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Sunstone Hotel Investors, Inc. (NYSE:SHO)

Q1 2010 Earnings Call

May 10, 2010 1:00 pm ET

Executives

Bryan Giglia – Vice President of Corporate Finance

Arthur L. Buser – President, Chief Executive Officer & Director

Kenneth E. Cruse – Chief Financial Officer & Senior Vice President

Mark Hoffman – Senior Vice President & Head of Asset Management

Analysts

Chris Woronka – Deutsche Bank Securities

Kevin Milota – JP Morgan

Patrick Scholes – FBR Capital Markets

Andrew Whitman – Robert W. Baird & Co., Inc.

Operator

Welcome to the Sunstone Hotel Investors first quarter earnings call. At this time all participants are in listen only mode. (Operator Instructions) I would now like to turn the conference over to Mr. Bryan Giglia, Senior Vice President Finance. Please go ahead, Sir.

Bryan Giglia

Thank you. Good afternoon everyone and thank you for joining us today. By now you should have all received a copy of our earnings release which was distributed this morning. If you do not yet have a copy you can access it on the investor relations section of our website at www.SunstoneHotels.com.

Before we begin this conference I would like to remind everyone that this call contains forward-looking statements that are subject to risks and uncertainties including those described in our prospectuses, 10Qs, 10Ks and other filings with the SEC which could cause actual results to differ materially from those projected. We caution you to consider those factors in evaluating our forward-looking statements.

We also note that this call may contain non-GAAP financial information including EBITDA, adjusted EBITDA, FFO, adjusted FFO and hotel EBITDA margins. We are providing that information as a supplement to information prepared in accordance with generally accepted accounting principles.

With us today are Art Buser, President and Chief Executive Officer; Ken Cruse, Chief Financial Officer. Mark Hoffman, Chief Operating Officer, will also be available to answer questions during the Q&A portion of this call.

I would like to turn the call over to Art. Art please go ahead.

Arthur Buser

Thanks Bryan. Good morning and/or good afternoon everybody and thank you for joining us today. Since we already provided an update detailing first quarter operating results on our business update call three weeks ago, during today’s call I will recap the highlights of the quarter. Following that I will provide an update on current operating trends and examples of how we are doing with our managers to build on this positive momentum and maximizing cash flow. Last, I will provide an update on both internal and external investment opportunities and the results of our RFP process. Finally, Ken will provide additional detail on our finance initiatives including the acquisition of two pieces of debt.

Looking at reviewing current operations for our 29 hotel portfolio adjusted EBITDA for the first quarter was $27.3 million and adjusted FFO and adjusted FFO per share were $4.2 million and $0.04 respectively. Reconciliations for adjusted EBITDA and adjusted FFO to net income can be found on our earnings release filed today. Again, all RevPAR stats discussed on today’s call are pro forma for our 29 hotel portfolio unless we note otherwise.

For the first quarter our total portfolio RevPAR was down 6.5% to prior year. Occupancy was up1.4 points and rate was down 8.4%. Excluding our two D.C. assets both of which benefited from the Presidential Inauguration in 2009 our total portfolio RevPAR was down 4% to the prior year. Occupancy increased by 2.1 points while rate was down 7%.

New York City and Boston continue to be leading indicator markets. Our Hilton Times Square generated 14 sell-out nights during the first quarter compared to two sell-out nights last year. Additionally, during the first quarter our Hilton Times Square realized 35 nights with a higher average daily rate than the same day in 2009. This positive trend improved further in April with 20 sell-out nights compared to 15 in 2009.

I think it is also important to note there were 15 sell-outs during the peak demand period of 2007. So that is a great comp. Like New York, Boston is also showing impressive recovery over 2009. Our Marriott Boston Long Wharf had 22 sell-out nights the first quarter compared to 5 first quarter of 2009. Still slightly less than the peak in 2007 where there was 28. It realized 14 nights with a higher rate. This trend continued in April with 11 sell-out nights compared to 2 in 2009 and 8 in 2007. So April in fact had more than 2007.

