Apple Hospitality REIT, Inc. (APLE) Q2 2017 Earnings Report, Transcript and Summary

Greetings and welcome to Apple Hospitality REIT Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Kelly Clarke, Vice President of Investor Relations. Thank you and you may now begin.

Thank you and good morning. We welcome you to Apple Hospitality REIT's second quarter 2017 earnings call on this, 8 August, 2017. Today's call will be based on the second quarter 2017 earnings release, which was distributed yesterday afternoon. As a reminder, today’s call will contain forward-looking statements, as defined by Federal Securities Laws including statements regarding future operating results. These statements involve known and unknown risks and other factors, which may cause actual results, performance, or achievements at Apple Hospitality to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. Participants should carefully review our financial statements and the notes thereto, as well as the risk factors described in Apple Hospitality's 2016 Form 10-K and other filings with the SEC. Any forward-looking statements that Apple Hospitality makes speaks only as of today, and the Company undertakes no obligation to publicly update or revise any forward-looking statements, except as required by law. In addition, certain non-GAAP measures of performance such as EBITDA, adjusted EBITDA, FFO, and modified FFO, will be discussed during this call. We encourage participants to review reconciliations of those measures to GAAP measures as included in yesterday’s earnings release and other filings with the SEC. For a copy of the earnings release or additional information about the Company, please visit applehospitalityreit.com. This morning you will hear from Justin Knight, our Chief Executive Officer; Bryan Peery, our Chief Financial Officer; and Krissy Gathright, our Chief Operating Officer. We will provide an overview of our results for the second quarter of 2017 and then open the call for Q&A. At this time it is my pleasure to turn the call over to our CEO, Justin Knight.

Good morning and welcome to our second quarter 2017 earnings call. Before I turn the call over to the team to provide detail regarding our performance during the quarter and Q&A, I want to take a moment to express my sincere gratitude for the tremendous outpouring of concern and support following my accident in early July. Unexpected interruptions to our daily lives often stand to remind us of the importance of each day and all that we have to be thankful for. I'm incredibly grateful to be a part of such a thoughtful and caring industry, so thank you. Shifting to results, we anticipated the current business demand trends, rising labor costs, calendar shifts, and outsized growth in 2016 in some of our markets would present challenges for our portfolio of hotels during the second quarter. Given our broad diversity of markets and concentration in the upscale segment of the industry, we navigated those challenges and overall produced stable operating results. We continue to be confident in the merits of our strategy and our ability to maximize shareholder value over the long-term. We have an incredibly talented, dedicated, and data driven team with tremendous industry experience. We are all focused on maximizing long-term shareholder value and are confident of our strategy, experience, and ability to execute on that strategy will continue to put us in a position to achieve that goal. It is now my pleasure to turn the call over to Bryan and Krissy to provide additional details for the quarter.

