Extended Stay America Inc (STAY) Q1 2019 Earnings Call Transcript

Our cost execution this quarter is another example of the record we have maintained for many years. For example, over the past 3 years, pro forma property level expenses have grown by only 1.7% per year despite some inflation pressures. Many significant areas have been flat or even down. And we have done well at managing costs in labor, property taxes and insurance expense. For example, our total room expense, which includes breakfast has dropped from $1.66 per occupied room in the first quarter of 2016 to only $1.36 this quarter, a nearly 20% reduction. And our corporate overhead expense in the first quarter of 2019 was down 5.8% compared to the first quarter of 2016, despite having built out a development and franchise team during that period. We’ve been able to achieve this through a more consistent operational performance, the elimination of waste in all of our operations and the application of more precise business intelligence. During the first quarter, we grew our pipeline by 5% to just over 7,300 rooms or more than 10% of our existing estate. I expect we’ll grow our pipeline further in 2019 and 2020. I’m also excited that we had our first franchise conversion hotel open just after the end of the first quarter in Houston, Texas, by Provident Realty. This is Provident’s 17th ESA branded hotel, all of which are independently managed.

We believe conversions represent a great opportunity for franchisees to grow their ESA footprint over the next several years and that existing third-party managers of ESA, including Sandpiper and hospitality management Corporation are well-positioned to execute successful conversions. Yesterday evening, we announced a 4.5% increase in our total dividend to $0.23 per Paired Share per quarter, our fifth year in a row of raising the dividend and a further raise of the uninterrupted annual dividend increases, since becoming a public company just over 5 years ago. Our dividend has increased accumulative 53% since that time despite having sold 130 hotels since going public.

This demonstrated commitment to raise our dividend highlights and is fortified by our strong free cash flow model and our healthy balance sheet. I’d like to close by acknowledging the strides we’ve made in our environmental social responsibly efforts. Extended Stay America has invested a significant amount of capital to reduce our energy and water usage over the last 7 years. This has been good for shareholders as well. It has enabled us to reduce our utility expense per occupied room over the last 7 years, despite inflationary pressures.

For example, in that timeframe, we’ve seen an 18% reduction in water usage per hotel, a reduction of more than 350 million gallons of water per year for the company through a combination of low-flow fixtures, smart irrigation controls and improved water meter monitoring. This represents more than $4 million in annual expense reduction in water usage over our 554 company-owned hotels. Investments in lighting, HVAC, boiler controls and other energy saving initiatives have reduced our electricity usage by more than 50 million kilowatt hours and nearly 1 million therms of natural gas per year over the last 7 years, representing more than $5.5 million dollars in annual expense reduction for our hotels. But we’re not done, we’ve identified further water reduction and energy efficiency projects in 2019, that we believe will have a less than 3-year payback, resulting in annualized savings of more than $0.5 million per year. And we won’t stop there. Investments of this type are a win for the environment, the communities in which we operate, our employees and our shareholders.

At least, once per year, we will provide an update on these exciting initiatives. For 5 years, we have partnered with the American Cancer Society to the hotel keys of Hope program, which provides free and deeply discounted hotel stays for cancer patients in need of treatment away from home. Today, Extended Stay America has donated over 130,000 hotel room nights throughout the U.S., helping over 17,000 patients and their families save over $7.5 million in lodging costs. Our hotel rooms are ideally positioned to help patients and their families, and we are proud to work with the ACS to provide this service.

This year is setting up to be an exciting year for our company. We expect to make more progress on ESA 2.0, including growing our pipeline, opening new hotels and setting ourselves up for meaningful unit growth in 2020 through our other development activities. We expect more refranchised units in the second half of 2019. Though the appetite for our hotels among investors remains very strong, we will take a measured pace on refranchising, balancing the benefit of building out our franchise program and establishing pipeline commitments from franchisee partners with the capital needs for ESA over the next few years.

I’ll now turn the call over to Brian to discuss our financial results further and our 2019 outlook. Brian?

Brian T. Nicholson — Chief Financial Officer

Thank you, Jonathan. As expected, the first quarter of 2019 was challenging due to cycling difficult hurricane comps in Florida and Houston, as well as calendar shifts for New Year’s, the government shut down in January and a general sluggish business environment. Comparable systemwide, RevPAR was down 1.6% in the first quarter in line with our expectations. Excluding Florida and Houston markets as well as renovation disruption, RevPAR increased approximately 1.5% during the first quarter, and our RevPAR index grew approximately 100 basis points. Additionally, a small help from Easter shift during the first quarter was largely offset by the quarter ending on a Sunday this year.

