Hudson Pacific Properties, Inc. Q2 FY2024 Earnings Call

Hello, everyone. Thank you for joining Hudson Pacific Properties' Second Quarter 2024 Earnings Call. My name is Sierra, and I will be your moderator. All lines will be muted during the presentation, and there will be a chance for questions at the end. I will now pass the conference to our host, Laura Campbell, Executive Vice President of Investor Relations and Marketing. Please go ahead.

Good afternoon, everyone. Thanks for joining us. With me on the call today are Victor Coleman, CEO and Chairman; Mark Lammas, President; Harout Diramerian, CFO; and Art Suazo, EVP of Leasing. This afternoon, we filed our earnings release and supplemental on an 8-K with the SEC, and both are now available on our website. An audio webcast of this call will be available for replay on our website. Some of the information we'll share on the call today is forward-looking in nature. Please reference our earnings release and supplemental for statements regarding forward-looking information as well as the reconciliation of non-GAAP financial measures used on this call. Today, Victor will discuss industry and market trends as well as other highlights from the quarter. Mark will provide an update on our office and studio operations and development and Harout will review our financial results and 2024 outlook. Thereafter, we'll be happy to take your questions. Victor?

Thank you, Laura. Good afternoon, everyone, and welcome to our second quarter call. The results we reported this quarter were in line with our FFO outlook with our office portfolio performing better than our expectations. This quarter, our team's strong execution resulted in leasing over 0.5 million square feet. This is our highest leasing activity since the second quarter of 2022, and our year-to-date leasing was up 40% compared to last year. Two-thirds of those leases were new, the most since the first quarter of 2019. Even after another strong quarter of leasing, our pipeline of deals in leases, LOIs or proposals is healthy at 2 million square feet with an average requirement of above 15,000 square feet, up from about 9,000 square feet two years ago. All of this is a testament to our team's ability to attract and capture demand and successfully move leases through the pipeline to execution. And while still challenging, there's a gradual strengthening across our West Coast office markets almost uniformly; relative to the trailing four-quarter average, available sublease space is declining, development pipelines are diminished, tenant requirements are growing, crime is falling and transit ridership is improving. Nowhere is this more evident than in San Francisco. The city had its second-best leasing quarter in two years at 2 million square feet, with several submarkets experiencing positive or near-positive net absorption. There were 13 deals signed over 40,000 square feet, the highest number since the third quarter of 2021, and kudos to our team for signing two of the 10 largest deals. Tenant requirements continue to increase, reaching 6.8 million square feet this quarter, up 50% year-over-year to levels not seen since late 2019. Continued strong investment in AI is reigniting the San Francisco office market and spilling over into our other markets, especially Silicon Valley and to some extent, Seattle. With over 600,000 square feet of AI leases signed in San Francisco year-to-date and 740,000 square feet of AI tenants already in the market, 2024 is on pace to be another significant AI leasing year. Second quarter U.S. VC investment of $56 billion was the highest quarter in two years, driven by AI mega deals. Reportedly, investors are gaining confidence in the U.S. market's relative performance and getting more pressure from LPs to allocate nearly $300 billion of dry powder. The Bay Area, where we have obviously a significant presence, continues to receive the largest allocation of VC funds along with about 75% of all AI funding in the first half of the year. We're energized by this positive leasing momentum and by significant funding for businesses that are choosing to locate in our core markets. While we cannot control the timing on leases closing, we expect our office fundamentals will gradually strengthen further as we move ahead. As for our studios, last week, the Teamsters ratified their contract with the alliance of motion picture and television producers, finally clearing the way for production activity to begin to normalize. This favorable resolution follows an unprecedented 18 months of strikes and difficult negotiations, which delayed greenlighting and overshadowed typical seasonality. Presently, we estimate that there are only about 80 productions in Los Angeles compared to approximately 100 during much of the second quarter, as the potential for additional strikes weighed on demand in July. While we expect some level of increased production through the balance of the year, what levels remain unclear. Beyond the strikes, consolidation, cost-cutting, and shifting content mix are altering not just show counts but also production type, number of episodes, and budgets. All of these factors influence demand for our stages and services, both in Los Angeles and outside of Los Angeles. While we believe Los Angeles will remain the epicenter of entertainment, in recent years, the city has lost some of its substantial lead in global production; other locations have enhanced their infrastructure and implemented favorable state film tax credits and sector-specific incentives. While the strike exacerbated this trend from 2021 to 2022, growth in the Los Angeles region's total scripted production capture was up less than 1% compared to 4% in total scripted industry output. In 2022, Los Angeles lost nearly $1 billion of production spend due to projects leaving the state for tax credits. While we are working closely with Los Angeles' Mayor Bass, governing boards, and other elected officials and industry experts on this front, Mayor Bass is committed to ensuring the industry continues to thrive in the city of Los Angeles and has established a commission to strategize on incentives and related topics. All of these dynamics are very fluid. As a result, we currently lack the visibility to assess with reasonable certainty how and when our studio operations will normalize. But they will normalize, and we believe that by the fourth quarter, production should start to get better even as new content investment remains cautious and more globally distributed. Importantly, we do not require production to return anywhere near our 2021 peak levels for our studio businesses to create meaningful value. At a point of reference during the fourth quarter of 2022, when we began to experience the early impacts of the pending WGA and SAG AFTRA strikes, we estimate there were approximately 120 productions filling Los Angeles. During that same period, our in-service studios generated an annualized NOI of $37 million, and our TOD businesses generated an annualized NOI of $41 million. Finally, turning to our balance sheet. Further deleveraging remains our top priority. We have no debt maturities until the end of 2025 and while we have already seen improvements in some of our leverage metrics, which Harout will comment on shortly, we anticipate that increasing studio cash flow will further strengthen these organically. As part of our proactive multi-pronged approach to managing our leverage, we will continue to pursue opportunistic dispositions and have strong buyer interest in several assets. We expect to be able to execute successfully on these types of transactions just as we did last year. With that, I'm going to turn it over to Mark.

