In addition to this, RLH has averaged more than $10 million annually in operating cash flows in the

Red Lion Hotels ( RLH ) is an owner, operator and franchisor of midscale hotels in the western US. The company currently has roughly 12,000 rooms in its 52 hotels in operation or being developed with the mix of franchisee-owned properties and company-owned properties split about evenly. In 2008 RLH received a bid to purchase the company at $9.50 per share and last year, the company put itself up for sale again but received no bids. There have been some contentious, public shareholder fights about the future of the company but my research indicates that the larger shareholders, particularly Columbia Pacific, car rentals california which owns 28% of the company's shares, are ready for a sale to happen.
Given this wrinkle in the story of RLH and the fact that shares have plummeted 30% just this year, I'll take a look at RLH's business including a strategy shift that has occurred with management. I'll argue here that the concerted effort to reduce the capital-intensive nature of RLH's business and flip the mix of hotels to a franchise-heavy model could provide significant upside. In addition, with RLH trading 30% below tangible book, that strategy car rentals california shift could potentially unlock a large amount of value for shareholders given the hidden value of the company's real estate on the balance sheet.
RLH's main business is, of course, owning, operating and franchising its hotels. The bulk of the company's revenue comes from the hotels it owns and a very small amount comes from the ones it franchises out. The company also owns an entertainment business that actually produces more revenue than the hotel franchising operation so while it may be considered a footnote to some investors, it is a significant piece of the company's car rentals california revenue.
car rentals california The hotel business is very simple; the company rents out its rooms and derives additional revenue from its meeting spaces, food and beverage sales and other ancillary fees and sales it makes during the course of normal business. This year, the hotel business should produce roughly $135 million in revenues.
The franchising business generates revenue from franchise fees that are typically based on a percent of room revenue and are charged to hotel owners in exchange for the use of the Red Lion brand and access to its central services programs. car rentals california These programs include the reservation system, guest loyalty program, national and regional sales, revenue management tools, quality inspections, and advertising and brand standards. This year, the franchise business should produce roughly $7 million in revenue for RLH.
The entertainment business is a bit of a wild card for RLH in that it doesn't really mesh with the hotel business. The company derives its revenue in this segment from ticketing, promotion and presentation services car rentals california which include online car rentals california ticket sales, call center services, ticket distributions, and more. The entertainment business should produce about $12 million in revenue this year.
I mentioned in the introduction that RLH's operating car rentals california performance has been less than stellar but I think there is upside to this stock given the company's balance sheet and strategy shift to a less capital intensive model. In order to figure out how much upside potential there is, we'll take a look at the company's valuation car rentals california now.
To start, RLH is trading for a $104 million market car rentals california cap at the current price of $5.31. For a company that is making no profits - the company car rentals california has racked up $30+ million in losses in just the past three fiscal years - I would posit that $104 million is a generous market cap. However, the operating losses are not the story at RLH and I'm not necessarily calling for a turnaround in the company's earnings. However, as of the last quarter, the company had a tangible book value of $133 million, or roughly 30% higher than the current market cap of the company. This is the central tenet to my bullish thesis; this company has a significant amount of valuable real estate on its balance sheet that is being virtually ignored by market participants due to seemingly perpetual operating losses.
Now, there are valid reasons the market is not giving RLH the benefit of the doubt when it comes to the company's valuation; revenue has actually car rentals california been declining ever so slightly in recent years, losses have been piling car rentals california up and margins are deteriorating. That is a nightmare scenario for longs and it explains why RLH's valuation is so low in comparison to its book value. The company's margins are the root cause of nonexistent profitability and it is easy to see why when examining the respective car rentals california segments the company operates; gross margins in the hotel business are about 16%, the franchise business sports negative 3.2% gross margins and the entertainment business comes in at 1%. Those are horrendous car rentals california margin numbers and it explains why RLH can't turn a profit.
