Mark Cohen of Stone House Capital originally posted the below investment thesis on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. This is not a recommendation to purchase and/or sell the specified security outlined in this report.

TravelCenters of America (AMEX: TA) operates a network of 229 truck stops across the United States. They are an integral part of the nation's transportation system, and for the past 70 years have offered truck drivers a home away from home. As interstates grew, the long-haul trucking industry expanded and truckstops became a major American industry. Truckstop operators built large businesses. In addition to selling fuel, truckstops offer a wide variety of food, truck maintenance and repair services, showers, laundry rooms, movie rooms, and entertainment offerings -- truly becoming a truck driver's home away from home.

Fuel represents only approximately 25% of TA's gross profit. In addition to making money on fuel and non-fuel services/products, TA also collects rents and royalties on subleased space. In addition, TA owns the land and buildings for nine of the locations and a handful of additional land parcels for future development. Together, this represents approximately $50-$75 million in additional value.

There are three large national chains: TA (which operates as TravelCenters and Petro), privately held Flying J/Pilot (which merged last year), and privately held Loves. As a result of the Flying J/Pilot merger and the TA/Petro merger, the top five chains have become three over the past two years. On top of that, the smallest of the three, Loves, is concentrated in the Southeastern U.S., so the truck stop business in many states has become a duopoly between Pilot/Flying J and TA/Petro. This business has become highly concentrated over a short period of time, which helps the three chains. After visiting truck stops on the east coast and having numerous conversations with truckers, it became clear that in the minds of truckers there are effectively two competing chains in most markets. Together, the three chains sell more than 75% of the diesel to the fleet truckers in the country.

It is very important to note that Flying J (which historically priced its fuel a few cents below the competition) has increased its pricing to match Pilot's after the merger, creating an opportunity for TA to follow suit and extract better economics out of the fuel business.

In September, 2006, TravelCenters of America agreed to be acquired by a REIT called Hospitality Properties Trust (NYSE: HPT) for approximately $1.9 billion. At the time, TravelCenters owned the real estate and ran the operations of the truck stops. Because of limitations of the Internal Revenue Code, Hospitality Properties Trust could not operate the truck stops and remain a REIT. It decided to spin-off the operations as TA. This is classic OpCo/PropCo math, similar to what legendary investor Bill Ackman was urging McDonald's and Target do with their real estate and operating businesses, and what he is proposing to do now at JC Penney. 

TA entered into a long-term lease with Hospitality Properties calling for annual rent payments of approximately $231 million. There is approximately $10 million in additional rent paid to landlords other than HPT. 

Immediately after the spinoff, TA's stock reached a high of $47.25. This was a great "growth story" with 6,000 truck stops nationwide, and was seen as a massive rollup opportunity for TA. It was only when the economy began to slow down that it became clear that the lease cut with Hospitality Properties was sucking the life out of TA while providing HPT with a very healthy return on its $1.9 billion investment. 

When it became clear that HPT was slowly bankrupting TA with this "above market" lease, in August 2008 TA and HPT entered into a rent deferral agreement. This allowed TA the option to defer monthly rent payments by up to $5 million per month from July 1, 2008, until Dec. 31, 2010. However, pursuant to this agreement, TA issued 1,540,000 shares to HPT (which represented approximately 9.6% of the shares then outstanding after this new issuance). Additionally, any deferred rent accrued interest at a rate of 1% per month and was due in full on July 1, 2011. 

Through Dec. 31, 2010, the amount of this deferral was $150 million, which accrued on TA's balance sheet as a current liability and was costing 1% per month in interest payments to HPT. With the debt coming due in July and a shareholder lawsuit alleging conflicts of interest regarding HPT's treatment of the lease, TA's management began negotiating with HPT to amend the lease. 

The amendment to the lease was recently announced. The key terms are as follows:

  1. Annual rent is decreased from $231 million to $194 million (a savings of $37 million annually) 
  2. The $150 million of deferred rent supposed to be due July 1, 2011 is now due between 2022 and 2024 (no coupon payments for 11 years, does not accrue interest, is unsecured). 

Another interesting point, if TA ever runs into trouble again, is that HPT will have to reset the lease terms or defer the rent payments again. HPT has no credible way of replacing TA with another tenant if TA doesn't come up with the rent money. The recent announcement shows that the dynamic is dramatically in TA's favor; HPT has basically created a permanent "put" on TA's business, telling the market TA will never go bankrupt even in the most adverse scenario.

Valuation:

17.3 million shares at $12 stock = market cap of $208 million 
Cash balance: $170 million 
Present value of $150 million of debt due in 11 years at an 7% discount rate: $75 million 

Enterprise value: $112 million. 

Over the past few years, TravelCenters has made improvements to its operations and cut overhead costs. With the trucking industry picking up steam (recent results from JB Hunt, YRC Worldwide, and others are very strong, January Cass Freight index up 20% in carloads and up 27% in expenditures), the positive trend in TA's underlying business will continue to improve. While gasoline sales are inherently a volatile business quarter to quarter, TA is operating very well on the non-fuel side: 75% of gross profit comes from products/services other than fuel and that is really tied to the economy and spending by the visitors to TA's locations. 

We are projecting $80 million of EBITDA and free cash flow of $55 million annually over the next few years.

