Service Properties Trust Q3 FY2021 Earnings Call

Good day and welcome to the Service Properties Trust Third Quarter 2021 Financial Results Conference Call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Director of Investor Relations, Kristin Brown. Please, go ahead.

Thank you. Good morning. Joining me on today’s call are John Murray, President; Brian Donley, Chief Financial Officer; and Todd Hargreaves, Chief Investment Officer. Today’s call includes a presentation by management, followed by a question-and-answer session with analysts. Please note that the recording, retransmission, and transcription of today’s conference call is prohibited without the prior written consent of SVC. I would like to point out that today’s conference call contains Forward-Looking Statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on SVC’s present beliefs and expectations as of today, November 5, 2021. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made on today’s conference call, other than through filings with the Securities and Exchange Commission, or SEC. In addition, this call may contain non-GAAP financial measures, including normalized funds from operations, or normalized FFO and adjusted EBITDAre. Reconciliations of normalized FFO and adjusted EBITDAre to net income, as well as components to calculate AFFO are available in our supplemental package found in the Investor Relations section of the Company’s website. Actual results may differ materially from those projected in these forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-Q filed with the SEC and in our supplemental, operating, and financial data found on our website at www.svcreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statement. And with that, I will turn the call over to John.

Thank you, Kristin, and good morning. Last night we reported third quarter normalized FFO of $0.27 per share, and adjusted EBITDAre of $137.3 million, an increase of 16% from the second quarter and 33% from the prior year quarter. Our results reflect improving revenues in our hotel portfolio, driven by elevated leisure demand, coupled with slowly rebuilding business transient demand, as well as steady high rent collections at our net leased service-oriented retail properties. Our hotel EBITDA has been positive on a monthly basis since April and increased 71% versus the second quarter. We recorded our strongest month year-to-date in July, with the COVID Delta variant slowing momentum in late August and early September, dampening demand. The spike in COVID cases in various markets resulted in some canceled room nights and in some urban centers, delayed employee return to office timing. Despite these headwinds, our operating performance improved from the prior quarter. For our 283 comparable hotels, average occupancy increased 2.9 percentage points to 60.9%, average daily rate increased 12.5% to $111.18 and RevPAR increased 18.2% to $67.71 on a sequential basis from the second quarter. Comparable hotel RevPAR was 30% below 2019 levels for the third quarter and improved from 46% below 2019 levels in the second quarter. Our extended stay hotels continue to maintain strong occupancy premiums relative to the industry and compared to our non-extended stay hotels. Our 160 extended stay hotels reported occupancy of 75.3% during the quarter, compared with occupancies of 48.9% and 50.2% respectively, for our 93 select service and 51 full-service hotels. Our extended stay hotel RevPAR was 20% below 2019 levels in the third quarter and improved to only 13% below 2019 levels in September. We expect this gap to narrow further as Sonesta continues to manage the extended stay mix to shorter stays to grow rates. While demand across the portfolio continues to be stronger on weekends versus weekdays due to the strength and leisure demand, weekdays have shown a noticeable increase as we begin to see business travel slowly rebuilding. As new COVID cases begin to subside, recovery momentum picked up in September and continued through October. For the fourth quarter, we expect further progress towards recovery tempered by normal seasonality. As business travel gradually returns, leisure demand remains elevated, and extended stay occupancies remain stable. We also believe that the trajectory of recovery, while it may be choppy at times, will accelerate in 2022 as urban markets and CBD office buildings continue to reopen. Historically, SVC select service and urban full-service hotels have generated approximately 75% to 80% of their revenues from business-related travel or meetings. And we believe a more widespread return to in-office work is going to be important to seeing that level of business demand resumed. On the expense side, labor continues to pose a challenge for the lodging industry in our portfolio. Wage increases to attract and retain staff and the use of expensive contract labor have negatively impacted results. On a cost per occupied room basis, wages and benefits increased 2% year-over-year for Q3. Wage inflation was partially offset by increased productivity and labor savings due to open positions and adaptive brand standards. It has only been a couple of quarters since many of the Sonesta transitions occurred, and because business demand remains anemic versus pre-pandemic levels, OTA usage was elevated this quarter, which drove higher commission expenses. Partially offsetting these costs was reduced pricing on key products and contracts by Sonesta due to their increased portfolio size. In 2022, Sonesta OTA commission rates have also declined approximately 25%, reflecting semester brand-wide hotel count and transaction volumes. For the 208 hotels that were transitioned to Sonesta over the past 10 months, RevPAR increased almost 22% to $64.43 in the third quarter, compared with $52.90 in the second quarter. We believe the transition disruption is generally behind us and Sonesta’s brand awareness is growing. In addition to benefiting from recovery in hotel industry demand and increasing brand awareness, Sonesta is also realizing the benefits of its larger scale, including integrating systems to reduce IT expenses and cluster staffing in concentrated markets like Atlanta and Chicago to reduce labor costs. Additional benefits from increased scale should flow through 2022 as annual contracts currently being renegotiated go into effect next year. As hotel industry fundamentals continue to improve, we expect Sonesta to build solid results on both the top-line and bottom-line. SVC is well positioned to participate in any upside realized by the evolution of Sonesta as a major hotel brand management franchise company through its 34% ownership. Finally, as we announced earlier this week, we amended our management agreement with Radisson for nine hotels. Under the amended agreement, Radisson will continue to manage eight of the hotels for a 10-year term. The amended agreement sets out an annual minimum return of $7.2 million, and Radisson provided us with a new $22 million limited guarantee for 75% of the annual minimum returns due to us beginning in 2023. We have also agreed to fund approximately $12 million of renovations that are expected to be completed by the end of 2022. We transitioned the management and branding of one hotel in Minneapolis to a Royal Sonesta on November 1, 2021. Turning to our net lease assets, this portfolio continues to provide a stable base of cash flows, and we collected all the rents due from our net lease tenants during the third quarter as well as in October. As you may have seen, a large net lease tenant, Travel Centers of America reported strong earnings earlier this week, as its transformation plan continues to produce financial and operating improvement. This is positive news for TA as our largest tenant and also because we own approximately 8% of the shares. We have taken steps to preserve capital and solidify our liquidity, including maintaining a nominal dividend, deferring non-essential capital spending and working with our operators to control costs. We are also well into the sales process with respect to 68 Sonesta branded hotels, which we expect to sell in the first quarter of 2022. Todd will discuss this in more detail. Overall, we remain encouraged with the recent performance of our hotel operators and net lease as well as progress on our initiatives to reduce leverage and improve liquidity. We look forward to positioning SVC to benefit as the lodging sector recovers from this historic downturn. With that, I will turn it over to Todd to discuss planned disposition of the recent transaction activity in the net lease portfolio in further detail.

