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Choice Hotels International 10-Q 2007 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007 OR
COMMISSION FILE NO. 001-13393
CHOICE HOTELS INTERNATIONAL, INC. (Exact name of registrant as specified in its charter)
10750 COLUMBIA PIKE SILVER SPRING, MD. 20901 (Address of principal executive offices) (Zip Code) (301) 592-5000 (Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Table of ContentsCHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES INDEX
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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying notes are an integral part of these consolidated financial statements.
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Table of ContentsCHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying notes are an integral part of these consolidated financial statements.
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Table of ContentsCHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED, IN THOUSANDS)
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The accompanying notes are an integral part of these consolidated financial statements.
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Table of ContentsCHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. Company Information and Significant Accounting Policies The accompanying unaudited consolidated financial statements of Choice Hotels International, Inc. and subsidiaries (together the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (which include any normal recurring adjustments) considered necessary for a fair presentation have been included. Certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States of America have been omitted. The year end balance sheet information was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The Company believes the disclosures made are adequate to make the information presented not misleading. The consolidated financial statements should be read in conjunction with the consolidated financial statements for the year ended December 31, 2006 and notes thereto included in the Company’s Form 10-K, filed with the Securities and Exchange Commission on March 1, 2007 (the “10-K”). Interim results are not necessarily indicative of the entire year results because of seasonal variations. All intercompany transactions and balances between Choice Hotels International, Inc. and its subsidiaries have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain amounts in the prior year’s financial statements have been reclassified to conform to the current year presentation with no effect on previously reported net income or shareholders’ deficit. The Company revised its presentation of cash flows for the nine months ended September 30, 2006 related to dividends received from equity method investees. During the first nine months of 2006, the Company had presented these cash flows as investing activities on its consolidated statement of cash flows. Statement of Financial Accounting Standards (“SFAS”) No. 95, “Statement of Cash Flows” requires these dividends, which represent a return on investments, to be classified as operating cash flows. There was no effect on any other previously reported income statement or balance sheet amounts. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with a maturity of three months or less at the date of purchase to be cash equivalents. As of September 30, 2007 and December 31, 2006, $7.1 million and $7.8 million, respectively, of book overdrafts representing outstanding checks in excess of funds on deposit are included in accounts payable in the accompanying consolidated balance sheets. Land held for sale In the second quarter of 2007, the Company acquired for resale 2.1 acres of undeveloped land in San Antonio, Texas at a cost of approximately $1.0 million. The Company concluded that the land qualified as land held for sale and has therefore recorded the land at its fair value as of September 30, 2007 in other current assets on the accompanying consolidated balance sheet. 2. Marketing Fees Receivable and Cumulative Reservation Fees Collected in Excess of Expenses The marketing fees receivable at September 30, 2007 and December 31, 2006 was $0.1 million and $6.7 million, respectively. As of September 30, 2007 and December 31, 2006, cumulative reservation fees collected exceeded expenses by $13.1 million and $8.4 million, respectively, and the excess has been reflected as a long-term liability in the accompanying consolidated balance sheets. Depreciation and amortization expense attributable to marketing and reservation activities was $2.0 million for both the three months ended September 30, 2007 and 2006, and $6.0 million and $5.9 million for the nine months ended September 30, 2007 and 2006, respectively. Interest expense attributable to reservation activities was $0.1 million and $0.2 million for the three months ended September 30, 2007 and 2006, respectively, and $0.4 million and $0.6 million for the nine months ended September 30, 2007 and 2006, respectively. 3. Income Taxes The effective income tax rate of 36.2% for the nine months ended September 30, 2007 differs from the statutory rate due to foreign income earned, which is taxed at lower rates than statutory federal income tax rates; state income taxes; and certain federal and state income tax credits. The effective income tax rate of 24.6% for the nine months ended September 30, 2006 differs from the statutory rate due to the reversal of provisions for certain income tax contingencies, foreign income earned, which is taxed at lower rates than statutory federal income tax rates; state income taxes; and certain federal and state income tax credits.
