Extended Stay America, Inc.
Q2 2017 Earnings Call Transcript

Published: 1 Aug 2017

[Operator:]

Greetings and welcome to the Extended Stay America Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Robert Ballew. Thank you. You may begin.

[Rob Ballew:]

Good morning and welcome to Extended Stay America's second quarter 2017 conference call. The second quarter earnings release and an accompanying presentation are available on the Investor Relations portion of our Web-site at esa.com, which you can access directly at www.aboutstay.com. Joining me on the call are Gerry Lopez, Chief Executive Officer; Jonathan Halkyard, Chief Financial Officer; Jim Alderman, Chief Asset Merchant; and Tom Bardenett, Chief Operating Officer. After prepared remarks by Gerry and Jonathan, there will be a question-and-answer session. Before we begin today, I'd like to remind you that some of our discussions will contain forward-looking statements, including the discussion of our 2017 outlook. Actual results may differ materially from those indicated in the forward-looking statements. Forward-looking statements made today speak only as of today. The factors that could cause actual results to differ from those implied by the forward-looking statements are discussed in our Form 10-K filed with the SEC on February 28, 2017. In addition, on today's call, we will reference certain non-GAAP measures. More information regarding these non-GAAP measures including reconciliations to the most comparable GAAP measures are included in the earnings release and Form 10-Q filed this morning with the SEC. And with that, I'll turn it over to Gerry.

[Gerardo I. Lopez:]

Thanks, Rob, and good morning everyone. Thank you for joining us to discuss our second quarter 2017 results. In this Q2, as has been the case for several quarters now, we are pleased to produce another strong three months of earnings growth. Driving the strength were two things; one, RevPAR growth of 2.4%; and two, hotel operating expenses lower than a year ago. This combination meant that property level flow-through was over 100% for the third quarter in a row and it enabled adjusted EBITDA growth of 5% to $172.8 million. No surprise, with RevPAR up and expenses under control, hotel operating margins expanded nearly 1 full point and on a 625 hotel basis enabled adjusted EBITDA growth of 5.9% in the second quarter of 2017. The quarter was about more than just numbers, as good as they were. In Q2 we completed our renovation program, on time and below budget, with our final hotel completed last May 26. This means all 625 Extended Stay America hotels have now been renovated in the last 5.5 years and we look forward to the next 18 months or so of significantly lower capital investment, a clear positive for our free cash flow. Completion of the renovation program was not the only big event in these last three months. As I suspect most of you know, our former sponsor group completed their final secondary block trade in early June, erasing all overhang worries. We also brought on board, pun intended, four new independent, highly qualified directors to serve on the boards of the C-Corp. and the REIT. We closed on the previously announced sales of our Canadian hotels and the one Northeast hotel. And perhaps most important to our immediate future, officially launched our franchised offering at the NYU Conference in early June, with a newly staffed development and franchise team. All this is in keeping to the plan, timeline and commitments that we've made to you in quarters past. Promises made, promises kept. Let's get into some color and context for our performance this quarter. After a strong start to Q2 on the top line, the last five weeks of the quarter or so produced slower RevPAR growth than we expected, as late demand generation fell off a bit from the pace that we have seen since early March. Still, growth for the full second quarter was sequentially stronger than the first quarter, and as I mentioned a few minutes ago, saw RevPAR grow 2.4% on a comparable basis in spite of an approximately 60 basis point headwind from the Easter calendar shift. This was roughly in line with the total industry, but better than STR reported numbers for suburban locations, where 75% of our hotels are. And a 2.4% RevPAR growth was, again per STR, better than the majority of the industry chain scales and better than our comp set. So we'll take it. For the quarter, RevPAR growth was strongest in our South and North positions, with continued softness, albeit positive growth, on the West Coast. The Bay Area and Texas were weak during the quarter but were offset from strong RevPAR performances in Denver, Orlando, Cincinnati, and New Jersey and Richmond. Revenue growth in the quarter came from increases in leisure business, primarily through our OTA partners, offsetting small declines in corporate travel and global distribution system channels. Don't forget, we think of the OTAs differently than many of our peers. OTAs [indiscernible], even after commissions, are accretive to our results. That may not be true elsewhere. Turning now to ESA 2.0, as we highlighted at our Investor Day last year, ESA 2.0 is our roadmap forward, our plan for the next stage in ESA's growth. In this call and future ones, we want to bring clarity to our progress here, like we have on renovations and the infrastructure buildout over last five years. In that vein, we like everyone to think of ESA 2.0 as having three predominant work streams. These work streams are; A, bulk hotel sales; B, franchised new build; and C, ESA owned and operated new builds. Over the last six months or so, Jim Alderman has built out the core of his team to take on these three work streams. Jim and his team have handled dozens of inquiries from interested partners, scouted locations for new construction coast to coast, opened up dialog with potential franchisees, completed designs in the new ESA 2.0 prototype hotel, and built model rooms in our Charlotte support center. So, when ESA 1.0 completed in late May, as our final hotel renovations wrapped up, it was natural that we launch our new program in early June at NYU. The first work stream that I mentioned a moment ago is hotel sales. In truth, this is work that we began even before NYU. We had opportunity, so why wait. In May, we sold and closed on four hotels, including three in Canada and one in Massachusetts, for gross proceeds of approximately $61 million. Combined with 53 other hotels that we sold previously, we think the pattern of asset recycling begins to emerge. We've been excited by the level of interest and deep conversations we are having with potential buyers of additional hotel assets in the last couple of months. While we have nothing official to announce yet, we are currently under active discussions and at a term sheet space with eight experienced owner-operators or hotel developers to buy and refranchise approximately 90 existing Extended Stay America hotels. We look forward to announcing deals in the coming months as they unfold and we are confident that we'll remain on track to sell and refranchise approximately 150 ESA hotels in the coming four to five years, as we laid out in our Investor Day. The second ESA 2.0 work stream, franchising new hotels, is also well underway. Our Franchise Disclosure Document is now effective and we think it outlines compelling value to potential franchisees, both because of the strong economics of our business model and a very simple fee and room structure that we've outlined in the FDD. We've received strong interest and demand for franchised hotels since NYU. We'll have focus, as promised, only on sophisticated and experienced owner-operators and developers who have access to their own capital, are already in the business, and know how to run a hotel. We are currently in very active discussions with eight of these types of firms, many of which overlap with the bulk sales offering and we think we can build as many as 85 or more new Extended Stay America 2.0 hotels over the next few years. We have additional earlier stage discussions with several more firms, all following the same pattern of experienced, well-capitalized operators. We remain confident we can meet or exceed the new franchised build targets that we laid out in June of last year and look forward to announcing signed new franchised hotel deals over the rest of 2017. Pace of work has also picked up on work stream number three, owned and operated ESA new builds. We currently have four signed purchase agreements with four more we expect to sign in August for land for new development on our own balance sheet in 2018 and 2019. We expect to close in at least half of these in 2017 and expect to begin moving dirt in early 2018 on the first couple of new builds. We continue to expect low double-digit to mid-teen unlevered cash and cash returns for the new builds and expect the new build program for the next five years to be fully funded by capital from asset sales. Overall, we are pleased with the progress we are making against the ESA 2.0 plans that we laid out last year and are excited to begin announcing deals in the near future. Now looking to the overall industry and ESA's positioning in the context of the larger arena, supply growth and economy in mid-scale segment continues to be muted, in the 1% range or so, or perhaps lower, and remains well below the industry's total expected supply growth for the coming years. Leisure customers remain robust and eager to travel and are the fastest-growing segment in the industry, while corporate travel demand has remained soft in 2017 despite recent optimism and improved reported corporate earnings. Net, we believe low single-digit RevPAR growth for the industry remains the most likely result in the next couple of years. In that future, we will remain committed to a focus on fundamentals, executing on ESA 2.0, delevering the balance sheet, and continuing to return significant amounts of cash to shareholders, both through a strong dividend as well as share repurchases. We'll do this with an improving free cash flow yield from lower capital expenditures due to the completed renovations as well as significant capital recycling from asset sales. Now let me turn the call over to Jonathan to give you more detail on our financial results and provide commentary on our Q3 and full year 2017 outlook. Jonathan?

