Extended Stay America, Inc.
Q3 2014 Earnings Call Transcript

Published: 7 Nov 2014

[Operator:]

Greetings, and welcome to the Extended Stay America third-quarter 2014 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, Kay Sharpton, Vice President of Investor Relations. Thank you. You may begin.

[Kay Sharpton:]

Good morning, and welcome to Extended Stay America’s third quarter 2014 conference call. Our third quarter earnings release was issued this morning. And it’s available in the Investor Relations section of our website at extendedstay.com. Replay information for this call will be available on our website following the call. Joining me on the call today are Jim Donald, Chief Executive Officer; Jonathan Halkyard, Chief Operating Officer and interim Chief Financial Officer and Tom Seddon, Chief Marketing Officer. After our prepared remarks there will be a brief question-and-answer session. Before we begin, I would like to remind you that some of the comments made by management during the conference call contain forward-looking statements including our 2014 outlook that are subject to risks and uncertainties that could cause actual results to differ materially from those forward-looking statements. Forward-looking statements made during this call speak only as of the date of the call and the factors that could cause actual results to differ are discussed in our 10-Q filing this morning and other public filings. In addition, on the call, we may reference certain non-GAAP financial measures. More information regarding our forward-looking statements and reconciliation of non-GAAP financial measures to their most comparable GAAP measures are included in the earnings release, and can be found on our filings with the SEC. Management believes these measures provide useful supplemental information to investors regarding the ongoing operation and facilitate comparison between the Company and other lodging companies, hotel owners and capital intensive companies. Now I would like to introduce Jim Donald. Jim?

[James L. Donald:]

Thank you, Kay. Thanks everybody for joining us this morning. I would like to comment on our third-quarter 2014 results. And then Peter will provide a more in depth discussion on the quarter and our outlook for 2014. This morning, we announced a third quarter RevPAR growth of 8.2% and adjusted EBITDA growth of 8.7%. Last quarter, our RevPAR grew 9.4% and we had expected the third quarter would be generally consistent, and we fell short. On our last call on July 31, I mentioned that July’s revenue performance was just over 9%, and our full attention was focused on driving solid results for the balance of the year. This run rate dropped in September, why? Our strategy to improve the guest experience, build our brand nationally, improve our mix of high-yield shorter stay guests, and invest in capabilities to enable more sophisticated pricing did not waver. In fact, we attempted to take advantage of the industry tailwind, and created multiple initiatives for our associates accelerating our efforts to transform the Company. But in doing so, we lost some momentum in local sales activity, got too far in front of our rollout of platinum properties, and posted these mixed results. Our platinum renovated hotels delivered nearly 11% RevPAR growth in the quarter. Our non-platinum renovated properties, which is about 33% of the Company, produced RevPAR growth of less than 5%. And I’d like to spend a couple of minutes on this point. The divergent performance of our platinum and non-platinum hotels and our plans to close that gap. We are finding our strategic initiatives gain more traction with our platinum hotels. The rate growth and the mixed shift to shorter stays was more effective in these properties, as their short stay revenue increased over 16%, while non-platinum short stay revenue increased 4%. Our corporate account sales efforts and our lean operational improvements, which we call Kai-ESA were and are also more effective at driving results in platinum renovated properties. September exposed some areas of opportunity for us. Growth from corporate accounts was softer than we expected. This tends to be longer stay, but is higher rated than the non-corporate business. And while there’s a number of reasons for the shortfall in corporate accounts, it falls squarely on our sales efforts and our service issues. We’ve replaced our head of sales, and we are realigning the sales organization to concentrate on the various tiers of our corporate business. We are in the process of piloting this in our Southeast division. The sales force will be strengthened by an inside sales team, which will give us more earnings oversight into these areas. And while the kai-ESA implementation is expected to generate greater consistency in the guest experience, higher service scores and lower cost, its implementation did represent a distraction for some of our properties and impacted local account sales. The bulk of the implementation was in the months of July, August, and September. And we have now completed the implementation for the back of the house and the front of the house. While we did set records for ADR and occupancy this quarter, we can’t get our automated revenue management system fully implemented soon enough. As this capability will greatly improve our ability to optimize price against periods of strong demand. Just last Friday, we rolled out 25 properties with first phase of our new system. And the system is providing rate recommendations to our revenue managers. Our plan is to have the majority of our hotels up and running by year-end. So while we didn’t achieve our expectations for the third quarter, I remain committed to our strategic initiatives, and believe that improved performance will soon develop from our focus on operational capabilities and our platinum renovation program. After all, the high returns on invested capital available to us through platinum renovations have been proven through multiple phases, and represent a highly accretive use of capital. That’s why this morning, we are announcing plans to accelerate to mid-2017 the completion of our platinum renovations throughout the Extended Stay America brand versus what would have been a completion date of mid-2019 under our current pace. Specifically, we plan to renovate an additional 85 properties beginning in the second quarter of 2015. Combined with the 60 hotel phase VII currently underway, this will bring the total to 467 hotels or nearly 74% of the Extended Stay branded hotels completed by early 2016, which is up from the 36% we had at the beginning of 2014. The rest will be done by the first half of 2017. Importantly, we will continue to return cash to our shareholders through our dividend. Even while accelerating the renovation of our remaining Extended Stay America hotels. We also expect our capital structure, which is currently have 4.9 times net debt to trailing 12 months adjusted EBITDA, to de-lever organically by year-end 2015. With three quarters behind us and mindful of our current trends in the business, we are adjusting our 2014 guidance. Our guidance range for the year is $1.210 billion to $1.216 billion in revenue, in revenue, and $550 million to $560 million in adjusted EBITDA. This reflects our October RevPAR growth of 5.6%, and a forecast of 3% to 6% for the remainder of the year. I’ll now turn it over to Jonathan who will provide greater detail on the third quarter, comments on our outlook for the remainder of 2014, as well as our ongoing priorities for free cash flow. Jonathan?

