Boring Portfolio

Boring Selling
FelCor Hotel Suites
By Dale Wettlaufer ([email protected])

Alexandria, VA (Jan. 11, 1999) -- What is it like to give someone a loan and then get your principal paid back to you with what you know is not really a return on the capital but which is called a dividend, which is further called "yield," and which is taxable at your income tax rate? That's pretty much what you get when you own a real estate investment trust (REIT) that creates neither a satisfactory return on equity nor a return on capital that beats the cost of that capital.

Unhappily for the Boring Portfolio, that's the sort of business we have in FelCor Lodging Trust (NYSE: FCH). When a company doesn't create a return on capital that is large enough to cover the cost of capital, all you really get when you receive a dividend is a return of capital. It could be a return of equity capital or it could be distribution of capital that has come into the company from some other source. In the end, though, you're getting back capital and you're taxed on it.

The way we look at the companies in the portfolio always comes down to one question: "Is this the sort of business we would like to own outright? Would we pony up the capital necessary to acquire this entire company?" Unless we got some sort of kick out of owning hotels and leasing them out to hotel management companies, the answer here would be a resounding "no."

First, let's consider the financial returns of this company. To do this, we're going to set some hurdles low, as well. Consider the company's return on common equity. Normally, we gauge return on equity by considering average equity in use by the company for the entire year. In this case, we're setting the hurdle low by considering return on beginning common equity.

The company started 1998 with beginning shareholders' equity of $1,078.498 million. We deduct $151.25 million in preferred equity (resulting in common equity of $927.25 million) and then use net income applicable to common shareholders to calculate ROE. That's the only rational way to look at it from our viewpoint, since we're owners of the common stock. Then we use net income applicable to common stock to see what our return is. Before a half-million dollar charge for a write-off of financing fees, net income available for common through six months was $38.578 million. Annualizing that, a full year's return is $77.156 million.

That's not the number yet, however. We need to tax that to put the company on par with a corporate structure. I'll say here that this might not agree with the way others look at a REIT, but I do happen to be involved with an S corporation that acts in the same way as a REIT, which is as a pass-through entity. For that company, I look at the after-tax return on capital because I have to pay tax on those returns.

For FelCor, let's just say we're in the 32% tax bracket. Multiply net income for common by 0.68 to get to your after-tax return of $52.466 million. Annualized return on beginning common equity was 5.66%. Sure, that's way better than the after-tax yield on bonds, but this is equity we have at risk here. You need a whole lot more return to justify this risk. We're talking about middle-market hotels such as Embassy Suites. Nothing special. There's no real franchise here that makes us believe our principal is safe and defensible. It's pretty much a commodity that we have on our hands.

We don't mind commodity businesses, either. One could call the PC industry very commodity-like, and there are lots of companies in that industry that we've liked historically. Some of the retailers we like are commodity businesses. So are many banks we like. I could go on. The difference here is that we like commodity businesses that are low-cost providers, that can overlay world-class service on top of the commodity, and that can, in the end, generate a satisfactory return on capital. We don't doubt that Felcor can satisfy the first two, but in the last regard, it doesn't satisfy our needs.

Historically, American business has been able to generate after-tax returns on equity of 11%. Yet here we are with a business that's doing about exactly half of that. However, the argument goes that these are safe yield-generating investments. That's because of the vocabulary of Funds From Operations (FFO) and EBITDA -- earnings before interest, taxes, depreciation, and amortization. I could kind of deal with that if we were senior creditors and we were looking at the ability to get paid off in the short term.

Sure, you can generate lots cash in a business and forego necessary reinvestments to perpetuate the business, but pretty soon travelers aren't going to want to stay in your hotels. If the company forgoes capital expendures, the snowblower to clear the path up to your suite's door is going to be broken; the check-in procedure is going to take three times as long when you've just gotten off the exit in Utica, New York at 2:47 a.m. because the information systems are bad; and the toilet is going to run all night before your big presentation.

The costs of maintaining the large fixed assets in this sort of business are tangible. As an owner of an ongoing franchise, you can't delude yourself into thinking depreciation and amortization of leasehold improvements are return on capital. They represent the consumption of capital, and anything paid out to shareholders that is backed by depreciation and amortization is return of capital. That capital has to go right back into the business, however, if a company wants to maintain the franchise for contributors of perpetual capital.

Now, we're not saying FelCor is failing to maintain its assets. It is. But the whole FFO model as a means of measuring shareholder returns is for the birds, in our opinion. Let's go to the cash flow through the second quarter and see how well net income for common shareholders matches cash flow attributable to common shareholders.

