Hersha Hospitality: Adversity Is Bitter, But Its Uses May Be Sweet (NYSE:HT)


This article was coproduced with Investing With Confidence.

iREIT on Alpha’s recent article on Hersha (HT) Preferreds (HT.PC) (HT.PD) (HT.PE) caused controversy and disbelief. So, in this article we describe in more depth the numerical basis of our reasoning.

We show why we believe the preferreds offer good capital growth over a two-year timeframe. They also offer a high future income, for investors willing to sit through an initial one to two year dry period.

Some commenters raised the possibility that our analysis was incorrect. This is important to look into, because we all make mistakes, and listening intelligently and dispassionately to others pointing out one’s mistakes is the best way to learn and grow. As Benjamin Graham made clear,

“The most durable education is self education.”

We encourage you to read our original article, to understand Hersha’s origin story, illustrating the readiness of the founding family to handle unexpected adversity deftly. Another Graham-inspired quote that I have taped to my computer screen,

Adversity is bitter, but its uses may be sweet. Our loss was great, but in the end we could count great compensations.”

Source

One of the pleasures of writing on Seeking Alpha is that many skilled investors share their insights and criticisms. Looking at all angles is vital to testing an investment case.

Balance Sheet collapsing – even before the pandemic?

And plotting the Balance Sheet data, from the MarketWatch link provided does indeed show the balance sheet going South.

(Apparent collapse in Total Assets at Hersha Hospitality Trust in the years before the pandemic. iREIT Econometrics Unit using balance sheet data at MarketWatch. Source.)

In such a situation, IwC’s embarrassment as an English gentleman would normally force him to resign from iREIT, book himself into a top story room at Hersha’s Cadillac resort in Florida, and throw himself out of the window.

(Cadillac Hotel, Florida. Source: Hersha Hospitality Trust website.)

However, just moments before he booked the fateful trip, IwC noticed a couple of things:

1. First, a closer look at the scale of the graph shows that the (accounting-standard) total assets have indeed trended down over those four years, but only from $2.16 billion to $2.14 billion.

2. Second, standard accounting requires the carrying value of a hotel to be depreciated over time, as though the buildings’ concrete melts in the heat. This accounting convention is wise for cars and computer equipment, which do indeed wear out in a few years, but for hotels it is largely an accounting artifact.

Replotting the graph, accounting for this, yields the following:

(Total Assets, defined at Debt + Equity. An additional faint green bar above shows the cumulative depreciation and amortization. iREIT Econometrics Unit analysis of company filings.)

Drawn at a proper scale, you can see that the standard accounting calculation of total assets ( grey debt + green equity) does indeed show a decline over the 4 pre-pandemic years, but only very slightly.

Moreover, you should only worry about this if you think the concrete really is melting, with a few rooms a year per hotel collapsing back into the ground. In that case, be guided by the black arrow.

Maybe, though, you think the buildings don’t really wear out like that? That the rooms that are considered to vanish under standard accounting, in reality do continue to exist (pale green bars)? In that case, follow the orange arrow, which treats the rooms that have been deleted by the accountants, as still existing and owned by the equity holders.

Too much debt?

Another experienced investor pointed out the heavy leverage used by Hersha, by comparison to other hotels.

The key to whether debt is helping or harming the company is whether it is breaking even. This is because debtholders get paid a steady amount whatever happens. When revenue is below breakeven, the debtholders are part of the reason there is negative cash flow.

But when revenue exceeds breakeven, every extra dollar of cash flow belongs to the equity holders. The more and more successful the business beyond that point, the more uproariously delighted we equity holders are. We don’t have to share the extra cash flow with anyone!

In the debt and equity chart above, you can see that under standard accounting rules, the debt-to-equity ratio at end-June is about 1.27. This is higher than many other hotels.

Two things should come to mind though.

First, what interest rate are we equity holders paying those money-grabbing creditors? As preferred shareholders, we are promised to (eventually!) receive a 6.5 to 6.875% return on the redemption value of $25 per preferred share.

In fact, if we buy preferred shares now at $15, if-and-when they return to paying dividends (more on that question later!) they will be paying an ~11% yield on cost. (Not to mention some catch-up dividends, again to be discussed later.)

We sure hope those debt holders are not being paid anywhere near 11%! And indeed they aren’t.

The average interest rate that Hersha is paying is only 3.7%. If $1 of extra property produces more than 3.7 cents of cash flow per year, we can consider that loan to be a good deal for the equity holders.

So the debt is a double-edged sword: On the one hand, it gets us capital at a far lower annual cost than we equity holders would be willing to provide. But on the other hand, if we do not pay, in full, and on time, the debt holders can legally slit our throats and leave us to die in the dirt.

Debt itself is not automatically fatal. During an economic recovery, it can magnify growth. The key question is whether we survive the downturn, so that we can benefit from the slingshot effect that debt provides.