Let’s talk about the improving business trends and business mix. As highlighted in New York and Boston our portfolio wide sell-out nights in the first quarter showed a meaningful improvement over 2009 and in several cases our sell-out nights are approaching levels seen during peak demand periods of 2007. Portfolio wide in April we had 144 sell-out nights in the first quarter as compared to 132 in 2009 and 192 in 2007. April’s results provide further evidence we have entered into the early stages of what we expect to be an extended cyclical lodging recovery.

April RevPAR for our portfolio finished up 3.6% to last year and up significantly to our prior internal forecast. 19 of our 29 properties had occupancy increases in April and 11 of our hotels recorded higher rates. Overall our outlook on the remainder of the year is very positive as our operators continue to handily beat their forecasts submitted just 30 days prior. That really speaks to the rate of acceleration we are seeing.

That said we do expect to see some pockets of weakness as the recovery takes hold. For example, and as we have previously noted, we expect our two Houston hotels to lag the broader U.S. lodging recovery for the balance of 2010 due to the reduction in certain government contract business and new supply in that sub-market and we expect softness in Chicago through 2010 due to a continued weak city wide calendar.

Our group booking pace continues to show significant improvement in each month. Current group pace is down just 10% to the same time last year. That is made up about half and half of occupancy and rate. That is a significant improvement to last year’s pace of down 12% and an even more meaningful improvement to our pace at the turn of the year which was down 18%. Actual group room nights booked at our hotels through April was 12% higher than April 2009.

I think this is very important to note. At our largest group houses, D.C. Renaissance, Orlando and Baltimore, the average rates on rooms booked in 2011 and 2012 are up 9% and 13% respectively, certainly boding well for ongoing improvements looking forward. Again for 2011 and 2012 group rates up 9% and 13% respectively.

Going forward our primary asset management focus is to drive rate and produce margin growth. We are encouraging our operators to set confident and aggressive rate strategies by; One, reducing inventory available through discount channels. Two, increasing benchmark rates. Three, projecting high compression nights farther out in order to more aggressively yield manage room inventory. These rate tactics are most effective in hotels with high occupancies.

Clearly as our portfolio average occupancy was approximately 70% at the end of 2009 and our occupancy improved during the first quarter our portfolio is well positioned to execute aggressive rate strategies. We understand by aggressively driving rate our RevPAR index may actually decrease in the short-term but we believe by taking a rate leadership role our hotels will stand to maintain the highest rates and we will be better able to sustain rates in the future.

Let’s talk about expenses. On the cost side we continue to see the benefits of the redefined cost structure implemented throughout the industry in the past few years. I’ll take a second to take hats off to Mark and his team for all of the things they have done there. In spite of a 1.4 point increase in occupancy during the first quarter over Q1 last year, and the general expectation that year-over-year expenses might begin to increase in 2010, as a result of the aggressive cost cuts we implemented in 2009 so it is going to make it a really hard comp, our absolute expenses decreased by $3.5 million or over 3% in the first quarter. Again, a herculean effort. Occupancy was up and even comping against some pretty tight expenses that expenses were down by that amount. Good job, Mark.

Going forward we expect that significant changes made to the hotel cost model including right-sizing the food and beverage outlets, streamlining management positions, the optimization of several operating processes such as housekeeping and beverage control and the upgrading of energy control systems that will provide significant flow through and results in margin just as we have seen and they should surpass prior peak margin as the cycle improves.

Let’s shift to my favorite subject and that is acquisitions. As we finished the first quarter with approximately $374 million of cash and cash equivalents we hold significant dry powder. Then again, who doesn’t. Accordingly we continue to evaluate both external and internal opportunities to invest our growth capital. Through both marketed channels and our own industry relationships we are seeing an increase in the quantity and quality of acquisition targets. Our primary focus continues to favor high quality, upper upscale or premium limited service assets in strong locations within top gateway markets that we expect to outperform the U.S. average.

We also look at value add acquisitions where there is a turnaround story and where we have the ability to create value through renovation, rebranding, implementation of our asset management systems. We are also evaluating targeted debt instruments, which Ken will speak to later on the call, consistent with our debt investment and our repurchase of the three Mass Mutual assets earlier this year, we continue to seek opportunistic, creative, non-traditional investments where meaningful value may be created.