During the quarter, comparable company-owned RevPAR declined 2.1%, slightly worse than our systemwide results, which include a relatively larger hurricane and renovation disruption impact. We saw slight increases in revenue from our short-stay guests, offset by declines in long-stay business in Florida and Houston driven by hurricanes Irma and Harvey. Gains in esa.com and OTA business were offset by declining revenue from property direct and opaque channels. Hotel operating margin declined 210 basis points in the first quarter to 50.1%. The decrease in hotel operating margin was driven by a 2.1% decline in comparable company hotel-owned RevPAR as well as increased payroll expenses and modest inflationary expenses in most other expense items. While we run a lean system and already have industry-leading hotel margins, we are focused on reducing turnover to improve labor costs and to boost our customer service levels.

In fact, our hotel management turnover as a whole has dropped from nearly 50% in 2017 to an annualized rate of 39% in the first quarter of 2019, and that’s against a backdrop of a tightening labor market. Corporate overhead expense included share-based compensation and transaction costs, which decreased 7.7% to $20.8 million during the first quarter. Total expense growth on a comparable basis at a consolidated level grew 2.9% during the first quarter of 2019 compared to the same period in 2018, with the decline in corporate overhead expense offsetting cost pressures at our properties.

Adjusted EBITDA in the first quarter was $116.3 million. Adjusted EBITDA during the quarter was impacted by the lost confirmation of approximately $6.9 million from hotel dispositions in 2018 as well as the declines in RevPAR and an increase in hotel operating expenses. Interest expense during the quarter decreased by $2 million to $29.6 million due to less outstanding net debt and a decline in the LIBOR spread on our term loan partially offset by an increase in LIBOR rates. Income taxes increased $0.3 million to $6.1 million during the quarter, driven by an increase in effective tax rate compared to the same period of 2018.

We continue to expect a similar rate for the full year of 2019 compared to full year 2018, however, a roughly 16% to 17%. Adjusted FFO per diluted Paired Share declined 14.3% in the first quarter to $0.36 per — compared to $0.42 in the same period in 2018. The decline was driven by the decline in company-owned RevPAR, and increase in hotel operating expenses and an increase in income-tax expenses. Net income during the first quarter decreased 8.7% to $28.4 million driven by the previously mentioned items to adjusted FFO. Adjusted Paired Share income per diluted Paired Share in the first quarter decreased to $0.16 per diluted Paired Share from $0.19 in the same period as last year. The decrease was due primarily to a decline in RevPAR at an increase in hotel operating expenses partially offset by a decrease in depreciation and lower net interest expense.

We ended the first quarter with our net debt to trailing 12 months adjusted EBITDA on a pro forma 554 hotel basis at 3.75x, roughly in line with the end of 2018. Our total cash balance finished at $304 million for the quarter, a little changed from the end of 2018. Gross debt outstanding was $2.44 billion. Our target net leverage ratio going forward is between 3.4x and 3.9x.

Capital expenditures in the first quarter were $55.3 million, including $14.8 million for renovation capital, $8 million for development, land acquisitions and other ECA 2.0 costs and $11.9 million in IT capital. Our renovation capital to date has been focused on our home market of Charlotte, North Carolina as well as the Pacific Northwest. Later this year, renovation capital will be focused on our California markets. We continue to expect a low double-digit cash-on-cash return from renovations for return, and we’ll update investors as we see results occurring, which generally speaking are notable 6 to 9 months after completion of a renovation. Our owned balance sheet development pipeline at the end of the first quarter stood at 17 hotels, while our franchise pipeline grew during the quarter to 43 hotels.

We’ve broken ground on a total of 8 hotels as of this morning, 7 owned and 1 franchised and expect a small handful of the hotels to open in the back half of 2019 with more opening in early 2020. Our total pipeline grew 5% during the first quarter to 60 hotels or 7,300 rooms. Additionally, we had our first franchise conversion hotel open in the beginning of April in Houston, Texas, and we believe this represents a great way to increase our system size in the near and medium terms.

Yesterday, the Boards of Directors of Extended Stay America, Inc. and ESH Hospitality, Inc. declared a combined cash dividend of $0.23 per Paired Share payable on May 30, 2019, to shareholders of record as of May 16th, 2019, which is an increase of 4.5% from our prior dividend. This dividend increase, our fit as a public company, highlights the robust cash flow our company generates and our commitment to return capital to shareholders. Our dividend yield is now approximately 5.1% of its trading prices, which is higher than our weighted average and marginal cost of debt. During the first quarter, we did not repurchase any shares. As we set about 2 months ago in our Q4 2018 call, we decided to suspend repurchases in light of consideration of various potential actions to create shareholder value. Our remaining share repurchase authorization is currently over $110 million.

