Description

FelCor 7.8% Preferred Investment Recommendation

FelCor Lodging Trust, $1.95 Series A Cumulative Convertible Preferred Stock

Ticker Symbol: FCH-A     CUSIP: 31430F200    

FCH-A stock price:  $26.25

Investment Thesis

On April 24, RLJ agreed to acquire FelCor Lodging Trust (FCH) for $1.1B in stock. The deal is expected to close by the end of 2017, with Felcor and RLJ shareholder votes scheduled to be held on August 15^th and approval highly likely.

The combination of RLJ and FelCor creates the third largest lodging REIT and on a pro forma basis results in a significant reduction in leverage as compared to Felcor on a stand-alone basis.

Felcor Lodging Preferred A (FCH-A) cannot be called, so it has significant upside potential.

FCH-A should trade at a current yield of 6.0% to 6.5% or between $30.00 and $32.50 were it to trade at a similar yield to the preferred stock of Hersha Hospitality, another hotel REIT with non-investment grade credit metrics.  (Hersha is in fact substantially more leveraged than Felcor at 8.9x net debt+preferred/EBITDA vs. 5.8x net debt+preferred/EBITDA at Felcor.)

Prior to the announced merger, Felcor had been selling hotels and deleveraging its balance sheet.  The combined company, which will be run by RLJ’s management, has indicated that it intends to reduce leverage further and is committed in the longer term to achieving an investment grade credit rating.

I believe that FCH-A is underfollowed and many are unaware that this preferred cannot be called, so it has considerable upside because the Company cannot refinance the preferred on more attractive terms as the credit improves.  I expect the credit spread to tighten once the acquisition closes and subsequently as investors begin to price in the credit enhancing nature of the RLJ acquisition.  I believe the credit spread will tighten even further as RLJ reduces debt further from cash on hand, proceeds from asset sales and free cash flow generation. 

As investors appreciate and begin to recognize the massive credit enhancing nature of this transaction to the preferred stock and RLJ management reduces leverage further the market should re-price the preferred stock at much higher price (and commensurately lower credit spread).  In the meantime, as a holder of the preferred stock you are paid to wait as this occurs from the 7.4% current yield on cost.

Merger Background

On April 24, 2017, Felcor announced that they had entered into a merger agreement with RLJ in an all-stock transaction. At closing, Felcor stockholders will receive 0.362 RLJ common shares for each share of Felcor common stock.

RLJ’s stock fell 6% on the day the acquisition was announced and is down ~15% since the transaction was announced.  Investors did not like the deal because they thought the acquisition was a bad fit strategically (RLJ had a portfolio of predominantly composed of focused-service hotels whereas FelCor’s portfolio was more weighted towards full-service hotels), because the acquisition was leveraging late in the business cycle, and because the deal was costly to RLJ shareholders—given the post announcement decline in RLJ’s stock price.

Investor criticism intensified after RLJ revealed that in June it was approached by an unidentified buyer offering to buy RLJ for about a 20% premium to then its share price. That buyer was reportedly private-equity firm Blackstone Group.

Notwithstanding those facts, we expect the deal to get approved by shareholders on August 15 (tomorrow).  Shares of both Felcor and RLJ are overwhelmingly held by long only mutual funds and index funds and no activist investors have emerged to oppose the deal.  The transaction is expected to close on August 31, 2017.

The acquisition will create the 3rd largest U.S. lodging REIT by enterprise value ($5.7B) and market cap ($3.5B).   Street estimates are for proforma adjusted EBITDA of $575 mm in 2017, falling slightly to $551 mm in 2018 a consequence of the completion of six planned asset sales.  New RLJ will have 160 assets and over 29,000 rooms that are well diversified across geographies and brand type.

Why FCH-A Can Never Be Called and Thus Has Significant Upside

FCH-A is a convertible preferred stock, so it has no call date. 

FCH can force FCH-A holders to convert their shares into common shares if FCH exceeds a price of $32.25 per share, but with FCH currently trading at $7.19, that is unlikely to happen.   Once the merger is effective, each share of FelCor Series A preferred stock will automatically be converted into one share of newly created RLJ Series A preferred stock.  Once the merger closes, RLJ may force conversion once the closing price of RLJ equals or exceeds $89.09 (as compared the current price of $20.12).

Unlike most preferred stocks, FCH-A is not anchored to a $25 call price and can rise significantly above $25.  EPR-E is an example of a par $25 convertible preferred issued by triple net lease REIT EPR Properties that now trades at ~$35 and at a ~6.4% current yield due to the fact that it cannot be called and because of EPR’s strong credit profile (net leverage of 5.2x debt/EBITDA and BBB-/Baa2 investment grade credit rating).

