Service Properties Trust Q1 FY2022 Earnings Call

Good morning. Welcome to Service Properties Trust First Quarter 2022 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. I now would like to turn the conference over to Kristin Brown, Director of Investor Relations. Please go ahead.

Good morning. Joining me on today's call are Todd Hargreaves, President and Chief Investment Officer, and Brian Donley, Treasurer and Chief Financial 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 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 security laws. These forward-looking statements are based on SVC's present beliefs and expectations as of today, May 5th, 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 EBITDAre. 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. Investors are cautioned not to place undue reliance upon any forward-looking statements. And with that, I'll turn the call over to you, Todd.

Thank you, Kristin, and good morning. Our first quarter results reflect sequential monthly improvement throughout the period as comparable RevPAR increased from 63% of 2019 levels in an Omicron-impacted month of January to 74% of 2019 in March, resulting in Q1 2022 RevPAR that was 69% of the same quarter in 2019. The improvement has continued into the second quarter with preliminary April RevPAR of $83 equal to approximately 82% of April 2019 levels. Room rates are beginning to approach 2019 figures with ADR improving from 83% of 2019 in January to 95% of 2019 in April. Notably, our full-service portfolio ADR has also returned to 95% of 2019 Q1 levels, highlighted by two of our best performers, Sonesta Hilton Head and Sonesta Miami Airport, achieving rates of 144% and 135%, respectively, of 2019 Q1 ADR, along with other leisure and urban hotels in markets such as Fort Lauderdale, San Juan, Scottsdale, and New Orleans; each outperforming Q1 2019 ADR by more than 110%. We have also seen considerable occupancy increases at some of our full-service urban hotels. The Royal Sonesta Toronto increased occupancy from 26% in January to 76% in April. And the Royal Sonesta Austin improved occupancy from 35% in January to 82% in April. The recovery of SVC suburban select-service and urban full-service hotels, which have historically generated approximately 75% to 80% of their revenues from business-related travel or meetings, continues to lag our airport reserve location, but that gap should continue to close as more workplaces reopen and employees return to the office. While compared to 2019, group pace of SVC's hotel operators is considerably above 2021 levels in both room nights and revenues, specifically Sonesta, with pace increases of 37 to 38 comparable full-service hotels. Sonesta is beginning to realize the benefits of its larger scale and increased national footprint to compete for more corporate business. While there are key markets that Sonesta will need to further penetrate to maximize its reach, notably Miami and Los Angeles, they recently established a major presence in one of the top international hotel markets through the acquisition of four hotels totaling 918 keys in Manhattan. As part of the acquisition, Sonesta also purchased the intellectual property of a well-known lifestyle brand, James Hotels, which it intends to scale across the Sonesta national portfolio, leveraging the brand's extensive industry-wide recognition. We have also implemented multiple portfolio-wide initiatives to support performance, including utilizing our increased scale to renegotiate agreements with our OTA business partners. Deployment of a new website and mobile app is underway to improve brand.com contribution and revenue strategies to capture incremental non-room income across the portfolio. As it relates to our ongoing plan to sell 68 Sonesta-branded hotels, we have closed on 22 hotels for $238 million, and we're under purchase and sale agreements for 42 hotels for an aggregate price of $301 million. We continue to market the hotels for sale, one of which is under letter of intent. Pricing for the hotels remains in line with expectations we discussed in our fourth-quarter earnings call, and we expect to close most of these sales over the balance of the second quarter. While our initial timelines have unexpectedly moved back as we work through negotiation, diligence, and closing coordination with over 20 different buyers, our goal with these dispositions is to maximize value for SVC, which we believe we will accomplish with sales to this buyer mix of smaller portfolios. There's also worth noting that the impact of volatility in the debt markets has not had a material impact on our sales process or the prices we expect to achieve. Over 70% of the sale hotels are expected to be sold encumbered by long-term Sonesta branding, maintaining Sonesta's distribution, as well as benefiting SVC through our 34% ownership in Sonesta. The balance of the sale hotels has or will be re-branded or otherwise converted to alternate uses, such as workforce housing. As we've stated previously, this is an opportune time to be selling select-service and extended-stay hotels, given investor demand in the market. We're looking forward to optimizing the portfolio for the sale of many of our relatively underperformers so that we can focus on what we view as our core strategic Sonesta branding portfolio. SVC's non-exit hotels have a $36 ADR premium to the exit hotels, and a $20 RevPAR premium during the quarter and grew RevPAR by 80% over the previous year quarter versus 40% for the exits, highlighting the relative quality of performance of the retained hotels. As has been consistent throughout the pandemic, the weakness in the lodging sector has been counterbalanced by the stability of our diversified net lease assets. Our largest net lease tenant, TravelCenters of America, reported another strong quarter earlier this week. Our holdings of 8% of TA's equity provides additional benefits to SVC as TA continues to excel. Our other net lease tenants also continued to perform with strong collections and increased rent coverage. In 2022, we have 180,000 square feet of leases expiring, representing 1.9% of our overall net lease rents, excluding TA. This includes three tenants across multiple properties known to be vacating. We are evaluating both leasing and sale options for these assets. We sold two vacant properties for an aggregate sales price of $5.4 million in the first quarter. Subsequent to quarter-end, we've sold four net lease properties for an aggregate sales price of $3.5 million and are under agreement to sell an additional five properties for $3.8 million, which we expect to close in the second quarter. In closing, we remain encouraged by the accelerated wind-down of many COVID-related restrictions, and an increasingly positive outlook for a return to normalcy. With the improving trends in business travel and the solid performance of our net lease portfolio, as well as the progress we've made on our initiatives to reduce leverage through asset sales and improve liquidity, which Brian will discuss in a moment. We believe SVC is well-positioned to benefit as the lodging sector rebounds with a higher-quality, optimized hospitality portfolio. We're also looking forward to introducing the Sonesta brand and leadership team to market participants, and highlighting Sonesta's recent evolution as one of the largest hotel brand and management companies in the country at the rescheduled SVC Investor Day later this month in Chicago. Today will include a tour of four SVC hotels managed by Sonesta, as well as the presentation from the SVC and Sonesta management teams. The presentation portion will be webcast. Please reach out to Investor Relations for more details if you are interested in attending in person. I'll now turn the call over to Brian to discuss our financial results in more detail.

