Holloway Lodging A Deep-Value Canadian Real Estate Play

Finding quality Canadian real estate equities that are also cheap requires a little digging. Yield-hungry investors have bid up the large cap names, while most small-cap REITs are basically vehicles for the founders to extract money through management fees as they build up assets on the fly.

For those willing to look beyond REITs and large dividend yields, Holloway Lodging Corporation offers a compelling opportunity to acquire quality cash-producing assets below their reproduction cost.

Holloway is a real estate corporation focused on acquiring, owning and operating limited service lodging properties and a small complement of full service hotels primarily in secondary and suburban markets. Holloway currently owns 18 hotels with 1,790 rooms and minority equity ownership interests, ranging from 6% to 19.1% in four other hotels.

Secondary markets are not as glamorous as big cities, but they provide opportunities for Holloway to acquire assets at higher cap rates. Average rates in these markets hover around 10 per cent compared to 7 per cent for urban cities such as Toronto, Calgary, or Vancouver. That spread can increase return on equity by 10 per cent when you combine them with today’s rock-bottom interest rates.

Based on the increasing value of its real estate, improving occupancy, free cash flow potential, share buybacks and debt reduction initiatives, I believe the intrinsic value of Holloway shares is above $5.75 per share and growing.

So why is Holloway stock trading at $4.00 with a market cap of only $75 million? That has more to do with the company’s past than its future.

A Little Background:

From its 2006 IPO until 2008, Holloway aggressively expanded using mortgage and high-yield debt financing. When the economy contracted in 2008, Holloway’s occupancy and cash flow dropped, forcing the company to eliminate its dividend as it struggled with its debt. Unable to pay back its unsecured debt in cash when it came due last year,Holloway converted $47 million in convertible debentures into common stock.

This lead to dilution of 94 per cent for existing shareholders and the stock dropped as low as 4 cents as investors and debt holders sold their diluted shares. However, the debenture conversion left the company with a healthier balance sheet and significant free cash flow. Over the past 12 months, Holloway has quietly paid down debt, resumed dividends and repurchased shares. The company has also completed a 40-to-1 share consolidation that reduced Beta and eliminated the company’s “penny-stock” status.

Holloway’s Improving Financials:

Holloway’s healthy financial situation is easily demonstrated by looking at its improved operating cash flow ratio (cash flow from operations/current liabilities) for 2012 as compared to 2011:

  • Operating cash flow ratio in 2012: 8.156M/17.174M = 0.47
  • Operating cash flow ratio in 2011: 1.1M/98.59M = 0.01

The company’s debt ratios have also improved:

Debt ratio

2012: 0.58

2011: 0.91

Debt to equity ratio

2012: 1.39

2011: 10.59

Holloway’s total debt now consists of mortgages on 16 of its 18 hotels. The clean balance sheet is allowing the company to return cash to shareholders through a $0.14 per share dividend and share buyback program — Holloway bought back 100,000 shares last quarter and has the right to purchase and cancel more than 1 million trust units under its normal course issuer bid.

What IFRS Accounting Doesn’t Tell You About Net Asset Value:

As of December 30, 2012, the net book value of Holloway’s cash and property is $85.511 million — or $4.58 per outstanding share. Holloway has valued its hotels under IFRS (International Financial Reporting Standards) using third-party appraisals and internal discounted cash flow models. As operations improve and capital improvements are completed, the IFRS value of the hotels increase (last quarter for example, Holloway’s net book value was $3.91 per share). Also, Holloway’s free cash flow keeps rising as the company’s debt servicing costs fall. Book value will also rise if the cash is retained — or Holloway will continue to return the excess cash to shareholders through share buybacks and dividends.

Analysis of Cash Flow:

Because the net income of real estate companies is distorted by non-cash charges, they are valued based on their free cash flow potential. This is measured by a metric known as distributable income or adjusted funds from operations (AFFO), which is calculated by deducting non-cash charges, one-time capital expenditures, gains from property sales, and maintenance costs from net income. For 2012, Holloway’s AFFO was $8.156 million as interest expenses dropped by more than $1 million dollars and profit margins increased 2 per cent from the prior quarter. Extrapolating Holloway’s reduced interest payments in the last quarter and increased cash flow from a new hotel over 12 months, I believe 2013 AFFO will be $10 million or $0.54 per share.

The Valuation Gap:

Holloway currently trades at less than 8 times my estimate of 2013 AFFO. Applying the average price/AFFO multiple for Canadian hotels of 10.8 gives a fair value of $5.85 per share. If you want to get really aggressive, U.S. hotels trade at an average P/AFFO multiple of 14.3 which implies a fair value for Holloway of $7.72.

Holloway has transformed itself into a profitable company with a clean balance sheet — and is now a low-risk way to get exposure to the Canadian real estate sector. Investors also get a 3.7% dividend while they wait for activist and strategic investors (Geosam Capital, Forward Management LLC and TSX-listed Temple Hotels own about 60 per cent of the outstanding shares) to boost the stock price towards the intrinsic value.

I expect the valuation gap to close quickly as Holloway keeps sending cash back to shareholders and investors realize this is a much different company from the one that had to restructure its debts 13 months ago. Don’t be surprised if Holloway ends up acquiring a smaller rival or gets swallowed up by a bigger player.

Disclosure: I am long OTC:HLREF.

Originally published at seekingalpha.com.

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