Not breaking even?

What level of occupancy do hotels need to break even? Dedicated hotel statistics firm HotStats has compiled an interesting dataset covering all hotels across the USA, shown below.

(iREIT Econometrics Unit display of data from HotStats.)

In general, when a hotel has higher occupancy than the levels shown here, its operations (revenues from travelers, minus local running costs of the hotel) contribute net cash to the company.

Note that high-end hotels tend to make extra profits from the add-on services other than the room itself (such as restaurants, fancy laundry services, etc.). Low-end hotels tend not to do so. Therefore, high-end hotels (such as Hersha’s) can break even at a slightly lower occupancy, once the full value-added features of the hotel reopen.

Across the whole of the USA, business intelligence website STR.com provides actual hotel occupancy rates. We plotted this in the last article, but because we didn’t explain it in detail, some people found it alarming.

(Hotel occupancy across the USA. Graphic from the iREIT Econometrics Unit. Gray bars show 2019 figures, and green bars 2020 figures from STR Inc.)

Remember that hotel occupancy rises and falls through the year. The grey bars show the 2019 figures, and the green bars the 2020. So the dip seen from August to September is not a pandemic-mediated collapse in interest, but merely the expected result of leaving the most popular months of the year for travel.

To understand this in context, we have now plotted the occupancy this year as a proportion of the occupancy last year. As a reminder, in a normal year, this graph would just hover around 100% throughout the year.

(Hotel occupancy 2020, as a proportion of occupancy in the corresponding week of 2019. Source: iREIT Econometrics unit from data in graph above.)

Put this way, it is easier to see that the ghastly nadir had only about 3/10 of the trade of last year, but this has now gradually crawled up to just over 7/10 of last year.

And the dip in August and September that worried some investors? It was expected due to the season. On a seasonally adjusted basis, these months actually showed a continued improvement in occupancy.

Won’t headquarters costs and interest payments still bury Hersha?

This was an important question raised by several commenters.

Of course, there are still two big bites to be taken out, after paying the costs at the hotel level, before we equity holders could even begin to lay eyes on the cash flow.

Corporate headquarters costs, also called “sales, general and administration.” If they aren’t paid, there will be no hotel chain.

Debt holders: banks and bondholders. If they aren’t paid, they can foreclose on a hotel (for secured debt) or even drive the company into bankruptcy (for unsecured).

Let’s look at how close we are to breaking even at the corporate level, i.e., after paying headquarters costs and interest.

Revenue

First, remember that the hotel business is uneven through the year. Q2 is the busiest, then Q3, Q4 and Q1. We have colored/shaded Q2 and Q3 to make it easier to see the pattern in the quarterly revenue data.

(Quarterly total revenue of Hersha Hospitality Trust. iREIT Econometric Unit from SEC filings of 10-Qs and 10-Ks. Busy two quarters in darker green. The 2020 quarters, affected by Covid-19, are in a paler color.)

You can see that Covid-19 hit in late Q1 2020, with revenue chopped by almost a third, by comparison to the upward progression in the previous three Q1s. Maximum devastation was Q2, of course, with almost no revenue.

Expenses – and which ones matter?

Here are the “operating expenses.” You can see that management achieved large reductions in property-level expenses, through staff reductions etc., but could not eliminate them all, because of the need to keep skeleton staff at all hotels that were operating and the unavoidable need to pay property taxes.

But look at the grey bars – depreciation and amortization. These are chunky expenses that must be listed in the operating expenses category, but we have realized are mostly not real cash expenses that have to be paid now from the company bank account. The depreciation of hotel properties is mostly an accounting artefact.

We should remove them from consideration for now.

Far more important is that we include the interest expenses. These are not considered “operating” expenses, but they are definite cash that must be paid out, or else! In the figure below we have inserted a red bar for the quarterly interest the company must pay.

Then at the very top we show the amount of excess revenue there is, after paying the three big unavoidable cash outgoings: hotel-level expenses, interest payments and headquarters costs.

As you can see, each quarter there was cash left over, until 2020.

More importantly, you can see the size of the headquarters expenses (black) and interest expenses (red) in the context of the usual property-level expenses (purple).

How can this hotel group be considered so heavily indebted and yet the red bars be so small?

The answer is in the interest rate being paid on the loans: just 3.7%. Had the loans been fixed-rate loans at (say) 7%, the red bars would have been twice as large, and more plausibly crippling. But at this interest rate, the loans are a cheap source of funding.

High leverage does not equal crippling debts.

No hope for recovery?

Many investors have noticed that Hersha’s revenues collapsed much more dramatically than the national average, as shown below. Hersha has many hotels in New York and Florida, hardest struck by the virus.

