I’ve finally had enough of the headlines, anecdotes, “anec-data.” Everyone thinks COVID is driving people crazy and ditching their city for the outskirts. I hear over and over that this is a new trend we need to watch.
Look, I’m not defending New York City. It is losing share of population. I’m pointing out a terrible narrative biasproblem. Narrative bias refers to people’s tendency to interpret information as being part of a larger story or pattern, regardless of whether the facts actually support the full narrative. In this case, COVID killed New York, or San Fran, or the office building, etc.
No. As they say, the 2010-2020 timeframe will mark the fifth consecutive decade in which population growth for the most dense states at that time ranked as the weakest quintile.
Where were these Miami headlines before when CT, NJ and NY were losing population share?
There are three other points I’ll make:
Talk to me when all of the allure of the major cities is able to turn back on, not when when it is closed.Similar to seeing E-commerce sales boost in Q2, we have to remember the alternative (brick and mortar) was largely shut down.Similarly, nearly all the benefits of a city have been taken away – colloboration in person at work, grabbing beers at 5pm on a Friday with everyone, going to the bars and great restaurants in general. Its no wonder to me that NYC is being cast out (with its current, stricter rules) in favor of Miami (which anecdotally seems like its operating back-to-normal).
Second, millennials. Millennials are finally aging into marriage and children age (the eldest millennials are nearing 40, while the youngest are mid-twenties). Households will be getting larger soon. No more living in the basement with mom and dad that was all the rage post financial crisis. Millennials now have enough savings to buy a home vs. the condo (especially with the drop in interest rates).
Therefore, it surprises me not at all that there is a boost in suburban sales.
Lastly, people have been congregating for thousands of years. In my sociology class in college, I learned the theory that if something has persisted for thousands of years in society, it probably has a purpose. I think humans will continue to congregate in cities, maybe just not the Northeastern or Western ones that have high taxes.
“But DD – we now have video conferencing! No need to go into the office!” We’ve had video conferencing for at least a decade. Everything thinks it works much better now. Maybe it does. But I think it works the best now because everyone is using it. Once half the team goes back into the office (including the Boss), people will start to not like it again. “Bill – you are on mute” isn’t as forgivable when everyone is in person except for you.
News of a Pfizer vaccine has sent COVID-impacted names soaring. However, some areas still look very cheap, particularly in the movie theater space. National Cinemedia is a decent bet and could possibly be a multi-bagger. There’s obviously a ton of risk – this is almost a microcap stock right now – so do your own homework please!
Let’s start with what I am not doing: I’m not looking at stock charts and saying, “well in January, it was $x and now its at $y, so it has a lot of upside if it just goes back to $x”.
The problem with that is that a lot of names have issued a lot of debt and or equity. For example, American Airlines just announced it was going to issue $500MM of stock. They’ve also issued a ton of debt to pad liquidity. Based on Bloomberg, the current EV is around $39.5BN compared to $41.9BN at the end of 2019… yet the stock has been cut in half. The value is being transferred to debt holders.
In fact, following yesterday’s move, a lot of center-of-the-storm names don’t have nearly the upside I would want for the uncertainty. And this includes some movie theater chains that were too levered and entered this crisis in too fragile of a position (looking at you AMC… AMC’s 1L term loans and bonds are well below par, implying that the company will still need to restructure).
But National Cinemedia does have the upside. And I don’t think they’ll need to restructure at all.
Why National Cinemedia? Several Reasons:
Solid balance sheet means it can wait this pandemic out
“Asset Lite” business limits cash burn now, also means cash turns back on quickly as movies come back
Confident that movie theaters aren’t dead and that the notion that “PVOD” or prime video on demand taking share of traditional theaters is overblown
Movie slate was deferred in 2020, but makes 2021-2022 likely a blockbuster year
Solid Balance Sheet & Asset Lite: National Cinemedia is an advertising business. They typically run the ads that you see 30 minutes before a movie run by national accounts. They don’t actually own any theaters, so the business model is very asset lite. The downside is that if the theaters aren’t open, there aren’t going to be people paying for ads!
The other issue right now is that we are in a limbo with new movies. The studios have a huge production slate they want to release (see more later below), but they want there to be fans in the stands, if you will. In sum, the theaters can be open, but if there are no films, the theaters might as well be shut to National Cinemedia.
