Holloway Lodging REIT – debt conversion

Following up from my previous post on Holloway Lodging’s (TSX: HLR.UN) debt situation, I notice on December 22, 2011 they gave a conversion notice of their debentures to units:

Holloway Lodging Real Estate Investment Trust (TSX: HLR.UN HLR.DB.A) (“Holloway” or the “REIT”) announces that it has today given notice to the holders (the “Debentureholders”) of its 6.5% convertible unsecured subordinated debentures (the “Debentures”) that it will redeem the Debentures in full on January 23, 2012 and that it will satisfy the redemption price of the Debentures on the redemption date by issuing trust units (“Units”) of the REIT in lieu of cash, in accordance with the terms of the trust indenture for the Debentures (the “Indenture”). Any accrued and unpaid interest on the Debentures will be paid in cash on the redemption date.

The number of Units to be issued to Debentureholders will be determined by dividing the aggregate principal amount of Debentures outstanding by 95% of the weighted average trading price per Unit for the 20 consecutive trading days ending on the fifth trading day preceding the redemption date (the “Current Market Price”). Based on the redemption date of January 23, 2012, the 20-trading day period commenced on and included December 15, 2011 and will end on and include January 16, 2012.

Holloway also announces that it will not make the interest payment on its Debentures when such payment is due on December 31, 2011. Holloway intends to make such payment by January 13, 2012, as permitted by the terms of the Indenture.

This is a significant development for unitholders in that the roughly $51.8M face value of debentures outstanding (at least as reported by the TSX; this may be slightly lower due to buybacks) will be converted at the rate of approximately 7-8 cents per share, at least given existing trading patterns to date. Unit prices cratered from 20 cents to as low as 4 cents upon the announcement (currently trading at 10 cents), while debenture prices dropped from 58 cents to as low as 40 cents and is currently at 53 cents on the dollar.

Assuming an 8 cent per unit conversion price, this would mean dilution of about 94% for existing unitholders. Somebody holding $1,000 face value of debentures would receive 12,500 units, implying a unit price of about 4.25 cents post-conversion. The remaining entity will have about 670 million units outstanding and at 4.25 cents per unit it would imply a market capitalization of about 28 million.

Using the 2010 cash flow statement as a very blunt proxy for future performance, the entity without the convertible debentures will be able to pull in about $5.9 million in operating cash flow, which would put it on sounder financial footing. It could suggest that the post-conversion trading price of the units will be around 7-8 cents.

Finally, the company has decided to consolidate the remainder of its non-mortgage debt on the chairman’s company Geosam:

Holloway also announces that it has entered into a second amendment to its credit agreement dated as of June 15, 2011 among Holloway, Geosam Capital Inc. (“Geosam”), as administrative agent, and Geosam, together with such other persons from time to time party to the credit agreement, as lenders, (the “Credit Agreement”) to increase the amount of funds available for drawdown by $3.6mn for certain limited purposes. Holloway has increased the amount outstanding under the Credit Agreement by $1.8mn in order to purchase from the holders of its interest-bearing promissory notes approximately $2.8mn of such notes, representing all of Holloway’s interest-bearing promissory notes outstanding.

This is presumably linked to the resignation of the CEO (Squires) that lasted in the company longer than I expected him to after the takeover of the company by George Aryoman and Geosam.

My conclusion here is that the market is valuing the debentures and units as slightly expensive, but it is within an order of magnitude of a fair valuation. Finally, my continuing thesis is that the only entity that will make any money from Holloway will be Aryoman and Geosam by virtue of their control of the company and the secured credit facility which will continue to hive off interest income from Holloway unitholders. This will continue as the assets are stripped and sold from the trust.

In other words, this is a fun one to watch, but not to invest in. I feel fortunate to dump my debentures at the price that I got for them (roughly 60-65 cents) and get out of dodge. If unit prices go down to the 4 cent level again, the trust may be worth putting a few pennies in, but this would be one of those typical “pick up the cigar butt off the street for one last puff” type value plays.

15 thoughts on “Holloway Lodging REIT – debt conversion”

  1. Welcome back Sacha. How do you get an implied unit price of 4.25 cents post-coversion? Later you suggest 8 to 9 cents might be appropriate. The market is agreeing with that so and Armoyan himself bought more units this week at 8 cents. If unit pricing is 8 cents or above post- conversion and the debentures convert at 7-8 cents (i agree this looks likely), then the debentures at $53 are a fantastic investment. You have been correct about the equity all along but not about the debentures.

