Service Properties Trust (SVC) Q3 2022 Earnings Report, Transcript and Summary

Good morning, and welcome to the Service Properties Trust Third Quarter 2022 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Stephen Colbert, Director of Investor Relations. Please go ahead.

Good morning. Joining me on today's call are Todd Hargreaves, President and Chief Investment Officer; and Brian Donley, Treasurer and Chief Financial Officer. Today's call includes a presentation by management followed by a question-and-answer session with analysts. Please note that the recording, retransmission and transcription of today's conference call is prohibited without prior written consent of SVC. I'd like to point out that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on SVC's present beliefs and expectations as of today, November 4, 2022. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call other than as required by law. In addition, this call may contain non-GAAP financial measures, including normalized funds from operations or normalized FFO and adjusted EBITDAre. Reconciliations of these non-GAAP financial measures to net income as well as components to calculate AFFO are available in our supplemental package found in the Investor Relations section of the company's website. Actual results may differ materially from those projected in these forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-Q on file with the SEC and in our supplemental operating and financial data found on our website at www.svcreit.com. And with that, I'd like to turn the call over to Todd.

Thank you, Stephen, and good morning. Our third quarter results are highlighted by the ongoing improvement in our hotel portfolio as comparable RevPAR was 86% of 2019 for the third quarter compared with 83% of 2019 in Q2. The continued recovery of SVC's urban full-service and suburban select service hotels contributed to the improvement as travel patterns normalize and workplace expectations for employees slowly shift toward prior standards. Combined with the solid performance of our leisure and extended stay hotels, room rates have surpassed 2019 figures for the third quarter, a trend that has continued into the fourth quarter with preliminary October ADR of $143, 2% above October 2019 levels. Notably, our full service portfolio RevPAR for the quarter increased to 91% of 2019 levels, highlighted by the strong year-over-year performance of our hotels in Kauai, Boston, Toronto, San Francisco and Chicago, which benefited from elevated leisure travel, improved group demand and the continued ramp of business travel. RevPAR growth continues to be driven through ADR increases at many of our leisure and urban hotels, resulting in our hotels in Fort Lauderdale, Hilton Head, Chicago, Miami Airport and Kauai, all reporting ADR during the quarter in excess of 125% of 2019 third quarter levels. While the recovery of our select service portfolio is trailing our other service levels, it continues to be a primary focus of ours and the gap relative to industry is tightening. Compared to Q3 2021, RevPAR for our select service hotels improved 28%, outpacing industry RevPAR growth by 2.4x. Specifically, RevPAR at our Sonesta Select portfolio increased by 40% year-over-year for the quarter. In terms of segmentation, group mix was 16% in the third quarter, up from 12% during the previous year quarter and now above 2019 levels of 15%. This increase was largely driven by elevated leisure group demand as well as the return of corporate group in markets, including Boston, Chicago and Philadelphia. Weekend occupancy in the portfolio is approximately five percentage points higher than weekday occupancy, a gap we expect to shrink into next year as corporate group and transient travel returns. Group pace across our operators is positive, led by leisure group demand, but also due to notable corporate group and citywide increased demand. SVC's hotels did not experience a material impact from Hurricane Fiona or Hurricane Irma during the third quarter, as any losses were offset by incremental revenue we received from guests displaced to our Sonesta Fort Lauderdale hotel, which was not directly impacted by the storms. Inflationary pressures are impacting hotel-level operating expenses related to labor, utilities and insurance, leading to compressed GOP and EBITDA margins. We are working with our operators to reduce the reliance on more costly contract labor and are encouraged by the improvement in permanent staffing levels and hope to see a deceleration of labor-related cost increases in upcoming quarters. Also, during the third quarter, we entered into an agreement to sell our remaining 16 Marriott-branded hotels for $137 million, excluding closing costs, which we expect will close in Q1 2023. And we continue to wind down the disposition process of the previously announced Sonesta branded hotels with only five of the original 68 still to be closed. To reiterate what we have said on past calls, the hotels which we have sold or plan to sell are relative underperformers, and we are retaining the hotels with superior RevPAR, margin and growth prospects. As of September 30, 2022, we owned 769 service-oriented retail net lease properties, including our travel centers, with 13.4 million square feet. Representing 45% of our overall portfolio based on investment, our net lease assets were 98% leased by 178 tenants with a weighted average lease term of 9.8 years and operating under 136 brands in 21 distinct industries as of quarter end. The aggregate coverage of our net lease portfolio's minimum rents was 2.88x on a trailing 12-month basis as of September 30, 2022, an increase versus last quarter and an improvement from 2.37x in the same period last year. I would like to highlight for TA, our largest tenant, site level rent coverage on a trailing 12-month basis was 2.54x, up from 2.46x last quarter. We believe the diversity of our net lease tenants and the continued strong performance of TA is an ongoing strength of our portfolio. In the fourth quarter, we have 205,000 square feet of leases expiring, representing less than 1% of our net lease rents, excluding TA. This includes six tenants across multiple properties known to be vacating and represents less than $1 million of annual revenue. We are evaluating leasing, redevelopment and sale options for these properties. Also, Cineworld, the parent of Regal Cinemas, our second largest movie theater tenant, filed for Chapter 11 bankruptcy during the quarter. Regal has rejected just one of the six leases that it has with SVC and we are in discussions with the tenant regarding the remaining five sites. Before handing it to Brian, I would like to emphasize that while we remain focused on working with our operators to return our hotels to pre-pandemic levels, we are encouraged by the improvement that we saw this quarter across our portfolio. We are optimistic that our operating performance will continue to improve into 2023 with positive trends in business travel benefiting our hotel portfolio, along with the reliability of cash flows from our sizable net lease portfolio. In addition, the improvement across the portfolio and our positive view of our businesses going forward has allowed us to return to paying a meaningful common dividend to shareholders, an important milestone for the company. I will now turn the call over to Brian to discuss our financial results in more detail.

