Hudson Pacific Properties Q2 2024 Earnings Call Transcript

Quartr
Provided by Quartr
August 7, 2024

There are 17 speakers on the call.

Operator

Hello, everyone. Thank you for attending today's Hudson Pacific Properties Second Quarter 2024 Earnings Call. My name is Sierra, and I'll be your moderator for today. All lines will be muted during the presentation portion of the call, with an opportunity for questions and answers at the end. I would now like to turn the conference over to our host, Laura Campbell, Executive Vice President of Investor Relations and Marketing.

Operator

Please proceed.

Speaker 1

Good afternoon, everyone. Thanks for joining us. With me on the call today are Victor Coleman, CEO and Chairman Mark Lamas, President Ruud Dier Marion, CFO and Art Suazo, EVP of Leasing. This afternoon, we filed our earnings release and supplemental on an 8 ks with the SEC and both are now available on our website. An audio webcast of this call will be available for replay on our website.

Speaker 1

Some of the information we'll share on the call today is forward looking in nature. Please reference our earnings release and supplemental for statements regarding forward looking information as well as the reconciliation of non GAAP financial measures used on this call. Today, Victor will discuss industry and market trends as well as other highlights from the quarter. Mark will provide an update on our office and studio operations and development, and Harut will review our financial results and 2024 outlook. Thereafter, we'll be happy to take your questions.

Speaker 1

Victor?

Speaker 2

Thank you, Laura. Good afternoon, everyone, and welcome to our Q2 call. The results we reported this quarter were in line with our FFO outlook, with our office portfolio performing better than our expectations. This quarter, our team's strong execution resulted in leasing over 500,000 square feet. This is our highest leasing activity since the Q2 of 2022 and our year to date leasing was up 40% compared to last year.

Speaker 2

2 thirds of those leases were new, the most since Q1 2019. Even after another strong quarter of leasing, our pipeline of deals in leases, LOIs or proposals is healthy at 2,000,000 square feet with an average requirement of above 15,000 square feet up from about 9,000 square feet 2 years ago. All of this is a testament to our team's ability to attract and capture demand and successfully move leases through the pipeline to execution. And while still challenging, there's a gradual strengthening across our West Coast office markets almost uniformly relative to the trailing 4 quarter average available sublease space is declining, development pipelines are diminished, tenant requirements are growing, prime is falling and transit ridership is improving. Nowhere is this more evident than in San Francisco.

Speaker 2

The city had its 2nd best leasing quarter in 2 years at 2,000,000 square feet with several submarkets experiencing positive or near positive net absorption. There were 13 deals signed over 40,000 square feet, the highest number since the Q3 of 2021 and kudos to our team for signing 2 of the 10 largest deals. Tenant requirements continue to increase reaching 6,800,000 square feet this quarter, up 50% year over year to levels not seen since late 2019. Continued strong investment in AI is reigniting the San Francisco office market and spilling over into our other markets, especially Silicon Valley and to some extent Seattle. With over 600,000 square feet of AI leases signed in San Francisco year to date and 740,000 square feet of AI tenants already in the market, 2024 is on pace to be another significant AI leasing year.

Speaker 2

2nd quarter U. S. VC investment of 56,000,000,000 dollars was the highest quarter in 2 years, driven by AI mega deals. Reportedly, investors are gaining confidence in the U. S.

Speaker 2

Markets relative performance and getting more pressure from LPs to allocate nearly $300,000,000,000 of dry powder. The Bay Area, where we have obviously a significant presence continues to receive the largest allocation of VC funds along with about 75% of all AI funding in the first half of the year. We're energized by this positive leasing momentum and by significant funding for businesses that are choosing to locate in our core markets. While we cannot control the timing on leases closing, we expect our office fundamentals will gradually strengthen further as we move ahead. As for our studios, last week the Teamsters ratified their contract with the Alliance of Motion Picture and Television Producers, finally clearing the way for production activity to begin to normalize.

Speaker 2

This favorable resolution follows an unprecedented 18 months of strikes and difficult negotiations, which delayed green lighting and overshadowed typical seasonality. Presently, we estimate that there are only about 80 production stemming in Los Angeles compared to approximately 100 during much of the second quarter as the potential for additional strikes weighed on demand in July. While we expect some level of increased production through the balance of the year, to what levels remain unclear. Beyond the strikes, consolidation, cost cutting and shifting content mix are altering not just show counts, but also production type, number of episodes and budgets. All of these factors influence demand for our stages and services both in Los Angeles and outside of Los Angeles.

Speaker 3

While we believe Los Angeles will remain the

Speaker 2

epicenter of entertainment, in recent years the city has lost some of its substantial lead in global production. Other locations have enhanced their infrastructure and implemented favorable state film tax credits and sector specific incentives. While the strike exacerbated this trend from 2021 to 2022, growth in the Los Angeles region's total scripted production capture was up less than 1% compared to 4% in total scripted industry output. In 2022, Los Angeles lost nearly $1,000,000,000 of production spend due to projects leaving the state for tax credits. While we are working closely with Los Angeles' Mayor Bass, Governor Newsom and other elected officials and industry experts on this front, Mayor Bass is committed to ensuring the industry continues to thrive in the City of Los Angeles and has established a commission to strategize on incentives and related topics.

