Service Properties Trust Q4 FY2022 Earnings Call

Good morning, and welcome to the Service Properties Trust Fourth Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. I would now like to turn the conference over to Mr. Stephen Colbert, Director of Investor Relations. Please go ahead, sir.

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 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'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 securities laws. These forward-looking statements are based on SVC's present beliefs and expectations as of today, March 1, 2023. 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 as required by law. 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-K on file with the SEC and in our supplemental operating and financial data found on our website.

Thank you, Stephen, and good morning. Our fourth quarter results are highlighted by the ongoing improvement in our hotel portfolio, as comparable hotel RevPAR increased by 21.4% versus the prior year period, with ADR up 14.5% and occupancy increasing by 3.3 percentage points, leading to a 98.3% increase in comparable hotel EBITDA over the same period last year. The continued recovery of SVC's urban full-service and suburban select service hotels contributed to the improvement as travel maintained its pace of recovery, consistent with typical seasonality and business-related travel reflected more in-person engagements. Combined with the steady performance of our leisure and extended stay hotels, room rates again surpassed 2019 figures in the fourth quarter. Notably, our full-service portfolio RevPAR for the quarter increased by 31.1% from 2021 levels, largely driven through ADR increases in many of our leisure and urban hotels. Our hotels in Fort Lauderdale, Hilton Head, Chicago, Miami, and Kauai led the strong performance of our full-service segment, which achieved aggregate ADR of $174.48 during the quarter, 14.5% above 2021 fourth quarter levels. While the overall performance of our select service portfolio remains behind our other service levels, we are encouraged that Q4 RevPAR of our scaled-down post-disposition portfolio of 45 Sonesta Select branded hotels improved 25% versus the same quarter last year, outpacing any other SVC-focused service brand and 8.7 percentage points above total nationwide industry growth. In terms of segmentation, group mix was 16.6% in the fourth quarter, up from 12% during the previous-year quarter and above 2019 levels of 14.5%. This increase was broadly attributable to increased demand for corporate, association, and citywide group business, particularly in Philadelphia, New Orleans, and Houston. Revenues as a percentage of total room revenue for the more costly OTA channels decreased from 30.8% in Q4 2021 to 26.4% in Q4 2022. Inflationary pressures seen across the economy are continuing to impact hotel-level operating expenses related to utilities, insurance, and specifically labor. Our operators remain focused on reducing the reliance on more expensive, less efficient contract labor and increasing permanent staffing levels, measures which we expect will help to offset some of these labor cost pressures during 2023. Our largest hotel operator, Sonesta, continues to establish itself as a leader in the North American lodging sector, and we expect SVC to benefit as it increases its brand awareness with national corporations as well as business and leisure travelers. Sonesta recently launched a multimillion-dollar advertising campaign, and this loyalty program is gaining momentum with Travel Pass revenues as a percent of total revenue increasing from 13.6% in 2021 to 21.2% in 2022. Travel Pass ADR increased 22.1% year-over-year and room nights nearly doubled over the same time frame. As referenced earlier, looking at the bottom line, SVC's Q4 hotel EBITDA increased by 98.3% year-over-year, largely a result of the performance of some of SVC's premier destination hotels in what we view as some of our flagship lodging assets. Our Royal Sonestas in Kauai, Boston, Chicago Downtown, and New Orleans, all of which contributed heavily to SVC's year-over-year EBITDA improvement. Turning to our net lease portfolio, which represents 45% of SVC's portfolio by gross assets. As of December 31, 2022, we owned 765 service-oriented retail net lease properties, including our travel centers, with 13.4 million square feet. Our net lease assets were 98% leased by 180 tenants with a weighted average lease term of 9.6 years and operating under 138 brands in 21 distinct industries as of quarter end. The aggregate coverage of our net lease portfolio's minimum rents was 3.0 times on a trailing 12-month basis as of December 31, 2022, an increase versus the same period last year and an improvement from 2.88 times in the third quarter. For TA, our largest tenant, site level coverage on a trailing 12-month basis was 2.74 times, up from 2.4 times last quarter, and TA reported another extremely strong quarter last night. We have 271,000 square feet of leases expiring in 2023, representing only 0.6% of our net lease rents. This includes five tenants across multiple properties known to be vacating, representing $732,000 of annual revenue. We are evaluating various options for the known vacates, which include re-leasing, redevelopment, and marketing for sale. As announced last month, the acquisition of TA by BP, upon completion, will be extremely positive for SVC as the revised lease agreements we negotiated will not only provide $379.3 million in upfront funds but will also significantly enhance the credit quality of our core travel center tenant, providing long-term investment-grade cash flows with fixed increases that we expect will result in a meaningful increase to FFO from prior levels. Before turning it over to Brian, as we have now wrapped up the fourth quarter and moved on to 2023, I would like to take a minute to summarize some of the accomplishments SVC achieved during 2022 and the early part of 2023. We substantially completed the disposition of approximately 20% of our hotel portfolio in an extremely challenging market to sell properties at our targeted pricing, helping to reduce leverage and improving the overall quality of the portfolio in the process. We improved the overall performance of our hotel portfolio and returned to the necessary levels to regain compliance with our debt covenants earlier than originally anticipated. Overall, we repaid $1.5 billion of debt in 2022. We reinstated a meaningful dividend to shareholders. Our largest hotel operator, Sonesta, continued to establish itself as a leading hotel brand, expanding into New York through its acquisition of four hotels with over 900 keys. We successfully completed a secured financing, monetizing some of our net lease portfolio and retiring our June 2023 debt maturities. Finally, we recently came to an agreement regarding the amendment of our travel center leases in connection with BP's announced acquisition of TA, which, once completed, will provide an improved tenant credit profile and additional liquidity.