Looking to the second quarter of 2019, we expect comparable systemwide RevPAR growth will be between 0% and 1.5%. Our second quarter outlook reflects an approximately 2% drag from hurricanes Harvey and Irma business cycling, as well as renovation disruption plus a 60 basis point drag from Easter during the quarter. Comparable systemwide RevPAR growth in April was negative 0.7%, including an approximately 200 basis point drag from the Easter shift on approximately 150 to 200 basis point drag from the hurricanes and a 30 basis point drag from renovation activity. We expect adjusted EBITDA to be between $153 million and $158 million during the second quarter.

For the full year 2019, we reiterate our previous guidance for all metrics. That includes expecting comparable systemwide RevPAR growth of 0% to 2% and adjusted EBITDA between $560 million and $580 million. The adjusted EBITDA totals include loss contribution of approximately $21 million from assets sold in 2018, but this guidance does not include any further asset dispositions. We continue to expect capital expenditures in 2019 to be between $310 million and $360 million. This includes approximately $80 million to $90 million in maintenance CapEx, including insurable events. $85 million to $100 million in renovation CapEx, $110 million to $125 million in new build CapEx with the remainder in IT and corporate investments.

We expect our annual interest expense to be approximately $126 million in line with 2018 as a rise in LIBOR is expected to offset decreased debt outstanding. We expect Paired Share income per diluted Paired Share of between $1.02 and $1.14 per Paired Share. Through our dividend and Paired Share repurchases, we continue to expect to return between $220 million and $270 million this year to our shareholders, which represents roughly 6.5% to 8% of our recent market capitalization.

Operator, let’s now go to questions.

Questions and Answers:

Operator

(Operator Instructions) Our first question comes from the line of Harry Curtis with Instinet. Please proceed with your question.

Harry Curtis — Instinet — Analyst

Good morning, everyone. I had a shorter-term question and then a longer-term question. The shorter-term question is, looking at your second quarter guidance for RevPAR, are you assuming that the — mainly the drag from the hurricanes/Easter are behind you, and what does that say about your view on — I think, you used the expression sluggish-business trends, are those improving in your core business? And then my longer-term question is you didn’t make any commentary about enhancing shareholder value in the press release. And so if you could give us your latest thinking and the Board’s latest thinking on that topic?

Brian T. Nicholson — Chief Financial Officer

Good morning. Harry, this is Brian. On the guidance and our outlook for the year, I think there are a couple of things going on here. First, you asked about the hurricane impact and how it will affect the way we view our RevPAR moving through the year? First quarter, the hurricane impact was more significant than what we would expect for the remainder of the year. Something in the neighborhood of the 300 basis point impact, which tapers down to about 150 basis points in second quarter and measurable but very small by third quarter. Nothing in fourth quarter.

Within the second quarter, it is our expectation that, that impact obviously, will be a little higher early and a little lower of late. But to give you an idea of, sort of, the scope of the Easter impact and why we feel good about the business where we stand today relative to kind of the chop that we saw in March? We — our April RevPAR is down slightly, it’s about negative 0.7% for the month. But if you look at a RevPAR unaffected by Easter, basically, the first 2 weeks, the 1st through the 14th, our RevPAR was positive 2.5%. Obviously, the rest of the month or at least the next 2 weeks were heavily Easter-affected.

Jonathan Halkyard — President and Chief Executive Officer

Harry, on your longer-term question, other than what Brian said in our prepared remarks, we really don’t have anything to add with respect to that topic.

Harry Curtis — Instinet — Analyst

Okay. Is it — is there still an appetite for enhancing shareholder value through a spinoff? I mean it — or should we be thinking that, that topic is off the table and we should be focusing just simply on enhancing value through current business trends?

Jonathan Halkyard — President and Chief Executive Officer

Yes, we are always focused on increasing shareholder value, both through the core business, through our development activities, as well as consideration of the corporate structure. So that is a constant priority for the company.

Harry Curtis — Instinet — Analyst

Okay. Well, we’ll leave that pregnant pause alone and let allow someone else to ask —

Jonathan Halkyard — President and Chief Executive Officer

Okay, thanks Harry.

Operator

Thank you. Our next question comes from the line of David Katz with Jefferies. Please proceed with your question.

