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Covering All Bases

Left-handed batter or right-handed batter? Interstate Hotels & Resorts is ambidextrous. Arguably one of the largest third-party hospitality operators around, Interstate manages 184 properties spanning 30 brands, owns six hotels, and has interests in 12 joint ventures. It's all part of the company's new strategy to diversify earnings due to changing market conditions — namely the wave of lodging REIT sales over the past 18 months.

“The company we have today is a composite of two sizeable companies — Interstate Hotels, founded in 1961, and Capstar, or what became MeriStar, founded in the 1980s,” says Tom Hewitt, CEO of Interstate Hotels & Resorts.

Interstate Hotels Corp. and MeriStar Hotels & Resorts both were independent third-party management companies when they merged to create Interstate Hotels & Resorts in July 2002. In early 2005, the combined company began to pursue new sources of income. “We anticipated losing a significant number of third-party contracts and we felt it was wise to diversify our earnings,” Hewitt explains.

Indeed, Interstate's third-party management business has been a casualty of the mergers and acquisitions boom, which resulted in the loss of 49 hotel management contracts in the first six months of this year alone. That number includes contracts lost following The Blackstone Group's acquisition of lodging REIT MeriStar Hospitality in May 2006. (Not to be confused with third-party operator MeriStar Hotels & Resorts, which was part of the 2002 merger that formed Interstate.)

All told, Interstate has lost 31 of its 54 Blackstone contracts since the sale. Initially 40 contracts were lost but nine came back through various deals. “You get a better price in selling your hotel without subjecting it to an existing management agreement,” says David Loeb, a hotel analyst and managing director with Robert W. Baird Co. based in Milwaukee. Loeb does not currently cover Interstate.

Despite the REIT sell-off, Interstate continues to manage 30 properties for Sunstone Hotel Investors, 40 for Equity Inns and another five owned by Ashford Hospitality Trust.

“We've been opportunistic,” says Hewitt. “We're looking for third-party contracts, we're looking for joint-venture opportunities and on a limited basis wholly owned assets.” Interstate manages 43,000 rooms across the country and overseas, but rather than counting hotel rooms, the company's primary measurement is earnings before interest, taxes, depreciation and amortization (EBITDA).

Prior to the change in strategy, EBITDA was made up of 99% third-party management contracts. Today, roughly 50% of EBITDA comes from wholly owned real estate.

Wall Street seeks storyline

Confused? Investors might be as well. Interstate Hotels & Resorts (NYSE: IHR) was trading at about half of its 52-week high of $10.49 on Oct. 23. “I think that because this is a management company that owns hotels, it's quite confusing to investors,” Loeb says.

Because Interstate is not a REIT but a hotel operating company that owns hotels, investors can't decide what box to put it in, Loeb says. The heavy drop in management contracts is another stumbling block for investors.

In addition, on Aug. 10 Goldman Sachs downgraded its 12-month target of the company's stock from $6 to $4 as a result of lost contracts, and the risk of a general deterioration in lodging fundamentals. “Interstate Hotels & Resorts is in a transition year, and for now our concerns about the lodging sector along with the timing of management's plan will probably lead the shares to underperform other hotel stocks,” writes Goldman analyst Steven Kent.

How long that transition period extends is anybody's guess, but it will likely be tied to the decisions of Blackstone and Sunstone as they decide what to do with various assets. REIT MeriStar Hospitality (now owned by Blackstone), is slowly but surely selling off hotels — and without management contracts. “The management income has been much more volatile than I think Wall Street generally likes,” Loeb observes.

Like Blackstone, Sunstone is also a wild card. Loeb says Interstate's position managing some of the REIT's smaller, longer-owned assets could potentially get caught in a capital recycling of assets.

The day before Goldman downgraded Interstate's stock, it issued a glowing report about the company's performance. Interstate is hardly shying away from its duties. Indeed on Aug. 9 Goldman noted that Interstate had beat earlier estimates on all fronts through the second quarter. The company's earnings of 5 cents per share topped Goldman's 2 cents estimate.

Revenue per available room (RevPAR) growth through the second quarter jumped to 8%, 260 basis points higher than Goldman's estimate; and termination fees from broken contracts came in $1 million over estimates. EBITDA comfortably exceeded by $1.6 million the analyst's estimate of $7.9 million.

In 2006, the company earned roughly $25 million in termination fees, primarily from Blackstone, $18 million of which was made in one-time payment from Blackstone. Termination fees are negotiated and can be as high as one year or more of remaining management fees.

