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.

Holloway Lodging REIT

Forgive my sarcasm, but my favourite nearly insolvent REIT, Holloway Lodging REIT (TSX: HLR.UN) announced their latest quarterly results. They weren’t that bad relative to the previous year, but the company has a huge debt anchor around its throat while it is being asked to swim across the Pacific Ocean.

More specifically, in order to pay off an earlier debenture, the company through a related entity, borrowed money at double-digit rates of interest and continues to have about $12M outstanding at this time through that loan. There is another debenture maturing in less than 8 months worth approximately $50M face value that they admitted they won’t be able to pay off when it becomes due.

The likely scenario is that they will be doing a debt-for-equity swap. However, there is a game of “chicken” being played – there could also be a chance that the controlling shareholder would float another bridge loan to the company and pay off the debenture to avoid massive dilution – similar to what happened with the first debenture.

This is the only reason why I can think that the debenture has a bid at 50 cents on the dollar. Even with this debt anchor removed, the underlying operations are not all that profitable – most of the profit is being sucked off by the controlling shareholder through related entities.

Holloway Lodging gets a stealth takeover

It appears that Holloway REIT (TSX: HLR-UN.TO) had its prior trustees, including the CEO W. Glenn Squires, were kicked out by George Armoyan’s group of people by a margin of 85% to 15%, according to SEDAR filings.

Now that Armoyan has full control over the company (and indeed, roughly a 20% equity stake by virtue of his ownership in Royal Host REIT (TSX: RYL.TO), it remains to be seen what his plans for the two companies are. There are logical synergies between both companies, but both companies face huge balance sheet issues – mainly that the cash that the properties are generating is not proportionate to the cost of capital required to finance such properties.

Looking at the last quarterly report for Holloway, their balance sheet has stacked up a significant amount of current debt maturities, including a $3.6M line of credit, $42.1M of mortgages requiring refinancing, and perhaps more urgently, $20.2M of convertible debentures that are maturing on July 31, 2011, just under two months away! The company has $300,000 in cash on the balance sheet and the line of credit is good for $5 million.

It should be noted on their MD&A that the company states that:

The REIT has a signed term sheet to finance the repayment of the debentures. The Board and management continue to explore other alternatives to raise funds to repay the debenture holders which may include other debt financing, the sale of certain properties, or some combination thereof.

One wonders what the terms on this term sheet is and who the heck would be willing to lend this company money on an unsecured basis.

The market capitalization for the firm at their existing price of 34 cents is about $13M, which means that if the company wished to pay off the debenture using equity (which I am not sure is legal without shareholder approval) then that would represent a significant dilution.

Interestingly enough, these debentures are trading at par.

Also, I have no position in any of these securities.

Holloway Lodging REIT – Default on radar screen

The last time I wrote about Holloway Lodging REIT (TSX: HLR.UN) was back in December when there was a corporate governance spat between a significant shareholder and management. That conflict resolved differently than what I had expected, with the significant shareholder being given a minority slate of trustees.

I have been continuing to dump my debentures in Holloway (the 2012 issue, TSX: HLR.DB.A) at around the 65 cent range and got rid of my last piece today at 62, leaving $1,000 in par value of debt just so I can see how this train wreck ends.

Holloway released their 2010 annual results yesterday, and reading it contains two not-so-subtle inclusions on their financial statements and management discussion that warrants further analysis:

The REIT is also subject to financial covenants on its mortgages and loans payable, which are measured on an annual basis and include customary terms and conditions for borrowings of this nature. These include the Debt Service ratio presented above. The REIT is in compliance with, or has obtained waivers for all of its financial covenants except one. One lender has not provided a waiver however, as a result of discussions with this lender, management believes the loans will not be called prior to maturity. The two mortgages with this lender, on hotels in Fort McMurray and Drayton Valley, are included in current liabilities and mature in October 2011 and January 2012.

Notably, the company has $153M of mortgages outstanding which are secured by the property and buildings within those mortgages. If the company does not abide by their debt covenants, in theory, the lender can call the debt unless if the company can cure the breach. If this occurs it would likely result in the company being pushed into creditor protection as their line of credit is not large enough to cover the difference.

The REIT has $25.4 million of mortgages maturing in 2011. The REIT expects to refinance its maturing mortgages at similar or better terms with existing or other lenders.

The REIT also has $20.2 million in convertible debentures that mature on August 1, 2011. The REIT has a signed term sheet to finance the repayment of the debentures. The Board and management continue to explore other alternatives to raise funds to repay the debenture holders which may include other debt financing, the sale of certain properties or some combination, thereof.

HLR has $45 million in debt in 2011 that they must be able to roll over in order to avoid creditor protection. The mortgage debt they should be able to renew at acceptable rates (they did so in 2010 for about 6.6% for a 5-year term). The August 1, 2011 debenture is an interesting issue ($20M) in that it is trading near par (TSX: HLR.DB, 93.5/97 bid/ask presently, albeit very illiquid) which suggests the company can refinance that, but the June 30, 2012 debenture (a $45M issue) is down to 62/63. This suggests the market is betting on the company being able to rollover the 2011 debt but not the 2012 debt. Both debentures are equal in seniority to each other.

It would be a logical and low-risk paired trade to short the 2011 debenture and long the 2012 debenture, but I could not short the 2011 debenture.

The business is not generating a sufficient amount of cash and this is in large part due to the interest bite that comes out of operating income. In 2010, the business pulled in about $19.3M in operating income, but the interest expense was $15.8M. This does not leave much room for other incidental expenses, such as general and administration, and future capital expenditures. Capital expenditures in 2010 I am presuming were of a maintenance-type nature, totaling $3.6 million.

There is nothing to suggest that they will be able to improve their revenue per room or capacity utilization rates over the next couple years.