Speaker 2

All of these dynamics are very fluid and as a result, we currently lack the visibility to assess with reasonable certainty how and when our studio operations will normalize, but they will normalize. And we believe that by the Q4 production should start to get better even as new content investment remains cautious and more globally distributed. Importantly, we do not require production to return anywhere near our 2021 peak levels for our studio businesses to create meaningful value. At a point of reference, during the Q4 of 2022, when we began to experience the early impacts of pending WGA and SAG after strikes, we estimate there were approximately 120 productions filming in Los Angeles. During that same period, our in service studios generated an annualized NOI of $37,000,000 and our Peyote businesses generated an annualized NOI of $41,000,000 Finally, turning to our balance sheet.

Speaker 2

Further deleveraging remains our top priority. We have no debt maturities until the

Speaker 4

end of

Speaker 2

2025. And while we have already seen improvements in some of our leverage metrics, which Harit will comment on shortly, we anticipate that increasing studio cash flow will further strengthen these organically. As part of our proactive multi pronged approach to managing our leverage, we will continue to pursue opportunistic dispositions and have strong buyer interest on several assets. We expect to be able to execute successfully on these type of transactions just as we did last year. With that, I'm going to

Speaker 3

turn it over to Mark.

Speaker 4

Thanks, Victor. This quarter we signed 540,000 square feet of new and renewal leases. On our first earnings call this year, we indicated our occupancy and lease percentages would likely dip in the first half with the potential to improve thereafter. The 30 50 basis point declines in occupancy and lease percentages this quarter are consistent with those early indications. Our GAAP rents grew 2.6% while our cash rents were off 13.3%.

Speaker 4

Excluding our 150,000 square foot 21 year lease with the City of San Francisco at 1455 Market, our GAAP and cash rents would have increased up 8% and 0.9% respectively. Note that more than half of the square footage leased by the city with former block space signed at peak of market 80 plus dollar rents, whereas the rent delta on the yet to be leased block space, most of which was signed in the mid-twenty 10s would be significantly less. The notable increases this quarter in both net effective rent to $57 per square foot and turned in 9 years were driven by mid to large size renewal leases in the Bay Area, some signed at $100 plus square foot rents. We had roughly 1,400,000 square feet of unique office tours again this quarter, up 20% from this time last year. Compared to Q1, tour activity increased 60% in San Francisco and 14% in Seattle.

Speaker 4

Year to date at Washington 1000, we have toured tenants representing in aggregate over 600,000 square feet of mid to large size demand. We also have planned tours for that project representing another 80,000 square feet. To underscore, this represents only very early interest, but we are pursuing all prospects from the entire region with vigor. Washington 1000 is among the best, if not the best product in the Seattle CBD. On the heels of yet another strong leasing quarter, as Victor mentioned, our over 2,000,000 square foot pipeline is up 8% from last quarter and 5% compared to Q2 last year.

Speaker 4

This includes 48% coverage, including deals and discussion on our remaining 2024 expirations. On our top 10 vacancies, which collectively total about 2,000,000 square feet, we have 47% coverage. This should allow us to begin to increase occupancy at assets like 1455 Market, 505 First, Page Mill Hill, 901 Market and 83 King. To put a finer point on our upcoming office expirations, we have roughly 800,000 square feet expiring through year end and 2,000,000 square feet expiring in 2025. Over the last 3 years, we have leased 470,000 square feet per quarter on average.

Speaker 4

Assuming we continue to accomplish only that and nothing more, over the next 6 quarters, we would have leased a total of 2,800,000 square feet exactly enough to address all remaining 20242025 expirations. Thereafter, our annual office expirations become substantially lower, including in comparison to majority of office peers. If our pace of leasing continues or even modestly accelerates as market conditions improve, there is a clear path whereby we will not just preserve but achieve sustained growth in occupancy. Turning to studios. On a trailing 12 month basis, our in service stages were 78.1% leased compared to 79.4% in the Q1, which reflects an additional vacant stage at Sunset Las Palmas.

Speaker 4

Our Quixote stages were 32.8 percent leased, up from 29.8% last quarter due to increased stage occupancy at Quixote North Valley. We currently have signed leases, are in contract or have client interest on 38 of our 59 film and TV stages. In May, we held our grand opening event for clients at Sunset Glen Oaks with major studio streamers and networks in attendance. Year to date, we have conducted over 20 unique tours at that asset, representing 11 active requirements, which resulted in 3 lease stages with a 4 stage in negotiations. Transportation utilization increased approximately 300 basis points to 24% compared to 1st quarter.

Speaker 4

We had more activity in the early half of the second quarter and have been gaining market share even as activity declined with production levels later in the quarter. This is a testament to what our sales team and unique integrated offering can accomplish as production normalizes. Our studio revenue grew 8% relative to Q1. This is due to $2,100,000 of additional stage of studio ancillary revenue from higher occupancy at Coyote North Valley, more Netflix production at Sunset Gower and initial occupancy and production at Sunset Glen Mills. It also includes $1,000,000 of incremental services revenue from higher transportation and location services utilization.

