Service Properties Trust (SVC) Q4 2015 Earnings Report, Transcript and Summary

Good day and welcome to the Hospitality Properties Trust Fourth Quarter Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Katie Strohacker, Senior Director of Investor Relations. Please go ahead.

Thanks Cary. Good morning, everyone. On today's call, John Murray, President, and Mark Kleifges, Chief Financial Officer, will make a short presentation, which will be followed by a question-and-answer session. Please note that the recording, retransmission and transcription of today's conference call is prohibited without the prior written consent of HPT. 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 HPT's present beliefs and expectations as of today, February 24, 2016. The Company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call, other than through filings with the Securities and Exchange Commission or SEC. In addition, this call may contain non-GAAP financial measures, including normalized funds from operations or normalized FFO. A reconciliation of normalized FFO and adjusted EBITDA 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 Web-site. 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 to be filed later today with the SEC and in our supplemental operating and financial data, found once again on our Web-site at www.hptreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. Before I turn the call over to John and Mark, you should be aware that TravelCenters of America's fourth quarter 2015 report on Form 10-K will not be filed until mid-March and accordingly the Company's remarks today with respect to TA's operating results will be limited to results through September 30th and we won't respond to questions related to TA's fourth quarter 2015 performance. And with that, I will turn the call over to John.

Thank you, Katie. Good morning and welcome to our fourth quarter 2015 earnings call. It was another strong operating quarter for HPT. This morning I'm going to provide a summary of our performance, discuss our investment activity and our outlook for 2016, and then Mark will provide a more detailed look at this quarter's financial results. Earlier today, HPT reported fourth quarter normalized FFO of $0.54 per share, a decrease of 33.3% compared to the $0.81 reported in the fourth quarter of 2014, due primarily to the $62.3 million or $0.41 per share incentive management fee recognized this quarter. The incentive fee is based on HPT's total shareholder return outperformance compared to the SNL Hotel REIT Index over the two-year period ending December 31, 2015. Excluding the impact of the incentive fee, normalized FFO for the quarter would have been $143.3 million or $0.95 per share, which we believe reflects the continued execution of our strategy to own a diverse portfolio of well-maintained hotels and travel centers, operated under long-term management and lease agreements. Our recently renovated primarily upscale portfolio and our continued asset management focus on revenue and flow-through improvement driving rate as well as occupancy were the principal drivers of our hotel portfolio's strong performance during the quarter. As Katie noted, we are not able to update you on TA's performance for the fourth quarter of 2015 because they will not report results until mid-March. Third quarter results for HPT's travel centers reflected continued strong performance with increasing fuel volumes and non-fuel sales and margin growth. Third quarter per gallon fuel margins, though strong, declined versus the same period in 2014 as expected due to the very favorable purchasing and pricing environment in 2014. Property level rent coverage for the year-to-date through September 30, 2015 was a healthy 1.8x. Turning to our hotels, the fourth quarter continued our positive RevPAR and margin growth momentum with RevPAR growth of 6.2% across HPT's 291 comparable hotels, 140 basis points above industry growth levels this quarter. This marks the 12th consecutive quarter where we've exceeded industry RevPAR growth. This performance which was 83% rate-driven continued to be broad-based, not dependent only on recent renovations. Hotels renovated in 2010 through 2013 produced RevPAR growth of 6.4% this quarter, 160 basis points above industry average RevPAR growth. This quarter's strong ADR growth resulted in continued margin expansion with GOP margin percentage up 210 basis points from the 2014 quarter. This represented a healthy 76% flow-through of this quarter's revenue increase. Hyatt led the HPT portfolios in the fourth quarter, increasing RevPAR by 14.5% and GOP margin percentage by 540 basis points. This strong performance reflects 2014 