Thanks, John. We continue to make progress in our hotel disposition initiatives to raise capital and reposition SVC’s Sonesta portfolio through the sale of 68 hotels, which had a net carrying value of $579 million as of September 30, 2021 across the Sonesta, Sonesta ES Suites, Simply Suites, and Sonesta Select brands. We launched our formal marketing effort in August and have recently received first-round offers. We are pleased with the initial pricing and interest level received, and we believe the timing of the sale was favorable given the considerable amount of institutional capital seeking hotel investments, coupled with the low interest rate environment driving cap rates downward. Generally interested investors or groups plan to acquire the hotels and then enter into long-term franchise agreements with Sonesta, so we have also received offers from groups that intend to rebrand the hotels or convert them to alternate uses. We expect to select buyers to enter purchase and sale agreements in Q4 2021 and close in Q1 2022. Post-sale, we believe we will have improved the overall quality of the portfolio from a financial, physical, and market perspective. In terms of other transaction activity during the third quarter, we sold two net lease properties totaling 6,600 rentable square feet for an aggregate sale price of $700,000. In October 2021, we sold one additional net leased property with 7,000 rentable square feet for $915,000. We have also entered into agreements to sell four net lease properties totaling 14,600 square feet with an aggregate carrying value of $1.8 million, for an aggregate sales price of $2.3 million. We currently expect these sales to be completed by the end of the fourth quarter of 2021. As with previous quarters, our net lease sales of properties have become vacant or we expect them to become vacated, and we believe the likelihood of leases being re-signed is low. As of September 30, 2021, we owned 794 net lease service-oriented retail properties, including our travel centers with 13.6 million square feet requiring annual minimum rents of $370.9 million. Representing 42.5% of our overall portfolio based on investment, our net lease assets were 98.2% leased by 175 tenants with a weighted average lease term of 10.3 years and operating under 134 brands in 21 distinct industries at quarter end. The aggregate coverage of our net lease portfolio's minimum rents was 2.37 times on a trailing 12-month basis as of September 30, 2021. And we collected all the rents due from our net lease tenants during the third quarter, including all deferred amounts due. We entered into a rent deferral agreement with one net leased tenant for $2.9 million during the third quarter. As of September 30, 2021, $10.8 million of deferred rents remain outstanding with 15 tenants, who represent approximately 3% of our annualized rental income from our net lease portfolio including TA. We have reduced our reserves for uncollectible rents, providing a positive lift to our third quarter results of $5.4 million or $0.03 per share, based on our cash collections from certain tenants and our collectability assessment on rents owed to us. This compares to reducing our rental income by $2.4 million for reserves for uncollectible rent during the prior year quarter. I will now turn the call over to Brian.

