Supertel Hospitality Preferreds Trade At Large Discount

Executive summary:

• Supertel Hospitality's rights offering should provide the catalyst to turn the company around


• Company is backed by Eduardo Elsztain and his firm IRSA


• Both the A and B cumulative preferred shares are trading at a significant discount and offer an attractive risk/reward ratio

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(Editors' Note: This article covers a stock that is trading at less than $1 per share and/or has less than a $100 million market cap. Please be aware of the risks associated with these stocks.)

Shares of Supertel Hospitality (SPPR) have the potential for massive gains if the upcoming rights offering provides the necessary liquidity and time for the company to dispose of their non-core assets, pay down debt and purchase upscale hotels. While Eduardo Elsztain's Real Estate Strategies LP has backed the company numerous times, Mr. Market could be right and Supertel's large debt load could crush equity shareholders.

Why take the equity risk when we can protect the downside and invest alongside Elsztain in either the A (SPPRP) or B (SPPRO) class preferreds, Elsztain and RES holds all C preferreds. We can purchase the preferreds for a large discount to the liquidation preference. The A shares are trading at 66 cents and the B shares trade at 64 cents on the dollar (at the time of writing). Both have their dividends suspended, however, they are cumulative preferreds and the imminent rights offering could provide the liquidity to either (1) reinstate the dividend or (2) pay off all or a portion of one or the other preferreds that would act as the catalyst to send shares back towards their liquidation preference. If all goes well, then both preferreds turn in equity gains and large future dividends. If all does not go well, we estimate we would get all or a vast majority of our money back in bankruptcy.

Background

Supertel is a nano-cap real estate investment trust (REIT) that currently owns 69 hotels in 21 states across the United States. The company has focused on the limited service economy and mid scale hotels which operate under several national and independent franchises. This strategy worked pre-2007, but their acquisition frequency grew as the economy boomed. Of course the economy collapsed, tourist travel declined and residential as well as commercial property prices fell which severely impacted Supertel's operations and property values. Supertel management was then faced with Nasdaq delisting pressures as their stock traded below $1 for more than 30 days (this was prior to the 1 for 8 reverse stock split), barring them from raising the necessary equity capital to further turn the company around. Fortunately, Real Estate Strategies LP (later referred to as RES), an investment vehicle run by Eduardo Elsztain's IRSA Inversiones y Representaciones S.A.(IRS), invested $30 million for C class preferred shares and gained 34% voting control of the company. For those who are not familiar with Elsztain, he is a large property owner and developer in Argentina who obtained financing from George Soros in the early 90's. Through IRS he has been able to compound the company's book value at a 11% CAGR for the last ten years. RES now has four directors on Supertel's board.

The $30 million capital infusion from RES offered the time necessary for Supertel to offload their poorly performing assets, pay down debt and refocus their portfolio of hotel properties from budget/economy towards upscale and upper midscale hotels. Since April 2009 the company has sold 54 hotels helping to pay off $71.4 million in debt since 2008. Supertel was also able to purchase their first upscale hotel Hilton Garden Inn in Dowell, Md., for $11.5 million in May 2012. Here the average rate per room was $122 in 2012 compared to the low $50 that the company was currently getting per room.

Further Problems

The company was on track with their new strategy by entering purchasing agreements for seven hotels from various sellers which would have been paid for by using the proceeds from a stock offering of 16 million shares which would have equaled $115 million. The company also entered a purchasing agreement for seven Savannah Suites hotels. Unfortunately timing was not on Supertel's side, again, and the company decided to pull the plug on the stock offering and terminated the imminent 14 upscale hotel purchases. The market slammed the stock as they had to scramble for liquidity by discontinuing their dividend payments on all three classes of their preferreds which includes the C Preferreds owned by RES.

To again give the necessary short term liquidity, RES has offered Supertel a $2 million loan while the company worked on a rights offering for 6,648,286 shares for a maximum proposed $30 million. Currently, the offering is not set in stone with the expected price or time of the offering, but the offering would buy Supertel the time necessary to sell some of their non-core, low-performing hotels and acquire one or a few new upscale hotels. The company has until April 15, 2014 to complete the offering or RES has the option up until July 9, 2015 to convert the $2 million loan into common stock.

Valuation

Supertel is cash flow positive looking at both FFO and AFFO, but both numbers have been falling lower. Currently the FFO is actually 36% of the market cap and the AFFO (excluding the botched equity offering expense) to market cap would have been 18%. The main concern that the market has is that Supertel has $117 million in debt and has limited liquidity to pay off the upcoming principle payments. Supertel has been trying to sell non-core hotels to pay their obligations but it might become difficult as ~$29 million comes due this year.

The liquidity crisis Supertel currently faces mainly involves two loans that are set to be due this year. One is due in June and the other in December of this year. We believe that the ~$30 million rights offering would afford Supertel the necessary liquidity to pay off the $11.2 million due in June this year, the $2 million loan due to RES and the $17.5 million loan due in December. This would allow the company to further dispose of their non-core assets to help fund a few acquisitions as well as reinstate the preferred dividends. Investors who buy the preferreds now for 66 to 68 cents on the dollar could receive their full dollar in the next few months and receive their 8% or 10% from the A shares and B shares respectively.

Now if Supertel was not successful in their rights offering and continued to have significant liquidity difficulties, then bankruptcy would follow. According to our back of the hand liquidation valuation, found below, we see that roughly $43 million would be left after selling assets and extinguishing all debt. $46 million would be necessary to liquidate all preferreds at their liquidation preference so even if C shares received full liquidation preference before either A or B shares, then A and B shares would get 19% reductions to the liquidation preference ($3 million total deficit 1.5/8= 18.75% discount). The shares currently trade at larger than 30% discounts to liquidation preference which gives investors now a margin of safety even in liquidation.

(Our Rough calculations)

Risks

Our calculations of liquidation could be wrong. We utilize the September 2013 numbers that are currently available and the balance sheet could have changed significantly since then. Additionally, our estimates of % received in liquidation could also be wrong. Both investments in continuing and for sale hotel assets could have appreciated from their values which are at cost on the books, however, in liquidation those assets could get wildly different numbers all depending on market conditions and timing. We think our estimates are fairly conservative. Note that we do not include the costs of bankruptcy which could be significant.

The rights offering could also go through and the management could undergo further bad luck. They could allocate the proceeds from the rights offering in different ways that would not be beneficial for either the shareholders or preferred shareholders. The dividends for the preferreds could be again delayed but because the preferreds are cumulative, investors would still get their payments paid when things turned.

Please note that the common shares and both the A and B preferred shares are extremely thinly traded. Keep that in mind when you are considering an investment.

Conclusion

Supertel Hospitality needs time and the finances to allow them to turn the company around. The upcoming rights offering should provide the necessary backing for the company and the potential upside for equity holders is large. We feel there are plenty of risks with the equity and that the preferreds, which trade at massive discounts, offer a better risk/reward ratio at current prices.

Source: Supertel Hospitality Preferreds Trade At Large Discount

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. The only kind of intelligent investing is through your own due diligence.

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