[Jonathan S. Halkyard:]

Thanks, Gerry. Comparable hotel RevPAR increased 2.4% in the second quarter to $53.04, driven by an occupancy increase of 220 basis points, partially offset by a small decline in average daily rate of 0.5%. The increase in occupancy was aided by 40 basis points from a decrease in rooms under renovation compared to the second quarter of 2016. With respect to ADR, this quarter we had significantly more net bookings from our OTA partners compared to last year, which reduced our ADR and RevPAR growth rates for the quarter by about 130 basis points. When a guest pays an OTA partner directly for his stay at ESA rather than paying at the hotel, the ADR and expense is the net amount rather than the gross amount, which has a dilutive effect on our ADR growth. For the first half of 2017, comparable hotel RevPAR increased by 2.3% to $49.44, driven by 150 basis point occupancy increase and a slight increase in ADR. Total revenues for the second quarter increased 1.7%, including the revenue impact of the four hotels that we sold in early May, which was approximately $2.6 million of lost revenue contribution. Room revenue increased 1.5% while other hotel revenue increased by 16.1% in the second quarter. Other revenue per occupied room increased $0.14 compared to last year, to $1.16. Total revenues for the first half of 2017 increased 1.5% to $629.4 million, and that also includes the loss of a day from leap year as well as the lost revenue contribution from the four hotels we sold in early May. Hotel operating margin expanded 90 basis points in the second quarter to 56.7% on a 111% property level flow-through. During the quarter, we saw a decrease in employee benefits expense, room expense and booking commission, partially offset by expected increases in labor cost and property taxes. For the first half of 2017, hotel operating margin expanded 150 basis points to 54.8%. Corporate overhead expenses, excluding non-cash share-based compensation and secondary costs, were approximately flat at $21.2 million in the second quarter compared to the prior year. For the first half of 2017, corporate overhead expenses increased 2.4% to $44.4 million, again excluding non-cash share-based compensation and secondary costs. Adjusted EBITDA increased 5% in the second quarter to $172.8 million, just above the midpoint of our guidance range. But remember that our guidance for the quarter and the year assumes no asset sales. The asset sales in early May reduced our property-level EBITDA by about $1.5 million during the quarter. On a comparable 625-hotel basis, adjusted EBITDA increased 5.9% during the quarter. For the first half of 2017, adjusted EBITDA increased 5.2% to $302.5 million. Adjusted FFO for the second quarter dipped 1.6% to $101.9 million, due to a one-time favorable tax adjustment in the second quarter of 2016 from the PATH Act that greatly reduced our tax rate during that quarter. Adjusted FFO per paired share increased 2.4% to $0.53 per paired share. Adjusted FFO for the first half of 2017 increased 1.6% to $170.6 million, while adjusted FFO per paired share increased 6.2% to $0.88. Net interest expense during the quarter was at $31.7 million compared to $35.8 million in the second quarter last year. For the first half of 2017, net interest expense was $65.3 million compared to $82.7 million last year. Our income tax expense was $15.9 million compared to $7.4 million in the second quarter last year, and our effective tax rate for the second quarter was 24.3% compared to 10.8% in the comparable period last year, due as I mentioned a few minutes ago to a one-time favorable adjustment last year from the PATH Act. Net income for the second quarter declined 19% to $49.7 million, and the decline was due to the increase in the tax rate and depreciation expense, an impairment charge of $7.9 million, and loss on the sale of hotel properties of $1.9 million, partially offset by of course increased revenue and other income. Net income for the first half of 2017 fell 13.6% to $65.8 million due to the aforementioned items. Adjusted paired share income dipped 4% to $60.5 million due to the increase in our tax rate. Our adjusted paired share income per diluted paired share for the second quarter was flat at $0.31 per paired share compared to the prior year. Adjusted paired share income for the first half of 2017 increased slightly to $89 million, while adjusted paired share income per diluted paired share increased 4.7% to $0.46. Capital expenditures for the second quarter were $44.6 million, and that includes $10 million in renovation and $33.2 million in maintenance capital. During the quarter, as Gerry said, we completed 17 hotel renovations, with all 625 hotels now renovated. With the renovation program completed, we have an additional $25 million or more per quarter that can be used for additional capital returns, ESA 2.0 investments, and deleveraging, over the next six quarters. During the second quarter, the Company repurchased and retired approximately 1.8 million paired shares for $30.9 million. Since commencing the repurchase program in the first quarter of 2016, our Company has repurchased and retired approximately 12.6 million paired shares at an average cost of $15.37 per paired share for $193.7 million through the end of June. These repurchases represent over 6% of shares outstanding when we began the program in the beginning of 2016 and will provide a nice tailwind to earnings, free cash flow and adjusted FFO per diluted paired share. The Company had approximately $106.3 million in share repurchase authorization remaining at the beginning