Description

Investment Summary  

We think MHGC offers investors a compelling risk/reward opportunity at its current price of $6.58/share.  We believe that poor liquidity aside, MHGC’s current price reflects a very negative outcome for the ultimate dissolution of Morgans’ hotel and hotel management assets.    We think that conservatively MHGC common stock will equal $8.20/share within the next 10 weeks, representing a 25% return.  In addition, we think that there is a real probability (~30%) that the stock could trade at $9.55/share within the same time frame if current management can optimize market pricing for both its hotel and hotel management assets.  Consequently, we think MHGC represents very little downside and material upside in a very short time frame for investors who can handle mark to market volatility from admittedly low liquidity.

Why does this opportunity exist (or why has such good fortune fallen into my lap):

MHGC is a well-known name to at least a few VIC members.  Historically, it suffered mightily from entering the Financial Crisis with a highly levered balance sheet secured by cyclical high-end hotel assets.  The stock peaked in 2007 at $24/share only to decline to $2.5/share in the throes of the 2009 recession.  Since then several different shareholder groups have struggled for control of the company, all with roughly the same end goal:  to move the MHGC assets to a much larger corporate structure which could scale Morgans’ still relevant hotel brands: Delano, Mondrian and Hudson as well as monetize Morgans’ owned hotel assets (which benefited materially from the Fed induced reflation over the last 5 years).   Despite shareholder activism, the stock has labored generally between $6-$8/share over the last 4 years.  More than anything, shareholder fatigue at a lack of asset monetization has dominated the share price.

However, we think that is about to change.  On May 19th, without much fanfare and most importantly, no increase in share price, Morgans’ CEO, Jason Kalisman, resigned his position and Howard Lorber (one of the top 3 shareholders through the Vector Group (VGR) of which he is CEO) assumed the Chairman role.  The company also announced on their Q1 FY15 earnings call one week earlier that Jonathan Langer (Head of US hotel acquisitions at Goldman Sachs) would resign his board seat and enter into a consulting agreement with MHGC.   The company charged Mr. Langer specifically to aid MHGC’s strategic review process (ongoing since May 2014) and they decided to compensate him via a quarterly contract in order “to incentivize him to push the strategic review to a conclusion”, in the words of the now ex-CEO Kalisman.  

Based on numerous conversations with company insiders, commercial real estate brokers and hotel buyers, we think these corporate actions imply a very real conclusion to the Morgans saga by August, 2015.  Specifically, we think Morgans will sell the entire company (both the hotels and the hotel management assets) to a larger hotel management company (Hilton, Wyndham, Hyatt, Marriott, etc).  We think that the company under Kalisman’s leadership was targeting a much less shareholder friendly strategy of selling the hotels and then executing a reverse merger with a larger but private hotel management company.  We think his departure signifies the end of this reverse-merger pursuit and the completion of the sale of all of the hotel assets to one buyer.   Our confidence about the specific timing of the sale stems from two data points: 1) the CMBS debt attached to the two hotel properties carries a pre-payment penalty that expires in August.  We don’t think any deal will close before that date to avoid these extra costs and 2) based on management and industry insider discussions we think Morgans is “hyper focused” on completing the deal by the end of the summer.  We also think the structure of the Jonathan Langer consulting contract (discussed below) indicates a management expectation of a short-term resolution to the strategic review.

Valuation of Morgans’ Assets

Morgans Hotel Group is a fairly simple corporate structure to analyze.  It owns 3 hotels (one through a 99 year lease), manages 10 hotels (11 by the end of the year) and owns long term leases on several restaurants in the Mandalay Bay Resort in Las Vegas.   Financially, Morgans has struggled the last 5 years.  Although in 2014 it generated -$3.8mm FCF from ops, it produced positive operating results when measured on an adjusted ebitda (MHGC experienced significant restructuring costs in 2014).  In 2014 Morgans’ adjusted ebitda less cash interest expense and less their preferred dividend expense was a bit above break-even ($48.72mm - $47.92mm).  Morgans suffers from high interest expense (effective debt yield = 6.7% v. < 5% for most hotel REITs/managers), onerous preferred equity financing, an inefficient corporate G&A structure given their current management fees and no ability to scale their hotel occupancy with a meaningful rewards  loyalty program as well as a substantial corporate marketing effort.  

