Description and Background

Founded by Ian Schrager in 1983, Morgans Hotel Group Co. (Nasdaq: MHGC) is credited as the creator of the first "boutique" hotel and a continuing leader of the hotel industry's boutique sector.  The Company operates Morgans, Royalton and Hudson in New York, Delano and Shore Club in South Beach, Mondrian in Los Angeles, South Beach and New York, Clift in San Francisco, Ames in Boston, Sanderson and St Martins Lane in London, and hotels in Isla Verde, Puerto Rico and Playa del Carmen, Mexico. Morgans also owns, or has ownership interests in, several of these hotels. 

Despite the Company's track record of building hip, ultra modern hotels designed by the likes Phillipe Starck, the Company is now rapidly transforming itself from a capital intensive boutique hotel owner and operator to an asset-light hotel manager and franchiser.   Through June of 2011, the Company has sold three of its wholly-owned hotels while retaining their management contracts at favorable terms and is currently marketing its assets in London.  MHGC will also eventually monetize its remaining wholly-owned hotels in New York and Miami.  

Hotels & Management Contracts as of 3/31/11

Thesis

Shares of MHGC appear highly leveraged and extremely expensive on traditional metrics (both on an absolute and relative basis), but the Company is, in fact, trading below the value of its core real estate holdings and you're getting the remaining high ROIC hotel management and franchising business and minority stakes in four boutique hotels for free.  In addition, the Company's debt profile has improved dramatically following the sale of hotels in New York and Los Angeles.  Pro forma for the sales that closed during Q2'11, the Company's total indebtedness has been reduced by almost 40% to $523 million, of which only $289 is recourse to the Company. 

I believe the key to achieving my  base case valuation of over $12 per share is the sale of MHGC's remaining core hotel real estate, the Delano in Miami, the Hudson in New York and the Sanderson and St. Martins Lane in London.  By unlocking the value of its real estate, the Company will be in a position to pay down all its debt and use the significant excess proceeds to invest in its management and franchising business. The London assets are presently being marketed for sale and I believe the U.S. assets will be sold once management has targeted an efficient use for recycling proceeds. 

How does MHGC make money? Is this a great business?

How does the MHGC make money?

As a hotel owner and operator, the Company primarily made money by investing significant amounts of capital into building and operating boutique hotels in gateway markets.  Ownership had two distinct ramifications on the cash flow of the business: (1) in order to grow, capital needs to be continually fed into the business in an effort to increase the unit base; and (2) owing to the fixed costs associated with operating a hotel (depreciation, staff, etc.), operating cash flows were extremely cyclical as operating leverage magnified positive revenue performance, but also penalized them as owners when they did meet their fixed costs. 

As a hotel manager, MHGC will generate revenue by receiving a contractually stipulated percentage of room revenue (typically base fees 3-5% of hotel revenues) at the hotels in its system, and in some cases, a percentage of operating income at the hotels (incentive fees) based on certain performance criteria.  In the U.S., incentive fees are generally 10-30% of a hotel profits after an owner priority, or profitability threshold.  Outside the U.S., there is typically no owner's priority, so management contracts can be more lucrative relative to U.S. contracts (all else being equal).  Owing to the minimal costs associated with this business, the fees generate extremely high operating margins.  Furthermore, the low fixed cost and fee-based nature of this business somewhat limit the volatility of cash flows through the lodging cycle.  As a manager, the Company may also be expected to provide hotel owners with sliver equity or mezzanine financing to show their commitment to the property by having "skin in the game". 

As a franchiser, MHGC will license the hotel owners the rights to the Delano and Mondrian brands.  The benefits to the franchisee from brand affiliation include national marketing and advertising programs, central reservation systems, ongoing training programs for employees, and sales and technology support.  In return, MHGC will receive one-time application fees, recurring royalty fees (typically 4-6% of room revenue and 2-3% of food and beverage revenue) and fees for use of the central reservation system.  

Is this a great business?

By moving into a less capital intensive and less cyclical business model, I believe MHGC will be viewed as a great business as the manager and franchiser model is generally characterized as having stable and extremely high returns on invested capital.  For instance, Choice Hotels (NYSE: CHH), the only listed pure-play hotel franchisor, has consistently generated ROIC's in excess of 50% throughout the last two lodging cycles (2002 - 2010).  I view these levels of returns as spectacular in any industry and indicative of a great business. That being said, there is still significant competition amongst hotel brands and MHGC's management team must execute to maintain and enhance their brand equity in order to grow.  I have also included MAR and HOT, which are also striving to increase their management and franchise business, to show the variance in returns of the different industry models and volatility through cycles.  