As a complement to our external growth strategy we have identified several meaningful investment opportunities in our existing portfolio where we believe we can achieve out-sized returns. 2010 projects include a complete renovation of the Embassy Suites Chicago, guest room renovation at the Renaissance D.C., rooms and meeting space upgrades at the Kahler Grand in Rochester, rooms at the Marriott Tysons Corner. These projects are scheduled to begin between the second and fourth quarter this year and will carry over to 2011.

With the acceleration of this program we will now expect to invest between $60-80 million into our portfolio during 2010. By proactively investing in our assets and increasing their ability to drive rate and penetrate the comp sets we expect to deliver a superior product during the early stages of what we think could be a prolonged cyclical recovery.

Before turning it over to Ken let me finish up on our management agreement RFP. Almost 6 months ago we initiated this process to evaluate the options regarding our non-branded operators for our hotels. The sole purpose of the RFP was to ensure we have the most highly qualified management companies operating our hotels in order to consistently delivery best in class results.

We concluded the evaluation and selection process in April. I am happy to say Interstate Hotels and Resorts will continue to manage 13 of our 15 non-brand managed hotels. In addition, we selected Davidson Hotel Company to manage our Embassy Suites Chicago and Sage Hospital Resources to manage our Hilton Del Mar. We do expect to incur some customary transition costs associated with those changes.

We are excited about our new relationship with Davidson and Sage as well as our renewal of the existing relationship with Interstate. We believe Interstate is really positioning itself to be the preeminent global independent operator of hotels. Our two new managers will provide a fresh set of eyes to evaluate our property strengths and weaknesses as well as access to new best practices and processes we can add to our existing policies and cross-pollinate across our portfolio.

I truly believe having relationships with the top management companies in the industry will result in the highest performing portfolio in both up and down markets. With that I would like to turn the call over to Ken to provide an update on our finance initiatives. Ken please go ahead.

Kenneth Cruse

Thanks a lot Art. Thank you to everyone joining us today. As we updated you on recent finance transactions during our April intra-quarter update my comments today will be fairly brief.

We ended the quarter with approximately $374 million in cash and cash equivalents including restricted cash and pro forma for the repayment on the mortgage of our Times Square Hilton, 11 of our hotels will be unencumbered with debt. With just over $1 billion of well-staggered, flexible debt and only $100 million of debt maturities through May of 2015 we feel our capital structure is appropriately balanced at this time.

With that in mind and in light of the continued economic stabilization and improving fundamentals in the lodging industry one of our key 2010 finance goals is to reduce our excess cash balance to a more appropriate level through disciplined investments. As previously disclosed subsequent to the end of the quarter we invested $83 million to release three assets from the $246 million cross-collateralized mortgage pool. These assets were the Courtyard Los Angeles Airport, the Kahler Suites in Rochester, Minnesota and the Marriott also in Rochester, Minnesota.

We are in the process of conveying the remaining 8 assets in this loan pool to the lender in satisfaction of the remaining debt balance. We expect to complete this process during the second quarter. We continue to work with the lenders representative on the prepayment of the $81 million Hilton Times Square mortgage which matures at the end of this year and we intend to complete this prepayment which will eliminate nearly $5 million of annual interest expense during the second or third quarter of this year.

Also on the finance front we recently purchased a package of two hotel loans with a combined principle value of $32.5 million plus approximately $800,000 of accrued interest for a total purchase price of $3.7 million or roughly $0.11 on the total dollar amount of the principle plus accrued interest. The first loan in the package is a $30 million 8.5% mezzanine loan maturing in January of 2017 which is secured by the equity interests in the Doubletree Guest Suites Times Square. You may recall Sunstone holds a preferred equity investment in this partnership which was marked down to zero in the fourth quarter.

The Doubletree Times Square mezzanine loan ranks junior to $270 million of mortgage debt which matures in 2012. You may also recall that Sunstone formerly owned this $30 million mezzanine loan. While a small investment dollar wise we believe given our history with and knowledge of the Doubletree Times Square as well as the strength of the recovery in New York City this mezzanine investment makes solid economic and strategic sense for Sunstone.