of the third quarter. We ended the quarter with unrestricted cash of $56.2 million. Total debt outstanding, including unamortized deferred financing cost, was approximately $2.6 billion, a decrease of more than $50 million during the quarter with a weighted average maturity of seven years. Net debt to trailing 12-month adjusted EBITDA has now fallen to 4x. We continue to expect to reduce this metric further to approximately 3.5x by the end of 2018. And this morning, the Boards of Directors of Extended Stay America, Inc. and ESH Hospitality declared a combined quarterly distribution of $0.21 per paired share. These distributions include $0.14 per ESH Hospitality Class A and Class B common share and $0.07 per Extended Stay America common share. The distributions are payable on August 29, 2017 to shareholders of record as of August 15, 2017. As a reminder, ESH Hospitality, Inc. expects to distribute approximately 100% of its taxable income. Overall, ESA's strong cash flow during the quarter allowed the Company to invest $44.6 million in CapEx, pay $40.6 million in dividends to paired shareholders, repurchase $30.9 million in stock, and reduce our debt outstanding by approximately $52.3 million, a balanced approach that we expect to orient even more toward capital return in the next year and a half. Looking to the third quarter, we expect comparable RevPAR growth between 1% and 3%. We expect adjusted EBITDA between $184 million and $190 million, and this reflects approximately $2 million of lost contribution from the four hotels that we sold in early May. For 2017, we still expect comparable RevPAR growth of 1.5% to 3.5%. To flow through the lost hotel EBITDA for the four hotels that we sold in May, we are lowering our adjusted EBITDA expectations for 2017 by $5 million to a range of $620 million to $635 million. Our expected tax rate, capital expenditures and interest expense remain unchanged for 2017 from our prior guidance. Operator, let's now go to questions.

[Operator:]

[Operator Instructions] Our first question today is coming from Harry Curtis of Nomura/Instinet. Please go ahead.

[Harry Curtis:]

Wanted to go to the 85 or so franchised hotels that you are hoping to develop over the next few years, are these signed deals or is it your gut feel at those numbers around 85?

[Gerardo I. Lopez:]

It's Gerry. Let me start out that answer. These are not signed deals yet. These are deals that are in various stages of negotiation with about eight different parties. Some of those are also parties who are interested in buying some hotels. So it's our first time in reporting what a potential pipeline may look like, but to be clear, these are not yet deals that have been inked with specific locations. So they are indications of interest from parties that are well-capitalized and who are already operating in this sector, in the lodging business, under various and sundry different banners for various brand owners out there. Jim, anything that you would add, did I miss any other details on that?

[Jim Alderman:]

No, Gerry, I believe you've covered it with the people that we've had in and out of the office for the last several weeks, the commitment to continue to expand what they are already doing with other brands and other formats but moving into extended stay really rounds out what they would like to do. So we've got people who are very interested in Gerry's stated strategy of owning their market and coming in and building out the balance of the market, acquiring properties from us and building out the balance of the market with new franchised units.

[Harry Curtis:]

So as a follow up then, I'm curious as to why you're actually spending the money on the new builds. Is that because you anticipate that you really won't be owning them very long?

[Gerardo I. Lopez:]

All along, Harry, the strategy has been to have a balance between the owned and operated and the franchised. The main difference here would be the geographies and the markets. We have markets that are more strategic to us than others. We have markets where we have greater operational density than others. So our plan all along has been to build on our own balance sheet in those markets where we already have a density, where we think that the growth is going to match our intentions, and where we've good operators in place, and so on, versus where the franchisees are intending to build, which are markets where they can buy some of the units that we may have where we don't have quite the same operational density which they do have because they have all the banners and which they can bring today when they put up the new builds. So all along the idea has been that we will do so side-by-side in different markets and on somewhat different timing. So it's never been one at the expense of the other. Does that answer your question?

[Harry Curtis:]

Yes, that was my first two-part question. My only quick follow-up is, you had touched on how the last five weeks you saw a slower demand. Were the results in July reasonably similar to the last five weeks or any evidence of meaningful change versus the last five weeks?

[Jonathan S. Halkyard:]

It's Jonathan. They were pretty much the same, Harry, in July for us as in June. Some of that we think was due to some calendar changes over the 4th of July weekend. We are also comping over the Republican and Democratic national conventions, which were pretty big business for us in those two markets during the month of July. But as we look forward to August and September, our booking pace looks pretty good, in line with the best months that we've had so far this year.

