Strategic Hotels

Strategic Hotels & Resorts, Inc.

10/1/20132013

Strategic Hotels & Resorts, Inc. October 1, 2013

Strategic Hotels & Resorts, Inc. (BEE)By: William Nixon, Guillermo Sacriste, Martin Bayersdorfer, Abhinavya Dasyam, Gregory Saville

Contents:Investment Thesis and Summary:................................................................................................................2

Industry Analysis:........................................................................................................................................3

Company Background:................................................................................................................................4

Porters Five Forces Analysis:......................................................................................................................4

Working Capital Strategy:...........................................................................................................................5

Capital Expenditures:..................................................................................................................................6

Dividend Yield:...........................................................................................................................................6

Growth and Value Factors in the Industry:..................................................................................................6

The REIT Industry Moving Forward:..........................................................................................................8

Valuation and Assumptions:......................................................................................................................11

Assumptions:.........................................................................................................................................11

Capital Structure:...................................................................................................................................12

Valuation:..............................................................................................................................................12

Recommendation:......................................................................................................................................13

Table 1 – Operating Assumptions:.........................................................................................................14

Table 2 – Capital Structure:...................................................................................................................14

Table 3 – Maturity Schedule:.................................................................................................................15

Table 4 – Property Level Mortgage Detail:............................................................................................15

Table 5 – Projected Income Statement:................................................................................................16

Table 6 – Free Cash Flow Projections:...................................................................................................16

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Table 7 – Sensitivity Table:....................................................................................................................16

Table 8 – Comparable Company Set:.....................................................................................................18

Investment Thesis and Summary:

The investment recommendation for Strategic Hotels and Resorts (BEE) is a buy with a price target of $12.00. This price target was achieved by evaluating estimates for growth and cost savings over time and identifying a sensitivity range of prices between $9.50 and $17.50. As the economy continues to recover, and occupancy and average daily room rates increase, BEE is well positioned with prime locations and well-known assets to take advantage of strong trends in the hotel industry. Finally, as BEE reinstates their common dividend, which we believe will occur in the next 12-15 months, they will likely gain more recognition and favor amongst REIT investors that often trade REITs based on dividend yield and Funds from Operations (FFO) payout.

Strategic operates as an equity U.S. Real Estate Investment Trust (REIT) exclusively owning luxury and upper upscale hotel properties in the United States, Europe and Mexico. The hotel REIT industry in the United States is relatively fragmented with many players across the broad spectrum of hotel owners. However, BEE operates within the luxury sector of the industry which allows for less competition and more room to develop a true comparative advantage. As with all real estate, location is the primary factor when judging relative value and BEE has terrific assets in terms of location as well as branding. BEE’s portfolio consists of 18 hotels under the following high end flags: Four Seasons, Intercontinental, Marriott and Ritz Carlton, among others.

Strategic has been able to opportunistically refinance property level mortgage debt and enact debt for equity exchanges in recent years to shore up liquidity and create runway within their debt maturity schedule to allow for more focus on the main operations of the business. Strategic has also used equity issuance to purchase hotels so as to avoid incurring more debt and further leveraging the company. The prudent management of debt, as well as successful value-adding asset acquisitions and dispositions, has allowed BEE to maintain strong liquidity since emerging from the financial crisis in 2010. Future strength in BEE also comes from their ability to cut operating expenses within their portfolio hotels and increase margins going forward. BEE’s operating margin currently lags comparable companies by approximately 400 bps with no clear advantage present for those comps except occupancy rates. A move toward industry comparable earnings and operating metrics is expected as occupancy continues to increase and average daily rates continue to rise. We feel that these industry trends are based on economic recovery which we feel has a high likelihood of ramping up in the coming 12-18 months.

The final factor which is vital to stock price appreciation for BEE is their ability to pay a common dividend in the future. BEE currently is not paying a common dividend and therefore is relatively under followed by REIT investors that often times invest based on dividend yield and Funds from Operations payouts. Until Q2 2012, BEE was deferring payment on their three preferred equity securities and as a result was unable to pay a common dividend until all accrued

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interest was paid out to preferred holders. By coming current on the preferred dividend last year, BEE took the first step necessary to being able to pay a common dividend. Due to a lack of net earnings and sufficient Fund from Operations (FFO), BEE has yet to pay a common dividend, but as our model shows, both those metrics should see an increase in the next several years and a dividend should be reinstated in the coming 12-15 months. The value of such a dividend being announced is great as it will generate interest amongst REIT investors and will likely see BEE trade in line with comparable hotel REITs.

Industry Analysis:

The REIT industry is composed of 8 segments, according to Rutgers, including hotel REITs. According to Bloomberg this is one of the smallest segments comprised of only 54 primary REITs. However, due to the recent macro environment and improvements in occupancy hotel REITs have been one of the biggest earners within the REIT industry with 15% growth over the past year.

The REIT industry is highly reliant on macro-economic factors such as employment, consumer confidence, and disposable income which tend to drive leisure and business travel. As the economy has slowly recovered in recent years the use of hotels has begun to increase with a staggering increase of 7.6% in occupancy in 2013. This increase coincided with a 15.7% increase in daily rates for hotels resulting in a 24.4% increase in average revenue per available room. However, since June the REIT market has become highly volatile as interest rate concerns have risen. From April to June the 10 year treasury rate has increased from 1.68% to 2.55% causing the REIT market to become somewhat bearish in the eyes of investors.

