Description

 Investment Thesis - TravelCenters is a long because:

¦ TA trades at about 2x normalized cash flow.

¦ Minimal liquidity risk makes a permanent impairment of capital unlikely.

¦ The company's well-documented corporate governance issues should not be overly problematic.

Maybe the third time's a charm ... TA has been written up twice before on VIC as a long idea (by madler934 in February 2007 at $34.50/share and in November 2007 by ladera838 at $26/share). At the time, TA appeared to have the characteristics of a classic orphaned spin-off. However, a combination of high operating leverage, strong sales correlation to U.S. economic activity and shady corporate governance combined to burn holders (including many thoughtful value investors). While these issues remain, the extremely low valuation and progress on cost reductions warrant another look at TA.

(Please refer to the previous write-ups for a description of TA's business and recent history)

TA's sales volumes are closely tied to overall U.S. economic activity; nearly everything manufactured or consumed in the U.S. is on a diesel-burning truck at some point.  As such, it is perhaps not surprising that a regression of real GDP vs. on-highway diesel demand over 23-years of data yields an r-squared of 0.995. As much as we all might like this to change, the United States' infrastructure is such that trucking is likely to remain the main mode of industrial transportation in this country for a very long time.  

With fixed costs of nearly $1B/yr (rent, labor, G&A, etc.), TA exhibits a high degree of operating leverage. Given the high operating leverage and correlation to the macroeconomy, as shown in Figure 2 below, even a moderate return to normal economic conditions would cause TA to become reasonably profitable. Therefore, "normalized" EBIT of about $50mm/year seems reasonable.

Figure 2: TA Normalized Earnings

Thus, assuming a current EV of $84mm (market cap of $64mm + capitalized leases and deferred rent of $177mm - excess cash of $150mm) TA currently trades at about 2.5x normalized NOPAT, which implies an equity value of approximately $15-$20/share or 4x-5x the current stock price, using a 10% cost of capital and backing out the liabilities and nonoperating assets (as shown below).   

Figure 3: Earnings Power Value

Other key valuation assumptions include:

• 1) Normalized sales volume 10% higher than LTM volumes - Based on the low end of recently released Fed GDP forecast for 2010 and 2011 only (6.5%) plugged into the long-term demand, regression yields a 13% expected increase in on-highway diesel demand. To be conservative, I gave a haircut to this.
• 2) Normalized crude price of $80/barrel - Based on approximate cost of incremental supply.
• 3) Normalized fuel margins at $80 crude of 5%-6% - Based on historical analysis of TA/competitor margins and conversations with industry participants. On a per-gallon basis, this is at or very slightly above LTM levels. Note: this may appear higher than TA's historical margins as TA had a very low/negative wholesale fuel business that it exited in 3Q08. Some have suggested that the expected merger between Pilot and Flying J could increase pricing power in the industry (http://www.glgroup.com/News/Major-Truck-Stop-Competitors-Merging---Flying-J-+-Pilot-=-Higher-Retail-Prices--41475.html), which could cause this assumption to be too conservative.
• 4) $0 value for NOLs.

Furthermore, TA has almost no liquidity risk, making it difficult to see how you lose here. TA has minimal covenants on its credit facility, ample liquidity ($185mm of cash on the books and another $40mm+ in available credit and assets sale allowances) and a landlord that has proven willing to be constructive. TA's landlord, Hospitality Properties Trust (HPT), has allowed TA to defer rent payments up to $5mm per month through the end of 2010. This rent deferment is not motivated by altruism. HPT took its pound of flesh in the form of 1.5mm common shares and a 12% interest rate after 2009. More important, however, since TA represents over 30% of HPT's operating income and over 40% of HPT's assets, TA's landlord will clearly do whatever is necessary to keep its tenant solvent.

TA has well-documented corporate governance issues regarding the company's relationship with HPT and REIT Management. On January 31, 2007, HPT purchased TA for about $1.9B. Subsequently, TA entered into a lease agreement with HPT for nearly all the company's properties and TA was spun off to shareholders. At the same time, TA entered into an agreement with REIT Management under which REIT Management would provide "services" in exchange for 0.6% of gross fuel profit and 0.6% of nonfuel sales. Currently this is about $9mm/year. REIT Management has a similar relationship with HPT and several other REITs once affiliated with HRPT Properties.

TA's CFO and CEO are also employees of REIT Management. The CEO used to work at HPT, and TA's chairman, Barry Portnoy, is the majority owner of REIT Management. As such, while TA's current relationship with HPT/REIT Management is not overly concerning - what these relationships could lead to is a serious issue.  As natey1015 pointed out in a response to the last TA write-up: "The other main question is where is management's bread really being buttered? ... we know that Reit management gets management fees from HPT based on assets managed. So the bottom line is that it is in Reit management's best interest for TA to grow the number of sites even if the returns are not sufficient because Reit management gets paid twice on that"

Clearly this is not an ideal situation, but there are several reasons I think you're going to be OK here:

• 1) After the end of the year, the company's CEO, Thomas O'Brien, will own an interest in approximately $2.5mm worth of TA shares while HPT owns $6mm worth, giving both an incentive to see shares rise.
• 2) In August, independent director Barbara Gilmore purchased $29k of common stock at about $3/share. This is a significant investment for Ms. Gilmore, and I do not believe she would have made the purchase unless she believes that much of the future value would accrue to common equity holders.
• 3) TA's payments to REIT Management are fairly small (for both parties). Thus, I do not believe that REIT Management would risk angering shareholders, as it needs the support of equity market to grow its other larger businesses.
• 4) Any significant growth by TA would almost certainly require an equity offering. As such, TA's growth (and thus growth in payments to REIT Management) will be exceedingly slow unless equity holders have faith that management will act in their interest.
• 5) Past proxy fights and ongoing shareholder litigation will hopefully encourage management to do the right thing.

The bottom line is that these corporate governance issues probably mean that once the company has paid off its liabilities, $1 on TA's books may be slightly less than $1 to a shareholder - I don't like it either, but you're getting in cheaply enough that you can live with it.

Catalyst