Thanks, Victor. This quarter we signed 540,000 square feet of new and renewal leases. On our first earnings call this year, we indicated our occupancy and lease percentages would likely dip in the first half with the potential to improve thereafter. The 30 basis point and 50 basis point declines in occupancy and lease percentages this quarter are consistent with those early indications. Our GAAP rents grew 2.6%, while our cash rents were down 13.3%. Excluding our 150,000 square foot, 21-year lease with the city of San Francisco at 1,455 Market, our GAAP and cash rents would have increased by 8% and 0.9%, respectively. Note that more than half of the square footage leased by the city was signed at the peak of the market at $80 plus rents, whereas the rent delta on the yet-to-be-leased space, most of which was signed in the mid-2010s, would be significantly less. The notable increases this quarter in both net effective rent to $57 per square foot and turnover in nine years were driven by mid- to large-sized renewal leases in the Bay Area, some signed at $100 plus square foot rents. We had roughly 1.4 million square feet of unique office tours again this quarter, up 20% from this time last year. Compared to first quarter, tour activity increased 60% in San Francisco and 14% in Seattle. Year-to-date at Washington 1,000, we have toured tenants representing in aggregate over 600,000 square feet, with mid- to large-sized demand. We also have planned tours for that project representing another 80,000 square feet to underscore, this represents only very early interest, but we are pursuing all prospects from the entire region with bigger interests. Washington 1,000 is among the best, if not the best, product in the Seattle CBD. On the hills, we've had another strong leasing quarter. As Victor mentioned, our over 2 million square foot pipeline is up 8% from last quarter and 5% compared to the second quarter last year. This includes 48% coverage, encompassing deals and discussions on our remaining 2024 expirations. On our top 10 vacancies, which collectively total about 2 million square feet, we have 47% coverage. This should allow us to begin to increase occupancy at assets like 1455 Market, 505 First, Page Mill Hill, 901 Market, and 83 King. To put a finer point on our upcoming office expirations, we have roughly 800,000 square feet expiring through year-end and 2 million square feet expiring in 2025. Over the last three years, we have leased 470,000 square feet per quarter on average. Assuming we continue to achieve only that and nothing more, over the next six quarters, we would have leased a total of 2.8 million square feet, exactly enough to address all remaining 2024 and 2025 expirations. Thereafter, our annual office expirations become substantially lower, including in comparison to the majority of office peers. If our pace of leasing continues or even modestly accelerates as market conditions improve, there is a clear path whereby we will not just preserve but achieve sustained growth in occupancy. Turning to studios. On a trailing 12-month basis, our in-service stages were 78.1% leased compared to 79.4% in the first quarter, which reflects an additional vacant stage at Sunset Las Palmas. Our Quixote stages were 32.8% leased, up from 29.8% last quarter due to increased stage occupancy at Quixote North Valley. We currently have signed leases and are on contract or have client interest in 38 of our 59 film and TV stages. In May, we held our grand opening event for clients at Sunset Glenoaks with major studio streamers and networks in attendance. Year-to-date, we have conducted over 20 unique tours at that asset, representing 11 active requirements, which resulted in three lease stages with four stages in negotiations. Transportation utilization increased approximately 300 basis points to 24% compared to the first quarter. We had more activity in the early half of the second quarter and have been gaining market share, even as activity declined, with production levels late in the quarter. This is a testament to what our sales team and unique integrated offering can accomplish as production normalizes. Our studio revenue grew 8% relative to the first quarter. This was due to $2.1 million of additional stage and studio ancillary revenue from higher occupancy at Quixote North Valley, more Netflix production at Sunset Gower, and initial occupancy and production at Sunset Glenoaks. It also includes $1 million of incremental services revenue from higher transportation and location services utilization. Finally, I'll note that construction at Sunset Pier 94 is on budget and on track for planned opening at the end of 2025. As Manhattan's first purpose-built studio, the project has garnered significant interest from high-profile studios and productions, and we are in discussions with multiple tenants for multi- and single-stage leases. And with that, I'll turn the call over to Harout.

