Description

TravelCenters of America (“TA” or the “Company”) operates a network of 163 travel centers (truck stops) located along major highways.  The Company was recently acquired by the REIT Hospitality Properties Trust (“HPT”) from its previous owner, Oak Hill Capital Partners for $1.9 billion.  As part of this transaction HPT acquired TA and concurrently spun off its operations into a new public company, TA, while retaining the associated real estate assets.  TA began trading on 2/1/07.  This is a classic undervalued spin-off because of the following characteristics: 1) the shareholder base of HPT, primarily REIT holders, had little interest in owning an operator of truck stops, 2) the deal was not marketed at all – no roadshow, investor presentation, or other materials besides an S-1 filing and 3) the relative sizes of the parent and spin off – HPT shareholders received 1 TA share for every 10 shares of HPT owned.  The dynamics of this transaction have all of the hallmarks of a security that will not be valued highly by the market. 

In the LTM period ended 9/30/06, TA generated $4.8 billion of revenues, $179.1 million of EBITDAR and $25.6 million of EBITDA and is currently valued at only $90.7 million on an enterprise value basis. 

I will point out from the start that this is a risky investment due to the lease deal that was negotiated between HPT and TA.  The lease agreement clearly appears to have been structured to funnel as much cash flow as possible from TA to HPT in the form of rent payments.  Despite this fact, I view TA as dramatically undervalued with a very strong likelihood of significant appreciation once the shareholder base transitions to a more appropriate long term base and the story is heard by investors.

Business Overview

TA operates a network of 163 travel centers located along US highways.  These travel centers are designed primarily to serve long haul truckers as well as other motorists.  A typical travel center contains:

• 20 acres of land with parking for 170 trucks and 100 cars
• 1 full service restaurant and 1-3 QSRs that operate under many of the major national QSR franchises
• A truck repair store
• Diesel and gasoline fueling stations
• A c-store, game room and other amenities (showers, bathrooms etc)
• In some cases a hotel

In terms of the network of 163 travel centers, these break down as follows:

• 136 centers that are leased from HPT
• 3 centers leased from 3^rd parties
• 1 center in Canada that is owned and operated by TA
• 3 centers that are leased from 3^rd parties
• 10 centers that are leased from HPT and subleased to franchisees
• 13 centers that are owned and operated by franchisees

All in all, the network of 163 travel centers contains 149 full service restaurants, 223 QSRs and 21 hotels (798 rooms).

The industry is attractive in the sense that the Company’s properties have been in place for a long period of time and have prime locations along the highways.  The number of attractive locations to build large new travel centers is limited these days.  The industry is highly fragmented as there are in excess of 3,000 travel centers or truck stops located nationwide.  To my knowledge, there is only one other large player in the industry – Flying J, a private company with 220 locations and 30 more currently under construction.  The fuel market is highly competitive and low margin, but profits are generated primarily through non-fuel sales.  This fact gives larger travel centers a competitive advantage as they can price fuel as a loss leader and generate substantial profits from non-fuel sales

See the table below for a breakdown of revenue and gross margin between fuel and non-fuel:

I think that over time there is a substantial opportunity for TA to extend its brand of travel centers through greenfields and acquisitions.  In this regard, HPT will act as a capital partner in the future (more on this later).  The benefits to consolidation are significant on both the cost side (purchasing power for diesel fuel, distribution efficiencies for QSR restaurants and truck repair services etc.) and in terms of having a nationwide brand of travel centers that has a consistent look and feel to attract long haul fleet and independent truck drivers.  Over the last few years the Company has spent significant capital to improve and standardize the look and feel of its centers – I would refer you to the company’s website:  http://www.tatravelcenters.com/taweb/home.aspx, for pictures of the Company’s travel centers.  In addition HPT has agreed to help finance the continued improvement of the Company’s travelcenters over the next 5 years (more on this later).

Relationship with HPT

The balance of power in the relationship between HPT and TA clearly rests with HPT.  The leases are triple net and year 1 annual rent is $153.5 million vs. LTM 9/30/06 EBITDAR of $179.1 million.  Clearly, the Company is leveraged aggressively out of the gates.  The rent level bumps to $157mm in 2008, $161mm in 2009 and so on.  Beginning in 2012, percentage of revenue increases kick in.  There will be incremental lease expense from the prior year in an amount equal to 3% and 0.3% of the increases in non-fuel and fuel revenues, respectively.