Key to success

Interstate's success going forward is likely to hinge on its stellar reputation as a third-party manager. That market credibility carries weight, especially when the company opts to invest capital via joint ventures into the projects it will also manage. Interstate's ability to wring out higher-than-average RevPAR from the hotels it operates is seductive to both banks and to the company's partners.

For instance, the company announced in January a joint venture with Chicago developer The John Buck Co. to build five to 10 aloft-branded hotels. In this deal, John Buck will handle the site selection, fund raising and development, while Interstate will operate the properties and contribute 15% equity in each $20 million hotel development.

“When we look at a joint venture, we're looking at really high returns,” says Hewitt. “We're getting a lot of mileage out of the precious dollars we have to invest.” Interstate's return on investment averages 30% for joint ventures, according to Bruce Riggins, the company's CFO. “Wholly owned is more in the mid to high teens because of the impact of the management fees of the joint venture model,” he adds.

For John Buck, Interstate's appeal stemmed from the company's track record operating select-service hotels — it currently manages 80 select-service hotels under 15 different flags. John Buck was also attracted to the geographic reach of Interstate's operating capabilities, which span 36 states and Belgium, Russia, Canada, Ireland and Mexico.

“Aloft is going to appeal to the new generation of travelers, and we think that it's an outstanding opportunity for that brand to expand and become a powerful brand within the select-service segment,” says Paul Novak, managing director of hospitality for John Buck.

Novak concedes that Interstate's involvement in the deal probably made the financing — using 70% leverage — a bit easier. “They're a known commodity as an operator, and certainly a lender feels more comfortable if the management also has got equity in the deal.”

The first two aloft hotels — the 136-room Rancho Cucamonga aloft in Ontario, Calif. slated to open next spring, and the 143-room Cool Springs, Tenn. aloft set to open in late 2008 — are horizontal mixed-use, or freestanding structures built around mixed-use sites.

The Rancho Cucamonga will be part of HavenPark, a $60 million, master-planned development near Ontario Airport, while the second aloft is in Cool Springs, a suburb of Nashville and future home of the North American headquarters for Nissan. Both are thriving, bustling markets.

South of the border

Not all joint ventures are as straightforward as the John Buck partnership. Others, like the joint venture Interstate forged three months ago with developer Steadfast Cos. to own and operate hotels in Mexico, entail a few more twists.

In the Mexico deal, Interstate owns 50% of the management company created to operate hotels in Mexico, including a portfolio of three Tesoro Resorts, which are owned by affiliates of Steadfast.

“I think Mexico is on the threshold of busting out of what's been a fairly stagnant industry environment and I think we've got the perfect time frame to take advantage of that,” says Hewitt.

In addition to owning half of the management company, Interstate de Mexico, Interstate invested $5.7 million into the three resorts: the Tesoro Los Cabos, Tesoro Manzanillo and Tesoro Ixtapa. That initial investment is expected to convert into a 15% equity interest in the near future.

“IHR is providing hotel management expertise in the JV, where Steadfast is providing the business development knowledge specific to Mexico and Latin America,” says Luis Garcia, president of Steadfast Resort Properties based in Newport Beach, Calif.

Despite the complicated nature of the deal, it will serve as a platform for future expansion in Mexico and Central America. But the joint venture is not Interstate's first foray onto foreign soil.

Its activities in Moscow, for instance, date back more than 10 years. Over that time, Interstate's portfolio in Russia's capital city has grown from three to seven properties, two of which are scheduled to open in the first quarter of 2008. Russian challenges included compliance with local laws, adapting to local cultures and labor markets, while still delivering U.S. expertise and efficiency.

“We're looking at a number of things in the Middle East,” says Hewitt, “and we think that international market holds great opportunity for Interstate because of its reputation and success with Russia.”

Generating value

While investors try to figure out exactly what type of company Interstate is, executives are making the most of the lemons they've been handed recently in the form of lost REIT contracts. At the same time, the company is growing its holdings using just 65% leverage on acquisitions.

“We also have funded some of the acquisitions with our credit facility along with accommodation of free cash flow, and some of our proceeds that we've reinvested from either termination fees or the sale of our BridgeStreet housing subsidiary,” says Riggins, Interstate's CFO. The sale of BridgeStreet in January netted a tidy $40.5 million.

So just when will this transition period for the hotel operator come to an end? Hewitt believes that 2007 was a pivotal year to work out the loss of the Blackstone portfolio and reposition the company. Now Interstate executives are concentrating on laying the groundwork for 2008 and beyond.

Like Interstate's executives, Loeb of Robert W. Baird Co. believes that the company is not yet getting full recognition for its swift move to diversify. “I think the Street is missing the value of their real estate investments,” he says, “both wholly owned and in joint ventures.”

Sibley Fleming is managing editor.

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