[Harry Curtis:]

Okay, that's great, thanks.

[Operator:]

Our next question is coming from Anthony Powell of Barclays. Please go ahead.

[Anthony Powell:]

Can you give some more color on some of the corporate [indiscernible] weakness you mentioned in the quarter, that would be great, what industries you think were weaker in the quarter, are you seeing any impact from some of the disruption in retail and store openings and whatnot in your business?

[Gerardo I. Lopez:]

The corporate sales during the quarter, Anthony, were about 2 to 2.5 points softer than what we had expected in prior year. No one particular industry distinguishing itself over any other in terms of huge deficiencies here or huge advances anywhere. It's more geography driven. Frankly the West Coast, the corporate business is softer, the leisure business is stronger there. The leisure business is stronger pretty much everywhere. But when we look at our North and when we look at our southern divisions, frankly the corporate business, it's a little stronger than – it's flattish to slightly up. So, it's more a geography driven phenomenon that we're seeing than it is an industry driven phenomenon that we are seeing.

[Anthony Powell:]

Got it, thanks. And you mentioned several times that leisure is a bit stronger than business and your OTA mix is higher. Has that changed where you seek to build new hotels that you franchise and buy land for development, has that changed the prototype at all, how are you responding in ESA 2.0 to this more leisure or OTA heavy mix?

[Gerardo I. Lopez:]

It hasn't really influenced the geography choices. What it has influenced is that we know we have a double room that holds great appeal to the corporate customer. The design in our new double room, in the new ESA 2.0 prototype, is very unique and very different from anything else in the marketplace, and it was very specifically designed for the corporate customer that we cater to with them in mind. The beds are head-to-head rather than side-by-side, and it makes a huge difference in the level of separation and privacy that you can provide in that unit. So, that had great influence. The number of those rooms in any one of the prototypes that we build will be greatly influenced by the percent of corporate customers that we have in any one geography. So, it does have influence in that regard. As to where the geographies are, not really. We've stated all along the strategically significant markets for us, California, Florida, the Southeast, the Southwest, is really what we are interested in. And it's driven not just by what may seem the obvious answer, which is the economic growth, the migration inside of the country, et cetera, but it's for us also driven by the operational density that we keep making reference to. Operational density, just to be clear, it's about having enough hotels in a marketplace to where the effectiveness of our triangle team, sales, operations, and revenue managers, are just the most effective. In a four-hotel market or five-hotel market, their effectiveness is good. In a 9 or 10 or 12 hotel market, their effectiveness is significantly higher. And that's what we seek to have is that operational density. So it's not just sunshine and good weather, not against those by the way, but certainly it's the operational density that drives us to make those geography decisions more than anything else.

[Anthony Powell:]

Maybe just one more on the OTA mix, was it higher in June and July given some of the softness you have described?

[Gerardo I. Lopez:]

Was what higher, I'm sorry?

[Anthony Powell:]

Your OTA mix.

[Gerardo I. Lopez:]

Yes, somewhat, but it's not a phenomenon of the last six weeks or for that matter three months. It's a trend that has been coming on for the last frankly 18 months. So I suspect a lot of it has to do with our aggressiveness in that channel and that aggressiveness is driven because others are walking away from it, and [indiscernible] the economics of that channel for us are hugely accretive. Even as consumers choose to pay through the channel, pay the OTA partner as opposed to paying us directly and that causes some changes in the way that the accounting flows, the channel has done really well for us and the ADRs that we get in that channel can be $18, $20-plus versus our standard for the entire state. So, when we can get in the high 70s or low 80s ADR in that channel versus our standard high 50s or low 60s, we will take it all day long, and it has worked really well for us, continues to do so. Just to put it in perspective, Anthony, the RevPAR that we reported of 2.4%, had the accounting on the OTA channel being consistent year on year, which obviously it wasn't because of the way consumers are choosing to pay for the reservation, but had the accounting been consistent, that would have been a 3.7% RevPAR growth, not 2.4%. We'll take the reservation, we'll take the occupancy gain, we'll take the customer, we'll take the guest in the front door all day long regardless of how they choose to pay us, but it's been a good story for us and a pretty story for us, continues to do so. Yes, it did better than the overall business in July, but again, a story that began a good year and a half ago, not in the last six or eight weeks.

[Operator:]

Our next question is coming from Shaun Kelly of Bank of America. Please go ahead.

[Shaun Kelly:]

Gerry, maybe to stick with the last discussion a little bit on kind of the OTA mix, could you just drill in a little bit, is this shifting more to the merchant model from agency model or do I have that backwards in terms of what you are exactly doing with the OTAs? I mean to be very clear, is this one of the biggest contribution in terms of what's driving the decline in hotel operating expenses so effectively, we are swapping this revenue for margin and that's where we see it?

[Gerardo I. Lopez:]

Correct on all counts. It is a shift to the merchant model and it is a contributor to some of the drop in expenses to a point, right, because it's a very efficient way for us to get business. Our marketing budgets are not of the size that are going to allow us to go out and get major broadcast television advertising for example, right. So you are not going to see Extended Stay America TV commercials on ESPN, on College GameDay, on a Final Four, that's just not what we do. We are however very active in the digital channels and we use the OTAs as our marketing vehicle. A lot, a significant number of our OTA guests are first-time triers, right. So, what we pay in commissions to the OTA is not just the commission rate of the distribution channels that everybody pays, but we think of it too as part of our marketing budget, and that has worked out really, really well for us. The demand, the other big piece of it, Shaun, is the way the demand presents itself, right. So we are literally using the OTA channel to fill demand that is literally within two to four days of arrival, right. So we are literally booking on Tuesday for Friday, Wednesday for Saturday. We know that those rooms are going to be available. We know that our 30+ business, it's stable, we know where it is. In fact the 30+ business in the quarter was up 1 point, so no issues there. So it's healthy and it's doing well. But we know the room is going to be sitting there and the demand presents itself through the OTA and that kind of an ADR with the potential to get us a guest that is a first-time trier, it just for us it just works well all the way around.

