Description

We recommend purchase of Extended Stay America (STAY-$11.61) for the following reasons:

o Cash machine business with 50% EBITDA margins; renovation program ending early 2017 will double current FCF

o FCF Yield of 13% (on a market cap of $2.4 billion we expect $310m of 2017 FCF) and a dividend yield of 5.9% ($0.68)

o Private equity ownership (Blackstone/Centerbridge) with an intense focus on returning capital to shareholders (div+bbk)

o Hotels located on outskirts of town, utilized by travelling workers, minimal exposure to Airbnb or slowing intl visitation

o 2018 de-pairing of “paired share” REIT structure seems likely, creating two different public companies, REIT and Opco

Description.  Extended Stay America owns and operates 629 mid-price “extended stay hotels” in the U.S. (626) and Canada (3) totaling approximately 70,000 rooms.  STAY’s hotels target self-sufficient, value oriented, longer term guests, and offer in-room kitchens, on-site guest laundry machines, free Wi-Fi, free grab and go breakfast and weekly housekeeping (daily is extra) for an average daily room rate during the trailing twelve months of $61.  Virtually 100% of revenues are derived from room rates which are a hotel’s highest margin revenue stream; there is no food and beverage revenue.

o Labor light model + 26 day average stay + virtually 100% revenue from high margin room rates = 50%+ EBITDA margins

o Revenue breakout by length of stay is as follows:  44% from 30+ night stays, 24% from 7-29 nights, 32% from 1-6 nights

o Hotel EBIT comes 35% from east coast states and 33% from west coast states (primarily California)

o 60% business travelers and 40% leisure travelers (40% of business travelers booked through corporate accounts)

o STAY is by far the largest player in the mid-price extended stay hotel segment with approximately a 48% market share

o Competitors include Candlewood (InterContinental) with 31,000 rooms and TownPlace (Marriot) with 26,000 rooms

History/Ownership. Following its November 2015 secondary offering, STAY is currently owned 21% each by Paulson, Centerbridge and Blackstone Group (the PE group that bought STAY out of bankruptcy).  STAY’s history is detailed below:

o Founded and IPO’d in 1995 by Wayne Huizenga as a developer and consolidator of mid-price extended stay hotels.   

o Blackstone acquired publicly traded Extended Stay in May 2004.  Blackstone sells STAY to Lighstone Group in June 2007.

o STAY goes bankrupt in June 2009 and is acquired by Private Equity firms (Centerbridge, Paulson, Blackstone) October 2010.

o IPO November 2013 @ $20.  Follow-on secondary offerings: August 2014 @ $21.75 and November 2015 @ $17.25.

Current Valuation.  On a market cap of $2.4 billion, STAY has net debt of $2.4 billion, (4x current year EBITDA) and an EV of approximately $4.8 billion.  At $600m of 2016 EBITDA with $250m Cap-ex, $125m of interest and $50m of cash taxes, FCF would be about $175m.  However, STAY is finishing up a multi-year $600m remodel effort and 2017 cap-ex is expected to drop to $125m – $625m of 2017 EBITDA less $125m cap-ex, $125m cash interest and $65m of cash taxes would bring $310m of FCF, more than $1.50 per share.  In a bear case scenario in which EBITDA declines from $600m to $500m, STAY could lower its cap-ex to a maintenance level of $90 million and still generate $1.20 per share in FCF.

Financials.  Revenue/EBITDA increases have come almost solely from rate increases as hotel count and occupancy have been relatively flat.  Rate increases have been driven by the multi-year renovation of STAY’s hotel base as well as the shrinking of the rate gap between STAY and its competitors.  Once the renovations are complete in 2017, STAY will begin to consider growth of the brand through new build hotels or franchising agreements (though heavy new hotel cap-ex seems unlikely).

*2016 EBITDA is impacted by the September 2015 sale of 53 Crossland Economy Studios hotels which generated $29 million in EBITDA for the TTM 6/30/15 period.  2016 Rate and RevPar is positively impacted by the elimination of the lower rate Crossland hotels.

Outlook.  We expect that historical revenue growth of 7% - 8% comes down to 3-4% annually as rate increases slow.  Smith Travel Research is projecting lodging industry RevPar growth of 5.0% in 2016 and 4.5% in 2017.  New construction growth seems limited in the suburban/economy segment in which STAY participates and the location/traveler profile of a typical Extended Stay hotel would suggest that AirBnb or the lack of foreign visitors due to a strong USD should not be an issue (there are no Extended Stay hotel in Manhattan).  Exposure to Oil/Gas is also somewhat limited with 10% of revenue from Texas but only 3.5% of revenue coming from Houston while the Dallas and Austin markets have been growing.  Extended Stay itself has a number of strong tailwinds including the renovation program which has and should continue to drive rate increases (not to mention the under construction rooms that will now be freed up), new ancillary revenue streams (i.e. daily housekeeping, faster Wi-Fi), a mix shift away from 30+ day stays, a newly implemented revenue management system (believe it or not there has not been one till now) as well as a new frequent guest program.  Expense discipline has been very strong and 3%-4% revenue growth combined with 2% expense growth would drive EBITDA growth of 5% annually.

