Morgans Hotel Group Co (MHGC)

[Enterprising Investor]

Morgans Hotel Group Co. (MHGC) Long Thesis (3/24/16)

By VW Staff

Long thesis on Morgans Hotel Group Co. (MHGC).

Executive Summary

The assets that Morgans Hotel Group currently own are worth around $22.15 per share:

Hudson Hotel

Utilizing a base case normalized NOI of $15.30m and a cap rate of 4.50%, we value the Hudson Hotel at around $340m or $9.79 per share. NOI averaged between 25m and 35m during the boom years before the Financial Crisis, but has not reached that level since then. NOI was around 15m for the last 2 years. The Hudson Hotel enjoys a best-in-market location, just a few blocks from Columbus Circle in Manhattan. Currently, luxury hotel properties in Manhattan trade at a cap rate of between 3.5-5%.

The Delano

At a base case normalized NOI of $12.45m and cap rate of 6.00%, we value the Delano at around $208m or $6 per share. We believe our base case NOI is likely conservative, given that it was 15m last year. NOI averaged between 15m and 20m before the crisis, and has recovering to the lower end of that range. Luxury hotel properties on the South Beach generally trade at a cap rate of between 5.5-7%.

Hotel Management Contracts

In addition to the Hudson and the Delano, Morgans Hotel Group currently manages 8 additional contracts, with 1 new contract poised to come on line in 2016, and 1 due to be terminated. We believe the hotel management business can earn normalized EBIT of around 11m/year. Hotel management businesses generally trade at a multiple of between 15-30x. Our base case valuation utilizes a multiple of 16x, valuing the business at $172m or $4.95 per share.

Other Assets

We value the company’s NOL carryforward assets at $34m, or $0.98 per share. The company also has around 15m cash or $0.43 per share.

With liabilities and preferred shares of $18 per share, shares of Morgans Hotel Group are worth around $4.15 per share. Currently, MHGC Common Stock is trading at around $1.50 per share, which implies an upside of around 177%.

Our base case scenario has the company divesting its properties whilst transitioning to a purely asset light hotel management business model. This is what the company has repeatedly said it would do, and it has taken steps to effect this transaction.

The shares are trading at a steep discount due to 1) a long history of mismanagement due to conflict within the board between two feuding groups of investors, 2) investor fatigue and 3) overhang due to an unfavorable financing arrangement concluded during the Financial Crisis. We believe these issues have not diluted Morgans Hotel Group’s brand equity, which we continue to believe can be a high quality business, given appropriate changes in management.

The company has not made a GAAP profit in its lifetime as a public company. It’s collection of assets are valuable individually, but it does not make sense for the company to continue as a consolidated entity any longer. There have been calls for the company to sell itself and/or its assets for a while which have obviously not come to pass. However, there is good reason to believe that a sale will happen shortly given that dividends on its preferred shares will hike to 20% at the end of the year, and to redeem the shares will require a sale of assets.

Thus the thesis is dependent on a transaction that may not happen, however improbable that may be. The value inherent in Morgans Hotel Group’s assets may not be realized without such a transaction, so we think it is important to be cognizant of the fact that this is a higher risk higher reward situation. As a heavily leveraged entity, slight changes in enterprise value will result in large fluctuations in equity value, so mark to market volatility should be expected going forward.

Morgans Hotel Group – Overview

Morgans Hotel (“MHGC” or “the company”) owns and manages a number of luxury boutique hotel properties in the United States and around the world. Currently it owns two hotel properties, the Hudson Hotel, located a few blocks from Columbus Circle in Manhattan, New York, and the Delano, located in Miami South Beach. The hotel management segment owns the Hudson, Morgans, Mondrian and Delano brands, licenses its brands to third party operators and manages properties in the U.S. (New York, Miami and Los Angeles), Europe (London and Istanbul) and the Middle East (Doha).

There is clear value in Morgans’s assets (corroborated by the number of offers for the company at prices that are materially higher than the current market price), but it seems that the market believes that the market believes that this value will not be realized in the near future, and will eventually be squandered away by management.

