Does Blackstone’s Sale of Hilton Hotels Suggest A Market Top (Part II)?

In Part I, we walked you through the story of a huge IPO from the Blackstone Group (BX) back in June of 2007.  That IPO nearly marked the exact top of that stock market’s up cycle!   This particular inauguration of a publically traded company turned out to be about as disastrous as any, ever.

Around the same time, Blackstone took the Hilton Hotel chain private for $26 billion (cash and debt). However, within two years the market was so horrible that Blackstone needed to write off one-half of its investment!  What a humiliating moment for the business tycoons at Blackstone. Within the financial world, it is the modern equivalent of a public “dressing down.”[1]

Let’s take some time to review in detail what Blackstone did about the “Hilton Hotel” mistake. What did Blackstone do about it?  Did it fire its long-time head of global real estate, Jonathan Gray? Absolutely not!  Gray had long before established his credentials as an effective and insightful real estate investment manager.  Fortunately for Gray, the Blackstone Board and management team approached the issue with a common mind!  Each one of them understood that real estate has always been a cyclical business. They realized that a willingness to “ride the cycles” is essential for success in the business.

Here is where a timeless song by Joni Mitchell (The Circle Game) comes into play. Although the song as a whole is the poetic story of the maturation of a human life, the song’s chorus can serve as a lyrical reminder of the inevitable rhythms, cycles, ups, and downs within real estate:

THE CIRCLE GAME

Chorus:  And the seasons they go 'round and 'round
And the painted ponies go up and down
We're captive on the carousel of time
We can't return we can only look behind
From where we came
And go round and round and round
In the circle game.
—  Joni Mitchell

Looking back to the days when Blackstone took Hilton private, Gray offers this very professional reflection: “We were just focusing on owning the right assets on the right basis!”  That is all any real estate professional[2] can do. As Gray aptly expresses it: “We didn’t know the storm of the century was coming!”

Fortunately for Gray and Blackstone, real estate is a solid long-term asset. Roger Freeman is an experienced analyst at Barclays Capital who unknowingly echoes the chorus of “The Circle Game” as he articulates here the essential strength of real estate: “The thing that we find so attractive about this asset class is that real estate is not subject to the whims of near-term capital markets conditions. They [have] the luxury of time on their side.”

From most objective perspectives, the decision to take the Hilton chain private in 2007 certainly seemed to be a promising one. During in the past 10-15 hears, the financial world has become more and more aware of the inestimable value of brands. No one can argue with the fact that, within the travel, leisure, and hospitality space, it would be difficult to find a brand better known (or more widely known, either) than that of “HILTON”. It is an extra bonus that Hilton enjoys international “cache”, as well. In fact, there is no way to deny the international fame of the “Hilton” brand[3].

The long heritage of Hilton Hotels began in 1919, when Conrad Hilton purchased his first hotel (the Mobley) in Cisco, Texas. Six years later, he opened a high-rise hotel in Dallas, Texas that he named the “Dallas Hilton” – marking the first hotel bearing the “Hilton” name!  The chain expanded from there, gaining magnitude from regular expansion while also gaining fame through the “history” made within its walls.  For example, a Hilton bartender from the Caribe Hilton Hotel in San Juan, Puerto Rico (Ramon “Monchito” Marrero) created the Pina Colada in 1949!!

A seminal moment in the Hilton history occurred in 1954, when Hilton bought the “Statler Hotel” chain – thereby becoming the largest hospitality company in the world!  In March of1969, John Lennon and Yoko Ono staged their first “Bed-In for Peace” at the Amsterdam Hilton[4] – Room 902![5]  From the world of technology, the world’s first handheld cellular call (in public) was made on April 3, 1973 to a man staying at the New York Hilton with a two-pound Motorola DynaTAC phone.  Alas, a number of tragedies have also occurred at a Hilton, including the February, 2012 bathtub death of Whitney Houston at the Beverly Hills Hilton.