  2. For the sake of argument, assume the debentures are trading at 53 cents today and the conversion price is 8 cents.

    If you spend $530, you can receive $1,000 face value of debentures and receive 12,500 units of HLR post-conversion. $530/12,500 = ~4.25 cents.

    Theoretically you could short HLR.UN at present prices (10 cents) and buy the debentures at 53 cents and arbitrage but obviously that is not possible due to the inability to short HLR units. After conversion there will probably be a rush to take the risk-free profit, but since the market is so thin I do not think you can get much profit in terms of dollar volume unless if you are a very small player.

    I’m not sure where you think my analysis of the debentures was incorrect – they are getting far from par, although I will confess that I thought they would be trading lower (roughly 30-35 cents) given all of this news. We’ll see the aftermath on January 23rd!

  3. Do you really think that the post-conversion price of the units is better estimated by using the “debenture implied price” of 4.25 cents instead of the price that the market is willing to pay for the units themselves (which is 10 cents)? Really?

    I’d say that the 4.25 cents is better considered to be “the equity-equivalent price that investors are willing to pay for debentures given that they may not be very liquid for some time post-conversion”. The price could also be a function of a dump and run mentality amongst certain debenture holders. Remember, currently the equity holders are down 50% (20 cents to 10 cents – they were down 75% initially) from pre-announcement trading pricing but the debenture holders are only down 12% ($60 to $53).

    You seem to be saying that buying debentures today in the low $50s is a poor investment because although they may double (to $100) upon conversion, investors may have to be patient in taking profits. Maybe months? Really?

    Look at the analysis this way. Pre-announcement, the 40MM shares of HLR traded around 20 cents for a market cap of about $8MM. There are $48MM of outstanding debentures that are converting to equity. The post-conversion company has a much improved balance sheet and better prospects than the pre-conversion company. The total equity in the post-conversion company is $56MM (8 + 48). There will be 640 MM shares (at 8 cents conversion) post-conversion, giving an “implied valuation” of 8.75 cents per unit without the impact of improved prospects.

    I agree that there could be a rush to the exits at first and a depression of unit market price but current buyers of debentures can accept up to a 50% haircut in a rush to exit and still be whole if they want out. Patient investors can wait for price stabilization based on the actual prospects of the new company. Remember the debentures were not due until June!

    I’ll concede that if you are writing for an audience of institutional investors or managers of large investment books, then liquidity will be a big issue (both getting in and getting out) but for an investment in the tens of thousands this is not the case.

    You have long admitted to being baffled by the market action on the debentures. You need to ask some deeper questions. Why would Armoyan buy another 500K of units this week at 8 cents if post-conversion pricing was going to 4 cents? Why is the market price of the debentures moving up, instead of down as we get closer to conversion? When the market disagrees with you, you should listen.

    Also – why would Armoyan harm himself and his pals by forcing the early conversion of HLR debentures to equity (remember his camp owns major equity, as does RYL – which he controls)? Could RYL be planning an all share offer for HLR post-conversion? Armoyan has been accumulating debentures and shares in RYL throughout December and RYL just completed a major repurchase of its own debentures in December also. An impending RYL takeout of HLR would explain the forced early conversion of HLR debentures, why Armoyan et al would accept a loss, and provide the necessary liquidity for investors to exit their post-conversion HLR positions.

  4. Before I begin, note my math is a little off – there are $46,660,000 outstanding of debentures, not $52M that I assumed earlier (what the TSX site says currently).

    There was no other estimate to use than 4.25 cents given the trading price of the debentures. There is that arbitrage opportunity, but I think you are making more of a “the intrinsic value of the company is higher post-conversion” argument.

    Without the albatross of the debt maturity and $3M in interest expense off the books the equity does look more attractive.

    I also notice the debentures are at 59 cents now, so hardly changed from the day before the conversion announcement was made.

    If the argument you are trying to make is that purchasing debentures at 59 cents is better than buying units at 11 cents, then I completely agree with you.