Speaker 4

Finally, I'll note that construction at Sunset Pier 94 is on budget and on time for planned opening in end of 2025. As Manhattan's 1st purpose built studio, the project has garnered significant interest from high profile studios and productions and we are in discussions with multiple tenants for multi and single stage leases. And with that, I'll turn the call over to Arun.

Speaker 3

Thanks, Mark. Our Q2 2024 revenue was $218,000,000 compared to $245,200,000 in Q2 last year, primarily due to asset sales and 2 move outs, 1 at 1455 Market and 1 at Sunset Las Palmas Studios, partially offset by improved studio ancillary revenue from increased production activity at Sunset Gower. Our Q2 FFO excluding specified items was $24,500,000 or $0.17 per diluted share compared to 34,500,000 dollars or $0.24 per diluted share in the Q2 last year. Specified items consist of transaction related income of $100,000 or $0.00 per diluted share and a one time derivative fair value adjustment of $1,300,000 or $0.01 per diluted share. The year over year change in FFO is mostly due to the items affecting revenue, along with less FFO allocated to non controlling interest following our purchase of our partner's ownership interest in 1455 Market.

Speaker 3

Our 2nd quarter AFFO was $24,200,000 or $0.17 per diluted share compared to $31,100,000 or $0.22 per diluted share in the Q2 last year, with the change largely attributable to the previously mentioned items affecting FFO, partially improved by reduced non cash revenue adjustment and 4 million less in recurring CapEx spend. Our 2nd quarter same store cash NOI was $105,200,000 compared to $119,300,000 in the Q2 last year, mostly driven by previously mentioned tenant move outs at 4 55 Market and Sunset, Las Palmas. At the end of the second quarter, we had $706,000,000 of total liquidity comprised of $78,000,000 of unregistered cash, cash equivalents and $628,000,000 of undrawn capacity on our unsecured revolving credit facility. There is also additional capacity of approximately $196,000,000 specific to our Sunset Glen Oaks and Sunset Pier 94 construction loans, our share of which represents $54,000,000 We continue to take proactive steps to reduce leverage and strengthen related metrics. Compared to a year ago, we improved our share of net debt relative to our share of undepreciated book value by 140 basis points to 37.3% and increased our percentage of debt fixed or capped by 6.90 basis points to 92.2%.

Speaker 3

Importantly, as Victor noted, we have no maturities until November 2025. One housekeeping matter before we discuss our outlook. With construction on Sustained Glen Oaks complete as of the Q2, we are now accounting for it as a consolidated property. Turning to our outlook. We are providing 3rd quarter FFO outlook of $0.08 to $0.12 per diluted share with no specified items.

Speaker 3

Our Q3 outlook assumes that our in service studio and Quoty businesses NOI is lower in the Q3 given the operating conditions are currently less favorable than the first half of the year and it will take time following the recent ratification of the Teamsters agreement to green light and prep for new productions. Our office leasing performance in the 2nd quarter was ahead of our expectations. However, our Q3 outlook assumes lower average occupancy and NOI, driven by lease expirations in the second and third quarter, even as we anticipate occupancy has the potential to be flat at the end of the third quarter. Regarding our full year FFO assumptions, we are lowering the range of same store property cash NOI growth to negative 12.5% to 13.5 percent due to the same store studios, specifically lower absorption at Sunset Las Palmas. A reminder that our same store portfolio excludes our Coyote business and now consolidates Sunset Glen Oaks studio.

Speaker 3

As always, our outlook excludes the impact of any potential dispositions, acquisitions, financings and or capital market activity. We will return to providing full year FFO guidance outlook once we believe production levels have normalized to a point that we can more accurately anticipate and project future cash flows related to show by show lease studio and service assets primarily at our Quoty business. Now we'll be happy to take questions. Operator?

Operator

Thank you. We will now begin the Q and A session. First question today comes from Blaine Heck with Wells Fargo. Your line is now open.

Speaker 5

Great, thanks. Good afternoon.

Speaker 3

Victor, I

Speaker 5

was hoping you could comment maybe a little bit more on the asset sales that you had talked about last quarter and again a little bit this quarter. Maybe just how the reception has been, where you guys might be in that process and maybe any color on potential pricing?

Speaker 2

Yes, Blayne, thanks. Good to hear your voice. So the asset sales, we are still in active discussions and beyond just conversations on at least a few assets. I don't want to get into details on numbers and I don't want to get into details on the amounts, but we're confident that we're going to execute on our asset sales like we did last year.

Speaker 5

Okay. That's helpful. Just to quickly follow-up on that. Are these the same assets that you were targeting last quarter? Or has there been any change to kind of the composition of those potential sales?

Speaker 2

Let me think about it. They're predominantly the same assets with the exception of 1.

Speaker 6

Okay.

Speaker 3

1, that's helpful.

Speaker 5

Okay, got it. And then I had asked last quarter about whether there were any kind of strategic alternatives you guys might be exploring. And I thought you gave a very candid answer that essentially all options were still on the table. So just wanted to follow-up there and maybe get any update to your thoughts on that subject and whether larger changes are still a consideration for you guys?