New York ## subheading

(Cases, upper panel, and deaths, lower panel, in New York. Source: worldometers.info)

New York was hit first and hit hardest by Covid-19. The lockdown caused economic crisis to millions, but was successful in arresting the huge peak in deaths in April. Note that the ratio of deaths to cases in September is far lower than it was early in the epidemic, when testing was less widely available and less expertly targeted.

Florida

(Cases, upper panel, and deaths, lower panel, in Florida. Source: worldometers.info)

Florida experienced its main outbreak much later, in June.

Notice that in Florida, the peak rate of rise in deaths (approximately July 23) is a full month after the peak rate of rise in new cases (approximately June 23), when for New York the lag was much shorter, just one week or so. The reason is that in New York, being early in the pandemic, testing was in the process of ramping up, delaying the peak rate of rise of documented new cases. In contrast, in Florida, the later date allowed testing to be better established and therefore more consistently reflect numbers of infected patients.

Hersha is more sensitive: but to both downswing and upswing

Bears have rightly observed that Hersha’s hotels, being concentrated in tourist locations, were pounded harder by the lockdowns (downward arrow between green bars) than the average hotel (blue).

However, this, like the debt, is a double-edged sword. While the decline from Q1 to Q2 was more intense in Hersha’s hotels than others, there is correspondingly more scope for recovery.

Hersha’s hotels have progressively been reopening during the latter half of Q2 and during Q3.

(Source: Hersha Hospitality Q2 report, with September count verified by iREIT checks that hotels reopened on schedule. Two hotels scheduled in Q2 report to open in September, Ritz-Carlton Georgetown and Boxer Hotel Boston, appear to now be reopening in October.)

More important than numbers of hotels open is their occupancy. Hersha provided weekly occupancy statistics for a set of 28 hotels that have been open throughout the period shown below, and therefore provides a window on the trend.

(Upper panel: Occupancy of Hersha’s 28 hotels open throughout this period (blue), mapped against national 2019 occupancy (gray). Lower panel shows the ratio between the bars in the upper panel.)

At first, the occupancy of Hersha’s hotels (upper panel, blue bars) looks not only anemic but also disappointingly flat. However, that is until we see the context of typical occupancy trends at that time of year (gray bars), which are of a decline.

The lower panel shows a more useful indicator of recovery of the business: how Hersha’s hotels are doing in occupancy, against a yardstick of how an (admittedly average non-Hersha) hotel should do at that time of a normal year.

At end-August, the Hersha occupancy is half what would be expected for that time of year. Ask yourself whether you think the trend is going upwards or downwards?

Will Hersha run out of cash?

If you think July and August form a downtrend, then you might be very pessimistic for September (the last month of Q3) and for Q4.

However, at iREIT we think July and August have seen Hersha’s hotel occupancy slowly but surely rise against the yardstick of expected rates for time of year. We do not expect that the remaining four months of the year will show a dramatic reversal of this trend.

With all this in mind, what do you think will happen in the weeks and months to come? Below we show a range of 3 possible projections for the remaining weeks of Q3.

(Three possible projections for recovery of Hersha occupancy. Source: iREIT)

The further out one extrapolates, the more uncertain the projections are, but only up to a point. We know for certain that, eventually, the pandemic will subside. The only uncertainty is how long it will take.

Hersha has told us in its Q2 report that monthly cash burn at the entire company level (including interest payments and headquarters expenses) has been cut down progressively from $10.5m in April, via $8.6 m, and $7.8 m, to $6.7 m in July.

Extrapolating current figures, Hersha will run out of cash in October. It began Q3 with $23 m of cash and cash equivalents, and if we conservatively estimate $7m per month for July-August-September, then it will begin October with only $2m.

But this doesn’t mean the company will go belly-up, for two reasons.

First, look at the chart above. Occupancy is higher in Q3 than Q2, and so revenue is higher, and cash burn is likely to be slower than our conservative $7m per month.

Second, and more importantly, lenders can see this too. While they could slit the company’s throat and sit in court for a few years to get back their original capital, they could instead scrutinize the red bars in the “excess revenue above cash expenses” graph above. Interest payments are small, so if lenders provide more liquidity now, payments should continue to stream effortlessly into their coffers.

Borrowing from Uncle Sam at near 0%, and lending to Hersha at about 4%, is easy money for lenders. If the existing lenders don’t want to play ball, new lenders can be found.

Generosity from the Federal Reserve is also why we expect the $216m debt refinancing in 2021 to progress smoothly. And alongside this, Hersha has 3 hotels currently under contract for sale: Autograph Blue Moon in Miami, Duane Street in New York and Courtyard South Boston. Whether those sales will ultimately be consummated and at what price, is unknown, but this does form a supplementary avenue for liquidity.

Investment case

Remember we are not advocating investing in the common shares. They do have the greatest potential to skyrocket if things go well for Hersha, but at iREIT we prefer an investment which needs less perfection, in order to provide a good long-term return.