What has Blackstone done to improve, expand, and “add value” to the Hilton chain? Consider the following:

1)    Management has increased the number of open rooms by 34%;
2)    Currently, 4.5% of all global hotel rooms belong within the “Hilton” family (per Smith Travel Research);
3)    In addition, a crescendo of additional rooms are in the “pipeline” – 18% of all rooms under construction worldwide belong within the “Hilton” chain;
4)    Blackstone has learned first hand how much more profitable it is to license the Hilton brand to other hotel operators than to own hotel directly;

1. The annual fees received by Hilton produce much better financial numbers than are derived from the standard “chain-owned” location.
2. Therefore, Blackstone has enhanced the magnitude of growth through strategic licensing!

Blackstone has refined and refocused the branding within the total Hilton chain. In accord with current industry practice, management has delineated a clear differentiation of the choices available across the broad umbrella of its brand:

LUXURY SERVICE AND FULL SERVICE:

“FOCUSED” SERVICE:[6]

VACATION OWNERSHIP:

The two largest competitors for Hilton are Starwood Hotels and Resorts Worldwide (HOT) and Marriott International (MAR). Take a look at this property summary of the three big competitors in this space:

In addition, Blackstone has enhanced its Hilton-related business in accord with developments that reflect current customer expectations and developments in technology, including tweaking its rewards program and adding a mobile application (Conrad Concierge).

Recent results have been quite impressive. For FY 2012, revenue grew to $9.3 billion – 15% higher than in 2010. FY 2012 “Adjusted earnings before interest, taxes, depreciation, and amortization”[7] totaled $2 billion – fully 25% higher than for 2010.  As one would expect, net earnings for 2012 showed a nice 39% increase – to $352 million.

This of course was not strictly the result of Blackstone management’s expertise. The industry as a whole reflected much better market conditions during this period. For example, within the top 25 U.S. hotel markets, occupancy rates have been trending upward. This past July, the occupancy rate reached 76.3%.

Within the hotel industry, the key financial metric is “Revenue per Available Room” (RevPAR). That data point has been witnessing a fairly steady rise during the past three years, and the most recent numbers for Hilton showed a growth on that metric of 6.2%.

Finally, the Dow Jones U.S. Hotel Index has moved upward this year by 18%, while MAR is up 15% and HOT is higher by 20%!

Given all of these trends, as well as the impressive growth reflected with Hilton’s “numbers”, it should not be surprising that Blackstone filed this month for an IPO on a minority interest in Hilton Worldwide Holdings Inc.  Consider this professional assessment recently offered by an industry expert, Jeffrey Sica, chief investment officer at Wealth Management LLC[8]. Referring to current market trends and conditions and the length of time Blackstone has waited for a recovery, Sica observes:  “For Blackstone, it doesn’t make sense to keep something this valuable on the books. Hilton’s business has been doing well, so it makes very good sense for them to do it now.”

The IPO will be scheduled for early in 2014 and is intended to raise $1.25 billion, which Blackstone intends to use for debt reduction; it will be the largest ever for a lodging company.  The quantity of shares to be released has not yet been revealed, but the total shares available will constitute only a minority stake. The financial service companies relied upon for executing the details of this new issue include:  Deutsche Bank AG (DB), Goldman Sachs Group Inc. (GS), Bank of America Corp. (BAC) and Morgan Stanley (MS).

A natural next question is how valuable experts think Hilton Worldwide Holdings Inc. should be?  Of course, we won’t (in fact) know until the actual even itself; but that never stops a Wall Street professional with financial data at hand, a pencil, and the back of a napkin available… on which to project possible valuations.  For example, one key metric is the valuation metric of comparable industry rivals. In this case, those are HOT and MAR – stocks which have been trending at approximately 12 times EBITDA[9].