Thanks, Todd and good morning. Starting with our consolidated financial results for the first quarter of 2022, normalized FFO was negative $3.4 million or $0.02 per share, a $38.6 million increase over the prior-year quarter. Adjusted EBITDAre was $90.1 million for the first quarter, a $41.4 million increase over the prior-year quarter. Although the first quarter is typically a seasonally weak quarter for our hotel portfolio and was compounded by the effect of the pandemic at the start of the year, these results exceeded our expectations from where we were projecting in February. Demand accelerated in late February and has continued through today. The major drivers impacting normalized FFO over the prior-year quarter include the results from our hotel portfolio, which generated $5.2 million in hotel EBITDA for the first quarter of 2022 compared to losses of $38.2 million in the prior-year quarter. Guaranteed payments that supported our hotel returns under our historical agreements declined $10.4 million, negatively impacting year-over-year comparisons. Net operating income from our leased properties for the first quarter of 2022 increased $5.3 million over the prior-year quarter, primarily as a result of a decrease in reserves for uncollectable rents for certain tenants. Interest expense increased $3 million over the prior-year quarter as a result of our revolver draw in January 2021. G&A expense decreased $675,000 or 5% to $12 million in the current year quarter, primarily as a result of lower legal and other professional service costs and lower business management fees due to RMR. We expect G&A to increase to approximately $13 million in the second quarter, largely driven by annual non-cash stock grants to our trustees. Lastly, our share of normalized FFO recognized from our 34% ownership interest in Sonesta increased by $1.8 million or $0.01 per share over the prior-year quarter. Turning to our hotel portfolio results. For our 295 comparable hotels this quarter, RevPAR increased 75%, gross operating profit margin percentage increased by 18.2 percentage points to 21%, and gross operating profit increased by approximately $56.8 million from the prior-year period. Below the GOP, line costs at our comparable hotels increased $12 million from the prior year with increased management fees driven by higher revenues at our hotels and an increase in insurance costs, partially offset by a decrease in real estate taxes. Our consolidated portfolio of 298 hotels generated hotel EBITDA of $5.2 million. Our 157 extended stay hotels continued to have the strongest performance, generating $10.4 million of hotel EBITDA during the quarter. Our 49 full service and 92 select service hotels generated losses of $1.5 million and $3.3 million respectively. Extended stay performance has benefited from strong occupancy premiums relative to the industry and compared to our non-extended stay hotels with occupancy of 64.6% during the first quarter, compared with occupancies of 46.3% and 44% respectively for our full service and select service hotels. Overall, RevPAR decreased 1.8% sequentially to $61.42 this quarter due to normal seasonality and the impact of Omicron during January, but improved on a monthly basis from $48 in January to $83 in April, or 82% of April 2019 levels. We currently expect this trend to continue and are projecting full-quarter Q2 RevPAR of $85 to $88, or around 82% of 2019 levels. Regarding the remaining 62 to 68 hotels to be sold as of quarter-end, 22 of which have closed in April and May to date. These hotels generated RevPAR of $45.08 in the first quarter compared to RevPAR of $64.51 for our 236 non-exit hotels. Hotel EBITDA for the 62 remaining sale hotels was negative $3.4 million in the first quarter compared to positive $9.1 million for the non-exit hotels. Despite the strong performance of hotels in leisure markets and in warmer climates, our hotels in certain urban markets experienced challenges that weighed on results this quarter. For example, our three