Service Properties Trust Q4 FY2021 Earnings Call

Good morning. Welcome to Service Properties Trust's Fourth Quarter 2021 Financial Results Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note today's event is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Director of Investor Relations, Kristin Brown. Please go ahead.

Thank you and 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 the 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'd 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 security laws. These forward-looking statements are based on SVC's present beliefs and expectations as of today, February 25th, 2022. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in 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 EBITDA reconciliations of these non-GAAP financial measures 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 on file with the SEC and in our supplemental operating and financial data found on our website at www.spt.com. Investors are cautioned not to place undue reliance upon any forward-looking statements.

Thank you, Kristin, and good morning. Last night, we reported fourth quarter normalized FFO of $0.17 per share and adjusted EBITDA of $119 million, representing an 83% increase from the prior-year quarter, reflecting a generally improving hotel portfolio, as well as steady performance from our net lease service-oriented retail properties. Demand across the portfolio continues to be stronger on weekends versus weekdays due to strength in leisure demand and warmer climates. Spiking COVID cases driven by the Omicron variant resulted in canceled room nights in late December and impacted January most acutely. Certain conferences opted to go virtual, dampening the return of business transient demand in what is already a seasonally weak month. For example, a decision to move the January JP Morgan Healthcare Conference virtual wiped out $3 million of revenue at the Clift hotel in San Francisco. With COVID cases subsiding, related mandates being lifted, and more employees returning to office work, we believe that the lodging recovery resumed in February and expect further improvement as business travel rebuilds, leisure demand remains elevated, and extended stay occupancies remain stable. We expect that the trajectory of recovery will accelerate as we move through 2022, particularly as urban markets and CBD office buildings reopen. Historically, SVC's 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 important to seeing that level of business demand resume. Half of room nights were booked through OTA channels among select properties this quarter due to lagging business transient demand. We believe 70% of the margin weakness at Sonesta select hotels reflects business travel-related revenue weakness rather than cost pressure. For the fourth quarter, SVC's comparable RevPAR was 72% of 2019 levels, an improvement from 69% of 2019 levels in the third quarter and ahead of our expectation to achieve between 63% and 65% of 2019 fourth-quarter RevPAR levels. Our extended stay hotels continue to maintain strong occupancy premiums relative to the industry, and compared to our non-extended stay hotels. Our 159 extended stay hotels reported occupancies of 65.9% during the quarter, compared with occupancies of 48.6% and 46.6% respectively, for our 51 full service hotels and 93 select service hotels. Extended stay RevPAR is also the closest service level to 2019 levels at 83% of the 2019 quarter, with each of our extended stay brands achieving occupancies above 90% of 2019 levels. On the expense side, labor continues to pose a challenge for the industry in our portfolio. Wage increases and the use of expensive contract labor have negatively impacted results. At Sonesta this quarter, wage-related costs were approximately 8% higher than Q3 due to wage increases to attract and retain employees, the use of contract labor, retention bonuses for employees at sale hotels, and overtime due to open positions. On a cost per occupied room basis, wages and benefits increased 7.5% year-over-year for the fourth quarter. Wage inflation was partially offset by increased productivity and labor savings due to open positions and adaptive brand standards. Effective January 1, we amended our management agreements with Sonesta. We had previously announced we would sell 68 hotels; two of them have been sold to date, with the remainder to be sold over the next few months. The 194 retained Sonesta hotels are included in a master management agreement with a 15-year term and 5-year renewal options. This amended agreement sets our annual owner's priority return for the retained hotels at $325.2 million, a 30% reduction from the owner's priority return amounts for hotels that were transferred from other operators. We have also agreed to invest approximately $600 million of expected revenue-enhancing renovations over the next three years to upgrade the portfolio to meet brand standards. For the sale hotels, the term was extended to the earlier of December 31, 2022, or until the hotels are sold. SVC's owner's priority return will be reduced by the current owner's priority return for these assets, already $2.7 million once the remaining 66 hotels are sold. The sale process has rolled out well, with over 70% retaining long-term Sonesta branding, agreeing to PIPs, and in some cases, agreeing to additional future franchises. These sales are strategic for improving the overall quality of our hotel portfolio and an important step to improve our liquidity. Todd will discuss the sales process in more detail. SVC transitioned 206 hotels to Sonesta over the past five quarters under very challenging industry conditions. But we believe the transition disruption is behind us, and as Sonesta's brand awareness is growing. Additionally, Sonesta is realizing the benefits of its scale, including savings from renegotiated contracts that have reduced pricing on key products and services at our hotels. With business demand still anemic versus pre-pandemic levels, OTA usage was elevated this quarter, which drove higher commission expenses. Although Sonesta OTA commission rates have decreased approximately 25% over the past year as a result of its increased scale, reliance on these more costly channels is still elevated. Targeted promotions and the expected rollout of a new mobile app should increase direct bookings and reduce reliance on the higher-cost OTA channels. As hotel industry fundamentals continue to improve, we expect Sonesta will deliver solid results on both the top and bottom line. Sonesta has rolled out several new revenue initiatives and is seeing good traction with corporate negotiated room nights at Sonesta Select hotels. They have also further adjusted labor standards and enhanced their scheduling tools to maximize labor efficiency. On the group business front, 2022 is pacing well ahead of 2021 despite the Omicron effects in January, though the pace remains behind 2019 levels. Group rates have generally recovered to or slightly above 2019 levels. As a 34% shareholder, we are encouraged by Sonesta's continued progress following a period of major growth and disruption. To give market participants a chance to get to know the Sonesta brand and highlight its recent evolution, we will be hosting an Investor Day with the Sonesta and SVC management teams for analysts and institutional investors at the end of March in Chicago. The day will include a tour of some of SVC's Chicago hotel assets managed by Sonesta, and the presentation portion will also be webcast. Please reach out to Investor Relations for more details if you are interested in attending. Turning to our net lease assets, this portfolio is continuing to provide a stable base of cash flow. As you may have seen, our largest net lease tenant, TravelCenters of America, reported strong earnings earlier this week as its transformation plan continues to produce financial and operating improvements. As an 8% shareholder, we are beneficiaries of this significantly improved performance. Our other net lease tenants also continued to perform well with a 100% rent collection rate for the fourth quarter. Overall, we remain encouraged by declining COVID cases, the end of related restrictions in many markets, and an increasingly positive outlook for a return to normalcy. With the recent performance of our hotel operators and net lease tenants, as well as the progress on our initiatives to reduce leverage and improve liquidity, which Brian will discuss in more detail, we believe SVC is well-positioned to benefit as the lodging sector recovers from this historic downturn. With that, I'll turn the call over to Todd to discuss hotel dispositions of the recent transaction activity and our net lease portfolio in more detail.

