Independents’ Day - Investment Outlook - September 2002

The merger of the largest third-party managers, MeriStar Hotels & Resorts and Interstate Hotels, forges a 402-hotel powerhouse with a mandate to grow and the cash to get the job done.

By Staff -- HOTELS Magazine, 9/1/2002

The third time was the charm for MeriStar CEO Paul Whetsell. First, market conditions unraveled a proposed deal between MeriStar Hospitality, a real estate investment trust (REIT), and American Skiing. Second, the shock waves of last year’s terrorist attacks swamped an all-but-completed merger with FelCor Lodging Trust. Then Whetsell began shopping operations companies to create a deal for MeriStar Hotels & Resorts and finally found what he wanted in Pittsburgh-based Interstate Hotels Corp. The July 31 merger that combined the United States’ first- and third-largest independent management companies creates a 402-hotel, 86,000-room giant with the critical mass and financial firepower to take on the brands.

Growth on this scale is part of Whetsell’s long-term strategy for building share value. “With 56,445 rooms, MeriStar alone was a large operating company but it didn’t even fit a small cap profile. We were a micro cap,” he says. “Our first objective with this merger is to increase our EBITDA from US$45 million to that US$100 million small cap level. To do that, we need larger assets with bigger income streams.”

Whetsell contends the merger, which resulted in the new Interstate Hotels & Resorts, creates a capital structure that allows for just this kind of expansion. The pre-merged Interstate carried “no net debt” on its balance sheet, according to Whetsell. Financial integration of the two companies delevered MeriStar Hotels & Resorts and unlocked shareholder value in what he views as “under-valued” shares. A new US$113 million senior credit facility replaces the existing revolving credit facilities of both companies. Interstate also benefits from MeriStar Hotels & Resorts sell-off of its leases, including 47 leases assigned to a subsidiary of Winston Hotels in a July 1 deal valued at US$17 million. With total debt outstanding, net of cash, expected to be US$135 million at closing, the new Interstate looks to have the resources necessary to execute an expansion strategy that combines strategic equity investment with growth via management contracts.

Though Interstate will not err on the side of over-committing to ownership, Whetsell is realistic enough to understand the new company will have to invest in real estate a little more to get the big deals done. Both MeriStar Hotels & Resorts and Interstate can build on existing relationships with satisfied owners, including Oak Hill Capital Partners and Lehman Brothers, respectively.

Like most management companies, Interstate will consider the standard co-investment options, ranging from performance guarantees to mezzanine financing. What Whetsell hopes to buy with his investment pool is security of tenure. His tools will include joint ventures, with at least minority participation in 60 to 70 key properties, and outright ownership of six to 10 hotels that would anchor the portfolio.

Even in an environment in which Wall Street clearly prefers a church-and-state separation of management and real estates activities, Arthur Adler, managing director, the Americas, Jones Lang LaSalle Hotels, New York, says asset ownership should work in Interstate’s favor. “A third-party management company is vulnerable when it is 100% reliant on management income. It is always subject to the risk of the owner selling the portfolio, so it needs more control over its income,” he says. “In this market, Interstate also may be able to get better terms for its management contracts by investing capital than it would with no investment.”

Large, urban hotels may be the prime target, but they will not be the only component in what Whetsell hopes will be a fast-growing portfolio. “We already have a sizable portfolio of limited service and proved we can operate them aggressively,” he says. “Our aim is not to grow from 400 hotels to 800 hotels or 1,000 hotels. What we want are hotels with a quality income stream. In terms of profitability, a quality income stream is far more important than the quantity of hotels.”

Predictions of a flat 2003 do not hinder Whetsell’s expansionary ambitions. He forecasts “a flurry” of buying and selling in 2003 as the life of various opportunity funds comes to an end. The current narrowing of the bid/ask gap should reach a more reasonable tension next year, making deals possible again. “During 2002, buyers and sellers could not agree on the numbers. Sellers did not want to sell on the trailing 12 months’ numbers, and buyers would not buy off the next 12 months’ projections. I think both sides are coming closer together,” says Whetsell.

Niche Plays

Known for his entrepreneurial spirit and development expertise, Whetsell is leaving room to explore various avenues beyond the urban hotel core. “We have always been focused on resorts because it is such a fragmented market,” he says. Ideally, Interstate’s luxury Doral resort brand would add 10 to 15 hotels in the next five years. “We are not competing with Starwood or Marriott for deals. We can grow Doral very selectively,” he says. Asset by asset growth is the most logical progression. Although the standards and style of Doral seem to mandate a new-build strategy, Whetsell says there could be “a couple of conversions.” Doral’s respected reputation as an operator of golf resorts may also hold the key to international development.