However, National Cinemedia has $217MM of cash on the balance sheet. At its current monthly cash burn rate of $11MM in October 2020, it can last ~1.5 more years in essentially hibernation mode. Management seems confident enough that they continue to pay a dividend of $0.28/share, or ~8.5% yield based on today’s price.
Confident in Theaters Coming Back: There seems to be this feeling that Netflix killed the theater. Wrong.
Look at box office sales over time:
You need to remember that because you may not go to the theaters, doesn’t mean others don’t. And the core group of movie theater attenders area die hard group. I hate to bring it up, but people still went back to the movies following the Aurora, Colorado movie theater mass shooting. If they still go back after that, I am confident they will go back now. There have been no COVID-19 outbreaks linked to movie theaters yet.
APAC is the leading indicator – already snapped back:
PVOD (Premium Video on Demand) is not a solution right now:
Here’s Disney on the matter:
“So we’ve got a pretty robust slate. And once again, we hope that the theaters are open. A lot of our films are films that the people who choose to go to movie theaters, the experience is very different than what they would have at home.So when you look at our box-office numbers over the last couple of years, we have — we drive a lot of people into theaters to see the Disney films. These tent-pole films become kind of part of zeitgeist of culture, whether it’s Marvel, whether it’s Black Panther that was a couple of years ago, but these are movies that people like to see in theaters and talk to their friends about. So once again, we hope the theaters stay healthy and can rebound from this COVID world we’re living in now.”
What about Mulan? That was released on PVOD? Well, it wasn’t Disney’s first choice and it largely was not a success. Disney had said in the past as well that it would not have been released this way if it weren’t for Theaters being closed:
“Well that — it has had some, but that was not the primary reason that we chose to release it this way. We chose to release it this way because the release date — as some people who were following just what was going on with theaters not opening and just shift, shift, shift, we had moved the release date several times. And we believe that, that movie — given that there’s so little new content out, that the movie was done and we wanted to get it out in the public domain. And so we chose to do it this way because we believed that it was the best way to get to the most people for them to enjoy it.”
Here is Bob Iger on whether Disney+ will be the new way to release movies. He says this because he knows that Movie Theaters still generate the bulk of a film’s profits:
“The theatrical window is working for this company. And we have no plans to adjust it for our business. Your comment about how those companies are faring on the market, I think, maybe is a reflection of how the other movie companies are positioning their films and their business. We’re not the only movie company. We had the biggest box office, but we’re not the only movie company. And I suspect that it’s not due to us or either a lack of conviction on our part or any suspicion that we might be — that we might not beat on the truth. But we’re not — it’s working for us. And we have no plans in the foreseeable future to change it and that”
Now there is news that MGM wants to sell its latest James Bond movie. Apple and Netflix reportedly offered a couple hundred million dollars and MGM wanted $600MM. The PVOD offer likely would’ve led to a big loss. It had a $300MM budget plus they had already spent tens of millions on marketing. And another problem – Daniel Craig and others own backend rights to the film based on how it does. This would’ve added to the cost of the film before MGM made any money.
I am not concerned about theaters living or dying. I think they will be around for many, many years to come.
My base case for NCMI is to generate ~$109MM of FCF before working capital changes, but if I am wrong, I still think there is a ton of upside on the stock. As shown below, my discounted EBITDA shows ~18-19% FCF yield plus they will have roughly half their market cap in cash by the time they reach these numbers (currently have about 85% of market cap in cash).
In short, I think NCMI can double from here, maybe more. There is a huge film slate just waiting to come out, so I think the vaccine news is actually game changing:
Obviously there are some risks. This company is tiny and while it may not have significant maturities until June 2023, its customers do. This can be complicated. You see, NCMI was founded as a JV between AMC, Regal, and Cinemark. They are the company’s largest customers, but also because it is a JV, they also own ~60% of the company.
AMC is the theater chain I am most concerned about filing for bankruptcy. AMC could reject its contract with NCMI in bankruptcy. However, this would be messy as it would create a giant unsecured claim and NCMI might end up with a huge chunk of AMC equity. I think AMC would avoid this situation and likely just re-instate the contract, but it is something I am monitoring. AMC doing an out of court restructuring would be the best outcome here.