Thanks, Mark. Our second quarter 2024 revenue was $218 million compared to $245.2 million in the second quarter last year, primarily due to asset sales and two move-outs, one at 1455 Market and one at Sunset Las Palmas Studios, partially offset by improved studio ancillary revenue from increased production activity at Sunset Gower. Our second quarter FFO, excluding specified items, was $24.5 million or $0.17 per diluted share compared to $34.5 million or $0.24 per diluted share in the second quarter last year. Specified items consisted of transaction-related income of $0.1 million or $0.00 per diluted share and a one-time derivative fair value adjustment of $1.3 million or $0.01 per diluted share. The year-over-year change in FFO is mostly due to the items affecting revenue along with less FFO allocated to non-controlling interest following our purchase of our partner's ownership interest in 1455 Market. Our second quarter AFFO was $24.2 million or $0.17 per diluted share compared to $31.1 million or $0.22 per diluted share in the second quarter last year, with the change largely attributable to the previously mentioned items affecting FFO, partially improved by reduced non-cash revenue adjustment and $4 million less in recurring CapEx spend. Our second quarter same-store cash NOI was $105.2 million compared to $119.3 million in the second quarter last year, mostly driven by previously mentioned tenant move-outs at 1455 Market and Sunset Las Palmas. At the end of the second quarter, we had $706 million of total liquidity comprised of $78 million of unrestricted cash, cash equivalents and $628 million of undrawn capacity on our unsecured revolving credit facility. There is also additional capacity of approximately $196 million specific to our Sunset Glenoaks and Sunset Pier 94 construction loans, our share of which represents $54 million. We continue to take proactive steps to reduce leverage and strengthen related metrics. Compared to a year ago, we improved our share of net debt relative to our share of undepreciated book value by 140 basis points to 37.3% and increased our percentage of debt fixed or capped by 690 basis points to 90.2%. Importantly, as Victor noted, we have no maturities until November 2025. One housekeeping matter before we discuss our outlook. With construction on Sunset Glenoaks complete as of the second quarter, we are now accounting for it as a consolidated property. Turning to our outlook. We are providing a third quarter FFO outlook of $0.08 to $0.12 per diluted share with no specified items. Our third quarter outlook assumes that our in-service studio and Quixote businesses' NOI is lower in the third quarter given the operating conditions are currently less favorable than the first half of the year, and it will take time following the recent ratification of the Teamsters agreement to greenlight and prepare for new productions. Our office leasing performance in the second quarter was ahead of our expectations. However, our third quarter outlook assumes lower average occupancy and NOI driven by lease expirations in the second and third quarters, even as we anticipate occupancy has the potential to be flat at the end of the third quarter. Regarding our full-year FFO assumptions, we are lowering the range of same-store property cash NOI growth to negative 12.5% to 13.5% due to the same-store studios specifically lower absorption at Sunset Las Palmas. A reminder that our same-store portfolio excludes our Quixote business and now consolidated Sunset Glenoaks Studio. As always, our outlook excludes the impact of any potential dispositions, acquisitions, financings, and our capital market activity. We will return to providing full-year FFO guidance outlook once we believe production levels have normalized to a point that we can more accurately anticipate and project future cash flows related to show-by-show lease studio and service assets, primarily at our Quixote business. Now we'll be happy to take questions.