Thanks, John. The Sonesta brand hotel sales and portfolio optimization initiative continues to be a primary focus of management, and we continue to make progress on the previously announced sales of 68 Sonesta branded hotels. We have closed on two hotels for $28 million, one during Q4 2021 and one during Q1 2022. We are under purchase and sale agreement to sell 45 hotels for $402 million and are under letter of intent for some additional 19 hotels for $132 million. There are two hotels for which we have not yet selected a buyer. Aggregate pricing for the hotels remains in line with expectations we discussed on our third quarter earnings call, and we expect to close the majority of these sales over the balance of Q1 and early Q2. We expect aggregate sale proceeds for the 66 hotels either sold or under agreement to total approximately $560 million, or around $66,000 per key. Approximately 72% of the sale hotels are expected to be sold encumbered by long-term Sonesta branding, maintaining Sonesta's distribution and assisting in jump-starting franchising efforts for the Sonesta brands, as well as providing SVC with an additional future revenue stream through its pro rata ownership in Sonesta and the royalties that we will receive from these franchisees. An additional 13% of the sale hotels are expected to be sold under short-term franchise agreements, while the buyers are exploring multi-family alternatives, which could potentially convert to more permanent branding arrangements if the buyers determine hotel logic is the highest and best use. The balance of the sale hotels will be re-branded or converted to an alternate use. We believe the timing of these sales has been favorable given the excess demand from buyers targeting hotels relative to the supply being offered. While most of the hotels will retain the Sonesta brand, the hotels that are being sold unencumbered of long-term franchising agreements are being sold at prices that command a premium compared to offers received to keep domestic Sonesta branded hotels. We believe our overall execution strategy on these sales will provide the maximum long-term benefit to SVC. In terms of other transaction activity during the fourth quarter, we sold six net lease properties, totaling 52,600 rentable square feet for an aggregate sales price of $9.1 million. For the full year 2021, we sold seven hotels and 11 net lease properties for total proceeds of $52 million. In addition to the hotel sales previously discussed, we are under agreement to sell one property for $4.1 million, which we expect to close in the second quarter. As of December 31, 2021, we owned 788 net lease service-oriented retail properties, including our travel centers, with 13.5 million square feet requiring annual minimum rents of $370 million, representing 42.5% of our overall portfolio based on investment. Our net lease assets were 98.1% leased by 174 tenants with a weighted average lease term of 10.2 years and operating under 134 brands in 21 distinct industries at year-end. The aggregate coverage of our net lease portfolio minimum rents was 2.58 times on a trailing 12-month basis as of December 31, 2021, and we collected all rents due from our net lease tenants during the fourth quarter, including all deferred amounts due. As of December 31, 2021, $7.6 million of deferred rents remain outstanding with seven tenants, who represent approximately 2% of our annualized rental income from our net lease portfolio, including TA. We also reduced our reserves for uncollectable rents by $600,000 this quarter, compared to reducing our rental income by $4.5 million for reserves for uncollectable rents recorded in the prior year quarter. In 2022, we have only 384 thousand square feet of leases expiring, representing less than 1% of our overall net lease rents. I'll now turn the call over to Brian.