Thanks, Todd, and good morning. Starting with our consolidated financial results for the third quarter of 2022, normalized FFO was $88.5 million or $0.54 per share, a 100% increase over the prior year quarter. Adjusted EBITDAre was $173.5 million for this quarter, a 26.3% increase over the prior year quarter. Major drivers impacting normalized FFO over the prior year quarter was the improving performance of our hotel portfolio with hotel EBITDA increasing 54% over the prior year to $78.9 million. Rental income declined approximately $900,000 compared to the prior year quarter as a result of the positive impact of reducing reserves for uncollectible revenues in the prior year period, partially offset by an increase in percentage rent recognized of $1.7 million relating to our travel center leases in the current year quarter. Net operating income from our leased portfolio for the third quarter of 2022 was flat compared to the prior year quarter. Interest expense decreased by $10.7 million over the prior year quarter, primarily as a result of the repayment of $500 million of senior notes in the second quarter and repaying $705 million of the outstanding balance on our revolving credit facility this quarter. G&A expense decreased by $2.9 million or 20% to $11.3 million in the current year quarter primarily as a result of a decline in business management fees. Lastly, our share of normalized FFO recognized from our 34% ownership interest in Sonesta increased by $1.2 million over the prior year quarter. Turning to our hotel portfolio results for our 240 comparable hotels this quarter: RevPAR increased 29.6%, gross operating profit margin percentage increased by 3.2 percentage points to 33% and gross operating profit increased by approximately $43.2 million from the prior year period. Below the GOP line costs at our comparable hotels increased $7.9 million from the prior year as a result of increased management fees driven by higher revenues at our hotels and an increase in insurance costs. Overall, RevPAR increased 29% over the prior year quarter to $92.15 due to strong occupancy gains in our urban full-service hotels and an ongoing recovery in our suburban select service hotels. Our consolidated portfolio of 242 hotels generated hotel EBITDA of $78.9 million, resulting in a net margin of 19.7%. By service level, the increase was driven primarily by an improvement in our 49 full-service hotels, which generated $39 million of hotel EBITDA during the quarter, a 186% increase over the prior year period. Our 114 extended stay hotels continued to deliver solid performance, generating $27.2 million of hotel EBITDA during the quarter, a 14.6% increase over the prior year period. Our 79 select service hotels also improved, generating hotel EBITDA of $14.4 million in the third quarter, an increase of 81% compared to the prior year period. Sequentially, net margins declined 180 basis points due to higher expenses. Although top line results exceeded our internal estimates, inflationary pressures weighed on the bottom line as the cost of labor, energy, supplies and materials continued to rise. On a cost per occupied room basis, labor costs increased 13.9% compared to the second quarter. The use of expensive contract labor continues to be a challenge, and we continue to work with our operators to find ways to control costs and improve productivity. The 21 hotels that are expected to be sold, which include the 16 Marriott hotels under agreement for sale, generated hotel EBITDA of $3 million in the third quarter compared to $78 million for the non-exit hotels. Preliminary October RevPAR was $95.37. As we look to the rest of the fourth quarter, we are currently projecting full quarter Q4 RevPAR of $77 to $80. Hotel EBITDA is projected to be in the $50 million to $60 million range with net margins in the 14% to 17% range. The second and third quarters and through the month of October are typically SVC's strongest periods, but we do expect to see seasonal declines in hotel activity as we move into the latter half of the fourth quarter. Turning to the balance sheet. As of today, our total liquidity is over $800 million, including over $100 million of cash and $705 million of undrawn amounts on our revolving credit facility. Our outstanding debt includes $95 million outstanding on our revolver and $5.7 billion of fixed rate unsecured senior notes with a weighted average interest rate of just over 5%, and we have over $9 billion of unencumbered assets. In October, we entered into an additional amendment to the credit facility and extended the maturity date to July 2023. The amendment removed restrictions on paying common dividends and issuing secured debt, which allows us greater flexibility to navigate the debt markets. We also continue to agree to maintain minimum liquidity levels as we prepare to address our next maturity, which is $500 million of 4.5% senior notes maturing in June 2023. We continue to monitor market conditions and evaluate strategies on our debt maturities, but we remain patient and we'll look to execute on the most cost-efficient options that may be available to us. Turning to investing activity. During the third quarter, we sold five hotels for an aggregate sales price of $29.7 million and six net lease properties for an aggregate sales price of $1.1 million. We sold one hotel in October for a proceed of $6 million, and we are currently under agreement to sell 16 Marriott branded hotels and four Sonesta branded hotels for a combined sales price of $162.5 million, which we expect to close by early first quarter. Additionally, we made $24.4 million of capital improvements at our properties during the third quarter. We currently expect our fourth quarter capital spend to be approximately $40 million to $45 million. We'll provide guidance on our 2023 capital expenditures during our fourth quarter earnings call. Finally, regarding our common dividend announcement, we are pleased to increase our dividend to $0.20 per share this quarter, representing a normalized FFO payout ratio of 37% based on Q3's results. The decision to reinstate the dividend was based on our outlook for the company, and we believe it will remain well covered as the lodging portfolio continues to recover. Operator, that concludes our prepared remarks. We're ready to open up the line for questions.