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Table of ContentsEffective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This pronouncement also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. As a result of the implementation of FIN 48, the Company increased its existing reserves for uncertain tax positions by $3.2 million with a corresponding net reduction to opening additional paid-in-capital and retained earnings. As of January 1, 2007 and September 30, 2007, the Company had $8.2 million and $8.0 million, respectively of total unrecognized tax benefits of which approximately $5.1 million and $4.8 million, respectively would affect the effective tax rate if recognized. These unrecognized tax benefits relate principally to state tax filing positions and previously deducted expenses. The Company believes it is reasonably possible it will recognize tax benefits of up to $2.1 million within the next twelve months. This is related to the anticipated expiration of statutes of limitations of previously deducted expenses. In many cases, the Company’s uncertain tax positions are related to tax years that remain subject to examination by the relevant tax authorities. The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state and foreign jurisdictions. The Company has substantially concluded all U.S. federal income tax matters for years through 2003. Substantially all material state and local and foreign income tax matters have been concluded for years through 2003. U.S. federal income tax returns for 2004 through 2006 are currently open for examination. Estimated interest and penalties related to the underpayment of income taxes are classified as a component of income tax expense in the consolidated statements of income and totaled $0.1 million for the nine months ended September 30, 2007. During the three months ended September 30, 2007, the Company reversed $0.2 million of accrued interest and penalties related to the resolution of previously unrecognized tax benefits. Accrued interest and penalties were $1.1 million and $1.2 million as of January 1, 2007 and September 30, 2007, respectively. We have estimated and accrued for certain tax assessments and the expected resolution of tax contingencies which arise in the course of our business. The ultimate outcome of these tax-related contingencies impact the determination of income tax expense and may not be resolved until several years after the related tax returns have been filed. Predicting the outcome of such tax assessments involves uncertainty and accordingly, actual results could differ from those estimates. 4. Comprehensive Income The differences between net income and comprehensive income are described in the following table.
5. Capital Stock Stock Options The Company granted 0.2 million options to officers of the Company during both the nine months ended September 30, 2007 and 2006 at a fair value of approximately $2.6 million and $2.8 million, respectively. No options were granted during the three months ended September 30, 2007 and 2006. The stock options granted by the Company had an exercise price equal to the market price of the Company’s common stock on the date of grant. The fair value of the options granted was estimated on the grant date using the Black-Scholes option-pricing model with the following weighted average assumptions:
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The expected life of the options and volatility are based on historical data and are not necessarily indicative of exercise patterns or actual volatility that may occur. The dividend yield and the risk-free rate of return are calculated on the grant date based on the then current dividend rate and the risk-free rate of return for the period corresponding to the expected life of the stock option. Compensation expense related to the fair value of these awards is recognized straight-line over the requisite service period based on those awards that ultimately vest. The aggregate intrinsic value of the stock options outstanding and exercisable at September 30, 2007 was $56.2 million and $48.7 million, respectively. The total intrinsic value of options exercised during the three months ended September 30, 2007 and 2006 was $1.6 million and $0.9 million, respectively, and $14.4 million and $41.5 million during the nine months ended September 30, 2007 and 2006, respectively. The Company received $0.6 million and $5.1 million in proceeds from the exercise of approximately 0.1 million and 0.5 million employee stock options during the three and nine months ended September 30, 2007, respectively. During the three and nine months ended September 30, 2006, the Company received $0.2 million and $8.2 million in proceeds from the exercise of 0.02 million and 1.0 million employee stock options, respectively. Restricted Stock The following table is a summary of activity related to restricted stock grants:
Compensation expense related to the fair value of these awards is recognized straight-line over the requisite service period on those restricted stock grants that ultimately vest. The fair value is measured by the average of the high and low market price of the Company’s common stock on the date of grant. Restricted stock awards in 2007 and 2006 vest ratably at 25 percent per year beginning with the first anniversary of the grant date. Performance Vested Restricted Stock Units The Company has granted performance vested restricted stock units (“PVRSU”) to certain officers. The vesting of these stock awards is contingent upon the Company achieving specified earnings per share targets at the end of specified performance periods and the employees’ continued employment. The performance conditions affect the number of shares that will ultimately vest. The range of possible stock-based award vesting is between 50% and 200% of the initial target. Under SFAS No. 123 (Revised), “Share-Based Payment” (“SFAS No. 123R”), compensation expense related to these awards will be recognized over the requisite period regardless of whether the performance targets have been met based on the Company’s estimate of the achievement of the performance target. The Company has currently estimated that between 100% and 130% of the various award targets will be achieved. The fair value is measured by the average of the high and low market price of the Company’s common stock on the date of grant. Compensation expense is recognized ratably over the requisite service period based on those PVRSUs that ultimately vest.
