Friday, November 25, 2016

Hilton Worldwide: Management Co, Hotel REIT, Timeshare Business

I mention from time-to-time that I co-host a monthly Special Situation Research Forum discussion group sponsored by CFA Society Chicago where we pick a specific company each month and have a deep dive discussion on it.  This month we picked Hilton Worldwide (HLT) which is splitting into three companies at the end of the year by spinning off its owned real estate into a REIT, Park Hotels & Resorts (PK), and its timeshare business, Hilton Grand Vacations (HGV), leaving an asset-light management company as the remaining parent.  The choice was made before the election and ensuing stock market run up, so while the situation is a little less compelling as one company today, as we've seen with RR Donnelley's (RRD) three way split, a lot of market distortions can happen in these scenarios which makes Hilton worth investigating ahead of time.

Founded in 1919 by Conrad Hilton, Hilton Worldwide is the second largest hospitality company with over 4,800 hotels flying one of their brand's banners across 104 different countries.  Hilton was one of the largest leveraged buyouts before the financial crisis with Blackstone taking it private for $26B in 2007 and then subsequently taking it public again in 2013.  Blackstone made out surprisingly well in the deal, and since reappearing on the public markets Hilton has been following the trend towards an asset-light management company model.  To that end, earlier this year Hilton announced intentions to break up into three companies, which should happen by year end.

Current corporate structure:
Post-spinoff corporate structure:
Why do the spinoffs?
  • Typical spinoff rationale of varying capital structures, aligning incentives, investor choice, etc.
  • REIT valuation arbitrage, as a pass through entity that pay high dividends REITs are valued more richly than the same real estate would be within a larger Hilton.
  • Financial engineering of turning Park Hotels management fees and Hilton Grand Vacations licensing fees from an expense that's eliminated in consolidation to a revenue stream at the parent Hilton where they'll likely earn a higher valuation than either spinoff.
  • The parent will be a vast majority of the value, by simplifying the business towards the management contracts, the parent should earn a higher multiple.  The market values simplicity, all three entities will be easier to understand separate than together.
Additionally, Hilton's larger rival Marriott (who recently merged with Starwood) has done similar spinoffs in the past of Host Hotels & Resorts in the 1990s (highlighted in Greenblatt's book) and Marriott Vacations Worldwide in 2011.  There's a clear precedent for this split-up and both Marriott spinoffs have been successful.  Hilton's current CEO, Christopher Nassetta, previously headed up Host Hotels and knows the playbook to make this a successful split-up.

Park Hotels & Resorts (PK)
The larger of the two spinoffs will be one of the last REIT spinoffs, Hilton secured an IRS private letter ruling before the crackdown in late 2015.  The new rule prevents spinoffs from converting to a REIT for ten years after the spin date, effectively eliminating the loophole.  Park Hotels & Resorts will be the second largest lodging REIT behind the old Marriott real estate spin, Host Hotels & Resorts (HST), and significantly bigger than the third largest in the sector.  Now that REITs are their own sector of the S&P 500, some active managers will be forced to add REITs where they were previously underinvested, as a sizable lodging REIT, Park Hotels might be a beneficiary of that index change.

Park Hotels will start off life with 36,000 rooms across 69 hotels, heavily tilted to their largest ten convention and resort style hotels below.  Due to their locations, these hotels are more difficult to replicate and thus face less competition than midscale and economy tier hotels in suburban locations.
Park will only have exposure to Hilton brands initially, but I don't see that as big of a problem as other single exposure REIT spinoffs as its an easier task to rebrand a hotel than say an Ameristar casino or an Olive Garden restaurant.  Park does intend to diversify away from Hilton's brands via acquisition, there are 22 public lodging REITs, some consolidation of this sector seems likely with another big player in the mix.  REITs are one of the few areas where M&A makes a lot of sense as operations are easier to integrate and G&A can more easily be cut at the target thereby spreading the parent's corporate expenses over a larger asset base.  Besides straight M&A deals, REITs can also take advantage of private/public valuation arbitrage, the public markets often times take shortcuts in valuing REITs (me included) and don't make cap rate adjustments for different local markets.  Assets in prime locations that would fetch very low cap rates are grouped in with the rest of a portfolio.  For example, last year Hilton sold the Waldorf Astoria hotel on Park Avenue to a Chinese buyer for 32x EBITDA, an amazingly high multiple, and invested the proceeds in Orlando and Key West hotels via a 1031 exchange at 13x EBITDA (still not cheap) as a way of recycling capital and showing higher EBITDA/FFO irregardless if the underlying real estate value didn't change.