A lot of people know Visa and Mastercard, but they don’t know how the business actually works. Simply put: card networks act as the toll booth connecting the “issuing bank” with the “acquiring bank” and they take a fee as the transaction goes across. The “issuing bank” is the bank that issued the credit card. The acquiring bank is the bank of the merchant. Ryan Reeves has great commentary on this network, which I found in a tweet of his. He also has a blog post on it where he explains it well:
The company where you put your money, called a bank, gives you a piece of plastic, called a credit card, that signals you will pay for something later. When you buy coffee from Starbucks using your piece of plastic, your bank sends the $4 to Starbucks, instead of you paying. But before Starbucks gets the money, two things need to happen.
Your bank has already made a promise with another company called a card network whose job it is to act like a toll booth between two banks. The most popular card networks are Visa and Mastercard. These card networks make promises with other banks called merchant banks, who hold money for the stores where we buy stuff. So the money from your bank first goes to through the card network and then to the merchant bank and finally to Starbucks, each company taking a little bit of money along the way for their services. And then the final piece, at the end of every month, you pay back your bank for the money they sent to Starbucks. And that’s how credit works!
Here’s a diagram from Plaid as well as their explanation:
Card networks—for simplicity in this explanation, let’s say Visa—receive fees from the issuing and acquiring financial institutions. Visa makes money by collecting a small percentage (0.13 percent as of early 2015) of total transaction volume, rather than by charging a fee on each transaction. But it also sets and doles out the rest of the fee paid by the merchant to the other players. While this percentage may seem nominal, billions of transactions processed each year (with minimal overhead) add up to a very profitable industry.
What’s more, a network like Visa’s entrenched partnerships and critical technologies create high barriers to entry for new players. Established card networks also have low marginal costs to continue operating, making them attractive business models.
So Plaid touches on a few things here: High barriers to entry, toll booth business, low marginal costs. This translates to really high margins and super high FCF. And since payment transactions are growing quickly (ex-COVID), the company is able to leverage those costs and expand margins. For example, look at both revenue growth and margin expansion. Most companies I follow don’t even have 50% gross margins…
People often look at the current market structure and think, “This will clearly be disrupted. It is too complicated.” Card networks work because they have high degrees of trust and a large network, which makes their usage more attractive. Take American Express on the other hand which actually has a different model. Have you seen many merchants say they don’t accept American Express? Amex “consolidate functions of the merchant bank, card issuer, and card network by personally extending credit and cards, and minimizing parties involved.” However, their fees are too high for the merchant and AmEx gives a lot back to the consumer.
Square also differs somewhat, too. Instead, they aggregate the merchant transactions and pass of the processing to Chase. You will always hear about one of these names (Square, Stripe, Apple Pay, etc) are “disrupting payments.” In reality, they are all still passing through the card network monopoly.
So why is there an opportunity now? Well, COVID-19 has caused investors to reset the bar lower this year. Sales were down 14% in Q3’20, but Op Income down 20% (due to fixed costs). You can’t have a dramatic recession and expect spending to be up. That obviously will have a direct impact on Mastercard. But that makes Mastercard interesting because its a very strong business, but also a recovery play. Indeed, there may even be higher tailwinds on the way out – think of less use of physical cash.
And the long-term growth story is still intact. Look at how much in transaction volume is still down via cash and check.
Is Mastercard Cheap? I think so. But you say – Mastercard trades at 45x 2020 EPS?? And 34x ’21. That is not cheap.
First of all, is Mastercard an above-average business? Yes. Is its long-term growth rate above the market? Yes. It should trade at a premium.
Second, Mastercard trades at ~3% FCF yield, but also it can grow FCF/share at a 10%+ CAGR for the next 10 years. This would be half the rate of the past 14 years. I think growth will continue from continued market gains (remember, pre-COVID, the company was growing top-line in the high teens and bottom line even faster due to operating leverage. This will continue at a high rate in a post-COVID world). That points to at least a low double-digit IRR for the stock. I would also point you to my post on how Growth can help pay for a lot of sins…
I’m not going to publish my whole model here, but I encourage you to check your models for this. This is the beginning FCF yield + what I expect FCF to compound out. It is interesting how it almost matches up perfectly with the IRR of the investment:
There are still capital structure benefits that could come. As I talked about in my MSCI post, MSCI is leveraging its cash flow and returning significant cash to shareholders. Mastercard is roughly net debt zero. If they had 2.0x of leverage, that would be an incremental $18-$20 billion available for shareholders, which would obviously boost returns. I also think they’d be comfortably investment grade at that level as well.