Thanks, Todd, and good morning. Starting with our consolidated financial results for the fourth quarter of 2022, normalized FFO was $73.3 million or $0.44 per share, a 162% increase over the prior-year quarter. Adjusted EBITDAre was $150.5 million for this quarter, a 26.5% increase over the prior-year quarter. The major drivers impacting normalized FFO over the prior-year quarter included: the improving performance of our hotel portfolio, which generated an additional $25.7 million of hotel EBITDA or a 90% increase over the prior-year quarter; a repayment of $500 million of senior notes in the second quarter and repaying the remaining balance on our revolving credit facility, which was fully drawn as of year-end 2021, resulted in a $14.6 million decline in interest expense. G&A expense declined $3.9 million over the prior year as a result of a $2.4 million decline in business management fees and a $1.5 million decrease in legal and other corporate expenses. Turning to the performance of our hotel portfolio. For our 236 comparable hotels this quarter, RevPAR increased 21.4%, gross operating profit margin percentage increased by 4.1 percentage points to 28.4%, and gross operating profit increased by $31.6 million from the prior-year period. Below the GOP line costs at our comparable hotels increased $4.4 million from the prior year as a result of increased management fees driven by higher revenues at our hotels and an increase in insurance costs. Our consolidated portfolio of 238 hotels generated hotel EBITDA of $54 million, resulting in a net margin of 15.4%. By service level, the increases were driven primarily by improvement in our 49 full-service hotels, which generated $26 million of hotel EBITDA during the quarter compared to just $2.7 million in the prior year quarter. Our 114 extended stay hotels remained steady, generating $21 million of hotel EBITDA during the quarter. Our 75 select service hotels improved, generating hotel EBITDA of $7 million in the fourth quarter, an increase of $3.7 million compared to the prior-year period. The fourth quarter results of our hotels were generally in line with our expectations as we entered seasonally weaker months for the portfolio. January 2023 RevPAR was $65.53 and, as we look to the rest of the first quarter, we're currently projecting full quarter Q1 RevPAR of $70 to $80 and hotel EBITDA projected to be in the $28 million to $35 million range. Turning to the balance sheet. Earlier this month, we successfully executed on a new five-year $610.2 million secured financing with a 5.6% coupon and have provided notice that we will redeem our $500 million of 4.5% senior notes that were originally scheduled to mature in June. Pro forma for these transactions, we have $5.8 billion of fixed-rate debt with a weighted average interest rate of 5.1%. Our next debt maturity is $350 million of senior notes maturing in March 2024. We currently have no amounts outstanding on our revolving credit facility, which matures in July of 2023. We have begun discussions with our lenders on a new credit agreement and currently expect the process to recast the line to be completed in the coming months. Turning to investing activity. During the fourth quarter, we sold four hotels for a total price of $25.8 million and two net lease properties for $2.3 million. We have sold eight hotels since year-end for proceeds of $53.3 million, and we are currently under agreement to sell 10 additional hotels for a combined sales price of $103.1 million, which we expect to close by the end of the first quarter. We made $36.8 million of capital improvements at our properties during the fourth quarter, and we currently expect full-year 2023 capital expenditures of $200 million to $250 million. Regarding our recent TA announcement, our leases with TA currently require a fixed minimum rent of $243 million over the life of the leases and require a percentage rent on non-fuel revenues, which totaled $10.6 million in 2022. Rents under the amended 10-year term will be set at $254 million with 2% fixed rent increases annually. BP will prepay $188 million of rent and will receive credits of $25 million per year against rents due. In addition to the rent growth we have secured as part of this deal, the transaction will provide SVC $379.3 million of additional liquidity upon closing, including $101.9 million for the TA common shares SVC owns, $89.4 million for the sale of the TA brands to be paid and the $188 million of prepaid rents. We expect the transaction will increase the value of our largest portfolio, which represents 64.8% of our net lease segment and 29.3% of our overall portfolio. Our leases with TA will be backed by BP, which will provide a significant credit enhancement to our tenant base and give us additional financial flexibility going forward. That concludes our prepared remarks. We're ready to open the line for questions. Thank you.