EV/EBITDA: 1.4x 
FCF to EV: 49%

Our near-term price target of $36 assumes an EV/EBITDA of 6.5x 

Other Notes:

  1. After speaking with many truckstop owners, maintenance capex per locations is about $150,000 a year, implying maintenance capex for TA of about $25-$35 million a year. This is consistent with management's guidance. 
  2. The bottom line here is that the equity is still significantly mispriced following the two major amendments to the lease that amount to enormous transfers of value from HPT to TA (extending the $150 million and lowering the payments by $37 million annually). This "newfound" value is still not reflected in TA's stock, where the market cap has increased $140 million since the announcement, versus the $37 million incremental cash savings alone from the lease amendment. 
  3. Simple math says this: If the company is saving $37 million annually, at 6.5x EBITDA that's worth $240 million to the TA equity or over $17. Plus, the $150 million debt extended for over a decade is a massive transfer from HPT to TA. 
  4. Many investors think HPT was wrong for saddling TA with an "above market" lease in the first place and therefore dislike management. However, TA is managed by the Portnoys' private management company, RMR, which earns 0.6% of the sum of fuel gross margins and non-fuel revenues (this was $8 million in 2009). The Portnoys' real interest is in keeping RMR profitable, and therefore keeping TA alive, growing, and profitable. Although the Portnoys' ownership of both TA and HPT is insignificant, they have an enormous incentive through RMR to grow profits. Management of TA owns just under 1 million shares of stock and clearly also has a large incentive to grow shareholder value. 
  5. TA also owns the land and buildings for nine of the locations and a handful of additional land parcels for future development. Together, this represents approximately $50-$75 million in additional value that is completely unrecognized by the market. 
  6. We have spoken to many truck stop owners. Universally, people are saying that business is continuing to improve, with many talking about the non-fuel side of the business being up 10% year over year. Fuel gross margins have been stable, and some have pointed out to us that the merger of Pilot and Flying J has created the room for small margin increases on fuel.

To summarize why the above view is contrarian to market consensus: 
The market sees TA as a leveraged play on fuel gross margins with no competitive advantages in a hypercompetitive industry. The reality is that: 

  • TA has $170 million in cash and a $75 million present value obligation and is not financially leveraged. While the lease expense is a fixed cost, it is no different than rent payments that any hospitality or retail pays to its landlords. Neither hotels nor retailers trade at 1.4x EBITDA and are just as operationally leveraged. In fact, TA has a clear advantage here: a retailer with an independent landlord always runs the risk of bankruptcy (see Circuit City). In TA's case, we just witnessed that the landlord, HPT, will never allow TA to run into trouble, as TA constitutes 40% of HPT's NOI. 
  • The industry has consolidated significantly, from having five equal-sized players to three large ones, and as few as two in many large markets (e.g., the Northeast). As with other consolidated industries, fewer players means more rational (i.e., higher) pricing and margins. Also, truckers universally agree that Petro dominates the truck maintenance business, which makes up more than 50% of the non-fuel gross margin for TA, and therefore dwarfs the fuel component of the business. No one focuses on the non-fuel segment even though it is 3x the size of the fuel business. 
  • Investors are skeptical that TA management has an interest in maximizing shareholder value. However, CEO Thomas O'Brien is an experienced Wharton grad and personally owns 900k shares of stock. He is 43, and the $11 million personal net worth in TA stock is material for him.

Capitalized leases: 
The capitalized leases should definitely not be included in the debt here. If you do want to add it to the EV, you have to exclude the rent payments that it represents. Not doing so you are double counting the same cash flow. The amount on the balance sheet is a subset of rent expense.

From the 4Q 2007 call:

TA has no funded debt. As of yearend, we show about $263 million on our balance sheet as short-term debt. This debt was paid in full in February 2008 with a trust set up for that purpose when TA purchased Petro in May 2007. As of yearend, we show $106 million on our balance sheet as capital lease obligations. As we've gone through before, although this is an unfortunate accounting confusion, this amount is merely a capitalization of some portion of the rental obligations that we have to HPT, and here is talk about rent, we generally are referring to the full amount of cash payments that is including the amounts that the accountants have allocated to these capital lease obligations.

From the S-1:

As a result of our application of Statement of Financial Accounting Standards No. 98 (SFAS 98), which sets forth rules related to sale leaseback transactions, to our expected lease with Hospitality Trust, 13 of the travel centers we expect to lease from Hospitality Trust do not qualify for operating lease treatment, because more than an insignificant portion of these travel centers is sublet to a third party. The amount shown as capital lease obligation will remain on our balance sheet unless and until the subleased portion of these travel centers is reduced to an insignificant level.

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The views contained in this article are based on publicly available information. It is provided for informational purposes only and should not be deemed as recommendation to buy or sell the securities mentioned or to invest in any investment product. Neither the author nor any of his affiliates makes any representations or warranties regarding, or assumes any responsibility for the accuracy, reliability, completeness or applicability of, any information, calculations contained herein, or of any assumptions underlying any information, calculations, estimates or projections contained or reflected herein. Actual results may vary materially from the estimates and projected results contained herein. The author is the principal of Stone House Capital Management, LLC ("Stone House"), an investment manager that beneficially owns shares in the Company and manages a fund in the business of trading -- buying and selling -- public securities. It is possible that there will be developments in the future that cause the author to change its position regarding the Company and possibly increase, reduce, dispose of, or change the form of its investment in the Company. This presentation should not be considered a recommendation to buy, sell or hold any investment. THIS ARTICLE SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY INTERESTS IN STONE HOUSE OR ANY OF ITS AFFILIATES. SUCH AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY INTERESTS MAY ONLY BE MADE PURSUANT TO A DEFINITIVE SUBSCRIPTION AGREEMENT BETWEEN STONE HOUSE AND AN INVESTOR.