There is probably residual value left in the operations, but I don’t want to be around to find out what low-ball offer management will be offering to the convertible debenture holders when maturity comes around. I’ve exited the 2012 debentures, short of $1k par value. My basis was about 44 cents on the dollar, so this is a nice gain for nearly 2 years of holding, but as I pointed out earlier, one of my largest mistakes during the 2008/2009 economic crisis was putting money in the debentures of this company compared to Innvest (TSX: INN.DB.B) at the same time period.

Holloway Lodging REIT vs. George Armoyan

I note with interest that Holloway Lodging REIT (TSX: HLR.UN) has finally received a notice from Royal Host REIT (TSX: RYL.UN) that they want to kick out the three independent trustees and replace them with people of their choosing. Royal Host REIT owns about 7.4 million shares of Holloway, which is about 18.9% of the equity.

Royal Host REIT is chaired by George Armoyan, an east coast Canadian that has various financial interests and is similar to a small-scale Carl Icahn. Armoyan, in addition to being the chairman of Royal Host REIT, former chair of Clarke (TSX: CKI), runs his private corporation Geosam Investments. He has a very interesting history of taking minority stakes of companies, enough to control the board, and then convert the operations into more profitable ones. While his record is not 100% by any means, he does generally have a track record of success mixed in with a few failures.

Holloway Lodging REIT can be classified as a broken income trust – having gone public in the middle of 2006 during the boom in income trust issuance (just before the federal government shut the door on trusts), their equity has more or less gone on a straight downward trajectory and now trades at about 28 cents a unit. At 39.1 million units outstanding, the trust has a market capitalization of $10.9 million. The company’s current operations involving owning and operating 22 hotels, which consist of 2,386 rooms. About 60% of the hotel rooms are in Alberta. You can also dig into their financials and see that management has been wheeling and dealing with related entities (Pacrim Hospitality) and has lost money on various failed joint ventures (Windham, Winport).

Not helping their business is that capacity has been growing in their target markets (which generally consist of Super 8-type motels in back-country areas like Grand Prairie, High Level, Fort Nelson, etc.) which has lead to price competition and a drop in booking amounts. The company’s operations on the eastern side of the country, however, have not been that bad. When you look at the bottom line statement, the company is barely operating cash flow positive – about $2.3 million for the first 9 months. The last 3 months of the year will likely be a net loss. When capital projects and other miscellaneous items are factored in, it is pretty clear that this company is not financially on strong ground.

On the balance sheet side is where things are interesting, and I am using September 30, 2010 figures. The cost basis of the various capital investments the corporation has made is $367 million (mainly buildings for $297 million), offset by $44 million in accumulated amortization. Thus, the book value of $323 million in assets is something to be considered, even if the market value of these assets are to be impaired further than what the stated carrying value is.

On the liability side, it is much more ugly – the company is $1 million into its $5 million line of credit, and has $154 million in first-line mortgages (with a blended rate of 6.81%). $1.3 million of this is due by year-end, $7.4 million of this is current (i.e. due by September 30, 2011) and $30.5 million is due by the end of 2011.

Finally, the company has two convertible debenture offerings outstanding. The first is a $20.2 million offering, 8% coupon, that matures on August 1, 2011. The second is a $52 million offering, 6.5% coupon, that matures on June 30, 2012.

Suffice to say, the company has no way of paying off the prinicpal of the convertible debentures without performing a wholesale asset liquidation. While they may be able to refinance the mortgage, using the building and property as security, they will have a very difficult time refinancing the debentures without raising cash.

The 2011 debenture trades at bid/ask 92/93 and the 2012 debenture trades at 51/55. Yield to maturity is an irrelevant calculation in this case – what matters is capitalization. Using midpoints for both of them, the debentures have a combined market value of $46 million.

The math for a potential investor, is simple. If you assume you can actually liquidate the assets at the stated carrying value, and use the proceeds to pay off the mortgage and convertible debentures, you are left with approximately $117 million (i.e. this is the amount of unitholders’ equity). This is considerably above the current $10.9 million market capitalization.

The market realizes that things are not this simple. For example, if you assume that the carrying value of the property assets are actually 30% lower than what is stated on the balance sheet, suddenly your $117 million has shrunk into $20 million take-home. Still, this is not a bad haul if you just paid $11 million for the company.

When you factor in the price of the debentures, and price the equity at zero, the market is implicitly assuming that the property and land is equal to about 65% of its carrying value. The question for an investor is whether this should be lower (in this case, sell the debentures) or higher (in this case, buy the debentures). This assumes that the operations of the company are cash-neutral.

Obviously George Armoyan is taking enough of an interest in Holloway’s assets that he is spending time and energy on this little project. His own REIT, Royal Host, is not exactly a financial superstar in its own right, but there are obvious administrative synergies to be obtained if it were to merge together with Holloway. The only downside is that there would have to be a mandatory offer to redeem the debentures at par – something that skittish debenture holders would likely waive if the debt were to be backed with a stronger partner than the existing management at Holloway, which has been proven to be a dismal failure.

It is likely management is going to spend time and energy, and more importantly, money to try to fight this battle. Hence, the debentures dropped from a quote of 60/61 to 51/55 when the news came out – normally a battle for the board would usually stimulate prices because somebody is actually interested in taking an economic interest in the company, more so than existing management.

The reason why I am taking an interest in what is otherwise a fairly obscure sector of the business world is because I have a position in Holloway Lodging’s June 2012 debentures. I bought them in the first half of 2009 during the economic crisis, and it was one of the worst binary decisions I made – although if I liquidated today I am still nominally up on the investment, my other option that I was contemplating at that time was InnVest series B debentures, which is now a “lock” for a maturity at par.