full-service hotels in Chicago generated operating losses of $5 million in the quarter on RevPAR of $22. These three Chicago assets improved RevPAR to $59 in April, and we expect significant ramp up in the summer months. The Clift Hotel in San Francisco, another strategic asset for us, lost $1.6 million on RevPAR of $60 in the quarter. RevPAR more than doubled to $122 in April for this asset. Our full-service assets in Kauai and Irvine, California lost a combined $2 million in one as they were negatively impacted by renovation disruptions. Looking ahead to the second quarter, we currently expect the portfolio's hotel EBITDA margins to be in the 19% to 22% range versus just under 2% in the first quarter as we enter our seasonally stronger periods and demand continues to accelerate. Turning next to our net lease portfolio. As of March 31, 2022, we owned 786 service-oriented net lease retail properties, including our travel centers, with 13.5 million square feet, requiring annual minimum rents of $372 million. Representing 42.7% of our overall portfolio based on investment, our net lease assets were 97.6% leased by 174 tenants with a weighted average lease term of 10 years and operating under 133 brands in 21 distinct industries as of quarter-end. In addition to fixed minimum rents, over 90% of our net leased assets have some form of rent escalator to help mitigate against inflation. The aggregate coverage of our net lease portfolio's minimum rents was 2.67 times on a trailing 12-month basis as of March 31, 2022, an improvement from 2.58 times last quarter, led by our TravelCenter properties and tenants in industries that were deeply impacted by COVID, including movie theaters and fitness centers. Turning to the balance sheet. Last month, we successfully amended our revolving credit facility and extended the maturity date to January 2023. As part of the amendment, we reduced the size of the facility to $800 million, extended covenant relief through year-end, and agreed to minimum liquidity levels to address near-term debt maturities. The amendment also allows for up to $300 million of acquisition and increases the limits on amounts SVC can fund for certain equity investments. We have one six-month option remaining subject to meeting certain conditions that could extend the maturity date further to July 2023. Turning to investing activity during the first quarter, we made $28.9 million of capital improvements at our properties and anticipate our capital spend for the full year of 2022 to be approximately $200 million. Capex is being deployed to renovate our Hyatt Place portfolio, our full-service routes in hotel in Salt Lake City, a dozen limited-service Sonesta hotels, and to complete phase renovations at two full-service Sonesta hotels. Our maintenance capital is expected to be around $70 million of our total capital expense. In April 2022, we made a $25 million capital contribution to Sonesta to partially fund their acquisition of the portfolio of hotels in New York City Todd mentioned earlier. We expect to fund another $21 million later this year as part of this transaction. After our $200 million pay down of the revolver and receipt of additional sales proceeds after quarter-end today, we have over $900 million of cash on our balance sheet and expect another $300 million of sales proceeds by the end of June. Our next debt maturity is $500 million of senior notes due in August, which we expect to redeem with cash on hand. Under our debt agreements, the ratio of consolidated income available for debt service to debt service is required to be at least 1.5 times on a pro forma basis to incur additional debt. As of March 31, 2022, we remain below the minimum level at 1.32 times. We currently expect to exceed the minimum ratio as of the end of the third quarter of 2022. Finally, regarding our common dividend, we expect to maintain the current quarterly distribution rate of $0.01 per share through year-end 2022, as agreed to as part of our credit agreement amendments.

