Supertel Hospitality (ticker SPPR) is a significantly undervalued (and logical takeover candidate) REIT which, PF for closed and pending  2007 acquisitions, owns 122 limited service hotels with over 10,500 rooms.  It is the only publicly traded REIT that focuses `on this end of the market which gives it a meaningful competitive advantage in finding attractive acquisitions. The company’s hotels operate under several national brand names including Super 8 and Comfort Inn/Comfort Suites and are located in 23 states, primarily in Midwestern and Southeastern states.  SPPR simply owns the hotels and outsources their management to a third party, Royco Hotels.  This enables SPPR, which has only 14 employees, to focus on finding additional acquisitions, which as discussed below are highly accretive. We view the company as undervalued (7.8x 2008 ffo), with well maintained real estate (capex 6% of rev)  that is worth significantly more than book( properties on books at original purchase price 10+yrs ago), underlevered, with a nice 5.6% dividend (which they could meaningfully increase) and a likely go private candidate given its small market cap, aged management team (CEO is 72 and CFO is 62), favorable industry dynamics (5% revpar growth expected in SPPR’s segment in 2008) and the continuing demand for hotel properties by strategic and financial players, as investors in KPA, WXH, LGN and EHP can attest to.    

 

 

 

The following valuation table reflects RW Baird’s estimates.  We note that SPPR has announced significant and accretive acquisitions that will close at various times during the year, so the 2007 figure is somewhat deceiving as its a reported estimate, not a PF figure.  Thus we would encourage you to value the stock based on 2008 estimates; however, we view the 2008 estimates as very conservative because they (unrealistically)  1) assume no acquisitions, which despite the need for equity would be highly accretive and 2) assume approx 1.5% adr and revpar growth, despite PricewaterhouseCooper’s Jan 2007 industry estimates of approximate 5% 2008 revpar growth for  hotel segments in which SPPR operates.  We have provided the estimates anyway since they from a published source (as opposed to from me, someone who is arguably biased and long the stock) and even if the estimates are not low, combined with other information we lay out, we believe this stock is dramatically undervalued.  The below figures also reflect no premium for control or profit enhancements that a buyer could generate. (Note: FFO estimates assume conversion of Preferred).

 

 

SPPR’s strategy is to take advantage of the favorable acquisition environment for hotels within in its segment.  SPPR typically makes acquisitions at highly attractive multiples (deals can be closed at cap rates within a disciplined 10-12% target range, comparing favorably to the full service lodging segment cap rates which run around 6.5%) and then improves the acquired hotels’ profitability through a combination of increased occupancy, increased average daily rates and reduced operating expenses.  SPPR is able to do this because it transfers management from the mom+pops who had been running the hotels to Royco Hotels, a multibillion operation with extensive hotel management expertise.  Acquisitions are also beneficial because they allow the company to further leverage its fixed corporate overhead.  SPPR achieves these acquisition multiples by sourcing deals through management’s extensive industry connections, and as the only publicly traded player, SPPR can quickly close multiple unit deals. 

SPPR looks for the following in its acquisitions:

-          nationally or regionally franchised hotels in locations with relatively high demand for rooms, and a relatively low supply of competing hotels

-          hotels which could benefit from new management, a new marketing strategy and association with a national franchisor

-          hotels which could benefit significantly from renovations

-          hotels in attractive locations that could benefit by changing franchises to a grade that is more appropriate for the location and clientele

 

 

SPPR’s incredibly conservative management team continues to see many attractive acquisition opportunities.  SPPR is able to quickly close and integrate acquisitions since it does not manage the hotels it acquires, so the time needed to integrate the acquisitions is minimal.  Furthermore, SPPR has minimal meaningful competition for most of the properties on which it bids.  We typically avoid acquisition stories but anyone who spends time with SPPR’s management team and understands the ease and accretion of their acquisitions will realize that management is not doing deals simply to “build an empire”, or use creative acquisition accounting;  rather they are creating significant shareholder value. 

 

As the below table illustrates, the company has been actively buying properties.  In fact, based on announced and closed deals, by the end of July 2007, the company will have invested over $125m on acquisitions this year alone, far more in amount and timing than the $69m analysts had  projected they would spend by June 2007, and the $110m by September 2007.  This is very meaningful as it accelerates the realization of the accretion that acquisitions bring to the company. 