Lodging REITs are on the riskier side of the REIT industry as their leases are the shortest, one night at a time, versus apartment REITs with 1 year leases, or office and industrial REITs that can have average lease terms of 10+ years.  It's not a great business, if it weren't for the REIT tax-free pass through status and investors desire for yield, Park Hotels would be the classic capital intensive bad business that the parent company is trying to shed via a spinoff.  Park puts up all the capital and has to pay Hilton 3% of gross hotel revenues, an incentive fee of 6% of hotel earnings and reimbursement of staffing and operating costs.  Lodging REITs are better than other franchisee businesses because of the tax-free pass through status, but otherwise it's very similar.  Although with corporate level taxes potentially coming down, REITs may lose some of their appeal.

Back to Park Hotels, a few of the particulars:
  • Tom Baltimore will become the CEO, he was previously the CEO of RLJ Lodging Trust and recently left that post specifically to become the CEO of Park Hotels & Resorts after the spinoff.  He's previously worked for Hilton, Marriott and Host Marriott at different times so he likely understands the benefits of the spinoff.  Part of his incentive compensation will be based on Park Hotel's total stockholder return compared to the FTSE NAREIT Lodging/Resorts Index over a 3 year period.
  • 90% of Park's hotel exposure is in the U.S., 10% is abroad, Hilton had to be careful to minimize the international exposure in order to meet REIT requirements.  I'd expect Hilton to continue to divest the owned international real estate in smaller one off transactions.
  • 85% of their hotels are upper upscale and luxury brands, basically this means the flagship Hilton brand level and higher.  90% of their rooms are either urban, resort, or airport hotels, versus only 10% in suburban locations with less barriers to entry.
  • There will be a special purging dividend of roughly $200MM sometime after the spinoff, 80% of the special dividend will be in stock (but still taxable) and 20% in cash.
  • Target leverage of 3-5x EBITDA, generally Lodging REITs are less levered than other REITs due to their cyclical nature.
  • Included in Park are 4 operated hotels and a laundry service business, likely these are the active trade businesses ("lemonade stands") that are required for a tax free spinoff.
Host Hotels is the best and clear comp, however Park Hotels probably deserves a little discount to Host because it's not diversified among hospitality management companies and doesn't have the long track record.  Host trades for 11.1x EBITDA, Park should trade for at least 10x EBITDA, especially given their hotels in New York, San Francisco and Hawaii, plus remember they bought their Orlando and Key West hotels at 13x EBITDA.  Park will have $3B in debt and has proforma 2016 EBITDA of $775MM, at 10x, Park's equity value should be $4.75B or $4.80 per share of HLT.

Hilton Grand Vacations (HGV)
Timeshare spinoffs have been officially a thing for a few years now, Marriott spun off Marriott Vacations Worldwide (VAC) in 2011 and Starwood completed a spinoff via a reverse morris trust of their Vistana Signature Experiences timeshare unit with ILG (f/k/a Interval Leisure Group, ILG) earlier in 2016.

The latest timeshare spin, Hilton Grand Vacations will have more than 265,000 timeshare owners, 46 resorts, and over 7,500 units.  Since being acquired by Blackstone, Hilton has made over its timeshare business to be predominately an capital-light model where instead of developing and funding the construction of the resort themselves, Hilton Grand Vacations partners with third-party developers (PE real estate funds) who then contract out the timeshare share sales and resort management to HGV for a fee.  More than 75% of their timeshare sales now comes from this fee-for-service or a just-in-time inventory method versus 0% in 2009, this has greatly increased ROIC.
Timeshare companies typically make money in four different ways:
  1. Selling timeshare units, this is a cyclical, expensive (tours, free vacations, etc), yet profitable business that's still significantly below pre-financial crisis levels.
  2. Financing the timeshare sales, this is a great business, typically these are 10 year fully amortizing loans that carry interest rates of 10-18% depending on downpayments and FICO scores (HGV's typical buyer has $100+k income and a 745 FICO score).  These loans then get securitized and sold with the timeshare company receiving servicing fees and an equity strip.  Timeshare securitizations have performed surprisingly well throughout the market cycle.
  3. Management contracts on the timeshare resorts, this is another great business, timeshare companies typically charge ownership associations a fee in a cost-plus arrangement (cost + 10% in HGV's case) for managing the resort and up-keeping the property, rooms, etc.  While the hotel management companies typically take a clip off of revenue, here the timeshare companies are taking one off of expenses, the result is a lower upside but a lower risk recurring revenue stream.  The management contracts are sticky, HGV hasn't had a contract terminated since the unit was created in 1992.
  4. Rental income from unsold inventory, units that haven't been sold to a timeshare purchaser can be rented out like any other hotel room, this is less than ideal but is a way of reducing inventory drag as timeshare units are sold.
Another interesting dynamic of the industry is the lack of a secondary market for timeshares.  Once you purchase a timeshare, it's difficult to sell them because the industry makes it difficult by offering perks only to members that buy directly from them that secondary purchasers aren't eligible for.  Another big factor is that there's a lack of financing options for secondary market timeshares, no one will lend to them because there's essentially no collateral.  The timeshare companies themselves are willing lenders because if a loan defaults, that timeshare unit can be foreclosed on and put back into their inventory to be sold to another buyer rather easily.  That mechanism isn't really available to anyone else.