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Table of ContentsThe following table is a summary of activity related to PVRSU grants:
A summary of stock-based award activity as of September 30, 2007, and changes during the nine months ended are presented below:
The components of the Company’s pretax stock-based compensation expense and associated income tax benefits are as follows for the three and nine months ended September 30:
Stock-based compensation expense on stock option and performance vested restricted stock units made to a retirement eligible executive officer during the nine months ended September 30, 2007 and 2006 was recognized upon issuance of the grants rather than over the awards’ vesting periods since the terms of these grants provide that the awards will vest upon retirement of the employee. Compensation costs for stock options and performance vested restricted stock related to vesting upon retirement eligibility totaled $1.2 million and $1.3 million for the nine month periods ended September 30, 2007 and 2006, respectively. Dividends In September 2007, the Company’s board of directors approved an increase in the quarterly dividend rate from $0.15 to $0.17 per share (or approximately $10.6 million in the aggregate), which was paid on October 19, 2007 to shareholders of record on October 5, 2007. In May 2007, the Company declared a cash dividend of $0.15 per share (or approximately $9.8 million in the aggregate), which was paid on July 20, 2007 to shareholders of record on July 6, 2007. On February 12, 2007, the Company declared a cash dividend of $0.15 per share (or approximately $9.9 million in the aggregate), which was paid on April 20, 2007 to shareholders of record on April 5, 2007.
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Table of ContentsIn September 2006, the Company’s board of directors approved an increase in the quarterly dividend rate from $0.13 to $0.15 per share (or approximately $9.9 million in the aggregate), which was paid on October 20, 2006 to shareholders of record on October 6, 2006. In May 2006, the Company declared a cash dividend of $0.13 per share (or approximately $8.6 million in the aggregate), which was paid on July 21, 2006 to shareholders of record on July 7, 2006. In February 2006, the Company declared a cash dividend of $0.13 per share (or approximately $8.5 million in the aggregate), which was paid on April 21, 2006 to shareholders of record on April 7, 2006. Stock Repurchase Program During the three and nine months ended September 30, 2007, the Company purchased 2.9 million and 4.1 million shares of common stock under the share repurchase program at a total cost of $109.2 million and $155.2 million, respectively. The Company did not purchase any common stock during the three and nine months ended September 30, 2006 under the share repurchase program. In September 2007, the Company’s board of directors authorized an increase under the Company’s existing stock repurchase program to acquire up to an additional three million shares of its outstanding common stock and as a result, at September 30, 2007 the Company had 4.0 million shares remaining under the current board of directors’ authorization. In addition, during the three and nine months ended September 30, 2007, the Company purchased 6,447 and 37,586 shares of common stock at a total cost of $0.2 million and $1.5 million, respectively, from employees to satisfy statutory minimum tax-withholding requirements from the vesting of restricted stock grants. During the three and nine months ended September 30, 2006, the Company purchased 1,172 and 27,966 shares of common stock at a total cost of $0.05 million and $1.3 million, respectively, to satisfy minimum tax-withholding requirements. These purchases were outside the share repurchase program initiated in September 1998. 6. Earnings Per Share The following table reconciles the number of shares used in the basic and diluted earnings per share calculations.