renovations at five of the portfolio's 22 hotels leading to a 10.7% increase in occupancy as well as improved revenue management from shifting mix and charging higher rates for rooms at higher floors and double-digit growth in food and beverage revenue following rollout of revised menus in the third quarter. Our Carlson portfolio increased RevPAR by 7.4% during the quarter as strong gains in transient contract and group rates drove overall rate growth of 7.6%. Our Marriott No. 1 portfolio continued its strong performance during the fourth quarter. RevPAR increased 6.8% and GOP margin percentage improved 170 basis points versus the fourth quarter of 2014. Driving this was small group business which was strong across all geographies and positive mix shift from negotiated corporate rate room nights to higher rated retail transient nights. This contributed to a 4.7% increase in rate during the quarter. Our Sonesta portfolio's comparable fourth quarter RevPAR increased 4.5% and comparable hotel GOP margin percentage improved 3.7 percentage points versus the fourth quarter of 2014 to 25.4%. The Royal Sonesta New Orleans was under renovation for all of the 2015 fourth quarter. Excluding this hotel and the nine non-extended-stay hotels that we acquired in July, Sonesta's 20 comparable non-renovation hotels increased RevPAR by 12.1%. Our comparable Sonesta ES hotels once again drove the portfolio's performance as the hotels continued to regain occupancy following last year's renovation activity. RevPAR at our full-service Sonesta hotels was negatively impacted by the Royal Sonesta New Orleans renovation and the Royal Sonesta Houston as a result of the soft energy sector. Our hotel portfolio's strong performance continues to be balanced across property types. RevPAR and gross profit margin percentage among our 157 comparable extended stay hotels were up 7.5% and 200 basis points respectively. Our 95 comparable select service hotels were up 8.5% and 200 basis points. Our 37 full service comparable hotels that were not under renovation during the quarter were up 6% and 270 basis points respectively. In each of these cases, rate was the principal driver behind the growth. Turning to transaction activity, in January, HPT agreed to acquire the luxury boutique Hotel Monaco in the center of downtown Portland, Oregon for a purchase price of $114 million dollars. This hotel has 221 rooms, the successful Red Star Tavern restaurant and bar, over 8,000 square feet of meeting space and a full service spa. The hotel Monaco will be added to our management contract with IHG and IHG will provide an additional security deposit to us of $9 million. The initial yield to HPT on our net cash investment will be 8.7% and we currently expect to close in March. There are no material near-term renovation plans with respect to the Monaco as it is in good condition and will be rebranded. In February, we closed the previously announced acquisition of two extended stay hotels with 262 suites located in Cleveland and Westlake, Ohio for $12 million. HPT converted these hotels to the Sonesta ES Suites brand and added them to our management agreement with Sonesta. Looking ahead, we and our hotel managers are optimistic about 2016. Industry experts seem to be forecasting RevPAR growth in the 5% to 5.5% range for 2016, down slightly from 2015 RevPAR growth but still well above historic long-term average growth rates. Our operators are budgeting full-year 2016 RevPAR growth generally in the 5% to 7% range and a GOP margin percentage improvement of 100 to 150 basis points versus 2015. We're continuing to benefit from renovations that have impacted 90% of our hotel portfolio. Our hotel portfolio's high 75.6% average occupancy positions our managers well to continue to improve average daily rate and guest segmentation, which translates to GOP margin improvement and increased EBITDA. We are monitoring supply growth which is near historic run rates and continuing to grow. Much of the recent new supply growth has been concentrated in a limited number of primarily urban markets and we do not expect supply growth to be a major headwind to HPT's hotel portfolio performance in 2016. Our expectations assume that the current economic expansion continues its path and doesn't encounter material unexpected shocks. January 2016 RevPAR increased 4.4% at HPT's 291 comparable hotels, exceeding industry RevPAR growth by 200 basis points. January is typically one of the weakest months of the year for our portfolio, so it's difficult to draw any conclusions from these early results other than to believe we are on track for another year of industry outperformance. I'll now turn the call over to Mark.

