SHO

Business Context and Reporting Period

Company: Sunstone Hotel Investors, Inc. (Sunstone)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2010
Business Overview: Sunstone is a self-managed Real Estate Investment Trust (REIT) that acquires, owns, and asset manages full-service hotels in the United States. As of December 31, 2010, the portfolio consisted of 31 hotels with 11,722 rooms located in 13 states and Washington, D.C. The portfolio is primarily composed of upper upscale and upscale properties operated under major brands including Marriott, Hilton, Hyatt, and Fairmont. The company leases its properties to a Taxable REIT Subsidiary (TRS), which contracts third-party managers to operate the hotels.

Key Financial Metrics

Operating Statistics (2010 vs. 2009):
- Occupancy: 69.6% (up 70 basis points)
- Average Daily Rate (ADR): $149.11 (up 1.4%)
- Revenue Per Available Room (RevPAR): $103.78 (up 2.4%)

Material Changes vs. Prior Period

• Portfolio Restructuring: The company completed a significant debt restructuring program initiated in 2009. In 2010, it deeded back 11 hotels to lenders (including the "Mass Mutual eight" hotels) or sold them via receivership, eliminating approximately $282.7 million of debt. Conversely, it acquired the Royal Palm Miami Beach (August 2010) and reacquired the Renaissance Westchester (June 2010).
• Discontinued Operations: Results for the 11 hotels disposed of or deeded back were classified as discontinued operations. This classification resulted in a significant gain on extinguishment of debt ($86.2 million) included in discontinued operations, which drove the net income turnaround from a $269.6 million loss in 2009 to a $38.5 million profit in 2010.
• Continuing Operations Performance: Excluding discontinued operations, the company reported a loss from continuing operations of $38.2 million in 2010, compared to a loss of $43.2 million in 2009. Operating income from continuing operations improved significantly to $32.0 million in 2010 from $5.3 million in 2009, driven by improved RevPAR and lower impairment charges ($1.9 million in 2010 vs. $30.9 million in 2009).
• Capital Structure: The company issued 19.5 million shares of common stock in November 2010, raising approximately $190.6 million in net proceeds. It also entered into a new $150.0 million senior corporate credit facility.

Guidance, Outlook, and Risks

Outlook and Strategy: Management believes the lodging cycle has entered a recovery phase. The company intends to deploy a portion of its cash balance in 2011 toward selective hotel acquisitions and capital investments. The strategy emphasizes acquiring upper upscale hotels in key gateway markets and optimizing portfolio performance through proactive asset management.

Key Risks and Contingencies:

• Debt Maturities: Approximately $98.3 million of debt matures over the next four years (excluding amortization). The company expects to refinance the $270.0 million mortgage on the Doubletree Guest Suites Times Square (matured Jan 2012) during 2011.
• Franchise Termination Fees: Five of the hotels deeded back to Mass Mutual remain subject to franchise agreements with corporate guarantees. If terminated, the company could be liable for up to $19.6 million in termination fees.
• Series C Preferred Stock Covenants: The company is subject to financial covenants on its Series C preferred stock. Failure to meet these ratios for four consecutive quarters could restrict common stock dividends and increase preferred dividends.
• Market Conditions: Risks include volatility in debt and equity markets, potential increases in capital costs, and the impact of general economic conditions on lodging demand.

Investor Verification Checklist

• Discontinued Operations Impact: Verify the extent to which the 2010 net income is driven by the $86.2 million gain on extinguishment of debt in discontinued operations versus core operating performance.
• Refinancing Risk: Confirm the company's ability to refinance the $270.0 million Doubletree Guest Suites Times Square debt maturing in January 2012, as this represents a significant near-term liquidity requirement.
• Contingent Liabilities: Assess the likelihood and potential financial impact of the $19.6 million franchise termination fees associated with the deeded-back Mass Mutual hotels.
• Capital Deployment: Monitor the execution of the acquisition strategy in 2011, specifically the use of the $190.6 million raised in the November 2010 equity offering.
• Series C Covenants: Review future quarterly reports to ensure compliance with Series C preferred stock financial covenants to avoid dividend restrictions.