[Jonathan S. Halkyard:]

Thank you, Jim. In the third quarter of 2014 we generated record revenue of $338.6 million, an increase of $24.9 million or 7.9% over the thrid quarter of 2013. System wide, RevPAR grew 8.2% driven by an ADR increase of 7.4% to $60.14, and an occupancy increase of 60 basis points to 79.3%. Adjusted EBITDA for the third quarter was $163.1 million. An increase of $30 million or 8.7% compared to the third quarter of 2013. Clearly, we had anticipated greater revenue growth and better flow through to adjusted EBITDA, and I’d like to share some highlights and challenges in the quarter. Platinum renovated properties, which are 51% of the Extended Stay brand hotels or 47% of our total portfolio, delivered strong results. The RevPAR growth for our platinum properties was 10.6% in the quarter, driven by an ADR increase of 8.1%, and an occupancy growth of 180 basis points. Our non-platinum properties, which include both silver refresh and Crossland suites, delivered weaker results. These properties did not keep pace with the other brands in their markets, and produced RevPAR growth of about 4.9%. While these properties achieved ADR growth of 5.5%, we saw a decline in their occupancy rates year-over-year of 60 basis points. As Jim mentioned, our strategy to improve our mix towards high-yield shorter stay guests is working. We’ve seen meaningful improvements in migration to shorter stay guests, and channels catering to higher rated transient guests are performing well. This quarter, our one to six night business was the primary driver of our occupancy growth. This shorter stay segment of our business accounted for 30% of our revenue in the quarter, yet contributed over 40% of our $24.9 million in revenue growth. Our online channels much used by our transient guests, contributed approximately 18% of our revenue, yet contributed over 50% of our revenue growth. Revenue growth was soft from corporate accounts, and within our non-platinum renovated properties. We are taking immediate actions to address the shortfall. As Jim mentioned, we’ve committed to the renovation of our remaining non-platinum renovated Extended Stay America brand hotels. We have a new head of sales. Under his leadership, we are targeting growth at our highest potential business accounts, and piloting a sales team record reorganization that increases the coverage on those accounts. We are pricing more aggressively on retail given the market strength we saw this quarter, and of course, we remain on track with our implementation of the new revenue management system. We expect to rollout this system to the majority of the properties during the remainder of the fourth quarter for one-way communications in which the system will provide pricing recommendations to the revenue managers. By the end of the first quarter of 2015, we expect to implement two-way communication or automated pricing on shorter stay guests. This critical tool will eventually enable us to price against demand from our short and long-term guests. The most complicated, but ultimately most rewarding pricing opportunity that we face. We believe our actions to improve the efficiency of our sales force and improve our pricing will be even more meaningful as we renovate the remainder of our Extended Stay America hotels. Our hotel operating margin was 53.1%. Last year’s comparable hotel operating margin, when adjusted for approximately $3.4 million of system-wide brand related cost, that were reflected in G&A expenses last year, was approximately even with this year’s margin. Flow-through in the quarter adjusting for this change was 51.8%. This is lower than our result last quarter, and was affected by increases in total marketing and reservation costs of $2.5 million. Primarily related to our national media campaign in July, and system-wide of our central reservation call center. We also experienced property insurance and maintenance expense $4 million higher than last year. An element of this was due to unusual incidents, but the increase is also reflective of the uneven and often unpredictable incurrence of costs related to building components such as roofs, plumbing systems, HVAC systems, and laundry machines. As we discussed last quarter, there was also a modest increase in payroll expense related to our training costs in the quarter for the kai-ESA operations rollout. G&A expenses were $19.6 million, a decrease of $4.9 million over the same quarter last year. Last year’s third quarter G&A expense of $24.5 million included the $3.4 million in system-wide brand related costs I mentioned earlier, $3.2 million in IPO costs, and $600,000 in non-cash equity-based compensation. The figure for comparability to this year’s G&A would have been $17.3 million. This year’s comparable G&A in the third quarter of 2014 was $16.5 million, adjusted for public company transition costs, and costs related to the secondary offering of $800,000, as well as $2.3 million in non-cash equity-based compensation. The decline in comparable G&A year-over-year is due to an adjustment in the incentive compensation expense, offset in part mainly by other personnel cost increases this year. Adjusted EBITDA of $163.1 million for