Service Properties Trust Q2 FY2023 Earnings Call

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 SEC. 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, August 8, 2023. 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 filings with the SEC, which can be accessed from our website. 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. 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 operating and financial data package which can be found on our website. With that, I'll turn the call over to Todd.

Thank you, Stephen, and good morning. SVC second quarter results reflect the continued improvement in our hotel portfolio as year-over-year comparable RevPAR gains outpaced the industry for the sixth consecutive quarter driven by increases in both ADR and occupancy. Portfolio RevPAR for our 219 comparable hotels increased 2.8% with ADR increasing 2.4% and occupancy increasing by 30 basis points. While leisure demand has softened in markets like Miami, Scottsdale, Fort Lauderdale, and Hilton Head, SVC's portfolio benefited due to our higher relative exposure to urban markets and reliance on business travel. We reported year-over-year RevPAR gains in our select service and full service portfolios of 3.8% and 3.6%, respectively, resulting from the recovery of urban markets, specifically on the East Coast and Midwest, and improving trends in business transient, group, and contract business. Revenues at our 48 comparable full-service hotels increased by $19.7 million from the previous year quarter with Sonesta posting a record quarter for ADR for our full-service hotels, driven by sizable year-over-year increases in group corporate negotiated and contract of 25%, 16%, and 11%, respectively. The largest increases in business travel were in Los Angeles, Boston, and Washington, D.C., and the increase in contract related business was largely driven by our hotels in Redondo Beach and Fort Lauderdale. The negative impacts from reduced leisure demand was mostly experienced in our hotels in Kauai, Hilton Head, New Orleans, and Florida. Our portfolio of 61 select service hotels reported revenues that were $3.1 million greater than the previous year quarter. The revenue gains were driven by group business, which was up 35% or $2.3 million. Excluding 4 properties under renovation, RevPAR for our portfolio of 40 Sonesta select hotels increased 7% year-over-year, while RevPAR in our portfolio of 17 Hyatt Place hotels increased 3.6%. Lastly, our portfolio of extended-stay hotels increased revenues by $1.6 million over the previous year quarter as both ADR and group revenues came in with the highest figure since the most recent brand conversions in 2021. Weekday occupancy, specifically at our Sonesta Select hotels, has lagged the balance of our portfolio, but we are now seeing the gap between weekday and weekend occupancy converge as leisure demand softens and business travel increases. In June, Sonesta's portfolio reached a new post-pandemic weekday occupancy high of 68.7%. The Sonesta is also seeing improvement in its loyalty program as TravelPass revenue as a percent of total revenue increased from 19.8% in Q2 2022 to 21.9% in 2023. On the expense side, we continue to see inflation headwinds and costs like insurance and waiver continue to pressure margins. For example, our annual insurance program was recently renewed, and our largest operator, Sonesta, expects to see premium increases of 60% or $6.8 million for the second half of 2023. On the labor front, contract labor expense per occupied room declined for a third consecutive quarter. However, we expect the use of contract labor will remain elevated given challenges in hiring full-time positions such as housekeepers, F&B attendants, and engineers. Turning to our net lease portfolio, which represents 45.4% of SVC's portfolio by investment as of June 30, 2023, our 763 service-oriented retail net lease properties were 96.1% occupied with a weighted average lease term of 9.3 years. Importantly, our largest tenant in the portfolio, TA, which represents 68% of our minimum rents, is now backed by an investment-grade rated subsidiary of BP. The aggregate coverage of our net lease portfolio's minimum rents was 2.94x on a trailing 12-month basis as of June 30, 2023, an increase versus the same period last year. Our near-term lease expirations are manageable, as we have 856,000 square feet of leases expiring in the remainder of 2023 and 2024, representing only 3% of aggregate annualized minimum rent, most of which we expect will renew. Regarding our movie theater exposure, annualized minimum rents from our AMC movie theater portfolio declined by $2.1 million from the previous year quarter related to AMC vacating 3 properties and converting to a percentage rent structure on 2 others and by $1.8 million due to the recent lease restructures in connection with Regal's bankruptcy. In June, we completed the acquisition of the Nautilus Hotel, an upper upscale hotel in a prime location in the heart of Miami South Beach, which upon renovation will be rebranded under Sonesta's lifestyle brand, The James. This hotel expands our resort destination offerings, provides an important entry into the South Beach market, and is representative of the type of hotel SVC may target as we take a disciplined approach to adding to the portfolio. Finally, before I turn it over to Brian, I want to emphasize the actions the company has taken over the last several quarters through refinancings, asset sales, and improved hotel performance to position SVC to address our upcoming debt maturities in 2024 and 2025. After the recent completion of our $650 million revolving credit facility and closing on the TA transaction, we now have over $1 billion of liquidity and have a large pool of valuable unencumbered assets, including all of our TA travel centers, which provides us access to a range of financing alternatives where we can be selective in securing the best relative execution from both a leverage and cost standpoint in these ever-fluctuating capital markets. I will now turn the call over to Brian to discuss our financial results in more detail.