While 5% annual EBITDA growth may not sound terribly exciting, STAY strikes us as a very nice FCF / return of capital story given the decline in cap-ex going forward (with no current plans to build any hotels) and a current FCF yield of 13%.  STAY is likely to increase its dividend going forward and recently announced a $100m buyback program.  With $400m in cash on its balance sheet (pro-forma sale of Crossland assets) we see no reason why the company wouldn’t be an active buyer of its stock.  We assume that essentially all FCF will be returned to shareholders via dividends and buybacks.    

Paired Share Structure.  Extended Stay America, Inc, owns the “Extended Stay” brand and manages the hotels, it has 205m shares outstanding.  ESH Hospitality is the REIT which owns the hotels.

• ESH Hospitality (REIT) has 455m shares outstanding,

• 250m (55%) of which are owned directly by Extended Stay America, Inc.

• 205m (45%) of which are paired and trade together with Extended Stay America, Inc., hence the “paired share” structure

ESH Hospitality (the REIT) pays 55% of its dividends to Extended Stay America Inc. which then owes taxes on its dividend income, the remaining 45% of ESH Hospitality’s dividend comes directly to shareholders without any REIT level tax liability.  The net of this arrangement is a cash tax rate of about 23%.

With the expiration of the lease agreement between Extended Stay and ESH in 2018, we believe it likely that the company splits into two separate publicly traded companies; Extended Stay would be asset light with recurring high margin management/franchising fees while ESH REIT would own the hotels and pay a significant dividend.

Valuation.  Given the increasing FCF going forward, we expect healthy dividend increases, perhaps $0.75 in 2017 and $.85 in 2018.  We assume that $2.8 billion of current debt stays flat and that post dividend FCF plus half of the current $400m cash balance (pro-forma for sale of Crossland hotels) is used to buy back stock, bringing the 2018 net debt balance to $2.6 billion and the share count to 180m from 205m currently.

A 10x multiple on 2018e EBITDA of $650m less $2.6 billion of net debt divided by 180m shares o/s brings an equity value of $22 which, combined with the dividends, brings an XIRR of 31%.  At a 9x multiple the value is $18.00 with an XIRR of 23%.

Bear in mind that maintenance cap-ex is quite low and cash taxes are in the low 20% range which implies an EBITDA/FCF conversion in 2018 of approximately 50%.  The 10x EBITDA multiple we are using to get to a $22 share price also implies a FCF multiple of 12.5x on the $1.75 in FCF per share that STAY should generate in 2018.

In terms of the downside, as noted above, Smith Travel is projecting mid-single digit RevPar growth for 2016 and 2017 and the location/traveler profile of a typical Extended Stay hotel would suggest that Airbnb or the lack of foreign visitors due to a strong USD should not be an issue – as an example, there is no Extended Stay hotel in Manhattan.  In the event of a 10% revenue decline, we assume a 2.5% expense decline and $600m of 2016 EBITDA would go to $500m which, as noted above with a $90m maintenance cap-ex level, would still bring roughly $1.20 per share in FCF more than covering the $0.68 current dividend and likely justifying a $10 share price.    

Summary/Thesis.

o Exceptionally well managed “private equity” like ownership mentality with industry leading EBITDA margins and FCF

o Less than 8 times 2017 FCF multiple with an intense focus on returning capital to shareholders via buybacks and dividends

o Likely split of the paired share structure would highlight value; sale of either or both pieces is certainly possible

o  About $1 million worth of insider buying by two insiders in the high $16’s per share during November 2015

We loved this quote from CFO Jonathan Halkyard at the BofA Lodging conference on September 9, 2015:

“We've talked a lot about the unique performance of our business, but we decided to test it, and did a little bit of research. We started with the Russell 1000, and then asked ourselves, how many of the Russell 1000 have a compound annual revenue growth rate over three years of greater than 8%, and that's about 324 companies. And then of those 324 companies, how many of those companies had over three years in each year operating margins over 25%, and that was a little bit over 40 companies. And then we asked ourselves, how many of those companies have a free cash flow yield of over 6%, and there are only eight; and how many of those eight companies have distributed that free cash flow to their shareholders delivering a dividend yield of over 3%, and there is only one company in the Russell 1000 that meets all of these tests.  So we think in terms of our revenue growth, our operating margins, our conversion to free cash flow through our tax structure, and our commitment to return that cash to our shareholders through a dividend are truly unique in the Russell 1000 in corporate America”

Catalyst

Agressive share repurchases / increasing dividends.

Split up of paired shared REIT structure (2018).