Thanks, Todd. Starting with our consolidated financial results for the third quarter of 2021, normalized FFO was $43.8 million or $0.27 per share, a $21 million increase over the prior quarter, and a sequential increase of almost $18 million over the second quarter of 2021. Adjusted EBITDAre was $137.3 million for the third quarter, a $33.7 million increase over the prior year quarter, and an $18.7 million or 15.8% sequential increase over last quarter. The major drivers impacting normalized FFO this quarter included the results from our hotel portfolio, which generated $51.1 million of hotel EBITDA for the third quarter of 2021, compared to negative $6.3 million of hotel EBITDA in the prior year quarter. Guaranteed payments and security deposit utilization that supported our hotel returns under our historical agreements declined $13.5 million, negatively impacting year-over-year comparisons. Rental income from our leased properties for the third quarter of 2021 increased $1.9 million year-over-year, primarily as a result of reducing our reserves for uncollectible rents, partially offset by a decline in non-cash straight-line rent adjustments related to lease restructurings and the sale of certain net leased properties since July of 2020. Interest expense increased $11.9 million over the prior year quarter as a result of our Q4 2020 senior notes issuance and our revolver draw in January 2021. G&A expense increased $1.9 million in the current year quarter, primarily as a result of increased business management fees due to RMR, as a result of an increase in our market capitalization when compared to the prior target period. We account for our investment in Sonesta under the equity method of accounting and include our share of Sonesta’s results in our earnings. Our share of Sonesta’s normalized FFO recognized from our 34% ownership interest was $2.8 million, an increase of $5 million or $0.03 per share over the prior year quarter. Turning to our hotel portfolio results, for our 292 comparable hotels this quarter, RevPAR increased 63.7%, and gross operating profit margin percentage increased by 10.2 percentage points to 31.2%. The gross operating profit increased by approximately $56.6 million from the prior year period. Below the GOP line, costs at our comparable hotels increased $10.2 million from the prior year, primarily as a result of an increase in management fees driven by higher revenues at our hotels and increased insurance costs. Our consolidated portfolio of 304 hotels generated hotel EBITDA of $51.1 million, compared to operating losses of $6.3 million in the prior quarter. 160 extended stay hotels continued to have the strongest performance, generating $29.3 million of hotel EBITDA during the quarter. Our 51 full-service and 93 select service hotels generated $14.4 million and $7.4 million respectively. Overall, RevPAR increased 21% sequentially to $69 this quarter as a result of strong leisure demand and the continued ramp-up from rebranded 88 hotels in Q1. Q3 RevPAR was approximately 32% below third quarter 2019 levels, showing improvement compared to Q2, which was 46% below Q2 2019 levels. Preliminary October 2021 RevPAR was similar to September’s results of $69. We currently expect Q4 RevPAR to be approximately 35% to 37% below Q4 RevPAR, with the expected drop-off coming from the historically weak holiday season for our portfolio. Our overall corporate cash flow was positive before capital expenditures for the third quarter. Based on our current outlook and expectation for improved lodging activity and stable rent collections from our triple net lease portfolio, we continue to expect to be cash flow positive for the full year 2021 at the corporate level before capital expenditures. We made $19.8 million of capital improvements at our properties during the third quarter and $73.2 million year-to-date. We expect to fund $35 million in the fourth quarter of 2021 for a total of $108.2 million projected for the full year. Project deferrals and lead times of vendors, as well as the finalization of Sonesta’s new brand standards, impacted our pace of capital expenditure activity in 2021. We are committed to spending over $60 million under our amended Radisson agreements for renovations and expect to renovate a significant number of Sonesta hotels. We anticipate our capital spend for 2022 to be around $200 million, assuming lodging fundamentals continue to improve and supply chain challenges abate. We will provide more color on our expected capital spend on our fourth quarter earnings call as we firm up our 2022 budgeting. Regarding our common dividends, we expect to maintain the current quarterly distribution rate of $0.01 per share through mid-2022. The quarter end, we had approximately $912 million of cash on our balance sheet, and our next debt maturity is in the third quarter of 2022. Factoring in our planned hotel sales, we currently believe we have adequate liquidity through 2022, and we continue to assess and explore all of our options to ensure we are well positioned until the effects of the pandemic are behind us and lodging fundamentals recover.