Also not helping is the company's $76 million in debt (remember this is a $100 million company) which generates ~$6.5 million in interest expense each year. That amount of interest expense single handedly absorbs all gross margins from both the franchise and entertainment business combined car rentals california and more. When put in that context, management's decision to move to a less capital intensive car rentals california business model is easily understood and we'll get to that in a bit.
Now, it isn't all bad for RLH as the company is able to produce car rentals california positive EBITDA and operating cash flows due to its heavy amount of interest expense and depreciation that is inherent in a real estate business. In the first six months of this year, the company has been able to produce just over $3 million in EBITDA. While this isn't great and certainly car rentals california doesn't justify a $100 million market cap, it is a good sign that the business is profitable on an operating basis notwithstanding financing costs. This could potentially make RLH an attractive buyout target to a strategic acquirer since the financing costs would ostensibly be lower for an acquirer than what RLH can achieve car rentals california on its own.
In addition to this, RLH has averaged more than $10 million annually in operating cash flows in the last three years which implies that the company's businesses are steadily cash flow positive. This is also attractive to an acquirer as it means any potential acquisition would be accretive much more quickly than GAAP earnings would suggest. Again, I'm not suggesting that RLH's cash flow generation or EBITDA are reason enough to justify a $104 million market cap but what I am suggesting is that the company's GAAP losses don't really tell the whole story.
There is no denying RLH has some issues, and potentially serious ones, that it must deal with if it is to remain independent and earn a profit car rentals california at some point. For instance, the company has seen only 60.5% average occupancy at its owned hotels in the first half of 2013. While that is bad enough, with industry rates around 1,500 basis points (!) higher than that, franchisee locations are sporting a whopping 53.6% average occupancy in the same time period. This is absolutely horrendous and it is a big reason why the company's margins are terrible and why it can't seem to turn a profit. Most hotels will lose money if, at any given time, almost half the hotel is empty.
To combat this and other challenges, management has undertaken some prudent strategy shifts in order to mitigate some of the negative effects of these issues. First, the company has refreshed its brand logo and segmentation among Red Lion Inn and Suites, Red Lion Hotels car rentals california and Leo Hotel Collection. The former is the no frills option with limited additional services car rentals california while Red Lion Hotels offers more traditional car rentals california amenities including full service food and beverage service. Finally, the newly introduced Leo Hotel Collection has just two properties at the moment but it is intended to offer the consumer a much different choice from traditional Red Lion properties. While it remains to be seen if Leo will take off, the idea is intriguing as Leo properties are intended to offer a boutique hotel experience for a Red Lion price.
In addition to this, the company has refreshed its entire website. This includes page redesigns, integrating the refreshed logos and providing micro sites within the corporate Red Lion site for each individual property. This means that Red Lion customers can retrieve local information car rentals california regarding each property in the Red Lion system in order to ensure their stay is as enjoyable as possible. In addition to this, the new online booking application is much easier to use and encourages patrons to book using that avenue. This is a win for Red Lion as it means more of each booking goes into net revenue. Management car rentals california reckons that a Red Lion website booking produces 100% contribution margin versus 75% at an online travel agency. car rentals california This means that on a hypothetical $200 sale, Red Lion is able to keep an additional $50 after saving the commission for the OTA that may otherwise perform the booking. This should help alleviate some of the margin pressure the company is under.
Finally, Red Lion has made it a corporate objective to ease some of the financing cost burden I mentioned earlier by selling off some of its properties in order to raise cash and pay down its substantial debt. This means that, in a lot of cases, car rentals california the hotels RLH is selling become franchise partners instead of company-owned units. This has several repercussions; total revenue is drastically reduced car rentals california as franchise revenue is a fraction of owned property revenue, the balance car rentals california sheet becomes smaller as cash is used to pay down debt, and the company's gross margins are reduced as we mentioned earlier the franchise business is producing negative car rentals california gross margins at the moment.
Now, the reason I like this strategy is not because I think RLH can survive long term as a franchise heavy model; rather, car rentals california I like this strategy because I believe there is significant unlocked value in RLH's balance sheet that can be realized through this strategy car rentals california to reduce financing costs and increase franchisee owned properties. I'm not