Thank you, Todd, and good morning. Starting with our consolidated financial results for the second quarter of 2023. Normalized FFO was $95.1 million or $0.58 per share versus $0.54 per share in the prior year quarter, an increase of over 7%. Adjusted EBITDAre increased 1.9% year-over-year to $185.3 million. The increase in normalized FFO this quarter was driven by lower interest expense, increased rental income, and improved hotel results, partially offset by our provision for income taxes. The decline in interest expense is largely the result of repaying amounts outstanding on our revolving credit facility and senior notes that were maturing last year. Regarding our income tax provision, we recorded a tax benefit of $3.8 million in the first quarter of 2023. This quarter, we recorded a tax expense of $5.2 million or $0.03 per share. The swing sequentially is a result of the seasonal ramp-up of our hotel portfolio. We're projecting a full year tax expense of $1.5 million. Most of our tax provision relates to certain state income taxes as well as our foreign operations. Rental income increased by $2.7 million this quarter compared to the prior year, largely as a result of the TA transaction closing mid-quarter. We recognized $3.5 billion of percentage rent during the quarter under the legacy TA lease terms. As a reminder, the new lease structure is a 10-year term, it calls for fixed annual 2% increases with no percentage rent component. TA also prepaid $188 million of rent, and we will receive $25 million of rent credits annually in return. Annual cash rents for the first year of our TA leases is $254 million of fixed rent, less the $25 million prepayment credit. We will recognize $271 million of annualized rental income in our earnings over the 10-year lease term which reflects our recognition of the fixed rents, the 2% rent escalators and the effect of the prepaid grants on a straight-line basis in accordance with generally accepted accounting principles. The increase in rental income this quarter from TA was partially offset by an increase in reserve for uncollectible rents and the movie theater closures that Todd outlined. Turning to the performance of our hotel portfolio. For our 219 comparable hotels this quarter, RevPAR increased 2.8%, gross operating profit margin percentage declined by 128 basis points to 34.4%, and gross operating profit increased by $3.5 million from the prior year period. Below the GLP line costs at our comparable hotels decreased $3 million from the prior year, driven by successful tax abatements and lower insurance costs driven by deductibles expensed in the prior year period related to various insurance claims. Our hotel portfolio generated hotel EBITDA of $93.1 million, a 3.5% increase over the prior year. By service level, the increase was driven primarily by improvement in our 111 extended stay hotels which generated $28 million of hotel EBITDA during the quarter, an 11.6% increase over the prior year quarter. Our 61 select service hotels also improved, generating hotel EBITDA of $13.5 million in the second quarter, a 26.2% increase over the prior year period. Our 49 full-service hotels generated hotel EBITDA of $51.6 million, a 3.1% decline over the prior year period. Turning to our expectations for Q3, preliminary July 2023, RevPAR was $100.52, and we're currently projecting full quarter Q3 RevPAR of $91 to $97 and hotel EBITDA in the $76 million to $86 million range. Turning to the balance sheet. In June, we successfully executed on our new 4-year $650 million secured revolving credit facility. The facility is secured by 66 hotels and 3 net lease properties and bears interest at plus 250 basis points. We currently have $5.8 billion of fixed-rate debt outstanding with a weighted average interest rate of 5.75%. Our next debt maturity is $350 million of senior notes maturing in March 2024. We have over 600 unencumbered assets across both of our real estate segments, including all of our travel centers leased to TA that have a gross book value of over $7 billion. We believe this vast asset pool will provide us flexibility as we look to address our 2024 debt maturities in the coming quarters. Turning to investing activity. During the second quarter, we acquired the Nautilus Miami Beach for $165 million and sold 2 net lease properties for a total price of $620,000. As part of the TA transaction, we received $102 million from the value of the TA common shares we held and $89 million for the TA trading we sold to BP. We made $42.8 million of total capital improvements in our properties during the second quarter, and we expect capital expenditures of $140 million to $160 million over the remainder of 2023. We currently have over $1.1 billion of total liquidity, including $500 million of cash today. In July, we announced our regular quarterly common dividend of $0.20 per share, which we believe is well covered, representing a 45% normalized FFO annualized payout ratio on the trailing 12 months ended June 30, 2023. That concludes our prepared remarks. We're ready to open the line for questions.

Our first question will come from Bryan Maher with B. Riley Securities.

