth effect from lower oil prices spills over into the broader economy. As mentioned above, Goldman focuses incorrectly on the 2008/2009 correction, ignores the 2 million barrels per day of incremental oil production Texas has added since 2009, which represented the majority of the economic growth achieved by the state through 2014. If JP Morgan's prediction is correct, perhaps utilization for that 27% group of hotels will decline by 10% and pricing by 10% (a modest assumption compared to the larger declines experienced in the 1980s), translating to a ~20% decline in revenue. This would represent 5.4% of the total revenue for La Quinta, which would more than offset the 3.9% revenue growth from La Quinta's non Texas hotels.

Ugly Math For La Quinta:

On page 141 of its October 2014 S-1, La Quinta discloses that it charged an average daily room rate of $83.92 across the chain, and achieved a "revpar" of $57.17, which is indicative of actual revenue achieved per room available. And it shows that occupancy was 68.1%. Here is where the math gets really ugly for La Quinta. Recall the above example of Midland La Quintas versus Little Rock. Little Rock rates were slightly below average, and Midland rates were as high as $290. Room rates get to 3.5x the system-wide average only because of astronomically high demand. This means that hotels like the Midland locations likely had been achieving as much as 3.5x higher than average pricing AND substantially higher than average occupancy, perhaps as high as 90%+. The operating leverage effect of these numbers was discussed above.

However, above there were certain assumptions made, such as that the 35% of hotels in Texas and similar areas earned the same revenue as the 65% outside of those areas. However, with room rates as much as 3.5x higher and utilization rates likely substantially higher too, these hotels may represent 50% or more of La Quinta's overall revenue. Unfortunately and likely not coincidentally, La Quinta does not break out its revenue by geography anywhere in its 364 page prospectus.

This means the math above is even worse. It is not unreasonable to assume that these 35% of hotels in areas with previously higher pricing and utilization may have actually been generating 65% of the revenue for the company (this makes sense when factoring in the higher rates and utilization discussed above, and is a reasonable guestimate considering lack of information from the company). In this case, the 25% revenue decline from the oil field proximity hotels would combine with a larger 6% revenue decline from Texas and other oil region hotels, to be offset by a smaller 2.1% revenue growth from the remaining hotels, or a system-wide ~29% decline in revenue.

Due to high fixed and limited variable costs related to the lodging business, and the high degree of cost cuts already undertaken by La Quinta management while under Blackstone ownership, most of this revenue decline would likely hit the bottom line. Trailing $340 million of EBITDA could decline to as low as $241 million, and with 1.9 billion in debt, this would get Debt to EBITDA to 7.88x, within 0.12x the leverage covenant on the debt. This would likely force equity issuance or forced sales of properties, and could materially affect the stock price.

Also, from a valuation perspective, La Quinta currently trades at 13.7x EV/EBITDA (trailing), with $1.9 billion of debt, $100 million of cash and a $2.85 billion market cap. If EBITDA fell to $241 million and La Quinta retained the same 13.7x multiple, its total enterprise value would be $3.3 billion, which net of debt and adding back cash would imply a $1.5 billion market cap. This would mean a stock price down 55%. And if the multiple contracted due to perceived financial stress, the stock price could decline further.

Obviously these numbers are based on a number of assumptions and are based on limited data. However, these assumptions are not unreasonable, and reflect the reality of a shift from boom pricing and profits to bust pricing and economic reality. A room at a La Quinta in Midland is the same brand and the same box as a room at a La Quinta in Little Rock or Omaha, the only difference had been a drilling boom, with increasing numbers of rigs and accompanying various other services businesses. None of the above discussion even addressed the potential overbuild of hotels in places like Midland in the past few years, which could accentuate a price correction, especially in the face of the crash in the price of oil and the ensuing bust.

No Longer Theoretical:

Subsequent to developing the above thesis, new information came to light proving that the above thesis is actually playing out in real time. After seeing alocal news article about the negative economic impact of the oil crash on Sweetwater, Texas, I checked the website Tingo.com. Tingo offers information on recent room rate changes. What I saw was astonishing - the La Quinta in oilfield town Sweetwater had dropped its rate (for the same dates as above) 8 times in the past 14 days! Dropping over $6 each time. The room rate is now $114, down from $163 14 days ago. This is exactly the type of change hypothesized in the above analysis. The change is happening quickly, in real time, and likely will have a material economic affect on La Quinta's revenue and cash flow (and likely its stock price). Here is the screenshot from the tingo.com search:

(click to enlarge)

Summary:

La Quinta is overly exposed to the oil industry, as disclosed in its prospectus. Oil prices have crashed and capex is being aggressively cut in the areas La Quinta has properties. La Quinta's largest shareholder and insider is aggressively selling its stake, in a move reminiscent of another aggressive sale by that same shareholder in another real estate company prior to another crash. La Quinta is highly levered, and its stock trades at a high valuation despite all of the above. That may change in the near term as the market recognizes La Quinta's effective oil exposure, high leverage, and the likelihood of further aggressive insider sales.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment adviser capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment adviser. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Note: this idea appears in other sources online as well. sharing this on VIC as I think VIC members would appreciate it and I'm interested in feedback on the thesis.