[Shaun Kelly:]

Perfect. Thanks for the color. And then to switch gears back to a little bit of what's going on in the asset disposition side, you mentioned the kind of developed conversations with the possible refranchising opportunity. When do you think it is sort of like the right timeline to hear an additional update or maybe get one of the first one of these closed? Do you think we could hear something within a quarter or by the back half?

[Gerardo I. Lopez:]

Our intention is to give you updates every quarter and that's why I wanted to sort of establish in the prepared remarks the notion that there are three work streams that refer to the sale of some of the assets, the franchise opportunities that we are going to be signing up, and then our own. In fact it's kind of what I was trying to do, Shaun, is say, if in the past four or five years we've been talking to you about renovations and the infrastructure through the RMS system that we installed and the work that we did to develop our sales group, those were the three initiatives of the prior five years. The work streams on ESA 2.0 for let's call it the next three to next five years are going to be these three things; the bulk sale of some of the assets so that we can do some of the asset recycling and generate capital that we can return to shareholders, use for delevering and use for our own builds; the franchise; and of course, our own builds. So that's the way that we are going to try and report back to you every quarter going forward, certainly would anticipate, but it's tough to predict with precision when deals get signed, particularly when construction begins, given some other permitting in some other locations and whatnot. So it's tough to predict on a quarter by quarter basis, but I will tell you that between now and the end of the year, we'll certainly anticipate the announcement on some of the asset sales as we're pretty far along on a few of those, and certainly an announcement on some of the franchised hotels we are also pretty far along on a few of those. And then on our own balance sheet, we are pretty far along on site selection and we've deployed some money to do due diligence on a few of these types and whatnot, so we anticipate being able to announce some sites that are no longer being scouted or scooped out but rather ready for some building. And then whether we'll start moving dirt later this year or early next, that's where some of that imprecision comes in. But we would come back at you I would certainly expect every quarter with progress reports on all three fronts, if that makes any sense.

[Operator:]

Our next question is coming from Chris Woronka of Deutsche Bank. Please go ahead.

[Chris Woronka:]

Not to beat the dead horse, I want to come back once again to that OTA mix, and really my question is, is it something that you guys can forecast with a lot of precision? I mean, I guess what kind of advanced look do you have into the trends there and is it something that you will be looking at going forward in terms of guidance?

[Gerardo I. Lopez:]

We can forecast with some precision, not with the same precision that we can forecast our long-term business, which is much more stable. And the forward look is not great. It's not great a quarter out. It gets significantly better the closer in. We know a month out, as a month begins, we have a much better view than we did a month before, and of course as the month progresses, it gets progressively better, I guess real good Tuesday for Friday, in fact the week. So we literally use it that way, rooms that would otherwise go unfilled get released into that channel, whether it's the [OPAs] [ph], whether it's the opaque. So it's not an exact science and it is not as forecastable, if that's a word, as some of the longer-term businesses, but we are comfortable as we factor it in into our guidance and what we expect and the trends that we see that on an educated basis, we are giving you about as good a guess as we can give, as good a forecast as we can put in front of you.

[Chris Woronka:]

Okay, thanks for that. And then I wanted to ask about margins. You guys have really done a terrific job on that front and with the occ gains and the lower ADR, second quarter performance is really impressive. I guess the question is kind of how sustainable is it as we look at kind of the various line items in that hotel operating expense line? I mean what do you think some of the puts and takes are going forward and is labor actually fairly sticky, because we have been obviously thinking that there has been some pressure there in some markets?

[Jonathan S. Halkyard:]

It's Jonathan, Chris. I appreciate you calling that out. I think this is now the third straight quarter where we have seen increased revenue and reduced operating expenses, and for that I get Tom Bardenett coffee every morning. We are proud of that performance and we are enjoying through the second quarter this year the benefit of year-over-year comparables against some cost actions that we took, which you'll probably remember, beginning in the third quarter of last year. So those will become a bit more difficult to compare against as we now lap those. At the same time, we continue to make progress on the standardization of our property operating model, and that is why we've been able to hold labor increases to very low single-digits. And so, I'm confident that we can continue to expand margins so long as we can grow revenue by call it low to mid single-digits. Now in the fourth quarter last year we did enjoy a $4 million property tax benefit, which we called out at the time and that's not going to be possible to comp over. So, in the fourth quarter, our margin performance will be particularly difficult year-over-year. But this is a model that is very straightforward operating model and we just get better and better at not only managing but forecasting our expenses.

[Gerardo I. Lopez:]

I think, Chris, it's important that – there's two components to this thing, right. One is the year-on-year improvement, but the other one is that in the absolute terms, the kind of margins that our new operating model is delivering with the cost reset that we put in place in Q3 last year that Jonathan made reference to, I mean those – we were pretty strong in margins, best in class before, and we even managed to put a little bit more distance now. So, the absolute level, the expectation is, we'll remain as you see it in the mid-50s, perhaps even a point or two better than that. Even as the year-on-year growth slows down because of the overlap, the fact is that we have a new way of running these things, we have new sense of control, we continue to standardize, as Jonathan mentioned. That operational density that I have already talked about a couple of times pays off. When you automate, when you put in front of the revenue managers the kind of automated system that allows them to be much more productive, that pays off, [because that] [ph] allow to increase. There's a lot of work behind the scenes that allow people who pick up two or three more hotels per manager, per salesperson or per field person, and that manifests itself in not only the sustainability of the model but some of the improvements that you've seen as well. It's really a combination of all of the above. There's no one home run, it's a bunch of singles and doubles.