Maybe starting with a big picture question on leisure travel's softening and yours is not the first company I've heard of that. How much of that do you think is related to maybe revenge travel exhaustion post-COVID? And how much of it do you think might be related to maybe some consumer belt tightening or pushback versus the rates that the industry has been pushing?

Yes, we are definitely noticing a decline in leisure travel within our portfolio. The positive aspect is that we have a greater focus on urban hotels and those that cater to business travelers. However, our year-over-year RevPAR growth, particularly in full-service hotels, could have been even higher if not for the leisure-focused properties. This situation results from a variety of factors. The surge in travel we experienced in 2021 and 2022, often referred to as revenge travel, is part of it. Currently, consumers have less discretionary income for travel due to rising interest rates and increased expenses like car payments. Additionally, while most of our hotels are domestic, there appears to be a significant rise in outbound international travel, partly fueled by the strength of the dollar. With travel restrictions largely lifted, more people are choosing destinations in Europe and Asia rather than our locations in Hilton Head, Fort Lauderdale, New Orleans, or Scottsdale. Overall, the situation reflects a combination of revenge travel, budget constraints, and increased international travel.

Okay. And then shifting to your liquidity and your capital availability and the maturities. And I know you addressed this in your prepared comments. But when we think about your liquidity over $1 billion and then the recent purchase of the Nautilus for $165 million, and I think that there are a couple of air pockets maybe in some gateway or leisure markets where you might want to have a Nautilus type situation. How should we think about deploying some of that capital should we think about maybe another 1 or 2 of those type of assets, but not 4 or 5 in order to not want to stretch your liquidity position in front of next year, where is your head on that?

Sure. Yes, it's a good question and something we're certainly discussing here every day. We are looking at potential acquisitions, but we obviously have other uses of that cash, whether it's CapEx into the hotels or dealing with these debt maturities that are coming up in 2024 and 2025. The Nautilus was a very unique opportunity in a market where we thought we were underexposed in a critical gateway market for a hotel company of our size to have something in. But we looked very hard at 10 to 15 hotels in different areas of Miami, most in South Beach, but also Brickell, Coral Gables, and Coconut Grove. It's challenging to find an opportunity that worked for SVC, given our cost of capital and yield hurdles. The Nautilus was something we think we could get in there, do a renovation, reposition that hotel, and get an outsized yield, especially for that specific area of South Beach. But, frankly, we're not seeing a lot of opportunities like that. We didn't see a lot of other opportunities in South Beach. We're also looking, like we've talked about before, in Southern California and other destination-type markets. With the hotel recovery, we're not seeing many distressed sales. A lot of owners are looking at their portfolios and saying, we've made it through the worst of it; I don't want to sell something for $0.70 or $0.80 on the dollar. The financing markets are tough. So we're being very aggressive in looking at opportunities, but we're not finding a lot of things that make sense. We're not going to force it. Again, we have other needs for that capital. So back to your initial question, it’s certainly not going to be 4 or 5; it could very well be that the Nautilus is the only property acquisition SVC makes in 2023. So I think it's either 0 or 1 or 2 most likely.

Okay. And just last for me, on the net lease portfolio ex the TAs. Do you plan on doing continued selective pruning there? And specifically, as it relates to the movie theaters, I think you have 18 or so, a $160 million investment. Given that movies are in the press these days in a fairly big way, is there any bid on those types of assets at this time?

Sure. Yes. We haven't really necessarily been pruning that portfolio. I think we're more or less selling assets that may have become vacant or assets that we don't think we're going to have success re-leasing, which is common for these types of granular assets. A lot of times the best exit is going to be through disposition to a developer. On the movie theater side, we've done 8 AMCs, we've done 5 Regals, and then for B&B, and 1 Marcus theater. Yes. I mean movies are coming back. Box office revenues are getting back to 2019 levels. The theaters that are doing well, and we have a number of those in our portfolio. I think you're starting to see those come back and those may be strong long-term holds for us. I don't think it's the right time to sell. I don't think you're going to get anything better than what you're seeing on any movie theater today. Maybe it's in an excellent location you could, but we haven't taken any to market, and we don't really plan to. But maybe in a couple of years, it will be the right time to dispose of some of those assets.

Our next question will come from Dori Kesten with Wells Fargo.

On your reduced expectations for CapEx this year, can you walk through the reason for that? And if your expectation is the cost will be pushed to '24?

I'll take that one. Some of it is just timing. We had originally projected up to $250 million for the year. Some of the projects are slower to get started, particularly with our Hyatt Place portfolio. We're still in the planning phase, ordering materials, and that sort of thing, but the renovations will begin later this year. Therefore, some of it will spill over to 2024, but we haven't really changed our plan regarding the number of hotels we intend to invest in. It's just a matter of timing at this point.

Okay. And then I guess, based on internal expectations for '24 taxable income versus 23%, would you expect to need to increase your quarterly dividend?