Basic earnings per share exclude dilution and are computed by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per share assumes dilution and is computed based on the weighted-average number of common shares outstanding after consideration of the dilutive effect of stock options and unvested restricted stock. The effect of dilutive securities is computed using the treasury stock method and average market prices during the period. At September 30, 2007 and 2006, PVRSUs totaling 70,921 and 49,780 were excluded from the computation since the performance conditions had not been met at the reporting date. In addition, the Company excluded 0.4 million anti-dilutive options from the computation of diluted earnings per share for both the three and nine months ended September 30, 2007 and 0.2 million for both the three and nine months ended September 30, 2006. 7. Pension Plans The Company sponsors an unfunded non-qualified defined benefit plan (“SERP”) for certain senior executives. No assets are held with respect to the plan; therefore benefits are funded as paid to participants. Effective December 31, 2006, the Company began accounting for the SERP in accordance with SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). For the three and nine
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Table of Contentsmonths ended September 30, 2007, the Company recorded $0.2 million and $1.0 million, respectively for the expenses related to the SERP which is included in selling, general and administrative expense in the accompanying consolidated statements of income. For the three and nine months ended September 30, 2006, the Company recorded $0.3 million and $0.9 million, respectively for the expenses related to the SERP. Based on the plan retirement age of 65 years old, no benefit payments are anticipated over the current year. The following table presents the components of net periodic benefit costs for the three and nine months ended September 30, 2007 and 2006:
Curtailment During the first quarter of 2007, the Company recognized a curtailment loss due to the termination of certain senior executive officers from the Company. The curtailment loss was equal to the unrecognized prior service costs attributed to these employees’ expected aggregate future services which totaled approximately $248,000. In addition, the monthly net periodic pension costs declined from approximately $106,000 to $82,000. The components of projected pension costs for the year ended December 31, 2007 are as follows:
The following is a reconciliation of the changes in the projected benefit obligation for the nine months ended September 30, 2007:
The amounts in accumulated other comprehensive income that have not yet been recognized as components of net periodic benefit costs at September 30, 2007 are as follows:
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Table of Contents8. Debt On June 16, 2006, the Company entered into a new $350 million senior unsecured revolving credit agreement (the “Revolver”), with a syndicate of lenders. The proceeds from the Revolver were used to refinance and terminate a previous revolving credit facility. The Revolver allows the Company to borrow, repay and reborrow revolving loans up to $350 million (which includes swingline loans for up to $20 million and standby letters of credit up to $30 million) until the scheduled maturity date of June 16, 2011. The Company has the ability to request an increase in available borrowings under the Revolver by an additional amount of up to $150 million by obtaining the agreement of the existing lenders to increase their lending commitments or by adding additional lenders. The rate of interest generally applicable for revolving loans under the Revolver are, at the Company’s option, equal to either (i) the greater of the prime rate or the federal funds effective rate plus 50 basis points, or (ii) an adjusted LIBOR rate plus a margin between 22 and 70 basis points based on the Company’s credit rating. The Revolver requires the Company to pay a quarterly facility fee, based upon the credit rating of the Company, at a rate between 8 and 17 1/2 basis points, on the full amount of the commitment (regardless of usage). The Revolver also requires the payment of a quarterly usage fee, based upon the credit rating of the Company, at a rate between 10 and 12 1/2 basis points, on the amount outstanding under the commitment, at all times when the amount borrowed under the Revolver exceeds 50% of the total commitment. The Revolver includes customary financial and other covenants that require the maintenance of certain ratios including maximum leverage and interest coverage. The Revolver also restricts the Company’s ability to make certain investments, incur certain debt, and dispose of assets, among other restrictions. As of September 30, 2007, the Company had $170 million of revolving loans outstanding pursuant to the Revolver. As of September 30, 2007, the Company was in compliance with all covenants under the Revolver. In 1998, the Company completed a $100 million senior unsecured note offering (‘the Senior Notes’) at a discount of $0.6 million, bearing a coupon rate of 7.13% with an effective rate of 7.22%. The Senior Notes will mature on May 1, 2008, with interest on the Senior Notes paid semi-annually. The Senior Notes have been classified as a long-term liability at September 30, 2007, since the Company’s intention is to repay the Senior Notes upon maturity by utilizing the available capacity of the Revolver. As of September 30, 2007, in addition to the Revolver and Senior Notes, the Company had a line of credit with a bank providing an aggregate of $10 million of borrowings, which is due upon demand. The line of credit ranks pari-pasu (or equally) with the Company’s Revolver and includes customary financial and other covenants that require the maintenance of certain ratios identical to those included in the Company’s Revolver. Borrowings under the line of credit bear interest rates established at the time of borrowing based on prime rate minus 175 basis points. As of September 30, 2007, the Company had $8.4 million outstanding pursuant to this line of credit. In the second quarter of 2007, the Company repaid an outstanding note with a balance of $0.4 million by utilizing proceeds from the Revolver. The note had an original maturity date of January 1, 2009. The loan bore interest based on seventy percent of prime and required monthly principal and interest payments. As of September 30, 2007, total debt outstanding for the Company was $278.4 million, of which $8.4 million was scheduled to mature in the twelve months ending September 30, 2008. 9. Condensed Consolidating Financial Statements Effective July 14, 2006, the Company’s Senior Notes are guaranteed jointly, severally, fully and unconditionally by 7 wholly-owned domestic subsidiaries. There are no legal or regulatory restrictions on the payment of dividends to Choice Hotels International, Inc. from subsidiaries that do not guarantee the Senior Notes. As a result of these guarantee arrangements, the following condensed consolidating financial statements are presented. Investments in subsidiaries are accounted for under the equity method of accounting.
