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Tuesday, March 2, 1999

An Investment Opinion
by Warren Gump

Saving Patriot an Expensive Endeavor

Patriot American Hospitality (NYSE: PAH), the once high-flying paired-share hotel Real Estate Investment Trust (REIT) that almost crashed into bankruptcy, yesterday announced a definitive agreement for a $1 billion equity infusion that will resolve its current liquidity crisis. This agreement means that management can now once again focus on operating and building the company's core Wyndham hotel brand without worrying about repaying its debt. To obtain this peace of mind, however, current shareholders will see their ownership stake diminished substantially, with the new investors initially owning about 29% of the company. An abridged version of the Patriot story follows.

In 1997, the company paid around $195 million to obtain the tax-advantaged paired-share REIT structure, which analysts thought would dominate the industry. Only five of these structures existed and no more could be created because of changes in the tax law. To reap the benefits of having this structure, Patriot and the other paired-share companies went on an acquisition binge. Their stocks soared throughout 1997 as strong underlying hotel fundamentals and an influx of capital boosted prices.

These stocks began turning in late 1997, however, at the pinnacle of this acquisition spree. Patriot had just agreed to acquire Interstate Hotels, a major hotel owner and manager. Starwood Lodging (NYSE: HOT), another paired-share REIT, had finalized an agreement to acquire ITT (owner of Sheraton and other brands) after a bitter battle with Hilton Hotels (NYSE: HLT). These two substantial acquisitions raised the ire of non-paired-share competitors. They lobbied Congress and the president, complaining that the paired-share companies had an unfair tax advantage. As rumors of potential legislation spread, investors shied away from the stocks, fearful that future growth would slow. In early 1998, the president proposed legislation that would limit the benefits of the paired-share structure, which Congress passed in the middle of 1998.

To fund its acquisition spree, Patriot took on a good deal of debt, much of it short term. Of the company's expanded $2.7 billion credit facility used to complete the Interstate transaction, $750 million was due within the first year and another $450 million was due within the second year. At the time this facility was entered, Patriot intended to float a longer term debt offering to pay off the short-term maturities. In fact, it even entered into several treasury lock transactions to protect itself against rising interest rates.

Another financing mechanism used by Patriot was an "equity forward," where the company borrowed money with shares of its own stock as collateral. If its stock price rose, it would pay off the debt with stock (obtaining the benefit of the higher stock price). If the stock price fell, the company intended to repay the forward with borrowing from its line of credit or from a long-term debt issuance. Management (as well as many investors and analysts) were anticipating great performance for the company and expected the stock price to rise.

Needless to say, the rosy scenario expected by analysts and investors didn't pan out. Several combined events engaged the emergency brakes on the Patriot train. The governmental restrictions on the future use of the paired-share structure hindered prospects for growth via acquisition and turned investment sentiment away from the paired-share REIT stocks. An agreement to settle a lawsuit with Marriott over Interstate reduced the benefit Patriot would realize from that transaction. On top of these issues, the severe market slump between August and October closed the door to the fresh capital that the company so desperately needed.

Patriot's capital structure, however, was the devastating factor. Having significant debt and forward equity maturities when the company had no cash and extremely limited access to capital crippled the company. It was at the mercy of bankers and scavengers interested in picking up specific assets at fire-sale prices. After months of negotiations, the company settled on an agreement that will preserve Patriot's assets, but cost current shareholders at least 29% of the company.

Patriot is actually fortunate to have found an investor group willing to pony up $1 billion. Right now, only limited capital is being allocated to the lodging sector. I believe the willingness of these investors to team up with Patriot is indicative of the high quality asset pool the company has accumulated over the past couple of years. In addition, the company has a strong operating management team led my just-promoted CEO Jim Carreker. (Former CEO Paul Nussbaum, the dealmaker who assembled all of the pieces of Patriot, resigned yesterday.)

This current deal, while dilutive to shareholders, is much preferable to the alternatives. The most discussed alternative for Patriot was a substantial asset sale to Hilton. In essence, Hilton would have stripped Patriot of some of its key properties, including flagship resorts and difficult-to-build urban hotels. Taking these assets out of the Wyndham system would have weakened, if not destroyed, Patriot's objective to build a preeminent nationwide brand over the next few years. Another alternative was settling the equity forwards with common stock, flooding the market when nobody wanted to buy. And the least appealing option was bankruptcy.

Although the company is in better shape than it was, the immediate future is not necessarily going to be rosy for Patriot stock. Investors have been burned by the company and will be leery until it demonstrates that its strategies are working. Shareholders holding the stock because of its high dividend and REIT status will pull out since the company is planning to convert to a traditional corporation and significantly reduce, if not eliminate, its dividend. In addition, the company will still have substantial leverage, although there won't be significant maturities for five years.

From an operational perspective, however, the Patriot management team can now focus on what it does best: increasing the value of its hotel brands. It can spend time integrating the various operations it has acquired over the past two years. One of the highlights expected later this year will be the launch of a new guest loyalty program. In addition, the company can continue expanding its distribution by adding new management contracts and franchise agreements. With a focus on operations rather than debt restructuring, the company should remain an important player in the lodging industry.

The most valuable investing lesson I learned from the Patriot fiasco is to look not only at debt/equity ratios, but also at the debt maturities of highly leveraged companies. If Patriot didn't have substantial principal payments due over the next year, it wouldn't have faced such a dire predicament -- it would have had more time to restructure debt and divest non-strategic assets. Although few people expected Patriot to face problems refinancing its credit facilities in late 1997, creditor perspectives can change on a dime. Investors in companies with substantial short-term debt maturities should be aware of this risk and the high toll extracted by a liquidity crisis.

For more on Patriot and paired-share REITs, check out last December's Daily Trouble on Patriot, or post your comments and questions on the FOTH message board.

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