The second loan in the package was a $2.5 million 8.075% subordinate note maturing in November of this year which is secured by a 101 room boutique hotel known as Twelve Atlantic Station in Atlanta, Georgia. As we have previously noted while we do not expect alternative investments such as hotel debt will represent a significant percentage of our total acquisitions we intend to continue to capitalize on creative opportunities to drive stockholder value as we uncover them.

Going forward it is our goal to maintain an appropriately leveraged capital structure to help enhance total returns to our stockholders through strong growth in FFO per share and by expediting the future reintroduction of cash common dividends when appropriate.

With that I would like to thank you for your time today. I will turn the call back over to Art to wrap up.

Arthur Buser

Thank Ken. You know, we end these calls by telling you we continue to run our business with a single focus we exist to outperform. As you might ask, what exactly is Sunstone going to focus on to outperform? Well in the 1/3 of the year behind us we remain focused on four things; growth, rate, expense creep and our people.

Let me speak to those first about growth. It is not news we are chasing acquisitions and a lot of others are too. I am optimistic we will transact the right deals for the company. To answer the question we are always asked, are you getting close on any deals? Let me simply say we cannot get any closer than we have without closing on one.

We have pointed to CapEx as an area to get returns that could be superior to some acquisitions and it appears now is the right time both in terms of minimizing cost and minimizing displacement. Fundamentals suggest we are at a point in the cycle that a company should grow and will do so with well timed and matched capital be it common, preferred to debt. Over-equitizing, while arguably is not a word, is something we don’t aspire to.

Let’s talk about rate. I am optimistic about the prospects of our managers to increase rate and well I should be. Sunstone and many of our peers ranked close to 70% occupancy last year and with higher occupancy trends this year rate compression ought to be happening right now. While 2010 rate is pretty well baked particularly for group and corporate negotiating segments the opportunity this year is probably mostly in mix. Now granted corporate negotiated volume is up a lot for some hotels, as much as 20%, but at the same time most often that amount of volume is at a flat or lower rate.

Getting more of the business and shutting other channels should lead to rate improvement. We will continue to encourage our managers to be aggressive in that regard. We all know until the worst hotel in a comp set increase its rate the best ones really have a ceiling. None of that happens until someone leads with moving price. So we have told our operators we would love to see rate index go up even if occ index goes down more.

In this cycle with the increased real-time access to date like Day and Week Star or Travel Click we expect the competition to watch and see the success of higher rates and then follow at some point. Operators need to stop living in the past. We are in a market where demand is increasing. Discounting helped no one and we need to get back to appropriate pricing.

I think everyone shares my impatience with this issue and I look forward to less talk particularly by me and more action. While we may see lower RevPAR indices in the short run, getting the managers to move now on rate is key to outperformance so focusing on 2011 we are again asking our managers to ensure that double digit rate growth is a real possibility if they manage mix and rate correctly. Knowing managers have much to gain by getting back to income levels that support their incentive fees I would expect they should have similar strong motivation to do so.

Preventing expense creep. Again one of the more frequent questions we are asked, again aside from when are you going to close on a transaction, is how sure are you that expense creep can be held in check? The answer is we are increasingly sure. The latest flow throughs of revenue over budget are a great indicator of that. While cost cuts are mostly behind us, re-engineering of food and beverage to make it consistent with our guest expectations should be an opportunity to do so. At the same time while most hotels have had revenues in excess of budgets we are closely watching the flow of this added revenue.

I can proudly say that for the first quarter for our portfolio the flow through was approximately 75% for the revenue that came in above budget. Again that is an impressive number of avoiding expense creep. That is on occupancy led revenue increases. It is really amazing results.

The hotels that have really performed at the highest level we are going to seek to employ their best practices across our portfolio. Focus on people. To outperform everyone has to be held accountable towards an ever rising standard of performance. Now is an exceptional time to invest in the best talent particularly for our hotels and the organization. We expect the quality of our results to match that of the quality of the people delivering the results.