That concludes our prepared remarks. We are ready to open up the line for questions.

Sure, good morning, thank you. A couple of quick questions for me. We noticed that the Sonesta Select hotels, the 63 had fairly weak occupancy down around 42%. I know that you are selling a chunk of those properties or with the disposition plan, how much of an impact are the assets being held for sale impacting RevPAR and occupancy across the portfolio? I’m assuming that those hotels that are being sold, management and the employees at those properties know they are being sold, is that correct?

Yes, that is correct, Brian. I think that the real issue is that there may be some impact on what you described, that there may be a negative impact on the hotels that are being marketed for sale. But I think really, the main impact for the select hotels is that they were designed from a location perspective to cater to business travelers. Many of them are in business park-type locations, where they are still getting business from leisure travel on weekends, from sports teams and other events. But they're not seeing sufficient business travel to get the occupancies up. We knew that would be an issue when we converted the hotels to Sonesta, and we have been working on initiatives to try to boost that occupancy. We were fortunate, I guess, to do the rebranding during the pandemic and put some systems in place to be ready to capture that business travel when it returns, but it really hasn’t come back in force yet. So I think that is really the reason why the Sonesta Select hotel’s occupancy levels are not where you might expect.

And we have noticed when we have been out on the road, some Sonesta have converted to the Sonesta brand, and still have some temporary signage up there. Is that because those assets are being held for sale, and you don’t really know if they are going to be Sonesta’s long-term, or is it because there is a delay in getting signage, permanent signage to put on those properties?

It is more of the latter, getting the signage delivered. Getting the signs manufactured and delivered has been a little bit more of an issue with supply chain concerns and worker shortages. In some markets, there have been elongated processes with local municipalities needing to get approvals for the new signs. There are a lot more restrictions today about blending in with the community, how bright the lights are, and there may be impacts due to local regulations, like restrictions for lighting in certain areas. So, we have seen a slowdown in certain locations.

Brian, I will add that you asked about the 68 hotels we are selling. Nineteen of those are Select. And those 19 hotels had a Q3 RevPAR of $40 compared to $48 for the total portfolio. So again, we are selling the lower performers.

Got it. And just one more for me, and then I will hop back into the queue. I think you mentioned at last quarterly call that, there is $579 million carrying costs on the 68 hotels for sale, and you felt pretty confident that you would be able to get nicely above that. Now that you have seen the first round offers, are you still comfortable with that statement?

Yes, Brian, it is Todd. I think based on the first round of offers we received—and just to clarify, we have received offers for the 65 select service and extended stay hotels that we are selling, as well as one full-service—we are still waiting on offers for the other two. But I would say generally, we would expect to get at or around that net carrying value in total.

Next question comes from Dori Kesten with Wells Fargo. Please go ahead.

Thanks, good morning. This is a little bit different way of asking Brian’s question. But can you walk through what RevPAR and EBITDA for key differences between the 68 hotels and the remainder of the portfolio, back on 2019 results?