Our first question today comes from Blaine Heck with Wells Fargo.

Victor, I was hoping you could comment maybe a little bit more on the asset sales that you had talked about last quarter and again a little bit this quarter. Maybe just how the reception has been, where you guys might be in that process? And maybe any color on potential pricing?

So the asset sales, we are still in active discussions and in beyond just conversations on at least a few assets. I don't want to get into details on numbers, and I don't want to get into details on the amounts, but we're confident that we're going to execute on our asset sales like we did last year.

Just to quickly follow up on that. Are these the same assets that you were targeting last quarter or has there been any change to kind of the composition of those potential sales?

Let me think about it. They are predominantly the same assets with the exception of one.

And then I had asked last quarter about whether there were any kind of strategic alternatives you guys might be exploring, and I thought you gave a very candid answer that essentially all options were still on the table. So I just wanted to follow-up there and maybe get any update to your thoughts on that subject and whether larger changes are still a consideration for you guys?

Well, as I said last time, listen, as a company, as the Chairman, as the Board of Directors always evaluates all potential opportunities, and we're going to determine whether they're viable. Obviously, they're going to be acutely discussed to look at what would maximize long-term value for our shareholders. There is nothing imminent at all that is currently in place today. But as I said, we're always evaluating and looking at alternatives.

Our next question today comes from Ronald Kamdem with Morgan Stanley.

Just two quick ones for me. Just one, is there a quick way to sort of bridge going from $0.17 to $0.10 quarter-to-quarter. Just what are the components of that? Just trying to figure out what pieces are driving that?

Sure. So the main drivers are lower same-store NOI at Quixote in our same-store studios. And that's related to a drop in activity at Gower and lower show counts in general. And then also lower office NOI related to the second and third quarter expirations, which results in lower average occupancy in the quarter. We still expect, however, that by the end of the third quarter, we could be in line with what we reported in the second quarter in occupancy.

And then we noticed that you disclosed 239,000 square feet of early terminations in the quarter. Just curious, what was that driven by? And were there sort of any one-timers in the office rent figures that we should be thinking about?

This is Art. There were really two major drivers. One was WeWork in totality for 112,000 square feet, and then there was a default for 40,000 square feet. And those are the big ones. The good news is that we already have a pipeline behind that or negotiations to backfill most of that space.

And to answer the second half of that question, we did not get any lease termination revenue from WeWork. So that's not in any of the numbers.

Our next question comes from Nick Yulico with Scotiabank.

I think earlier, Mark, you said something about the coverage on the expirations for this year. I thought you said 48%, I just want to make sure that was right. And then I don't know if you have a number you could share on 2025 expirations?

Yes. So you're right on the 48%. That's the coverage on the 800 or so we’ve flagged for this year on '25 and just look at it.

Yes. Currently, we have about 25% coverage for 2025. Our average tenant size is under 7,000 square feet. Many of these tenants are just starting to engage, so the coverage percentage can definitely increase from the current 48%.

And then I guess, turning to AI. You talked about that a bit earlier, what we've heard is that in many cases, these firms will want to have more prebuilt space or that they've taken sublease space because of that issue, they don't want to put much capital in. Can you just talk about maybe how you've situated your portfolio, whether it's spec suites or anything else that you think you could be competitive to create that tenant in the city of San Francisco versus the valley?

It's divided. On one side, there's AI with substantial growth, and on the other, there's the early-stage AI that we see in the Peninsula and the valley. I'll address the latter first. In the valley, our prebuilt space, which totals about 300,000 square feet, has been essential for us. This space is appealing to tenants because they can move in quickly without any hassle. As a result, we are performing well with those properties. In terms of larger spaces, we typically prebuild just one floor. For tenants seeking multiple floors, we haven't constructed them, and neither has anyone else, which is why they tend to prefer high-quality sublease options.

And I think you were able to just share just following up in terms of like the pipeline or some of the leasing activity you've done, what the composition has been of AI firms?