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Statement of Income For the Three Months Ended September 30, 2007 (Unaudited, In Thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Statement of Income For the Three Months Ended September 30, 2006 (Unaudited, In Thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Statement of Income For the Nine Months Ended September 30, 2007 (Unaudited, In Thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Statement of Income For the Nine Months Ended September 30, 2006 (Unaudited, In Thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Balance Sheet As of September 30, 2007 (Unaudited, In thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Balance Sheet As of December 31, 2006 (In thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Statement of Cash Flows For the Nine Months Ended September 30, 2007 (Unaudited, In thousands)
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Table of ContentsChoice Hotels International, Inc. Condensed Consolidating Statement of Cash Flows For the Nine Months Ended September 30, 2006 (Unaudited, In thousands)
10. Reportable Segment Information The Company has a single reportable segment encompassing its franchising business. Revenues from the franchising business include royalty fees, initial franchise and relicensing fees, marketing and reservation fees, brand solutions revenue and other revenue. The Company is obligated under its franchise agreements to provide marketing and reservation services appropriate for the successful operation of its systems. These services do not represent separate reportable segments as their operations are directly related to the Company’s franchising business. The revenues received from franchisees that are used to pay for part of the Company’s central ongoing operations are included in franchising revenues and are offset by the related expenses paid for marketing and reservation activities to calculate franchising operating income. Corporate and other revenue consists of hotel operations. Except as described in Note 2, the Company does not allocate interest income, interest expense or income taxes to its franchising segment.
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Table of ContentsThe following table presents the financial information for the Company’s franchising segment:
11. Commitments and Contingencies The Company is a defendant in a number of lawsuits arising in the ordinary course of business. In the opinion of management and the Company’s legal counsel, the ultimate outcome of such litigation will not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows. In April 2007, two federal securities law class actions were filed in the United States District Court for the District of Colorado on behalf of persons who purchased the Company’s stock between April 25, 2006, and July 26, 2006. These substantially-similar lawsuits assert claims pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, against the Company, its current Vice Chairman and Chief Executive Officer, and its former Executive Vice President and Chief Financial Officer. These claims are related to the Company’s July 25, 2006 announcement of its results of operations for the second quarter of 2006. Since the initial filings, the Company has filed a motion to transfer the litigation from Colorado to the United States District Court for the District of Maryland. Additionally, one plaintiff has petitioned the Court to be named lead plaintiff in the dispute. At this time, the Company has not responded to the complaints filed and is not required to do so until after a lead plaintiff is appointed and a consolidated complaint is filed. The Company believes that the allegations contained within these class action lawsuits are without merit and intends to vigorously defend the litigation. The Company’s management does not expect that the outcome of any of its currently ongoing legal proceedings individually or collectively, will have a material adverse effect on the Company’s financial condition, results of operations or cash flows. In March 2006, the Company guaranteed $1 million of a bank loan funding a franchisee’s construction of a Cambria Suites in Green Bay, Wisconsin. The guaranty was scheduled to expire in September 2010. In February 2007, the Company was released from its obligations under the March 2006 guaranty, and subsequently, on May 3, 2007, issued a new $1 million guaranty for a bank loan funding the construction for the same franchisee’s Cambria Suites in Green Bay, Wisconsin. The guaranty expires in August 2010. The Company has received personal guarantees from several of the franchisee’s principal owners related to the repayment of any amounts paid by the Company under this guaranty. In the ordinary course of business, the Company enters into numerous agreements that contain standard guarantees and indemnities whereby the Company indemnifies another party for breaches of representations and warranties. Such guarantees or indemnifications are granted under various agreements, including those governing (i) purchases or sales of assets or businesses, (ii) leases of real estate, (iii) licensing of trademarks, (iv) access to credit facilities, (v) issuances of debt or equity securities, and (vi) other operating agreements. The guarantees or indemnifications issued are for the benefit of the (i) buyers in sale agreements and sellers in purchase agreements, (ii) landlords in lease contracts, (iii) franchisees in franchise agreements, (iv) financial institutions in credit facility arrangements, and (v) underwriters in debt or equity security issuances. In addition, these parties may