Ladder Capital stock is a high conviction name for me. It is one where I see little downside and significant upside and also a situation where you are paid to wait (~10.8% dividend). Lastly, I can’t say enough how high I hold management (which also owns ~10-11% of the equity).
Ladder Capital is a mortgage REIT. Unlike typical REITs that specialize in the actual real estate, mortgage REITs specialize in… you guessed it… the mortgages that secure property.
Mortgage REITs have sold off significantly as the market becomes more concerned with commercial real estate. Several mortgage REITs used significant repo financing coming into the COVID crisis, so when there was a disruption in the mortgage market and all securities were crashing, several seemed unable to meet their margin calls…
That did not really impact LADR. In fact, management issued an unsecured corporate bond in 2019 to reduce reliance on repo funding… very timely. Did I mention management is A+ quality?
I tend to think of LADR as an investment company. We want them to make high earning, good risk/reward assets and we understand that they will use leverage in normal course of business. “Do what you think will make money, just don’t blow yourself up.” It’s clear to me they realize all of this.
LADR trades at a steep discount to book. In a hypothetical scenario, we need to ask ourselves that if we foreclosed on LADR, would we get book value or not. What price could we liquidate the assets for in an orderly liquidation. If we can get book value, the stock has 65%+ upside.
See, a lot of times investors buy financial assets below book value. But if the assets are earning a low ROE, the book value may be worth a low amount. Or you may not realize that book value for a long, long time (think of a 100 year bond with a 1% coupon when prevailing rates are at 6%… it will take a long time to get “book value”.)
My goal of this post is to show you that you can bank on book value here. And that because of the short duration of the assets, we know cash will be coming back in the door soon. As a friend put it, soon a large majority of Ladder’s book will actually be post-COVID loans…
Here is my thesis:
Ladder’s book is high quality; Stock at ~60% of GAAP book value, 52% when incorporating appreciation of real estate
Book consists of transitional first lien mortgages (which I’ll define later), but also investment grade CMBS, small amount of conduit loans, and they also have a portfolio of triple-net leased properties and other CRE that they own outright.
~93% of their market cap in unrestricted cash; Or 14% of assets
43% of asset base is unencumbered, 74% of which is either cash or first mortgages. This means the company has significant borrowing capacity as well (which is important, as LADR is like a bank – you want them to take $1 and make $2 or $3 of loans with it).
Mgmt is top notch and has history of deploying capital attractively. Dare I say, the Warren Buffett of mortgage REITs (patient, cash not burning hole in pocket)
Buying back both bonds and stock – both at discounts to par / book value
Cash is both a downside backstop, but opportunity as they deploy into distressed sectors
Let’s Break Down Ladder’s Book: Here I will detail the bulk of Ladder’s assets. Note, this is just the bulk. They also have a small amount of conduit loans (which means they make loans which will soon be bundled and sold into CMBS).
Transitional Mortgages(43% of Assets, 53% of Equity): These are loans to commercial properties undergoing a… transition. LADR has a first lien on the property, while the borrower uses the capital to bridge it through renovations, repositioning of the asset, lease-ups, etc.
While COVID has created “income uncertainty” for a host of real estate assets, these transitional properties are inherently not generating much income at the time of the loan! And here’s some commentary on that from Management’s Q2 call:
[Our transitional loans] are close to stabilization and require minimal capital improvements. Our balance sheet loans have a weighted average seasoning of 18 months, which is a little over 15 months remaining to initial maturity and 27 months remaining to final maturity. Further reflective of the lightly transitional nature of our portfolio, we have less than $150 million of future funding obligations over the next 12 months and less than $250 million in total, all of which we can comfortably meet with current cash on hand. The majority of these future funding obligations are conditional and are subject to the achievement of predetermined good news events like tenant improvements and leasing commissions due upon the signing of new leases that enhance the cash flow and value of the underlying collateral. We continue to have limited exposure to hotel and retail loans, which comprise only 14% and 8% of our balance sheet loan portfolio, respectively. Currently, almost half of our loan portfolio remains fully unencumbered, and our exposure to mark-to-market financing on hotel and retail loans is just 1% of our total debt outstanding.