AI and tech, yes, I'll share with you. So as we mentioned in our prepared remarks, it's still a little bit more than 2 million square feet. It's grown quarter-over-quarter, chiefly 65% new to renew deals. Year-over-year, our tech as the composition of the pipeline has grown 15% to almost 40%. Right? So we're starting to see more tech in the pipeline. We're also seeing the size of the tenant grow. So the mid-sized tenant is carrying the day, between 20,000 to 60,000 square feet, and that's up actually 40% year-over-year. Of that, most of that is in the city. Most of the AI, as you've seen, is in the city for the larger users. We've seen it in the Valley, again, in really the startup realm. We've seen maybe three or four mid-sized AI deals in Seattle, but the preponderance of all of that is in San Francisco. And of the tech that I just mentioned to you, I would say that maybe 20% of that is AI. If we carry 40% tech, then 20% of that is AI.

Our next question comes from Caitlin Burrows with Goldman Sachs.

I was wondering if you could talk a little bit about office retention, what it's been this year, maybe how it compares to history, the expectation for the rest of the year. And then as you look forward into 2025, whether you have any insight yet one way or the other on any of the maybe larger lease expirations.

Sure. This is Art. Mark had mentioned that it's about 48% of the retention. We think we can get it better than that. Why? Because there's a lot of smaller tenants that still haven't engaged yet in the fourth quarter. So we can get that north of 50%. We feel we can get it north of 50%. That stacks up to the last, I would say, the last three or four years, for sure. But 25%, again, it's very early, and we have about 25% coverage on those expirations. So obviously, that number is going to grow.

And just to clarify, is the 48% retention figure related to the 48% coverage for the second half expirations? Are there two different statistics that both need to be at 48%?

Yes.

And then just on two different stats that happen to both be 48%.

No. He's just saying we have coverage on the 800,000 feet. That represents the ability to retain that expiration.

Maybe I'll follow up on that. Regarding the dividend, it is currently $0.05 per quarter. Can you share how that relates to your anticipated taxable income for the year and what factors might lead to any changes in the dividend moving forward?

Sure. It's a bit early to compare to taxable only because half of the year is left. Like we always evaluate the dividend every quarter. It's really the Board's decision when it comes to the status of our dividend.

Our next question comes from John Kim with BMO.

I still don't really understand guidance for the third quarter. You had it at $0.10 the midpoint, that's down 41% sequentially. Your original guidance provided six months ago implied $0.29 per quarter in the second to fourth quarter. And I understand the studio is down, but at its peak, the studio is only 11% of NOI. So I guess a lot of this is from occupancy, but the expirations were known a few months ago. So I just don't really understand how it could drop so much in one quarter, and I was wondering if there was anything that surprised you or anything incrementally new looking at the third quarter.

Our office performance has shown some improvement compared to our previous guidance and the full-year estimates we shared earlier. This is primarily due to the Quixote business and the same-store studio operations, which are not performing as we had anticipated for both the full year and the next quarter. This is what is driving the current situation. I understand your perspective regarding the percentage of the company you mentioned, which reflects a percentage of NOI, but it's important to note that this does not correspond directly to the percentage of FFO. FFO is also influenced by interest and G&A, which have seen larger fluctuations. So while it may seem significant when viewed as a percentage of NOI, it represents a larger figure when compared to FFO. Based on our understanding, we expect recoveries to improve significantly once studio activities ramp up and more shows are produced.

So same-store studio NOI was $7.6 million in the second quarter. Does that become a significantly negative number in the third quarter?

No. The $7.6 million refers to the in-service studio number. We anticipate that figure will decrease, similar to what we expect with Quixote.

Let me just maybe take just a somewhat different tack on it. Harout gave you the drivers of the difference between the $0.17 or 16% under Nareit definition and the $0.10 midpoint, right? That's half studio-related, half average office occupancy related. Hopefully, that's fairly clear. As it relates to your sort of the reach back to the earlier guidance and sort of trying to bridge, if you will, to that early number and the $0.10. I think what you have to appreciate is that the Quixote business, especially, is highly, highly leveraged to its fixed cost. And so if show counts and the other drivers that really drive that business markedly improve, you can generate a heck of a lot of incremental FFO off that. And if they don't improve, which for the time being at least, show counts are pretty stagnant, what you realize is that you're kind of bumping along not too far away from, say, where we reported NOI negative $3 million. As we sit today, our third quarter expectations is that it's going to take a little while for the show counts to meaningfully improve. So we just haven't been able to really get the real lift off in terms of the impact that Quixote has the potential to make on FFO.