Relative Value Considerations to Value FCH-A Preferred

Hersha Hospitality (ticker HT) is another non-investment grade hospitality REIT.  HT-E is the largest preferred issue with a par value of $150 mm and the 6.5% coupon issue trades at 25.25 or at a 6.44% current yield and at a substantially similar yield to worst.  As noted earlier, Hersha is substantially more leveraged (net of cash) than the pro forma FCH/RLJ (“NewCo”).  Hersha is leveraged 8.8x through the debt and preferred stock and 6.7x through the debt vs. NewCo at 5.8x and 4.8x, respectively.  Ashford Hospitality Trust (ticker AHT) is another highly leveraged hotel REIT comparable and notably proposed a business combination with Felcor earlier this year (that was rejected by Felcor).   The AHT 7.39% Series G (the most recent preferred stock to be issued by the Company) trades at $25.00 or a 7.38% current yield.  Ashford is also much more levered than Felcor.  AHT leverage through the preferred is 11.0x and through the debt only is leveraged 9.6x.  It’s difficult to say precisely where NewCo’s preferred stock should trade given the previously mentioned relative value comparisons but I think a 6.0% to 6.5% current yield is fair.   Another useful approach is to look at where FelCor’s unsecured debt is trading and then to apply a credit spread of 250 bps to account for 1 turn of greater leverage through the preferred than through the debt (5.8x net debt to EBITDA vs. 4.8x).  250 bps is the spread relationship for example between iStar’s (a mortgage REIT) unsecured debt yield (5.0%) and the firm’s preferred stock yield (7.5%).  FelCor’s 6.0% 06/21/25 senior unsecured bonds recently traded at 108 or a 4.0% yield to worst.  At a 250 bps spread to the unsecured bonds, FelCor’s preferred stock should yield 6.5% rather than the 7.4% current yield that the preferred stock trades at currently.  Were FCH-A valued at a 6.0% to 6.5% current yield, FCH-A would trade at $30.00 to $32.50, almost $3.25 to $5.75 per share higher than its current price.

RLJ/FCH Plans to Delever Which Should Benefit the Preferred Stock

As of 06/30 2017, RLJ’s Net Debt + Preferred Equity / 2017E EBITDA was 3.0x whereas Felcor was much more highly levered (on the same basis) at 7.3x.  As previously mentioned the combined company will be leveraged on a net basis at 4.8x and 5.8x when including the preferred stock.

Historically, RLJ has maintained a conservative (low leverage) balance sheet and kept debt leverage well below target of 4.0x.  

Prior to the announced merger, Felcor had been reducing leverage.  Felcor had been on a mission for some time to improve the Company’s balance sheet by selling non-core hotels.

The Street expects net debt to EBITDA to initially rise to 4.8x, up from RLJ’s current 2.9x, before falling to 4.0x following an estimated $1.1B debt reduction using cash on hand and proceeds from asset sales. 

Planned asset sales are a key part of the de-leveraging strategy of NewCo with the sale of six hotels potentially dropping net leverage from 4.8x to 4.0x or less by the end of 2018.  RLJ’s management has announced plans to sell six FelCor assets post-close, which together with the recent FelCor sales of Morgans and Royalton, may yield ~$524 mm in net cash. Tapping both proceeds from asset sales as well as unrestricted proforma cash on hand of ~$595 mm could allow for up to $1.1 bn in debt reduction.

FCH had already started that process with the sale of the Morgans and Royalton this summer for gross proceeds of $92 mm.  Felcor continues to proceed with its previously announced efforts to market the (330 room) Knickerbocker for sale.

Some analysts believe RLJ may also consider selling FelCor’s two full-service San Francisco assets once RevPAR rebounds following the re-opening of the Moscone Convention Center in 2018.

Street estimates are for the pro forma company to generate $575 mm in EBITDA, ~$2.00 per share in AFFO or (based on 174 mm shares) ~$348 mm in AFFO.  Net of a $1.32 per share dividend the Company should generate $115 mm of free cash flow which could be used to reduce leverage further.

Newco will have significantly liquidity to delever with ~600 mm in unrestricted cash.  The combined company has publicly committed to delivering and achieving (in the long term) an investment grade credit rating.  Newco maintains a significant pool of unencumbered assets and should be able to refinance FelCor’s unsecured debt maturities at lower interest rates (FelCor’s bonds trade substantially over par) which will reduce interest expense and improve Newco’s fixed charge coverage.

Newco plans to initially targeting repayment of FelCor’s $525 million of 5.63% senior secured notes (03/01/23 maturity) callable in March 2018, with planned asset sale proceeds.  Were Newco to choose to refinance rather than retire the senior secured notes, the Company should be able to refinance the bonds on an accretive basis at 3.0% to 3.5%.

There are additional opportunities to refinance or pay down higher cost debt over time.  FelCor’s $475 mm of 6.0% senior unsecured notes are callable June 2020 and trading at 108 and a yield to worst of ~4.0%.

Finally, NewCo’s liquidity remains strong with 129 unencumbered hotels and unrestricted cash of ~$600 mm.

Catalyst

Shareholder vote on August 15 and closing of the FCH/RLJ merger by the end of the year.