The RMR Group Inc. (RMR) Q2 2017 Earnings Report, Transcript and Summary

Good day and welcome to The RMR Group Second Quarter 2017 Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tim Bonang, Senior Vice President. Please go ahead.

Thank you, Phil and good afternoon everyone. Thank you for joining us today. With me on the call are President and CEO, Adam Portnoy and Chief Financial Officer, Matt Jordan. In just a moment, they will provide details about our business and our performance for the second quarter of 2017. They will then take questions. I would like to note that the recording and retransmission of today's conference call is prohibited without the prior written consent of the company. Also note 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 RMR's beliefs and expectations as of today, May 10, 2017 and actual results may differ materially from those that we project. The company undertakes no obligation to revise or publicly release the results of any revisions to the forward-looking statements made in today's conference call. Additional information concerning factors that could cause any differences is contained in our filings with the Securities and Exchange Commission or SEC, which can be accessed from our website rmrgroup.com or the SEC's website. Investors are cautioned not to place undue reliance on any forward-looking statements. In addition, we will be discussing non-GAAP numbers during this call, including adjusted EBITDA and adjusted EBTIDA margin. The reconciliation of net income determined in accordance with US Generally Accepted Accounting Principles or GAAP to adjusted EBITDA and the calculations of adjusted EBTIDA margin can be found in the News Release we issued this morning. And now I would like to turn the call over to Adam Portnoy to begin our quarterly review. Adam?

Thanks, Tim and thank you to everyone for joining us this afternoon. For the second quarter of fiscal 2017, which ended on March 31, we reported revenues of $54.3 million, which was a 12.3% increase over the prior year. We also reported net income attributable to RMR of $6.9 million or $0.43 per share, which was a 13.2% increase compared to last year. It is important to note that net income this quarter includes $1.3 million or $0.02 per share of elevated general and administrative expenses. A significant amount of these elevated expenses relate to third-party costs associated with possible future growth initiatives. During the quarter, we also reported adjusted EBITDA of $26.6 million or a 13.6% increase over the prior year. As of March 31, our assets under management were approximately $27.6 billion, an increase of $1.1 billion as compared to last year. The growth in assets under management is primarily from growth at our client companies. For the second quarter, approximately 85% of our management services revenue was earned from our four managed REITs. Hospitality Properties Trust reported a 6.2% year-over-year increase in normalized FFO and comparable hotel RevPAR grew 1% during the quarter. Also during the quarter, HPT priced $600 million of unsecured senior notes at a weighted average interest rate of 4.8% and HPT used part of the proceeds from this offering to accretively redeem $290 million of 7.125% preferred stock. HPT also raised its dividend for the second time in four quarters to $0.52 per share per quarter. Senior Housing Properties Trust grew consolidated cash NOI by 2.7% during the quarter compared to last year. SNH also announced during the quarter a joint venture with a sovereign institutional investor to own two Class A buildings in Boston Seaport District, which are long term leased to Vertex Pharmaceuticals. SNH raised $261 million in the transaction and it is retaining a 55% equity interest in the buildings. This is the first significant joint venture for an RMR managed company and introduces a possible new capital source for our managed businesses in the future. The valuations for these two buildings increased by $75 million since they were acquired by SNH approximately three years ago. Select Income REIT was active with leasing once again during the quarter. SIR executed leases for 484,000 square feet for a 20.9% roll up and rents and a weighted average lease term of 10 years. Additionally, SIR acquired land to expand the building for an existing tenant and entered agreements to acquire two additional properties. Government Properties Income Trust continue to focus on leasing its properties and managing its growth. During the quarter, GOV completed leases totaling 360,000 square feet for a 5.2% roll up in rent and weighted average lease term of 10.6 years. Since the beginning of 2016, GOV’s consolidated and same property occupancy has averaged approximately 95% and on average, we have leased approximately 395,000 square feet per quarter with a 5.7% rollup in rent. On a combined basis, RMR ranged almost 1.1 million square feet of leases during the quarter on behalf of our client companies for 11.3% [indiscernible] and a weighted average lease term of 9.3 years. RMR also supervised approximately $20 million in capital improvements at our client companies during the quarter. RMR’s real estate services division, which provides property management services to more than 600 buildings at approximately 70 million square feet of office and industrial space, was recently recognized for excellence with 17 separate awards from the industry during the quarter, including from the Building Owners and Managers Association and the US Environmental Protection Agency. I believe our operating results this quarter are a reflection of the strength of RMR’s operating platform and speak well to the efforts of our over 475 real estate professionals working throughout the United States. Through April of this year, all four managed REITs have performed their SNL peer index on a total return basis year to date, including HPT by approximately 27%, SNH by almost 11%, SIR by almost 15% and GOV by almost 1%. As it relates to possible future growth at RMR, we continue to actively assess opportunities to grow our existing client companies and managing in-client companies. While we expect that the continued high cost of properties in the marketplace may temper some of the growth at our client companies through the remainder of the year, we hope to identify ways to take advantage of our strong operating cash flows and strong balance sheet to diversify our revenues in the future. To that end and as I mentioned earlier, we had some elevated transactions costs included in G&A expenses this quarter, which relates to some growth opportunities that we are currently pursuing. Unfortunately, given where we are in the process with these growth -- potential growth initiatives, we cannot give much detail on this call regarding these efforts. It is too early to tell who will be successful with any of these opportunities. I’ll now turn the call over to Matt Jordan, our Chief Financial Officer who will review our financial results for the quarter.