During the recession new hotel construction came to a near halt as capital reserves shrank and distressed properties became available at significantly undervalued prices. As a result, few groups tried to enter the REIT industry while existing REITs focused on the acquisition and renovation of existing properties. However, available capital appears to be increasing since 2011 which could signal a movement in the industry back to construction and aggressive acquisition. In 2011 the REIT industry raised $51.3 billion in capital and $73.3 billion in 2012. By comparison, in May 2013 the REIT industry had already raised $40.5 billion.

This upswing in capital generation might signal entrants to join the market, but with increasing interest rate peruses and a general uncertainty within the economy, this may still be a few years out. If competition enters the market within the next year it will be a minor risk as it will take massive capital generation and renovation of facilities to become competitive in the Luxury Hotel REITs. In addition, it is unlikely that the regulatory environment for the operation of REITs will change in the near future. The current requirement for a REIT to pay off 90% of its income to investors in order to maintain its tax benefits is one of the prime drivers for the interest of investors in this asset class.

The existing hotel REIT market is highly competitive on price as well as location. However, the luxury hotel REITs are starting to pull away from this trend as the economy recovers, and compete more on the basis of location and amenity offerings. These REITs will most likely

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continue to compete through acquisitions of properties and renovations as the supply of new properties remains low.

Overall, the economic recovery is a significant opportunity to REITs as occupancy due to leisure and business travel increases. In addition the growth of REITs is still possible through the purchase of undervalued properties. While these opportunities exist, increasing interest rates threaten the operation of REITs and have the potential to decrease the offerings of REIT dividends. These factors will most likely prevent new entrants from competing in the near future.

Company Background:

Strategic Hotels and Resorts, Inc. is a Real Estate Investment Trust (REIT), which was incorporated in 2004 that owns and asset manages upper upscale and luxury hotel properties. Currently, the company owns 18 hotel properties in the United States, Mexico, England and Germany, under the flag names of J.W. Marriott Essex House, Ritz-Carlton, Hyatt Regency, Four Seasons, Loews, Marriott, Westin, Fairmont, and InterContinental. BEE’s properties involve both resorts and urban properties in high demand metropolitan and tourist cities. The company’s shares trade on the New York Stock Exchange under the ticker symbol BEE and have a market capitalization of over $1.75 billion.

Porters Five Forces Analysis:

Threat of New Entrants (Low):

Due to the stagnation of the hotel industry and slow recovery of leisure and business travel in the U.S. few forces are looking to enter the industry. In addition, limited capital is present in the market for the acquisition of hotel properties. For the most part, the only ones taking part in these transactions are existing REITs. However, as the economy recovers and the availability of credit increases you will most likely see an increase in competitive entrants due to low barriers to entry. This possibility is not likely though in the near future. However, these forces have a somewhat diminished effect on BEE due to the nature of its luxury lines. The high income clientele associated with these luxury chains recovered significantly faster from economic pressures in relation to the middle income clientele that was downgraded out of these level of hotels during the 2008 recession and associated recovery.

Threat of Substitutes (High):

There are little to no switching costs between hotels for consumers. Due to the depressed nature of the travel industry a majority of hotels currently compete on cost, which could be an issue for BEE considering its focus on upper upscale and luxury hotels. A majority of the hotels in the REIT such as Marriott and the Four Seasons employ a customer rewards program in order to retain consumer loyalty and in turn occupancy. However, the rewards of such a system may not be significant enough to offset the effects of price competition due to the weakened state of the economy. However, luxury hotels within the vicinity of urban centers still face high competition in relation to amenities and location.

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Bargaining Power of Customers (Moderate):

Consumers have significant pull in the management of hotels within the REIT asset class. In order to maintain if not improve customer occupancy rates, the properties must keep pace with the ever changing demands of their consumer base. This means providing differentiating advantages such as unique luxury amenities. Since occupancy is further compounded by trends in leisure and business travel as well as economic factors such as employment and consumer confidence, properties need to be periodically renovated to drive occupancy and obtain customers from competitors. In addition, consumer desire for luxury locations is significantly driven by hotel location. As a result, luxury location is greatly determined by consumer demand.

Bargaining power of Suppliers (Low):

For the purpose of this analysis the suppliers of REITs are defined as the groups responsible for the construction and renovation of hotel properties. Since the 2008 financial crisis capital markets have been slow to respond to the slow recovery of the economy, as a result the construction of new properties has significantly slowed to a near halt. Instead hotels and commercial properties have focused on the renovation of existing properties to meet the demand of their customer base. As the capital markets recover, the creation of new properties could increase the bargaining power of suppliers, but this will most likely not occur in the foreseeable future.

Intensity of competitive rivalry (High):

Due to the nature of the luxury hotel industry, competition is significant within REITs. While BEE focuses on the upscale to luxury end of the spectrum, economic factors have forced them into a position of price competition while maintaining renovations to keep pace with consumer demand. In addition, competition within the luxury class is greatly defined by amenity offerings and hotel location. Due to high availability of substitutes within the industry and low switching cost BEE must maintain these strategies to remain competitive and continue to drive occupancy.