Thanks, Todd. Starting with our consolidated financial results for the fourth quarter of 2021, normalized FFO was $27.9 million or $0.17 per share, a $50.4 million increase over the prior-year quarter, and a sequential decrease of $15.8 million over the third quarter of 2021. Adjusted EBITDA was $119 million for the fourth quarter, a $54 million increase over the prior year quarter, and an $18.3 million or 13.3% sequential decrease over the last quarter. The major drivers impacting normalized FFO this quarter included the results from our hotel portfolio, which generated $28.4 million of hotel EBITDA for the fourth quarter of 2021, compared to a negative $26.1 million of hotel EBITDA in the prior year quarter. Guaranteed payments that supported our hotel returns under our historical agreements declined $13.4 million, negatively impacting year-over-year comparisons. Rental income from our leased properties for the fourth quarter of 2021 increased $8.6 million over the prior-year quarter, primarily as a result of a $4.3 million increase in annual percentage rents recognized under our leases with TA and a $4 million decline in reserves for uncollectable rents. Interest expenses increased $9.7 million over the prior year quarter as a result of our senior notes issuance in November 2020 and our revolver draw in January 2021. G&A expense decreased $445,000, or 3% in the current year quarter, primarily as a result of lower legal and other professional service costs, largely offset by higher business management fees due to RMR, as a result of an increase in our market capitalization compared to the prior-year period. We account for our investments in Sonesta using 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 $397,000, an increase of $4.6 million or $0.03 per share over the prior year quarter. The net loss for the fourth quarter of 2021 includes a $76.5 million impairment charge as a result of reducing the carrying value of 35 hotels and 21 net lease properties to their estimated fair value. Given our current expectations on pricing compared to the book value of the other 32 hotels that are held for sale, we expect to record aggregate gains on the sale of real estate, largely offsetting these impairment charges when those hotels are sold in 2022. Our total proceeds on the 68 hotels are projected to approximate the unadjusted carrying values we disclosed last quarter, of approximately $579 million. We also recorded a $35.8 million charge this quarter related to our write-off of working capital advances we had funded in 2020 under our agreements with Marriott and IHG, and those amounts are no longer expected to be recoverable. Turning to our hotel portfolio results for our 298 comparable hotels this quarter, RevPAR increased 77%, gross operating profit margin percentage increased by 18.8 percentage points to 25.2%, and gross operating profit increased by approximately $65.8 million from the prior-year period. Although the GOP line costs at comparable hotels increased $5.4 million from the prior year, increased management fees driven by higher revenues at our hotels and an increase in insurance costs were partially offset by a decrease in real estate taxes. Our consolidated portfolio of 303 hotels generated hotel EBITDA of $28.4 million. Our 159 extended stay hotels continued to have the strongest performance, generating $24 million of hotel EBITDA. The 51 full service and 93 select service hotels generated $2.42 million respectively. Overall, RevPAR declined 10% to 10% sequentially to $62 this quarter due to normal seasonality, although Q4 RevPAR was above our expectations at approximately 72% of fourth quarter 2019 levels, an improvement compared to Q3, which was 70% of Q3 '19 levels. RevPAR for the month of December was 80% of December 2019 levels. January of 2022 was negatively impacted by the Omicron variant and an already seasonally weak period, and our hotels generated RevPAR of $48, which was 61% of January 2019 RevPAR levels. Overall, although we expect the first quarter of 2022 to be softer relative to Q4 '21, we are seeing signs of increased activity in February and expect to see similar lifts from leisure demand in March as we did last year. With more people returning to the office, mandate rollbacks, and markets reopening, we are optimistic business travel will begin to ramp up more meaningfully in the coming months. Regarding the 67 hotels to be sold in 2022, these hotels generated RevPAR of $46 for the full-year of 2021, compared to RevPAR of $58 for our 236 non-exit hotels. Hotel EBITDA for these 67 sale hotels was $3 million for the full-year of 2021, compared to $58 million for the non-exit hotels. Turning to investing activity during the fourth quarter, we made $30.4 million of capital improvements at our properties and $103.6 million for the full year 2021. We anticipate our capital spend for 2022 to be around $200 million, including $62 million we have committed to spend under our amended Hyatt and Radisson agreements for renovations, as well as to renovate a significant number of Sonesta hotels. As John mentioned, we expect to invest $600 million over three years in our Sonesta portfolio. Turning to the balance sheet, our upcoming debt maturities include $500 million of senior notes due in August, which we expect to redeem with cash on hand. Our $1 billion revolving credit facility matures in July of 2022, and we are currently in discussions with our lending group regarding extending the maturity date and additional covenant relief. As a reminder, our credit facility is fully collateralized and we are optimistic we will come to terms in the coming weeks. We currently have approximately $950 million of cash on our balance sheet and expect an additional $550 million from the hotel sales in the next few months. We believe between our expectations on extending the revolver and the enhancement to our liquidity, we will be well-positioned to support our operations as we hopefully turn the corner from the effects of the pandemic. Finally, regarding our common dividend, we expect to maintain the current quarterly distribution rate of $0.01 per share through late 2022. Operator, that concludes our prepared remarks. We are ready to open up the line for questions.