[Operator Instructions] Our first question will come from Bryan Maher with B. Riley Securities. You may now go ahead.

Thank you, and good morning Todd and Brian. Just a couple of questions for me. On the Sonesta hotels, I mean, there was a lot of talk and activity regarding moving those from the Marriott and Intercontinental brands to the Sonesta brand over the past two years. Can you give us a little bit of color as to how you think that the RevPAR of those properties ends up progressing against what you would have considered you would have gotten if they stayed in Marriott and Intercontinental brands? And maybe offsetting that, the benefits of having them in the Sonesta brand versus under those two big brands?

Sure. So you're right. We now have several quarters of data post conversion of the 200 hotels that we converted to the Sonesta brand. So I think we're starting to get - every quarter, we're getting a better idea of how close we think we can get to the previous operators' performance. I'd say it depends on what we're learning. I think it depends on the service level and the previous brand as well as the brand we converted to. I think for the most part, most of the brands we fully expect to get back to where the previous operators were at. The Royal Sonesta are performing extremely well. They are widely recognized in the industry. Most of our full-service Sonestas, I would say the same thing about, the extended stay brands as well. I think we expect they will get back to the previous operators as well. I think the one area where we may not get back to the previous operators are Sonesta select brands that we converted. And we converted those in Q1 2021. That was a new brand for Sonesta. And there's a history too with implementing new brands at Sonesta. Sonesta did the same thing with the Sonesta ES Suites back in 2012. And it took a couple of years to get ramped up, to get recognized. And now Sonesta ES Suite is widely recognized as one of the best upper mid-scale extended stay brands in the industry. So we expect to get back close to where the previous operator was, but we acknowledge that, that may not occur for those specific hotels. To the second part of your question, you're right, there's gives and takes for us converting those hotels and growing our relationship with Sonesta. Number one - and it wasn't necessarily related to the conversion of those hotels and our decision to exit those agreements and convert those hotels to Sonesta long term, but in one of the recent amendments we did with Sonesta, we did get 34% ownership interest. And we'll really try to do a good job of attempting to quantify this as we move forward. But we really see a lot of upside in that 34% ownership interest, especially on the franchising side of the business, which we really think will grow over the next few years. And having the ability to benefit from that 34% of those future royalty fee streams, I think is really going to show it's going to more than offset any loss that we had on a long-term basis converting those selects. But overall, I think the majority of our hotels and our brands will get back to, if not, above the previous operators.

Okay. And my second question relates to the full service hotels. I mean there's been so much discussion over the past two years with limited service and extended stay hotels, having performed very well during COVID. But it seems like all of the lodging companies reporting these days really are centering in on their urban full-service hotels and how well those are recovering as business travel returns. And so I don't think that people spend enough time kind of thinking about the fact that you have those hotels. How are those recovering in this market? Can you drill down on that a little bit?

