SHO

Business Context and Reporting Period

Company: Sunstone Hotel Investors, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2007
Business Overview: Sunstone operates as a Real Estate Investment Trust (REIT) owning, acquiring, and managing luxury and upscale hotels in the United States. As of March 31, 2007, the portfolio consisted of 51 hotels with 16,659 rooms. The company leases properties to a taxable REIT subsidiary (TRS) which contracts third-party managers (e.g., Marriott, Hyatt, Hilton) for operations.

Key Financial Metrics

Operating Margins: Operating income margin was approximately 12.2% for Q1 2007 ($29.2M / $239.8M) compared to 13.2% in Q1 2006.

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 21.4% year-over-year, driven primarily by the acquisition of six new hotels (including LAX Renaissance and Marriott Long Wharf) and organic growth in the existing portfolio. Room revenue rose 25.6% and Food & Beverage revenue rose 17.6%.
• Net Income Decline: Net income decreased 72.9% to $4.8 million. This decline is largely attributable to the absence of $17.3 million in income from discontinued operations (gains on the sale of 15 hotels) recorded in Q1 2006.
• Common Shareholder Loss: While the company reported a net profit, income available to common stockholders turned negative ($0.4 million loss) due to preferred stock dividends and accretion ($5.2 million) exceeding net income.
• Debt Expansion: Total notes payable increased by approximately $456 million to $1.81 billion, reflecting new mortgage financing ($176 million) and credit facility draws ($138 million) to fund acquisitions.
• Operating Performance: Pro forma RevPAR for the total portfolio increased 8.5% to $110.62, with occupancy up 2.5% and Average Daily Rate (ADR) up 4.9%.

Outlook, Risks, and Unusual Items

• Acquisitions and Capital Expenditures: The company acquired two major properties in Q1 2007 (LAX Renaissance and Marriott Long Wharf). It expects total capital expenditures for 2007 to range between $120 million and $130 million, with six major renovation projects underway.
• Liquidity: As of March 31, 2007, the company had $49.6 million available under its $200 million credit facility. In April 2007 (subsequent event), the company settled a Forward Sale Agreement for $111 million in gross proceeds, which will be used for general corporate purposes.
• Discontinued Operations: Q1 2006 results included significant gains from the sale of 15 non-core hotels, which are not present in the current period.
• Risk Factors: Key risks include high leverage levels, variable interest rate exposure on the credit facility (7.6% of total debt), competition for acquisitions, rising operating costs (wages, utilities), and the need for significant capital expenditures to maintain properties.
• Legal Proceedings: A lawsuit regarding Legionella bacteria exposure at a formerly owned hotel was settled in Q1 2007; the settlement was covered by liability insurance.

Investor Verification Checklist

• Debt Covenants: Verify compliance with financial ratios under the $200 million credit facility and mortgage agreements, given the significant increase in total debt.
• Renovation Impact: Assess the operational displacement and cost overruns associated with the six major renovation projects scheduled for 2007.
• Preferred Stock Obligations: Confirm the sustainability of dividend payments on Series A and Series C preferred stock, which currently exceed net income available to common shareholders.
• Acquisition Integration: Monitor the performance of the newly acquired LAX Renaissance and Marriott Long Wharf properties to ensure they meet pro forma revenue projections.
• Forward Sale Settlement: Verify the utilization of the $111 million proceeds from the April 2007 Forward Sale Agreement settlement.