    I have no idea why Aryoman would buy 500k@0.08 ($40k total). I also notice that Royal Host apparently got rid of its 6 million units (December 15). I don’t know who owns a large portion of debentures either – a sufficiently large stake of debentures will let them control the whole company at the next AGM.

    When the market disagrees with me, it means either the market is right or I am. Usually the market is, but the whole point of investing is to be more correct than the market. Since I have zero dollars invested with this one, it is not too dissimilar to following a sports team at this point.

    I think post-January 23rd will make this one easier to discuss.

  5. The post-mortem after the 23rd should be very interesting for sure.

    Just so the facts are straight – Royal Host didn’t dump their units, they transferred them from Royal Host Inc. to the wholly owned Royal Host Limited Partnership. I don’t know if that is significant.

    On who owns the debentures – I have never been able to find a public source of this information. Presumably Holloway REIT knows because they have to mail out information – or are they blinded from the holders by the brokers?

    On why Armoyan bought the 500K units – I now have two theories. One is that he sees post-conversion pricing for the units above 8 cents. Second (courtesy of a friend) is that he is loading his gun to incite panic selling (by unloading his units into a flooded market) after conversion so that RYL, he and/or his cronies can scoop up units extremely cheap then have RYL swoop in with an “attractive” offer to save the day. I guess we’ll see after the 23rd.

  6. “Just so the facts are straight – Royal Host didn’t dump their units, they transferred them from Royal Host Inc. to the wholly owned Royal Host Limited Partnership. I don’t know if that is significant.”

    Thanks for clarifying that. I’m not sure how you got that information. In any respect that 6 million units will be irrelevant in terms of voting stake post-conversion.

    “On who owns the debentures – I have never been able to find a public source of this information. Presumably Holloway REIT knows because they have to mail out information – or are they blinded from the holders by the brokers?”

    Good question. I forgot whether there are reporting requirements for a minimum percent stake of debentures. I know the threshold in Canada for equity is 10%, but I don’t know whether debentures are the same. Because Royal Host and Aryoman and Geosam are insiders, they do have to report their debenture holdings.

  7. Small clarification – Royal Host was an insider until it dumped its 10% stake; presumably the limited partnership (or whoever picked up the trading block) will have to report if they picked up the 10%.

    Won’t be a 10% stake for much longer, however!

  8. Data source for the Royal Host internal transfer was INK Insider report. Looking forward to the post-conversion shake out.

  9. Somebody has clearly been pounding that bid with impunity over the last couple of days, pushing that conversion price even lower.

  10. A lot of volume is coming from an “anonymous” source. Looks like conversion price is settling around 8 cents, as we predicted, although this could drop if the selling pressure continues.

  11. About 750M units outstanding of the trust post-conversion, question remains whether the entity is worth the $30M in market capitalization or not.

  12. Agreed. The current price action implies about $30MM of market cap. Pre-announcement market cap ($8MM) plus the debentures ($46), suggests $54MM of equity. $30MM is a 44% discount, despite an improved balance sheet (from conversion and two recent hotel sales) and improving fundamentals of the company.

    Another way to question is how big should the discount be? We are about to find out.

    Lastly, at current pricing, debenture holders who bought in during the past year are likely to be made whole.

  13. Very brief post-mortem. Conversion occurred at 6.5 cents. Units closed at 6.0 cents yesterday. Therefore, the debenture holders who sold their converted bonds at that price received $92.31. Investors who bought at the low just after the announcement made more than 100% in one month. Investors who bought debentures during the last year earned ~50% capital gain plus the coupon.

    You were right to seriously dislike the equity. Unitholders currently are sitting with about 30% of their pre-announcement capital. Unitholders may yet get some relief if some competition for a Holloway takeover emerges between Temple REIT and Royal Host REIT.

    Thanks for the great dialogue!

  14. It looks like your trade worked very well.

    If you picked up those debentures at 55 cents (I generally don’t like to assume perfect execution and market timing) and assuming you sold the equity at 6 cents even, that’s an effective cost basis of 3.575 cents, and a sale of 6 cents, so a gain of about 68% not factoring in expenses. Wouldn’t have been bad for a few weeks’ work!

    The core assumption is that you would have had liquidity – and indeed, the past couple days featured a couple 100M+ share trading days, so that would have been ample liquidity to get your 6 cent price point.

Comments are closed.