David Katz — Jefferies — Analyst

Hi, good morning, everyone. I’m hesitant to go back and ask the same question again, but in between the, sort of, larger scale spin-type questions and much more dramatic outcomes, and putting value through growing system and executing. Are there any sort of interim ways or other strategies you can pursue that affiliate the branded system with larger platforms that might help you execute and might help you add units and might help you RevPAR drive a little bit faster that you may or may not have considered?

Jonathan Halkyard — President and Chief Executive Officer

We believe setting aside questions of — or pursuit of development unit expansion, franchising and corporate structure, we believe there are a number of opportunities for us to create value within the core business. Some of those are innovations within our business model itself and some are continued improvement in our pricing and our sales activation process. In terms of any affiliation with outside brands that I don’t think that, that’s something that’s a meaningful opportunity for value creation right now. I think, we spent of course, a few years before and after going public consolidating from 5 brands down to 1 and then investing in the Extended Stay America brand, both through renovations as well as through our marketing activities, improving the website and the loyalty program and so on and so. So we believe that the Extended Stay brand — Extended Stay America brand is a healthy one and haven’t really considered any kind of short- or medium-term brand affiliation.

David Katz — Jefferies — Analyst

Got it. I do have one follow-up that I hope can maybe produce a bit less of a, kind of, an awkward exchange. I wanted to ask about the competitive landscape, which — those of us that have spent some time on it, have — obviously, are aware of what’s going in the progress they’ve made. And then a private of some size, I think it’s in-town suites and then it becomes considerably more fragmented. If you could talk for us just a bit about what you’re seeing in the competitive landscape from your larger and smaller competitors in terms of pricing aggressiveness, key money and any dynamics that may have evolved over the past few quarters?

Jonathan Halkyard — President and Chief Executive Officer

Sure. And we’re not troubled by awkward exchanges at all. It’s a very good question. And the competitive landscape, it is interesting, while it is certainly true that would spring a competitor you named has been successful on adding units over the past, I guess, 12 months or so. And there are some other competitors that have also added supply in the more upscale Extended Stay segment. Our experience on the ground has continued to be a positive one competitively. And I think that’s for a couple of basic reasons. One is that we cater to and go after a market that neither would spring nor some of the upscale Extended Stay players really go after. And that is — that’s our core guest, that’s a business traveler who’s staying a few days to a few months. Secondly, our competitive position is strengthened considerably by the locations that our assets have.

These — this is a portfolio that was largely built out 15 to 20 years ago in locations that are really unobtainable, particularly for somebody who is going to compete in Extended Stay in our segment. I think all of this is evidenced by our occupancy levels as well as our business mix. So we’re not dismissing the competitive impact. We agree that there is a market opportunity here for new Extended Stay supply, and that’s why we are participating in that. But if you look over last 20 years, this is segment where supply growth has been fairly steady and yet occupancies remain high, ADRs continue to go up. And that’s because of the fundamental fact that the Extended Stay demand in this country is underserved by the amount of purpose built Extended Stay supply. So we all I think, will be successful in converting customers or currently — Extended Stay customers, currently serve — underserved by transient hotels and are going to find a much better solution in Extended Stay hotels.

David Katz — Jefferies — Analyst

Got it, thank you very much. I appreciate it.

Jonathan Halkyard — President and Chief Executive Officer

Okay, thanks.

Operator

Thank you. Our next question comes from the line of Thomas Allen with Morgan Stanley. Please proceed with your question.

Thomas Allen — Morgan Stanley — Analyst

Hey, good morning. When you go out to market and you’re building new hotels, or you have franchises building new hotels, can you talk to us about the dynamic or the changing dynamic in terms of construction lending, cost of construction and how that’s factoring into decision making?

Brian T. Nicholson — Chief Financial Officer

Thomas, this is Brian. Yes, we are seeing some construction cost rise, those are primarily focused in 2 areas. You have some component costs primarily related to tariffs and then you also have labor costs that we have seen rising. In terms of our own on balance sheet builds, we factored a fair amount of contingency into our planning and still — we’re still bringing these projects in where we expected to. And frankly, we’ve seen maybe more enthusiasm on the part of franchisees who are building in terms of their unability to manage cost. You also asked about financing. Financing is still there, financing is still available. And I guess it’s generally the case that it’s available up until it’s not, but at least, where we sit today, we think the environment is still very good and lend itself well to solid continued activity.

Thomas Allen — Morgan Stanley — Analyst

Helpful. And then just on the refranchising front, you made a couple comments in the prepared remarks, spray more color around like pace and size?