Thanks Justin. To reiterate Justin's comments we very much appreciate everyone's concern and support and are very thankful for his speedy recovery. As always we have been amazed by his strength and resiliency. Justin was engaged with the team and business soon after the accident and we look forward to having him back in the office in the near-term. Next I will cover some of our second quarter highlights and then Krissy will provide greater detail regarding performance within our markets and the industry overall. We finished the second quarter with revenue of $332 million, adjusted EBITDA of $126 million, and corporate G&A expense of 6 million. Modified FFO per share was $0.51 down from $0.52 in the second quarter of 2016. As anticipated the second quarter was a challenge for a number of reasons. Year-over-year comps in a couple of our larger markets, soft business demand, and calendar shifts led to comparable RevPAR for the second quarter being down slightly from last year. Although continued pressure on labor costs and property taxes combined with a lack of growth in ADR led to a decrease in hotel adjusted EBITDA margin, we still achieved a very strong margin of 39.9%. Although overall macro economic factors in the U.S. continued to be modestly favorable with GDP growth, low unemployment although currently a negative to our labor cost, and high consumer confidence and uncertain direction of the federal government appears to have impacted business investment and CEO confidence which is led to reserved business travel. The restraining corporate spending mixed with increased supply in many of our markets has muted our ability to increase rates. Since we do not anticipate there will be an immediate change in Washington or a meaningful increase in travel from the business sector, we are tempering our full year adjusted EBITDA guidance by $5 million on the low end and $10 million on the high end. Lowering our full year RevPAR growth guidance by 50 basis points on the high end and reducing our hotel EBITDA margin guidance by 50 basis points on the low end and tightening the high end by 80 basis points. Based on our operating performance to-date, our visibility into business drivers for the remainder of the year and completed transactions we anticipate net income between $207 million and $225 million, comparable hotels RevPAR growth between 0% and 1.5%, comparable hotels adjusted hotel EBITDA margin between 36.8% and 37.5%, and adjusted EBITDA between $425 million and $440 million. Although we have adjusted our outlook for the remainder of the year, we do believe we are well positioned to exceed expectations should there be a stronger improvement in the economy and/or an increase in business travel. As we've discussed on previous calls, we continue to look for opportunities to reduce the ownership of our full service assets, to focus solely on our core select service and extended stay products where we believe we can generate stronger, more stable returns for our shareholders overtime. In April we completed the sale of our full service Hilton hotel in Dallas, Texas for $56 million and as a result of the sale we recognized a gain of approximately $16 million during the second quarter. In June, we entered into a contract with the sale of our 316 room Marriott Hotel in Fairfax, Virginia for a gross sales price of $42 million. Should closing conditions be met we anticipate the sale would be completed by the end of this year and that we would recognize a small gain on sale. If the Fairfax sale is completed, our remaining full service portfolio would consist of 30 hotels or 1% of our total portfolio. We continually look for accretive opportunities for our shareholders. However, the acquisition market remains a challenge with the uncertainty in operations, more competition, and sellers with seemingly little incentive to sell. Although construction is not complete, we do anticipate closing on our previously disclosed contract for the purchase of a dual branded Home2 Suites and Hilton Garden Inn in Birmingham, Alabama upon opening in September. The total purchase price for these assets is $38 million and they will have a combined 210 rooms. This is another good example of an effective piece of our strategy. We entered into the contract for these hotels in the middle of 2015 for a fixed price thus taking no development risk. With a significant increase in construction costs in the last couple of years, we believe that we have achieved a very attractive price per key for new assets in a growing market. After closing on the purchase of these properties we will continue to have outstanding contracts for the purchase of two hotels both of which are currently under construction for a combined purchase price of $65 million. We anticipate these two projects will be completed in mid 2018. With 235 hotels located in 87 markets across 33 states, our portfolio of hotels is one of the largest, most geographically diverse hospitality portfolios in the United States. Our exposure to a wide variety of markets and demand generators minimizes the overall impact of volatility within a single market region or industry. Coupled with our focus on select service and extended stay product in Marriot and Hilton brands, we are able to effectively maximize operating opportunities across our portfolio producing strong stable risk adjusted results. Although we saw some pressure on results in the second quarter we continue to be a leader in hotel EBITDA margins, EBITDA margins, and EBITDA after CAPEX margins which highlights the benefits of our strategy. It’s now my pleasure to turn the call over to Krissy.