With those as our focus items for outperformance combined with the right capital structure it is worth re-mentioning free cash balance is well in excess of the next five years of debt maturities, our debt being fixed at 5.5% averaging nearly 7 years on life, having exposure to outperforming markets like New York, Boston, D.C., Rochester, Minnesota, combined with increasing operating results I am optimistic about the prospects of Sunstone and its stockholders.

With that I would like to open up the call to questions. Operator, please go ahead.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Chris Woronka – Deutsche Bank Securities.

Chris Woronka – Deutsche Bank Securities

I wonder if you could talk about the rate strategy. Do you feel as if you are differentiated there and what is the operator reaction so far in terms of being able to push rate down? I think some of the other weaker players might still be having some ground to make up on occupancy. What has your reaction been from the operators?

Arthur Buser

Sure. Mostly great. Again, because many management contracts have incentive fees they have a financial incentive to be aggressive. Like I mentioned because there is more clarity in how any market competitors are pricing I think hotels simply can watch. If the hotel next door is charging more and having success at the asset management level, Mark Hoffman is on the phone within a day or a week saying why aren’t we doing the same or why aren’t we leading in that regard. I think the information flow helps there. So it has been mostly good.

In terms of the first question on do we differentiate ourselves. We are a REIT. We don’t manage the hotels so we are simply asking and directing. It is difficult to say we have this special sauce that is going to allow people. We are being possibly more aggressive and we are telling our managers take risks. As we have mentioned if we see falls in occ index but increases in rate that is the right thing to do. So nothing secret about that. Probably more of a point of view in style than anything in particular.

Chris Woronka – Deutsche Bank Securities

On the loan purchases I think the two you have done are pretty straight forward. Are you finding a lot less competition for these kinds of things relative to stand-alone hotel assets?

Arthur Buser

No, what we have really observed is as there is increased competition for single assets people were having a tough time getting deals done but a lot of money was shifting into debt as well. Again it depends on the size. The larger the loan probably the less competition but we see equal competition in that space.

Operator

The next question comes from the line of Kevin Milota – JP Morgan.

Kevin Milota – JP Morgan

I was hoping you could provide some trajectory in terms of your pro forma expenses going forward and where you see some of the inflationary pressure. Also just upward pressure as occupancy continues to claw its way back?

Arthur Buser

I can tell you thus far we have been surprised. At the beginning of the year if I would have seen where our first quarter numbers would have ended up I would have guessed that our margins would have been far worse because when occupancy increases and rate declines you certainly would have seen that. To have us take 3% of our costs out when occupancy went up that wasn’t anticipated. So difficult to project because we haven’t given guidance on how it is going to look going forward but certainly if we continue to deliver that I think the outside risks are taxes, utilities and of course in the long run healthcare. That probably reaches out beyond 2010 but if you look 2-3 years out and the healthcare bill expands that is something we look at.

Operator

The next question comes from the line of Patrick Scholes – FBR Capital Markets.

Patrick Scholes – FBR Capital Markets

I wonder if you could give a little more color on in your prepared remarks you talked about the rates for next year for certain segments being up high single digits. A little bit of color you could provide on what types of customers at this point are booking those rates. Are we talking groups or corporate customers? You also mentioned about mix shift. Can you give a little more color on who is sort of being mixed out and who is being mixed in at those higher prices?

Mark Hoffman

Good question. I will run through the segments. The good news is on the group side where we have continued to have better production we are booking next year’s rates and out-year rates at better rates than this year. I think Art talked about that being roughly about 9% for our three big hotels. We are seeing that consistently. As it relates to the mix management piece what we are seeing aggressively being mixed out is what you want to see mixed out. Priceline is going away. Hotwire is going away. Lower end of the spectrum of discounts are going away.

As it relates to corporate negotiated, the managers are in that mix right now today and certainly the messages we have gotten back from them and have given to them is to be one very simple four-letter word and that is “bold”. We think boldness is the right approach. I think what we will end up seeing is through 2009 and 2010 and 2008, 2009 and 2010 what we saw is the hotels ended up giving value adds they gave internet and those types of things, they will continue to keep those value adds but they will build rate above the value adds. Our hope is that we will see in the high single digits increases in corporate negotiated.