[Operator:]

Our next question is coming from Michael Bellisario of Baird. Please go ahead.

[Michael J. Bellisario:]

Just on the development franchising front, are the owners and operators that you are in discussions with, are these guys more regional sharp-shooters or do you think you'd be able to grow with them in multiple markets, because basically what I'm trying getting at is, they're going to have to continually find new partners as you look at more markets?

[Jim Alderman:]

It's Jim. They are really both. Primarily the ones we have had in here have a high degree of concentration in a couple of markets, but there's always those other sexier markets that they want to build in as well, the opportunistic markets, the Floridas, the Texas, the super high growth areas. But most of the ones that have been in so far are kind of very dominant in two or three metro areas and expanding out from there into the exurbs of those areas where the new growth is in their market. So, it's a combination of both, but it's always hard for developers who like to develop where the people are, by nature it's hard for them to avoid the sexier markets. So we think it will be a mix and we think it will – we've not had any issue at all to date locating people who are interested in this format.

[Gerardo I. Lopez:]

Our intention, Michael, if I were to think – just to use round numbers for a moment – if I were to think of 200 franchised hotels, a combination of sales and/or new builds by those franchisees, for those 200 units the ideal situation is to have a meeting with 20 franchisees, not 200 franchisees, if you catch my drift. We want multi-unit operators who know how to run the business, who know how to run a hotel, have their own access to capital, who are already experienced in all the nuances of construction and management, and who frankly at the end of the day when we need to pivot, make decisions, do new things, can get in a room with them and it's a smaller conference room, it's not a big ballroom, okay, and these are folks who are motivated by their returns on their capital like we are and there is a certain level of affinity in the things that motivate them, motivate us, and we can work with these folks. So, it's a tight number of folks, it's not an endless stream of individuals, if that makes any sense to you.

[Michael J. Bellisario:]

It does, thank you. And then just on the development returns, I think I heard you mention mid double-digit returns on the unlevered side. Have your return expectations changed at all? I think you've been talking about low double digits. And then maybe just on the land deals, how has pricing come in versus your original expectation?

[Jonathan S. Halkyard:]

We have not changed our return expectations from those that we have communicated in the past and the land acquisition cost contemplated by the deals that we are looking at right now are consistent with the ranges that we have given in the past.

[Operator:]

Our next question is coming from Joe Greff of J.P. Morgan. Please go ahead.

[Joseph Greff:]

A quick question on asset dispositions, with regard to the 90 existing hotels that you are in discussions with these eight different firms, can you talk about your valuation expectations, and maybe the way to kind of be helpful to us, if you don't want to be talking about specifics, how does the valuation compare for these 90 existing hotels versus the four hotels that you've sold in May, which I'm presuming is somewhere around 135,000 to 140,000 per key on a per key basis?

[Gerardo I. Lopez:]

I'll start the answer, Joe, and Jonathan and Jim will keep me honest. So, a couple of different things that are in play here. A, not all hotels are created equal. So the valuation for these hotels that we are talking about now will be very specific to the portfolios that are being assembled. So we have our entire estate for example divided into five different tiers, Tier 1 being the best, Tier 5 being the lower RevPAR, slower growing hotels. We would expect valuation on a hotel that we will sell in Tier 5 to be not quite the same as it is for a hotel that we'll sell in Tier 1, assuming for that matter that we would even be selling anything in Tier 1 because those are likely not the ones that we are going to be looking to sell as you can imagine, they tend to be the best performers. So that's kind of point one is that the valuation will be greatly determined by the composition of the portfolio that anyone of our potential partners is interested in. These guys are interested in geographies, they look at our other margins and our P&Ls, and they try to understand, how do you guys do that, they find out that proximity and number of hotels in a single market matters, and all of a sudden it's like, okay, they get it. And that's why as they assemble, as we help them assemble these portfolios, there's going to be Tier 5s and Tier 4s, those are our priority to sell, they are not going to command the same valuation that a Tier 1 hotel would. So that's kind of there's different grades, shades of gray areas that would greatly influence how we think about it, number one. Number two, we have sold, if we go back all the way to December of 2015 and when we sold the Crossland and a few ESAs that went along with that deal, the Canadian hotels that we sold now, the Austin hotel sale pending, the Massachusetts hotel that we closed on, all of those were sold unencumbered. All of those were sold to owners who were to do something else with them. They were not sold to remain on flag, they were not sold with a management agreement, as some of these that we're selling now may be, they were not sold with a franchise agreement where there is a royalty and a program fee that is going to be coming back after the hotel sale goes through. So totally different situation and circumstances as you know when you sell an encumbered versus unencumbered. So that will figure also of course into the valuation. So those are at least two big differences. Jim and Jonathan, I know I'm missing a couple of points.

[Joseph Greff:]

Maybe a way to kind of pinpoint it a little bit is, the four hotels that you sold in May, would you say those are closer to being Tier 1 versus Tier 3?

[Gerardo I. Lopez:]

The one that we sold in Massachusetts was a Tier 5. I mean that hotel wasn't even branded ESA any longer. The ones that we sold in Canada were Tier 3 and we sold it for strategic reasons, three hotels in Canada in three different provinces, hundreds of miles apart from one another. So that was more of a strategic sales than it was anything else. But off the top of my head, I'm going to say they were Tier 3s up there. So, I think one way that we think about it is, look, we are not going to sell hotels that we believe are dilutive to shareholder value. We have not done that in any of the 67 that we have sold. Why would we start now? There are future commitments for hotel builds by these people that we are engaging with in the sales now. So there it's a different ballgame when you are selling someone 12, 14, 15 hotels and they are committing to build another 8, 10 or 12 hotels on top of that. They are actually making a two dozen unit commitment to the flag. It's a somewhat different relationship than a one-off sale we think. So, does that help you?