Working Capital Strategy:

Forecasting BEE’s working capital was a challenging situation. Currently, the company is operating under a working capital deficit. However, management has successfully restructured the company’s debt, and they have been experiencing increases in Account Receivables and decreases in Account Payables. Furthermore, the working capital of BEE’s comp set seems to be in comparison to the company. Both their direct upper upscale and luxury and indirect diversified REITs have similar—or experienced similar—working capital profiles. As per the cash flow cycle, the upper upscale and luxury hotel REITs do not keep and/or have significant inventory accounts that they keep track of, as well as follow the conventional report of accounts payable and receivable such as manufacturing or retail companies. Thus, cash flow conversion cycles are not truly reported in this industry. Consequently, as the industry continues to fully stabilize, and taking into account the factors mentioned above our group decided to use a 3% of total revenue growth rate in our assumptions. Refer to Table # for the results of the comp set’s year-over-year change in working capital.

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Capital Expenditures:

Historically BEE’s capital expenditures have represented an average of 6.5% of total revenues. Our group decided to use this figure in our assumptions, as we did not find a sign to expect that BEE would change this in the near future.

Dividend Yield:

Presently, BEE does not pay a dividend on its common stock, thus it does not have a dividend yield. The company does issue three types of preferred stock yielding 8.25% to 8.5%. In comparison to its competitors, in which eight out of the nine are currently paying a dividend at a yield range of 1.55% and 6.64%, with the average being 3.49%. Refer to Table # in the appendix for the results of the comp set and their respective dividend yields.

At the height of BEE’s operations (i.e., before facing financial hardship due to the economic downturn), the company paid a dividend yield of 9.6%. As it is currently up to date on its dividend payments to its preferred shareholders, we foresee BEE reinstating its dividend payments to its common shareholders at a yield that is comparable to its comp set and to that of Treasury’s rates.

Growth and Value Factors in the Industry:

BEE’s continued growth depends on several key factors, some of which are generic to the REIT industry and some of which are specific to BEE. BEE struggled heavily during the recession, but one of the key elements in its resurgence over the past two years is that luxury hotels recovered much faster from the economic downturn in 2008 than many other businesses. Sections of the market have recovered quite well from the recession in the past few years, and a key element of BEE’s model is that they cater to patrons that would be involved in the section of the market that has recovered well. This has contributed to BEE’s ability to increase its room occupancy rate since 2008; from a low of 68% in 2009, BEE has increased their occupancy rate to 76% in 2012 and 80% thus far in 2013. This, in turn, has keyed strong revenue growth, which has enabled it to regain a sounder financial footing in the wake of its struggles in 2008-2009.

The elements of BEE’s growth that are more specific to the company are twofold. The first, and most important component, is that they have switched from fixed-rate debt to a mixture of fixed- and floating-rate debt. This was particularly important because it was their previous capital structure, which utilized exclusively fixed-rate debt that caused them to sustain such significant losses when the economy went into a recession in 2008. BEE was left paying high fixed interest rates that bore no relation to their revenues, which were declining dramatically from their previous levels. BEE’s current mix of debt sits roughly at 60% floating-rate debt and 40% fixed-rate debt, and the company continues to shift more towards floating-rate debt. This kind of debt model makes sense for BEE because it, in a general sense, allows the interest rate on its debt to more closely correlate with the revenue that is taking in. Changes in the REIT industry are generally tied to macroeconomic factors, and interest rates generally tend to follow macroeconomic trends.

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Ashford Hospitality Trust, Diamondrock Hospitality Company, LaSalle Hotel Properties, Pebblebrook Hotel Trust, and Sunstone Hotel Investors are some of the other major competitors for BEE in the REIT industry, and two in particular stand out as highly comparable to BEE: Diamondrock and Pebblebrook. Diamondrock and Pebblebrook are slightly larger than BEE—they have 27 and 25 hotels, respectively, and are predominantly centered in the United States. Their strengths are similar to BEE’s in that they focus on high-end properties centrally located in getaway destination cities in the United States, and while that leaves them in a strong position to grow given the continued recovery of the economy, both Diamondrock and Pebblebrook have some weaknesses relative to BEE’s position.

Diamondrock, like BEE, has mortgages out on roughly half its properties; in Diamondrock’s case, twelve of twenty-seven properties are mortgaged. What Diamondrock does differently, however, is that they have mostly fixed-rate debt on those properties—which is what caused BEE to run into significant difficulties during the financial crisis. The debt burdens are not especially onerous; for example, Diamondrock has the mortgage for the Washington, DC Westin locked in at 3.99%. That said, were the economy to enter a sustained period of recession, it is entirely possible that Diamondrock would have been able to obtain a lower rate without refinancing, and the fact that their debt is at a fixed rate of interest leaves less flexibility in their operations should they wish to make an adjustment.

Diamondrock also has a very highly concentrated revenue stream: 69% of their revenue comes from 30% of their properties, which is indicative of both a very top-heavy operation and of possibly underperforming properties. Given that REITs tend to acquire and divest from properties with reasonable frequency, this is not a significant threat to Diamondrock’s business, but if the properties are underperforming it would make them more difficult to sell if Diamondrock did not believe it could enhance the quality and performance of the asset.