Back to HGV, Mark Wang leads the division now and will be the CEO once the spinoff commences.  He's been in charge of Hilton's timeshare operations for many years and as led the company through the current transition to an capital light business model.  Unlike Park, HGV doesn't plan to diversify away from the Hilton Brand and has signed a 100 year licensing deal to use the Hilton brand name in exchange for 5% of timeshare sales.  Mark Wang has done an admirable job at HGV, they've grown timeshare sales every year through the recessioin, with a CAGR of 7.9% from 2007 to 2015, outperforming the industry, which experience a decline of 2.6% over the same time.

Marriott Vacations Worldwide (VAC) is a pretty good comp, their business segments are nearly identical with Hilton Grand Vacations being a little farther along in their move to a capital light model.  VAC trades for about 8x EBITDA (excluding securitization debt), HGV's proforma 2016 EBITDA is expected to be $380MM and it will have $500MM of non-recourse debt, at 8x EBITDA the equity value of HGV should be $2.54B or $2.56 per share of HLT.

At a $2.5B market cap, Hilton Grand Vacations has the potential to be sold by large cap indexes and unlike Park Hotels & Resorts, HGV won't pay a dividend and doesn't have the REIT investor backstop, in my mind it has the most potential to be mispriced following the spinoffs.

Hilton Worldwide (HLT)
Following the spinoffs of PK and HGV, the parent Hilton Worldwide will generate over 90% of its EBITDA from fee based capital light sources, the remaining 10% from owned hotels which should go down over time in smaller owned hotel sales and as the fee based business continues to grow organically.  Hotel management is a great business as others put up the capital to develop and construct the hotels and then contract out to the likes of Hilton to manage the hotel and be included in their rewards program (HiltonHonors) which brings immediate patronage that being an independent hotel otherwise wouldn't.

Hilton is able to grow very quickly with minimal additional invested capital, since year end 2007, as shown below, Hilton has invested $184MM in the fee businesses which has created an additional $726MM in run rate EBITDA.
Hilton's pipeline is equally impressive, they currently have 789,000 rooms in the system or 4.8% of the global supply, but have over 21% (288,000 rooms) of the new development pipeline (again at minimal additional investment), which should drive growth for years to come.  Next year they expect to add 50,000 - 55,000, or a growth rate of about 6%  from current levels, much of this growth is in overseas markets.
What will Hilton do with their cash flow?  Management's plan is to maintain a low investment grade credit profile, dividend out 30-40% of recurring cash to shareholders, with the remaining cash flow available for share repurchases in a new program to be initiated after the spinoffs occur.  So with Hilton, you have a business that needs very little capital to grow and will return the vast majority of cash to investors via dividends and share repurchase, the best of both worlds.  Marriott paid 14x EBITDA for Starwood earlier this year, backing out a takeover premium and valuing Hilton at 13x EBITDA seems reasonable to me.  At 13x, with $1.76B in 2016 EBITDA and $6.1B in debt would make the equity worth $16.8B or $16.97 per share of HLT.

Adding up the three pieces and I come up with $24.33 per share, a slight discount to the current share price of $25.31 and the $26.25 that HNA Group recently paid for a 25% stake from Blackstone (BX).  This is more of a growth situation than value, and much of the valuation rests on Hilton Worldwide's EBITDA growth trajectory, which since it's not the spinoff, we have little insight into how they've calculated the proforma 2016 EBITDA.  They've disclosed approximately $200MM in transaction expenses, which seems extreme to me, and there's roughly $180MM in management and licensing fees coming from the two new spinoffs into the parent.  If those aren't included in the proforma number or somehow netted against the transaction costs, that would be an additional $2.36 per share in value, plus the additional organic growth coming online in 2017.  I've seen 2018 EBITDA estimates above $2B for proforma Hilton.  The company is hosting an investor day on 12/8, maybe we get some more clarity on the parent at that time.

