Ted Darnall, Partner & CEO of Lodging and Technical Services, discusses why he believes HEI is better positioned today than ever before.
As we move quickly through the second quarter, I wanted to provide an update on the progress we’re making against what we consider to be the core objective of our organization. This, as most of you would know if you’ve been following these notes over the past year, is to restructure our operating model to improve profitability through a more efficient enterprise-level labor structure and provide higher cash flow returns even as our revenues take time to recover.
It is now apparent that this will be a slow recovery, and it will take tremendous efforts to return EBITDA at most properties to 2019 levels. To help accelerate that process and provide better underwriting potential for assets trading on 2019 levels, we set out to restructure our operating model to greatly reduce our properties’ fixed costs, reestablish a more variable-based expense structure, and improve efficiencies through greater enterprise-level execution of property functions. As the year progressed and we started to see both the immediate fruits of our labor as well as the long-term potential for what we had begun, we refined our ultimate objective, which is now to actually improve profitability over historical levels. We now see the final measurement of our success as our ability to meet or exceed 2019 EBITDA performance at lower revenue levels. Our ability to achieve this initial measure of success will also demonstrate something quite powerful: that we’ve developed a new and sustainable business model that will create greater real estate value in perpetuity.
In this journey, March 2021 was a critically important month. We had been consistently meeting our short-term objective of improving profitability month after month, which was a result of driving significant flow-through of every incremental revenue dollar from one month to the next month. However, March’s results are now the most compelling indicator to date of what we are capable of achieving. As you well know, last March marked the real beginning of the pandemic’s toll domestically. And while we did not equal our 2020 revenue levels, we did see glimpses of the tremendous potential of our new operating model as it related to both margins and overall cash flow. We increased our GOP margin year-over-year by over 1,270 basis points. We increased our GOP performance to budget by 70%, and even more importantly we increased GOP margin to last year by over 1,600 basis points. We reduced the cost of our deduct departments by over 9% to 2019. We saw improvement in our operating department profit margins – nearly 1,000 basis points in rooms and 1,900 in F&B to 2020 and nearly matching our 2019 margins despite only a third of the revenues. All of this indicates to us that our commitment to developing a more profitable operating platform as one positive outcome of the pain and suffering we’ve all experienced with the pandemic is in fact quite possible. There is no doubt, if you look back over the history of our industry, at least through my tenure, that at the end of each of these cycles we have become a better and a more efficient industry. It is our belief that this industry evolution will continue, and that here, once again, we will see performance levels that reinvent the value potential within our real estate segment. It is also our belief that HEI will be the leader in rewriting the industry rules necessary to deliver that performance.
So the question is, how do we measure progress on this front as we go forward? In our opinion, the first answer is to look to the flow-through of incremental revenues from month to month. We believe we must equal or exceed 50% flow-through of every incremental revenue dollar, in every month, as revenues grow. Furthermore, we must sustain this 50% flow-through on incremental revenue even as growth slows and we enter a more stabilized environment in 2022 (and possibly into 2023). Of course, this will only be achieved by closely managing and measuring our profitability as business levels increase. Then, a second key measurement of success will be achieving a 300-500 basis point improvement in our deduct departments. While some of this will come naturally as less variable costs (like utilities) become a lower percentage of total revenues, the bulk will need to come from a continued expansion of our enterprise-level platform in order to further drive down fixed property expense.
If we can achieve this level of consistency in our results we will have established permanent improvements in GOP margin performance. And we are confident that when the dust settles, with continued refinement of the programs we have put in place, we will have produced a growth in GOP that is somewhere between 200-300 basis points favorable to that which we accomplished in 2019 or at any time in recent history. This clearly will have created significant real estate value.
We understand that March is just one month and Q1 is just one quarter, and it is too soon to include these successes in our underwriting. However, these are results that we are confident can be achieved, and be achieved in a sustainable manner. So while you may be most keen to watch revenues grow in order to restore and increase the value of your assets (as we all are), I want to give you confidence that the value of your real estate will grow even further – and more sustainably, thus more easily captured on sale – thanks to the new operating structures that we have been so successful in implementing.