Net cash from operations was $64.474 million. That includes $33.316 million from depreciation and another $1.5 million or so in amortization. From the first number, we deduct the preferred dividends from the "net income" line, because net income there refers to net income available for all equity. So $64.474 million less preferred dividends of $7.803 million equals $56.671 million. Then we deduct capital expenditures of $22.244 million to get a free cash flow to common equity figure of $34.427 million. That's not too far from net income for common as calculated using Generally Accepted Accounting Principles. Annualizing this after tax gives us a 5% ROE.

Since we're the most junior investors in all of this, we measure the junior cash flows of the corporation. We don't buy into the concept of measuring gross cash flows against just the junior portion of the capital structure. The bond holders and the preferred shareholders are both in front of us. Meanwhile, we are exposed to one of the more volatile classes of real estate earning a 5% to 5 1/2% return on our equity. The answers to the questions of whether we like this business and whether we want to be involved in this sort of business are both resounding "nos."

As another way to measure returns, we look at return on all capital invested in this business. This measures the after-tax return on capital on an unleveraged basis, meaning we are looking at the after-tax return on all invested capital assuming that all the capital is equity without interest expenses or minority interest expenses. The product of that calculation, measured against beginning invested capital, is 5.89%.

Cost of capital in this company's case comes in a number of flavors. There's the cost of debt, preferred equity, common equity, and minority interests. The cost of all this capital, using book value measures of capital in the weightings and not ascribing any beta values to the cost of equity, is 8.82%.

This kind of business is a value destroyer. And I don't like to beat on the management of this company, because there's really not a whole heck of a lot they can do about this. Real estate has not historically been a bastion of investing rationality (for a fun read, check out Tom Wolfe's latest, A Man in Full). If Alex and I start thinking that it's all right for us to continue as owners of this company, we're no better than the S&L operators of the 1980s that made terrible loans to the real estate industry.

Sure, we didn't make the decision to buy this company, but we would be guilty of continued irrationality if we didn't sell it because we think the market's going to do this or that, or someone's going to upgrade it, or the company's acquisition of Bristol Hotels is going to somehow improve the dubious economics of the industry and this company. As the Chairman of another Boring Port holding observed once (and this is a paraphrasing), "When management with a good reputation tries to tackle a business with a bad reputation, it's usually not the reputation of the management that survives the confrontation."

FelCor owners will recognize that I have left out looking at the company with Bristol included. I've done that purposefully because the results for the third quarter include Bristol for only 65 of the 92 days in the quarter. We've also done that because we want to get a feel for the economics of this industry. To check the forward plan of FelCor with Bristol included, we've looked at estimated net income and discounted that because we just don't buy the FFO mumbo-jumbo.

Regarding value, the company said in its third quarter release that it believed "...that the 1998 declines in stock valuations of FelCor and the hotel industry are an overreaction by Mr. Market. FelCor's common stock is currently trading at approximately 38% below estimated replacement cost, approximately 13% below our investment in hotels, at cost..." You know, the thing about Mr. Market is that he's usually not that unstable a guy. It's only periodically that he has these bi-polar episodes where he wants to buy out your share of a business at twice or half the intrinsic value of the business. Most often, though, he's a rational guy that will give you a pretty good idea of what your share of the business is worth.

The citation of "Mr. Market" in the FelCor earnings release doesn't touch off the value investor Pavlovian reflex in us. Mr. Market is quoting us this number because FelCor doesn't generate a satisfactory after-tax return on equity or on all capital invested in the company. So Mr. Market is not some dummy who is going to give you a multiple to equity if the company can't give him an 11% after-tax return on equity, just as no one lending the company money would do so at an after-tax rate of 2 1/2% or so.

Discounting EPS growth of 3%, 4%, and 5% forever, we see intrinsic value for the common equity of this company between $20.50 and $27.32 per share. We get this by assuming net income for common for 1999 will be equal to 58% of funds from operations. After tax at a rate of 32%, that's net income for common of $1.64 per share. At the present quote, that's 13.9 times 1999 EPS, giving us a 7.2% earnings yield on 1999 earnings. And we're not talking "yield" as in what will be called a dividend next year. Some value investors would not mind paying for that sort of an after-tax earnings yield.

If we sell at the current price, we will recover not only $22.75 per share, but tax assets of $4.75 per share. Discounting that at 10% (from April 2000, when the tax assets will be used), the tax losses we're generating have a present value of $4.18 per share. Therefore, our economic recovery of nearly $27 per share matches what we think is a middle-of-the-road estimate of the intrinsic value of this company. We can definitely find companies selling at intrinsic value with better growth prospects and more defensibility in the business model. Of course, we consider the best defense to be buying excellent businesses at less than their intrinsic value, but in this market environment, we often have to pay up for quality. What we're saying here is that the intrinsic growth of the market for mid-range suite hotels doesn't excite us and that we're happy to exit this business receiving a fair value for our shares.

We've also included some cash flow work in our spreadsheet suggesting that the intrinsic value of the common stock is $24.89 to $29.37 per share, but again, we don't have a very good idea how FFO translates into cash flows that reflect economic reality. Our estimate of $60 million in maintenance capital expenditures for 1999 may be too low.