Speaker 3

Well, as I said last time, listen, as

Speaker 2

a company, as the Chairman, as the Board of Directors always evaluate all potential opportunities and we're going to determine whether they're viable. And obviously they're going to be acutely discussed to look at what would maximize long term value for our shareholders. There is nothing imminent at all that is currently in place today. But as I said, we're always evaluating and looking at alternatives.

Speaker 5

Great. Thanks. I'll leave it there.

Speaker 2

Thanks, Blayne.

Operator

Our next question today comes from Ronald Kimpton with Morgan Stanley. Your line is now open.

Speaker 7

Hey, just two quick ones for me. Just one, is there a quick way to sort of bridge going from $0.17 to $0.10 quarter to quarter? Just what are the components of that? Just trying to figure out what pieces are driving that?

Speaker 3

Sure. So the main drivers are lower same store NOI at Quixote and our same store studios and that's related to drop in activity at Gower and lower show counts in general. And then also lower office NOI related to the second and third quarter expirations, which results in lower average occupancy in the quarter. We still expect, however, that by the end of the Q3, we could be in line with what we report in the Q2 in occupancy.

Speaker 7

Got it. That makes sense. And then we noticed that you disclosed 239,000 square feet of early terminations in the quarter. Just curious what was that driven by? And were there sort of any one timers in the office rent figures that we should be thinking about?

Speaker 7

Thanks.

Speaker 6

Yes, this is Art. There were really 2 major drivers. 1 was WeWork in totality for 112,000 square feet and then there was a default for 40,000 square feet and those are the big ones.

Speaker 3

The good news on those is there is good

Speaker 6

news on those is that we already have pipeline behind that or negotiations to backfill most of that space.

Speaker 3

And to answer the second half of that question, we did not get any lease termination revenue from the WeWork. So that's not in any of the numbers.

Speaker 7

Okay, great. That's it for me. Thanks so much.

Operator

Our next question comes from Nick Yulico with Scotiabank. Your line is now open.

Speaker 8

Thanks. I think earlier, Mark, you said something about the coverage on the expirations for this year. I thought you said 48%. I just want to make sure that was right. And then I don't know if you have a number you could share on 2025 expirations?

Speaker 4

Yes. So you're right on the 48. That's the coverage on the 800 or so, it's fine to back up the year. On 25, I'm just looking at Art.

Speaker 6

Yes. So on 25, right now, we're sitting at about 25% coverage on it. Final point on the 48, our average tenant size is below 7,000 square feet. A lot of these guys are just barely engaging right now. So that number that 48 can go up very clearly.

Speaker 8

Okay. Thanks. And then I guess, turning to AI, you talked about that a bit earlier. What we've heard is that in many cases, these firms will want to have more prebuilt space or that they've taken sublease space because of that issue, they don't want to put much capital in. Can you just talk about maybe how you've situated your portfolio, whether it's spec suites or anything else that you think you could be competitive to grab that tenant in City of San Francisco versus the Valley?

Speaker 6

Yes. So it's bifurcated, right? So you're talking about AI with the large growth, and you're talking about kind of the early stage AI that we deal with on the peninsula and through the valley. I'll deal with the second one first. In the valley, our prebuilt space, which we have about 300,000 square feet of in the Valley, and we've it's been our bread and butter.

Speaker 6

That space is attracting these tenants because they don't have to plan it, they don't have to think about it, and we get immediate move in. So we're doing really well in those. On the larger spaces, oftentimes we'll pre build a single floor. In this case, if they're looking for multiple floors, we haven't built out multiple floors, which is why nor has anyone for that matter, which is why they've been gravitating to really top end sublease space.

Speaker 8

Okay, thanks. And anything you're able to just share just following up on terms of like the pipeline or some of the leasing activity you've done, what the composition has been of AI firms?

Speaker 6

AI and tech, yes, I'll share with you. So as we mentioned in our prepared remarks, it's still a little bit more than 2,000,000 square feet. It's grown quarter over quarter. It's chiefly 65% new to renew deals. And I will say this, year over year, our tech is a composition of the pipeline has grown 15% to almost 40%, right?

Speaker 6

So we're starting to see more tech in the pipeline. We're also seeing the size of the tenant grow. So kind of the midsized tenant is carrying the day, 20,000 to 60,000 square feet and that's up actually 40% year over year. Of that, most of that is in the city. Most of the AI, as you've seen, is in the city for the larger users.

Speaker 6

We've seen it in the valley, again, in really the startup realm. We've seen maybe 3 or 4 midsize AI deals in Seattle, but the preponderance of all of that is in San Francisco. And of the tech that I just mentioned to you, I would say that maybe 20% of that is AI.

Speaker 9

Okay. That's helpful. Thanks a lot.

Speaker 6

Right. So if we carry 40 yes, if we carry 40% tech, 20% of that is AI.

Speaker 9

Appreciate it.

Operator

Our next question comes from Caitlin Burrows with Goldman Sachs. Your line is now open.

Speaker 10

Hi, good afternoon, everyone. I was wondering if you could talk a little bit about office retention, what it's been this year, maybe how it compares to history, the expectation for the rest of the year? And then as you look forward into 2025, whether you have any insight yet, one way or the other on, any of the maybe larger lease expirations?