Sure. Yes, I'll start, and Brain can jump in. But yes, this is - it's a good question. And you're right, the urban full service, especially over the last two quarters, I would say have really started to recover. We, I think relative to some of our peers, our full-service hotels are a lot more concentrated in urban areas versus resort hotels. And like you say, limited service and extend stay recovered early on, but so did the resort and luxury hotels really in terms of rate recovered earlier as well. So now you're starting to see our portfolio, I think, catch up the industry, especially on the urban full service side. Our total full service that was our best performer relative to 2019, we're back to 91% of 2019 levels in terms of RevPAR. And we are really starting to see the pickup of citywide events business travel, corporate travel at those hotels. If you remember, our Q1, especially early on in Q1, a lot of the hotels that we have urban hotels in markets like Chicago, San Francisco, D.C., Boston, Philadelphia, those just had not reopened yet at the major conferences just hadn't returned yet. And now I think when you look at Q1 2023, we expect that to be well above Q1 2022. And a lot of that is going to be driven by those urban full-service hotels.

Yes. And I'd just add to that, the full service - the 49 full-service hotels are the lion's share of the revenue on a gross basis. And Todd mentioned the RevPAR and from a rate standpoint, it's over 110% of 2019. And the bottom line, we're creeping up to close to 100% too we're in the 80s as far as percentage of hotel EBITDA to 2019. So there's still some room to run there. There's still certain markets that haven't fully ramped all the way up. You look at places like San Francisco and others, but our Kauai asset, Royal Sonesta Kauai and another one that was under the knife for renovations, room renovations last year has come back very strong and actually was our biggest producer this quarter. So we feel pretty good about that portfolio as we move forward here.

Right. And just lastly, I mean we get a lot of questions related to the value of your hotels on a per key basis. And we've done studies where we back out what we think the value of the TAs are worth, with the value of the net lease assets are worth. And you get to a ridiculous number of like $45,000 to $50,000 a key for the value of your hotels when you're selling your noncore hotels for somewhere in the keys. And I don't think people are focused on the fact that you own large full-service hotels in Puerto Rico and Boston and San Francisco and in Chicago that one could easily argue are worth hundreds of thousands of dollars per key. I mean, can you give us just a little bit of color as to how you look at the value of what has become an increasingly important part of your portfolio?

Sure. Yes. We think the same thing. And I think what we've been selling over the past 12 months, as we've mentioned, has really banded the lower quality portion of our portfolio from any way you look at it in terms of performance, in terms of age, in terms of location. And the select service on average, we've been selling above $50,000 a key, the extended stay, we're selling closer to $70,000 a key. But you're right, there's - especially our luxury resort hotels, those are valued well above - well in the hundreds of thousands per key. So you're right. We have our internal analysis on what we think valuations are that we haven't made public. But I think you're on the right track. If you look at each hotel, by hotel on a per key basis on a stabilized cap rate basis, I think you'll - it sounds like you're coming to a similar conclusion as we do. And we get off-market offers all the time for some of our hotels and our hotel in Cambridge and Hawaii, we did off-market offers all the time that we look at everything. But we're not interested in selling those hotels now. But we get - I think we have a pretty good sense of what value is for our assets, and it's well above the levels that you mentioned.

Okay. Thank you very much.

[Operator Instructions] Next question will come from Dori Kesten with Wells Fargo. You may now go ahead.

Thanks. Morning. Can you just walk through what the options are on the table with respect to your mid-23 maturities? Is it more asset sales potentially resource secured advancing?

Sure, Dori. Thanks for the question. We're going to keep looking at the debt markets and look at our different options. The bond markets and unsecured notes today would be pretty expensive to do. We do have some asset sales still on the table and significant amount of liquidity sitting there. But I think we are going to look to refinance all if not part of those $500 million notes. And whether that's with senior unsecured bonds or some sort of secured financing or bank debt remains to be seen. But we feel pretty good that even despite the market backdrop and the issues with interest rates would look. We just want to make sure whatever we execute will be the best cost option for us to not increase our cost of capital radically.

Okay. And investors have been asking about the potential for equity issuance. And since the last raise was done under a prior management team. I was just wondering if you could provide your view.

Yes, we're not interested in issuing equity at these levels. We looked at the portfolio - the last equity issuances around $30, $31 a share. We certainly don't think the value has decreased to where it is today for the portfolio. So we're not interested in that today.

