Description

Lodgian is a very high-risk, high-reward micro-cap stock. What makes the situation so interesting is the extreme but manageable financial leverage, which when coupled with the inherent operating leverage of the hotel business offers unusually large equity upside.

Formerly Servico, Lodgian emerged from Chapter 11 in November 2002. Ironically Servico itself had emerged from bankruptcy roughly a decade before and been a ten-bagger stock before leveraging itself up with some foolish hotel acquisitions. The company operates 97 hotel properties (18,265 rooms), mostly midscale (Crowne Plaza, Doubletree, Hilton, Holiday Inn, etc.). Fourteen hotels are for sale, leaving 83 continuing properties. Because of the bankruptcy, they are not in great condition; however the company has a $76 million 2-year renovation program. ADR is in the mid-$70’s.

Lodgian has $440 MM of debt, a $134 MM PIK preferred issue and only 7 MM primary shares (the warrants are very out of the money), giving it a firm value of $609MM. The leverage to an improving hotel industry is obvious. The bulk of the debt was issued to (and presumably resold by) Merrill and Lehman as part of the reorg plan. I won’t go into all the details, but it is expensive, relatively short-term but allows the company to extend the maturities for a couple of years. Almost all is composed of first mortgages. The upshot is that the company should have enough liquidity for several years unless business really deteriorates further.

The lodging business has had a tough couple of years, but is most likely near a bottom. REVPAR is down about 10% from late 90’s peaks, and profitability has fallen dramatically. However, the prospects seem to be brightening. Expected supply growth is about 1.5% per year (the pipeline is pretty bare), below roughly 3% long-term trend demand growth, and demand seems to be picking up.

Based upon current numbers, LGN is not a bargain; EBIDTA should be about $60MM this year, based upon continuing revenues in the low $300MMs. On an asset valuation basis, the stock is inexpensive. FV of $609MM represents less than $40,000 per room. The rule of thumb in the hotel industry is that replacement value per room is $1000 X ADR or about $70,000, but given the poor condition of the properties, this is much too high for their sale value, even in a better industry environment. A more reasonable figure to use is the $50,000 per room valuation that Servico traded at in the late 1990s. This yields a target price of $30. Incidentally, assuming that REVPAR and margins recover to their previous peak levels, a $30 price is a little more than a 7.5x EBIDTA multiple.

Given the huge financial and operating leverage here, I would not ascribe any real importance to any one specific target price. The preceding discussion is only to illustrate the magnitude of upside in the stock, which I believe outweighs the potential downside.

Catalyst

Operating and financial leverage to an improving hotel industry.