Owned Hotels:

Morgans owns three hotels: the Hudson (NYC), The Delano (South Beach) and the Clift (SF), although it leases the Clift via a 99 year lease.  The Hudson and the Delano are primary to the Morgans’ valuation given their attractiveness as profitable, marquee hotels in flagship US cities.  

The Hudson: The Hudson is an 878 room hotel located 1 block from Columbus Circle in Manhattan.  Its rooms are about 2/3-1/2 the size of a traditional hotel room (200 sq. ft. v 350 sq. ft.) and it also possesses 60 SROs (which predate Morgans’ ownership of the hotel - the SRO occupant has the right to occupy the unit until their death or until they sell to Morgans).  The Hudson also has 6 food and beverage offerings on premise.  The Hudson’s ADR (average daily rate) in 2014 equaled $229, down 3% from 2013 (RevPAR was down 1% YoY).  In Q1 the Hudson’s ADR declined 9% (rev par -14%) as increased supply from competitor hotels and FX volatility (~25-30% of Hudson guests are European) hampered operating results.  

Our valuation of the Hudson includes both a NOI and a per-key analysis.  We use the 2014 financials to calculate NOI. We recognize the material decline in RevPAR in Q1 FY15 but feel it is more temporary or at least less relevant for four reasons: 1) Q1 FY15 total hotel ebitda declined marginally (from -$.858k to -$1.108K YoY) as Q1 is by far the least economically important quarter for the Hudson, 2) European demand should normalize as their economies begin to reflate and they continue to want to travel to Manhattan, 3) food and beverage revenues become a larger portion of total hotel revenues at the Hudson and 4) new hotel supply in Manhattan begins to lessen (as it already has – in Q1 new supply grew 3.1% v. 6% for all of 2014).

Our base case valuation for the Hudson equals $351mm which averages a $/key of $400k and a 4.5% cap rate.  We list comparables for Hudson pricing in the following section but $400k/key falls on the low end recent transactions and the 4.5% (TTM ebitda) cap rate falls in the middle of the 4-5% range for comparable properties (the Waldorf traded on a 2% cap rate in Dec. 2014).  We would stress that the Hudson would benefit measurably from a larger manager platform that could attract more corporate customers as well as a rewards or loyalty program to increase its occupancy rate.  

The Delano:  The Delano is a 194 room hotel with 8 poolside bungalows, 5 food and beverage offerings and a full service spa.  The Delano is a high-end, premium resort located within a few blocks of the South Beach neighborhood in Miami Beach, FL.  The Delano’s ADR equaled $520 in 2014 (down 1% from 2013, although its RevPAR increased 2%).  In Q1 FY15, the Delano’s’ ADR increased 5% but its RevPAR declined -7% as occupancy declined 12% given the recent hotel room supply increases in Miami Beach in early 2015 as well as FX volatility (which reduced demand from LatAm customers).

We value the Delano on both a NOI and a per-key basis.  We use 2014 financials to calculate the Delano’s NOI despite a Q1 decline in RevPAR primarily because in Q1 FY15 total hotel ebitda increased 3% YoY (from $7.95mm to $8.13mm) as food and beverage continue to represent a larger portion of total hotel revenue.  We also think the FX headwind will prove temporary over the long term.  We would point out that the increased supply of hotel rooms in Miami Beach could be an issue in the short term as at least 4 new hotels opened this past winter.  However, we think most of this supply offers less direct comparables for two reasons: 1) these comps don’t generate comparable F&B (food and beverage) revenue  and 2) all are located 20-40 blocks farther north from the commercial district of South Beach (the Delano is located at the northern tip of South Beach).

