SHO

Business Context and Reporting Period

Company: Sunstone Hotel Investors, Inc. (Sunstone)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2008
Business Overview: Sunstone is a self-managed Real Estate Investment Trust (REIT) focused on acquiring, owning, and asset managing full-service hotels in the United States. As of December 31, 2008, the portfolio consisted of 43 hotels with 14,569 rooms located in 14 states and Washington, D.C. The portfolio is primarily composed of upper upscale and upscale properties operated under major brands including Marriott, Hyatt, Fairmont, Hilton, and Starwood. The company also holds a 38% equity interest in a joint venture owning the Doubletree Guest Suites Hotel Times Square.

Key Financial Metrics

Portfolio Performance (2008 vs 2007):
- Occupancy: 74.2% (decreased 250 basis points)
- Average Daily Rate (ADR): $160.99 (increased 1.1%)
- Revenue Per Available Room (RevPAR): $119.45 (decreased 2.2%)

Material Changes Versus Prior Period

• Revenue Stability: Total revenues increased slightly by 0.8% to $969.2 million, driven by a 0.4% increase in room revenue and an 8.1% increase in other operating revenue (partially due to a $3.5 million performance guaranty from Fairmont). Food and beverage revenue declined 0.2%.
• Profitability Decline: Net income decreased 40.5% to $74.7 million. Income available to common stockholders dropped 47.9% to $53.9 million. This decline was primarily due to a 27.0% decrease in income from continuing operations and a 50.3% decrease in income from discontinued operations.
• Discontinued Operations: The company sold two hotels in 2008 (Hyatt Regency Century Plaza and Crowne Plaza Grand Rapids). While the Century Plaza sale generated a $42.1 million gain, the Grand Rapids sale resulted in a $16.1 million loss. Income from discontinued operations fell significantly compared to 2007, which included gains from seven hotel sales.
• Impairment Charges: The company recorded $2.9 million in goodwill and other impairment losses in 2008, primarily a $2.8 million write-off of goodwill associated with the Marriott Napa Valley hotel. No such charges were recorded in 2007.
• Liquidity Improvement: Unrestricted cash increased by $112.9 million to $179.0 million, reflecting a strategic shift to capital preservation during the economic downturn. The company repaid all outstanding balances on its credit facility.
• Capital Expenditures: Renovations and additions totaled $94.7 million in 2008, down from $135.2 million in 2007.

Guidance, Outlook, and Risks

Management Outlook:
Management anticipates that lodging demand will not improve and may weaken further in 2009 due to the U.S. recession and credit market disruptions. They expect demand to begin showing year-over-year increases in 2010 or 2011. The company intends to maintain higher-than-historical cash balances until the lodging cycle enters a new growth phase. No hotel acquisitions are expected in 2009; the focus remains on dispositions of non-core assets and capital preservation.

Financial Covenants:
The company warns that if economic trends continue to negatively affect hotel demand, it 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 these covenants could result in default dividends, restrictions on common stock dividends, or the election of a director by the Series C holder.

Key Risks:
- Economic Environment: The U.S. recession and global economic slowdown have adversely affected demand for hotel rooms. - Debt Markets: Volatility and liquidity disruptions in debt markets may limit the ability to refinance debt or sell assets. - California Concentration: 17 of the 43 hotels (31% of 2008 revenues) are located in California, exposing the company to regional economic downturns and natural disasters. - Refinancing Risk: Approximately $329.2 million of debt matures over the next three years ($81.0 million in 2010 and $248.2 million in 2011).

Important Facts for Investor Verification

• Covenant Compliance: Verify the company's ability to meet financial covenants under the credit facility and Series C preferred stock given the projected decline in 2009 demand.
• Debt Maturities: Confirm the refinancing strategy for the $329.2 million of debt maturing in 2010 and 2011, particularly given the tight credit markets.
• Performance Guaranty: Note that the company utilized $3.5 million of a $6.0 million performance guaranty from Fairmont in 2008 and expects to utilize the remaining $2.5 million in 2009.
• Dividend Policy: The company declared a $0.75 per share dividend for Q4 2008, payable in cash and stock. Investors should monitor the cash portion of future dividends given the liquidity preservation strategy.
• Impairment Testing: Review the methodology for goodwill impairment testing, as the company recorded a $2.8 million charge in 2008 and noted that market capitalization is below book value.