Thanks, Adam. Good afternoon, everyone. As Adam highlighted earlier, we reported net income attributable to RMR of $6.9 million or $0.43 per share for the quarter ended March 31, 2017. Net income this quarter includes $1.3 million or $0.02 per share of transaction costs and costs associated with the annual grant of share awards to RMR’s directors. Adjusted EBITDA this quarter was $26.6 million, which when measured against our adjusted revenues of $46.6 million, results in an adjusted EBITDA margin of 57%. On a year-over-year basis, adjusted EBITDA increased $3.2 million or 13.6% and adjusted EBITDA margin increased 120 basis points, with both of these increases being primarily driven by revenue growth as a result of share price appreciation at certain of our managed REITs. On a sequential quarter basis, adjusted EBITDA increased $500,000 and adjusted EBITDA margin increased 40 basis points. These increases reflect sequential quarter growth in revenues of the managed REITs and reductions in recurring G&A costs offset by modest increases in compensation and benefits. Quarterly management services revenues were $43.3 million, a $4.2 million increase on a year-over-year basis, primarily due to share price appreciation at the managed REITs, most significantly at HPT and SNH. Management services revenue declined $51.9 million on a sequential quarter basis, primarily due to the $52.4 million incentive fee earned from HPT in the first quarter of fiscal 2017. Excluding incentive fees, on a recurring revenue basis, management services revenues increased $500,000, primarily due to share price appreciation at HPT. As a reminder, we are only able to record GAAP revenues for incentive fees at December 31 of each year. If March 31, 2017 had been the end of a measurement period, we would have earned almost $31 million in incentive fees as it relates to the three year measurement period that ends December 31, 2017. For the second quarter, approximately 85% or $36.7 million of our management services revenues was earned from the managed REITs. Of the revenues we earned from the managed REITs, $28.4 million represents base business management fees. For all months in the second quarter, SNH and GOV paid their base business management fees based upon the average historical cost of assets under management, while HPT and SIR paid their base business management fees on an average total market capitalization basis. If HPT and SIR’s fees had been based upon the average historical cost of assets under management, our revenues for the quarter would have been approximately $700,000 higher. Turning to expense for the quarter, total compensation and benefits expense was $24.5 million, comprised of $23 million in cash compensation, a portion of which is reimbursed by our client companies and $1.5 million in non-cash share-based payments, a significant portion of which is reimbursed by our client companies. It's important to note that while cash compensation is largely controllable, non-cash share-based payments will fluctuate over time based on the share price activity of our client companies. Cash compensation of $23 million represents an increase of $2.8 million on a year-over-year basis and $1 million on a sequential quarter basis. The year-over-year increase is primarily due to headcount additions to support growth at our client companies as well as the impact of annual merit and benefit increases. The sequential quarter increase is primarily due to certain payroll taxes and Employee Benefits. G&A expense for the quarter was $7.1 million, which includes $1.3 million of transaction costs and the cost of annual share awards granted to RMR’s directors. It is our expectation going forward that annual share awards to RMR’s directors will continue to occur in the first calendar quarter of each year. Our resulting recurring G&A expense of $5.8 million is consistent with historical amounts on a year-over-year and sequential quarter basis. Regarding our balance sheet, we continue to maintain a conservative balance sheet and we ended the quarter with approximately $133 million of cash and no debt. Overall, we are pleased with our quarterly results and believe we are well positioned for future growth. That concludes our formal remarks for this quarter. Operator, would you please open the line to questions?