The one element of Pebblebrook’s business practice that stands out as having potential negative consequences is the fact that their six New York City properties are owned by a joint venture that Pebblebrook has 49% ownership of. The inability to exercise complete control over these assets could easily become a stumbling block for Pebblebrook in the future; were they to have an issue with their partners in the joint venture, the company could be deprived of the revenue from their six hotels in the number one market in the United States. While joint ownership does decrease many of the costs of operating the hotel that would otherwise fall to Pebblebrook, it also creates other potential problems and does not allow Pebblebrook to maximize its revenue from those particular assets.

BEE offers luxury hotel services which recovered faster than the general economy due to the high net worth associated with its target clientele. During the recession, hard economic times caused middle income clientele to downgrade to lower level hotels, but as the economy recovers they will most likely transition back to the luxury end hotels as disposable income becomes available. As a result, BEE has realized a near 95% occupancy rate, up from 72.6% in 2012, resulting in increased revenues. This excess capital in combination with controlling costs, such as refinancing debt, will allow BEE to continue expansion through the acquisition and renovation of properties.

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BEE derives its value based on the hotel location in high income urban areas. The 8,271 rooms within the 18 hotels owned by BEE are all located within these high income urban centers. In addition, these rooms not only aggressively compete on location they provide high level amenities, such as world-class restaurants, unique wine and cocktail bars, high-end spas and desirable retail offerings at competitive prices for its hotel class. In addition, the hotels take part in periodic renovations to keep pace with consumer demands. This allows BEE to maintain property desirability and market share within the recovering economy.

The REIT Industry Moving Forward:

Growth:

Since their inception, REITs helped in the growth of the economy by directing capital into real estate by making real estate investments more transparent and adding to the tax base. Over the last decade, the percentage of 401 (k) plans offering REITs as an investment option has increased from 5% to 30%. Over long holding periods, equity REIT returns have outpaced the inflation rate, helping investors hedge the purchasing power of their portfolios. This growth is likely to continue in the future.

Outperform the market:

In the last 30 years, publicly traded equity REITs outperformed the leading stock market indexes, including the S&P 500, Dow Jones Industrials and NASDAQ Composite. Several sectors of the REIT market delivered double-digit total returns for the past 10 years, 20% for Self-storage, 14% for Residential, 12.5% for Retail and 18% for Healthcare. From January 1978 through December 2012, equity REIT performance exceeded both the broad equity market and other forms of real estate investment by more than 1 percentage point per year, producing an average annual return of nearly 12.9 percent. In 2012 alone, there was a 20.14% total return for the year for the FTSE NAREIT All REITs Index, as against a 16% gain for the S&P 500. This performance is likely to continue in the coming years.

Accelerated Earnings:

Historically, there is a strong inverse relationship between REIT prices and interest rates. Interest rate decreases are likely to be met by REIT price increases. Low interest rates mean REIT companies can borrow money for pennies and invest in new real estate properties. REITs have reinforced their balance sheets by using low borrowing costs and capital markets. With the interest rates not likely to increase substantially in the near future, REITs will have considerable earnings.

Continued popularity:

The law requires REITs to pay at least 90 percent of their taxable income to shareholders. REITS have been particularly attractive to small investors, because they pay out hefty dividends as they usually carry higher yields than other types of investments. The average REIT dividend yield is about 3.4%, according the Dow Jones REIT index, compared with an average of 2% for the

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Standard & Poor's 500 stocks. An investment in a REIT represents an investment that is diversified across a range of real estate properties in a variety of geographic locations making them relatively less risky than buying real estate in a particular city. Moreover, REITs are a hit with small investors as REITs give everyone an opportunity to invest in real estate properties that they can only dream of owning.

Use of Technology:

In today’s world, technology plays a big role in every aspect of our day-to-day lives, not just in the real estate industry. As the economy continues to recover, REITs are trying to gain momentum by adopting and leveraging technologies such as Salesforce and other Customer Relationship Management (CRMs) tools to the maximum. Technology helps open new avenues and alternative growth strategies when other traditional outlets have been tried and tested. Although, the REIT industry has been slow in adapting to new technologies compared to the other industries, commercial real estate companies are now increasingly embracing technological innovations such as cloud computing, mobile applications and social media to better reach their end customers and grow their businesses by improving sales through occupancy rates.

Non-Traded REITs:

Non-Traded REITs like the name suggests are REITs that are not traded on a securities exchange. These REITs carry front-end fees as high as 15% and are not as liquid as traditional REITs. These REITs are extremely popular among commissioned brokers as they pay high commissions and claim to offer higher yields than many competing products. Non-traded REITs create their portfolios around a niche like senior or student housing, resorts and leisure in order to lure investors. Investing in a niche market means that the investors cannot diversify their risk and unlike in ordinary REITs, investors cannot get out of non-traded REITs if the sector or market goes bad. The non-traded REIT industry has raised a record $17 billion in 2013 and about $94 billion since it started to attract capital in 2000. However, non-traded REITs have come under increased regulatory scrutiny with the SEC as they have not lived up to their hype and expectations, most of them promising the sky but in the end just managing to breakeven the costs.