Speaker 6

Sure. This is Art. Mark had mentioned that it's about 48%, the retention. We think we can get it better than that. Why?

Speaker 6

Because there's a lot of smaller tenants that still haven't engaged yet in the Q4. So we can get that north of 50%. We feel we can get it north of 50%. That stacks up to the last, I would say, the last 3 or 4 years for sure. But 20 5, 20 5, again, it's very early and we have about 25 percent coverage on those expirations.

Speaker 6

So obviously, that number is going to grow.

Speaker 10

And just to clarify that 48% retention, is that just coincidentally, I think you mentioned 48% coverage for the second half expiration? Is there 2 different stats that both happen to be 48%?

Speaker 1

Okay. And then just on

Speaker 10

but 2 different stats that happened to both be 48%?

Speaker 4

No. No, no, no. Cover he's just saying we have coverage on the 800,000 feet that represents the ability to retain that expiration.

Speaker 10

Okay. I think I got that. Maybe I'll catch circle back on that. But then maybe on the dividend. So it's at $0.05 a quarter now.

Speaker 10

Wondering if you can comment on how that compares to your expected taxable income for the year and what could cause, any incremental change to the dividend one way or the other at this point?

Speaker 3

Sure. It's a bit early to compare to taxable only because the past year left. Like we always evaluate the dividend every quarter. It's really the Board's decision when it comes to the status of our dividend.

Speaker 10

Okay. So early in the year. Got it. Thanks.

Operator

Our next question comes from John Kim with BMO. Your line is now

Speaker 4

open. Thank you.

Speaker 11

I still don't really understand guidance for the Q3. You have it at $0.10 at midpoint. It's down 41% sequentially. Your original guidance provided 6 months ago implied $0.29 per quarter in the second to 4th quarter. And I understand studio is down, but at its peak the studio is only 11% of NOI.

Speaker 11

So I guess a lot of this is from occupancy, but the expirations was known a few months ago. So I just don't really understand how it could drop so much in 1 quarter. And I was wondering if there was anything that surprised you or anything incrementally new looking at the Q3?

Speaker 3

It's a good question. So like we said, our office is actually a little bit improved based compared to our previous guidance or even our full year guidance that we provided earlier in the year. It is really due to the both Quixote business and the same store studio business. They're just not performing in line with our projections, both the full year and next quarter. That's the driver of it.

Speaker 3

I know again from the percentage you're holding in terms of percentage of the company, that's the percentage of NOI, but that's not a percentage of FFO. The FFO is also driven by the interest and the G and A, which there's a larger movement as a result. So it's not just if you just take it as percentage of NOI, yes, it feels large, but when you compare it to FFO, it's a bigger number. And assuming our understanding is correct and the recovery is that that is going to turn around pretty drastically once studio activity picks up and number of shows increase.

Speaker 11

So same store studio NOI was $7,600,000 in the second quarter. Does that become a significantly negative number in the 3rd quarter?

Speaker 3

No. No. The $7,600,000 is the, I think, in service studio number. So we expect that to come down. And same with Kiyo.

Speaker 4

Let me just maybe take a just somewhat different tact on it. Haruk gave you the drivers of the difference between the $0.17 or $0.16 under NAREIT definition and the $0.10 midpoint, right, that's half studio related, half average office occupancy related. Hopefully that's fairly clear. As it relates to your sort of the reach back to the earlier guidance and sort of trying to bridge, if you will, to that early, early number and the $0.10 I think what you have to appreciate is that the Quoty business, especially is highly, highly leveraged to its fixed costs. And so if show counts and the other drivers that really drive that business markedly improve, you can generate a heck of a lot of incremental FFO off that.

Speaker 4

And if they don't improve, which for the time being at least show counts are pretty stagnant, what you realize is that you're kind of bumping along not too far away from say where we reported NOI negative $3,000,000 And as we sit today, our Q3 expectations is that it's going to take a little while for the show counts to meaningfully improve. And so we just haven't been able to really get the real lift off, if you will, in terms of the impact that Quixote has the potential to make on FFO.

Speaker 11

Mark, you mentioned that the fixed cost nature of Quixote. I just wanted to ask about same store studio expenses being up 33% this quarter. I would have thought it would be a lower number than that.

Speaker 9

The sequential, I don't know, Haru's looking at it.

Speaker 3

I apologize, I wasn't prepared for that specific question.

Speaker 11

It's just the same store studio expenses was up a lot.

Speaker 4

Yes, it could be. We did enjoy pretty high production levels at Sunset Gower in the quarter, in fact, higher than we had initially projected. Lighting and grip, when production levels are high, it tends to mean lighting and grip is high and they carry with it higher operating expenses. So that's likely the reason for the sequential increase. Okay.

Speaker 11

Great. Thank you.

Operator

Our next question comes from Alexander Goldfarb with Piper Sandler. Your line is now open.

Speaker 12

Hey, good afternoon. Good afternoon down there. Just two questions. First, and sort of piggybacking on John Kim's question on the earnings, it seems like the earnings this year have come down pretty quickly just given the issues that you guys have been dealing with, especially on the studio front. When things right size and occupancy for office improves, studios rebound, should we think about the quarterly progression of earnings rebound to be as sharp and upward as it has been on the down?