That's a good question. I don't think we will be required to make any mandatory distributions at SVC under REIT rules, and I believe many other lodging REITs have accumulated some net operating losses that could offset taxable income. So, my short answer is no. However, the current dividend is well supported. We discuss this regularly. If we continue to see improvement in the hotel portfolio, we can revisit the conversation about adjusting the dividend.

Okay. Where are your NOLs today?

We have various NOLs at the hotel/taxable REIT subsidiary level as well as the corporate level, call it, around $500 million today.

Okay. And then any key takeaways from your first few months partnering with BP? And do you have a sense of how much capital they'll be investing in these assets over the next few years?

Yes. I mean I think at this point, BP is really just like any other tenant. It's no longer sort of a related party connection as we had in the prior periods with being an affiliate of RMR. Beyond what their public statements were when they announced the deal, we don't really have much visibility into what they've deployed to date, but they did say they're going to invest upwards of $200 million per year in this portfolio as they have various initiatives they're looking to do, whether it be for ESG purposes and others.

Our next question will come from Tyler Batory with Oppenheimer.

First question for me. In terms of the Sonesta brand, can you talk a little bit about how it's resonating with consumers, how it's competing in the marketplace, what you're seeing in terms of RevPAR index, and any uptick in the loyalty program usage as well?

Sure. The Sonesta brand is making progress, though it varies by service level. For instance, our Royal Sonesta hotels and Simply Suites Hotel, which launched during the pandemic as a mid-scale extended-stay brand, are performing well at the higher end among their peers. However, the Sonesta Select hotels in the select service category are still lagging behind the competition, especially since they heavily depend on midweek business travelers. As you mentioned, these hotels are also reliant on guests using rewards points for their stays. We are noticing positive trends in loyalty program revenues through Travel Pass, which increased from 19.8% to nearly 22% year-over-year. Yet, some leading brands in this area reach around 50%, indicating there’s still significant potential for growth. Sonesta is benefiting from their advertising and brand awareness initiatives, with increasing traffic to brand.com. We anticipate that the hotels they own in New York and the newly acquired hotel in Miami will further enhance brand recognition for Sonesta. There’s still much to achieve, but they are showing promising direction.

Okay. How about on EBITDA margin for the hotel portfolio? I mean, I think the guidance implies low 20s for Q3. You called out some of the items impacting that. Just kind of based on seasonality and the timing of some of those items, I mean, is it reasonable to expect margin to decelerate in Q4 versus Q3? And then also remind us where EBITDA margin roughly was for this portfolio on a comparable basis pre-COVID.

Sure, Tyler. I'll take that one. It is reasonable to expect the fourth quarter will soften and margins will decline. The fourth quarter starts off pretty strong October through mid-November and then you see the seasonal drop-off as we get into the holiday season. So we do expect bottom line hotel EBITDA margins, call it, the high teens at this point for Q4, which for the average for the year will put us in that high teens, low 20 range. As far as the portfolio pre-COVID, we were sort of in that mid-20s to high-20% range.

Okay. A couple of follow-ups on the capital allocation topic and you're talking about acquisitions on the hotel side of things. Todd, what are you seeing in terms of net lease transactions? Is that something that might make sense? Is there anything interesting out there maybe from a portfolio perspective that you could look to grow your net lease exposure?

We continue to actively consider net lease acquisitions alongside our focus on hotels. We are facing similar challenges in finding yields that are appealing for SVC. While there are some assets and portfolios that could align with our cost of capital, they often do not meet our standards in terms of real estate and tenant quality. We are noticing a gradual increase in cap rates, indicating potential opportunities. However, similar to the hotel side, we are not compelled to rush into acquisitions. We are still exploring net lease properties and believe that eventually, we will be in a position to be more aggressive in acquiring assets and growing that portfolio in the long term. For now, we are uncertain if this is the right time to proceed.

Okay. And then last question for me. In terms of options on the table for the 2024, where are market rates right now secured or unsecured debt? And if you did utilize the travel center assets, what sort of pricing improvement could you see versus the transaction you did earlier this year?

It's an important question for us as we consider addressing those upcoming maturities in the next few quarters. Currently, our public bonds are trading in the 9% to 10% range, which represents a costly form of debt. We completed the ABS lease transaction in the first quarter with an effective debt yield close to 7%. If we use travel center assets, we would likely see similar figures. We are looking at BP's credit regarding those net leases, which will provide us considerable flexibility and value for raising funds through those assets if we opt for that strategy. We believe there is a difference of over 200 basis points between public bonds and what we could achieve in secured markets, depending on how we structure the financing package for secured financing.

This concludes our question-and-answer session. I'd like to turn the call back over to Todd Hargreaves for any closing remarks.

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

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