As such, they typically are low duration (<2 years), lower LTV (67%), and as mentioned – 1st lien on the property. In a sense, the property value would have to be marked down 33% for Ladder to begin taking a loss. Here’s a comment from the Q1 call on the borrower – you have to think they’ll want to preserve that equity value if they can and have a long-term view:
These same loans currently have a 1.26x DSCR with in-place reserves. The significant third-party equity our borrowers have in these loans provides strong motivation for them to protect their assets and provides the company with a substantial protective equity cushion. Like all prudent lenders, we’ll be very focused on asset management to protect and enhance the value of our loans
Here is more commentary on the assets performance and the short duration:
The property types are highly varied too. In other words, it’s probably a good thing it’s not all Hotels right now. But even so, they have significant cushion above the loan value.
Let’s say you don’t like this situation. Well think about this: We are buying LADR today below book value. Therefore, you could look at as us buying 1L mortgages on a look-through basis of ~40 cents on the dollar (i.e. 60% of Book value * 67% LTV). Do you think a 60% haircut is coming across the board?
Securities(23% of Assets, 8% of Equity): These are primarily AAA-rated real estate CMBS that has very short duration (2.1 years as of 9/30/2020) and significant subordination (i.e. it would take a lot of losses for the AAA tranche to lose money). In fact, even at the height of COVID where gold, treasuries, investment grade corporate credit were all tanking, the company was able to sell assets at 96 cents on the dollar. This speaks not only to the quality of the loans, but also liquidity.
As I think about this portfolio and the low duration, you should think of it this way: in 2 years, if the company did not re-deploy this capital, they’d have ~$1.45BN on loans that would pay off. They do have ~$1BN of leverage against them, so you’d have $383MM of equity back in cash. Keep this in mind for later.
Commercial Real Estate (16% of assets, 6% of equity though the assets are carried at historical cost, so there is significant unrealized gains not captured by GAAP)
Net Leased Commercial Real Estate (~65% of CRE): Ladder outright owns triple net leased properties, where the primary tenants are Dollar General, BJ’s, Walgreens and Bank of America.
Diversified CRE (~35% of CRE): these are other properties Ladder owns across office buildings, student housing and multifamily.
Now that I’ve discussed the book, it’s important to quickly discuss how they capitalize themselves. Again, very limited repo facilities and that source of funding continues to decline.
Note the unsecured corporate bonds. This brings me to one of my investment points: Ladder issued these opportunistically and has since been able to repurchase them at a discount to par. Ladder has repurchased $175MM of bonds.
At the time of writing, their 2027 4.25% unsecured notes trade at ~86 cents on the dollar. Every dollar used to repurchase these notes at a discount builds equity value on the balance sheet. There’s also the added benefit of decreased interest, which is a drag when they have so much cash.
As an example, let’s say we had a company with $200MM of assets ($100MM of which is cash), $100MM of debt, which would imply $100MM of equity. Using $25MM of cash to pay down $25MM of debt at par would not build book value on the balance sheet. However, if you paid down debt at a discount, it would.
Here’s that illustration shown below. Notice you actually build incremental equity. Given financials typically trade on a P/BV, I feel like this topic is warranted.
But obviously more importantly, it’s an attractive return of capital to shareholders if you think the stock is worth at or above book value. However, management may have opportunities to deploy this in attractive assets, noted below in the management section.
Adding up the pieces:
I wanted to do a build up of “what you need to believe” here. Maybe you don’t like the assets, even though I personally view them as very low risk. Well, the securities portfolio itself is worth $3/share. That’s very liquid and something you can take home in a few years if they decided not to reinvest the proceeds. We could get those assets tomorrow.
I also started with the corporate debt, subtracted cash, and looked at the equity value after paying that all back against the balance sheet loans (the transitional mortgages). I didn’t assume this debt was retired at a discount at all.
As we discussed, the transitional mortgages are low LTV properties and worth ~$6 share. You could haircut this by 40%, add in the securities portfolio and everything else is free.
Next you have the real estate assets, worth $1.8 share on the books. Fine, don’t give credit to the unrealized value here (another $1.8), but the company did sell 3 properties in Q3’20 for a gain relative to BV.
Our downside is very well protected. Given the short tenor of the loans, we will either see Ladder receive cash or take-over properties and sell above the loan amount (which they did with a hotel in the quarter, one of a few assets in trouble per mgmt).