Thank you, Bryan. With our toughest comparison of 4.5% RevPAR growth in the second quarter of 2016, the continued softness in business demand, and the shift in holiday timings we expected the second quarter of this year to be our most challenging quarter. Comparable hotel RevPAR declined 20 basis points with a modest occupancy decline of 50 basis points and a modest rate increase of 30 basis points. Transient rooms sold declined 60 basis points, just slightly more than the first quarter decline of 40 basis points. Group room nights grew 1.8% and the group rate increased 50 basis points with group mix remaining relatively consistent at 15%. With leisure outpacing business transient growth, our room nights in the retail and corporate negotiated segments declined with the offset being an increase in the discount segments which muted overall rate growth. As we move forward into the second half of the year, we would expect our geographically diversified portfolio results to approximate the upscale industry average with growth remaining slow until we see a pickup in business demands. Taking into consideration contribution to EBITDA, our strongest markets during the quarter were Seattle, Richmond, San Diego, and Denver. Our weakest markets were Austin, Omaha, Dallas, and Los Angeles. The West South central region was our poorest performing region with a RevPAR decline of 7.1% with the previously mentioned under performance in Dallas and Austin as well as continued impact from declines in energy related demand. Although the Austin market only represented 2.2% of our EBITDA contribution in the quarter, the 14% decline in RevPAR led to a 40 basis point drag on our overall RevPAR growth. All of our Austin hotels experienced RevPAR declines as the new supply in Austin is outpacing demand and the markets are becoming more compartmentalized with less compression from downtown. Our three Parma Lane [ph] hotels declined the most as they are being impacted by new hotel openings in the Round Rock and the domain submarkets. While we expect continued softness in the near-term as supplies absorb, we feel positive about the submarket long-term as existing large companies like Apple, Samsung, GM, and Home Depot have technology innovation centers located there. In addition 3M just announced that they are establishing a new state of the art campus in the Parma Lane [ph] corridor in 2019. Dallas has been impacted by a softer convention calendar in 2017 and the impact of new hotels opening ahead of the ramp of new business generators in the area. Including Toyota's New York headquarters, Liberty Mutual's new regional business centers, Boeing's new global service headquarters, and the Dallas Cowboys new training center. That said the convention calendar is pacing well for 2018 and beyond. With the exception of Los Angeles, our West Coast markets continued to perform well. Our Los Angeles market RevPAR declined 6.4% with continued quarter rates impact in May. Although a 4% average market share growth for the group mitigated the impact to our portfolio. Excluding those hotels, our rate and RevPAR growth would have been 40 basis points higher. Strength in the technology sector primarily with Amazon and military defense spending with Boeing have persisted to drive strong growth in Seattle. And our San Diego hotels continued to benefit from strong leisure groups and government business. We are very excited about the addition of the Birmingham Hilton Garden Inn Home2 Suites combo to our portfolio later this year. The hotels are well located within walking distance of three major hospitals; UAB, Children's, and the VA Hospital. RevPAR growth from our two owned hotels in the market was 11.7% in the second quarter just slightly higher than the Star Market results as the market has benefited from expansion in manufacturing, life sciences, information technology, finance, and insurance sectors. For a broader perspective on new supply as it relates to our portfolio, the outlook for our hotels is unchanged from what we reported for the first quarter. With just over 60% of our hotels expecting one or more upper midscale, upscale, or upper upscale new construction projects within a five mile radius to be completed within the next 18 months. From that perspective the pipeline of rooms and construction appears steady which is consistent with the smooth travel specifics for the industry. Turning to profitability, adjusted hotel EBITDA margin decreased 160 basis points during the quarter due to a slight decline in RevPAR and expense growth in the mid 2% range when factoring out the ramped hotels. Continued labor pressures resulting from reduced availability of qualified labor and minimum wage increases accounted for 70 basis points of the margin decline consistent with the first quarter. We do expect labor costs to continue to be a challenge with labor shortages in several of our markets. The starting wage rate for hourly workers has been increased in several markets to attract additional hires and minimize turnover costs. We have almost completed the test phase of the whole house labor management technology platforms which should help mitigate labor cost increases through better monitoring over time and productivity. We expect 75% of our hotels to have implemented the new systems by October. Although in line with expectations utility expense picked up slightly in the quarter equating to a 20 basis point to the margin decline. Our asset management team is working closely with our property management team to drive additional savings in utilities, including the following projects among others. Selective energy management systems and higher efficiency equipment installations, LED lighting upgrades, irrigation monitoring, and low flow toilets retrofit. Increases in real estate taxes also accounted for 20 basis points of the margin decrease. Reflective of the assessments catching up with the appreciation in values, we aggressively appeal increases in assessments and expect results of those appeals to keep increases to a mid single-digit level in 2017. I will now turn the call back over to Bryan to provide additional details on our financial results.