Particularly what will happen there is you will start to see the lower rated corporate negotiated companies who are providing lower numbers of rooms being swept out or even higher number of rooms and you will mix to a higher corporate negotiated.

Operator

The next question comes from the line of Andrew Whitman – Robert W. Baird & Co., Inc.

Andrew Whitman – Robert W. Baird & Co., Inc.

I wanted to dig in a little bit on the two debt purchases here. In the past Art you mentioned you might do some debt repurchases with a partner. Was there anybody who brought you this deal that is helping to advise at all in either of these deals?

Arthur Buser

No and in particular because on with Doubletree Times Square we were the previous owner this is probably the one marked exception where we had great knowledge of both the asset and the instrument.

Andrew Whitman – Robert W. Baird & Co., Inc.

The same thing goes for Atlanta?

Arthur Buser

We were not the previous owner of it but given that it was a $250,000 investment the risk/reward felt asymmetric.

Andrew Whitman – Robert W. Baird & Co., Inc.

A question on Times Square. Is there an option here to take out your partner? I have to assume the venture is obviously you wrote down the equity. Is there an option to take them out and get this thing totally onto your balance sheet before the maturity in 2017?

Kenneth Cruse

I wouldn’t say there is an explicit option. What we have invested in though is the first loss debt position in the capital stack. There is $270 million of senior debt in front of us. As I noted in my comments we feel this is a pretty good strategic investment for Sunstone but it does not come with an explicit option to buy out or take out any of the partnership equity.

Andrew Whitman – Robert W. Baird & Co., Inc.

But this transaction is being kind of the mezzanine position doesn’t get you consolidated today? This will still remain an unconsolidated venture going forward?

Kenneth Cruse

Correct. It will still remain unconsolidated.

Andrew Whitman – Robert W. Baird & Co., Inc.

So in Atlanta I am hoping for a little bit more color here. Maybe you have mentioned this and I missed the note but could you give us kind of what your last dollar is on maybe a per key basis or maybe a little bit of color on what the capital structure looked like when the original deal was transacted whenever that was?

Kenneth Cruse

Sure we can give you a little bit of additional detail on that one. Again this was thrown in as part of a package with the Doubletree Times Square deal which we felt had much greater strategic significance for the company. The Atlanta deal has $17 million of senior debt in front of it and our $2.5 million fee note position is [inaudible] with a second side of the same B note so there is $5 million of B financing. Total capital stack of $22 million.

Andrew Whitman – Robert W. Baird & Co., Inc.

When was it last sold? Do you know when this was kind of lined up?

Kenneth Cruse

It was a new build and this was lined up I believe in 2006.

Andrew Whitman – Robert W. Baird & Co., Inc.

Now that you are beating your internal forecasts to me that is some indication visibility is improving. What is your outlook for providing guidance?

Arthur Buser

When we get numbers I can rely on I will look forward to sharing them. As I mentioned, opposite of last year…last year we were getting numbers that 30 days later proved to be wrong in the wrong direction. Now we are getting numbers 30 days later that prove to be wrong in the right direction. Just to give you some comment on that, when you look at we are mostly a transient hotel company; 70% of our business. I had heard of a stat that was more countrywide but the group of hotels said their transient pace was 4% above last year a week out but after the actual was realized they were up 11%.

So hotels are realizing more business even a week out a lot more. So while it is great we are having misses to the up we are still not getting numbers we can rely on and we pass them along to you and ask you to rely on them. The good news is we are wrong in this direction and the marketing team does a great job of managing costs. We just need to find a way to deposit the cash quicker. So that is a good business challenge to have.

Operator

There are no further questions at this time. Please continue.

Arthur Buser

We appreciate everybody’s time today particularly on a Monday morning or afternoon as well as your continued interest in Sunstone. We look forward to speaking with you on our second quarter intra-quarter update later this summer. Thank you.

Operator

Ladies and gentlemen this concludes the conference call for today. Thank you for your participation. You may now disconnect your lines.

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