Often, the missed piece of any thesis is management. Boy, all I can say is go read their calls. These are truly savvy investors, which is what you want in an mREIT.
Here are some examples of great quotes from mgmt:
From the Q2 Call – I get Buffett vibes:
My instincts are telling me that it might be better to actually be the borrower in a market like this as opposed to be a lender. Occasionally, we’ve talked about that on some of our calls. Conduit lending is back in a very soft kind of way. And a lot of cleanup from inventory that was sitting on the shelf is getting done. But I would say the typical conduit loan today that’s getting written is a 3.5% to 4% 10-year instrument at 50% LTV.
I think if we begin to deploy capital, and I think we will, we’ll probably be a borrower of funds like that because I think we can find some attractive situations where, perhaps, somebody has to sell something. And in addition to that, I would say that a stretched senior used to be, if a guy bought a property for $100 million, he could borrow $75 million. I think $100 million purchase today, you can probably borrow about $60 million. And so a stretched senior now goes from maybe 60% to 70%, 75%, and I think that is a sweet spot for risk/reward right now on the debt side.
If you remember, in 2008, when we opened, we had quite a few mezzanine loans in our position because we felt that the capital markets were very fearful and maybe too fearful. And so then once we got to around 2012 or ’13, we stopped writing mezzanine loans because we felt at that point, markets were priced right. And then around 2016, we felt that mezzanine money was too cheap. So I would imagine it will feel and smell like equity in some cases, or at least in some scenario where somebody is forced to transact.
And another from Q3’20 from Pamela McMormack, the other Co-Founder
I’ve been with Brian, forgot, I’m turning 50, I think, since I was 30. And so I’m a little bit of the cycle in that regard. But what I’ll say is, I remember, when we opened the doors in 2008 with the private equity guys, and they were begging us to make loans, make loans, make loans. And we were sitting on a lot of cash, we had raised over $611 million back without placement agent in 2008. And Brian was very patient, had a set up to become a (inaudible) borrower. We’re buying securities, and they said they don’t pay people to invest in securities.
And we were very patient about making loans until we felt like the market was right. We’re not incapable, we’re not afraid. We are intentionally and purposely waiting for what we think is a better risk-adjusted return.
There in lies WHY they have so much cash right now. Unfortunately, COVID is not going away tomorrow and there will be some desperation out there. I like this management team’s ability to take care of it.
Here is LADR’s ROE over the years. Not too shabby! I’d add this to the rationale that the company should trade at at least 1x BV (this ROE excludes gains on sale).
I have the opportunity to again share the work from a friend & prior guest poster – the same author who imparted his views on cruise stocks in a prior post. This time, he’s back with some thought-provoking views on the hotel industry and the hotel stocks. Enjoy.
In #Is It time to Buy Cruise Stocks? Pt 2, we went into the heart of the Covid storm, and found that there may be solid upside if the risk sits well with you. For this article we’ll move to some of the “lighter” outer bands, as at least some portion of revenue stream continues for hotels, whereas cruise departures have been completely halted. Let’s start with some high-level thoughts on the industry, and then dig into some of the players.
If we break down hotel stays between business and pleasure, it seems reasonable to say that ~40% of booked hotel stays are business related. For the time being that implies a complete halt on 40% of hotels’ revenue. Assuming the other 60% of revenue is vacation related, it may be reasonable to assume ~50% of the vacation bucket is attributable to Loyalty Program members (see snipit from 2019 10-K below).
Digesting the above, it seems like (i) 40% of hotel revenues are completely compromised, and (ii) possibly another 30% is disrupted, as Loyalty Program members develop a lot of their status from business travel.
Enter Airbnb. Its presence represents an approximately decade long build of disruption to the hotel industry. In terms of annual revenue, it looks like Airbnb falls somewhere above HLT but less than MAR – it had approx. $1bn of revenue in Q4 19 (assume $4bn annually at this rate) – we can potentially get more details this year if they move ahead with IPO. Note that when considering HLT and MAR revenue, I’m excluding “Cost reimbursement revenue”, as there’s corresponding expense with this item (e.g. franchisor pays some expenses, and franchisee reimburses). Airbnb is a sizable force in the markets, but I’d also assume it does not have and cannot really get a share of business travel yet (easier from liability perspective to encourage employees to stay at big name hotels, rather than with miscellaneous landlords). What does this mean in Covid?
