All about converts

Trade idea: Gaylord Entertainment (GET)

I like the GET 3.75% convertible bond that is trading at 150.375 vs. 38.87. Using 600 spread, the converts imply 29.5 vol., 88 delta and trade at 7.73 points of premium. This is a very low premium for a convert with 3.75% coupon with 2.24 yrs remaining. I calculate the converts to have 5.6 points of cash flow to maturity after financing.  I would run them on theo 88 delta as I feel that the stock risk is balanced to the upside and downside. As the stock moves up, the points premium would likely hold given the cash flows. To the downside, I believe vol. would pick up on any large drop in the stock which would also benefit the converts. The converts trade at such a low premium because investors fear that volatility in GET will contract substantially after expected REIT conversion in 1/1/13. However, I see several reasons why this may not be the case.

1)      Unlike other REITS, Lodging REITS have realized decent vol. in the range of 30-35. This could be due to the nature of Lodging REITs, which essentially leases space on a daily or weekly basis, compared to Office REITs or Shopping center REITS that have leases of 10+ years and much higher visibility.

The table below shows a list of Lodging REITS and their realized vol. over the past quarter, half year, and year. This leads me to think that GET may not see a de-rating of its implied volatility even after REIT conversion.  If we compare to HST, there’s no reason to think that GET should trade at a lower volatility, especially given that we are using 600 for the 2 yr credit spread assumption for GET while HST has a credit assumption of about 250. A stock with a higher credit assumption should usually trade at a higher vol., all else being equal.

2)      GET has only 4 properties (Nashville, Dallas, Orlando, Washington DC). This should make the stock more volatile since the concentration of assets exposes GET to more company specific risk. For example, in 2010, an historic flood occurred in Nashville and GET’s Opryland was significantly damaged. After insurance payouts, the net cash impact of the flood was ~$150 million, or ~$3 per share.

Aside from freak occurrences such as floods or other unpredictable events, limited diversity also puts GET at risk of; 1) market specific slowdowns, 2) union labor strikes (16% of GET’s employees are unionized), or 3) the negative impact of new supply in a specific market.

3)      Although GET has agreed to the brand name sale/REIT conversion, there is some risk that the deal falls through. In this case, we could see a large drop in the stock followed by a volatility spike.

What if vol. does go down to 25

In the case where I am wrong and vol. does collapse, I would expect to see a corresponding tightening of credit spread. If implied vol. were to drop to 25 and credit spreads tighten to 250, it would be neutral to the valuation. I do not see much risk to the downside even if vol. were to decline.

Company profile

Gaylord Entertainment (GET) is a hotel company that focuses on large groups and conventions. The company has 4 properties:

1)      Gaylord Opryland (Nashville) – 588k sq. ft. total meeting and exhibit space

2)      Gaylord Texan (Dallas) – 400k sq. ft. total meeting and exhibit space

3)      Gaylord Palms (Orlando) – 200k sq. ft. total meeting and exhibit space

4)      Gaylord National (Washington DC) – 470k sq. ft. total meeting and exhibit space

These four large properties serve as an “All in one place” solution for large group meeting planners. GET derives about 20% of sales from transient customers and 80% from groups. Group business tends to correlate with corporate spending (50% of groups business) and associations (34%).

GET had originally planned to build a 5^th property called the Aurora in Denver but decided to postpone the plans following the REIT conversion announcement.  GET will no longer commit large amounts of capital to new projects but will explore other ways to fund projects that require less capital from GET.

Conversion into REIT

GET will sell its Gaylord brand to Marriot International for $210m and convert itself into a REIT effective 1/1/13. Marriot will manage the hotels for a fee, while GET will own the real estate. GET will distribute a dividend of $415 to $450m ($8.3 to $9 per share) to shareholders consisting of $83 to $90m in cash ($1.67 to $1.80 per share) and the remainder in stock.  The converts are fully protected for cash and stock dividends. The deal should benefit Gaylord hotels by being on the Marriot reservation system.

Credit analysis

The pari passu straight bonds of similar maturity (11/15/14) trade at a z-spread of about 600, which is a good assumption for the converts. I view GET as a solid credit, especially if it turns into a REIT and abandons risky new projects such as the Aurora. The converts are the first debt due. The pari passu senior notes will likely be called and refinanced later this year.

Cash = $20m

Debt = $1.06B

3.75% convertible bonds 10/1/14 $360m

6.75% notes due 11/15/14 $152m (callable at par in 11/12)

Term loan 8/1/15 $400m

Revolver 8/1/15 $185m ($525 size)

Market cap = $1.9B

Debt/ebitda = 5.0x

GET is expected to generate $100m of FCF in 2012

Covenants:

Funded debt to assets less than 65% (currently 41%)

Tangible net worth more than $850m (currently $1.1B)

Min fixed charge coverage ratio more than 1.75x (currently 3.3)

Debt service ratio more than 1.6x (currently 3.3)

Equity analysis

There are a couple of reasons why GET stock should continue to rise, even though the stock is already up over 60% year to date. First, GET has not realized the full re-rating of converting into a REIT. Lodging REITS average 12.4x EV/EBITDA  (2013) compared to 11.0x for lodging non-REIT stocks. This is due to a more efficient tax structure for REITS among other things. If GET were to trade at 12.4x 2013 ebitda, the stock would reach $44. Second, with the new operating efficiencies of the REIT structure and access to Marriot’s reservation system, we could see EBITDA 5-10% higher, thus giving another lift to the stock.

To the downside, GET has risks including a slowing corporate travel market, competition from new hotels near its properties, a convention revival in Las Vegas, and concentration risks of its 4 properties. On 6/20/12, a fire at Opryland caused the stock to drop 3%.

Convertible characteristics

Full cash dividend protection

Get last coupon if converting prior to maturity

Lose 2.7 points on a takeout at $50 on 88 delta (I feel a takeout is unlikely because GET explored all options including takeouts prior to the REIT conversion announcement)