Mark, you mentioned the fixed cost nature of Quixote. I just wanted to ask about same-store studio expenses being up 33% this quarter. I would have thought it would be a lower number than that.

The sequential impact is something Harout is examining. I apologize, I wasn't ready for that specific question.

Our next question comes from Alexander Goldfarb with Piper Sandler.

Just two questions: first, sort of piggybacking on John Kim's question on the earnings. It seems like the earnings this year obviously have come down pretty quickly just given the issues that you guys have been dealing with, especially on the studio front. When things right-size and occupancy for office improves, and studios rebound, should we think about the quarterly progression of earnings rebound to be as sharp and upward as it has been on the downside? Just trying to get a sense of how long it will take to get earnings back to where it was with expectations at the beginning of the year versus where we stand right now?

Yes, it could be very sharp. The previous remarks indicate that Quixote has the potential to generate significantly higher NOI than the negative $3 million noted in previous quarters. When you run the numbers, there's not much added cost involved in improving that NOI; it essentially flows directly to the bottom line. FFO could increase quite rapidly and significantly when that occurs.

Victor, regarding the asset sales you're considering, as you evaluate the portfolio, particularly where some assets might have underperformed recently, do you see a possibility of selectively divesting some of the weaker assets? This could lead to a Hudson that is more focused on top-tier assets, while allowing for the removal of the underperformers, or is that a challenging task?

So listen, on a general comment, as you will know, once the debt markets open up, the disposition market is going to increase. We have allocated our energy around two tiers, right? The assets that we don't think are long-term assets for the portfolio going forward, which will make the enterprise a much higher quality enterprise. Those assets are already identified. To some extent, they are in conversations, we've looked at them. There are a couple of assets that are in that bucket that clearly are not salable in this market, given where the debt markets are. The other alternative is for us to also look at where we get a much higher capital amount to the bottom line of the company. As a result, we would look at a couple of the maybe better assets in the portfolio. But the goal is exactly how you sort of stated it. We're looking at having a much higher quality portfolio with high-quality assets that are going to be performing. It's just taking us some time to get through that, but they've already been identified.

Our next question comes from Tom Catherwood with BTIG.

Maybe Mark and Harout, sorry to keep sticking with guidance here. But following up on John's question, if we do a quick back of the envelope on the guidance swing quarter-over-quarter, it implies studio performance could be pretty close to in line with the 4Q '23 numbers, which was the peak of the strike impact. Is that really what you're building into guidance for next quarter?

I don't think it's really that low. As I mentioned, I'm not sure if I provided estimates around the numbers. We anticipate a sequential decline, but I don't believe we expect it to be as low as in Q4 2023.

I don't think so either. If you look at Q4, Quixote had a negative NOI of $11.8 million. The most recent quarter shows a negative NOI of $3.9 million, with the show count remaining around 80, similar to July. We probably won't see significant improvement until maybe late September. We are not expecting to approach a negative $10 million or the negative $11.8 million from Quixote. Our assumption is that the Quixote business will stay more or less at its current level.

Maybe similar to Q1 for Quixote now.

And then Victor, following-up on your response to Blaine's question about the asset sales. You mentioned one more being added to the bucket. Just to clarify, was that one in addition to what had been expected before? Or did something fall out of the potential sales pool?

Something fell out of the sales pool, and this was a reverse inquiry by a user that we're in talks with. They are almost at the same valuation, though this one is slightly higher.

Then last one for me, just quickly, if I can. Art, in terms of the lease in our pipeline, specifically in Silicon Valley and the Peninsula, do you have a sense of how much of that is tenants relocating from properties within the market and submarkets versus tenants maybe relocating from other markets?

Generally, there, it's not relocating from other markets. Generally, it's growth, right? Because our bread and butter is kind of the 5,000-foot perhaps for startup, high-growth companies that we're banking on. And those are taking more space. Beyond that, it's space within the market. But we're seeing more and more of that growth users taking additional space.

Our next question comes from Michael Griffin with Citi.