We can take a leap toward a valuation projection if we combine the information above with the following opinion from Keith Brenan, chief operating officer of Weitzman Group, Inc.: “[Hilton] competes very favorably with Starwood and Marriott and Hyatt which are already there [in the public market]. They probably do quite well in that spectrum.”  I don’t know about you, but my “back of the envelope” shows a valuation of $30 billion.

Now here is where we move into the dark arts of corporate psychology. If we sat on the Blackstone Board, how would we evaluate the 2007 purchase of Hilton?  You may not know it, but that is a fascinating question!

Consider this analysis:[10]

1)    Cash equity of $19 billion in 2007; debt of $7 billion;
2)    Potential recovery to $23 billion equity;
3)    $4 billion gain over seven years averages out to 2.45% annual compounded growth.
4)    Is that “adequate”… “adequate under the circumstances”… or perhaps  “thank heavens we did not lose money!”

Here is an alternative analysis:

1)    Cash equity of $19 billion in 2007; debt of $7 billion;
2)    Wrote off $9.5 billion in 2009;
3)    Potential recovery of $13.5 billion in 2014;
4)    That is a return in just 5 years (2009-2014) of 142%!! 

As you might imagine, there are a wide range of alternative ways to evaluate the ownership of Hilton during the 2007-2014 period. Some would be more proper than others. In theory (at least) only one would be both “in accordance with GAAP” and broadly accepted as credible by Wall Street. However, I personally suspect that, when the CEO composes the next “Annual Letter” to shareholders, one of the really, really impressive looking analyses will be the one presented – front and center.[11]

Before I wrap up this long article, let me emphasize how divided professionals are regarding the precise real estate cycle through which we are currently moving. I have already pointed out that Sam Zell (Equity Group Investments) sold over $30 billion of real estate to Blackstone at the very peak of real estate market prices.  Zell has been criticized for several years because he did not “jump in” during the 2008-10 real estate “fall out” cycle and buy up property. He has pointed out (ad infinitum) that folks should not “misinterpret caution with inaction”!  He currently holds 30% of his assets in real estate.[12] Some other prominent players in real estate share Zell’s caution, including the chairman of Vornado Realty, Steve Roth — who wrote the following in last year’s “investor letter”: “I find investing in this market difficult!”

Mirroring his current views regarding the challenges presently facing real estate professionals, consider this recent true story involving Sam Zell. Evidently, Zell was speaking this spring at a real-estate conference hosted by New York University. During a break, a student approached Mr. Zell and asked for advice regarding getting into the business. Zell replied simply: “Go to medical school!”

INVESTOR TAKEAWAY:  Lots of reporters and commentators within the financial press have gotten overly enthused about real estate during this recent accelerating period of recovery. For example, until recently, builders’ stocks had been ZOOMING upward. Now we are beginning to see deeper, more complex economic realities kick in.  For example, as interest rates accelerate upward (rates from 1.6 upward to 3% on the US 10 year Treasury Bond … in less than a year)… real estate prices cool down.   NOTHING goes up in a straight line.

Blackstone won't admit it, but they made a mistake 7 years ago. Now they are (understandably) trying to take advantage of positive market conditions to offload some of their risk to others (ie. new shareholders)!!!

Currently, no one should take Blackstone's step regarding a new IPO alone as a sign of “topping” in the market. (I refer, of course, to Blackstone’s 2007 IPO that came right near the market top at that point.)  However, that said, we all should reflect upon what this action might mean for where we stand now in “The Circle Game” of real estate (as well as stocks and interest rates/bonds).

Finally, you really should (must) take three minutes to let Joni Mitchell serenade you. The song is absolutely beautiful!  http://www.youtube.com/watch?v=V9VoLCO-d6U.

DISCLOSURE: Nothing in this article is intended as a recommendation to buy or sell anything. The author has stayed at various Hilton Hotels through the years. The author has never owned BX, but he has invested in various closed end funds (or ETFs) managed by Blackstone, as well as K.K.R. (KKR).  Always consult with your financial advisor regarding changes in your portfolio – either subtractions or additions.

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