[Operator Instructions] Our first question comes from Owen Lau from Oppenheimer. Please go ahead.

Hi. Thank you for taking my questions. So I have a question about Tremont. Over the past few months, we’ve seen decelerating loan growth in the commercial real estate for banks and I just want to get your observation on the lending activity in the middle market CRE space. Do you see anything differently?

Yes. I think the thesis by which we’ve originally acquired Tremont last August is really playing out very well for us. When we bought Tremont, what we were attracted to was the fact that they had an origination capability across the country. They had historically raised about $4.6 billion of mortgages, either broker or for accounts they had managed and almost all of that money that they had raised in the past had been for middle market transactions. It was our view at the time and continues to be our view that the middle market continues to be hollowed out. There's a lot less banks in the market today than they were a few years ago. There are certainly a lot less banks in the market today than they were 20 years ago. And most of the banks that are disappearing are the smaller community banks and they are also the types of banks that historically had been servicing the middle market. At the same time, we've become aware of what's been going on in the CMBS market where you know usually issuances has increased over the last couple years. So it leveled off where it is today at about 75 billion a year, but that's a market that also, given what's going on there, it's still very muted compared to where it was during the hiatus of the CMBS market and let’s say the mid-2000s. And because of that sort of contraction in banks, contraction in CMBS market, at the same time, the increase in regulation is really having the biggest impact on smaller community banks, we thought there was a real opening in the middle market to lend money against real estate and that was specifically one of the things that we were attracted to Tremont buy. And yes, I think that thesis luckily is playing out very much in our favor exactly the way we planned to and we saw it the year ago and I would say it’s even more prevalent today that when you say middle market, loans less than $50 million, let’s say, there's a real demand out there for more providers to provide capital to that segment of the market. I think we’re well positioned to do that.

Okay. Yeah. That's very helpful. Another question is related to the new healthcare bill, I know it's still under discussion and could be a long way to legislation, but given that the House passed a bill and Adam, you mentioned that SNH has limited exposure to Medicare and Medicaid. I'm just wondering what kind of adversities, both like rational and irrational you’ve observed over the past few months and how you would position the managed REITs to navigate through the uncertainty? Thank you.

Yes. I think it's hard to know exactly how to position yourself given the fact that the House has passed the bill. As everyone knows, it’s got to go the Senate and then it's going to be reconciled, then the President's going to sign it. We're a long way away from knowing what if any changes there will be to health care. I think the only thing that we're confident about in terms of an outlook is that I think reimbursement around Medicaid is going to continue to come under a lot of pressure at the state level. Whether there is, bill is passed or not and I think that’s the only thing that we have any conviction around, but we've got a conviction around that for some time and that's why we’ve been strategically staying away from government reimbursement programs, but specifically Medicaid. If you have to pick between the two, you can take some more Medicare. Medicaid is what I'm most worried about going forward. That being said, the biggest dynamic or issue in the healthcare space, especially on the senior living sector today, I would say is just oversupply in the market. The industry as a whole is dealing with a lot of new buildings that have come online, both last year and into 2017. I think we're lucky that we don't think a lot of new buildings are being started now. We don't think lot of new building is going to come online in ’18 or ’19, but we're right in the midst today of a lot of new supply coming online for senior living assets or senior living communities. And so that’s putting a lot of pressure on occupancy and your ability to raise rates at the type of properties that we focus on, which are private pay. I don't think it's catastrophic, I don't think it's going to be a meaningful impact on our operations, but I think we’re just going to have to work really, really hard, operating those types of communities to keep them sort of flat to slightly up over the next -- given a year, year-and-a-half. And so that’s my take on what's going on in healthcare.