I’d guess Airbnb is benefiting from the suffering of hotels. Would you rather stay in an isolated mountain/lake house, or in a hotel resort teeming with tourists? Assuming you’re not a Covid denier, then probably the former.
While business travel should in theory return to the big-name hotels, this may not come for a longer time – why would a business risk Covid outbreaks for the sake of business travel? Seems unlikely unless business travel is essential to the functionality of the business. Further, a blow to business travel inevitably means some level of reduction to vacation stay for hotels.
Similar to analysis in Covid so far, showing e-commerce adoption has accelerated, it could be the same that Airbnb share has also accelerated (hence why they may be pushing for an IPO despite a terrible operating year…)
While hospitality may not be an awesome industry to be in at the moment, can we still find businesses that will persevere, and potentially emerge well once the dust settles? In exploring MAR and HLT below, we’ll discover that a sizable portion of their businesses come from franchisor/franchisee relationships. This leads to another question – is it better to be the franchisor or the franchisee? We can explore Park Hotels and Resorts Inc (PK) to get a flavor for the differences. Unlike the Cruise Pt 2 analysis, less of the below focuses on whether these companies have the liquidity to survive Covid – cash is still coming in the door, even if the demand recovery may not be as a resilient. It instead explores more of the pre-Covid operations for MAR and HLT, and thoughts on what that means going forward.
MAR and HLT
Historical revenue demonstrates a push to franchisor/manager business, rather than own and operate. Note that HLT spun off PK and Hilton Grand Vacations Inc (HGV) (owned hotel and timeshare businesses) at the very beginning of 2017, hence why you’ll see the change in revenue presentation and overall split.
My quick takeaways are:
Revenue per Available Room (“RevPar”), hotel room revenue divided by room nights available over the applicable period, has had immaterial changes for each company over the last six years, but MAR converts more $ per room then HLT.
MAR derives larger portions of its revenue from franchise/management fees than HLT. Given HLT’s spin offs of PK and HGV, it is clear the biggest players see more value in reducing the tangible assets on their books.
I’m not seeing crazy differences in the debt profile of the two. But compared to cruise lines, MAR and HLT are noticeably better capitalized and have generated sizable free cash flows compared to the debt on their books (15-20% each year). But MAR and HLT are noticeably more expensive – EV/EBITDA at 20x+, while cruises were closer to half that.
How well do MAR and HLT translate revenue into cash? #What Drives Stock Returns Over the Long Term? pointed out that growth in free cash flow per share often drives long term value. In looking over a 6 year horizon, the below free cash flow illustrations seem to speak to this point, with better overall performance from MAR.
In the above, I removed timing differences between reimbursement revenue and expenses; these items are supposed to offset one another over time, so it seems more appropriate to exclude noise from these pieces.
So, what does this mean going forward? MAR and HLT’s stock prices are down ~32% and ~18% since beginning of 2020. As you’d expect these entities faced losses, largely driven in Q2. However, there are still positive free cash flows, expectedly coming from changes in working capital accounts.
Looking at 2019 10-ks, debt maturities don’t become significant for HLT until 2024 (i.e. less than 40m), while MAR’s are more significant at ~1bn+ each year 2020-2022 (bigger red flag). The cash situation for these two feels better than what we saw in cruise stocks, but I think a significant con is that business travel may not come back for some time (i.e. until a vaccine is found)- I’d be more inclined to bet on cruise demand coming back faster than business need for travel lodging.
The Q2 MAR earnings call transcript may be worth a read. In that, they discuss cash burn with in a scenario where demand doesn’t pick up meaningfully from here. Running a quick liquidity analysis on MAR below, survival horizon for MAR seems around 3+ years.
If you’re quietly optimistic that Covid will be meaningfully resolved next year, then there may be potential upside in these stocks, but if you consider FCF yield then you’re probably disappointed at current stock prices. The 2019 FCF per share were $5.57 and $4.76 for MAR and HLT; if we want a 10% FCF yield that implies stock prices slightly above and below $50, but meanwhile the stock prices are around $100 and $90. Additionally, it’s probably going to take some time for FCF per share to come close to the 2019 levels. Not attractive points from a cashflow perspective.