the third quarter increased $13 million or 8.7% when compared to the third quarter of 2013. Adjustments to EBITDA are detailed in our earnings release, and include the aforementioned G&A adjustments, as well as three other adjustments. First non-cash foreign currency transaction loss of $1.1 million in the quarter related to the appreciation of the US dollar versus the Canadian dollar at our Canadian properties, which have US dollar denominated debt. Second, a gain on the sale of two non-core HomeTown Inn properties of $900,000. And last, a loss of on the disposal of assets of $200,000. Interest expense of $33.4 million this quarter was nearly $20 million lower than a year ago, driving a meaningful increase in cash flow. This was primarily due to the elimination of mezzanine debt, partially offset by interest expense related to the new term loan. With 75% of our debt fixed rate, our interest expense this quarter represents the approximate quarterly interest expense we would anticipate on a run rate basis. Net income increased 29% over the third quarter of 2013 to $60.2 million. Income tax expense for the third quarter of 2014 was $19 million, compared to $400,000 in the comparable period in 2013. The effective tax rate for the third quarter of 2014 was 24% and our full-year tax rate is also expected to be approximately 24%, reflecting the efficiency of our paired share structure. Adjusted paired share income for the three months ended September 30, was $59.9 million or $0.29 per paired share based on a weighted average diluted paired shares outstanding of $204.5 million. Adjusted paired share income, a non-GAAP measure, represents net income, as adjusted, attributable to the consolidated entity. These adjustments are detailed in our earnings release. We ended the quarter with total cash of $181.5 million, composed of $20.4 million in unrestricted cash on hand and $161.1 million of restricted cash. Net debt was approximately $2.7 billion at the end of the quarter, and net debt to adjusted EBITDA on a trailing 12 month basis came down to 4.9 times. Capital expenditures for the third quarter totaled $40.5 million, primarily related to maintenance capital and hotel renovations. Year-to-date, our capital expenditures totaled $125.9 million. As we look forward to the rest of the year, we have adjusted our guidance to take the most current trends into account. The vast majority of the change in our outlook relates to our revenue outlook. As we begin the fourth quarter, October RevPAR growth was 5.6%. We recently lapped the initiation of an important online channel partner last year, and have seen slower RevPAR growth both in September and continuing on into the fourth quarter. Revenue growth for the remainder of fourth quarter is expected to be between 3% and 6%. While we expect to benefit from the lapping of the displacement from the 92 property Phase VI renovations of which 64 begin in the first quarter last year, this benefit will be largely offset by the displacement from the remaining 52 properties of the phase VII renovation, which began earlier in the quarter. We anticipate total consolidated 2014 revenue $1.210 billion to $1.216 billion, or approximately 6.8% to 7.3% growth over 2013. We expect fourth-quarter adjusted EBITDA to range from $116 million to $126 million. And the resulting annual adjusted EBITDA is anticipated to be in the range of $550 million to $560 million, or approximately 6% to 8% growth over 2013. Annual net income is now anticipated to range from approximately $145.5 million to $154.9 million. Please refer to our earnings release for the details. Our CapEx for 2014 is now anticipated to be between $170 million and $180 million for capital renovations, IT projects, and regular maintenance capital in 2014. And its increase due to an earlier start of the remaining 52 hotels in our phase VII renovations, and slightly higher than expected maintenance investments. This morning, the Board of Directors of ESH Hospitality Inc., the company’s subsidiary, declared a cash dividend of $0.15 per share for the third quarter of 2014 payable to ESH Hospitality Inc’s Class A and Class B common shareholders. The dividend will be payable on December 5, 2014 to shareholders of record as of November 20, 2014. Our continuing dividend policy will be to target a payout of 95% of REIT taxable income. And as REIT taxable income increases, dividend increases will follow. Finally, we remain enthusiastic about our business model. Our segment enjoys a favorable supply-demanded balance, and we are the leading brand in the segment. Our renovations and strategic initiatives will continue to drive revenue growth. Our operating margins, improved capital structure, and tax structure enable our enterprise to convert this to strong free cash flow. And as we look forward, we will apply our free cash flow to deliver the highest returns to our shareholders through accelerated renovations and an attractive dividend. The remaining free cash flow will be available for debt reduction, future development, and returns of capital to our shareholders through increased dividends or share repurchases as market conditions warrant. I’ll now turn the call back to Jim.