The next question comes from Mitch Germain with JMP Securities. Please go ahead.

Good afternoon. Adam, without providing details of what you're working on in the growth perspective, I know you mentioned some charges this quarter. Last quarter, it did seem like you were favoring more kind of organic growth rather than M&A and I'm curious if that has changed your thinking or has the M&A pricing come back to a point where you could consider doing something with your cash right now?

It's a good question, Mitch. I will tell you that you know generally speaking in terms of our growth initiatives nothing broad-brush strokes, nothing has change in terms of what we're broadly looking at compared to what we've talked about in the past with both most of the analysts on the call and with investors and others, which is really sort of falls into three big buckets. That’s obviously trying to figure out a way to grow the term off and lending business obviously trying to figure out a way to break into the institutional capital raising business and raise capitals from institutions to invest in real estate. And then finally trying to figure out a way to grow our securities management business, I call those three big buckets that we've been trying to figure out how to grown in, all the growth initiatives that we’re spending some third party capital on right now are fall in those buckets. So there's nothing far from what we've been talking about, it's sort of right down the middle in terms of what we've been talking about for several quarters in those broad-brush strokes. But more specifically around your question, we are looking at both organic things and external things I will point out. But again it is way too early to tell if any of it is going to come to fruition. I would say we're very strategic with our organic activities meaning we're very obviously we have a lot of control over that and think about a lot more, we pick our spots and then we execute. M&A is much more opportunistic, you can't plan for when something might come for sale. And so, yeah, we're looking at some things that could result in a use of our cash but it's way too early to tell if it will come to fruition and it’s way too early to tell but even go into detail what sort of bucket that even falls in. But when things come available on the M&A side and it did sort of in those buckets that I talked about, yeah we take a look. Doesn’t mean we’re going to execute, but we do take a look.

And is pricing at a level which you would feel comfortable putting capital to work?

Yes, I mean it is - it could be, if we execute, yes. We’re in the process of evaluating some things and we'll see where pricing shakes out. Yes, I think it could - I think there's a potential that pricing could be attractive for us, but it have to be sort of a very one off situations.

Commercial real estate seems to be playing a bit of catch up on the technology side. And I'm curious if that's an avenue where you think you can maybe become a consolidator over time?

I’m sorry, on the property management side, is that the…

Sorry, technology.

Technology side, well it's an interesting question, Mitch, on the technology side. We actually are pretty early adopters of a lot of different technology that we're using in fifty or more platform. And in fact given the size of our organization, a lot of folks actually approach us very early on and why give us opportunity to use technology, if these costs were free, because they all want us - they almost want to use us as a I guess, I’m not whether we're just having a guinea pig to see how it works. You have to balance doing that versus the time it takes and the distraction it can cause of management and personnel in the organization. So while we get offered a lot of opportunities in technology, we're very careful in terms of what we pursue and what we decide to get behind. But I do think - the good news in terms of our size is that a lot of folks come to us and want to work with us on the technology side to challenge in deciding what to work on because obviously we don’t want, I don't want to roll out a technology and burden our staff with trying to use a new technology, if it’s really going to take away from what the most important thing for our staff out in the field to be doing which is asset managing and process managing the assets we have. So, yes we are innovative when it comes to technology but we have to be very careful because I don't want to be a distraction at the same time.

Our next question comes from Brandon Dobell from William Blair. Please go ahead.

Maybe it’s a quick numbers question, so we expect the next couple quarters to see $0.01, $0.02 $0.03 in some of these business and corporate development expenses or it can go as more of an aberration just a bunch of things we’re going on at once and the next couple of quarters won’t see the same kind of - same kind to spending level?

I think it's fair to assume you will see some level of activity for transaction costs to continue the size and magnitude. I think is going to vary based on the opportunities Adam talked about earlier and how many of them were active in.

As maybe as you're looking at acquisition and disposition opportunities within the managed rates, one of the things we’ve continued to hear from the brokers is that the bid ask spread on properties remains pretty wide for a variety of reasons, right, certainty rates, tax policy, et cetera et cetera. Maybe some color from you guys on how you think about the bid asks out there or is there a lot of opportunities to make acquisitions to properties but the prices are too high, due you see those coming in at all, how do you think that it plays up the next couple of quarters.