Thanks John. Operating results at our comparable hotels were strong again this quarter with RevPAR up 6.2%, a 210 basis point increase in GOP margin percentage and growth in cash flow available to pay HPT's minimum returns and rents of 15.4%. The 6.2% increase in RevPAR this quarter was driven by a 1.1 percentage point increase in occupancy and ADR growth of 4.6%. This quarter's RevPAR growth benefited from the outperformance of the seven hotels that were under renovation during the 2014 fourth quarter with RevPAR up 30.1% at these hotels, but was also impacted by the 19.2% decline in RevPAR at the five hotels under renovation during the quarter. Our portfolios with the highest RevPAR growth this quarter were our Hyatt, Carlson and Marriott No. 1 portfolios with increases of 14.5%, 7.8% and 6.8% respectively versus the prior year quarter. RevPAR was up 12.1% this quarter at the 20 comparable Sonesta hotels not undergoing renovations during the quarter. GOP margin percentage for our comparable hotels increased 210 basis points from the 2014 quarter to 38.2%. Of our portfolios, Hyatt and Wyndham had the strongest margin growth this quarter with gross operating profit margin percentage up 540 and 510 basis points respectively versus the 2014 quarter. The combination of strong RevPAR growth and GOP margin expansion resulted in $11.9 million or 12% increase from the 2014 quarter in cash flow available to pay our minimum returns and rents. As a result, cash flow coverage of our minimum rents and returns improved for eight of our nine hotel agreements versus the prior quarter and portfolio-wide coverage increased to 0.92x for this traditionally weaker quarter and 1.07x for the trailing 12 months. All but our Sonesta and Wyndham portfolios and our Marriott Kauai hotel were above 1x coverage on a trailing 12 month basis. This strong performance resulted in net guaranty and security deposit replenishments of $24.7 million during 2015. Turning to HPT's consolidated operating results for the fourth quarter, this morning we reported normalized FFO of $81.1 million compared to normalized FFO of $121.5 million in the 2014 fourth quarter. The $40.4 million or 33.2% decrease in normalized FFO was due to the impact of the $62.3 million or $0.41 per share of incentive management fee expense recognized in the 2015 quarter. Excluding the impact of incentive management fee expense, normalized FFO for the quarter compared to the same period in 2014 increased 18% to $143.3 million or $0.95 per diluted share. This increase was due primarily to the higher level of minimum rent and returns earned in the 2015 quarter as a result of our hotel and travel center acquisitions, our funding of capital improvements to our hotels and travel centers and the improved operating results of certain of our hotels. Adjusted EBITDA was $123.7 million in the 2015 fourth quarter, a 24.7% decrease from the 2014 quarter. Excluding the impact of the $62.3 million of incentive management fee expense, adjusted EBITDA for the quarter compared to the same period in 2014 increased 13.2% to $186 million. Turning to our capital commitments, we funded $34.1 million of hotel improvements and $29.7 million of travel center improvements in the fourth quarter. We currently expect to fund $81.4 million of hotel improvements and $150 million of travel center improvements in 2016. Our hotel funding amounts cover planned renovations at 14 hotels, a majority of which are scheduled to be completed during the first half of the year. In addition to our TA improvement fundings, in 2016 we expect to purchase three of the five newly developed travel centers we previously agreed to acquire and lease back to TA for an aggregate purchase price of $78 million. We currently expect to acquire these properties in the first, second and fourth quarters of 2016%. With respect to our liquidity and recent financing activities, we had approximately $13.7 million of cash, which excludes $51.2 million of cash escrowed for improvements to our hotels at year-end. In December, we amended the agreement governing HPT's revolving credit and term loan facilities which resulted in the maximum amount of borrowings available under our revolving credit facility to increase from $750 million to $1 billion. As of December 31, debt to total book capitalization was approximately 53.9% and debt to total gross book value of real estate was only 39.8%. Earlier this month we issued $750 million of unsecured senior notes, which included $400 million of 4.25% notes due in 2021 and $350 million of 5.25% notes due in 2026. The net proceeds from these offerings were approximately $732 million. On February 9, we gave notice that we would redeem at par in March all $275 million of our 6.3% senior notes due in June of this year. We have no additional debt maturities until March 2017. Operator, that concludes our prepared remarks. We're ready to open up to questions.

[Operator Instructions] Our first question comes from Ryan Meliker of Canaccord Genuity. Please go ahead.

I was hoping you could give us a little bit of color on your CapEx plans for 2016. Just want to make sure that we model that out right given the impacts that it has on I guess your minimum rents, [is there anything or if that is connected] [ph]?