Thanks Krissy. I will quickly highlight a few balance sheet items of note before we get into Q&A. Our balance sheet continues to be one of the strongest in the industry. At the end of June the company had 1.3 billion of outstanding debt with a combined weighted average interest rate of 3.4% for the remainder of 2017. Excluding debt issuance cost and fair value judgments on acquired debt, our debt is comprised of 433 million in property level debt and 876 million of unsecured debt. In July, the company entered into an unsecured $85 million seven year term loan. The net proceeds from the term loan were used to pay down borrowings on the company's revolving credit facility. In conjunction with the term loan we also entered into an interest rate swap agreement to effectively fixed interest rate on $75 million of the $85 million term loan at 3.76%. Our undrawn capacity on our unsecured credit facilities after completing the term loan was approximately $340 million. Also after completing the term loan three fourths of our debt is effectively fixed rate. Continuing our objective of maintaining our hotels in a relevant and competitive position in the market, during the first six months of 2017 we invested approximately $24 million in carefully timed and effectively managed renovations and plan to spend an additional $35 million to $45 million during the remainder of 2017. While we utilize our scale to reduce total renovation costs, the scope of each renovation is tailored to the specific needs of the asset and its competitive positioning within a market. Although we had no activity in the second quarter, the company continues to have in place both an aftermarket common share offering and a share repurchase program that provides for opportunistic share issuances or share repurchases in open market transactions. The flexibility of these programs allows us to further enhance shareholder returns by issuing shares when market conditions are appropriate and use proceeds to further enhance the strength of our balance sheet in anticipation of future opportunities such as individual asset transactions or to repurchase shares if they trade at a level that makes the purchase of our own shares significantly more attractive than asset opportunities. Lastly during the second quarter the company paid distributions of $0.30 per share to annualize $1.20 per common share representing an annual 6.6% yield based on our August 4th closing price of $18.18. Thank you for joining us this morning. Despite lower growth prospects in 2017 we continue to position ourselves to effectively increase shareholder value when opportunities present themselves. We will now open the call up for questions.

[Operator Instructions]. Thank you. Our first question is coming from the line of Ryan Meliker with Canaccord Genuity. Please proceed with your questions.

Hey, good morning guys and Justin glad to hear you're feeling well. A couple of quick questions that I had for you; first of all, I apologize if I missed this but the reduced guidance, is there an impact there tied to the asset sale that is pending right now? [Multiple Speakers]

A very limited impacted.

So that is not driving that.

Actually there is still bit of reduction from Fairfax and a little bit of an increase from Birmingham. They essentially offset.

Okay, that's helpful. And then one of the things I noticed, I'm curious what your take is, it looks like -- if we look at your year-to-date numbers, by and large your comparable Marriott brands are really outperforming your comparable Hilton brands from a top line perspective. We kind of look at in the upper mid scale segments, Fairfield Inn really outperforming Hampton Inn. TownePlace is really outperforming Home2, Residence Inn outperforming Homewood and then Courtyard and SpringHill kind of performing in line with Hilton Garden Inn. Are you seeing any shift in demand trends towards Marriott over Hilton or is that just kind of funky for your portfolio specifically and anomalistic for the first half of the year?

Good morning Ryan. What we've actually seen from our portfolio is more related to the market mix of the hotels that are in those plans. We're not seeing any overall trend suggesting that there is a shift in demand going from Hilton to Marriott. And you wanted the big trends related to the fact that we have more of our demand, the majority of our demand in the business travel segment is brands like Courtyard and Hilton Garden Inn, were both softer because of the timing in the second quarter of the Easter Holiday. And brands like Residence Inn as well as even Homewood Suites there is the extended stay brands who, while they do have business travelers, they also appeal to leisure travelers and they have a longer-term stay. So they tend to fare even better when you do have some softness in that business travel demand. Home2 Suites offers a very strong brand for us. With the ramp of the Atlanta Home2 impacts the year-over-year comparison there. That hotel we still feel that there's opportunities to improve in RevPAR, so their RevPAR for the second quarter was approximately, I think it was $95 which is lower than the average for the portfolio.