[Joseph Greff:]

That does. And then with respect to the new build franchisee hotels and again these discussions involving the 85 or so 2.0 hotels, on average what would be the cost per key to develop those hotels? I'm presuming they would be at a higher price than say the current per key value of the equity or the per key value of these four hotels that were sold, but just to give us some perspective?

[Gerardo I. Lopez:]

Yes, it will be. Jim, what are the latest projections on the new builds?

[Jim Alderman:]

Without land, Joe, it's indexing anywhere from about $80,000 a key to $95,000 a key depending on where we're building. That's without dirt and without any other special requirement that a local municipality might have. In some cases you have got some pretty substantial impact fees or design issues with façade, but we still expect that what we've put into the FDD is accurate, about probably $80,000 to $95,000 a key.

[Gerardo I. Lopez:]

Per key plus $1 million or $2 million for the land, obviously depending on location, and then in some jurisdictions you've got some regulations to comply with and all of that, but we still in all of the instances, I mean as we get closer and closer and more specific to these projects, we have not seen anything to discourage us from any of the projections that we have made or any of the going-in assumptions that we have made. We'll see what develops. In any given moment in time, you have fluctuations in some of the commodities markets, right. Forest fires in Canada, the price of lumber goes up. We'll see where it settles out by the time that we start building. We are months away from building. So we'll see what the lumber is at that point. Labor, it's a big challenge in a lot of markets. You see that manifest not only in our sector but in housing. So, all of those we'll factor in, but so far the projections that we have been operating against remain fairly steady.

[Operator:]

Our next question is coming from Smedes Rose of Citi. Please go ahead.

[Smedes Rose:]

I wanted to ask you on the 90 or so hotels that you anticipate selling I guess in the near term. Would you expect to [have to] [ph] kind of sell a financing associated with those or are the potential buyers asking for that or would you expect them to scale to tap traditional other sources of capital to purchase those?

[Gerardo I. Lopez:]

No, the point or kind of what we have said all along and the targeting that we have done, Smedes, is about those that have their own access to capital, who are already in the business, who have whether it is through lenders or through investors, that syndicate with them, there is any number of creative ways that folks put capital to work in this sector, and we thought we have seen them all and then we are finding that there are some new ones, so learning something new every week. But at no point has anyone yet asked us to commit our own capital or use the famous keen money or things like that. That's not in play for us at this point and none of the partners that we're dealing with that has been a part of the conversation.

[Smedes Rose:]

Thank you. And then just in terms of the scope of your own development program, would you see it limited to maybe three to four hotels under construction at any given time or would you see having a dozen hotels under construction on balance sheet or how do you think of just kind of the total scope of that investment I guess?

[Gerardo I. Lopez:]

The lower number rather than the higher number. To be honest, it's going to be opportunistic. Although our capital is such that we could do the higher number, the truth is that the permitting requirements and the pace of construction and the number of people that we can deploy into project management and so on, will likely force us into the lower number. We did say in the investor presentation a year ago that we would commit about $500 million over five years to the entire program. So we rather be measured and thoughtful than rush out and try to do a land grab. That is really not our intention. The supply in this changed scale for our extended stay remains relatively muted. I mean we are talking about 0.5 point supply growth against an industry that is growing 2.5 to 3 points or so. So, we don't look to accelerate that supply by building a dozen and a half hotels simultaneously. We rather be measured. Plus frankly, we want to give some geography and some room to some of the franchisees to build as well. So there may be a dozen hotels being put up at any given point in time in the future that are all extended stays, they will not all be by us, they will be with – if you add it up what a couple of three partners may be doing what we may be doing, then you may get to a dozen, but you won't get to a dozen on our own balance sheet, not at the same time.

[Operator:]

Our next question is coming from Stephen Grambling of Goldman Sachs. Please go ahead.

[Stephen Grambling:]

Maybe I'll follow up on that on CapEx specifically, I think you said $25 million in savings per quarter that would put you at a run rate of about $120 million or so a year. Is that the right run rate or should we be assuming there will be some incremental offsets from ESA 2.0 or other projects?

[Jonathan S. Halkyard:]

I think in 2018 there will be some offsets to that. It's hard to know exactly at this point what that amount will be. We'll provide guidance for 2018 CapEx either late this year or early in 2018. But it's still a substantial improvement in free cash flow for the next year and a half, no doubt about that.

[Stephen Grambling:]

So would that just be kind of a sustainable or maintenance CapEx level to think about?

[Jonathan S. Halkyard:]

Would what be a sustainable or maintenance CapEx?

[Stephen Grambling:]

The $120 million range.

[Jonathan S. Halkyard:]

No. Our maintenance capital, we expect to be between $90 million and $100 million a year. And then there will be some amount of corporate capital, which is principally IT related, which in the past has been around $10 million.

[Stephen Grambling:]

Okay. And then I guess going back to some of the OTA and pricing comments, and I know you alluded to this already, but generally speaking as we lap over this shift, I guess are you going to see pricing normalize, maybe if you can just talk through the puts and takes on pricing, specifically ADR or longer-term, as we balance renovations coming to completion, this OTA shift and then the continued focus on corporate account?