We still see a lot of quality properties that are coming to market. There is no shortage of opportunities to bid. Unfortunately, you’re right, the bid ask is still pretty wide and we are not able to hit the bid basically in most cases. If you look historically, if you dove through all of our four REITs and looked at what we’ve buying in the last six to nine months, you see other than in HPT, where we’ve had a few chunky hotels maybe bigger, when I say chunky more than 50 million, almost all the acquisitions have been smaller principally office buildings that are well reached as a MOB or as a single tenant net lease building or as a government lease. And the building you know transition size I’m speaking roughly here less than 20 million. And so, I don't know what a better analogy to say, you got to kiss a lot of frogs before… Or you can hit one of those and we're just watching because given the breath of the organization size, we can maintain you know we have 36 offices around the country, we're in 48 different states, we have presence. So we can effectively still buy building for let’s say $18 million. There are a lot of our competitor REITs do just because they don't have the scale and the personnel in the ground. So we do have an opportunity to buy things, but you got to look long and hard to find the right opportunities where you can find that we can reach agreement on price. But there's no shortage of opportunities. So to end of the question where - to pick up on the question where you think things are going, it really all depends on what happens to interest rates between here and the end of the year. There was a push and interest rates rose a little bit in the first part of the year here. And a more data that’s going to push out the levered buyer but spreads came in. And so the all-in costs for the levered buyer in the marketplace didn't change much through the first four or five months, first three, four months of the year here. If that meaningfully changes, that will have an impact going forward. So if interest rates raise, rising I think and spreads don’t come in and then all-in cost for the levered buyer really does go up and I think at that point you’re finally going to start seeing some movement in cap rates.

Got it. And I guess just to extend that a little bit as you guys think about the balance sheet at the managed rate and your own balance sheet. Any change in how you think about what the right level of leverage or structural leverage should be these days or you waiting to see how maybe see how interest rates play out the next six months to see what that - what the level might be?

Sure. I'd say of the four managed REITs, I think in most of them I'd like - we're sort of the upper end of the range of leverage that we'd like to operate them at. We would like to take leverage down a little bit, we do not think that we are at a danger point at all in terms of leverage. We think we can comfortably continue to operate all the REITs at the leverage they are operating at, but we're trying to balance leverage with where our spot prices are. And we're trying to be very disciplined in picking our spots when to raise equity and so that we don't do dilutive deals. So that's where the pushing and the pull in terms of leverage. We are comfortable where leverage is at the REIT. Yes we would like to take leverage down a little bit if we could. But you have to temper that with where their stock prices are at the different REITs. And so that's the sort of regulator on that.

And then final one from me. Maybe Matt, as we think about the last the next six months or so of the P&L, anything to keep in mind year-on-year or quarter-on-quarter kind of measure impulses and expenses or strange things that happened last year that would be to make sure will be taken into account in terms of year-on-year comparisons for the P&L.

Yeah. Fair question, the biggest thing I would highlight is comp and bens, I think that is the one area with volatility that I would not use the prior year number as a metric to measure future stake. This quarter and we go through great pains to try and articulate the two pieces, but the 23 million in cash is a good proxy of run rate based on our employment levels today in the mix of employees and were benefits for a go forward perspective. On the G&A front I think we've shown here that we're right in the 586 million range when you exclude some of these transaction related items in one off like the share awards this quarter to the board members.

The next question comes from Bryan Maher from FBR and Company. Please go ahead.

You guys are starting to grow your cash and you’re at like 133 now. And when you're analyzing your balance sheet versus these opportunities you're looking at, what's kind of the level that you feel comfortable within holding and cash. And when we get to the third calendar quarter, your fourth fiscal quarter, how would you think about that excess cash in the way of a special dividend or increase in the regular dividend. And then I have a follow up.