For now I've just purchased a placeholder position via just in the money January 2018 calls.  If the growth strategy works out, so will my LEAPs, if not, I've limited my downside.  Once the spinoffs occur maybe one of the three will be more interesting as the investor bases turnover.

Disclosure: I own HLT LEAPs

Wednesday, November 16, 2016

Resource Capital Corp: Dividend Cut, New Management Simplifying Portfolio

C-III Capital Partners, led by Andrew Farkas, in September closed on the purchase of Resource America (REXI) which was the external manager of Resource Capital Corp (RSO), a troubled commercial mortgage REIT that has struggled since the financial crisis.  Prior to the financial crisis, as was popular, Resource Capital financed most of their commercial real estate loans through the CDO market, unlike the other mortgage REITs of that era, the company has pretty much stuck to that strategy creating a confusing portfolio with a eclectic mix of assets financed through securitization structures.  These assets include syndicated bank loans, middle market bank loans, life settlements, etc., more fit for a BDC but all squeezed into the 25% taxable REIT subsidiary carve out along with another side pocket of residential mortgages and mortgage servicing rights.  To be cynical, it appears that prior management would see an opportunity to earn a fee managing a new pool of assets, and simply used Resource Capital as a seed investor whenever needed, how else do you end up with that mix of assets in a commercial mortgage REIT?

The company reported third quarter earnings on Monday, first under C-III, and new management basically hit the reset button on the balance sheet, strategy, and the dividend policy all in one swoop.  Book value went from $17.63 to $14.71 per share as they took several impairment charges, and the dividend was cut from $0.42 to $0.05 per quarter.  The result was as you'd expect with many yield investors selling sending the stock down ~30% as they reacted to the dividend cut irrespective of the underlying value.  While certainly tough for previous RSO shareholders, the changes C-III Capital is making should result in the company trading closer to book value over time compared to a 40% discount today.

Capital Structure: $275MM market cap ($450MM book value), $270MM in preferred stock (3 tranches), and $1.4B in debt (both recourse and non-recourse).  Resource Capital reports leverage just under 2x which includes the preferred stock in denominator, putting the preferred in numerator would result in the common shares being levered 3.7x equity.

New Business Plan
The old plan in the 10-K.  It's odd that they use "commercial finance assets" for bank loans and CLOs, never heard that before but maybe because it sounds closer to "commercial real estate"?
C-III Capital's plan:
"Our plan, candidly, is simplify the Company and make it more understandable for investors and improve the transparency of RSO's performance.  We're going to do this by disposing of underperforming assets, divesting non-core businesses, and investing solely in CRE assets that produce consistent recurring cash flows and pay dividends out of earnings and not just out of cash that's on the balance sheet." - Bob Lieber, RSO CEO
The fact that this is a new plan says a lot about previous management.  I've talked about how public investors, especially in REITs like clean and simple portfolios, and that investors could get ahead of this when management is prepared to execute on that plan.  We saw that with Gramercy Property Trust (GPT) twice, first when they were transitioning from a mREIT not unlike Resource Capital to a triple net REIT and second when they absorbed the mix and match portfolio that Chambers Street Properties had created as a private REIT.  A good example of that today would be iStar (STAR) as they clean up their foreclosed operating and land assets, eventually returning to a hybrid mortgage and net lease REIT.  I think Resource Capital could do something similar as Gramercy and iStar, but in a quicker 12-15 month timeline.