Victor, I want to go back to your opening comments around how you don't think studio production needs to return to peak levels for it start contributing to your business. I was wondering if you could expand on this a bit. Does this mean that just the rate of change in the recovery is going to be beneficial? I recall when you initially did the Quixote deal, I think it was about $80 million of run rate EBITDA kind of initial expectations. Do you think that's still possible as the business recovers?

This is Mark. I'm going to try to tackle that. It really starts with LA show counts improving to levels consistent with periods less affected by either a pandemic or a strike, such as 2019 or 2022, the average of which is about 120 shows. Even if we assume that current production budgets, which are reflecting real cost-cutting measures, even if we assume those cost-cutting measures continue to limit the number of trailers and other production vehicles, let's say, seven vehicles per production and also we hinder our ability to push stage and service rates back to more historic norms. As long as LA show count simply reaches something like 115 or 120 shows, our Quixote stages should get to about 65% to 70% occupied, and our projected annual NOI for Quixote should reach between $45 million and $50 million. From there, any number of improvements have the potential to push NOI to $60 million and above $60 million. For example, if you get to 75% Quixote stage occupancy, that drives another $5 million NOI increase. If trailer and other vehicle counts go from the current seven or so vehicles to back to historic levels of eight million to eight and a half million, that drives another $7 million to $10 million of NOI. Of course, as market conditions tighten, with show counts improving, we could then look to potentially push rates and maybe we might be able to increase our market share a little bit. All of those would ultimately contribute to getting that NOI number not just to $60 million but somewhere well north of that.

And then maybe for Harout, just updated thoughts maybe around issues with potential covenants. I imagine that EBITDA is expected to decrease with the third quarter relative to the second quarter; I think you might be pushing up on a couple of covenants there. So any thought or updated around how we should think about that?

We always project our covenants in advance. This quarter, our actual results were better than our projections across all our covenants and outcomes. Despite our more cautious expectations for the future, we believe we will not breach any covenants, and I think the next quarter may be similar to this one. We feel quite confident, and our projections are reliable in terms of our expectations.

Our next question comes from Dylan Burzinski with Green Street.

Just wanted to go back to your comments around tenant demand or tenant requirements picking up in San Francisco. Can you kind of talk about some of the drivers of that? Obviously, I'm sure some of it is a pickup in activity from AI companies, but if you can sort of give any other details as to the other drivers of that? And then as sort of a parallel to that, a lot of the reason why market vacancies have continued to go higher in San Francisco is because those space givebacks by big tech. Can you kind of just talk about expectations for there to be a continuation of this, a change in this? Because as we sort of think about where big tech is investing their capital today, it's primarily in AI and data center infrastructure. And so just curious if you can give us any insight into any potential further space to go back on this segment of the market.

This is Art. Yes, AI has clearly been a significant factor in driving the market. Last year, it accounted for approximately 1.7 million square feet. We kicked off the first half of the year on a strong note with over 600,000 square feet in the active AI pipeline. The demand is still around 7%, but since then we are pushing close to another 1 million square feet. We are tracking similarly to last year. However, it's important to remember that while AI is currently a driving force, the tech sector is also returning to the market more significantly. Throughout the pandemic, professional services and law firms leasing space have been the mainstay for all markets, including San Francisco. This trend continues, albeit somewhat overshadowed by the focus on AI and the returning tech sector, as everyone is waiting with anticipation. Nonetheless, that sector is still growing, and while not at the same pace, it will help support the market. Regarding large tech companies giving back space, we observed a lot of givebacks initially, but this has recently become more measured. These companies are making strategic decisions regarding how they will manage their space utilization and givebacks. With some expirations approaching in the next 1.5 years, I believe they will address those situations then. We are seeing a more calculated approach to what this will mean moving forward. I think the demand we see in the market, when acted upon, will ultimately exceed any space givebacks.

Dylan, it's Victor also. I just want to give some macro highlights in the city. I know you guys are on top of this stuff. But we follow this very closely. When I made my prepared remarks about the reduction in crime, I mean, we're seeing that it's hitting its lowest mark in the last five years. We're seeing, obviously, activation centers, areas that are being capitalized for activation centers in the city that are going well. Barred exits have gone up almost 7%. San Francisco tent counts are down since 2018; they are at their lowest levels. There is a 41% reduction in tents, and the homeless business is down 13%. So these are all factors that are helping the macro basis for growth in San Francisco. I've always said when San Francisco turns, it will turn quicker than people think. I think that's what's driving some of this activity.