For 2019? Yes. So for 2019, for the 68 hotels we are selling, we were at $74 RevPAR versus the hotels remaining portfolio, or just Sonesta versus $111, and EBITDA was, again, this is for the quarter, around $11 million for the 68 hotels. And then for the Sonesta excluding the exit hotels, we were at about $106 million.

Sorry, you said $11 million versus $106 million?

Right.

$31 million—what was the remainder on an annual basis?

The full-year number for the 68 was around $31 million in hotel EBITDA.

Okay. $31 million and the remainder is what on an annual basis?

I’m sorry. Say that again, Dori?

So, the 68 was $31 million, what was the remainder on an annual basis?

Yes. That was the whole portfolio of our 304 hotels, we were at $500 million in 2019. So this was a very small percentage of the overall portfolio.

Another way to look at it, Dori is—just normalizing things for the entire portfolio, the sale portfolio is about 10% of overall EBITDA and over 20% of the rooms and hotels.

Okay. And can you talk about the difference in the cost structure with the hotels now under Sonesta as a manager versus Marriott and InterContinental? Just trying to think through what the margin upside that may exist versus 2019 beyond just with the industry niche to be the type of hotel?

That is a good question, but the answer is it is still evolving. There are some fees that Marriott charged against our hotels that Sonesta doesn’t charge, primarily on an individual basis as sort of ankle biters, but together they amount to a couple of percent of revenue. The OTA charges due to Marriott's significant size and volume of transactions are around 13% to 14%. Sonesta’s are slightly above 20%. Contracts are in process of being executed that will reduce that to around 17%. So still not as low as the top three or four hotel companies, but a significant decline in those costs for Sonesta. Also, because of Sonesta's increased size from the transitions completed over the last nine months, and because of the Red Lion acquisition, they are renegotiating a lot of contracts for various services such as trash collection, supplies, etc. So the Sonesta cost structure is changing quite significantly, and it is not static. Hence, it is hard to compare. I think it is fair to say that due to Marriott's size and stability, their costs are a little lower on some contracts compared to Sonesta’s today.

Okay. Thank you.

Next question comes from Jim Sullivan with BTIG. Please go ahead.

Thank you. John, I’m curious, there was a comment made in the prepared remarks that offers were being received for the portfolio of assets for sale, both on an encumbered and unencumbered basis. This obviously, this sale will perhaps provide a good example for us, if we are aware of the difference that the encumbrances make in terms of the terminal cap rate. One of your peers on the call today, or their call this morning, talked about a 50 basis point difference if you are selling an asset on an unencumbered versus an encumbered basis. Obviously, in the case of service properties, you own a significant chunk of Sonesta. So you would be retaining the fees, or a share of them. So what if you could help us understand the calculus? Presumably selling it unencumbered, you would demand a higher price. But because you would lose your share of the fee revenue, there would be something to take into account. I wonder if we could help us understand the calculus as you think about it. If you are going to sell the assets encumbered, how much of a difference in the cap rate would you accept to kind of put you in the same position as selling them unencumbered at a lower cap rate?

Thanks, Jim, that is a good question. It is a complicated answer. Firstly, strategically, it is in our interest because of our ownership of Sonesta to continue to see Sonesta do well, and there has been a lot of news about their significant growth over the last year. So we have to be careful about how we do that. When we evaluate the offers that we receive on these hotels, we look at both the purchase price and our estimate of the royalty revenue that Sonesta would generate if they stayed encumbered, less a cost factor, and then our percentage ownership of Sonesta to estimate the value to SVC of keeping them encumbered. Additionally, Sonesta has been discussing possible transitions or new developments of hotels with a number of these potential buyers as part of this process, which we are also considering in our analysis. Some of the hotels, particularly certain extended-stay hotels, are being sold in an encumbered basis, and we are seeing higher pricing for these hotels compared to a traditional unencumbered sale. It is difficult for me to provide an exact percentage difference, but generally, if the hotels can be easily rebranded to a Hilton or Marriott brand, there is likely to be somewhere around a 50 to 75 basis point higher pricing difference between encumbered and unencumbered.