Currently, there are a number of issues afflicting the company that have been priced into the stock:

- High Leverage and Cost of Capital. The company has been undercapitalized and overly leveraged since the Financial Crisis. Long term debt peaked at 699m at the end of 2008, supported by EBITDA of only 55m (for a ratio of 12.60x) and declined to 440m in 2011m only to increase again to 607m in 2014 (supported by EBITDA of around 30m, for a ratio of almost 20x). After prepaying $28.8m worth of debt, the company has around 578m of debt outstanding. The business has been continuously hampered by excessively, and in our view, unnecessarily high interest expenses and years of negative free cash flow and net losses have forced the company to pile on leverage in order to finance capital expenditure and debt repayment. In our view, this is unsustainable.

- History of GAAP losses and negative free cash flow. The company has consistently lost money on both a FCF and GAAP net income basis. In the most recent year, the company managed to lose 57m even as the U.S. hotel industry has enjoyed booming revenue and record room rates. In fact, the company has never managed to turn a GAAP profit as a public company.

- Dysfunctional board: There have been two groups publicly feuding for control over the company since 2013: one group is affiliated with Yucaipa, the company’s largest creditor, and the other with OTK, the company’s largest shareholder. The dislike between the two groups have become personal, and political loyalty rather than competence is the most important criteria for appointment onto the company’s board or as CEO. In 2013, the chairman of Yucaipa, Ron Burkle, released a letter to the public where he called Jason Kalisman of OTK a ‘little boy who should get his mother to buy him a new toy’, and OTK has refused to nominate Yucaipa’s candidate to the board after they took control, costing shareholders money. The merger between SBE and Morgans Hotel failed due to opposition from director Jason Kalisman and OTK. The board seems to have forgotten their duty to act in the best interests of shareholders, and as a result, the company’s intrinsic value has been impaired by the incessant and unceasing conflict.

- Lack of Leadership. There has been no CEO since Jason Kalisman resigned from the interim CEO post in May of 2015. The CEO search has taken an inordinate amount of time: currently 9 months and counting. During that period, no new management contracts were signed, one management contract was terminated (Shore Club), and investors have been informed that there is the possibility that additional contracts at two of the company’s landmark hotels (the company’s namesake Morgans and the Royalton) may be terminated after it is sold by its current owner. There is no reason why the search for a new CEO should take such a long time and current management (CFO Szymanski and team) has not made every effort to secure new business despite the lack of CEO.

- Management lacks credibility and investor fatigue: Despite having announced a plan to shed assets and retire debt seven years ago1, the company still owns two hotel properties, and have made no progress on that front since 2010, when three properties were sold (indeed leverage has increased since then). Execution of the purported growth strategy (growing the management contract portfolio) has been poor; currently, the number of managed hotels is actually lower than the number of hotels managed at the end of 2010. Correspondingly, revenue from the hotel management segment is also lower than it was six years ago.

After the board announced that it had 1) formed a committee to explore ‘strategic options’, 2) retained Morgan Stanley as an advisor and 3) paid director Jonathan Langer over $1m for advice on the ‘strategic process’ in the spring of 2014, no transaction, either involving the hotel properties or the entire company, was completed. In August 2015, or one year after it had announced it was considering a sale, the company announced that it was involved in merger talks with SBE, a competing boutique hotel management company. However, predictably the talks failed to materialize into anything of substance.

Time and time again, management has failed to execute on its stated goals. As a result, both the board and management have lost credibility with the market.

Our thesis for this investment is predicated on our belief that the future will not look like the past, and that the company’s hotel properties will be sold in the near future allowing the value of the company’s assets to be realized for the benefit of shareholders. We believe the market has discounted the probability that this transaction will take place.

The purpose of this write up is to argue that the market perception of the stock is wrong. This will be accomplished firstly by establishing the value inherent in the company’s assets and then by determining the probability that such a transaction will take place. We believe that the downside has already been priced in by the market, and that the stock is worth between $1.00 and $10 per share (or a market capitalization of between 35m and 350m), which represents an asymmetric opportunity at current prices ~$1.50 or market capitalization of around ~40m.

Background

Morgans Hotel Group Co. was by Ian Schrager and Steve Rubell with the opening of the first ever boutique hotel, Morgans Hotel in 1984. The company has a long history of designing and managing modern, ultra-hip boutique hotels like the Royalton (renowned for its night club like lobby), Paramount and Delano, many of which were created in collaboration with Philippe Starck. These high profile properties have been credited with popularizing such concepts as ‘lobby socializing’ (in which the hotel lobby became a gathering place for guests), ‘cheap chic’ (which offered luxury in an affordable, stylish and sophisticated environment) and ‘urban resort’ (where the hotel’s amenities like spas and elaborate fitness centers make it a destination point amid the bustle of a city)2.