Thank you. We will now begin the question-and-answer session. And the first question will come from Bryan Maher with B. Riley Securities. Please go ahead.

Thanks. Good morning, Todd and Brian. Just a couple for me. On the asset securitization that you just completed, can you share with us which types of assets you pledged on that? Was it hotels? Was it TAs? Was it net lease? How should we think about that? And going forward, if you use that same structure for your 2024s and your 2025s, do you tend to get a better rate on those depending upon which assets you pledge?

Thanks, Bryan, and good morning. So, as far as the assets pledged, it was a mix and cross-section of the entire net lease segment, excluding travel centers, and there were no hotels in that deal. It was all single-tenant net lease properties with a significant concentration of quick-service restaurants, fitness centers, auto change, oil repair shops, and that kind of thing. So, really a good cross-section of what we have in the portfolio. As far as going forward, our preference would still be to tap unsecured debt, but the ability to use securitization of the portfolio has been demonstrated and it's something we'll continue to compare and contrast based on market conditions and what we see in rates and spreads in the debt markets.

Okay. And in the past, I think maybe a year ago when you came off the first quarter, hotel margins, you provided a bit of an outlook for your expectations for the balance of 2022. Can you share with us what you're thinking about for hotel margins for 2023?

Yes. I mean, I think, in the prepared remarks, given the outlook for Q1, not for the full year, but we do expect improvement over 2022, and we'll see how the year plays out. But we still think we have room to make up based on the performance starting last year and the ramp-up that really didn't start until Q2 of last year. So, our focus is definitely on the bottom-line and improving margins. That's one of our primary goals this year is to continue to close the gap from where we were in '19 and get back to where we should be.

Thanks. And just two more for me. On the hotel dispositions, is that going to continue or are you starting to wind that down? And then, lastly, what are your usage thoughts for the $380 million you'll be getting in a few months?

Sure. Good morning, Bryan. I'll address the first part of your question. We are currently finalizing the dispositions. Out of the original 68 Sonesta branded hotels we began marketing for sale over a year ago, we've sold 67 and expect to close the final one later this month. Regarding the 68 Marriott branded hotels, we also anticipate wrapping those up this month. We are selling them to the same buyer group but have agreed to close in three phases. We completed the first seven last week and expect to close the next two phases this month. At the moment, we haven't identified any other hotels in the portfolio for sale, but we can consider that throughout 2023 as we evaluate our hotel portfolio and its performance overall. However, nothing is currently in the pipeline. Additionally, it's challenging to sell assets right now, so it may not be the ideal time. Nevertheless, it's an option for us in the future. Brian, would you like to...

Yes. As far as the proceeds and cash we received from the BP deal, it's something we'll continue to discuss with the Board in the coming months. Obviously, we have significant debt maturities coming next year. But whether or not we deploy early or look to invest in opportunistic type investments that could be accretive remains to be seen, but we'll let that play out over the course of the next few quarters.

Good morning. Thank you. First question, a follow-up on the guidance. If I'm doing my math right, it looks like 10% to 12% roughly net margin in terms of Q1, so did I do that math correctly? And just help us think about what margin in Q1 was like pre-pandemic kind of what you're expecting for operating expenses in Q1 in terms of growth year-over-year?

Hey, Tyler, good morning. Yes, your calculations are mostly accurate. We anticipated that January and early February would be weaker due to the seasonal trends in our portfolio, particularly affecting occupancy rather than rates. We expect the portfolio to pick up momentum rather quickly as we move into March and early spring, leading to improvements in the upcoming months. Regarding expense pressures, we are experiencing the same challenges as everyone else, particularly with rising costs in labor, utilities, and other operational areas. While our margins are currently trailing behind 2019 levels, we anticipate that this gap will close fairly soon as we progress into the middle of the year.

Okay. That's great. In terms of the Sonesta branded hotels, you gave some positive commentary, I thought, in the prepared remarks, but a little more perhaps in terms of brand awareness, RevPAR index, just kind of how Sonesta is doing in the marketplace vis-a-vis some of the other brands out there?