Comparison of Select Lodging Company ROIC's

Why and how is MHGC cheap? How should the company be valued?

As stated above, on traditional metrics MHGC looks very expensive and overleveraged; shares presently trade at over 25x LTM EV/adjusted EBITDA and 18x Net Debt/LTM adjusted EBITDA (debt calculation includes non-recourse hotel debt).  How then are the shares cheap?  MHGC is cheap because at the current share price you're only paying for the real estate underlying the Delano, Hudson Hotel and share of the London hotels and getting a growing hotel management business and joint venture assets for free.

I believe shares of MHGC should be valued on a sum-of-the-parts basis rather than on traditional EV/EBITDA metrics as this method separates the value of the real estate, minority investments and hotel management business. 

Sum-of-the-Parts Walk Through

2011 YTD Sale Transactions

Through June of 2011, the Company has already successfully sold off three hotels for over $150 million in proceeds.  The assets, which were purchased by REITs, averaged valuations of $534K/Key and ~20x EV/2010 EBITDA likely due to the following:  1.) we're in the early stages of the lodging recovery suggesting significant upside to 2010 EBITDA, 2.) MHGC's assets generate significant streams of income besides lodging related revenue (more on this below), and 3.) the condition and quality of the assets.  

Pro Forma Balance Sheet ($ in millions)

With the sale of Morgans, Royalton and Mondrian the Company's net debt declines from $659 million to $407 million.  Excluding non-recourse property debt, the Company's net debt is now down to $173 million.  The Company is also left with an NOL worth ~$100 million that could be used for limiting tax leakage from future asset sales.  

London Hotel Sales

MHGC owns 50% stakes in two London hotels, the Sanderson and St Martins Lane, which it also manages.  Per press reports, the Company and their joint venture partner, Walton Street Capital, are looking to sell the hotels in London and have MHGC retain the management contracts.  I am valuing the London assets at $250 to $319 million, which would yield net proceeds of $84 to $119 million to MHGC.  My valuation is supported by press reports and prior transactions for these assets that indicate potentially higher values.  For instance, in 2007, when Lehman Brothers offloaded the hotels to Walton Street the implied value was ~$300 million and Property Week has published reports that the sellers are seeking £215 million, or $346 million at today's exchange rates.  As the Company's 50% ownership in these assets are held through equity in a joint venture, management believes that they could use their U.S. NOL's to limit tax leakage.  

London Hotel Assets ($ in millions)

Sanderson Hotel Overview

Opened in 2000, Sanderson has 150 guestrooms and suites, seven with private terraces and 18 suites, including a luxury penthouse and apartment. The hotel is located in London's Soho district, within walking distance of Trafalgar Square, Leicester Square and the West End business district. Sanderson's structure is considered a model of 1950s British architecture and the hotel has been designated as a landmark building. Designed by Philippe Starck, the guestrooms do not have interior walls (the dressing room and bathroom are encased in a glass box that is wrapped in layers of sheer curtains). Dining and bar offerings include Suka restaurant, Long Bar and the Purple Bar. Other amenities include the Courtyard Garden, the Billiard Room, and Agua Spa. Like the Light Bar at St Martins Lane, the Long Bar is a popular destination that has consistently attracted a high-profile celebrity clientele and has generated significant media coverage.

St Martins Lane Overview

Opened in 1999, St Martins Lane has 204 guestrooms and suites, including 16 rooms with private patio gardens, and a loft-style luxury penthouse and apartment with expansive views of London. The renovated 1960s building that previously housed the Mickey Mouse Club and the Lumiere Cinema is located in the hub of Covent Garden and the West End theatre district, within walking distance of Trafalgar Square, Leicester Square and the London business district. Designed by Philippe Starck, the hotel's meeting and special event space includes the Back Room, Studios, and an executive boardroom. St Martins Lane features Asia de Cuba Restaurant; The Rum Bar, which is a modern twist on the classic English pub; the Light Bar, an exclusive destination which has attracted significant celebrity patronage and received frequent media coverage; and Bungalow 8, a members-only bar. Gymbox, a state-of- the-art gym, is operated by a third party under a lease agreement.

Delano and Hudson Hotels

As the Company pursues its asset-light strategy it will also opportunistically look to unload its remaining wholly-owned hotels, the Delano in Miami and the Hudson in New York City, and retain the management contracts at those properties.  Based on recent press reports and my own due diligence, I believe that the Company could again garner significant premium valuations for these trophy assets and fetch upwards of $300 million in net proceeds. 