And before I let any of you point to us as a “one trick pony” with regards only to expense controls, know that throughout all of these operating modifications and improvements we have not skipped a beat as it relates to our revenue and group room performance. In fact, our group closure rates have never been higher, our overall group share has grown with consistency, and our revenue share has never been greater. Let me remind you of what I shared in my last letter: that we continue to operate well above 110% of our comp set average revenue with average rate penetration of over 100%.
But our goal is simple. We need to make more money on the same revenues. We need to take advantage of our lessons learned over the past nine months and our shift to capture enterprise efficiencies, and we need to expand that as far as possible to make these margin improvements permanent. In addition, we need to redefine what fixed staffing is, move more costs back to variable, and change our operating standards to be consistent with the new expectations of our customers. We cannot let the brands lead this process; we must be the ones that develop strategies to meet the changing needs of the customer. Success moving forward will not come from brand standards, it will come from reputational management. It’s about how our guests perceive what we offer, what we deliver, and what we charge for. It’s about understanding the different buying decisions of our value and premium customers and offering different products to suit their needs accordingly. We must not lose sight of the fact that what leads to the greatest positive impact on profitability in any economic cycle has been reacting to the behavioral changes of the consumer. Disregarding this, or assuming that consumer expectations are going to revert back to where they were two years ago, is simply ignorance. How many of us today still feel it necessary to have a specialty restaurant in their full service hotel in order to buy? How many of us today still look upon the need for a bellman as opposed to rolling our own luggage? How many of us today still work only at the desk in our room as opposed to seeking out other dynamic environments to fulfill the need of being “alone with others?” Changes in consumer behavior are natural outcomes of every industry cycle.
The fact is, our industry changes in every cycle. We must adapt in this and every cycle to ensure we are adjusting our services and amenities to meet the new needs of our evolving customer. It is only through these important modifications in the way we operate that we will achieve our objectives. But once again I appeal to you, our owners, that we must not leave this to the brands. The brands have historically turned their reactions to any type of challenging economic environment into an “arms race.” They have implemented standards and amenities that are easily replicable and only exist as competitive advantages for extremely short periods of time. We, the ownership and management communities, must insist that the measurement of performance is based on reputational management results, customer reviews, and overall feedback that truly defines the priorities of our customer.
I remember back in the late 1990s thinking that the industry was undergoing a change that would permanently redefine the landscape – that is, how costs and efficiencies were managed. However, only a few years later virtually every hotel had reverted back to their old habits, “just because.” But today, with your help in supporting a positive associate environment, demonstrating discipline with our brands, and trusting the voice of our customer, we can ensure that the hotel segment of the commercial real estate industry comes out of this pandemic as the preferred investment choice and a true leader moving forward.
But let me not dwell too much on this point, as I’ve made it many times before in my letters of the past twelve months. Instead, let me conclude this short note by saying we are extremely pleased with our March results. We think they are strong indicators of what our platform and our people are capable of achieving. We know what to measure going forward, we know what success looks like, we are committed to ensuring that the results we achieve today are sustainable, and we are confident that our model will be the formula followed by the industry going forward for years to come. Despite how tragic this pandemic has been, and how proud I am of the entire HEI organization for its resilience to overcome the challenges of the past year, I sit here optimistic that our ultimate success will come from not just surviving the pandemic, but delivering next-level value for years to come. We are mastering the art of enterprise-level efficiencies, strengthening our properties’ reputations, providing an outstanding associate environment, and with your support creating a culture where our teams have confidence, they have the tools to do their job, the respect of their employer, and are paid and compensated fairly.
In closing, let me say thank you for your confidence, for the partnership of your asset management teams, for your decisions to work with us, and for your trust. We know there is still work to be done. The labor market is tight. Our teams are tired from a year of heroic efforts, and we must leap at the first opportunity to reinstitute their bonus programs. I am humbled by the efforts I see across the HEI family and the growth I’ve seen in so many of our associates. Our team is strong. Our platform is sound. And I have never in my career been more excited for the opportunities the future holds.