also be indemnified against any third party claim resulting from the transaction that is contemplated in the underlying agreement. While some of these guarantees extend only for the duration of the underlying agreement, many survive the expiration of the term of the agreement or extend into perpetuity (unless subject to a legal statute of limitations). There are no specific limitations on the maximum potential amount of future payments that the Company could be required to make under these guarantees, nor is the Company able to develop an estimate of the maximum potential amount of future payments to be made under these guarantees as the triggering events are not subject to predictability. With respect to certain of the aforementioned guarantees, such as indemnifications of landlords against third party claims for the use of real estate property leased by the Company, the Company maintains insurance coverage that mitigates any potential payments to be made.
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Table of Contents12. Termination Charges During the first quarter of 2007, the Company recorded a $3.7 million charge for employee termination benefits relating to the termination of certain executive officers. Termination benefits include salary continuation of approximately $2.5 million, SERP curtailment expenses of $0.2 million and $1.0 million of accelerated share based compensation. Termination benefits payable to the executives were accounted for under SFAS No. 112 “Employer’s Accounting for Post-employment Benefits”. At September 30, 2007, approximately $2.8 million of termination benefits remained of which $2.7 million is included in current liabilities and $0.1 million in other long-term liabilities in the Company’s consolidated financial statements. 13. Acquisition of Suburban Franchise Holding Company, Inc. During 2005, the Company acquired 100% of the stock of Suburban Franchise Holding Company, Inc. (“Suburban”) and its wholly owned subsidiary, Suburban Franchise Systems, Inc. Beginning on the third anniversary of the closing, the merger provided for contingent cash payments of up to $5.0 million to be made upon the satisfaction of certain criteria. No liabilities had been previously recorded related to the contingent cash payments. During the three months ended September 30, 2007, the Company has determined that the performance conditions can no longer be satisfied and therefore the contingent consideration will not be earned. 14. Recently Issued Accounting Standards In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements’” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the impact, if any, the adoption of this statement will have on our consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”) which provides reporting entities an option to report certain financial instruments and other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective as of the beginning of a reporting entity’s first fiscal year beginning after November 15, 2007. We are currently evaluating the impact, if any, the adoption of this statement will have on our consolidated financial statements.
Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand Choice Hotels International, Inc. and subsidiaries (together “the Company”). MD&A is provided as a supplement to—and should be read in conjunction with—our consolidated financial statements and the accompanying notes. Overview We are a hotel franchisor with franchise agreements representing 5,533 hotels open and 954 hotels under development as of September 30, 2007, with 450,280 rooms and 76,823 rooms, respectively, in 49 states, the District of Columbia and 39 countries and territories outside the United States. Our brand names include Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Sleep Inn®, Econo Lodge®, Rodeway Inn® , MainStay Suites®, Suburban Extended Stay Hotel®, Cambria Suites™ and Flag Hotels®. The Company conducts its international franchise operations through a combination of direct franchising and master franchising arrangements (which allow the use of our brands by third parties in foreign countries). The Company has made equity investments in certain non-domestic lodging franchise companies that conduct franchise operations for the Company’s brands under master franchising relationships. As a result of our use of master franchising relationships and international market conditions, total revenues from international operations comprised only 7% of our total revenues for the nine months ended September 30, 2007 while representing approximately 21% of hotels open at September 30, 2007. During 2006, the Company acquired 100% of the stock of Choice Hotels Franchise GmbH (“CHG”). CHG was a wholly owned subsidiary of one of the Company’s master franchisees, The Real Hotel Company PLC (“RHC”), formerly known as CHE Hotel Group PLC. Under the master franchise agreement with RHC, CHG franchised hotels under the Company’s brands in Austria, Germany, Italy, Czech Republic and portions of Switzerland. As a result of this acquisition, the master franchise agreement between the Company and RHC covering these countries terminated. The results of CHG have been consolidated with the Company since October 30, 2006. During 2006, the Company acquired RHC’s assets, including franchise contracts, related to its franchising of hotels under the Company’s brands in France, Belgium, Portugal, Spain and portions of Switzerland. As a result of the acquisition, the master franchise agreement between the Company and RHC covering these countries terminated and the Company commenced direct franchising operations in these countries on November 30, 2006.