[James L. Donald:]

Thank you, Jonathan. Before we open up the call to questions, I want to assure you that not only for myself but for the entire organization, our full attention is focused on driving results inside with regard to our initiatives, and outside with regards to our bricks and mortar. Having said that, the results of this quarter were not an issue of the market, nor was it the strategy, the results were the execution and timing of our transformational initiatives, combined with our rollout of our platinum properties. My focus remains the same with one exception. First, continue building a culture of service and engagement. Second, improving the guest experience through renovations. Third, fine-tuning our operational practices for consistency. Fourth, evolving our sales team under new leadership to drive results by realigning their roles and expectations. And finally, evolving our customer mix with and through improving the sophistication of our pricing and marketing. The one exception is that this focus has fewer moving parts as we migrate into our second year of public life. As I have said before, this is a Company in transition. While this quarter’s results did not meet our expectations, we remain confident in our strategic plan. Regarding our news on accelerating our capital our experience with the platinum renovation confirms that they are performing beyond our expectations, and represent a compelling use of capital. The plan to accelerate that process will result in continuous improvement for the chain, and help coordinate with our ongoing slate of performance producing initiatives. I’m convinced that we remain today the best self-help story in the industry. I’ll now turn the call back to Kay.

[Kay Sharpton:]

Before we begin the question-and-answer session, I would like to ask everyone to limit their questions to one, with one follow up, in order to try to accommodate everyone in the queue. Thank you, and operator, we will now go to questions.

[Operator:]

Thank you. At this time, we will be conducting a question-and-answer session. (Operator Instructions) Our first question is coming from the line of Anthony Powell with Barclays. Please proceed with your question.

[Anthony Powell:]

Hi good morning everyone.

[James L. Donald:]

Good morning.

[Anthony Powell:]

Nice, so you mentioned your RevPAR growth was 10.6% at the platinum renovated properties. That’s still basically just in line with TownePlace, which did 10.7%. We would think you should outperform given they were recently renovated. So what do you think is driving that performance relative to your peers?

[James L. Donald:]

I’m sorry. Are you saying what is driving TownePlace’s performance.