Our base case valuation for the Delano equals $219mm which averages a $/key of $1mm and a 6.25% cap rate.  We list comparables for Delano pricing in the following section but $1mm is a bit below the Dec 2014 sale of the Satai (a higher end luxury hotel farther north in Miami Beach) and the 6.25% cap rate matches the cap rate that the James Royal Palm traded for in Feb 2015.  The Delano would also benefit from a larger manager platform that could use loyalty programs to utilize space at the hotel during its slower summer and fall months.  

Comparables:

Hotel Pricing Commentary:  

The Hudson - Based on conversations with NYC commercial brokers we think most mid-town, centrally located hotels trade within the 4-5% cap range.  Given the generally acknowledged perception that foreign buyers will pay a premium for higher end NYC hotels, we think the Hudson should trade on the lower end of that range if not below it.  Although public companies might have a hard time convincing shareholders that a cap rate below 4% makes sense, we think there are plenty of non-strategic buyers who would view the Hudson as a wise long term investment, particularly if they could convince a larger management company with marketing scale to manage the asset.  These hotel values also benefit from the option to convert rooms to condominiums and/or retail space.  Finally, we are giving no credit to the 60 SROs within the Hudson that ultimately will become part of the hotel over time

The Delano – Based on conversations with Miami commercial brokers and S. Florida hotel buyers, we think buyers in the Miami Beach market (Miami) are more economically driven than NYC hotel buyers given the still large white space in Miami to build higher end hotels.  However, the Delano is a very profitable hotel, including its food and beverage revenue.  It is also a destination in of itself, given its proximity to South Beach along with its very popular pool and nightclubs.  Although we don’t price it as such, it should generate a price more akin to a trophy asset than a high end luxury hotel.  

Below we summarize our pricing of the two hotels individual as well as theoretical cash on cash returns given our base case pricing.  Below that is the average of the two pricing metrics per hotel.

Clift Hotel:   Although Morgans effectively owns the Clift through its 99 year lease, the property hasn’t experienced a renovation in 15 years and its food and beverage lags similar type properties in SF, LA and NY. The Clift generates marginally break-even cash flows but would certainly benefit from a renovation and a manager with more marketing scale.  We think the Clift lease represents value for a potential buyer of Morgans but we do not include it in our valuation.

Hotel Management Asset:

Morgans manages 8 hotels currently with the 9th coming online in Q4 2015.  It also licenses its brand to two hotels and self-manages three fully owned hotels.  We break out the management fees per hotel below.  We want to stress that MHGC doesn’t break down management fees/hotel but based on discussions with the company and reconciling with historical financials, we think this a very good estimate.  We do not include the signed management agreements (the Delano Dubai and the Mondrian Dubai) in our “Total Management Fees Existing”.  However, we do include the management fees from the Mondrian Doha which is expected to start operating by Q4 of 2015 (we annualize these fees as if they will occur for the full year (2015) for valuation purposes).

Quality of contracts:  The quality of hotel contracts depends on 1) length of contract and 2) leniency of sustainability tests.  Morgans’ contracts for the most part extend out for 20 years when extension options are included.  Their contracts also contain 2 part fulfillment tests in which MHGC must miss either some percentage (usually 85%) of their forecasted budget or some percentage of a comparable RevPAR index.  Morgans must also miss these targets for 2 succeeding years.  Consequently, we think Morgans’ existing contracts are as good if not better than the average contract of the Kimpton Hotel management group (based on conversations with several hotel managers).  Kimpton Hotels is the most recent sales and probably most applicable comparable for MHGC’s hotel asset management group.  

One contract that could pose a problem in 2016 is the Shore Club which has stated that it wishes to reduce its hotel footprint to 100 hotel rooms and 85 deluxe condos.  When we value MHGC’s management fee stream we haircut the Shore Club by 100% (from $2mm to $0mm).   