In my base case sum-of-the-parts, I assume that the Delano is sold for $184 million by assuming $950K/Key.  While on the surface this appears to be a very rich multiple, I believe it is defensible and could, in fact, prove conservative.  For instance, at $950K/Key for the Delano a buyer would be paying only ~7.5x peak EBITDA for THE landmark hotel in Miami (see valuation matrix below).   In addition, I believe the Delano deserves a premium valuation due to its diversified income streams.  Unlike most full service hotels in the U.S. that generate less than 30% of their revenue from food and beverage business, the Delano earns greater than 50% as the hotel is designed to capture significant non-guest restaurant and bar business.  Finally, I believe my valuation is further supported by management's statement that the property has historically been appraised at $160 million, or $825K/Key, for the credit facility.

I estimate that The Hudson will be sold for $396 million in my base scenario, or $475K/Key.  This valuation is supported by several New York City transactions of comparable assets (see below) and commentary from Real Capital Analytics that the average value per transaction was $435K/Key in the trailing twelve months. 

Delano Overview

Opened in 1995, Delano South Beach has 194 guest rooms, suites and lofts and is located in the heart of Miami Beach's fashionable South Beach Art Deco district. Room renovations began in 2006, including technology upgrades and upgrading of suites and bungalows, and was completed in October 2007. Formerly a 1947 landmark hotel, Delano South Beach is noted for its simple white Art Deco décor. The hotel features an "indoor/outdoor" lobby, the Water Salon and Orchard (which is Delano South Beach's landscaped orchard and 100-foot long pool) and beach facilities. The hotel's accommodations also include eight poolside bungalows and a penthouse and apartment. Delano South Beach's restaurant and bar offerings include the recently re-concepted restaurant Blue Door Fish, which opened in November 2010, Blue Sea, a poolside bistro, the Rose Bar and a lounge, The Florida Room, designed by Kravitz Design. The hotel also features Agua Spa, a full-service spa facility.

Delano Historical Results ($ in millions, expect ADR and RevPAR)

Delano Valuation Matrix 

Miami Hotel Upper Upscale and Luxury Transactions

Hudson Hotel Overview

Opened in 2000, Hudson is MHGC's largest New York City hotel, with 834 guest rooms and suites, including two ultra-luxurious accommodations - a 3,355 square foot penthouse with a landscaped terrace and an apartment with a 2,500 square foot tented terrace. Hudson occupies the former clubhouse of the American Women's Association, which was originally constructed in 1929 by J.P. Morgan's daughter. The hotel, which is only a few blocks away from Columbus Circle, Time Warner Center and Central Park, was designed by Philippe Starck to offer guests affordable luxury and style. Hudson's notable design includes a 40-foot high ivy-covered lobby and a lobby ceiling fresco by renowned artist Francesco Clemente. The hotel's food and beverage offerings include Hudson Hall, the primary restaurant, which was renovated, re-concepted and opened in May 2010, Private Park, a restaurant and bar in the indoor/outdoor lobby garden, Hudson Bar, the Library Bar and Sky Terrace, an exclusive landscaped terrace on the 15th floor. In February 2010, we completed and opened Good Units, an exclusive venue for special functions. The raw space was conceived for performances and other experiences. Good Units is located in approximately 8,000 square feet of previously unused basement space within the hotel.

Hudson Hotel Historical Results 

New York City Luxury and Upper Upscale Hotel Transactions

Core Real Estate Value ($ in millions, except $/key)

On real estate value alone, I believe the Company is worth between $6.56 and $9.05, so at present levels you're getting the operating business and remaining joint ventures for essentially free.  But who is going to buy the assets and why? MHGC's assets are most likely to be acquired by either hotel REITs and/or private equity firms that are awash with cash given the present industry dynamics favor buy vs. build strategies.  

The major hotel REITS presently have significant liquidity and capacity for asset purchases and per Bjorn Hanson, dean of the Tisch Center for Hospitality, Tourism and Sports Management at New York University, "there are over 40 private equity funds hunting for deals in the sector, and many are under the gun to buy earlier than later".  These players are motivated buyers for a variety of reasons, including: 1.) the existing room supply pipeline is significantly below historical norms (< 1% room supply growth) and should be easily absorbed by surging demand, 2.) the lead time for new hotels is ~3 years and there is limited/no financing for new developments, and 3.) asset values remain below replacement cost.  