Unlike most of our picks, Hersha Preferreds are speculation rather than a current source of income. By speculation, we mean that we are purchasing them at a deep discount with the intention of later selling them when their value is more obvious to the market in general.

However, unlike a day trader’s speculation based on short-term trends, our speculation is based on the fundamental value of the security which has not been recognized by the market.

Our analysis is that Hersha is very likely to pull through this difficult phase. When it is obvious that it has done so, and the preferreds are streaming out dividends steadily, they will likely trade around par, $25.

The investment case is that to buy the preferreds at under $15 provides a good likelihood of a return of $25 within about 2 years.

Alongside that, since the beginning of April 2020, the preferreds have been quietly accumulating $1.63 to $1.72 per year of dividends. As long as the company does not go bankrupt, these dividends will eventually be paid.

Because the company has secured a 1-year covenant holiday (to end June 2021), it is likely that it has promised not to pay any dividends in that period of time. Therefore, the earliest one could expect to receive dividends is the end of Q3 2021.

Why not wait?

The principal reason that Hersha preferred stock is available so cheaply now is that it pays no income. Investors who need immediate income have understandably cast the shares aside in disgust. But if you don’t need immediate income, you don’t have to be so averse to the shares.

Their entitlement to dividends grows quietly in the background, even as nothing is paid out. Common stockholders, including the Shah family (who are the CEO and COO/President, and who between them own over 12% of the commons) cannot receive a penny of dividends, until all the preferred dividends are paid.

It would be entirely reasonable to bide one’s time and purchase Hersha preferreds later, perhaps in a few months. Of course, the more obvious it is that the company will survive the crisis, the less likely it is you will obtain the preferreds at such a deep discount.

The case of Exantas Capital Preferreds may be a reminder of the wisdom of buying before the dividend stream actually arrives.

(Share price of Exantas Capital Preferred. Source: Yahoo Finance)

The chart above shows how Exantas Preferred, whose dividend has been suspended during the coronavirus crisis, responded to the announcement of restarting the preferred dividends.

Investors knew all along that they would have to start within a quarter or two, but did not know exactly when it would be announced. Selling pressure, from investors and funds that could not hold non-dividend paying stock, kept prices depressed for months.

Speculators, including IwC, benefitted from that rise. But only because they bought before the dividend re-establishment was announced.

Which Preferred?

If the company is taken private – for example, by the controlling Shah family – the acquiring company would choose between:

Continuing to pay the preferreds under the original agreement Buying out the preferreds, for $25 + any missed dividends.

There is an extra right available to preferred shareholders in the event of a privatization. Individual preferred shareholders have the option of swapping to common shares, according to a formula.

The formula provides 2.31 common shares (for HT-C), 2.88 shares (HT-D) and 2.81 shares (HT-E), in each case capped at $25 plus missed dividends. (The 2.31 ratio for HT-C is tricky to calculate because the prospectus states 9.24, but this must be adjusted for a later 4-fold reverse split of the common shares.).

In practice, however, if the company is taken private, preferred stockholders are very unlikely to want to exercise their right to convert to commons, so the slight difference in conversion ratio is moot.

There is a difference in dividend entitlement, 6.875% for HT-C versus 6.5% for HT-D and HT-E, but this is small. At current prices, with HT-C trading about $0.50 above HT-D and HT-E, all three classes are equally good prospects.

Summary

Hersha preferreds, purchased around $15, provide a very good likelihood of achieving $25 par level over the next two years. Over the two-year window to end-Q3 2022, the 2.5 years of accumulated preferred dividends (at least $4) are likely to be paid or be recognized by the market as likely to be paid. Thus, over the 2 years, you are speculating on a gain of $10 + $4, which is +93%.

Revenue collapsed by ~90% in Q2, by comparison to the previous year. There will be no dividend in 2020, nor the first half of 2021. This is preventing income-oriented investors and income funds from investing in the stock.

However, Hersha’s hotel occupancy has subsequently been creeping up during July and August, and all the more impressive in the context of these historically seeing declines in occupancy. By the end of August, Hersha’s occupancy was already above 50% of that of a typical US hotel at that time of year.

Although debt to (depreciated) equity is high, interest payments need only a little more recovery to become manageable, thanks to the 3.7% average interest rate, and slimming of headquarters expenses. Lenders have already granted a long covenant holiday and are likely to extend more credit when it is required (probably by October) in recognition that the long-term business itself is sound and well-managed.

An investor who has no need for income in the next two years, and would be happy with a gain of +93% in about two years, should find Hersha to be an attractive investment. Once the preferred dividends start to flow, the investor could exit with that gain, or hold on for a >11% yield on cost.

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I am/we are long HT.PC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: IwC is long all 3 classes of preferred in Hersha, but predominantly the C class.

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