Speaker 12

Just trying to get a sense of how long it will take to get earnings back to where it was with expectations at the beginning of the year versus where we stand right now?

Speaker 2

Yes. I mean,

Speaker 4

it could be very sharp. What I was just walking you through in the prior question points to that. I mean, Quixote has the potential as you know to generate considerably higher NOI than the negative 3 or previous quarters before that. And if you just run the math, I mean there's not that much incremental cost associated with improving that NOI. And so it essentially drops to the bottom line.

Speaker 4

And FFO would could go up pretty quickly and significantly when that happens.

Speaker 12

Okay. And then the second question is, Victor, on the asset sales that you're contemplating, as you guys look at the portfolio and especially where some of the assets may have been weaker as of late, is there do you envision a scenario where maybe surgically you can remove some of the weaker assets and that way end up with a Hudson that has is much more concentrated in the top tier assets across the portfolio and that the laggards you can remove or it's easier done than said than done?

Speaker 2

Alex, so listen on a general comment as you well know, once the debt markets open up, the disposition market is going to increase. And so we have allocated our energy around 2 tiers, right. The assets that we don't think are long term assets for the portfolio going forward, which will make the enterprise a much higher quality enterprise. And those assets are already identified and to some extent are in conversations, we've looked at them. There are a couple of assets that are in that bucket that clearly are not salable in this market given where the debt markets are.

Speaker 2

The other alternative is for us to also look at where we get a much higher capital amount to the bottom line of the company. And as a result, we would look at a couple of the maybe better assets in the portfolio. But the goal is exactly how you sort of stated it. We're looking at having a much higher quality portfolio with high quality assets that are going to be performing. It's just taking us some time to get through that, but they've already been identified.

Speaker 3

Okay. Thank you, Victor. You're welcome.

Operator

Our next question comes from Tom Catherwood with BTIG. Your line is now open.

Speaker 13

Thank you and good afternoon everybody. Maybe Mark and Harut, sorry to keep sticking with guidance here, but following up on John's question, if we do a quick back of the envelope on the guidance swing quarter over quarter, it implies studio performance could be pretty close to in line with the 4Q 2023 numbers, which was the peak of the strike impact. Is that really what you're building into guidance for next quarter?

Speaker 3

I don't think it's exactly that low. Like I said, it was about I don't know if I gave estimates around the numbers. We expect a sequential drop, but I don't think we expect one to be as low as Q4 2023?

Speaker 4

I don't think so either. I mean just if you look at Q4 CHIOD NOI, it was 11.8 negative. The most recent quarter is 3.9. Same show count sort of stay at around in the 80 ish level, which they did in July and probably don't really start showing meaningful improvement until maybe late September. You're not even at that level, I don't think you're approaching 10 negative 11.8 on Quixote.

Speaker 4

And that's so we're not making that level of assumption on the Quixote business. We're really assuming it sort of stays more or less where

Speaker 3

it is today. Maybe similar to Q1 for Quixote. Yes.

Speaker 13

All right. Thank you for that clarification. And then Victor, following up on your response to Blaine's question about the asset sales, you mentioned one more being added to the bucket. Just to clarify, was that 1 in addition to kind of what has been expected before or did something fall out of the potential sales pool?

Speaker 2

Something fell out of the sales pool and this was the reverse inquiry by a user that we're talking to. And they're almost roughly the same valuation. This one's a little higher.

Speaker 13

Got it. Appreciate that. And last one for me just quickly if I can. Art, in terms of the leasing in your pipeline specifically in Silicon Valley and the Peninsula, do you have a sense of how much of that is tenants relocating from properties within the market and submarket versus tenants maybe relocating from other markets?

Speaker 6

Yes. Generally, there it's not relocating from other markets. Generally, it's growth, right? Because our bread and butter is kind of the 5,000 foot, perhaps a startup high growth company that we're banking on. And those are taking more space.

Speaker 6

Beyond that, it's space within the market. But we're seeing more and more of that, growth users taking additional space.

Speaker 13

Appreciate the answers. That's it for me. Thanks everyone.

Operator

Our next question comes from Michael Griffin with Citi. Your line is now open.

Speaker 3

Great. Thanks. Victor, I want

Speaker 14

to go back to your opening comments around how you don't think studio production needs to return to peak levels, for it to start contributing to your business. I was wondering if you could expand on this a bit. Does this mean that just the rate of change in the recovery is going to be beneficial? And I recall when you initially did the Quixote deal, I think it was about $80,000,000 of run rate EBITDA kind of initial expectations. Do you think that's still possible as the business recovers?

Speaker 4

This is Mark. I'm going to try to tackle that. It really starts with LA show counts improving the levels consistent with periods less affected by either a pandemic or a strike, such as 2019 or 2022, the average of which is about 120 shows. Even if we assume that current production budgets, which are reflecting real cost cutting measures, even if we assume those cost cutting measures continue to limit the number of trailers and other production vehicles, let's say, 7 vehicles per production. And also, we hinder our ability to push stage and service rates back to more historic norms.