 

The table below shows the SPPR’s closed and pending acquisitions over the last 18 months:

 

 

 

SPPR will benefit from favorable industry dynamics in the two segments (Economy and Midscale without Food and Beverage Service) in which the company operates.  According to Pricewaterhouse’s June 2006 study, based on supply and demand estimates, occupancy rates by 2008 in these two segments will hit their highest levels since 1995.  In addition, recent estimates from Smith Travel Research have revised down new room supply for 2006 to (0.8)% and +1.6% for 2007, respectively, and even moderate new supply will be well matched with increased demand.  New supply has been revised down due to the increasing cost and time required to build hotels.

 

These favorable supply and demand characteristics bode well for the entire lodging industry, but are especially significant for SPPR since it can expect an elongated cycle due to the absence of new supply, which has historically been the knock against this industry since it has been (relatively) easy and inexpensive to build new limited service hotels.  SPPR should be able to realize significant pricing and RevPar gains which, given the relatively high fixed costs associated with operating hotels, should lead to meaningful earnings appreciation.

 

SPPR is run by a very (too?) conservative and highly experienced management team, with the CEO and CEO having over 30 years of combined industry experience.  Importantly, insiders own over 15%of the company’s stock, so their incentives are highly aligned with those of other shareholders.  Management has not sold stock in a long time.  When the company did an equity offering late last year, management theoretically could have sold stock then, in a somewhat rare liquidity event, but they chose not to.  The CEO Paul Schulte and CFO Don Heimes are 72 and 62 years old, respectively.  While they are hard working individuals, we suspect they would like to begin considering other alternatives given their ages.  Furthermore, we believe that a younger, more financially sophisticated management team could significantly enhance profitability by lowering the company’s cost of capital (more debt, more efficient debt structure), accelerating the acquisition program and reducing operating expenses (fees paid to company that manages hotels, public company expenses, etc). 

 

The company’s dividend yield is currently 5.6% (Q1 run rate) and SPPR could easily pay a larger dividend.  Management has increased its dividend each of the last 5 quarters and has expressed a keenness to continue doing so.  While we continue to expect increases in the dividend, management sees such a robust acquisition pipeline that they would rather keep some of their powder dry by not maxing out their dividend and instead retaining some of their cash flow to fund acquisitions and thus minimizing the need to raise additional equity.

 

We believe SPPR’s real estate is worth significantly more than book as many of its properties are on the books at their original purchase price 10+ years ago. While it is difficult to estimate exactly how much the properties are worth, we have used data published by the Office of Federal Housing Enterprise Oversight which provides data by state (and some cities) for historical appreciation of residential  properties.  We then applied the appreciation as best we could to each property based on its location and date of acquisition.  We applied this approach to pre-2006 properties only (with total historic acquisition costs of $172.7mm), presuming that all properties acquired in 2006 have a fair market value equal to book value.  Our detailed analysis yielded $126mm of total appreciation since acquisition, which implies an average 5.1% annual appreciation rate.  In other words, based on the OFHEO data, the hotels currently on the books have increased in value by $126mm, and current net book value of $79.6mm ($94.8mm per the balance sheet, less $15.2mm of preferred convertible stock treated as debt) can be increased by this amount to give an adjusted book value/fair value of $205.8mm.  Note this analysis excludes any appreciation on the $29.5mm of post-acquisition improvements the company has made on these properties.  

 

The analysis also considers $54.3mm of hotel accumulated depreciation.  Different people treat depreciation differently in such analyses, and we have simply added back $54.3mm to the adjusted book value. (See table at end of this write up for detailed property data).

 

 

 