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Table of ContentsOur Company generates revenues, income and cash flows primarily from initial and continuing royalty fees attributable to our franchise agreements. Revenues are also generated from brand solutions qualified vendor arrangements, hotel operations and other sources. The hotel industry is seasonal in nature. For most hotels, demand is lower in December through March than during the remainder of the year. Our principal source of revenues is franchise fees based on the gross room revenues of our franchised properties. The Company’s franchise fee revenues and operating income reflect the industry’s seasonality and historically have been lower in the first quarter than in the second, third or fourth quarters. With a focus on hotel franchising instead of ownership, we benefit from the economies of scale inherent in the franchising business. The fee and cost structure of our business provides opportunities to improve operating results by increasing the number of franchised properties and effective royalty rates of our franchise contracts resulting in increased initial fee revenue; ongoing royalty fees and brand solutions revenues. In addition, our operating results can also be improved through our company wide efforts related to improving property level performance. In addition to these revenues, we also collect marketing and reservation fees to support centralized marketing and reservation activities for the franchise system. As a lodging franchisor, the Company has relatively low capital expenditure requirements. The principal factors that affect the Company’s results are: the number and relative mix of franchised hotels; growth in the number of hotels and hotel rooms under franchise; occupancy and room rates achieved by the hotels under franchise; the effective royalty rate achieved; and our ability to manage costs. The number of rooms at franchised properties and occupancy and room rates at those properties significantly affect the Company’s results because our fees are based upon room revenues at franchised hotels. The key industry standard for measuring hotel-operating performance is revenue per available room (“RevPAR”), which is calculated by multiplying the percentage of occupied rooms by the average daily room rate realized. Our variable overhead costs associated with franchise system growth have historically been less than incremental royalty fees generated from new franchises. Accordingly, continued growth of our franchise business should enable us to realize benefits from the operating leverage in place and improve operating results. We are contractually required by our franchise agreements to use the marketing and reservation fees we collect for system-wide marketing and reservation activities. These expenditures, which include advertising costs and costs to maintain our central reservations system, help to enhance awareness and increase consumer preference for our brands. Greater awareness and preference promotes long-term growth in business delivery to our franchisees, which ultimately increases franchise fees earned by the Company. Our Company articulates its mission as a commitment to our customers’ profitability by providing our customers with hotel franchises that generate the highest return on investment of any hotel franchise. We have developed an operating system dedicated to our franchisees’ success that focuses on delivering guests to our franchised hotels and reducing costs for our hotel owners. We strive every day to continuously improve our franchise offerings to enhance our customers’ profitability and create the highest return on investment of any hotel franchise. We believe that executing our strategic priorities creates value. Our Company focuses on two key value drivers: Profitable Growth. Our success is dependent on improving the performance of our hotels, increasing our system size by selling additional hotel franchises and effective royalty rate improvement. We attempt to improve our franchisees’ revenues and overall profitability by providing a variety of products and services designed to increase business delivery to and/or reduce operating and development costs for our franchisees. These products and services include national marketing campaigns, a central reservation system, property and yield management systems, quality assurance standards and qualified vendor relationships. We believe that healthy brands, which deliver a compelling return on investment for franchisees, will enable us to sell additional hotel franchises and raise royalty rates. We have established multiple brands that meet the needs of many types of guests, and can be developed at various price points and applied to both new and existing hotels. This ensures that we have brands suitable for creating growth in a variety of market conditions. Improving the performance of the hotels under franchise, growing the system through additional franchise sales and improving franchise agreement pricing while maintaining a disciplined cost structure are the