Speaker 4

As long as LA show counts simply reach something like 115 or 120 shows, our CHIODI stages should get to about 65% to 70% occupied and our projected annual NOI for CHIODI should reach between 45,000,000 and $50,000,000 From there, any number of improvements have the potential to push NOI to 60 and above 60. For example, if you get to 75 percent Peony stage occupancy, that drives another $5,000,000 NOI increase. And if trailer and other vehicle counts go from the current 7 or so vehicles to back to historic levels of $8,000,000 to $8,500,000 that drives another $7,000,000 to $10,000,000 of NOI. And then of course, obviously as market conditions tighten, with show counts improving, we could then look to potentially push rates. We might be able to increase our market share a little bit.

Speaker 4

And all of those would ultimately contribute to getting that NOI number not just to 60, but somewhere well north of that.

Speaker 14

Got you. Appreciate the color on that, Mark. And then maybe for Harut, just updated thoughts maybe around issues with potential covenants. I imagine that EBITDA is expected to decrease with the Q3 relative to the Q2. I think you might be pushing up on a couple of covenants there.

Speaker 14

So any thought or updated around how we should think about that?

Speaker 3

Hey, Michael. Good question. So we always project out our covenants. And like this quarter, our projections came in our actuals came in better than our projections in all of our covenants and our results. So given that our even our lower expectations in the future, we don't think we're going to break any covenants or I think maybe next quarter might be similar to this quarter.

Speaker 3

So we feel pretty confident, but our projections are solid in terms of our expectations.

Speaker 14

Great. That's it for me. Thanks for the time.

Speaker 6

Thanks, Michael.

Operator

Our next question comes from Dylan Brzezinski with Green Street. Your line is now open.

Speaker 9

Good afternoon. Thanks for taking the question guys. Just wanted to go back to your comments around tenant demand or tenant requirements picking up in San Francisco. Can you kind of talk about some of the drivers of that? Obviously, I'm sure some of it's a pickup in activity from AI companies, but you can sort of give any other details as to the other drivers of that.

Speaker 9

And then as sort of a parallel to that, a lot of the reason why market vacancies have continued to go higher in San Francisco is because of space givebacks by Big Tech. Can you kind of just talk about expectations for there to be a continuation of this, a change in this? Because as we sort of think about where Big Tech is investing their capital today, it's primarily in the AI and data center infrastructure. And so just curious if you can give us any insight into any potential further space givebacks from this segment of the market?

Speaker 6

Sure, Dylan. This is Art. Listen, yes, AI has been clearly driving the market. Last year, that was responsible for about 1,700,000 square feet. We started off the first half of the year strong with about 600, just a little over 600,000 square feet and the active AI pipeline, the demand sits.

Speaker 6

I mean, I think we reported it was somewhere around 7, but

Speaker 3

it's since it's gone, it went

Speaker 6

to print, I mean, we're literally looking at and pushing up against another 1,000,000 square feet. So we're tracking as we did last year. But don't forget, yes, AI is driving the market now. Tech is coming back in the market in a more meaningful way. But the bread and butter, not just for San Francisco, but for all the markets through the pandemic was professional service law firms leasing space.

Speaker 6

That continues. It's just been overshadowed in the headlines because of AI and because of tech coming back, everybody is anxiously awaiting. But that sector has continued to grow as well, not at the same rate, but it also, like I said, it's going to bolster the market. Relative to tech, big tech givebacks, we were seeing them wholesale for a while. I think these givebacks have become more measured.

Speaker 6

I think some of these big tech have made decisions about how they're going to give back or how they're going to utilize space and how they're going to give it back. Listen, they're up against some expirations in the next year and a half, and I think they're going to deal with it then. But I think we've seen a more far more measured approach about what that means going forward. And I think that the demand that you're seeing in the market, when executed is going to ultimately more than offset any of those givebacks.

Speaker 2

Dylan, it's Victor. Also, I just want to just give some macro highlights in the city. I know you guys are on top of this stuff, but we follow this very closely. And when I made in my prepared remarks the reduction in crime, I mean we're seeing that it's hitting its lowest mark in the last 5 years. We're seeing obviously activation centers, areas that are being capitalized for activation centers in the city that is going well.

Speaker 2

Bard exits have gone up almost 7%. The San Francisco tent counts are down since 2018. They're their lowest levels. They're a 41% reduction in tents and the homelessness is down 13%. So these are all factors that are helping the macro basis for growth in San Francisco.

Speaker 2

And I've always said, when San Francisco churns, it will churn quicker than people think. And I think that's what's driving some of this activity. And one more

Speaker 6

thing, Dylan. Other than the obvious demand drives gross leasing and things like that, the number I'm looking at is the sublease availability. It was excuse me, the net absorption, which was negative 290,000 square feet, which seems like normally a high number, it's been trending through the pandemic. It's been trending to about $1,100,000 right? So if you think about it, it's come down over the last few quarters.

Speaker 6

But it was trending at $1,100,000 It's now kind of moving back to a manageable number.

Speaker 9

Appreciate those comments. And then maybe just a follow-up to some of that. I mean, are you seeing I know Governor Newsom really recently ordered the state agencies to address homeless encampments. Are seeing that sort of be obviously that's recent news, but are you seeing that sort of be talked about in leasing discussions? And then then obviously, it seems like recession odds are higher today than they were 2 or 3 weeks ago.