[Anthony Powell:]

No, just why isn’t the delta of your performance relative to your closest peers have been bigger, given your refreshed products?

[James L. Donald:]

Well, I would tell you that our refreshed product, I’m not quite sure I understand this. We’re not displeased with our fresh product is 10.6%. In addition to the platinum renovations. If you do a deeper dive inside our length of stays, as Jonathan mentioned, the more transient business that we have is greater than that 10.6%, and we’re quite please with that. I will also say, when you breakout the ADR increase from the platinum versus the rest of the – our company, it’s about 100 basis points improvement as well. Tom do you have anything to add this vis-a-vis TownePlace?

[Thomas Seddon:]

Yes, I think we have probably running with just some different markets and some different segments. We see within our plan of hotels, consistent results from the renovations as we continue to do them. And they’re tracking against our business expectations. For us it’s really about shifting the mix in those hotels to more attractive short stay business getting higher rates, and continuing to build on that. And that’s what we feel like we’ve been seeing in the quarter very consistently with those properties.

[Anthony Powell:]

Okay. All right. And just on the renovations for I guess, 2015 and 2016, how do you plan to manage potential disruption as you accelerate your renovation plan? Thank you.

[Jonathan S. Halkyard:]

Thanks, Anthony. It’s Jonathan. Now having been at this through seven renovation phases, I think we’ve gotten pretty adept at managing the displacement as it relates to these phases. Certainly, we are taking on 85 hotels next year. That’s still not the largest phase we’ve taken on, we did a 90 hotel renovation in Phase VI. And we’re also more recent renovation phases, we are taking a more fine-tuned approach to selecting the markets and time the time of year that we do them. For example, we did our – we’ve already done eight hotels in Phoenix, we did those in the late Summer, which was a period of low occupancy for those. And are now taking on the remainder of the phase VII renovations. So we’ll use the same approach for phase VIII in selecting the hotels and the markets at their points of lower occupancy. But there still will be displacement in the second half of 2015 related to this large phase. But we think that is out weighed by the benefits of getting the remaining Extended Stay America hotels renovated as soon as practical.

[James L. Donald:]

And, Anthony, in Phoenix, we actually picked up our pace there. This would be the way that we go about with each tiering the floor and snaking the rooms. And so we were able to get through those renovations quicker. Consequently, we’re starting to see a faster ramp up on our RevPAR.

[Anthony Powell:]

Got it. Thanks for answering the questions.

[James L. Donald:]

Thank you.

[Operator:]

Thank you. Our next question is comes from the line of Steven Kent with Goldman Sachs. Please proceed with your question. Mr. Kent your line is now live. You may proceed with your questions. We will move on to our next question. (Operator Instructions) Our next question is comes from the line of Chris Woronka with Deutsche Bank. Please proceed with your question.

[Chris Woronka:]

Hi, good morning guys.

[James L. Donald:]

Good morning.

[Chris Woronka:]

Kind of, I wanted to ask you on the cadence of the renovations, vis-a-vis the RevPAR growth. I think in the fourth quarter last year, you said you started 64 of the phase VI. And I think you said this fourth quarter, you’re going to be – can you remind us how many you’re going to be starting in the fourth quarter this year? Just really trying to bridge the gap. It seems like your fourth-quarter comp is a lot easier than the third quarter. And yet we have your RevPAR guidance, and understand some of the issues you pointed out. But can you maybe sort through for us the breakdown of how much incremental renovation displacement you have in the fourth quarter versus prior?

[Jonathan S. Halkyard:]

Sure, Chris. Jonathan. You’re right. We started 64 renovations last fourth quarter. We presently have 26 hotels in phase VII that are under renovation. Most of them just begun in the last two weeks. So we’re starting while we – and we’ll have 52 under renovation by the end of December. So while it’s true that there are fewer this fourth quarter than last fourth quarter, 52 versus 64, we’ve actually started this phase a little bit earlier than we started the phase VI last year in the fourth quarter. We didn’t really get started on those 64 until about this time last year, right in the middle of November. So basically, the year-over-year renovation comp is about the same. Just because of the earlier start offsetting the slightly fewer hotels.