Snapshot of Hotel REIT Liquidity ($ in millions)

Joint Venture Assets ($ in millions, except $/key)

In addition to the above mentioned properties, the Company holds minority stakes and management contracts at four U.S. hotels.  I assume that the Company will eventually look to monetize these assets so I valued the real estate on a per key basis and value the management contracts separately on EV/EBITDA.  As stated above, I believe the Company will likely grow their portfolio of minority-owned assets as a means to grow the management and franchising business, so I would expect greater turnover in these assets going forward. 

Management Contracts

Assuming the Company sells the Delano, Hudson and London assets and retains the management contracts, MHGC's consolidated revenue and income will consist mainly of high margin hotel management and franchising fees.  I believe the recurring revenue/EBITDA from these contracts will be approximately $25 million.  

In addition to the Company's existing base of management contracts, MHGC has a pipeline of four hotel management contracts that are in various stages of development.  Importantly, three of these contracts are outside the U.S. so incentive fees will come quickly as there is no owner's priority.  I believe the earnings power of the management fees alone could generate an additional $7.5 million by 2014 by assuming $1 million in fees per 100 rooms.  Management will endeavor to supplement this pipeline with two to three management contracts per year.  If successful, by 2014 MHGC will have at least 21 contracts that are generating over $40 million of annual EBITDA.

I have NOT included any value for MHGC's announced pipeline or potential growth in my sum-of-the-parts, but a highly a conservative DCF of just those contracts that have been announced yields at least $0.60/share in incremental equity value.  I assume the $7.5 million of EBITDA from 10-year contracts and discount them at 15%, which yields an NPV of $38 million.  I then discount the NPV from 2014 back to today using the same discount rate of 15%, which yield ~$25 million in equity value. 

Existing Management Contracts Expirations

Consolidated Sum-of-the-Parts

Yucaipa Warrants

In October of 2009, when the Company had approximately $736 million of consolidated debt, $275 million of JV debt and was facing mounting property-level maturities, Yucaipa, the private equity firm founded by Ron Burkle, purchased of $75 million of Series A preferred securities to enhance the Company's liquidity profile. In connection with the issuance of the preferreds, Yucaipa received 12.5 million warrants exercisable using the cashless exercise method at an exercise price of $6.00/share.  For their investment, Yucaipa also received a seat on the board and nominated Michael Gross, who served as a consultant to Yucaipa.  When Michael Gross became CEO and discontinued his relationship with Yucaipa, Ron Burkle replaced him as Yucaipa's board designee.

I reflect the dilution from the warrants in my sum-of-the-parts, but believe their repurchase on favorable terms to the minority shareholders would add significant value. 

 Why will MHGC shares reach their intrinsic value (catalysts)?

• Hotel real estate sale announcements
  • London assets (Sanderson and St Martins Lane),
  • The Delano in Miami, and
  • Hudson Hotel in New York
• New hotel management and franchise contract announcements
• Repurchase of Yucaipa warrants
• Acquisition of the Company's management and franchising business by a strategic acquirer

Investment positives?

• New management team with interests that are well aligned with shareholders via the Outperformance Award Program.  This program will entitle management to 10% of the total market value created in excess of the 30% cumulative return over $8.87/share over a three-year period. 
• The U.S. is in the early stages of a lodging recovery which should bode well for reported results, especially as gateway cities should lead the rebound
• Room supply growth near historic lows and anticipated to come mostly from the upper mid-scale segment. 

• Positive lodging trends in Miami should support a premium valuation for the Delano.  I'll defer to the experts at Jones Lang and LaSalle to describe the improving market dynamics (see link: http://www.joneslanglasallehotels.com/hotels/EN-GB/Pages/NewsItem.aspx?ItemID=21330)
• Significant underlying real estate value already recognized by strategic investors, such as HG Vora who had filed a 13D (the HG stands for Highgate, as in Highgate Holdings the real estate PE firm who's holdings include Highgate Hotels)

Investment negatives/risks?

• Collapse of the capital markets could stymie potential asset sales
• Slower RevPAR growth and increased room supply in Manhattan
• October 2011 debt maturities at the Hudson
• Unsuccessful outcome of Shore Club litigation
• Failure to successfully grow the management contract pipeline
• The Company has significant exposure to the New York City, which would not bode well for an investment if there were, god forbid, another terrorist attack 

• Hotel real estate sale announcements
  • London assets (Sanderson and St Martins Lane),
  • The Delano in Miami, and
  • Hudson Hotel in New York
• New hotel management and franchise contract announcements
• Repurchase of Yucaipa warrants
• Acquisition of the Company's management and franchising business by a strategic acquirer