Another important point to disclose is the potential for conflict of interest.  Two trustees of HPT will serve on the board of TA and are likely looking out for HPT’s interests more than TA.  Further, REIT Management, an entity controlled by Barry Portnoy (trustee and largest holder of HPT stock) will be a director of TA and has negotiated a “management services contract” with TA that pays ~$6 million in the first year from TA to REIT Management for HR services, investor relations etc.  This contract expires at the end of 2008.  This expense item is included in all financial information presented in this write-up.  Further, the lease agreement between HPT and TA effectively prohibits a change of control of TA or asset sales without consent.

Aside from the mostly negative factors surrounding the lease deal, HPT has agreed to play an extremely constructive role in the liquidity and future growth prospects of TA.  Specifically, HPT has agreed to fund $125 million of improvements to TAs travel centers staged $25mm/year for the next 5 years.  This will act as a significant liquidity benefit to TA and will also allow the Company to continue to improve the quality of its travel centers.  Furthermore, HPT and TA will agree on an annual capital expenditures budget which HPT will fund for renovations, equipment and improvements at the travel centers.  These capital expenditures funded by HPT will result in incremental rent to TA equal to the amount of capital expenditures multiplied by 8.5%.  These two factors will increase TAs liquidity and operating flexibility significantly given the high level of operating leverage.

Financial Overview

The following is an overview of TA’s financials since 2003, including pro forma rent and the management services contract.  Note that some of the leases were accounted for as capital leases (the ones that TA leases from HPT and then subleases to franchisees).  For purposes of my financial analysis, I treat this as rent above the EBITDA line as I believe it is a more appropriate way to analyze the business.

There are two other items worth mentioning regarding the financials above.  First, I applied the 2007 pro forma rent level across all of this historical financials to illustrate how the Company would have looked historically with the current lease structure.  Clearly, this is conservative since historical lease payments would not have been at the same level as they will be in 2007 since there were fewer centers in operation and because of inflation.  Second, it is somewhat unclear as to what maintenance capital expenditures will be going forward but I think it is clear that they will be much less than the historical numbers presented above.  This is due to the funded capital expenditures and annual maintenance budget from HPT that is described above.

Valuation

As shown below, the market is valuing TA at just $90.7 million on an enterprise value basis.  This represents just 3.5x LTM EBITDA for a business with huge scale and significant operational upside.  Though I can’t define an exact number I believe there is potential to generate EBITDA significantly in excess of current EBITDA as the company continues to improve its travel centers.  As a further check on value, the current market capitalization represents a multiple of 1.1x tangible book value.  As discussed above, in my analysis I choose to treat the capitalized leases as operating leases.  The payments to HPT on these capital leases are mirrored by lease income from TA’s franchisees; hence I treat the “interest expense” related to these capital leases as rent and exclude the capital leases from the enterprise value calculation.

I have a price target on TA of $60.  At $60, TA would have an enterprise value of $315.3 million.  This seems like a reasonable value for a business that has 149 full service restaurants, 223 QSRs, 21 hotels, and $866 million of ­non-fuel revenues.  This is not to mention the $125 million of funded capital expenditures from HPT over the next 5 years.  Based on LTM financials, a $60 price would represent 12.3x EBITDA, 1.8x TBV and 0.4x revenues but as stated above I believe there is significant upside to the EBITDA number over time.

Risks

The key risks in this investment are clearly the level of operating leverage and the potential conflicts of interest. 

With respect to the leverage and potential for liquidity problems should profitability temporarily decline, the key mitigants include 1) the $125 million of funded capital expenditures from HPT, 2) the fact that the Company was capitalized out of the gate with significant excess cash of $213 million, 3) HPT’s commitment to funding ongoing maintenance and improvements and 4) HPT’s overall interest in seeing TA be a financially healthy enterprise and the unattractiveness to HPT of seeing TA in financial distress or a BK where they could reject the leases.

With respect to the conflicts of interest, the key mitigant is again the fact that incentives here are aligned such that it is in HPT’s interest that TA is successful.  However, this is my #1 risk factor as it relates to this investment.

Catalyst