[Chris Woronka:]

Okay. Got you. And then you guys obviously have a lot of moving pieces now with the renovations, the new revenue management system. You talked about the sales force. As we look out to next year, I mean, how do we think about as you guys will probably give guidance early next year. I mean, how do you – given the visibility of the business, I guess, how are you going to approach guidance? And is it reasonable to assume there’s still going to be a lot of disruption early next year, whether it’s renovations or implementation of these new systems and initiatives?

[James L. Donald:]

No, it’s Jim. As I mentioned in my closing remarks, and I’ll let Jonathan talk a little bit more about the guidance. We went public a year ago next week. And we basically said that the six initiatives that we needed to complete in 2014 are either completed or in the process of being complete. And it’s now just a matter of using the renovations to fuel the add-on bolt-on initiatives, including our service initiatives, to basically start to get this return that we want to get. I would tell you that this year has been thinking that the great, it is a great year for the industry. And we thought that by accelerating some of these initiatives, we’d be able to accelerate some more tailwind. And unfortunately, we got maybe a little bit two carry away with the number of initiatives that we put out. Next year it’s a little bit different. These initiatives, as I mentioned, are in the process of being completed or are complete. And we feel confident that now we’ll be able to get the returns from a full-fledged attention to these without having other ones in the way with the exception of the increased renovations.

[Jonathan S. Halkyard:]

Just that you’re right. At this point, we’d expect to offer guidance around 2015 early in 2015. And I’d just amplify that notion that Jim said in his closing remarks, that there are actually fewer moving parts as we go forward. The operational changes now we’ve done at the hotel level are largely behind us. RMS is of course a large opportunity for us, but that project is underway. We talked about the reorganization of the sales force, also underway. And then the acceleration of the renovation of the hotels, this is a program that we’re very confident in. Not only our ability to execute, but the returns associated with that. So I actually think we’ve narrowed the scope of initiatives meaningfully in 2015, and that’s going to help us.

[Chris Woronka:]

Okay. Thanks guys.

[Operator:]

Thank you. Our next question is comes from the line of Joe Greff with JPMorgan. Please proceed with your question.

[John Morez:]

This is John Morez on for Joe. Jim, could you talk about how the CFO search is progressing? Are you looking for candidates that primarily come from the lodging industry? Or are you looking at candidates outside the industry? And whether prior CFO experience is a prerequisite? Thanks.

[James L. Donald:]

It’s progressing quite well. I’m on my track to get somebody by the end of the year. We’ve gone from a pool of about 14 candidates to 10 candidates, to probably 6. They’re coming from inside the industry of hospitality. I’m looking at several CFOs with retail experience, but have had some consumer experience as well, B2B. And so that primarily would be the bulk of whom I’m speaking with. We are looking at different talented candidates that might come from apparel. But by and large, I’m focusing highly on and keenly on both hospitality and retail. And when I say retail though, I do want to add retail that has a wide base of bricks and mortar across this country or international.

[John Morez:]

Yes, that’s very helpful. Thank you.

[Operator:]

It appears we have no additional questions at this time. I would like to turn the floor back over to Mr. Donald for any additional concluding comments.

[James L. Donald:]

Yes. Thank you, operator. I’d just like to close with this. Our expectations have not changed. We came out-of-the-box several times in this Company, one from the bankruptcy, one from the IPO, running fast and running hard. We got up to the point that we’re at now that we are a market different company than we were just 12 months ago, post the IPO. I would tell you that as I look forward, the excitement of accelerating our renovations is something that I look forward to each and everyday. However, it’s not the silver bullet, but it helps with all of the other areas that we’re continuing to work on as Jonathan and I mentioned earlier. Be it the service initiatives at the property level, be it the sales initiatives, revenue management. And so it’s a combination of all these things coming together to continue to what I can fair to be to be just a great opportunity for us to continue to grow this company and to grow this brand. So I appreciate everybody’s time this morning. And we have several conversations lined up over the next two days. I look forward to speaking with those of you that are calling in. Thank you very much.

[Operator:]

Thank you, ladies and gentlemen. This does conclude today’s teleconference. We thank you for your participation. And you may disconnect your lines at this time.