International REITs:

For a long time, publicly traded REITs were only available in USA and Australia. However, a lot of countries have now opening up to the idea and adopting similar structures. While, the U.S. remains the hotbed for the largest and most efficient listed real estate market, the global real estate securities market is increasing in popularity globally. In fact, non-U.S. REITs makes up almost half of the global REIT market. The biggest driver for REIT popularity is the diversity factor, where investors can invest in diverse real estate markets in the country. Now, with the help of international REIT portfolios, investors are further diversifying their portfolio risk by not just investing in the U.S. real estate but also by investing in REITs.

Expanding into fast growing markets:

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Nearly 30 countries have adopted variations of the U.S. REIT model. Today, anyone in the world can invest in REITs. Diversifying into domestic and international markets differentiated by well-managed portfolios has become the norm. Not simply diversifying, but diversifying into emerging and fast growing markets like Canada, Brazil, Mexico and Chile is the key.

Tax increase on qualifying dividends:

The dividends yielded from REITs are not treated as qualified dividends by the U.S. government and are taxed according to the investor’s income tax bracket. If however, the government decides to do away with the “qualified” dividends status and starts treating and taxing all dividends equally, then it would level the playing field for REITs and make them more attractive to the investors. REITs would now be on an even footing with other types of investments in terms of tax rates, and may have an added benefit over them because of their high rates of dividend.

Losing Tax exemption status:

It is a known fact that REITs have to return 90% of their taxable income to shareholders in the form of dividends, thus making REITs virtually tax-free. REITs do not have to pay corporate taxes on the disbursed dividends to shareholders as the responsibility of paying these taxes fall on the shareholders who are taxed at their income tax rates. However, in recent years, in order to avoid paying corporate taxes, many nontraditional real-estate companies have gained acceptance from the IRS to convert their businesses to a REIT. In order to raise more revenue and eradicate loopholes, The House Ways and Means Committee is presently probing how REITs are taxed. If REITs lose their tax exemption status, they would be required to pay corporate taxes like any other industry, thus forcing the REITs to cut down on their dividend yields, making them less attractive to the investors.

Interest Rates:

If the interest rates remain low, REITs will continue to give accelerated earnings to investors. However, if there is a sudden hike increase in interest rates, money becomes more expensive to borrow and REITs cannot generate substantial revenues, as investors can no longer invest lump sum amounts of money. If interest rates climb up, investors will have to pay more to borrow, and the dividends from REITs will look less attractive to investors compared with the other high-yielding investments.

Inflation:

Investors have long recognized that investing in commercial real estate can provide a natural protection against inflation, as rents tend to increase when prices do. However, with high inflation comes high interest rates and that could mean trouble for the REIT industry at least in the short run.

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Valuation and Assumptions:

Assumptions:

Revenue Growth:

Revenue growth has been very volatile for BEE as they have emerged from the financial crisis. Many economic factors have hindered revenue growth within the hotel industry over the last several years, but the first half of 2013 has been promising. BEE’s first half 2013 revenue growth of 17.4% is slightly higher than the average growth of comparable companies of 16.5%. This illustrates BEE’s general ability to perform in line with market comps and supports our thesis that BEE has comparable revenue generating capabilities to its peers. Operating segment specific revenue growth projections can be found in Table 1 in the appendix. We feel that revenue growth will increase due to occupancy and average daily rate growth, as well as through at least one hotel acquisition. As the economy picks up in 2-3 years there will be substantial revenue growth for BEE.

Margins:

Gross and operating margins for BEE have recently lagged those of the industry for no apparent reason. Historically, BEE’s margins were in line with those of its peer group and the recent underperformance likely can be attributed to higher fixed costs associated with luxury properties and underperforming revenue generation due to previously mentioned macroeconomic factors. We are conservatively estimating that BEE is able to reach an operating margin level in line with today’s industry average of 11.5% over the next 5 years. If this conservative doubling of operating margin is achieved over the next 5 years, BEE will likely still be underperforming its peer group, but will benefit from an operating margin that is twice what it is today on revenues that certainly will not double over that same time period. The assumptions for operating segment specific margins can be found in Table 1 in the appendix.

Cash Flow Generating Ability:

As the economy recovers so too will BEE’s ability to generate significant cash flow. RevPAR will pick up as occupancy and average daily rates increase as the economy continues to strengthen. BEE’s ability to generate cash is dependent upon its ability to manage near term liquidity and achieve effective operating leverage. BEE’s capital expenditures on its current portfolio of properties will be minimal as substantial CapEx has been invested in the last few years to make current properties more valuable and attractive to a more discerning consumer. The working capital necessary to run the business is minimal if BEE can continue to increase its accounts receivable and decrease its accounts payable by effectively managing relationships with its property management companies. Cash generation will be strong as BEE takes advantage of its strong core portfolio of hotels and leverages its ability to cut costs and generate outsized revenue growth.

