Sunstone: Up, Up, Upper-Upscale REIT
We expect that a strong U.S. economy will lead to increased demand for lodging from corporate and leisure travelers, while only a limited supply of new hotel rooms comes to market. Those trends should provide a boost for lodging-industry real estate investment trust Sunstone Hotel Investors' (SHO) recent price ($28) in our view. We believe Sunstone, with its portfolio of primarily upper-upscale properties and exposure to large urban markets, is well positioned to capitalize on the positive current environment in the lodging industry.
We find Sunstone's shares compelling, trading at the low end of its industry peer group on a 2007 price-to-FFO multiple (FFO, or funds from operations, is a widely used measure of operating performance of REITs). And the stock also provides a dividend yield of 4.2%. We expect that the shares will outperform the S&P 500 and lodging REIT peers over the next 12 months. Our investment recommendation is 5 STARS (strong buy).
San Clemente (Calif.)-based Sunstone owns 61 hotels located in 17 states and Washington, D.C., with a significant concentration in California. The company's hotel properties have an aggregate of 17,901 rooms.
Sunstone's portfolio consists of properties primarily in the upper-upscale and upscale categories that are managed by third parties and operated under well-known national brands owned by companies such as Marriott, Hilton, Hyatt, and Fairmont. The majority of Sunstone's revenue is derived from room revenue with the remainder coming from food and beverage and ancillary hotel services.
Since going public in late 2004, Sunstone has undertaken an aggressive acquisition and disposition program to increase its focus on upper-upscale and upscale full-service properties. We view the higher-end hotel segment as having significant barriers to entry, given higher required purchase prices and the capital commitment needed to bring properties to upscale standards.
Sunstone has focused on acquiring underperforming, mismanaged, or unbranded properties and making significant capital improvements to these properties. Since the beginning of 2003, it has invested almost $230 million in capital renovations throughout its portfolio to better position its properties. We believe this acquisition and renovation program has proven successful and has been a key driver of the improvement in Sunstone's results over the past two years.
For 2005, Sunstone reported an average daily rate (ADR) of $113.75, occupancy of 71.2%, and revenue per available room (RevPAR) of $80.99. All of these metrics represented growth from 2004 with an ADR of $98.95, occupancy at 71.0%, and RevPAR of $70.25. We expect continued improvement across each of these fronts in 2006 as the industry, and Sunstone in particular, continues to benefit from strong business and leisure travel and limited new supply. For 2006, Sunstone is forecasting an improvement in RevPAR of 7% to 9%, with the majority coming from higher ADRs. Our 2006 RevPAR growth estimates are at the high end of this range.
With the growth in RevPAR, Sunstone is looking for 2006 adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) of $257 million to $263 million and adjusted FFO of $2.52 to $2.62 per share. Our estimates of $263 million and $2.62 for these measures, respectively, are at the high end of company guidance and reflect our positive outlook for lodging fundamentals and our belief that Sunstone is well positioned to capitalize on these fundamentals.
We believe several catalysts could enable the Sunstone shares to outperform its peer group over the coming 12 months. Specifically, we highlight the opportunity for further dividend growth, the potential for margin enhancement from the company's renovation program, and the repositioning of the portfolio through the acquisition of higher-end properties and the disposal of mid-scale hotels.
We see Sunstone's steadily improving financial results positioning the company for future dividend increases. Sunstone modestly increased its dividend in the fourth quarter of 2005, and the payout has remained constant at 30 cents per share for the past three periods. With our expectation for growth in cash available for distribution as operating results continue to improve, we expect higher dividend payouts in future quarters. Sunstone shares currently yield 4.2%, slightly below the current peer average of 4.5%.
One area that we believe sets Sunstone apart from its competition is its aggressive investment program in its current portfolio. We believe the company's current renovation and repositioning program should lead to above-industry-average margin expansion. We think a key component of Sunstone's strategy has been the acquisition of relatively undervalued assets and making investment by both physically upgrading the properties and repositioning them within their respective markets. We believe a number of value-enhancing opportunities still exist within Sunstone's current portfolio.
In our opinion, recent acquisitions have positioned the company to better capitalize on the positive industry environment. We see these properties delivering better RevPAR and EBITDA growth than the mid-scale hotels, which Sunstone has been in the process of selling. Since the middle of March, the company has completed three significant acquisitions: the Hilton Times Square in New York City; the Embassy Suites in La Jolla, Calif.; and the W San Diego in downtown San Diego. The acquisitions have increased Sunstone's exposure to upper-upscale and luxury properties as well as key tier-one markets. The three properties were acquired for a combined purchase price of approximately $450 million.
Driven by favorable supply-and-demand dynamics, and the resulting improvement in financial results, publicly traded lodging REITs have enjoyed several years of strong stock performance. Despite substantial appreciation for most stocks in the sector since bottoming in early 2003, we continue to expect that the group will outperform over the coming 12 months.
We see underlying fundamentals remaining strong, driving higher earnings and dividend payouts. We believe companies with upper-upscale and luxury properties in tier-one markets are best positioned to outperform ahead as we move deeper into the current cycle.
We arrive at our 12-month target price of $34 through a combination of peer and net asset value analyses. Our peer analysis derives a value of $33.35 per share based on a 2007 price-to-FFO multiple, while our net asset value calculation produces a target of $34.36 per share. A blend of these two methodologies results in our $34 target price.
In our peer analysis, we look at price-to-FFO multiples, dividend yield, and debt-to-equity and debt-to-capital ratios. Given Sunstone's strong portfolio of upper-upscale properties, we think the shares should trade at a slight premium to the peer average. Our peer group consists of eight REITs, which currently trade at an average multiple of 10.5 times 2007's consensus FFO estimates. We apply a 10% premium to the peer average and use an 11.5-times multiple applied to our $2.90 2007 FFO estimate to arrive at a value of $33.35 per share.
In terms of net asset value analysis, we derive assumptions for future net operating income for the current properties and adjust for maintenance capital expenditure, current debt, and cash. Our net asset value analysis values Sunstone at $34.36 per share.
We have a favorable view of Sunstone's corporate governance practices. In particular, the company has a seven-member board that is composed of six nonaffiliated outsiders. Also, directors must be elected annually. Additionally, the company's compensation committee consists entirely of independent outside directors. We also are encouraged by the fact the company does not have a poison pill or any other potentially restrictive anti-takeover provision.
Risks to our recommendation and target price include terrorist attacks that adversely affect the travel industry, a slowdown in the macro economy that hurts demand for business or leisure travel, a greater-than-expected increase in energy costs, and a rise in the development rate of new properties.