Growth of Contracts: Most importantly, we think the three brand names owned by MHGC: the Delano, the Mondrian and the Hudson all have significant room to expand both nationally and internationally.  Within the US, these three brands are located in only 3 cities, missing out on many other potential regional locations; such as other west coast cities (SF, Seattle, etc.), mountain and south west cities (Denver, Phoenix, Austin, Dallas/Houston) and the mid-west and eastern seaboard cities (Chicago, Philadelphia, Boston, etc.).  Morgans recently signed two new management contracts (they will not commence until 2017) in Dubai and should find plenty of expansion opportunities in Europe (outside of London) as well as Asia where either of the three brands still resonates with the more affluent traveler (Delano, Mondrian) or the more budget-conscious but boutique-minded consumer (the Hudson).   One recent positive indicator for the Delano brand is the success of the Delano Las Vegas which opened last September.  This hotel is located in the Mandalay Bay resort and was formerly branded “The Hotel”.  Since “becoming the Delano, the property has seen more leads from Mandalay Bay’s robust convention business and has jumped over 100 spots on TripAdvisor”, according to Travel Weekly.

Morgans’ brands have suffered from their lack of a larger, more extensive marketing program, including a loyalty plan.  We think Morgans’ brands would benefit greatly from a larger, well-capitalized and international hotel manager (similar to Inter-Continental buying Kimpton).  

Valuation of Hotel Management Fee Stream:  We list below the components of a normalized 2015 management fee stream for MHGC.  We would note that it differs with our above individual hotel analysis by $2m as it accounts for the reduced fee stream from the Shore Club.  We also handicap the annualized revenue number by 25% in order to account for SG&A that a potential buyer would expense in order to maintain and grow the brand.  This 25% amounts to ~$6.25mm which we think makes sense in the context of MHGC current corporate expenses.  Currently, MHGC generates about $20mm in corporate SG&A.  Roughly $4mm of those expenses is public company costs, leaving $16mm of corporate expenses.  We assume an acquirer would be able to eliminate 60% of those costs immediately (most industry insiders thought more like 75%) which would leave the residual $6mm of corporate expenses.

In our base case analysis we use a 15x multiple of this “net ebitda” of $17.75mm ($23.66mm of management fees less $6.25mm of corporate expenses) to derive a value of $266mm for the management assets.  We believe the best comparable for this asset is the Inter-Continental acquisition of Kimpton Hotels in Dec 2014 for 21.5x TTM ebitda (InterContinental paid $430mm for Kimpton Hotels and Kimpton’s 2014 ebitda equaled ~$20mm).  We haircut the multiple we apply to MHGC by 6.5 turns v. the Kimpton acquisition multiple given Kimpton’s 52 hotel contracts and much larger corporate infrastructure and loyalty program.  However, we think the discount is conservative, particularly given the growth potential for the MHGC brands.

The “Non-Owned Management Fees  - ‘14” are 2014 management fees less MHGC’s portion of the TLG (the Light Group) revenue as well as the fees earned at the Mondrian SoHo (MHGC is no longer the manager of that hotel).  “Current Mgmt. Contracts – 14 – Annualize” are the revenues from the London Hotels (the Sanderson, St. Martin’s Lane and the Mondrian) normalized for a full year as they were off-line in 2014 for ~45% of the year as well as the revenue from the Delano Las Vegas which did not open until September, 2014.  Finally the “New Management Contracts ‘15” are the new contracts for the 10 Karakoy and Mondrian Doha.  Although the 10 Karakoy will be open for all of 2015, the Mondrian Doha will not open until Q4 2015.  We assume full year revenues for the Mondrian Doha in this valuation.

Timing

From our discussions with most informed observers of MHGC, most people do not disagree with our valuation, rather they find fault in the timing of the monetization of the assets.  After all, MHGC has been in some form of “strategic review” for over 18 months.  At its current price, the market either thinks very little of MHGC’s asset value or more likely, believes MHGC management will not monetize the assets within any reasonable time frame.  We would argue that the management change 3 weeks ago serves as the most significant catalyst for asset monetization within the last 18 months.

