Check Into La Quinta
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Buoyed by a restructuring efforts and a travel-industry turnaround, the hotel chain earns S&P's highest investment recommendation
The events of the past three years have stress-tested hotels, airlines, and other travel-related industries, pushing several big names to the brink of insolvency. One hotel owner, La Quinta, was particularly vulnerable. It was already in the midst of a major restructuring when the attacks of September 11, 2001 hobbled the industry. Now, in light of the restructuring's completion, and based on our belief that the overall industry is recovering, we at Standard & Poor's Equity Research Services see significant value and upside potential in La Quinta's shares. The stock carries Standard & Poor's highest investment recommendation of 5-STARS, or strong buy.
As the economy slowed in 2001, business travel began to taper off, and the industry appeared to be headed for a cyclical downturn. However, in our view, subsequent events threw travel-related companies into turmoil. We attribute the exceptional length and depth of the downturn to the combined effects of the terrorist attacks of September 11, a recession, the SARS outbreak, additional "orange level" terror alerts, and the wars in Afghanistan and Iraq. The years following 2000 represented the first time industry revenue per available room (or RevPAR) declined for more than one consecutive year. Liquidity became a concern for several hoteliers, particularly after some of the major airlines filed for bankruptcy.
EXPANDING MARGINS. Stock prices of lodging real estate investment trusts (REITs) followed fundamentals lower into the first half of 2003. Consequently, shares of some lodging companies, including La Quinta, began trading at what we view as significant discounts to book value. Given our view that these detriments are quickly fading, we believe the industry is poised for a sustained recovery.
In the second half of 2003, some hotel companies, including La Quinta, began reporting improving RevPAR trends. Since then, company reports and industry data from Smith Travel Research have indicated that occupancy levels and average daily room rates (ADR) have remained above year-earlier levels for nearly one year. We see a sustained industry recovery through yearend and into 2005 and 2006.
Although year-on-year RevPAR growth comparisons will become more difficult as we enter 2005, the industry has largely regained pricing power. Many lodging companies have reported occupancy approaching 2000 peaks and have indicated they expect future revenue growth will likely come from ADR increases. We believe this bodes well for the bottom line of companies such as La Quinta because very little variable cost is associated with increased room rates. We expect to see widening operating margins throughout 2005.
MARKETING SAVVY. La Quinta opened its first hotel in 1968, next door to the San Antonio World's Fair. By 1999, it had become a part of Meditrust, a highly leveraged REIT that owned disparate property types. From early 2000 to 2003, the company underwent a restructuring which included the sale of nonlodging related assets, the reduction of debt levels to $665 million from $2.6 billion, management changes, merging the REIT structure into a C corporation with paired shares, and a corporate name change.
In September, 2004, La Quinta completed the acquisition of 89 Baymont Inns & Suites, seven Woodfield Suites, and one Budgetel as well as the Baymont franchise system of 88 hotels. With more than 550 hotels in 39 states, La Quinta is now one of the largest owner/operators of limited service hotels in the U.S.
The company's turnaround efforts began well before the industry downturn, and it has continued to modernize and improve its operations. We believe La Quinta is poised to outperform its peers as the industry recovers. It has overhauled its information-technology systems in order to enhance its reservations system, facilitate better rate management, and allow electronic booking through third-party and proprietary Web sites. La Quinta also has launched promotional efforts, including a frequent-stayer program, and doubled the size of its sales force.
FRANCHISE STRATEGY. These initiatives are gaining traction, in our opinion. Guest-satisfaction scores have been rising consistently, a factor we believe should enable La Quinta to continue expanding its frequent-stayer program, which recently accounted for 30% of revenue. Also, La Quinta has increased its aggregate revenue booked through Internet channels. Moreover, it has recently reduced inventory and raised rates at third-party Internet sites. As a result, the percentage of Internet bookings being generated by La Quinta's proprietary site, which provide wider margins, has risen to 50%, from 35% a year ago.
With proceeds from an equity offering in late 2003, La Quinta acquired Baymont Inns & Suites from Marcus Corp.(MCS ) for about $415 million. We view this purchase as a good strategic fit, adding significant geographic diversification outside the company's Southern base. La Quinta has also begun to leverage what we view as its strong brand by expanding its footprint through a franchising program.
Because the acquisition was treated as an asset purchase, La Quinta should not incur any significant increase in general and administrative expense, nor will it inherit legacy liabilities. Although integration charges are likely over the next couple of quarters, we see the acquired properties contributing immediately to recurring earnings before interest, taxes, depreciation, and amortization (EBITDA).
La Quinta is also shifting its focus from hotel ownership to management and franchising. We believe this will allow chain expansion and income improvement, with a lighter balance sheet. As it continues to upgrade its existing locations, La Quinta has earmarked $100 million for conversions between the Baymont and La Quinta brands, property redevelopment, and maintenance capex for full year 2005.
SOARING YIELDS. Members of the new management team have an average 25 years of industry experience, and we believe the group has an excellent track record. Their experience includes senior positions at Marriott, which involved the development of the Courtyard by Marriott brand, and being part of the team involved in taking Red Roof Inns public. In the latter case, a similar franchise model was successfully employed, and shareholder value was maximized, in our view, when Red Roof was acquired at a substantial premium to the IPO price.