Jonathan Halkyard — President and Chief Executive Officer

Sure. I think I do believe that this year we are going to refranchise additional Extended Stay America hotels. There is no question that demand exists for these hotels among our current franchisees as well as outside other groups. I don’t believe that we will do as much as we did in 2019, which was — 2018, sorry, which was around 70 hotels. We put out a plan of — to do about 150 by 2021, I believe we’ll get there and we’ll get there probably by doing 30 to 50 hotels this year, just to kind of pick a range. So more than 0 but less than 70 we did last year.

Thomas Allen — Morgan Stanley — Analyst

Helpful, thank you.

Brian T. Nicholson — Chief Financial Officer

All right.

Operator

Thank you. Our next question comes from the line of Joe Greff with J.P. Morgan, please proceed with your question.

Joe Greff — J.P. Morgan — Analyst

Hi, good morning. Jonathan, this last July when you proactively talked about the board evaluating corporate structure and here we are, almost a year, not quite a year, but almost a year later and we all know updates. So one, why is it taking so long? Two, is there a social issue at the Board level or management level that precludes reaching a conclusion? And three, does the board think that focusing on the operations, in their operational initiatives that could bear greater equity value increase than a new corporate structure evaluation?

Jonathan Halkyard — President and Chief Executive Officer

Joe, with respect to the first question, that’s a difficult or impossible one to answer, and I really can’t answer that. With respect to the second question, there are no social issues at all. Our sole determinant and northstar is creating the most value for our shareholders. So there’s not any social or other issue that would ever get in the way of that. With respect to your final question, I mean, that is the central question and it is how — what is the best way to create value for shareholders? It Is certainly through continuing to improve the core operations and applying capital to in our case, renovations and new unit construction. And so we’re continuing to pursue those. But like Brian said in the prepared remarks, other than that, we really don’t have any update at this time.

Joe Greff — J.P. Morgan — Analyst

Thank you.

Jonathan Halkyard — President and Chief Executive Officer

Thanks.

Operator

Thank you. Our next question comes from the line of Anthony Powell with Barclays. Please proceed with your question.

Anthony Powell — Barclays — Analyst

Hi, good morning. Can I ask as a follow-up, is there a possibility that we are here, let’s say at the end of the year or even early next year and the current corporate structure remains, is that a potential outcome of your deliberations?

Jonathan Halkyard — President and Chief Executive Officer

Hey, Anthony, I really don’t want to speculate on that.

Anthony Powell — Barclays — Analyst

All right. Just going on to franchise new builds, it sounds like you see a big opportunity for franchise conversions in the next couple of years, because you update us on how the potential for franchise new builds to ramp up over the next few quarters?

Brian T. Nicholson — Chief Financial Officer

Sure. Anthony, this is Brian. We — franchise conversions, obviously, offer a quick way to add units to the system. We did one in Texas, we’re very pleased with how it’s performing. In order to do that, you have to have purpose-built Extended Stay, and it has to basically meet certain criteria. Probably an important one for us is that, it would be a property that is generally operated with transient-demand drivers that aren’t particularly well-suited to the demand in that market where the profitability for that property and for that owner might be enhanced by a conversion to our true Extended Stay business modeled. But then in terms of new builds, obviously, there is a longer run way to get to bringing these things out of the ground.

In addition to the land acquisition, there is an entitlement process depending on the market can be anywhere from 6 months to much higher. California could be a couple of years. And so while we do have franchise new construction coming out of the ground, we broke ground at the end of next year on the first one in Colonial Heights, Virginia just south of Richmond. Generally speaking, while we have a number of these deals cooking, it is going to take some time before you see a significant number of them coming out of the ground.

Anthony Powell — Barclays — Analyst

Okay. And just one more on the kind of the core 7 data, multi-lead customer. Last year, it seemed like a lot of that growth of that business was due to temporary hurricane driven demand. Can you just update us on what the kind of underlying demand dynamics are for that type of customer and all of your various industries? And also, are you moving toward efforts to gain more of those customers through Google search ads and whatnot?

Jonathan Halkyard — President and Chief Executive Officer

Sure. Yes, you’re spot on. Last year, we had a lot of Extended Stay demand that was driven by the hurricanes, primarily in the Houston and Florida markets, we also had some FEMA business in the Northeast related to Puerto Rico. In a lot of cases, these were guests who were paying full retail rate even though they ended up staying in our hotel for 30 days or longer. And so there was a beneficial impact, both to our average length of stay and the cost to serve those guests as well as to our ADR. As we lap that, you see a number of kind of interesting things going on. One of them is the reduction in our ADR, driven not only by that lapping but also by an intentional effort on our part, especially in certain markets to make sure that we have a good base load of solid Extended Stay business.