Okay, that's helpful, thanks Krissy. And then one last one for you Krissy, just looking at the margin guidance change, it looks like you lowered the bottom end of the margin guidance without the lowering of the RevPAR guidance. Just can you give us some color on what you guys are seeing and what is concerning you. I know that you held the Investor Day back in March and kind of accounting the asset management capabilities and your ability to move more quickly and be faster as things are starting to shift. But here it seems like you are lowering the margin assumptions while maintaining almost entirely your RevPAR outlook other than 50 bps drop at the highend?

Yes Ryan, that is primarily because we expect as I mentioned in my comments, we expect more of our RevPAR growth to actually come from -- or less rate growth than we originally had anticipated which leads to lower margins. But also a shift in business to leisure traveler as we've replaced some of the business travel. The leisure traveler tends to be a little bit less profitable, they tend to have multiple occupants so that increases cost a little bit as well as we haven't seen a significant pick up in acquisition cost or travel agent commissions yet. But we are cognizant as we look towards you continuing to replace that business travel but that could drive additional acquisition costs. Really the main thing is what I highlighted previously, that labor and real estate taxes continue to trend above inflationary levels for the remainder of the expenses are below. And then to go into little bit more detail on the labor software piece, we have been doing very extensive testing and most of our management companies have tested one to two properties. So we wanted to make sure during the testing phase, the phase that we've got the process right including making sure that we are verifying all the standards that are being input into the systems to make sure they were actually tracking and holding the management company and the teams accountable to benchmark standards. So we -- as I mentioned it will October of -- September and October of this year that we will be rolling that out on a wider basis, and from that we expect to see benefits of a reduction over time, better here, it’s the standards. We are working with our teams to roll out some additional incentives too so that employees can share those savings for achieving productivity savings and better tracking of turnover associated costs. So what we're seeing more of now is that our managers in certain markets as the supply picked up and the unemployment is low that we've had to in many cases increase wages and the increased wages in the short-term are negatively impacting margins. But, we believe in the longer-term once that settles out that we will see reductions in training -- reduction in training and turnover cost. So we're really estimating that most of the impact of the mitigation of the increases will because of the rollout later in the year, we will see and we will budget for that in 2018.

Great, that was a very thorough response. Thanks for that additional color.

Thanks Ryan.

[Operator Instructions]. The next question is from the line of Michael Bellisario with Robert W. Baird. Please proceed with your questions.

Good morning everyone.

Good morning.

Just want to focus on 2Q for a second. Can you give us a sense of how the top line and bottom line perform versus your internal expectations not just that, I know, you had telegraphed that it would be the weakest quarter of the year from a growth perspective, maybe the absolute dollar amount top line and bottom line versus your budgets?

The main list of expectations or slightness of expectations related to top line which then flow to the bottom line. But we knew April was going to be soft obviously and then May was stronger. June came up a little bit short. We did see positive impacts from the Porter Ranch going away, the year-over-year disparity going away. So L.A. -- Los Angeles market did improve and it was solid in the mid single-digits in June. But the markets that I mentioned in my commentary, I don't know how often in Dallas from the beginning of the quarter to the end of the quarter softened a little bit more than expected. Omaha was really a loss of the slim trial year-over-year impact in the last week of June and the first week of July. Plus there was a less favorable draw of [indiscernible] teams which means that we had a little bit more to lose with respective to weather which has impacted our share. Our teams felt like they could replace more of slim trial business and they ultimately did. And Austin, and I mentioned that one as well, Austin is one of the markets where you are still seeing demand growth but the supply percentage increases the largest of any of our markets. And we did have and I didn’t allude to this in my comment but we also did have see more[ph] business in house year-over-year that was -- it was close to 100,000 in June and that we had last year. That was the additional supply we weren't able to replace. We do think that there's some market share opportunities even though that, that particular track is a tough track. So we're working with our management team on that. And then Dallas, Austin is a market where this year we expect demand to be a little bit down. As I mentioned the city wide aren’t as robust this year but looks good going forward. And the supply is opening in advance of all the great demand generators that are coming in. So Austin and Dallas we would expect continued softness in Q3. Omaha should get a little bit better in August. We have Boeing project piece of business that fits -- that is helping us out. As we look to just to give you a little bit more clarity, as we look to the third quarter we would expect July did start off soft for us. The first week was very soft with the July 4th holiday moving to Tuesday. So we did see quite a bit of impact on business travel. We expect August to be stronger and -- but September is -- we have a less visibility on September. We expect to have a little bit less of an impact from the Jewish holiday shifts in some of our peers that may be more exposed to convention and urban markets. We will have some impact. So for the third quarter we would expect to be towards the lower end of our full year range or about full year range but in the fourth quarter we would expect to be in the higher end of our full year range.

