SHO

Business Context and Reporting Period

Sunstone Hotel Investors, Inc. (Sunstone) is a self-managed real estate investment trust (REIT) owning 43 hotels in the United States, primarily upper upscale and upscale properties. This Form 10-Q covers the quarterly period ended March 31, 2009. The company operates in a cyclical decline phase of the lodging industry due to the U.S. recession, resulting in reduced demand and RevPAR.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Total revenues decreased 15.3% year-over-year, driven by a 16.5% drop in room revenue and a 13.6% drop in food and beverage revenue. This was caused by a 670 basis point decrease in occupancy (to 65.6%) and a 7.4% decrease in Average Daily Rate (ADR).
• Operating Income: Operating income fell 80.8% to $4.0 million due to lower revenues and a new $3.7 million charge for goodwill and other impairment losses.
• Net Income Improvement: Despite lower operating income, Net Income increased significantly to $6.5 million from $0.2 million. This was primarily due to a $28.0 million gain on the extinguishment of debt from repurchasing $64.0 million of Senior Notes at a discount.
• Discontinued Operations: Q1 2008 included $5.5 million in income from discontinued operations (hotels sold in 2008), whereas Q1 2009 had none.
• Impairment Charges: The company recorded a $3.6 million goodwill impairment loss for four hotels and a $0.1 million impairment on land, totaling $3.7 million, compared to zero in the prior year.

Guidance, Outlook, and Risks

• Outlook: Management expects lodging demand to remain weak throughout the remainder of 2009. They anticipate demand may begin to show year-over-year increases in 2010 and 2011, assuming the recession ends in late 2009.
• Capital Strategy: Sunstone intends to maintain higher-than-historical cash balances to preserve capital during the cyclical decline. No hotel acquisitions are expected in 2009.
• Debt Tender Offer: On April 16, 2009, the company initiated a cash tender offer to repurchase outstanding Senior Notes. The offer price was subsequently increased to $700 per note. The company expects to need approximately $130.0 million to consummate the offer if fully subscribed.
• Credit Facility Amendment: The company is negotiating an amendment to its $200 million credit facility to convert it into an $85 million senior secured facility. This amendment would reduce the minimum fixed charge coverage ratio covenant from 1.50:1.00 to 1.00:1.00.
• Risks: Management warns that if economic trends continue to negatively affect demand, the company may fail to meet financial covenants under its credit facility and Series C preferred stock within the next 12 to 24 months. Failure to meet Series C covenants could result in the preferred holders electing a director and receiving a default dividend.

Investor Verification Checklist

• Debt Covenant Compliance: Verify the status of the credit facility amendment and the company's ability to meet the fixed charge coverage ratio given the current economic environment.
• Tender Offer Funding: Confirm the final results of the Senior Notes tender offer and the funding sources used (cash on hand vs. new borrowings).
• Impairment Scope: Assess whether the $3.7 million impairment charge in Q1 2009 indicates further potential write-downs for the remaining portfolio as market conditions persist.
• Liquidity Position: Monitor the cash balance relative to the $130 million estimated cost of the tender offer and ongoing capital expenditure commitments ($15.5 million).
• RevPAR Trends: Track occupancy and ADR metrics in subsequent quarters to determine if the 16% RevPAR decline stabilizes or worsens.