Thank you. We will now start the question-and-answer session. Please hold while we assemble our roster. The first question comes from Bryan Maher with B. Riley Securities.

Good morning. Am Bryan thanks for the comments on the capital stack and the expected maturities that hit some of my questions here. But once all is said and done, and it seems like you're well-positioned through 2022, where would you like the cash position to be once you've paid off the $500 million and taken care of the revolver? Holding a billion dollars in cash clearly is not ideal. Where should we think that level is three or four quarters from now?

Thank you for the question, Brian. Good morning. We expect to maintain our cash on hand through late 2022, with a significant change happening once we exit the penalty box related to our bond covenants. We are currently not meeting the 1.5 times incurrence tests, but we hope to overcome that by the end of the year. Once we achieve that, we will be able to incur debt and utilize the revolver as intended, and then we will consider reducing the cash on our balance sheet.

Okay. And as it relates to capex, the $600 million over three years, I know you said $200 million this year, but should we expect the other $400 million offset to be equally split amongst 2023 and 2024?

I think that's a good estimate for now. We're planning and strategizing the order of renovations for the hotels, and due to supply chain issues and other timing challenges, we might begin some of the renovations on Sonesta properties later this year. It's possible that the spending could be somewhat lower this year and slightly higher than $200 million in the next couple of years. However, for now, I believe the best estimate is that we'll distribute it evenly.

Great. And the recovery in extended stay and select service hotels has been pretty well documented, and you're seeing it in your portfolio. But maybe, John, could you give us a little color on how the urban full-service hotels are doing in some of your markets? And is there any notable highlights where you're seeing a faster recovery than you might have thought?