We’ve been doing some promotional and other activity to make sure that it’s especially in lower demand, lower occupancy markets, we maintain pretty solid occupancy although giving up some ADR. And so that’s been happening over the course of the last quarter or so. And I think you’ll see that continue where our occupancy will be very positive and very healthy relative to our comps set, certainly, but you might see somewhat lower ADR. That also comes with it a lower cost to serve those guests because of less frequent housekeeping and less frequent other touch points.

In terms of what those demand drivers are, we’ve mentioned this before, there are a few — a handful of industries that contribute a lot of that through Extended Stay demand, healthcare being key. Manufacturing has actually ticked up for us as there’s been more manufacturing hiring and some more manufacturing coming back online domestically. We’ve seen some, call it, residential displacement relative to those manufacturers that have benefited us. Demand drivers like construction probably been a little flat year-over-year, but certainly, we’ve seen growth in some others, especially healthcare and manufacturing.

Anthony Powell — Barclays — Analyst

Got it. And just on the promotional activity, what kind of customer are you targeting with that? Is it a kind of the old residential customer? Or is it something else?

Jonathan Halkyard — President and Chief Executive Officer

It’s — we’re — it probably, is more residential than anything else. These are some ring-fence markets, if you will. We’ll call them around 100, maybe a little bit more markets where we’re running these — this kind of testing in this promotional activity, where the hotels have lower occupancy than our system average even in the high season in the summer. And where — frankly, the demand drivers are just not as strong as they are in other markets. So it makes sense to use the capacity that we have serving maybe a little bit more of a residential customer when frankly, the demand drivers aren’t there for other sources that are the focus, for say, 400 of our other hotels.

Anthony Powell — Barclays — Analyst

Okay, all right, great, thank you.

Operator

Thank you. Our next question comes from the line of Shaun Kelley with Bank of America. Please proceed with your question.

Daniel — Bank of America — Analyst

This is actually Daniel on for Shaun. Real quick on the renovation timing. Can you — you did touch on the markets that you’re going to be rolling out this year. Can you maybe help us with the trend that how that’s going to cycle throughout this year in terms of the renovations?

Jonathan Halkyard — President and Chief Executive Officer

Sure. I’d be happy to do that. The — as we think about the rental impact, we’ve mentioned that it’s going to be back-end loaded in the year. I think that is possibly more true than we anticipated even 6 months ago. It has been our intent to focus on markets whose low season is first quarter and fourth quarter. To do those renovations in first quarter and fourth quarter to minimize disruption. We encountered some permitting and other delays beyond what we had expected, especially in California markets for properties that we had anticipated renovating in the fourth quarter of last year, first quarter of this year. By the time those permits came in, we thought it would frankly be uneconomical to proceed immediately with the renovations.

And have instead, deferred those to begin in late third quarter or fourth quarter. So the impact there, in first quarter, we had maybe about a 40 to 50 basis point effect on RevPAR from our renovations, that number will be similar, although maybe slighter lower in Q2, call it, 30 to 40 basis points. But by third quarter, we’ll ramp up to be more like 90 and then by fourth quarter, we would expect about a 200 basis point impact. Now that cycles on call it, 50 basis points primarily from activity in the Charlotte market in the Pacific Northwest in fourth quarter last year. So maybe it’s a net impact of about 150, but still it’s significant relative to what we would’ve seen as we move through 2019.

Daniel — Bank of America — Analyst

That’s really helpful. And then just following up on Anthony’s question. You’re — if we’re looking at new builds versus conversion, going forward, which would you expect to be a bigger driver of pipeline growth? Or percentage may be even?

Jonathan Halkyard — President and Chief Executive Officer

Going forward and certainly, longer term, I would expect new builds to be a larger portions, simply because conditions have to be right for a conversion to work. The physical building has to be right, it has to work within our operating model, the old gem 1 Residence Inn’s that were multi-building campuses, really don’t work in terms of our housekeeping model and frankly, can be more of a maintenance challenge than we would really want to take on with a dozen plus boilers, a dozen-plus roofs, et cetera.

So we’re looking for single buildings, somewhat similar to what we have, where the operating model is similar, where the common areas are not completely out of whack, where other amenities are fairly similar, but also where the demand drivers as those businesses are currently being utilized or those buildings are currently being utilized would be better served by a conversion to our more true Extended Stay demand drivers. How many of those opportunities are out there, I can’t say exactly, it’s pretty difficult to measure, but I would think that it’s maybe 100 or less in terms of realistic conversion opportunities and how many of those we’ll be able to capture, I just can’t speculate on.