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Capital Structure:

BEE has a simple and straightforward capital structure comprised of property level, non-recourse, mortgage debt, a bank facility, three issued of preferred equity and common equity. The company is equally as levered as other companies within the industry at 39% debt compared to 41% debt for peers. Total leverage of 40-50% in the capital structure appears to be the ideal amount of leverage in a more normalized operating environment for hotel REITs. BEE has worked hard to achieve this level of leverage through mortgage refinancing, moving from fixed to floating rate debt, debt for equity exchanges, debt retirement and paying for properties with equity rather than incurring new mortgage debt. Due to the secured nature of BEE’s debt, they have a relatively low cost of debt at 4.88% for $1.16 billion in mortgage debt and 3.20% for $157 million of bank credit facility. As with most REITs, BEE has several preferred equity issues outstanding. The average cost of its three preferred issues is 8.34% (Series A at 8.50% and Series B & Series C at 8.25%) on $280 million. Due to liquidity constraints, BEE had been deferring payment on its preferred shares since 2009 and came current on those deferred payments in June of 2012 as liquidity was sufficient. This return of value to preferred shareholders was well received and signaled to the market that liquidity and the operations at BEE were strong. Finally, with a market cap of $1.75 billion, BEE has been able to utilize equity issuance as a tool to minimize further leverage when purchasing properties and seeking new capital. Although dilution has been significant over the last few years, leverage has been kept in check and operational metrics have been able to be maintained. Now that BEE is current on its preferred equity payments, they will be able to return to paying a common dividend once they return to positive free cash flow and profitability. Once this occurs, the stock will likely trade in line with industry peers in terms of dividend yield and an increase in share price and market cap is likely, further improving credit and leverage metrics.

Valuation:

Our valuation judgment is based primarily on our discounted cash flow analysis with some influence put on relative valuation to a set of comparable companies within the hotel REIT industry (Table 8). As mentioned above, the operating assumptions we made are based on various sources of information, including past company results in a more normalized operating environment, comparable company projections and analyst projections for the industry. The terminal value was based on a steady state growth for BEE of 5.00%. The discount rate we used when valuing the future cash flows of BEE was derived using an APV analysis. Due to BEE’s designation as a REIT they do not pay taxes and therefore we did not have an interest tax shield component to our APV analysis, thus resulting in the same cost of capital as a simple WACC analysis would have provided. We assumed a similar capital structure to today at 40% debt and 60% preferred and common equity and used an average asset beta of the comp set. Assigning a risk-free rate of 3.50% and a market risk premium of 6.00%, we generated a cost of capital for BEE of 9.87% which is approximately 40 bps higher than industry averages for cost of capital. Applying this cost of capital to the future projections of cash flow, we ended up at a stock price of $12.50. When sensitizing the projected stock price to come up with a fair range for future stock price outcomes, we used +/- 3% for revenue delta with +/-1 and 0 intervals, and +/- 2% margin delta with +/-1 and 0 as intervals. This sensitivity analysis resulted in a stock price range of $9.40-$17.30. Feeling that our revenue growth assumptions are relatively conservative and

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our margin assumptions are where the model gets slightly aggressive, we decided to assign our target price of $12 slightly lower than our base case projection of $12.50. This price of $12 is closer to our sensitivity projection given our current revenue projections and margins approximately 1% lower than projected.

The relative valuation analysis we conducted resulted in slightly skewed valuations for BEE due to a lack of net income in the last twelve months as well as for the next two projected years. As a result, P/E ratios were not helpful when ascribing a value to BEE. When looking at Enterprise Value/EBITDA, BEE is currently trading at a premium to the comp set average and a reversion to the comp set mean would result in a significantly lower stock price than where BEE is currently trading. We took this data point into consideration as it indicated relative overvaluation versus the comp set, which to us signaled that the market is not necessarily trading BEE off EV/EBITDA multiples.

The more likely scenario for relative valuation which we need to consider is the value which will be assigned to BEE once they turn their common dividend back on and begin trading off a comparable dividend yield to peers. The current average dividend yield for our comp set is 3.49% with a FFO payout ratio of approximately 40%. We believe that once BEE starts trading off these metrics the market will likely assign a discount to BEE since they will be reinstating their common dividend for the first time since emerging from financial distress. We are projecting that they will trade at a slightly higher dividend yield of approximately 4% (50 bps premium to comps) and will likely need a higher initial FFO payout ratio to entice investors back to the stock. At an aggressive FFO payout ratio of 50% of 2017 projected FFO/share of $0.82, and a dividend yield of 4% on a dividend of $0.41, we arrive at a stock price between $10-$11. 2017 projections for FFO/share are used due to our opinion that that accurately represents the normalized environment in which BEE will be operating in. We believe our FFO projections are somewhat conservative since we have limited ability to project acquisition and disposition activity in the future, but feel that the trading activity will certainly increase as a common dividend is paid and the market can more comparably value BEE versus its peers.

After applying various valuation techniques; DCF and comparable company analysis, we feel that the appropriate target price for Strategic Hotels & Resorts is $12. The investment timeframe is 12-15 months until year end 2014. The analysis we have conducted is projecting forward without accounting for a systemic problem or macro shocks that will adversely affect BEE. These are real risks to consider, however we feel that they are minimal as the economy moves toward expansion and there seems to be support for economic growth.

Recommendation:

As per our valuation and analysis it is with confidence that we recommend a “Buy” on Strategic Hotels and Resorts at a target price of $12.00 per share. The main catalysts we are foreseeing will drive the value of BEE include the continuing improvements in their overall financial position, which should be driven by the overall recovery of the U.S. and global economy, and the reinstatement of a dividend to their common stock, which we are forecasting to occur within the next 12-15 months. Additionally, we believe we have been conservative in our assumptions and

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have done a careful analysis of the current strategy and state of the company and its competitive advantages, value and forces in its respective industry.