Speaker 9

And so are you at all hearing any discussions on that with tenants or?

Speaker 2

I think, listen, on the recession, it's too early to tell, right? This is it's sort of new news that's come out in the last 30 less than 30 days. In terms of the governor's movement to move the encampments, it's absolutely affected San Francisco. I think better more so than it has for sure in Los Angeles, because listen, there's an election in San Francisco, right? So London Breed is up for reelection.

Speaker 2

And so she's going to push on that as a platform where Karen Bass, Mayor Bass doesn't have to do that. She's got another 2 plus years to go.

Speaker 9

Great. Thanks for the details guys. Really appreciate it.

Speaker 2

Thanks, Dylan.

Operator

Our next question comes from Peter Abramowitz with Jefferies. Your line is now open.

Speaker 15

Yes. Thank you for taking the questions. Just wanted to go back to those comments about kind of the ability to drive some meaningful value in the studio portfolio even if things don't get back to where they were before the strike. I guess, is there anything you can do or anything you're expecting to do on the expense side to kind of close some of the gap and get back to the NOI run rates you sort of underwrote when you did the Quixote deal, just to sort of close that gap because obviously demand in the revenue side is not going to be quite where you were probably expecting it a couple of years ago.

Speaker 4

Yes. There's some measures we can do and are doing. I mean, we did, on the heels of the acquisition of Quixote, the third of the 3 companies in the fall of 2022, we did implement a lot of efficiency measures including 2 pretty sizable risks. And so we believe we've largely right sized the headcount. There are other things we are looking into really at the operations level, looking at our footprint in terms of our various facilities, ways to save costs there, looking at efficiencies on the manufacturing side in terms of our trailer manufacturing.

Speaker 4

And so we'll just continue to pursue those and try to make inroads on the cost side to try to help improve those margins.

Speaker 15

Okay. That's helpful. And then you published an interesting chart, I think, in your NAREIT presentation that utilization, transportation utilization in the studio business had gone from about 10% during the back half of last year, up close to 30% by April. Apologies if I missed this upfront, you already covered it, but you just provide an update on where that is as of July?

Speaker 4

Yes. Well, we mentioned in our prepared remarks of the 24%. I would mention that if you think about where we finished the quarter at 82 shows in LA, to be a 24% utilization at show counts at that level really points to a lot of potential here. I mean, 30% was back when show counts were in the low 100 range. To put a finer point on it, we averaged 96 in the second quarter and we only tapered down to 80 towards the end of June.

Speaker 4

We're sitting at about 80 as of the end of July. We might hopefully we start coming off that bottom soon. But if we're at 24 at 80, we could easily get to 30 quickly. We think we are picking up market share on the trailer side through a lot credit to our sales team picking up on improving relations, picking up just more sales. So I think 30 is something we can get to quickly.

Speaker 4

And then if show counts get

Speaker 3

to the levels we were just talking

Speaker 4

about, the 115, 120 level, we should be back above 50 plus percent utilization.

Speaker 15

That's all for me. Thank you.

Operator

Our next question comes from Rich Anderson with Wedbush Securities. Your line is now open.

Speaker 16

Thanks. Good afternoon. I was asked and asked a similar question on Quixote, specifically on the expense side, the $25,000,000 you run roughly per quarter, something a lot of that is lease expense. Have you inquired or thought about sort of a rent restructure for the 23 leased studios? Or has it not gotten that bad?

Speaker 2

Rich, no. But Rich, what we have done is we are I mean, you're absolutely right. A lion's share of that is lease cost. But we are also looking at some consolidations that are not studio lease costs, but transpo storage lease costs and the likes of that and consolidating. We're in conversations on that.

Speaker 2

We do have several leases that expire in the next, 24 to 36 months that we're working on a master plan around that. So that will also help the overhead process.

Speaker 16

Is there any scenario where you could own some of those studios at some point down the road?

Speaker 14

Yes. Yes. Okay. That's all I need

Speaker 16

to add there. And then last question, the someone brought up recession and I had it on my list too. What let's put all the noise of the very thing that's happened to in terms of strikes and so on aside. What is a recession due to production, the production business generally? Like how if you look back in history, what happens?

Speaker 2

I mean, historically, the entertainment industry has performed exceptionally well during recessionary times because it's providing a cheaper form of entertainment clearly. And so, not to say that anybody wants a recession, but at the end of the day, it's always performed well. And that was sort of part of the prepared remarks, you're saying, even in a downturn, content will be produced.

Speaker 16

Yes. Okay. That's all I had. Thanks very much.

Speaker 2

Thanks, Rich.

Operator

Thank you all for your questions. There are no longer questions in queue. So I will pass the conference back over to Victor Coleman for any closing or further remarks.

Speaker 2

Thank you so much for participating in our Q2 call and

Speaker 3

we look forward to speaking

Speaker 2

to you guys all soon.

Operator

That will conclude today's conference call. Thank you all for your participation. You may now disconnect your line.

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Earnings Conference Call
Hudson Pacific Properties Q2 2024
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