That's a good question, Brian. We've seen some positive trends in a few markets. St. Louis has recently gained good business from Wells Fargo, and their performance is improving. Our full-service hotels in resort and other southern markets are doing well. Properties like San Juan, Fort Lauderdale, and Miami Airport have performed exceptionally with both local corporate clients and by taking advantage of challenges in the airline industry and the impacts of COVID. These hotels are doing very well and have even boosted leisure business, especially during holidays, outperforming our expectations. On the other hand, we are still seeing weakness in cities like Washington DC and San Francisco. We anticipated a strong start to the year, but the cancellation of the JP Morgan Healthcare Conference led to significant revenue losses for the Clift Hotel, which was a key venue for the event. San Francisco continues to struggle, and Philadelphia is also showing some weakness. Overall, that's the current situation.

Once you're comfortable with results across the hotel segment, the sale of the hotels, full-service starts to recover and you start to get back to normal for lack of a better word, and when you start to move back into growth mode, whenever that might be, 2023, 2024, where across your three segments, hotels, I break it down. Hotels, net lease, and TravelCenters, do you think you might pursue the most growth?

That's a great question. I believe that TA has been actively franchising and acquiring assets for their own purposes, and I do not anticipate any significant activity between us and TA properties in 2022 or 2023. However, I expect a mix of retail and hotel acquisitions. Sonesta has been actively bidding on hotel properties and exploring potential franchise growth, and if they proceed with transactions, we may see capital calls to maintain our 34% interest, which could lead to growth in our ownership stake in Sonesta. Additionally, as we assess our portfolio, we recognize that markets like New York, Miami, and Los Angeles lack sufficient penetration, and we could benefit from increased resort exposure. This strategy has proven advantageous for some of our peers recently, particularly as revenge travel has surged. The impact of reopening international markets remains to be seen, but there is definitely a need for more resorts in our portfolio.

Just to follow up on your TA comment. I think at one time you guys had a low fall on any properties TA would look to acquire. Is that still in place? And are they putting properties to you to see if you want them first before buying them themselves?

That's correct. You have an excellent memory. There is a right of first offer. So when TA acquires properties, they are required first to show them to us. When they franchise properties, because we own the TA brand, there's some consents required before they can franchise, and there are some trade area protections that we have as well regarding how close new TA franchises might be located to our existing sites, a 75-mile radius. That sounds like a big distance, but it's not very much when you drive between TravelCenters. So anyway, yes, we do have those provisions in our leases, and our board regularly, just about every quarter, reviews that activity and makes decisions about it, our independent trustees.

Thanks, and last for me. I know you touched upon it, but I think I might have missed some of it. Can you give us a little bit more color on the labor issue, and how and when you see that starting to dissipate, hopefully some point this year or the next?

Yes. I mean, it's challenging. We see it. TA is probably doing a little bit better than our healthcare and hotel operating companies at attracting employees. TA is maybe down about 15% from its normal levels. Sonesta is about 20% of their normal positions unfilled. An active effort is being made to fill those positions and offer pay rates that are compelling so that employees stay for a long period of time, but the more less skilled the positions, the higher the turnover seems to be. Throughout this past year, Sonesta has run at about a 20% deficit in terms of open positions. They've tried to manage brand standards, such as how often they clean rooms and depending on the price point of the hotel and how you manage guest expectations. Some housekeeping and food and beverage employees have been working extra shifts and overtime. In some hotels, front-desk employees have been helping at peak hours to clean rooms, with sales staff covering the front desk. While it's great to see teamwork and everybody pulling together, it causes burnout and some job dissatisfaction as well. It's been a constant battle; the contract labor is very expensive. I think Sonesta is getting better at managing shifts to try to get the least amount of contract labor and overtime to ensure that they're getting all the rooms cleaned and that all the guests in the restaurant are attended to. It is a little speculative, but I believe that all of the operators are keenly focused on this and are doing a better job with each passing day. As business levels continue to grow and become more predictable, the effort on the labor front becomes easier. When you think everything is figured out, and you're on a good trajectory, and then a new variant comes out of the woodwork, then business drives up, and labor management really becomes problematic. However, we are confident that the worst is behind us, and that we will see less reliance on contract labor and less overtime, and that the wage increase issue will abate.

That's all from me.

Thank you. This concludes the question-and-answer session. Now I'll turn the call to John Murray for any closing comments.

Thank you everyone for joining us today, and we look forward to hopefully seeing some of you in Chicago at the end of the month. Thanks.

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