Yes. Thank you. As mentioned, we will now begin the question-and-answer session. If you're using a speakerphone, please pick up your handset before pressing the keys. At this time, we'll pause momentarily to assemble the roster. And the first question comes from Bryan Maher with B. Riley.

Good morning, Todd and Brian. Congratulations on your recent promotion, Todd. Can you discuss the expense aspects related to the hotels? What are your main concerns, and where is the most pressure coming from? I assume labor costs are significant, but could you also address taxes, utilities, and supply chain issues? Brian, you mentioned that margins were 2% in the first quarter and are expected to be between 19% and 22% in the second quarter. How sustainable are these increases? My concern is that we might see a decline after the typically strong second and third quarters. Could you provide some insights on that? Thank you.

Sure. Thanks Bryan, for the question. I'll start and then Bryan can weigh in. But you're right on the expense side. Labor is certainly one that we're tracking closely, and we're seeing wage increases across all positions: front office, housekeeping, servers. We saw about a $3 hourly rate increase year-over-year, and there's a lot higher increases in the hospitality industry relative to retail as well. Our operators are increasing their recruitment efforts. They are offering referral bonuses, looking at other things to retain employees, but there has been an impact. There has been more out-of-order rooms due to housekeeping shortages. There's certainly a reliance on more expensive contract labor as well, while unemployment overall is down. The workforce participation rate is also down, so we're continuing to see hotel workers leave for other industries. They're going to work for Amazon, Uber, or leaving the industry overall. But we're also seeing expense increases, like you pointed out, on the insurance side, as well as on the utility side. Real estate taxes were actually saving some money as we're going back and challenging some valuations. So we're seeing some decreases in real estate taxes. But overall, there's certainly inflationary pressures on a lot of the expenses. As far as your question on the margins, Bryan, I think what I mentioned, Q2 was a range of 19% to 22%. I would think in Q3, there's some incremental improvement there. And seasonally in Q4, there'd be some pullback, but nothing like we saw in Q1. I expect a more modest pullback as we go through the curve of the seasons.

Okay. Regarding Sonesta, we noticed their purchase of four hotels in New York City and the $25 million capital commitment you mentioned. Is the $21 million planned for later this year an additional contribution towards the purchase of those hotels, or will it be allocated for other capital expenditures needed at those properties?

Bryan, I'll take that one. That was more of a liquidity thing for SVC. SVC, Sonesta, and their other shareholder agreed, based on liquidity constraints at SVC, to defer our contribution until we get more of the sale proceeds behind us. So all in, SVC's 34% contribution would be the combined amounts.

Yeah. I'll just add in too. The 34% that is the equity portion of the deal and there are some renovations taking place at one of the hotels, but that will cover both the purchase price as well as any additional capex. So that should be it after the additional contribution.

Do they have to clear that with you first? I would suspect as being a 34% shareholder that you're going along with that?

Yes. We had to provide consent.

Okay. And then just kind of shifting gears to RevPAR. Now that you've converted the Sonesta, the IHG and Marriott properties to the Sonesta flag, there were some optimism that you could get RevPAR back up to a comparable Marriott and InterCon level. I don't think most of the buy-side that I speak to thought that that was realistic, but thought that kind of puts and takes of being Sonesta and more flexibility, slightly lower fees, etc., made it worthwhile. But now that you've had these for several quarters, what are your thoughts on the ability to push RevPAR and Sonesta, mainly the select service extended stay stuff closer to those bigger brands that they were before?

That's a great question, Bryan. We are closely monitoring this situation. It varies by brand, particularly with Sonesta Select, which is new for us. We're seeing significant improvements in market share related to rates and occupancy at some leisure and airport hotels. There's definitely more room for improvement on the select service side. Bryan and I are collaborating with our asset management team at Sonesta to establish measurable goals. We're already beginning to see progress. For instance, in December, the Sonesta Select reached 73% occupancy, and we targeted an 80% goal for the end of the quarter, which they almost achieved at 79%. We plan to keep tracking this closely as we recognize the need to catch up to market standards, especially for Sonesta Select. Additionally, there's a gap with the Royal Sonesta urban hotels, largely due to competition being skewed towards leisure hotels.

As for our service hotels have, at least on the revenue side, more full-service urban hotels. So I think as return to office and more business travel comes back relative to leisure, I think you'll see us close that gap. But the focus for us right now is on the selects, specifically. But we are performing cognizably on a lot of the other service levels. That answer your question, Bryan?

Yeah. Sorry, you guys had out there for a second. Last for me and maybe this is a fair question, but I am going to ask it anyway. Having covered the company for almost 25 years, you've evolved from hotels only to then TravelCenters to now net lease, and I get a lot of calls; would you ever part with your travel centers, which are easily probably worth $3.5 billion if you need to raise capital. Can you maybe prioritize how you think of the importance of hotels versus TravelCenters versus net lease? Again, it's kind of unfair because TAs and net lease performed very well during the pandemic relative to hotels, but hotels were how the company was formed. Maybe your answers, we love all of our children the same, but can you give us thoughts on the prioritization within the firm?

