It’s not often that a company’s management tells you the company is grossly undervalued and it’s looking to sell itself, effectively giving investors a chance to jump into the stock before it takes off.

This is a form of pre-emptive merger-arbitrage investing. However, when a company has retained an investment bank to help with the sale, it’s even less speculative than the usual merger-arb investing.

This potential buyout opportunity gets even better when the stock also has downside protection, where the company is trading below replacement cost.

Well, that’s exactly the case with Strategic Hotels & Resorts (NYSE: BEE), the only publicly traded real estate investment trust (REIT) that focuses exclusively on the luxury hotel and resort markets.

	Flickr/SD Dirk
	Strategic Hotels owns a stake in the world-famous Hotel del Coronado in San Diego.

There are several catalysts that could help expedite a sale of Strategic, and not just the fact that the REIT has hired investment bank Eastdil Secured to explore the possibility.

First, Strategic’s founder, Laurence Geller, abruptly left the company in November. Geller still owns 2.2 million shares of his company, but he would like to buy other properties. A sale of Strategic might allow him to get the most value out of his shares so he could put that money to work.

The second catalyst is that Geller and other insiders with notable ownership (more than 5% of the company) have a combined 23% stake. These shareholders are aligned in looking to create the most value for themselves, and a sale of the company may be the best way to do so.

Third, activist investor Orange Capital has a 3.7% stake in the company. Orange Capital started pressuring the company earlier this year to hire an advisor and explore all options, including a sale. It appears that pressure has worked so far, and I don’t expect Orange to ease up until the company is sold.

The great thing about Strategic Hotels is that its portfolio doesn’t contain run-of-the-mill hotels, but high-end hotels and luxury resorts. The company owns or has interests in properties under top brands such as the Four Seasons, JW Marriott, Hyatt, Westin, Intercontinental, Fairmont and Ritz-Carlton, among others. The company’s 18 hotels and resorts are found in markets with high barriers to entry in the U.S., Mexico and Europe. Strategic also owns several parcels of prime land for development.

Strategic does not manage any of its properties directly but instead uses hotel management companies. Thus, the company looks to grow through asset management and maximizing the value of each property, and does this all with only 35 full-time and four part-time employees. 

Industry Tailwinds
The luxury hotel segment was hit hard during 2008 and 2009. Strategic was one of the companies hardest hit as it lost hundreds of millions from low occupancy. The company was seen as being on the verge of bankruptcy, and its stock plunged to as low as $0.61 a share in March 2009. It’s still more than 60% off its 2007 high.#-ad_banner-#

But the companies that survived the crisis now enjoy reduced competition. The Great Recession led major hotel builders to put the brakes on new buildings. There are fewer competitors as a result of a slowdown in the construction of luxury hotel properties. Three years ago, 23 luxury hotels opened in the U.S. Last year, that number dropped to only six. This decreased supply is actually a tailwind for the company, as demand continues to outpace supply, which is a positive for pricing.

Overall, the luxury hotel industry in the U.S. has seen positive growth in revenue per available room (RevPAR) growth since February 2010. Prior to that week, the industry saw 96 consecutive weeks of negative RevPAR growth.

One of the real benefits of the luxury hotel business is that it tends to outperform other major hotel businesses during economic recoveries. Specifically, lodging tends to have an 80% correlation with GDP. During the recovery years of 1992 to 2000, the industry saw nine straight years of RevPAR growth, 8.9% annually. And then from 2002 to 2007, the industry had five straight years of RevPAR growth, 8.2% annually. 

Company Tailwinds
As the only pure-play high-end lodging REIT, Strategic estimates its average replacement costs, excluding land, are at more than $750,000 per property. For 2013, growth in total hotel RevPAR is likely to be between 5% and 6%. Strategic is also looking to dispose of two of its non-core assets.

The other key benefit for Strategic is that it enjoys industry-leading earnings before interest, taxes, depreciation and amortization (EBITDA) per available room. For 2012, Strategic generated $81 per room of EBITDA. Compare this to top comps LaSalle Hotel (NYSE: LHO) at $74 per room and Pebblebrook Hotel Trust (NYSE: PEB) at $71. The reason for this is that Strategic is much less reliant than its peers on rooms, with much greater exposure to food and beverages. Strategic earns 53% of its revenue from rooms, while its peers get around 66% of revenues from rooms.

The Upside
Orange Capital estimates Strategic could fetch $11 to $14 a share if sold, which would equal upside of 25% to 60%. The valuation is supported by the fact that Strategic’s properties are in prime locations that cannot be duplicated. Orange also believes that the company has to push for a sale to ensure shareholders’ best interest. This, given its leveraged balance sheet, makes the return of capital to shareholders in the form of dividends or repurchases unlikely.

The most difficult aspect to valuing Strategic is that there is no publicly traded competitor that owns similar hotel properties. What has happened is a disconnection between the public and private valuation for Strategic’s hotel properties. One Raymond James analyst noted: “The best way for them to close the valuation gap that exists between the public valuation and the private valuation, or what the collection of assets are worth, ultimately is the sale of the company. The portfolio is one of the best portfolios of hotel assets that has ever been put together. We think there are groups out there that would love to own the assets.”

Risks to consider: The big risk is that the economy takes a step back in its recovery, as the luxury hotel industry is heavily tied to the broader economy. The other risk is that a buyer comes to the table, but the deal fails to materialize and the stock tumbles. 

Action to take –> Buy this luxury hotel REIT for a buyout, but in the worst case, you’re getting the assets for less than replacement cost. The company has taken a big step in the sale process by hiring an advisor to help monetize its impressive asset base. In a sale, the company could see upside of more than 25%. Regardless of how a sale shakes out, investors should continue to enjoy Strategic’s success on the back of a rebounding economy.

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