Yes, we have excess cash. What’s the right level of cash, I mean the good news is, we're very fortunate we're generating cash every quarter and so that cash balance is going up on a recurring basis and grows the incentive fees, taking synergies off the table. So that’s good news. I'm just going to throw out a rough number here and it could change but I think we're generally comfortable if we have 50 million of cash on the balance sheet operating. Don’t hold me to that forever, but that's the way I think about it right now. In terms of the future in terms of what we're going to do with the excess cash at the end of year, it’s still sitting there, it’s building up if we have the good fortune of collecting more incentive fees. Look, I think we've been pretty consistent about this over the last few quarters which is, we’ve said all along, for 2017, we’re going to take and run it and trying to grow some new business lines. We might do that, might be organically, we might have some M&A. If we are able to be successful in aiding that that’s when you use up some of the cash, it’s unclear to me how much at this point it will use. But regardless of how much it uses and/or if we're unsuccessful at some or all these initiatives, we could have a lot of cash at the end of the year and I think our view is pretty much the same it’s been for a while which is, I’m sure at that the board would back and think about at the very least increasing the dividend at that point in increasing the return to shareholders with some of the cash. Again, just remind everybody, I personally, I’m a very large shareholder of the company. I would too benefit from the dividend. So I'm perfectly well aligned on this in terms of a recommendation that I will make to the board around a possible return of capital to shareholders. But in terms of return of capital to shareholders I think it would be - my preference today would be a dividend rather than a stock buyback and the reason for that is just I think we have a pretty well flow and I think our preference would be if we’re going to do something like that it would be around the dividend rather than the stock buyback. But thinking has been pretty consistent for several quarters now and we really want to just see how 2017 plays out. How these growth initiatives if they work, if they don't work, if M&A works, if it doesn’t work, we’re simply on target to get a incentive fees or not by the end of the year. A lot of things weigh in on and we’ll make a decision as to what to do is we either at the end – either before or after the end – as soon after the end of the year.

And then when it comes to your managed companies, it's a little farfetched to have somebody think that they would successfully take a run at one of the big externally managed REIT, especially when it comes to terminations fee payable to RMR. But when we look at something that's small or as it relates to its impact on RMR, in this case TA. If somebody were to make a run at TA and was willing to pay your kind of roughly $40 million terminations, would you be somewhat agnostic to that from a standpoint of trying to hold onto it or letting it go and again assuming that HBT's board was willing to reassign the leases.

Thanks for the question, Bryan. Again just a level set for others that may not be familiar with TA was, it’s about maybe 5% of the overall revenue, so it’s not a big part of our business. And then [indiscernible] by another 5% of our revenues as well invested and our managed funds make up the balance of that sort of 15% of the other revenue. If any of our companies you know this is also true to the REITs, all of our companies are managed by – has outside directors to make up the majority of the board. The major of shareholders are typically public shareholders in most of the situation. I can't help but say there is a element or is a conflict of interest that exists at certain point between RMR and the managed businesses we had. And we're highly cognizant of it we're aware of it. Our boards are aware of it, we spent enormous amount of time whenever a conflict of interest like that could arrive and presents itself. There's a lot of laurels and advices involved in that, and truth be told, if someone like myself in a type of situation that you describe I probably wouldn’t be that involved, I would probably have to cruise myself from that situation. The board might ask me what I think, but they would - I would not be in the room during the deliberations and I'm certainly I'm sure they would have their own advisors giving them advices well in a situation like that. So if you ask me personally, I might have opinion on it but that opinion may not carry as much weight as you think it might just because all of our boards understand that their independent directors of publicly traded companies, they understand they have fiduciary duties and they understand I have a conflict of interest with RMR. It’s all very up and up on the open with the board, they all understand this. And I can’t tell you as many times we recommend the boards in certain situations say listen, we got a conference, you need hire - you need a form a special commitment, you need to hire your own advisors in this situation, yeah we'll tell you what we think, but it's really your call. And so that's how I think we’d approach any situation involving any of our companies that you describe.

This concludes our question-and-answer session, I would like to turn the conference back over to Adam Portnoy for any closing remarks.

Thank you for joining us this afternoon, we will be presenting at JMP Financial and Real Estate conference in New York City on June 22, we look forward to seeing some of you there. Also we look forward to update you on the progress our third quarter conference call. Operator that concludes our call.