We also see growth that potentially could be extracted from the balance sheet. La Quinta carries both debt and preferred equity with yields significantly higher than those at which it has recently been able to issue debt. It has seen even higher yields in potential acquisitions, and it has continued to pursue that course. However, as growth slows, and acquisition opportunities become scarcer, we believe La Quinta could refund debt and preferred issues, some of which yield 9%, in order to wring additional earnings from the balance sheet.
As with any real estate operating company, getting an accurate reading of earnings can sometimes be difficult. This is because accounting based on generally accepted accounting principles (GAAP) is not optimized for real estate owners, who have to expense tremendous depreciation charges. Properly maintained buildings typically appreciate, rather than depreciate, in value. Despite ongoing GAAP losses, La Quinta has remained cash-flow positive, allowing it to self-fund capital expenditures.
We forecast same-property occupancy rates averaging in the 70% area for 2005, with mid-single-digit year-over-year increases in same-property RevPAR. La Quinta's business is highly cyclical, and we would not be surprised to see typical earnings slippage in the fourth quarter of 2004 and the first quarter of 2005. In addition, we expect one-time charges to be incurred over the next two quarters.
SWINGING TO THE BLACK. However, by mid-2005, we anticipate that La Quinta will boast a return to GAAP profitability. We forecast an operating loss of 10 cents a share for 2004 (29 cents net) -- improving to breakeven results in 2005. The company's relatively high fixed-cost structure should allow it to leverage top-line growth, particularly ADR increases. In other words, each incremental dollar of additional revenue offers a greater contribution to bottom-line growth.
We expect EBITDA to be about $178 million for 2004, a 15% improvement over 2003. After subtracting $18 million of preferred dividends (now reported as minority interest after restructuring), recurring maintenance capital expenditures, and costs related to the Baymont integration, but not the acquisition, we see free cash flow (defined as cash flow from operations less capital expenditures) rebounding to $78 million from about $65 million in 2003.
Over the next couple of years, as capital-intensive projects reach completion, EBITDA grows organically, and with contributions from the Baymont assets, we see cash flow growing rapidly. In 2005, we expect EBITDA to jump to $230 million.
Aside from La Quinta's many restructuring-related charges, we think its S&P Core Earnings are fairly solid. Option expense has been limited to two or three cents a share per year. However, with a weighted average strike price of $6.50, we think this could increase slightly as the shares appreciate. In 1999, the company converted its defined benefit pension plan into a cash balance plan. We do not expect La Quinta to have any ongoing unfunded pension liabilities.
UNDERVALUED STOCK. We believe La Quinta's enhanced liquidity and improving outlook will allow investors to focus on the value of underlying assets. We view this as the near-term catalyst that will continue to move the stock higher. Longer term, we see the prospect of a return to quarterly GAAP profitability and the potential for reinstatement of a common dividend as drivers.
We believe the stock remains undervalued based on several valuation methodologies. We think the shares are trading at a material discount to net asset value. We calculate book value at nearly $8 per share, which should provide the shares with substantial support at recent levels. Subtracting intangibles such as name-brand trademarks, we see a tangible book value of over $7.
There have been several hotel-property transactions this year. When applying similar multiples to property operating earnings, we estimate net asset value, at real estate market prices, of about $10 a share. This represents an estimated liquidation value, assuming that an orderly liquidation of such a large portfolio could be effected.
We estimate replacement cost of La Quinta's portfolio at about $2.9 billion. This assumes a construction cost of about $65,000 per room for the Inns, $75,000 per room for the Inns & Suites, and $55,000 per room for the Baymont assets, on average. After subtracting out liabilities, our estimate of replacement value is nearly $11 a share.
HIGHER END. We expect 2004 free cash flow of $78 million. As the lodging industry gains traction, we believe we will see a normal business cycle, boosting cash flows for each of the next several years, with growth eventually peaking and tapering off. Industry RevPAR has seen a compound average growth rate of about 4% over the past decade. We have assigned a perpetuity cash flow growth rate of 4%. Assuming an inflation-adjusted $35 million maintenance capex run rate, our discounted free-cash flow model indicates an intrinsic value of over $11 a share.
The current enterprise value of $2.6 billion is only 11 times our estimated forward EBITDA estimate. In our opinion, this makes La Quinta an attractive takeover candidate for a better-capitalized company, which should further support the share price. We believe with bottom-line improvement, this multiple could expand to the higher end of its historical range of 8 to 12, which indicates a price of $10 a share.
Barring any unforeseen complications, we believe the shares should return to tangible book value over the next 12 months. As La Quinta approaches GAAP profitability, we see the stock reaching our 12-month target price of $10.
SPRUCED UP. One of the most prominent risks to our recommendation and target price, in our view, is the possibility that the lodging industry recovery will suffer a setback, either due to a recession or other outside events, such as additional terrorist activity. There's also risk that it will fail to execute on its acquisition-integration plan. However, we believe management has a solid track record with limited-service hotel operations.
In our opinion, new management has done a commendable job turning around La Quinta, by correcting operating deficiencies, reducing leverage, and expanding the geographic footprint. Given our view that an industry recovery is gathering steam, we think La Quinta will outperform peers. |