So all that is to say in the short term you might see a flurry of conversion activity relatively speaking and conversion activity may actually be higher for 1 year, 18 months than new build activity. But eventually for the long-term new build activity will be the more significant contributor to unit growth.

Daniel — Bank of America — Analyst

Great. And maybe one last one, just from your experience and what you’ve been doing — seeing so far, what is your typical conversion cycle. So from like when you sign something to when it opens, how long does it take?

Jonathan Halkyard — President and Chief Executive Officer

It’s not long at all. It’s a matter of weeks. Once the franchisee acquires the building that’s under a different banner, we work with them very expeditiously. They want to get that banner changed immediately and so it’s just a handful of weeks to get that conversion complete.

Daniel — Bank of America — Analyst

Got it. Okay, that’s it from me. Thank you.

Operator

Thank you. Our next question comes from the line of Michael Bellisario with Robert W Baird & Company. Please proceed with your question.

Michael Bellisario — Robert W Baird & Company — Analyst

Good morning, everyone. Just wanted to touch on leverage. You mentioned 3.4 to 3.9x, I guess first part of the question is that a new range for you because it’s the first time I’ve heard that at least in a while. And then how are you thinking about this range potentially evolving and maybe moving higher over time as you build out your franchise business?

Jonathan Halkyard — President and Chief Executive Officer

Hi, Mike. Yes, we haven’t really said it in those terms before, but we have tried to communicate that idea before. We think it’s important certainly where we are now to have our leverage below 4x, that carries with it positive view, if you will from rating agencies and others. Although we don’t believe that there is really material benefit to being significantly below 3.5x. So there’s kind of a sweet spot there in that 3.4x to 3.9x. As we continue new build activity, obviously, there’ll be EBITDA contribution from those new builds as they come online, and so we would not expect a big ramp up in terms of that ratio.

And while, I guess, it is possible that we could creep above that 3.9x over time, that would be because there would be other contributors, if you will, to asset quality, age of the portfolio, et cetera, that comes along with that build activity, that would essentially de risk if you would the portfolio in other ways. But at least as we look out into the future more over the next couple of years, we think that 3.4x to 3.9x is the sweet spot that we want to stay in.

Michael Bellisario — Robert W Baird & Company — Analyst

Okay, that’s helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Stephen Grambling with Goldman Sachs. Please proceed with your question.

Stephen Grambling — Goldman Sachs — Analyst

Morning. Could I ask the question maybe more specifically or directly. Are you restricted from buying back stock currently? And then as you think about the capital structure, whatever is holding you back from repurchases comes to an end. Should we anticipate a stepped up buyback in the near term?

Jonathan Halkyard — President and Chief Executive Officer

We are — we have suspended our share repurchases activity and it remains suspended. If at some point that situation reverses, then I think that we will look at the valuation of our shares at the time and against other alternatives of the capital and then proceed. Our — I would say as a general matter that our — we believe that our capital allocation strategy for the long-term includes, of course, investment in our existing estate, development of new assets, payment of our dividend and return of capital to shareholders through share purchases. So as a general matter we expect share purchases to be an important part of our capital return or our capital allocation strategy for the long-term.

Stephen Grambling — Goldman Sachs — Analyst

And then in the beginning, you mentioned 25% of revenues converted to free cash flow. Is that the right way to think about steady-state free cash flow for the portfolio as a whole? Of what’s included in that assumption as it relates to capital expenditures?

Jonathan Halkyard — President and Chief Executive Officer

Yes, I guess I think of that in this way, Stephen. The — that free cash flow calculation, that’s the one that essentially we’ve used in terms of our discussions to end — generally speaking, the valuation of the assets that we’ve sold. It’s really simple, it’s EBITDA, we subtract maintenance CapEx, IT CapEx, interest and taxes from that. We also have an estimate, essentially a multiyear estimate for basic renovations that it will take to keep properties up to snuff, if you will. And so, if we do that over the course of 7 years, we essentially apply a seventh of that expected cost to the portfolio in any given year. And we believe that a free cash flow yield like that of about 25%, is pretty unique to us and something frankly that we would expect to continue to try to produce over time, at least, something in that neighborhood.

Stephen Grambling — Goldman Sachs — Analyst

That’s helpful. And one last quick follow up. How are you investing behind technology and distribution channels, specifically, to optimize your effectiveness from capturing that core Extended Stay customers?