The good news is that roughly 70% of Resource's portfolio is already CRE whole loans with a subset of that being legacy pre-2007 loans.  But most of these are senior mortgages on stabilized properties, 80% LTV, 3-5 year maturities and financed with cheap non-recourse (to RSO) funding via securitization structures.  They're currently passing all their OC/IC tests in these structures, if these were to fail cash flow would be diverted to pay down the senior notes.  This portfolio can earn mid-teen ROEs before expenses.
Outside of the CMBS piece, the rest of the assets (C-III's pegs it at 22% of the portfolio) are now considered non-core and will either be sold or allowed to runoff (much of it in the next year).  Included in ABS and other is more syndicated and middle market bank loans that are held via CLOs, these can either be sold into the secondary market or possibly Resource could utilize call features as the equity holder and liquidate the CLOs as pricing on bank loans has bounced back significantly from earlier in the year.  To quote the CEO again:
"To summarize, our strategy is to prudently divest non-core and underperforming assets, which account for nearly $0.5 billion, or 22% of our book value and as we realize the proceeds from the maturities and sales, we will deploy incremental capital into our CRE lending business and CMBS acquisition business" - Bob Lieber, RSO CEO
In setting the stage for the updated business plan, new management took the opportunity to take $55.3MM worth of impairment charges and reset book value lower.  Much of the impairments were related to their middle market and syndicated bank loan operation that they're exiting, along with write-downs of pre-financial crisis CRE loans in legacy securitizations.  While each of these were likely prudent, it has the effect of lowering the bar for future incentive fees RSO will be paying to C-III Capital if the new plan materializes as expected.

Management Agreement
Andrew Farkas, the new Chairman of Resource Capital, is a veteran real estate investor who founded Insignia Financial Group in 1990, took it public in 1991 and eventually sold the business to CBRE in 2003.  More recently he started C-III in 2010, and has since acquired special servicers, real estate brokers, and asset management groups to create a diversified real estate company.  Farkas is savy and RSO is their new fund to extract management fees, important to never really forget that management and shareholders aren't on the same side.

The external management agreement is typical-to-bad:
  • 1.5% of equity base management fee (better than if it was of assets, but REXI called this 70% margin revenue in their own presentation materials)
  • 25% incentive fee over 8% return (25% of which is taken in shares, 75% cash)
  • Expense reimbursement for CFO's salary and partial reimbursement on investor relations team (not covered in the base management fee apparently)
  • Termination fee equal to 4x the average base management fee and the average incentive compensation earned by the manager during the two 12-month periods prior (this would be at least 20% of the market cap, and that's low because no incentive has been earned in recent years)
C-III Capital is inheriting 714,000 shares of RSO from Resource America, or 2.3% of the company, rather insignificant compared to the fees they'll be earning annually.  But from C-III's perspective, their goal is to get RSO in a place where they could raise capital and grow the platform, that will only happen at a share price closer to book value and by playing nice in the sandbox with investors going forward.

The larger, best of breed, commercial mortgage REITs like Starwood Property Trust (STWD) trade well above book value, other smaller externally managed ones like Ares Commercial Real Estate (ACRE) trade for about 95% of book value.  At even 85% of current book value, Resource Capital's upside is 35+% and over time as the new plan is executed even that discount should close to peers.  New management has guided that 2017 will be a transition year, and that dividends will likely stay in the $0.05 a quarter range, once the dividend policy is updated about this time next year, I'd expect RSO to be trading at least 85% of a simpler to understand book value.

New management plans to have an investor day soon where they will disclose more details on their future plans which could be an additional catalyst for the shares.

  • External Management - There's always going to be inheritent conflicts of interest with external management agreements.  With C-III Capital and RSO it seems to be initially surfacing with the buyback, the old management repurchased 8-9% of the shares at prices above $12 over the last year.  C-III plans to shelve the plan and instead deploy capital in CRE whole loans, with the stock trading at a 40% discount, there's no CRE investment I'm aware of that would equate to the same return as buying back shares.  But buying back shares would reduce equity and thus reduce management fees.
  • Leverage - Mortgage REITs are leveraged bets on the underlying portfolio.  CRE whole loans are typically floating rate so the portfolio shouldn't have much interest rate sensitivity but will be concavely exposed to any defaults.  I don't believe we're on the edge of another blowup in CRE/CMBS, but that's certainly always a risk.  
  • More Non-Core Impairments - C-III Capital took $55MM worth of impairments in their Q-3 earnings, about half of that was on the non-core, non-CRE assets and business lines that they're looking to sell.  Logic would say that they'd take the opportunity to get those marks correct, but they could need to come down more as they market these assets and determine what they're really worth.  The good news is CLO/bank loan market is open for business, but as we saw in the first quarter of 2016, these markets can close very quickly.
I bought some shares on Tuesday for $8.70, and expect the share price to be a little volatile over the next few weeks.  I'm not a long term holder of externally managed companies as eventually the conflicts of interest usually settle with management being the beneficiary.  But my plan is to hold RSO until it finishes management's capital recycling plan and the dividend normalizes which should bring back in the typical yield investors and push the price back up near book value.

Disclosure: I own shares of RSO