When we look at the net operating profit after tax that we've estimated for 1999 and compare that to beginning invested capital (as of the end of Q3), the return on invested capital is 5.68%, which is in the range of what the company has done in the past. Furthermore, the implied cap rate on estimated 1999 EBITDA, counting debt, preferred equity, and common equity (at market value) in the enterprise value, is 11.63%. As a multiple of EBITDA, that's 8.59x, which is not out of line with the multiple that people who base their decisions on EBITDA would pay for the company. It's actually a little rich, though some more depreciation will probably come into the picture to increase EBITDA, as weird as that sounds.

As far as economic value added analysis goes, there's nothing conclusive we can show there. It comes down to your guess as to if and when the company can start to generate positive economic returns on capital, which is defined as returns on capital above and beyond the cost of capital. Treating the company in that way, the equity becomes a call option representing your belief as to when it can do so and by how much it can do so. We don't have any idea on that score.

We're aware that this stock can go higher in the short run, and we're sure we look at the economics of this sort of business differently than do the management of FelCor, the analysts that cover it, and many other investors. We would rather that readers discount our analysis as the work of complete amateurs than to base any sort of decision on the way we look at it. Consider us to be fools on this subject.

We will sell 200 shares of FelCor Lodging Trust Inc. within the next five business days.

Our spreadsheet is available for download in Excel 97 format and Excel 95 format.

Pursuant to our December 28, 1998 buy report, we are also increasing our stake in Berkshire Hathaway (NYSE: BRK.A and BRK.B). We will acquire two additional shares of "B" class Berkshire stock within the next five business days.

1/28/99 Note: FelCor's chief financial officer recently sent us a note on our treatment of their financials. It was very kind of them to help us educate our readers on the REIT industry. I will concede that historical corporate return on equity (ROE) certainly understates an investor's ROE. However, for a company that retains all earnings, there is only one layer of taxes on the company's ROE, just as there is for a REIT. Granted, when the investor does sell, he incurs a capital gain if he has done things correctly. In all, though, I could have stated this better. I'm glad the company does think about after-tax return to investors, though.

Regarding the company's discussion of depreciation, funds from operations, and cash available for distribution (CAD), one note that we would have is the following:

When we said we don't believe in "FFO (funds from operations) mumbo jumbo," we meant the way the entire REIT industry goes about FFO. Maybe that's a little harsh on our part. We just don't agree with the institutionalization of a measure that includes return of capital as well as return on capital as the bottom line performance measure of an investment.

As we said in our analysis of the company, take what we say with a grain of salt. We're new to REITs and we don't understand them. Therefore, we don't want to be involved with them. One should never commit capital to an investment where one has little familiarity with the basic measures of performance or with the basic moving parts of the underlying company.

Apparently, REITsters look at CAD as somewhat analogous to net income and then look at CAD over shareholders' equity as a measure of return on capital. The line of reasoning goes that book depreciation overstates economic depreciation. I understand why depreciation would be accelerated for tax purposes, but not really for financial accounting purposes. For tax purposes, the higher depreciation, the more cash flow is sheltered from taxes.

However, if you want to say book depreciation overstates the true economic depreciation of the assets in question and you then present a CAD figure to represent the analog to net income, then you have to increase book value to get a truer return on investment. Book value would be increased by the accumulated amount of over-depreciation and the ROE analog would be calculated using CAD over the new, higher amount of owners' equity. The over-depreciation over the years contributes to a degraded book value for the purposes of calculating ROE, increasing return on capital, as presented in Mr. Churchey's note. You can't have it both ways. If you want to present ROE with less depreciation in the earnings analog, then you have to present a higher book value for the ROE analog. If you take less away from the assets, then you take less away from either liabilities or owners' equity or a combination of the two to balance both sides of the balance sheet. In this case, the accumulated depreciation above and beyond the economic depreciation would all be added back to both assets and shareholders' equity, reducing return on investment below Mr. Churchey's ROI presentation.

Finally, when looking at a tax-advantaged investment, we also like to build in a margin of safety in our valuation efforts because tax legislation can and does change. Anybody that invested in limited partnerships in the 1980s will tell you that and more. If the company's undervalued with taxation standards built into the model, then the rest is gravy. That's one big reason why we look at return on investment after taxes and compare it to "C" corporations' tax status.

Here's a link to the entire presentation of FelCor's letter (in Word format), which includes tables on CAD and return on investment. (For a version of just the text of the letter, click here.)

Report, Part 1

**This trade is being made under the regular portfolio policy, namely, once The Boring Portfolio announces an intention to trade, that trade will be made within the next WEEK, as opposed to the next day. For more detail, please read the "New Trades" section in the hall of portfolios.**