Sure. Good morning, Tyler. Thanks for the question. Yes, Sonesta is very focused on increasing brand awareness, which is critical. Looking back three or four years, Sonesta had only 60 hotels. Through the conversion of some of our owned hotels, the acquisition of the Red Lion franchise platform, the launch of the franchise platform for Sonesta branded hotels, and their acquisition of four hotels in New York, they have become one of the largest hotel brands in North America. It's crucial for them to enhance their brand visibility. In January, they launched a multimillion-dollar digital marketing campaign, and we expect to see results from that soon. We're also tracking other areas. There's a growing amount of business from sonesta.com, which reduces bookings from more expensive OTA channels. We've noticed an increase in Travel Pass usage and the revenue percentage from their loyalty program. We see positive outcomes, though there’s still room for growth. They are increasing the number of RFPs requested in RFP business, showing early results from their brand awareness efforts. Regarding competition, Sonesta has demonstrated the ability to compete well among various brands. The Royal Sonesta's Simply Suites, a relatively new brand in the mid-scale extended-stay market, is performing at 90% to 95% of 2019 RevPAR levels. We also see improvements in urban full-service hotels. Similar to previous quarters, the Sonesta Select brand, where they still have significant growth potential, remains a focus area. This is partly because business travel has not fully recovered, and Sonesta needs to enhance its market share in that segment. However, they have increased RevPAR by 25% year-over-year, showing improvement. While there is still progress to be made, we remain optimistic about this brand's potential.

Okay. Great. Last one for me. The CapEx guide, $200 million to $250 million is right in line with what we were looking for. Just remind us what's maintenance assumed in that number? And then, kind of what exactly is some of the spending going to be allocated to this year?

Sure. Yes. So, the maintenance number for our portfolio is roughly $65 million to $75 million for the year. A big part of the spend in '23 will be to renovate our Hyatt portfolio. It's something we had originally slated for 2022 based on cost inflations and scheduling and scoping changes to try to control cost inflation, we pushed it off to '23. So, we're going to do that string of hotels, one Radisson hotel and then about a dozen Sonestas across a couple of different other brand segments for next year.

Thanks. Good morning. Is there anything in the BP amendment that deals with incremental CapEx for that portfolio?

Hey, Dori, good morning. In the historical leases, TA had the option to request reimbursement from SVC for the capital expenditures at our sites in exchange for an 8.5% rent increase. However, that provision is no longer applicable under the amended agreements. BP has indicated that they plan to invest billions into these sites without expecting us to bear those costs or increase their lease liability. Thus, that feature is no longer included in the leases.

Okay. Sorry, just to be clear, so they're going to be paying for this, not you?

All CapEx at these travel centers will be funded by BP on their own balance sheet.

Okay. That's great. I believe you touched on the $65 million to $70 million maintenance CapEx. For the hotels, you'll be investing $200 million to $250 million each year over the next few years, mostly related to Sonesta. Within the Sonesta properties, how much of that do you consider to be defensive versus offensive during this three-year period? Also, what kind of returns do you anticipate for the more offensive investments? I want to ensure we account for the potential upside in our estimates.

Yes. I'd say, if you back off the $75 million, you're looking at $125 million to $150 million-ish of offensive capital. And we've said in prior commentary that we expect around an 8% return on those dollars.

Sure. Good morning, Dori. We are actively assessing several opportunities. Currently, we don't have any agreements in place, but we are closely examining selective assets. We’ve mentioned before that with our exposure to Sonesta in New York City, we aim to increase our presence in several other markets on the hotel side, particularly in Miami and Los Angeles where multiple opportunities are being considered. On the net lease side, we continue to evaluate several opportunities, primarily focusing on portfolio-level transactions. From a capital rate perspective, we have seen rates move higher in recent weeks. While there has been a slowdown in overall transaction activity, it doesn't indicate a lack of listings. However, we have noticed a decrease in the pace of completed deals. In the hotel sector, specific markets and certain property types continue to attract interest from both owners and lenders, but many transactions are stalled because sellers are not meeting their asking prices. Capital rates in the hotel sector have increased, and we observe similar trends in the net lease market. Some smaller, granular properties still appeal to all-cash buyers involved in the 1031 exchange, which have not seen as notable increases. Overall, we estimate that capital rates on the net lease side have risen by about 75 basis points, and we believe the same is true for the hotel sector. It’s a unique situation as there are opportunities available, so if the right one comes along, we might pursue a transaction.

Okay. Thank you.

Thank you, and thank you, everyone, for joining today's call. We appreciate your continued interest in SVC. Thank you.

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