As I mentioned in the prepared remarks, we're going to – currently we expect to spend, to fund $81.4 million at our hotel portfolios and $150 million at our travel center facilities. The $81.4 million of hotel improvements, $48 million of that is at our Sonesta portfolio, $17.8 million at our InterContinental portfolio and the rest is spread between our Marriott No. 1, Marriott 234 and Wyndham portfolios. The amounts for Sonesta, that would be the renovation of the nine extended stay properties we acquired during 2015 as well as the two properties that we recently closed on. And then the InterContinental fundings were principally related to renovations at the two properties we acquired in Denver and outside of Chicago during 2015. And then in terms of how that total CapEx spend of $231.4 million is going to fall out during the year, and obviously this is subject to change, as you know projects never seem to go as planned, but currently anticipate $55 million in the first quarter, $62 million in the second quarter, $51 million in the third and $63 million in the fourth.

Alright, exactly what I was looking for. That's really helpful. And then I was just wondering, you guys obviously bought three properties since the end of the quarter. What is your appetite for continued growth in the portfolio, whether it would be on the hotel side or the travel center side, given A, I guess some of the concerns [kind of] [ph] where we are in the lodging cycle, I know your portfolio is doing well and imagine you'd probably think it will continue to do well, so maybe that's less a risk, but also just given some of the challenges with where you guys are from a leverage perspective limiting some of your capacity for growth without equity issue?

Sure, I'll answer that. Our leverage is a little bit higher than we would like it to be, and so we're being very cautious about acquisition opportunities, but we are continuing to underwrite opportunities that we see because we don't want to miss any especially good opportunities. And so we're continuing to closely monitor transaction activity but acting as though we may not have a kind of capital market access that we've enjoyed over the last 20 or so years. We may have to wait a little bit longer for equity prices to be at the right spot. So being very cautious but we are – and we have commitments obviously to acquire some to-be-developed travel centers and we haven't closed on the Portland transaction yet. So those will – we have the capacity for and those will go forward but I expect our external growth will slow this year.

Okay, that's helpful. I guess one of the thoughts I had, and I'm curious what your take on it is, we continue to hear that the CMBS markets are pricing private equity out of select service portfolio acquisitions today. We've seen several select service portfolios pulled off market over the past few months. It seems like a lot of the public REITs aren't really interested in acquiring those types of assets today. I'm just wondering what your appetite is for some of those larger scale opportunities and how willing you would be to move some of the – take on added leverage in the short-term with the idea that down the road you might be able to issue equity to reduce leverage?

I can't speak – my knowledge of where the CMBS market is as it relates to private equity is, you're probably closer to that than I am. So I'm not going to touch that part of the question. But we don't have an appetite for the portfolios of select service assets that I think you may be referring to. As I've mentioned on prior calls, we see those as collections of individual assets, not portfolios, and so they don't fit the type of transaction structure that we believe is warranted for investments in that type of asset. So we are not currently looking and I don't expect us to be looking at portfolios like that.

Okay, thanks John. And then one last one, you ended the quarter at 53.9% debt to total book capitalization. I know you've mentioned that is a little higher than where you'd like to be but you're comfortable there. I guess where does the comfort level start to become uncomfortable, are we talking 55%, 60%, just wondering how much real runway you guys have from [that] [ph] perspective before you start to want to make a change to the capital structure?

Ryan, this is Mark. I think around that 55% debt to total book capitalization, 40% to 45% debt to gross value of real estate, in that neighborhood is kind of where we'll cut things off.

Thanks. That's all for me.

Our next question comes from Bryan Maher of FBR & Co. Please go ahead.

So Ryan took all the good questions, but if we could just drill a little bit deeper, kind of a little bit more color, when you're out looking at acquisitions, who are you guys typically running into these days since most of the lodging REITs are seemingly out of the market? We're hearing mixed signals from private equity buyers, but clearly there are some transactions going on out there as a number of the REITs we cover are selling and listing hotels. So can you tell us, give us a little bit more color on what the environment is there for acquisitions?