As mentioned above, we believe SPPR is a logical takeout candidate due to its small size, old management, ease of integration and due dili (the company outsources management of its hotels) and the significant opportunities for buyers to derive cost savings.   Regarding cost saving, remember SPPR will generate $6.6mm of net income this year.  If you assume a buyer can save $1mm, that implies an immediate increase in Net Income of 15%.  Corporate expenses at SPPR should be $3.5mm this year and depending on the type of buyer, much of this expense could be eliminated.  Remember, this company only has 14 employees since it outsources the hotel management.  Therefore, the only key employees are someone who finds acquisitions and someone to liaison with Royco Hotels, the management company.  So a financial buyer could, at the very least save public company expense.  A strategic buyer could obviously save public company and many other operating expenses.  Furthermore, we believe a more financially sophisticated owner could reduce costs by negotiating better rates with lenders, using more debt (existing management is financially conservative), using sale leasebacks, renegotiating with vendors and if desired, further accelerating the highly accretive acquisition program.  Also, a buyer might discontinue/downsize the $10mm annual cash dividend considering the money would be better used to fund acquisitions.  WXH, KPA, LGN and EHP are four small cap hotel reits that have decided to put themselves up for sale, presumably due to 1) their undervaluation due to their small market cap and limited analyst coverage; 2) the increasing costs of remaining public, and 3) the huge demand by financial and strategic buyers for properties.   While the convert is not callable until Jan 2009 it is deeply in the money and held by retail investors so I doubt it will be an impediment to a sale of the company.

1)      SPPR is a microcap stock with limited float and limited analyst coverage. 

2)      Given its significant acquisitions, it is difficult to assess the “real” numbers as the reported figures vary significantly from our view of the PF numbers.  Also, SPPR has not yet filed PF data for all its acquisitions and some of the filed pro forma numbers (while accurate for SEC purposes) are also a bit difficult to analyze (for example, they have some stub periods which are not that helpful with a seasonal business).

3)      SPPR operates dull, limited service hotels in the Midwest (which happen to throw off lots of free cash flow!); however, these hotels are not as exciting to own or talk about as is the Four Seasons chain.

4)      Management is old school.  They do not do earnings calls or roadshow.  They are, however, extremely accessible if anyone wants to call them or visit them in Nebraska.

5)      There is a hidden asset in the value of the real estate; but like most hidden assets unless someone takes time to look deeply at the company (which we would argue the analysts have not) such assets can remain hidden.

 

While there are no direct comps to SPPR given its limited service hotels, we have laid out multiples for several hotel comps.  ENN (upscale extended stay, all-suite, and midscale limited-service hotel properties), HT (mid scale limited service hotels in the Eastern United States) and WXH (premium limited service, upscale extended stay, full service hotels which recently agreed to sellout) are three larger REITs, with a higher asset quality and barriers to entry, and MDH is a micro-cap full service lodging REIT.  Limited service hotels have historically received lower multiples due to the perception of lower barriers to entry (limited service hotels are relatively inexpensive and quick to build), however, increased construction costs/time (permitting, etc) have increased the barriers to entry.  Furthermore, the benefit of economy segment hotels are the higher cap rates and lower volatility inherent in the industry.  We are not trying to argue that SPPR should get the same multiple as these comps, but rather that the discount is too large.  

As per below, the discount to 2007 and 2008 peer average FFO multiples is over 14% and 17%, respectively.  We have shown 2007 estimates, but as discussed above, believe 2008 numbers are more appropriate given the meaningful and accretive acquisitions SPPR has announced in 2007.  The valuations (except WXH) obviously do not reflect the (relatively) meaningful profit enhancements a buyer could achieve at SPPR or the undervaluation of its real estate.

 

 

The following table show’s the implied stock price given $0.5mm increments to 2008 FFO estimates that could be achieved under various scenarios:

 

 

            SPPR has historically issued equity to “reload” its balance sheet to allow for additional acquisitions.  They issued preferred in late 2005 and raised $45 mm in equity (primary shares only..$7/share) in late 2006.  Given their strong acquisition pipeline, their relatively conservative approach to leverage, and deals announced to date, we would not be surprised to see the company seek additional equity later this year.  We are not concerned by this as the raise could lead to a few outcomes:

1)      The equity offering occurs and a larger market cap as well as additional new sell side coverage, brings new investors into the stock.  The offering would also allow instituitions to invest in this relatively illiquid stock, as occurred in the Dec 2006 offering.

2)      The need for equity creates catalyst for management/board to consider selling the company.  While it may seem counterintuitive for a company that is trying to delever to sell itself, we believe that management is too conservative regarding its debt levels and a financially sophisticated purchaser would be willing to use equity and additional debt to buy and further expand SPPR.  Besides being (overly) conservative regarding its capital structure, SPPR likes to have lots of financially flexibility so it can quickly close deals.  A larger, more sophisticated buyer with deeper and easier access to capital would not have that problem.