Got it, thanks, that's very helpful. But because it sounds like it was a slight shortfall and the top line then went to a slight shortfall in the bottom line too, you kind of held the margins. And then just kind of on the top of the RevPAR, your portfolio RevPAR index in the quarter, did you guys gain or lose market share and how are your hotels holding up to the comp sets respectively?

On average for our portfolio we gained 50 basis points in market share. We would always like it to be more but we did gain 50 basis points in market share.

Got it and then kind of the big picture on capital allocation, stocks at $18 today, you mentioned a much more competitive acquisition environment. I guess what needs to happen and how do you think about buybacks today in the context of the comments you made earlier on where the stock price is today?

Well, you know we can continue to look at all of our options that are out there. We would like to be in a position where we've aggressively underwritten a large number of hotel transactions. We can't seem to get there on price. We're still trading, looking at it from a share buyback standpoint, we're still trading inline if not slightly better than most of our peers not all of them but most of them. If we get in a position where there's a disconnect, our stock drops and nobody else's does we would aggressively begin by next year. You know right now at $18 or so we are probably not quite in that position yet.

Thanks and then just to follow-up on your acquisition comment, maybe how far off are you on pricing for deals that you are underwriting that you're not winning?

I mean it varies. I mean we have never really gotten into publicizing cap rates or anything like that. But I mean the sellers have a lot of confidence right now with the number of bidders in the market and the marketplace being able to refinance their debt. Operating results are good. They're uncertain as we have seen in the future a little bit but as an owner there's not a whole lot of intending to sell unless you're getting a really, really tough dollar price. And we're just not prepared to overextend ourselves and put ourselves in a position where it's not where we can’t clearly see it is an accretive transaction. So we’ve even had some sellers in essence the retraders we think who are at a reasonable price and then they come back and increase it 10% or 15% and then we just have to walk away.

And Mike our expectation is that not the constant state. What we've found historically is that in periods of time like this it behooves us to be patient. As Bryan said we're continuing to underwrite a tremendous number of deals, some that are being publicly marketed and some will lead to solicited potential sellers directly. You should expect that as the year continues then we will find opportunities to make acquisitions that did make sense, are accretive in the statements in our portfolio.

So, it sounds like despite the lack of acquisition activity that we see you start to assume that you've been more aggressive in your pursuit in your underwriting recently?

In our pursuit yes, our underwriting criteria really has remained fairly consistent.

Okay, that's helpful. Thank you.

Thank you. At this time I will turn the floor back to Justin Knight for further remarks.

Thank you for joining us this morning and thank you again for all of your support. Despite a challenging second quarter we delivered stable operating results and strong margins. While we anticipate continued headwinds from restrained corporate spending and rising labor cost, we have confidence that our project diversification, exposure to a wide mix of demand generators, and focus on selector [ph] or some extended phase segment of the industry position us to be successful. We continue to see opportunity within the industry and believe in our strategy to mitigate volatility and increase shareholder value over the long-term. We hope that as you travel you will take opportunity to stay with us at one of our hotels and on a personal note, I would like to thank Bryan and Krissy for picking up some of the flags for me as I have continued my recovery. I anticipate being back full time here in a very near future and look forward to continuing to work with them. Have a great day and look forward to talking to you soon.

This concludes today's conference. Thank you for your participation. You may now disconnect your lines at this time.