Jonathan Halkyard — President and Chief Executive Officer

investments have been higher than our run rate level here. last year and in 2019. A major portion of that investment is improving broadband capabilities at our hotels, not only for guest use, guest Wi-Fi, but also we’re doing that hand-in-hand with a conversion of our property management system to a more updated property management system that will give us better CRM capability, that will give us better capture on who our guests are? Why they are in our hotels? And frankly, where they might be going next and how we might serve them better in the future? So that internal investment is in large part geared toward understanding our guests better and being more effective in selling to our guests, future needs.

Additionally, we are making investments in and some of these are experimental investments, if you will, but our leading toward better and better use of funds. We’re investing in digital marketing search terms, other ways to reach extended-stay guests who can be a little tricky to get via a search engine optimization unless you’ve really began to work with those search terms because you have to think about how those guests may be perceiving their needs, why they’re not coming directly to us in the first place, what alternatives they think, might be good alternatives for them and then finding those guests, searching for those alternatives and presenting the options that we have to offer.

Stephen Grambling — Goldman Sachs — Analyst

And would that generally move more to direct through your channels? Or would that also potentially have an impact in the mix with OTAs?

Jonathan Halkyard — President and Chief Executive Officer

Yes, it would move to our channels. So generally speaking, if we can find that guest, who is looking for a furnished apartment with a kitchen or what have you, we’re able to direct them to our website where they’d see our offerings and it would be our inspection that they would book with us, simply through the website or through other owned channels.

Stephen Grambling — Goldman Sachs — Analyst

Great, thanks for the color.

Operator

Thank you. Our next question comes from the line of Chris Woronka with Deutsche Bank. Please proceed with your question.

Chris Woronka — Deutsche Bank — Analyst

Hey, good morning guys. I wanted to ask you an infrastructure related question. I know that you talk about that kind of ebbs and flows and we are probably on the 17th iteration of negotiations. But in any event something actually comes to fruition at some point, and we think your portfolio is, kind of, in the bull’s-eye of a lot of those investment zones. Are you guys, kind of, fully ready operationally to go out and take that business? Or what would have to happen internally before you could do that?

Jonathan Halkyard — President and Chief Executive Officer

We agree, Chris. Construction is our largest vertical and we — and even in advance of large infrastructure investment nationally, we get this business routinely at the state county level. So, it’s a category of demand that we are well-versed in competing for and winning. So we think that this is a very important long-term opportunity for us, and if you’re asking, internally, can we get after it? Do we have the capacity both in terms of rooms or management capabilities? The answer to all of those is, absolutely, yes.

Chris Woronka — Deutsche Bank — Analyst

Okay, great. And then just want to, kind of, revist that conversion question from a different angle maybe, which is, you obviously, the kitchen is an integral part of your product, but given that you have the new construction prototype with a smaller footprint and kind of that, I guess, a little bit more streamlined kitchen, their situation where you could economically see hotels without kitchens, where you can go in and add them, if the size is large enough and can that economically pencil in certain cases?

Jonathan Halkyard — President and Chief Executive Officer

I would doubt that we’ll have a advantage, if it doesn’t have a kitchen. I think we’re certainly open and interested in to how our customers interact with our room product and if there are ways to do that more efficiently and use the space more effectively. Where we are not going to preclude that. I do think that full-size refrigerator and the full kitchen, meaning, microwave, a stovetop as well as the refrigerator. I think that’s an important element of our offering, it’s a differentiator certainly, from transient hotels. So we’ll be reluctant to part from that in any meaningful way. But I do think, you can expect to see some evolution occur.

Chris Woronka — Deutsche Bank — Analyst

OK, very good. Thanks.

Jonathan Halkyard — President and Chief Executive Officer

Thanks.

Operator

We have reached the end of our question-and-answer session. I would like to turn the call back over to Mr. Halkyard for any closing remarks.

Jonathan Halkyard — President and Chief Executive Officer

Yes, thanks very much. Thanks, everybody for joining us, and we look forward to speaking with you to review our second quarter results in a few months. Thanks.

Operator

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.

Duration: 57 minutes

Call participants:

Rob Ballew — Vice President of Investor Relations

Jonathan Halkyard — President and Chief Executive Officer

Brian T. Nicholson — Chief Financial Officer

Harry Curtis — Instinet — Analyst

David Katz — Jefferies — Analyst

Thomas Allen — Morgan Stanley — Analyst

Joe Greff — J.P. Morgan — Analyst

Anthony Powell — Barclays — Analyst

Daniel — Bank of America — Analyst

Michael Bellisario — Robert W Baird & Company — Analyst

Stephen Grambling — Goldman Sachs — Analyst

Chris Woronka — Deutsche Bank — Analyst

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