Park Hotels & Resorts, Inc. (NYSE:PK) is one of the largest REITs, with a $5 billion market value and an EV of $9.1 billion. It was spun off from Hilton (NYSE:HLT) several years ago and focuses on luxury end hotels, such as the midtown NYC Hilton. You can read several really good articles on Park Hotels in Seeking Alpha by Brad Thomas and Marel. I don’t need to duplicate their excellent work.
I will give you an alternative way to look at Park Hotels. I like to focus on the basics of company finances in analyzing high-yield stocks. I will show that Park Hotels simply cannot afford its dividend payments and how it overcomes this on a practical and accounting basis.
I have found that many companies in the high-yield sector, especially some BDC stocks, as well as some closed-end funds and MLPs, simply cannot afford their high dividend payments on a cash flow basis. They come up with innovative ways to mask this.
The REIT industry is also guilty of this in some cases like Park Hotels.
I will also try to keep the analysis as simple as possible in order to make things very clear. I also have a surprising conclusion.
Stock Dividends and Free Cash Flow
There is simply no question that Park Hotels has had some difficulty in its free cash flow (“FCF”) generation in the past several years. As you know, FCF is defined as cash flow from operations (CFFO) less capital expenditures (“capex”). You can see the history of the company’s FCF in the table below:
Source: Mark R. Hake, CFA
I put together this chart from the company’s SEC filings taking CFFO and subtracting capex spending, as defined by the company. The table shows that FCF has been falling for the past three years, including estimates based on the company guidance and my estimate for 2019 and 2020.
Now, it turns out that FCF is much lower than the amounts being paid out. You can see this in the chart I prepared below:
Source: Mark R. Hake, CFA
This is very interesting. It shows that up until 2017, FCF was greater than dividends paid out. But since then dividends have been rising, but FCF has been falling. The gulf is now over 100% of FCF. That is dividends are now over 100% higher than FCF generated by the company.
None of this is in the company reports. You can only see this in the 10-Q filings. Now, just so you don’t think I am lying, here is the company’s own synopsis of the latest nine-month cash flow statement found in the 10-Q:
Source: Q3 2019 10-Q, page 30
If you look carefully at what I have highlighted, you can see that for the first nine months of 2019, CFFO was $349 million, but dividends paid out were $382 million. And that does not even deduct capex spending. If you deduct the capex of $133 million (see what I highlighted), then the net deficit after the dividend payment is $166 million.
Source: Mark R. Hake, CFA
So, there is simply no question that dividends cannot be financed by normal REIT operations. But here is what the company says: Funds from Operations (“FFO”) cover the dividends.
Relationship Between Adjusted FFO and Dividends Paid
To put it simply, Funds from Operations metrics are a reformulation of net income. It is not a cash flow metric. Let’s look at this more carefully.
First, it is clear that FFO actually does “cover” the dividend payments:
Source: Mark R. Hake, CFA
That’s great. But what exactly is FFO and how does it differ from FCF?
Here is how the company portrays its FFO for the first nine months of 2019:
Source: Park Hotels Q3 Earnings Report
To simplify things, I highlighted the major items in yellow. The single most important thing to note is that adjusted FFO starts with Net Income. It then adds back a bunch of expenses, mainly depreciation, acquisition costs, and share-based compensation (“SBC”) expenses.
Note what it does not include: capex spending. This is extremely important. Capex is a must spend item. It is necessary for the running of each hotel to cover repairs, renovations, maintenance, etc. In fact, here is what the company says in its 10-Q:
Source: Q3 2019 10-Q, page 17
Source: Same, page 29
This shows at a minimum that the company takes its obligations to spend capex very seriously. In the first citation above, the company says capex includes $68 million, which it might not have to spend, but which it is under contract to have to spend. In the second citation, the 10-Q says that it reserves 4% of total hotel revenues to spend on capex.
But FFO does not deduct this 4% of revenues. It is simply held in a reserve or liability account. The company knows it will likely have to spend it. But for some reason, the company feels that by adding back depreciation, it gives investors a view of its “funds from operations”, even though those operations really do require the spending of capex.
You get my point. FCF is a much more realistic view of actual funds generated by operations. So to say that FFO “covers” the dividend is something of a mask of the reality that capex spend is necessary, perhaps even before the dividend payment, in order for hotel operations to continue.
And, of course, I am not going to point out that the SBC charges are actually not one-time expenses. They are ongoing expenses, just capex. So why are they excluded? One could probably say the same thing about acquisition expenses. Park Hotels continuously finances its cash flow deficit with hotel sales and purchases. So, in a sense, these expenses are continuing and normal part of the operations of the company.
How Does Park Hotels Finance the Dividend Deficit?
Again, we must look at the cash flow statement, not the income statement.
Source: 10-Q, page 4
Remember how I pointed out above that there was a $166 million dividend deficit after deducting capex from FCF? The picture of the Cash Flow statement above shows that the company financed this deficit by doing two things: (1) a net purchase of $683 million of hotels, after making some sales of hotels, and (2) an increase in its credit line of 850 million. This provided a net $167 million.
So Park Hotels financed the portion of the dividend that its FCF did not cover in the first nine months of 2019 with a mixture of debt and asset sales. This is typical of what it has been doing for the past several years where its FCF did not cover the dividend payments to shareholders.
So What? Why Should I Care? The Park Hotels Stock Dividend Yield is 9.4%
That is a good question. I have thought about it a lot. In the end, as long as you are aware that the company is essentially borrowing money and trading assets in order to finance a portion of the dividend, maybe it doesn’t matter that the company cannot afford the dividend.
After all, real estate allows the company to borrow money fairly easily. It has $4.1 billion in fixed and variable debt and is expected to produce about $778 million in EBITDA. So the company’s debt-to-EBITDA ratio is 5.3 times. That is not a low ratio. So maybe there is a limit of its borrowings going forward.
Note that I pointed out that the nine-month dividend deficit works out to a $221 million annual deficit rate. If the upper limit of Debt-to-EBITDA allowable by the company’s banks is below 6.0 x EBITDA, it could borrow up to another 0.7 x EBITDA, or $544 million (0.7 x $778 million). That means that only 2.5 more years of dividend deficits could be financed (i.e. $544 million / $221 million = 2.46x).
But, of course, the company can finance the dividend deficits by selling assets, raising equity, raising the FCF level through efficiency measures, and maybe even slowing the increase in dividends per share.
So, for all practical purposes, it seems that Park Hotels has a good number of options whereby it will be able to continue paying the 9.4% dividend yield. Just remember that if a recession occurs, the dividend would not survive since it has to be financed by leverage and asset sales. These sources would dry up during a recession.
Summary and Conclusion
There is a reason why famous investors like Warren Buffett do not invest in high-yield REITs like Park Hotels. They know that FCF does not cover the high dividend payments for many of these REITs.
But, for all practical purposes, it seems that the company’s dividend payments can easily continue at these levels for the next several years, short of a recession. In essence, Park Hotels needs to raise the profitability of its operations if it does not want to continuously have to finance the dividends outside of cash flow by using asset sales, leverage or equity.
I tend to focus on high total yield companies which are the exact opposite of this kind of company. These stocks can finance their high dividend yields, plus buy back shares, reduce debt solely from their free cash flow. These kinds of stocks are much better investments in the long run than companies like Park Hotels.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.