Stocks Fools Love
February 11, 1998

Patriot American Hospitality
by Michael Dowd (TMF Yorick)

Patriot American Hospitality <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PAH)") else Response.Write("(NYSE: PAH)") end if %>
3030 LBJ Freeway, Suite 1500
Dallas, Texas 75234
http://www.patriotamerican.com
$26 3/16 as of February 9, 1998

For a Valentine's Day movie you need a committed pair, a love story, glamorous locations, a plot with "boy meets girl, boy loses girl" -- something to prove "the course of true love never runs smooth." A movie about Patriot American Hospitality could give you all that, but while drama is nice, you need a happy ending for Valentine's Day. A happy future seems likely for Patriot American, but with stocks as with romances, it is never a sure thing.

Upscale hotels have been good places to be lately, not just because the towels are fluffy and the Martinis are dry. Since 1991, we have created lots more upscale hotel guests than upscale hotel rooms. In 1988 luxury hotels were 60% occupied at an average daily rate (ADR) of $93. Revenue per occupied room (RevPAR) was only $64. About 30% of room revenues pay variable costs like maids and linens. The other 70% goes to pay overhead and meet the bottom line. (This is a gross over-simplification of hotel economics, but it is not far off as marginal cost estimates go.)

Since 1988, luxury hotel RevPAR increased every single year -- except 1991. I think we will run a 1998 luxury hotel ADR of $146 at an average occupancy of 76%. If I am right, RevPAR will be $112. Today's average luxury hotel room is dropping about $78 per room each day to pay overhead and investors. That suggests a pre-inflation 70+% increase in the value of luxury hotels. These "hospitable times" will not go on forever. RevPAR growth will slow as more luxury hotels are built, and slow more if the Asian crisis cuts into demand. Still, there is not much in the upscale development pipeline yet.

The hottest performer in the luxury hotel world up 'till now has been Starwood Lodging. Two factors drove that. First, Starwood's CEO Barry Sternlicht showed a brilliant vision of the hotel industry and consistently dazzling footwork in negotiating its rapid changes. (Patriot's CEO Paul Nussbaum has also been an industry leader, but you would have to say that until now Sternlicht has been ahead.) Second, there has been an obscure tax advantage called "paired-shares." Under that provision of the tax law, only four of the nation's 210 publicly traded real estate investment trusts (REITs) have the right to manage and franchise their own hotels. The advantage is complex, but it gives them the opportunity to generate about 20% more long-term earnings from buying a hotel over other REIT competitors. Sternlicht took over the bones of an old hotel REIT that already possessed grandfathered "paired-share" REIT status. The advantage was so powerful it was key to Starwood beating Hilton to acquire ITT-Sheraton. Starwood is now poised to be a $20 billion hotel giant.

Patriot, however, was an IPO in 1995 and had to compete with Starwood without any paired-share stimulus. Then in mid-1997, it acquired another paired-share REIT and the race was on. For six short months, Patriot had the same advantages as Starwood, and it acquired two major companies:

1) Wyndham Hotels sported a $70 million market cap, and gave Patriot a shot at creating a national upscale brand to franchise.

2) Interstate Hotels with a market cap of over a billion dollars laid claim to being the largest remaining independent public hotel company.

Now Patriot was on a level to compete with Starwood, Marriott, and the big boys. At year end, although Starwood was larger and getting ready to close on ITT-Sheraton, Patriot and Starwood ranked fairly closely based on some standard industry criteria:

- Starwood traded at an implied value of $165,280 per hotel room, while Patriot traded at $153,882 per room.

- Based on the hotels each owned on 9/30/97, Starwood was selling at a 5.2% "cap rate," and Patriot was at 5.1%. By way of comparison, shares in Host Marriott, which is not a REIT and can manage its own properties, traded at $182,259 a room and a 4.9% implied cap rate. FelCor Suite Hotels, which is a non-paired-share hotel REIT, found shares in its very good but less upscale properties trading at an 8% cap rate.

Then came the dramatic scene in Act Three. President Clinton announced this month that he would propose drastically restricting the activities of paired-share REITs. They fell hard despite continuing good news from the RevPAR front. FelCor actually traded up 4% from 12/31/97, but it would not be harmed by the proposed legislation. Host Marriott, a non-REIT that should have been unaffected by proposed changes in the law, is down 3.2%. Starwood lost big-time -- dropping 8%. Patriot was whacked for 4.2%.

If this were a Shakespearean tragedy, we would now have a very unhappy ending. Crushed by their hubris at trying to make hotel REITs take over the world, Sternlicht and Nussbaum would be destroyed. Luckily for them, I (and I think the market) have decided to make this a comedy. Anyway, it's Valentine's Day, so we need a happy ending. Here's how I guess that ending will occur.

- The market is about to think more favorably (I think) about Patriot's quite safe current yield of 4.7%.

- It will consider whether (as I believe) there will be continuing same-store upscale hotel NOI growth at over 7%.

- The market will think about continuing improvements already built in as the full-year 1998 results of the Interstate and Wyndham mergers flow down to into the bottom line.

- It will take Patriot's tough, aggressive, but not ebullient CEO seriously when he said, "For 1998 we are highly comfortable with our ability to reach ($2.56 per share) on an internal basis."

- The market will listen with some respect when James Carreker, the man who runs Patriot's hotels, says the company could achieve 1997 and 1998 year earnings targets by greater economies of scale such as common purchasing strategies and re-branding of recently acquired hotels. He also says that the company expects to see $10 million in savings from purchasing efficiencies this year and $100 million in such savings over the next two to three years. (Here Yorick is not nearly so sure, but he's willing to listen.)

In the spirit of admiring loving pairs, a Valentine observer may wonder whether President Clinton's final proposed tax law will be as unkind to paired-share hotel REITs as it presently appears, particularly in an election year when so many politicians want to make peace with generous friends, not create new enemies. The world loves a lover, and it may wonder whether a Patriot with about $3 billion in assets won't have an easier time growing by making new associations than a Starwood/ITT that has to look for really big game to make meaningful impact on its nearly $20 billion pile of assets.

Therefore, if I had to bet my heart this February afternoon, I think it would be on Patriot American. Be kind to it, Messrs. Nussbaum and Carreker. We can all get more money if we work and save, but hearts are hard to come by.

P.S. Any Fools who would like a copy of a brief Foolish spreadsheet analysis in EXCEL of a few key public company hotel statistics have but to E-mail [email protected] and ask.

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