Let’s explore a player on the ownership side of the house to see if that noticeably changes what we’re seeing.
As noted above, PK was spun off of HLT back at very beginning of 2017. As expected in looking at end of 2019 vs Q2 2020, there’s more debt on books to generate cash on hand, and unlike the above franchisors, the costs associated with maintenance and operations of the hotel real estate is entirely reflected on PK’s income statement. The stock price has declined ~62% since beginning of year (significantly more than MAR and HLT), with its discontinuation of dividend payments back in May further crushing investor sentiment. See below for some quick snipits comparing PK’s 2020 financials to 2019.
Reductions in PP&E, wipe out of goodwill, increase in cash with corresponding increase in debt – all things I’d expect to see in this Covid environment.
The income statement data isn’t any better.
Free cash flows are also already negative – noticeably worse cash situation than MAR and HLT, as those companies have still been able to stay free cash flow positive in 2020 thus far.
PK is a Real Estate Investment Trust (“REIT”) for US tax purposes, meaning there are requirements from the IRS that need to be met for the entity to preserve flow through status (i.e. no entity level income tax for federal tax purposes). These requirements include and are not limited to distributing the majority of taxable income to shareholders (REITs often distribute all of taxable income anyway), holding a certain % of assets in real estate, and ensuring the majority of income is derived from passive real estate sources (see Section 856 of the US tax code for additional details). Hotel REITs include additional complexity, as most hotel REIT structures involve (1) creation of a Taxable REIT Subsidiary (“TRS”) where hotel operations occur, and (2) a lease agreement between TRS and REIT whereby REIT owns the assets and TRS makes payments to REIT for use. The nature of this arrangement is intended to mirror a typical real estate arrangement. Hotel REIT players try to maximize REIT income by ensuring the lease agreement strips most of the kosher earnings out of TRS.
My concern here is more a generally pessimistic view of the recoverability of REITs post recession. Distribution requirements make it hard for a REIT to hold on to cash; there is a concept known as “consent dividends”, whereby REIT shareholders may agree to recognize a deemed dividend in their income without cash actually moving outside the REIT, with this fulfilling the REIT’s distribution requirement. But this obviously does not apply in a public REIT context.
Furthermore, REIT investors are mostly concerned with annual yields generated by investment, making cash collection more impractical. While REITs are able to generate net operating losses (“NOLs”) to the extent that they have taxable losses, NOL usage is done on a “post-dividend basis”, making it tough to monetize them since REITs typically distribute out most of their taxable income.
While I think the above points make it hard for REITs to come back after a downturn, I can see a potential opportunity for prospective Buyers (e.g. Blackstone, Brookfield, etc) with cash on hand to buy real estate at a heavy discount (see WSJ article Public Real-Estate Companies Are the New Way to Buy Distress for example). In looking at PK, I tried to compare the net asset value to market capitalization to assess how discounted PK is currently trading. Below I’m assuming that the FMV of land and buildings/improvements is equal to original cost (likely conservative since most of the real estate was acquired back in late 2007).
I’m estimating market cap at ~2bn and net asset value at ~4.7bn; these quick estimates at least directionally tell me that prospective buyers could likely get a pretty sweet discount if they tried to buy the assets.
That said, I think that you can probably find this trend and opportunity across non-hotel REITs as well, and therefore would be more inclined to pass on buying PK.
Thank you again for this great guest post. My main takeaways from this are:
Cruise lines over hotel operators might be better risk/reward, as at least with cruise lines there are signs that demand is still strong once ships can take-off (so becomes just a liquidity consideration in the near term, which you can bracket)
Not getting paid much for the franchisors. The franchisors, MAR and HLT, are historically good businesses. Asset light and generating strong FCF, but at the end of the day, revenues / performance are going to be tied to how the hotels are doing. Its going to be hard for them to just sit and generate FCF when their franchisee base is struggling. With the stocks currently trading at ~20x peak FCF (2019 levels), it doesn’t feel like you are getting paid for any downside risk (e.g. do the franchisees want forgivable loans or some re-cut of the franchisee agreements to survive)
Airbnb wildcard. Airbnb has been a concern to the industry for years, but frankly the impact hasn’t been too noticeable yet (e.g. hotel revenues continued to march up despite Airbnb’s new presence). However, that may change in the future….