In 1998, NorthStar Capital, an investment fund run by ex-Apollo partner Edward Scheetz, paid $255m for 84% of the company.

The hospitality industry went through a slump following 9/11, and, as a property owner and developer, the company suffered from its highly levered balance sheet, a problem that would resurface in the future. In 2003, the Clift filed for bankruptcy. It reemerged from Chapter 11 in 2004, when the company sold the hotel in a sale/leaseback transaction. All of the company’s lenders and trade creditors were paid in full and the company received $71m in cash. However, it also saddled the company with a 99 year lease at an extremely high interest rate pegged to inflation, and also led to the departure of Mr. Schrager as CEO and Chairman in 2005 (Schrager said that the bankruptcy was ‘embarrassing’ for him because his ‘name was on the hotel’)3. In the meantime Schrager was able to renegotiate when the debt on his other properties came due, but the travails of the early ‘00s foreshadowed what was to come as the assets again became distressed during the 2008 credit crunch4. The company went public in 2006 following Schrager’s departure, offering shares for between $19-$22/share.

During the Financial Crisis, Yucapia, the private equity firm run by Ron Burkle, injected $75m into the company, in exchange for preferred shares and warrants to buy up to 12.5m shares of stock at $6 a share. The agreement also gave him the right to name a director to the board as well as veto power over transactions that involved the company or assets of the company. The preferred shares had a dividend rate starting at 8%, but it would rise to 10% in 2014 and 20% in 2016 if the shares were not redeemed. The CEO at the time called the investment ‘shareholder friendly’ that provided the company with a ‘great deal of flexibility to weather the remainder of the downturn5’, and Burkle’s compatriots filled the board. From 2009 to 2012, Morgans’ assets recovered but the company made numerous investments through the P&L line item and did a variety of other things that has kept the stock price depressed. Some thought that Yucaipa had no desire to make historical numbers look good, because they had been trying to increase their ownership stake of the company and/or its assets at lower valuations. The company also began their attempt to transform the company’s business model from one of property ownership and development to service-based hotel management.

In November 2012, and again in February 2013, Hyatt Hotels made an offer of $7.50 a share for Morgans. The company was trading at around $6 a share when the bid was made but the board rejected it as too low6. In the meantime, the company seemed to be making progress in its strategy, with then CEO Michael Gross managing to sign 9 new management contracts in FY 2012.

Frictions within the board became apparent when the company’s largest shareholder OTK Associates launched a proxy contest in the spring of 2013 despite the progress made by Gross. At the time, the incumbent board was aligned with Yucaipa. This would also be the start of a feud between the two groups that would last until now, and would have a material impact on the company’s operations. When it became apparent that Yucaipa would lose the contest, the company announced a recapitalization plan to maintain control of the company7. The proposed transaction would have exchanged Yucaipa’s 75,000 shares of preferred stock, warrants and $88m principal amount of company’s senior subordinated convertible notes for ownership of the Delano South Beach hotel and the company’s interest in the F&B management business TLG. The recap plan would also have given Yucaipa more shares (potentially owning as much as 30% of the company) in a rights offering that was backstopped by Yucaipa. OTK filed an injunction block the transaction, alleging that it undervalued the Delano property, and that it was a ‘coercively dilutive recapitalization’ that was ‘an obvious attempt to place a large block of stock in friendly hands prior to the annual meeting in order to preserve the positions of its incumbent directors’8. The injunction was granted, and OTK won a clean sweep over the incumbent board shortly after. There was another attempt to unseat the board in 2014, when Kerrisdale, a hedge fund allied with Yucaipa launched a proxy contest of their own. Kerrisdale claimed that the company was undervalued and called for the now OTK-controlled board to sell the company in order to realize this value. While Kerrisdale’s proxy contest failed, they did manage to place two of their candidates on the board.

On May 13, 2014, the company announced that it had retained Morgan Stanley as its financial advisor in exploring its ‘full range of strategic alternatives’9.

http://www.valuewalk.com/2016/03/morgans-hotel-group-co-mhgc-long-thesis/?all=1