[Gerardo I. Lopez:]

I think the OTA trend is relatively stable. We would expect those ADRs to move with market. There is no reason to believe that it will be – we see nothing in the horizon that will change the trajectory that we are on. We enjoy advantages I mentioned before in that channel relative to our other channels. So a lot of it is driven frankly by the length of stay, right. It's a two or three night stay that comes at us in the OTA channel versus our own property generated business which comes at us in the 30+ day flavor. So no significant changes expected in that trajectory for pricing or for that matter occupancy. It's been growing healthy double digits. Some of those healthy double digits are beginning to slow down, primarily as a result of overlap. To put it in context, whereas a year ago we might have been growing 30% in the OTA channel year-over-year, now we are growing high-teens to low 20s, but it's a third year of double-digit. So sooner or later, you got to expect the rate of growth to moderate somewhat. It is now the OTA channel represents a little over a fifth of our business in the low 20s. So that's a good spot for it. We'll see where it continues to develop. We actively sell through our sales force and property direct and reservations office, we actively sell for the longer length of stay. So it will be a battle at each individual property for which booking shows up into the system and at which price it shows up first. And we're letting it, we kind of let it on a property by property basis, we let it sort itself out. That's the whole infrastructure that we've put in place with the revenue management system, is to optimize to each individual hotel every single week.

[Operator:]

Our next question is coming from Thomas Allen of Morgan Stanley. Please go ahead.

[Mark Savino:]

It's Mark Savino on for Thomas. Just to follow up on a question I was asked earlier, in terms of the third quarter RevPAR guidance of 1% to 3%, is it fair to assume you are baking in a similar sort of 130 basis point dilutive impact from that OTA mix or do you expect the order of magnitude to be any different there? And then can you also just sort of help us think through what you are baking-in in terms of the headwind from some of the holiday shifts in the quarter?

[Jonathan S. Halkyard:]

It's Jonathan. One of the reasons we provide the range is because it is difficult to forecast with precision the customer behavior related to things like net versus gross bookings, but we do expect that there is going to be a similar kind of dilutive effect to ADR growth in the third quarter as we have experienced in the last couple of quarters, just from that dynamic. It of course doesn't affect EBITDA, but it does affect RevPAR growth. And then our forecast for the third quarter really doesn't include any holiday shifts other than that which we experienced in early July from the 4th of July calendar shift.

[Gerardo I. Lopez:]

And the expectation in Q3 is 1% to 3% in RevPAR. So we think we are comfortable with it. It's a branch that we just revised last call. I think for the balance of the year it's going to be consistent. We are not making any revisions to that guidance at this time.

[Mark Savino:]

That's helpful. And just as a follow-up, as we think about the full-year guidance, it does imply I guess depending on where you fall in that range, it does imply some acceleration in the back half versus the first half. Is that mainly reflecting sort of some of the renovation disruption going away and some of the renovation tailwind starting to kick in?

[Jonathan S. Halkyard:]

Yes, it certainly does. I think it's important to note that those hotels that we renovated last in our schedule, that are now kind of coming off of renovation, they were the lowest priority hotels to renovate. So they typically had lower ADRs than the system in general. So we don't want to overstate the impact of that. Clearly it's a benefit to have no renovations going on right now. So we enjoy, we no longer experience that disruption. Also we continue to get better at this, we get better at pricing, we're expecting our corporate sales force to deliver growing revenues from our larger corporate accounts, and that's incorporated in our guidance as well. And it's important to remember that we increased our guidance in the first quarter, the earliest we have done that in the time that we have been a public company, we did that early in New Year and we are maintaining that higher level of guidance for the remainder of the year.

[Thomas J. Bardenett:]

Just to add to that, this is Tom Bardenett, we just completed sales training in our quarter two for our field national in our sales, getting the folks here in Charlotte, so about 140 of our members. In addition to that, we went to the GBTA event in Boston, which is the Global Business Travel Association, and we had for the third consecutive year probably the highest amount of interest because our product is now consistent and with our renovations in the rear-view mirror we now are able to really sell a consistent product throughout the country. So we feel good about our sales organization going forward for the remainder of the year.

[Mark Savino:]

Very helpful. Thank you.

[Operator:]

Our next question is coming from Chad Beynon of Macquarie. Please go ahead.

[Chad Beynon:]

Just one for me in the interest of time on the other revenue line, obviously small from a revenue standpoint, but I'm assuming it's pretty high-margin and this was a fast grower in the quarter. In the Q you noted that you had a nice increase in paid Wi-Fi upgrades and parking revenues. Is this something that can kind of juice the EBITDA and the margins going forward, is this something that you are just kind of rolling out? And then maybe just bigger picture, as we have talked about on prior calls, anything else in the other hotel category that can kind of diversify? Thanks.

[Jonathan S. Halkyard:]

We have a huge opportunity as it relates to other revenue in our hotels. We know our customers, many of whom of course are staying with us for several weeks. They consume things, they run out of things, they forget things, and they are spending money while they are with us, unfortunately not spending enough of it with us. We've had bigger fish to fry over the past couple of years, and renovating our hotels and growing our marketing capabilities and raising price on our core product, our hotel room, but there is no question in my mind that there is a huge opportunity for us with only 1% of our revenues being from non-room sources, which stands alone really compared with other companies and hospitality, rental cars, airline, you name it. So, I think this can be $5 per occupied room at some point and it could be a real contributor for us to EBITDA growth. It already is of course, but whether it would be pet fees, Wi-Fi, pantry, storage, and so on, we think it's a huge opportunity, and that's why we continue to report our progress.

[Gerardo I. Lopez:]

Thank you for noticing, Chad. 60% growth year on year and it is on top of clearly that we've just begun to explore. So, thank you for noticing.

[Chad Beynon:]

Appreciate the color. Thanks.

[Operator:]

Thank you. At this time, I'd like to turn the floor back over to management for any additional or closing comments.

[Gerardo I. Lopez:]

Thank you. I just want to thank everyone for joining us today and I look forward to speaking with you in about three months with our third quarter results. Have a great day everyone.

[Operator:]

Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may disconnect your lines at this time and have a wonderful day.