Sure, Bryan. I'll address that. As you mentioned, particularly during the pandemic, the cyclical nature of the lodging industry meant that our net lease, both for TravelCenters and others, has really supported us, especially recently. TravelCenters performed consistently well. We faced some challenges with our movie theaters and fitness centers, but those rebounded quickly. Regarding your question on prioritization, you may have asked before about the allocation of assets moving forward. We see hotels making up about 50% to 60% of the portfolio in the long term, which is about where we are now. It will depend on various factors. Currently, our main focus is on completing the asset sales and managing our liquidity, but ideally, we want to be in a position to pursue acquisitions again. The relative value of acquisitions will play a significant role in that. One of the advantages of our diversification is that sometimes it may make more sense to invest in hotels, while other times it may lean towards net lease. This gives us added flexibility, but in the long run, I believe we will maintain above that 50% threshold for the lodging segment, with the rest being net lease and TravelCenters.

Again, that's helpful. Maybe we can kick it around more at NaREIT, but thank you for your comments.

Thank you. And the next question comes from Dory Heston with Wells Fargo.

Thanks, good morning. When you think about your capex spend over the next few years of about $200 million annually, should we expect operating headwinds in the first year, kind of neutral in the second, and tailwinds by the third?

Yeah. I would say that we try to mitigate disruption on any renovation projects and a lot of these projects go through the planning phases during peak seasons and they're measured in phases by floor to limit disruptions. So I think it'll be spread out, Dory. It's a good question, and the exact timing is difficult to predict because a lot of these projects are taking longer to get off the ground based on just market factors, supply chain issues, and obviously rising costs as we might change scope, if prices continue to rise. But typically, capex is more weighted towards the back end of the year, given our seasonally weak periods, our Q4 and early Q1.

Okay. And is there any plan within that now that Sonesta owns the James brand to rebrand any of your city center hotels with that brand?

Yes, Sonesta is currently assessing the portfolio, and I believe some of our hotels in Chicago and Washington, DC, particularly the former Kimptons, could be a suitable match for that. This evaluation is ongoing.

And then after the $500 million notes mature mid-August, their pay downs, and I think you said in Q3 you should exceed your minimum covenant. Is that when you would expect to pay down the balance, or would you expect to hold onto the cash for some time longer?

That's a great question, and there's still some things to play out as far as the '23 notes that come due in June. That's one of the things tied neck and neck with the revolver and how we structured that last amendment. We have to make sure we have adequate liquidity to take out the June '23 notes. But our expectation is by the end of the year, we'll be able to commence with normal refinancing activities and take out either the revolver and both the revolver and the senior notes. So yes, we want to get back to being able to use the revolver as it's intended and not sit on cash. But I think late '22 or early '23 is the best guess for timing.

Okay. My last question is kind of back to Brian. It's about the margins. I think at prior peaks you were in the mid-20s range, maybe 25% margins. I understand what these asset sales are coming up; it should be slightly higher. When you compare that to your peers, whether it's collector full-service, they're materially lower, and I'm just trying to get a sense of the age of the hotels, location, management. What do you attribute most of those lower levels and what can you do to be, I guess, higher 20s, low 30s if possible?

That's something we are monitoring as well, especially on the operational side where improvements are being made relative to the market, particularly in terms of GOP margin. Our operators are focusing on expense management strategies. One advantage Sonesta has achieved through their increased scale, both on the managed and franchise sides, is successful renegotiation of the OTA commissions. They are also addressing the rising costs of food and commodities by exploring various ways to optimize their menu options and cut costs. There are cost reduction initiatives in place aimed at driving those margins up, but it's an important point and something we are keeping an eye on.

If you noticed that the Sonesta Select brand, it's a little under a year since that was launched, and we really want to be able to see business travel back and more for us before we can sort of form any conclusions, but we do expect the margins again; Q1, I think it's an anomaly and it will get closer to that 20% range as we roll through going forward.

Good, thank you.

Thank you. And this concludes the question-and-answer session. I'd like to turn the call over to Todd Hargreaves for any closing comments.

Great. Thank you everyone for joining, and we look forward to seeing many of you at our Investor Day later in Chicago this month.

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