Table 1 – Operating Assumptions:

2013 2014 2015 2016 2017 2018Revenue GrowthRooms 7.50% 9.50% 11.50% 10.00% 8.00% 6.00%Food and beverage 3.75% 4.75% 5.75% 5.00% 4.00% 3.00%Other revenue 3.75% 4.75% 5.75% 5.00% 4.00% 3.00%Leasing revenue 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%Terminal growth 5.00%

Operating ExpensesRooms 28.00% 28.00% 28.00% 27.75% 27.75% 27.50%Food and beverage 72.75% 72.75% 72.75% 72.50% 72.50% 72.25%Other expenses (% of tot rev) 26.00% 26.00% 25.75% 25.75% 25.50% 25.50%Management fees (% tot rev) 3.00% 3.00% 3.00% 3.00% 3.00% 3.00%Other hotel expenses (% tot rev) 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%Lease expense (% lease rev) 95.00% 95.00% 95.00% 95.00% 95.00% 95.00%Depreciation (% CapEx) 200.00% 200.00% 200.00% 190.00% 190.00% 180.00%Corp expenses (% tot rev) 3.50% 3.50% 3.50% 3.25% 3.25% 3.00%

Capital RequirementsWorking capital (% tot rev) 3.00% 3.00% 3.00% 3.00% 3.00% 3.00%Capital expenditures (% tot rev) 6.50% 6.50% 6.50% 6.50% 6.50% 6.50%

Assumptions

Table 2 – Capital Structure:

Security Amount OutMortgage debt $1,161.7Bank credit facility 157.0Preferred equity 279.5Equity market cap 1,815.1Total capital $3,413.3

Current Capital Structure

Table 3 – Maturity Schedule:

2013 (remainder) $113.02014 15.32015 173.22016 150.72017 548.2Thereafter 318.2Total $1,318.7

Maturity Schedule

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Table 4 – Property Level Mortgage Detail:

Property Spread Rate SizeMarriott London 3m GBP LIBOR + 425 4.75% $106.5Four Seasons Washington, DC LIBOR + 315 3.34% 130.0Loews Santa Monica LIBOR + 385 4.04% 110.0JW Marriott Essex House LIBOR + 400 4.19% 189.3InterContinental Miami LIBOR + 350 3.69% 85.0Fairmont Chicago Fixed 6.09% 93.8Westin St. Francis Fixed 6.09% 211.1Hyatt La Jolla LIBOR + 400 (50bps fl) 4.50% 72.0Hyatt La Jolla Fixed 10.00% 17.4InterContinental Chicago Fixed 5.61% 145.0Total $1,160.2Average Mortgage Rate 5.23%Weighted Average Mortgage Rate 4.88% 1,160.2

Property Level Mortgage Detail

Table 5 – Projected Income Statement:

2013 2014 2015 2016 2017 2018Revenues:Rooms $480.3 $525.9 $586.4 $645.0 $696.6 $738.4Food and beverage 284.1 297.6 314.7 330.5 343.7 354.0Other hotel operating revenue 86.0 90.1 95.3 100.1 104.1 107.2Lease revenue 4.8 4.9 4.9 5.0 5.0 5.1

Total revenue 855.3 918.5 1,001.3 1,080.5 1,149.4 1,204.7Operating Costs and Expenses:Rooms 134.5 147.2 164.2 179.0 193.3 203.1Food and beverage 206.7 216.5 229.0 239.6 249.2 255.8Other departmental expenses 222.4 238.8 257.8 278.2 293.1 307.2Management fees 25.7 27.6 30.0 32.4 34.5 36.1Other hotel expenses 59.9 64.3 70.1 75.6 80.5 84.3Lease expense 4.6 4.6 4.7 4.7 4.8 4.8Depreciation and amortization 111.2 119.4 130.2 133.4 141.9 140.9Corporate expenses 29.9 32.1 35.0 35.1 37.4 36.1

Total operating costs and expenses 794.8 850.6 921.0 978.2 1,034.6 1,068.4Operating income 60.5 67.9 80.3 102.4 114.8 136.3

Interest expense 75.0 75.0 80.0 80.0 85.0 85.0Income tax expense 0.0 0.0 0.0 0.0 0.0 0.0Net income (14.5) (7.1) 0.3 22.4 29.8 51.3

Operating margin 7.1% 7.4% 8.0% 9.5% 10.0% 11.3%EBITDA/Interest 2.29x 2.50x 2.63x 2.95x 3.02x 3.26x

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Table 6 – Free Cash Flow Projections:

2013 2014 2015 2016 2017 2018Operating income $60.5 $67.9 $80.3 $102.4 $114.8 $136.3Add: depreciation and amortization 111.2 119.4 130.2 133.4 141.9 140.9Cash flow from operations 171.7 187.3 210.5 235.8 256.7 277.2Less: D net working capital 27.6 30.0 32.4 34.5 36.1 37.9Less: capital expenditures 55.6 59.7 65.1 70.2 74.7 78.3Free cash flow $88.5 $97.6 $113.0 $131.1 $145.9 $161.0Terminal value $3,471.3

Table 7 – Sensitivity Table:

-3.0% -1.0% 0.0% 1.0% 3.0%-2.0% $9.42 $10.42 $10.95 $11.50 $12.68-1.0% $10.27 $11.36 $11.94 $12.55 $13.840.0% $11.12 $12.31 $12.54 $13.60 $15.001.0% $11.98 $13.25 $13.93 $14.64 $16.162.0% $12.83 $14.20 $14.93 $15.69 $17.32

D Revenue Growth

D O

pera

ting

Mar

gin

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Table 8 – Comparable Company Set:

Current Shares Market Total Enterprise Net Interest EV/ EV/ EBIT/ EBITDA/ EBITDA Gross Operating Net Debt/ Dividend AFFOTicker Price Out Cap Debt Value Revenue Income EBIT EBITDA Expense P/E EBIT EBITDA Interest Interest Margin Margin Margin Margin EV Dividend Yield Payout

Ashford Hospitality Trust AHT $12.53 80.566 $1,009.5 $2,381.9 $3,117.8 $955.3 ($49.2) $129.6 $262.9 $145.0 -20.52x 24.06x 11.86x 0.89x 1.81x 27.5% 36.7% 13.6% -5.2% 0.76x $0.44 3.88% 29.53%DiamondRock Hospitality Co. DRH $10.69 195.471 2,089.6 1,064.1 3,011.3 855.8 (43.2) 47.3 161.7 57.8 -48.40x 63.72x 18.62x 0.82x 2.80x 18.9% 26.3% 5.5% -5.0% 0.35x $0.32 3.25% 41.03%FelCor Lodging Trust FCH $6.00 124.126 744.8 1,691.9 2,795.9 930.2 (9.6) 39.7 167.6 117.1 -77.43x 70.35x 16.68x 0.34x 1.43x 18.0% 31.9% 4.3% -1.0% 0.61xHersha Hospitality Trust HT $5.52 202.669 1,118.7 917.4 2,002.8 380.5 26.2 60.3 122.9 43.6 42.75x 33.20x 16.30x 1.38x 2.82x 32.3% 38.1% 15.9% 6.9% 0.46x $0.24 4.27% 63.16%Hospitality Properties Trust HPT $27.81 139.747 3,886.4 2,793.0 6,885.8 1,419.2 144.1 274.4 555.5 139.5 26.96x 25.09x 12.40x 1.97x 3.98x 39.1% 42.7% 19.3% 10.2% 0.41x $1.84 6.68% 60.73%Host Hotels and Resorts HST $18.22 750.031 13,665.6 4,724.0 17,996.6 5,679.0 142.0 489.0 1,288.0 372.0 96.24x 36.80x 13.97x 1.31x 3.46x 22.7% 24.7% 8.6% 2.5% 0.26x $0.30 2.69% 28.85%LaSalle Hotel Properties LHO $28.54 96.256 2,747.2 1,216.8 3,939.0 907.9 83.7 137.8 267.3 56.4 32.84x 28.58x 14.74x 2.44x 4.74x 29.4% 38.6% 15.2% 9.2% 0.31x $0.71 3.94% 34.13%Pebblebrook Hotel Trust PEB $28.64 61.587 1,763.8 535.3 2,134.8 440.3 34.0 47.2 97.1 19.6 51.87x 45.19x 21.98x 2.41x 4.96x 22.1% 32.4% 10.7% 7.7% 0.25x $0.48 2.24% 41.03%Sunstone Hotel Investors SHO $13.03 162.871 2,122.2 1,296.2 3,274.5 867.6 6.7 85.4 212.8 72.7 314.45x 38.33x 15.38x 1.17x 2.93x 24.5% 28.3% 9.8% 0.8% 0.40x $0.20 1.56% 16.67%

Comps Average 1,381.7 37.2 145.6 348.4 113.8 38.61x 40.59x 15.77x 1.42x 3.21x 26.1% 33.3% 11.4% 2.9% 0.42x 3.56% 39.39%Comps Min 26.96x 24.06x 11.86x 0.34x 1.43x 18.0% 24.7% 4.3% -5.2% 0.25xComps 25th Percentile 855.8 (9.6) 47.3 161.7 56.4 31.08x 28.58x 13.97x 0.89x 2.80x 22.1% 28.3% 8.6% -1.0% 0.31xComps Median 907.9 26.2 85.4 212.8 72.7 37.80x 36.80x 15.38x 1.31x 2.93x 24.5% 32.4% 10.7% 2.5% 0.40x 3.57% 37.58%Comps 75th Percentile 955.3 83.7 137.8 267.3 139.5 44.99x 45.19x 16.68x 1.97x 3.98x 29.4% 38.1% 15.2% 7.7% 0.46xComps Max 51.87x 70.35x 21.98x

Strategic Hotels & Resorts BEE $8.78 205.527 $1,815.1 $1,318.7 $3,357.5 $874.3 ($48.7) $61.2 $168.1 $79.6 -0.18x 54.90x 19.98x 0.77x 2.11x 19.2% 22.5% 7.0% -5.6% 0.39x

Implied Share Price:Comps Average $5.66 $6.48Comps Min $0.74 $3.28Comps 25th Percentile $2.09 $5.01Comps Median $4.54 $6.16Comps 75th Percentile $7.03 $7.22Comps Max $14.52 $11.56

Trailing 12 Months

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Documents

Strategic Hotels