I can try. The brokers don't often give us a list of who we are competing against, so it's somewhat speculation. But there are private equity firms that are out looking for hotel transaction opportunities. There are a number of sovereign wealth funds and other foreign capital sources that are looking at the U.S. as perhaps the most stable real estate market to invest in, and so that's attracting them, and I think they are looking at the hotel space. Unlike where the capital markets [indiscernible] pricing things, I think they are looking at the hotel space as having multiple years to run in terms of its continued recovery. We're also seeing high net worth individuals in certain markets bidding on properties and some pension insurance money chasing transactions as well. So there's still depth to the market. There's perhaps less buyers chasing individual transactions or portfolio transactions today than there was a year ago, but if you want to sell a property, you'll have more than one bid.

So, two things on your comment. One, you commented that some of these potential buyers are looking at still multiple years left in the cycle, which is something that we would agree and [what we've] [ph] written about. What are your thoughts as it relates to the length of the cycle?

I mean I look at supply growth as just now getting to historical long-term average run rates, in 2016. I look at – ignoring the fact that we expect to have stronger RevPAR growth than where Smith Travel or PKF are projecting or PWC are projecting for 2016, the projections are around 5% for this year and in the 4.5% to 5% for next year, both of which are more than 50% higher than historical long-term run rates for RevPAR growth. And then typically, the industry continues – even after you have historical RevPAR growth dropping to average levels and supply growth at or above average levels, typically you still see, because of the high occupancies, you still see continued rate growth beyond that for a couple of years. And with rate growth comes increased profitability because it's the most profitable way to grow revenues. So we expect not just to see 2016 and 2017 as good years but probably a couple of years beyond that. Obviously I don't have a crystal ball, and you never know what kind of unusual shock may occur, but absent any crazy economic change around the world someplace impacting the U.S., I expect that we have three to five years of continued good performance in the hotel space.

And then just lastly, kind of going back to the acquisition environment, are you seeing any easing up on pricing when you're looking around relative to what you might have thought 6 or 12 months ago?

Yes, I think we have seen price expectations and the reality of transactions pricing at lower levels. I think that during sort of the November-December-January timeframe, there's cap rates in my view have moved up almost a percentage point.

Okay. Thanks a lot, John.

Our next question comes from David Loeb of Baird. Please go ahead.

Actually want to follow-up on one of Ryan's, you were really clear, both you and Mark were really clear about the balance sheet and what your long-term intentions are, but I guess what I want to ask is, what happens if the stock market stays depressed concerned about the outlook for the lodging sector until we get into a downturn? In the last downturn, which was obviously really severe, you have an investment grade balance sheet, you still do, but you still [declared your dividend] [ph]. So what's your thought on your ability to sort of ride out the cycle with this higher level of leverage?

I think that it sounds to me like you're not even looking with a glass half empty, it seems like your glass is completely empty.

If you read my [indiscernible].

The premise behind your question seems like completely disconnected with reality. So it makes it a hard question to answer. We're not riding out a downturn, we're riding out a recession. We are outperforming the industry at this point in the cycle where the industry continues to outperform its long-term averages. So I expect that we'll continue to build our security. I expect that if we are the only ones who continue to outperform, that our share price will continue to outperform on a relative basis and we'll be in a position where we're better able to access the capital markets than our competitors. And if we're not the only ones who are outperforming, then the stock market is going to realize that it's mispriced and then all of our share prices are going to come back. But I don't at the current time believe that the equity markets have reached a long-term correction or that they're going to stay where they are, because investors are going to realize that they are missing opportunities if the prices stay where they are. So if a year from now the world has permanently changed, obviously we'll re-evaluate. We try to keep in touch with where the market is day to day. But at the time being, we believe that the equity markets are mispricing what industry expectations ought to be and we feel like we're well-enough capitalized and conservatively enough leveraged that we can easily ride through the current environment until the things become more appropriately priced.

And David, in terms of, you brought up the dividend in your discussion, and I think our dividend, as I know you know, is well covered even on a CAD/FAD basis. Even with the impact of the incentive fee in there, our payout ratio is only around 70% for 2015. So we feel good about our ability if and when the downturn does come to weather it from a dividend perspective.