Shareholder Dynamics:  We think MHGC has suffered because its shareholders have historically been divided between two equally powerful groups who wanted two very different outcomes.  One group led by Kalisman (the ex-CEO) wanted to revamp operations at Morgans, including growing the brands to other markets.  This group was motivated less by short term price appreciation and more by the upside optionality that would come from merging MHGC’s brands and public stock with a private hotel manager whose scale could add incremental value to the MHGC assets.  This strategy could work well if 1) MHGC could lower its operating costs and grow its brands in a meaningful way and 2) could find a private, scalable operator who wanted to merge with MHGC.  Unfortunately, this group couldn’t cut expenses fast enough or grow quickly enough to achieve any meaningful financial value and the most optimal candidate for a reverse-merger (the Kimpton Hotels) was bought in Dec 2014.  Despite a poorly performing stock and continued shareholder dissent from some of the larger shareholders (we have heard both Burkle and Lorber were increasingly critical of the strategy), MHGC continued to pursue the strategy through April of this year.  Although we credit Kalisman with signing new management contracts in the Middle East (and affirming the value of the Delano and Mondrian brands), he ultimately failed to add any value over the Kerrisdale/Burkle strategy to sell the company in the spring of 2014.  In fact, if measured by the stock price, he failed significantly ($7.80 in May, 2014 v $6.58 today).  

The second group (led by Burkle and allied with Lorber) values short-term appreciation and liquidity over “potential self-created” longer term value.  This group in general bought their common stock at much lower prices than the Kalisman group (~$7/share v. $15/share) and therefore would accept lower prices than Kalisman on the eventual sale of the company.  Furthermore, this group, unlike Kalisman who manages his own family capital, must answer to other investors/shareholders, particularly when illiquid investments do not perform and consequently, do not have luxury of a multi-year time horizon.

We think this group was beginning to actively confront Kalisman about the lack of success of his strategy when Kalisman’s personal situation changed dramatically.  Kalisman’s grandfather, Alfred Taubman, unfortunately passed away in April and Kalisman became one of the primary managers of the multi-billion dollar Taubman estate.   Kalisman’s MHGC common stock position immediately became one of his smaller positions and his CEO position, likewise, reduced materially in its importance relative to his new duties with the Taubman family estate.  Kalisman resigned his position at the end of May and effectively ended the corporate strategy of improving MHGC assets while looking for a longer term operating partner through a reverse merger.

Howard Lorber assumed the Chairman role of MHGC after Kalisman’s resignation and has now directed Morgans to directly pursue the “second” shareholder group’s strategy to sell the company’s assets to a larger hotel owner/manager as soon as possible.  For those unaware of Lorber’s bio, he is the CEO of the Vector Group, a $2.5bln market cap holding company that owns businesses in tobacco (Liggett Tobacco), commercial real estate (Douglas Elliman Realty), various direct commercial and residential real estate investments, hotels (Morgans as well as several independent projects), financial services (Ladenburg Thalmann) and liquor manufacturing/distribution (Castle Brands).  Lorber also serves as the chairman of Douglas Elliman, the largest residential real estate broker in the NY MSA.

Sale Dynamics:  Morgans also suffers from the dynamic that it possesses two assets that are worth more in the hands of two very different investor groups then they are as one entity.  Larger (and most likely public) hotel management companies can provide the most scale to the MHGC hotel management assets and are therefore, the highest bidders for those assets.  The Delano and the Hudson, on the other hand, are most valuable to an institutional or high net worth capital provider who range between Chinese insurance companies ( Howard Lorber’s 111 Murray Street project just received a “9 digit” investment from an unnamed Chinese insurer and the Chinese insurer Anbang Group bought the Waldorf in Feb for $1.95bln) and high net worth investors (the Nakash family, founders of the Jordache Jeans empire, purchased the Setai Hotel (Miami Beach) in December 2014).  This investor types value return of capital v. return on capital as well as the cachet attached to owning a landmark hotel in a gateway US city.  