Okay. That is helpful. And secondly, back at the time a year ago when you were having your ultimately failed negotiations with Marriott, you commented that the Marriott strengths in terms of putting heads in beds was really with the business traveler due to their corporate rate arrangements and relationships. We are now at a point in time where the leisure traveler has come back strong, but the business travel hasn’t fully returned. However, we are hearing in this quarter, a lot of positive commentary about business transient returning, and the market getting excited about this January 4th date being a potential pivot point for next year for business travel. I just wondered, do you have a sense that, as that business traveler comes back, the Sonesta brands are not going to be able to keep pace in terms of the gains in the market versus the bigger established brand like Marriott, or do you think that you are growing in confidence that Sonesta can be competitive to achieve the same kind of growth?

I mean, I think we are confident that Sonesta is going to compete well. Companies like Marriott and Hilton and IHG are much bigger with much larger reward programs and they are great hotel companies. They will always be tough to compete against. But I think Sonesta is putting programs in place to attract business travelers. Their salespeople are aggressive, they get out, press the flesh, pound the pavement, and develop relationships, because that effort is crucial for a smaller hotel company to be competitive. Our experience—not in every case, but in a lot of cases—was that some salespeople in hotels managed by the bigger operators developed some complacency because their strong rewards program made them less likely to actively pursue sales. Sonesta does not enjoy that luxury; they must actively work to generate business. Hence, because of their extensive effort and focus, I believe they will be very competitive. We still have 16 hotels that Marriott manages for us, and they are not outperforming the Sonesta branded hotels that are similar, so we feel pretty good about how the Sonesta brands can stack up.

The next question is a follow-up from Bryan Maher with B. Riley. Please go ahead.

Thanks. John, can you give us an update on the franchising opportunity with Sonesta? I know that when you brought in Red Lion, the goal was the thought process was it would help ramp that process. Can you tell us where you are in that stage and when we might see that rollout in a meaningful way?

Just to clarify, we are not in that space, but that’s a fair question, because we do own a third of Sonesta. At the beginning of October, Sonesta filed their franchise disclosure documents for the Sonesta Simply Suites, Sonesta ES Suites, Sonesta Select, and Sonesta Hotels. The timing of that was opportune, it was right before the start of the Phoenix Lodging Conference. They were able to officially start selling franchises at that time, and simultaneously, we had launched the sale process for the 68 hotels. The initial feedback has been much stronger than we had expected. However, the rubber meets the road when Sonesta finalizes all their brand standards, both operationally and from a capital perspective, which is currently at a very advanced stage. I think Sonesta is in a good position. What we are hearing is that one of the big attractions to Sonesta as a franchise organization is SVC's 34% ownership. Most big hotel franchise companies today operate asset-light models, so their decisions are less complicated. In contrast, when Sonesta decides to raise brand standards, SVC is required to comply just like any franchisee. This has proven appealing to potential franchisees, lending a strong early momentum to the program.

And just lastly for me on the net lease portfolio, it seems like you have been selectively pruning some assets there. Is there a common denominator among what it is you are selling? Any thoughts, current thoughts on the movie theater component there with what has been going on in that industry?

Yes, Brian. So as you can see, they are mostly smaller assets and typically, our strategy there is if something is going to become vacant or is vacant and we don’t think we can re-lease it, we try to sell it. That is typically how we can optimize price in that space. So that is most of what we are selling; we haven’t been selling anything that we consider to be core. In terms of the movie theaters, when we first acquired this portfolio, we had indicated that we are unlikely to grow that sector. I think all of our theaters are now current on rent, and it is just not the right time to sell them. I don’t think you will see significant growth from that part of our net lease portfolio. A lot of our other sectors, like quick-service restaurants and others, are experiencing cap rate compression. In contrast, I think movie theaters and even fitness centers still exhibit wider caps. I don’t believe the timing for selling is optimal now, but you may see us sell those next year or the year after as the market recovers. The movie theater industry is coming back, and we are seeing that in our theaters as well. Again, they are all current on their rents. We still have some deferrals outstanding, but we have no major concerns today about our theaters.

Okay. Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to John Murray for any closing remarks.

Thank you everyone for joining us today, and we look forward to speaking with some of you at the Virtual NaREIT next week or maybe even our next teleconference.

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.