One more thing, Dylan, other than the obvious demand drivers stabilizing gross leasing and things like that. The number I'm looking at is net absorption, which was negative 290,000 square feet, which seems like normally a high number. It's been trending through the pandemic; it was trending to about $1.1 million. Right? So if you think about it, it's come down over the last few quarters, but it was trending at $1.1 million; it's now kind of moving back to a manageable number.

Could you provide an update on whether you're observing any discussions related to the state agencies' recent efforts to address homelessness with cabins in your leasing conversations? Additionally, given the current economic climate, it appears that the likelihood of a recession has increased compared to a few weeks ago. Are you hearing any related discussions from tenants?

I think it's too early to determine the impact of the recession, as this information has only emerged in the last month. The Governor's initiative to move the homeless into cabins has definitely impacted San Francisco, likely more than it has in Los Angeles. This is particularly relevant because there is an election in San Francisco, and Mayor London Breed will likely use this issue as part of her campaign, while Mayor Karen Bass does not face the same urgency, with more than two years remaining in her term.

Our next question comes from Peter Abramowitz with Jefferies.

Just wanted to go back to those comments about the ability to drive some meaningful value in the studio portfolio even if things don't get back to where they were before the strike. I guess, is there anything you can do or anything you're expecting to do on the expense side to kind of close some of the gap and get back to the NOI run rates you sort of underwrote when you did the Quixote deal, just to sort of close that gap because obviously, demand on the revenue side is not going to be quite where you were probably expecting it a couple of years ago.

Yes, there are some measures we can do and are doing. I mean, we did on the heels of the acquisition of Quixote, that involved the three companies in the fall of '22. We did implement a lot of efficiency measures, including two pretty sizable risks. We believe we've largely rightsized the headcount. There are other things we are looking into really at the operations level, looking at our footprint in terms of our various facilities, ways to save costs there on efficiencies on the manufacturing side in terms of our trailer manufacturing. We'll just continue to pursue those and try to make inroads on the cost side to try to help improve those margins.

And then you published an interesting chart. I think in your Nareit presentation that utilization, transportation utilization of the studio business has gone from about 10% during the back half of last year, up close to 30% by April. Apologies if I missed this upfront, you already covered it, but can you just provide an update on where that is as of July?

We previously noted that our utilization was at 24%. Considering we finished the quarter with 82 shows in LA, being at 24% utilization with that show count indicates significant potential. Back when show counts were in the low 100 range, we were at 30%. To clarify, we averaged 96 shows in the second quarter and only decreased to 80 towards the end of June. By the end of July, we were at about 80. Hopefully, we can start to improve from that point soon. If we're at 24% with 80 shows, reaching 30% could happen quickly, especially as our sales team enhances relationships and drives more sales on the trailer side. Achieving 30% seems feasible. Additionally, if show counts rise to levels like 115 or 120, we should see utilization exceed 50%.

Our next question comes from Rich Anderson with Wedbush Securities.

I was asked a question about the expense side, specifically the $25 million you incur each quarter, a significant portion of which is likely lease expense. Have you considered or looked into a rent restructuring for the leased studios in 2023, or is that not yet on the table?

What we have done is acknowledge that a significant portion of our costs is associated with leases. We are also exploring some consolidations related to transportation and storage lease costs, among others. We are actively discussing these aspects and have several leases that are set to expire within the next 24 to 36 months. We are developing a master plan around this, which will also aid in reducing overhead.

Is there any scenario where you could own some of those studios at some point down the road?

Yes.

And then for the last question, someone mentioned recession, and I had it on my list as well. Putting aside all the disruptions from strikes and other events, what impact does the recession have on the production business in general? Looking back in history, what typically occurs?

I mean historically, the entertainment industry has performed exceptionally well during recessionary times because it's providing a cheaper form of entertainment, clearly. Not to say that anyone wants a recession. But at the end of the day, it's always performed well, and that was sort of part of the prepared remarks, just saying even in a downturn, content will be produced.

Thank you all for your questions. There are no longer questions in the queue, so I will pass the conference back over to Victor Coleman for any closing or further remarks.

Thank you so much for participating in our second quarter call. We look forward to speaking to you all soon.

That will conclude today's conference call. Thank you all for your participation. You may now disconnect your lines.