Okay. And previously, you said that you expect hotel EBITDA margins to get back to prior peak in the next few years. Do you continue to expect that full recovery?

Yes, we do. We do. We expect it to - it's hard to put a time frame on it, but we do expect to get back to EBITDA margins from where we were before.

Okay. Thank you.

Sure. Thanks for the question, Dori.

Our next question will come from Tyler Batory with Oppenheimer. You may now go ahead.

Good morning. Thank you. First question for me, clarification on the RevPAR guidance. How does that $77 to $80 you guided for Q4 compared with 2019? I mean, in other words, are you assuming that the comp with 2019 will improve in Q4 versus Q3 and Q2?

Yes. I think from a seasonality standpoint, the declines compared to Q3, I think the relative measurement to '19 will sort of trend in the same way. Q3 was 86% and of 2019's Q3. I don't think it's going to vary that much. And in this environment, it's pretty tough to predict what's going to happen in a week, never mind a couple of months, but we think generally it will be in that same range.

Okay. Great. And then just a follow-up question on the margin topic. Can you talk a little bit more about the cost environment out there? I mean it does sound like it's gotten incrementally worse. And you gave some guidance on your margin expectation for Q4. But just kind of wondering a little bit more in detail what you're seeing there? I'm not sure if perhaps the pressures are more isolated to the full-service properties compared with the select service.

Yes. I think from a labor standpoint, which is obviously the biggest expense in the company, that continues to be a challenge. I've put some metrics in the prepared remarks about on a cost per occupied room basis, double-digit increases sequentially, contract labor, which is roughly 20% of wages as we look to fill positions and it's no secret that it's been tough to hire leisure and hospitality workers. And I think the job support came up today saying that there were gains in that area. We're seeing the same thing. We've shrunk the open position significantly, but it's still a cost drag. We continue to try to push top line to make up for some of the difference on the cost structure. But you're seeing it elsewhere too. Utilities, for example, energy cost was up 15% over the last year. Just the cost of everything is going up. And again, that's not unique to us. It's just part of reality today and the best we can do is continue to mitigate costs and try to push rate to keep margin going.

Okay. And then in terms of the asset sales, the 16 Marriott hotels specifically, how did pricing come in versus your expectations? And what's your confidence level in terms of getting that transaction closed by early Q1.

So the asset sales of the 16 pack, they came in, frankly, much higher than we expected. We were under agreement, if you remember, to sell these hotels before the pandemic for $107.5 million. And without getting too much into the details, it was under that sales scenario, we were required to deliver fee simple title. And if we didn't, the price would have dropped to $93 million or $94 million. So now that we're at $137 million, it's a significant increase even the guidance that we started out with at this time in the process was, I think, around $110 million. So much higher than we expected. It ended up - we got a significant number of bids from highly qualified groups. So we are under agreement now. We're expected to close these in the first quarter. And we had the benefit of having, as I mentioned, those highly qualified groups. So we selected a well-known buyer that was well capitalized, had a history of closing transactions of this size. So at this point in time, I'm confident that we will close. There's no guarantee. There is no guarantee until it does close. But we've tried to structure the deal appropriately as well, so that there are protections for us if it doesn't close. But at this point in time, I'm still confident that it will close in Q1.

Okay. Great. Last question for me. In terms of the dividend announcement. Can you provide a little bit more detail in terms of why you thought this level was appropriate interested in your perspective on a potential payout ratio going forward? And how did you think about reinstating the dividend vis-a-vis some of the other avenues for capital that are out there like CapEx or paying down debt or something like that?

Sure. It's a good question, Tyler. We started, obviously, being a REIT dividend, paying a dividend is very important to us. So as we really at the kind of end part of the first quarter of this year, coming into the second quarter, we really started to see significant recovery in the lodging side of our portfolio. And you combine that with the stable net lease cash flows for almost half of our overall portfolio. We started to have meaningful conversations with the Board about two things, when to reinstate the dividend above the $0.01 per share we have been paying and at what level to reinstate the dividend. So I think it's an indication of our view of the lodging portfolio going forward. What we're seeing in terms of group pace and business travel. I think the goal was to set a dividend level that was well covered and a dividend that we could at a minimum maintain going forward. So that was the rationale. We ran a variety of analysis, downside analysis. And we thought we settled on this level, and again, mostly due to both the coverage today and what we think the coverage will be going forward.

Okay. Great. That's all for me. Thank you for the detail.

Sure. Thanks Tyler, for the questions.

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

Thanks, everyone, for joining today's call. We appreciate your continued interest in SVC, and we look forward to seeing many of you in San Francisco at NAREIT later this month.

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