International properties currently make up only 5% of Interstate’s entire portfolio, leaving ample room for growth and diversification. Going forward, that could expand to 15%-20%. Any expansion outside the United States would have to be strictly opportunistic. “I do not know that you necessarily protect yourself through international diversification. You have to keep a focus on the market,” says Whetsell.

Interstate may be able to capitalize on the overseas success of its corporate housing division, BridgeStreet, to gain entree. In the United States, BridgeStreet has suffered along with the corporate housing business, where margins declined more than 730 basis points in 2001. Lehman Brothers’ model predicted another 360 basis point drop this year, then a rebound. “We knew this would be a longer term play,” says Whetsell, “It is a terrific business and we are not unhappy.”

Better Than Brands?

Whether competing for management contracts, deals or a broader institutional investor base, Interstate will have to prove it is not only a bigger company—but a better one. The old Interstate had gone through some clouded times after being acquired by Patriot American, only to be spun off prematurely after Patriot imploded and Marriott International tested the case further in court. Though Interstate continued to be regarded as a talented operator, the consensus is that it never had time to regain its corporate focus. MeriStar Hotels & Resorts traveled a smoother road but began to find its options limited because of its size and market capitalization.

With 86,000 rooms and 402 hotels, Whetsell believes the new Interstate combines the numerical strength of a brand with the flexibility of an independent. As the single largest franchisee of many hotel brands, Interstate offers owners not only the ability to match the brand with the property and the market but also to deliver more favorable terms. A 30-year veteran of the hotel industry, Whetsell knows it will take more than a brand menu and a good story to win management contracts.

“Owners now focus on every aspect of operations. They have asset managers. They want control over staff approvals,” says Whetsell. “To be honest, what they want is to make the operators be better operators. That is why the merger was so critical. It gives us the programs and systems that will produce more for owners. If we cannot prove that we can produce more than the owner could or than another operator could, we will not get the contract.”

Systems-oriented management is one of the biggest differences between running a company of 225 hotels and managing one with more than 400. John Emery, Interstate’s president and COO, says the company is focusing on integrating systems that make the decision-making process pro-active. “Technology is about speed and accuracy,” says Emery. “The best system now is the one that enables general managers to identify opportunities and act on them as soon as possible. We do not want hotel executives waiting for information they need to make business decisions.”

No system can build slack demand, a factor that threatens hotel performance throughout the United States. What it can do is protect market share. “We cannot convince corporations to restore travel budgets, but we can make sure we are creating programs that enable each hotel to maximize market share by capturing more of the existing business and generate higher flow-through,” Emery says.

Templates for corporate programs are tailored to the needs of each hotel. Interstate also maintains more than 10 distinct positions in sales and marketing to create expertise in selling to markets as diverse as group business, Internet users and airline contracts. “We are using our size to personalize our corporate services to the individual hotels,” Emery adds. That means more help in identifying travel patterns and new markets, micro-managing yield and controlling costs.

Interstate also will be using its synergies to save US$8-10 million. The former Interstate office in Pittsburgh will remain as a regional office, while headquarters operations will continue from MeriStar Hotels & Resorts’ Washington, D.C., office. Emery predicts cost savings will be derived primarily in the “public company areas” such as back-office finance and accounting, office space and duplicated overhead. He says there were some “redundancies” at the corporate level.

Near-term, month-to-month volatility in room demand makes any meaningful reward from Wall Street unlikely. However, with most analysts giving good marks to the performance of Interstate’s limited-service hotels and its cost control plans, share price targets are expected to continue to edge upward into 2003.

On The REIT Side

Though the Interstate merger pushed MeriStar Hospitality out of limelight this year, Whetsell believes REITs will be major players in the more active business environment of 2003. He says he is “still interested” in doing a deal on the REIT side, but not necessarily with the same type of company or for the same reasons.

“The deal with FelCor made sense in May 2001. But whether it continues to make sense now is another matter. Both companies have external growth potential they did not have then,” says Whetsell. “I do not think the financial markets are ready for that kind and that size deal.”

For MeriStar Hospitality, growth will come via acquisitions that can return 13%-15%, which, says Whetsell, should be achievable given the paucity of new supply. Analysts such as Lehman Brothers’ Joyce Minor also see some upside. Though more conservative with estimates for lodging REITs than for the lodging group, she and her team issued a “strong buy” rating for MeriStar Hospitality based on its cost control program and improved operating margins.