Look, John and Mark, I agree with your outlook, and that's what I've been saying in my research, I agree that the market is missing opportunities today. I guess the premise of the question was more of what if a worst-case scenario does play out. So I appreciate your discussion about it. I guess just one quick follow-up, Mark. Your distribution was taxable income. So do you have kind of continued pressure to pay out that level of dividend going forward or do you have levers you could pull if you wanted to pay less dividend?

I'll be honest with you, I haven't done the analysis assuming we pay a lower dividend, but I would think that the tax laws do provide you flexibility and ways to get around one-off one year where you have a distribution issue. You obviously can't – there aren't enough levers to pull where you could do it for multiple years consecutively, but if we ever got to that position, we could deal with it. But you're right, our distribution was 100% ordinary income this year, which tells you that – which confirms that our payout ratio is relatively low.

Okay. Can I ask a little more on acquisitions and dispositions?

Sure.

On the acquisition side, what do you see as IHG's willingness to do deals for Kimpton Hotels given that there are some of those on the market? And I know dispositions are more complicated but have you considered that or what circumstances would make you consider potentially selling [indiscernible]?

I don't think it's appropriate really for me to speak to IHG's appetite. I do know that they would like to grow the Kimpton brand, and to the extent that any of the Kimpton hotels that are on the market to be sold by their current owners might be available unencumbered that they would like to keep their brand size as it is and growing. So what steps they take to do that, I won't say. In terms of dispositions, because of our portfolio structure, as you noted, it's more complicated for us to sell assets because we have – just as we keep our managers from being able to cherry-pick at renewal times against us, we sort of afford them the same protections in the other direction, and so it's not an easy process to sell assets. But we do nonetheless consider it on a regular basis, whether there's hotels that make sense for both our manager and ourselves to prune from portfolios and we have from time to time sold some and we may continue to, but at the present we don't have any that we've identified to sell at this time. Our returns are pretty good on the hotels that we own and they are in pretty good shape. So we feel like the returns we're getting on most of our existing portfolios is better than the returns we could get from alternative investments.

Our next question comes from Wes Golladay of RBC Capital Markets. Please go ahead.

With the $1 billion line of credit now, would you run a higher line now throughout the year, and right now post RMR payment and [the two main] [ph] acquisitions and the retirement of the debt, is your line balance roughly around $175 million pro forma?

Pro forma. Well, today we have got nothing out on the line today and have probably $170 million of cash. Obviously next month we're going to redeem the $275 million of notes. So borrow $100 million or so on the line to do that. And then Monaco, we'll borrow a little over $100 million to do that. So that will take us up to a couple of hundred million out on the line.

Okay. And would this be a balance you want to run the rest of the year or would you look to tap the debt market one more time?

I think it really depends on how high the revolver balance gets and what the markets themselves look like. Part of the reason for having large credit line is to afford us the flexibility to tap the markets when we think they are favorable. So I think a lot of that is just dependent on what's out in the line in our view of the unsecured debt markets.

Okay. And then real quick, how do you view your cost of capital? So I mean we talk about the dividend being well covered, yet you have about 8.5% yield [indiscernible], at least AFFO yield around 4% and the cost of debt long-term around 5.5%, gets you just under 9% on a blended 50-50 basis for the WACC. Some of these acquisitions, they still tend to be in the high 8%. Are you expecting a lot of growth for these assets or are you going to start [with probably] [ph] more when you buy stuff, at least a higher initial yield?

I assume you're calculating that WACC off of the current share price, right?

Correct, yes.

And I think what we tried to be clear about is, it's not our intent to issue equity at the current share price. So I guess when we look at where we'd like to issue to would be comfortable issuing equity, we're comfortable with the yield on the assets versus our blended cost of capital.

Okay, thanks a lot.

This concludes our question-and-answer session. I would now like to turn the conference back over to John Murray for any closing remarks.

Thanks everyone for joining us. We may see some of you at the Wells Fargo Real Estate Conference later today and tomorrow, otherwise thank you for your time.