The management contracts that implicitly are attached to the owned hotels make the separation of these assets more difficult than appears at first glance.  Because management fees from owned hotels represent over 25% of Morgans’ 2015 normalized management fees,  Morgans (or rather the ultimate buyer of Morgans’ brands) only wants to sell the hotels to a buyer who will renew Morgans as the hotel manager.  Consequently, if MHGC wants to maximize the price it receives for its assets, it needs to line up two sets of buyer for its company; the hotel management buyer (and most likely conduit for the hotels) and the ultimate hotel buyer.   This is a complicated sales dynamic and would lead to longer sales negotiations than a more straight forward asset sale.  We think this dynamic combined with the previous management strategy has produced zero strategic review announcements in 12 months and a stock trading at its 12 month low.

Overall Valuation

A SOTP analysis of MHGC assets requires detailed accounting for its liabilities and assets.  We break out the assets and liabilities below along with the most current share count and the potential dilution from Yucaipa’s warrants.

All of the liabilities and cash are taken from MHGC’s balance sheet as of 3/31/15.  We assume the full face value for the preferred stock owed to Yucaipa.  We also assume MHGC would have to pay all of their “Other Liabilities” which is primary a lawsuit brought by Ian Schrager against the former parent of MHGC.  We doubt the actual settlement would equal this amount.   Cash includes restricted cash since restricted cash is released once the hotels are sold and their debt is repaid.  Finally, MHGC has in excess of $380mm of NOLs and we value these at 15% of $380mm since a buyer of MHGC could use the NOLs to offset future capital gains.

Below we list the bear, base and bull case scenarios for MHGC common stock.  We list the key assumptions that drive the valuation as well.  We think the bear case is a very low probability (<10%) given that it will occur only if there is a major economic shock between now and when MHGC announces a deal.  We also think it is equally as likely for either the base or bull case to occur.  Either scenario depends on how well MHGC management can optimize pricing between the likely ultimate buyers of the hotels and the hotel asset management assets (they will not be the same) within the next 10 weeks as we think there is tremendous pressure on management to complete a deal as quickly as possible.

We would also point out that our valuation doesn’t include any potential settlement between Deutsche Bank and MHGC over the termination of MHGC’s management contract of the Mondrian SoHo.  In April of 2015 MHGC was replaced as the manager of the SoHo by the new owner despite Morgans’ outstanding long term management contract attached to the property.  MHGC is suing Deutsche Bank for $100mm as it believes DB wrongfully misrepresented MHGC’s long term rights as the hotel manager to the new owner.

Summary

We think the underlying assets of MHGC deserve a materially higher valuation than currently awarded by the market.  We think most of this discount stems from a lack of clarity on the timing of the monetization of MHGC assets.  We think the recent management change at MHGC marks a clear change in corporate strategy and we are confident the new strategy will focus on the sale of the entire company to a 3rd party (most likely a strategic buyer).  Finally, we think the company is sold within the next 10 weeks.  Our conviction on the timing comes from several industry sources as well as commentary from the company about the desire of Lorber to complete the strategic review in a timely manner.  We would note that the company’s hotel debt carries pre-payment penalties up until August of 2015 which leads us to assume any deal would close after August but certainly could be announced before August.  

The sales dynamic described above could lead to a wider range of upside value than we have estimated in our base and bull case.  However, we are confident that Burkle and Lorber are the right people to lead the monetization process and ultimately, we believe MHGC stock is materially higher than its current price.

Risks

• A macro-economic shock that reduces demand for hotels and leisure travel

• Liquidity – the stock is very illiquid and any 100k shareholder who wants to sell (or buy) will move the stock 2-3% on any given trading day

• Kalisman attempts to thwart any transaction that doesn’t result in a materially higher stock price –  as detailed above we think this is a remote possibility

Catalyst

-Potential sale of MHGC within 10 weeks