SoTHERLY Hotels, Inc. - SOHO

SoTHERLY Hotels, Inc. owns nine upscale hotels located mostly in coastal markets in the American Mid-Atlantic and Southeast, as well as a minority interest in another hotel in Miami. SoTHERLY's properties produce nearly twice the EBITDA they did in 2005 and the company has made great progress in replacing expensive financing with mortgage debt. Despite its solid operations and improved balance sheet, SoTHERLY offers a distributable cash flow yield more than twice its competitors. SoTHERLY Hotels is a REIT and is listed on the NASDAQ as SOHO.

Here's a map of SoTHERLY's properties from a presentation the company made in June.

SoTHERLY's corporate structure is a little convoluted, and has potential for conflicts. (These potential corporate governance issues are SoTHERLY's biggest weakness, so I want to discuss them up front.)

First, a little explanation. Like many real estate companies, SoTHERLY conducts its business through a limited partnership. SoTHERLY's limited partnership is called MHI Hospitality, L.P. SoTHERLY is general partner and holds a 77.6% ownership interest in the LP. The remaining units are largely held by management, chiefly the Kim family that founded the company back in the 1950s. SoTHERLY reports its funds from operations on a per share/unit basis, so shareholders must be careful to adjust the reported funds from operations for the 22.4% economic interest that belongs to limited partners other than SoTHERLY Hotels, Inc. This is not a potential conflict, just something shareholders must know and adjust for.

Then there's the fact that a REIT cannot actually operate or manage the properties that it owns. To deal with this restriction, SoTHERLY leases its hotels to one of its subsidiaries, MHI Hospitality TRS, LLC. That subsidiary is required to pay federal taxes, which are then rolled up into SoTHERLY's results. The effect is that SoTHERLY Hotels, Inc. is a tax-paying REIT, a truly strange animal.

MHI Hospitality TRS, LLC has entered into contracts with a management-owned company called MHI Hotels Services to operate and manage the leased hotels. The company discloses in its annual report that these management contracts were not negotiated at arm's length and the company could potentially pay less to an independent company. These contracts also contain provisions for large cancellation fees.

The company also discloses that its decision-making may be affected by the Kim family's desire to avoid taxation. The Kims enjoy a partial tax indemnification agreement with the company, though this expires in 2014.

These conflicts are worth noting and investors should monitor management carefully. However, thus far management seems to be reasonably focused on creating value for all shareholders. Compensation for top officers is reasonable, and the Kim family has adequate incentive to increase dividends and share value because the value of their ownership stakes far exceeds their annual compensation.

With those caveats on the table, let's take a look at the financials. Hotel occupancy and profitability has risen steadily over the last several years. Here's a look at yearly hotel EBITDA before corporate costs, adapted from the June investor presentation.

Growth in hotel earnings has been increased by additions to the portfolio, but also by improved occupancy. The financial crisis hurt hoteliers badly as businesses and consumers reduced travel. Average occupancy in SoTHERLY's hotels in 2006 was 69.7% and daily revenue per available room was $78.26. In 2009, occupancy fell to 60.4% and daily revenue per available room was $64.71. Only recently have results improved to close to pre-crisis levels. SoTHERLY's 2012 figures show occupancy of 68.9% and daily revenue per available room of $78.65.

The company's improved results at its hotels have driven operating income to record levels: $10.31 million in 2012 and $11.29 million for the twelve months ended September 30, 2013.

Balance sheet improvements are the other half of SoTHERLY's improved cash flow equation. The company has made huge strides in replacing expensive financing with cheap financing, pushing out debt maturities along the way. Here's a comparison of the company's debt load at year-end 2011, year-end 2012 and now.

Since year-end 2011, SoTHERLY has managed to reduce its cost of debt by 131 basis points, from 6.76% to 5.45%. The financing mix has been shifted away from lines of credit and redeemable preferred stock in favor of mortgages and unsecured notes. The average debt term has grown worryingly short, but the company has been making progress in extending its maturities, including refinancing the Doubletree Hilton Brownstone University hotel to a 2018 maturity and the Holiday Inn Laurel property to a 2021 maturity.

Improving hotel results and lower cost debt have enabled SoTHERLY to generate increased funds from operations. As usual with real estate companies, the income statement provides a poor picture of actual earnings. Funds from operations is a better metric that strips out depreciation and amortization as well as unusual or non-recurring items like gains on property sales and in SoTHERLY's case, non-cash losses due to the increasing value of its outstanding warrants.

For the trailing twelve months ended September 30, SoTHERLY Hotels produced 92 cents per share/unit in adjusted funds from operations, a 26.1% increase over 2012.

At a share price of $4.67, the 92 cents per share in adjusted funds from operations represents a rich AFFO yield of 19.70%, much higher than any of SoTHERLY's public competitors. The eight smallest hotel REITs I could find have FFO yields averaging 6.1%.

On a cash flow basis, SoTHERLY trades much cheaper than its peers. Then again, relative valuation matters little to me unless a company is cheap on an absolute basis in terms of P/E, free cash flow yield, or assets. Funds from operations tells part of the story, but it doesn't include the cash drag of necessary capital expenditures. While a large part of a hotel operator's depreciation charge is non-economic, some level investment is still necessary to maintain the competitiveness of its properties. Even assuming all of SoTHERLY's capital expenditure goes toward maintaining its properties at their current levels of quality, SoTHERLY still offers a generous free cash flow yield.

In both 2012 and over the last twelve months, SoTHERLY produced enough free cash flow to yield over 10% at the current share price. By comparison, some of its competitors offer scarcely any free cash flow after taking capital expenditures into account.

In a few quarters, SoTHERLY's trailing cash flow could look even better. Remember that trailing numbers are depressed by the expensive preferred stock that was paid off only very recently. If the US economy picks up steam, hotel occupancy could push results even higher. Sustained higher cash flow will enable the company to continue increasing its dividend, which currently only consumes 31% of free cash flow. I expect the market will eventually notice SoTHERLY's improved results and healthy yield and award it a more reasonable price.

One last big consideration for SoTHERLY. Now that its balance sheet restructuring is complete, the company is on the acquisition trail once again. In its earnings call for the most recent quarter, the company confirmed it is very close to announcing an acquisition. If the acquisition is attractively priced and easy to integrate, all will be well and shareholders will benefit from increased cash flow. If the company overpays for the new hotel and has trouble integrating it with the existing portfolio, there could be trouble. Management has been in the hotel game for a long while, but that's no guarantee that things will go smoothly.

Accounts I manage hold SoTHERLY Hotels, Inc.