keys to profitable growth. Maximizing Financial Returns and Creating Value for Shareholders. Our capital allocation decisions, including capital structure and uses of capital, are intended to maximize our return on invested capital and create value for our shareholders. We believe our strong and predictable cash flows create a strong financial position that provides us a competitive advantage. Our business does not require significant capital to operate and grow, therefore, we can maintain a capital structure that generates high financial returns and use our excess cash flow to increase returns to our shareholders. We have returned value to our shareholders in two primary ways: share repurchases and dividends. In 1998, we instituted a share repurchase program which has generated substantial value for our shareholders. Through September 30, 2007, we have repurchased 37.8 million shares (including 33.0 million prior to the two-for-one stock split effected in October 2005) of common stock at a total cost of $867.1 million since the program’s inception. Considering the effect of the two-for-one stock split, the Company has repurchased 70.8 million shares at an average price of $12.26 per share through September 30, 2007. In September 2007, the Company’s board of directors authorized an increase under the Company’s existing stock repurchase program to acquire up to an additional three million shares of its outstanding common stock. At September 30, 2007 the Company had 4.0 million shares remaining under the current board of directors’ authorization. The Company expects to continue to return value to
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Table of Contentsits shareholders through a combination of dividends and share repurchases, subject to market and other conditions and upon completion of the current authorization we will evaluate the propriety of additional share repurchases with our board of directors. During the three and nine months ended September 30, 2007, we paid cash dividends totaling approximately $9.8 million and $29.5 million, respectively, and we presently expect to continue to pay dividends in the future. On September 11, 2007, our board of directors declared a cash dividend of $0.17 on outstanding common shares payable on October 19, 2007 to shareholders of record on October 5, 2007. Based on our present dividend rate and outstanding share count, aggregate annual dividends would be approximately $40.2 million. We believe these value drivers, when properly implemented, will enhance our profitability, maximize our financial returns and continue to generate value for our shareholders. The ultimate measure of our success will be reflected in the items below. Results of Operation: Royalty fees, operating income, net income and diluted earnings per share (“EPS”) represent key measurements of these value drivers. In the three months ended September 30, 2007, royalty fees revenue totaled $73.2 million, a 14% increase from the same period in 2006. Operating income totaled $62.4 million for the three months ended September 30, 2007, a $7.8 million or 14% increase from the same period in 2006. Net income and diluted earnings per share declined 17% and 14%, respectively from the same period of the prior year primarily due to the resolution of income tax contingencies during third quarter of 2006 totaling $12.8 million or $0.19 per share compared to $0.7 million or $0.01 per share for the same period of 2007. These measurements will continue to be a key management focus in 2007 and beyond. Refer to MD&A heading “Operations Review” for additional analysis of our results. Liquidity and Capital Resources: The Company generates significant cash flows from operations. In the nine months ended September 30, 2007 and 2006, net cash provided by operating activities was $100.4 million and $115.6 million, respectively. Since our business does not require significant reinvestment of capital, we utilize cash in ways that management believes provide the greatest returns to our shareholders, which include share repurchases and dividends. We believe the Company’s cash flow from operations and available financing capacity are sufficient to meet the expected future operating, investing and financing needs of the business. Refer to MD&A heading “Liquidity and Capital Resources” for additional analysis. Operations Review Comparison of Operating Results for the Three-Month Periods Ended September 30, 2007 and September 30, 2006 The Company recorded net income of $38.4 million for the three months ended September 30, 2007, an $8.0 million, or 17% decline from the $46.4 million for the quarter ended September 30, 2006. The decline in net income for the three months ended September 30, 2007 is primarily attributable to the resolution of income tax contingencies totaling $12.8 million during the three months ended September 30, 2006 which resulted in an effective income tax rate of 11.3% compared to 35.3% for the current year period. The increase in the Company’s effective income tax rate was partially offset by a $7.8 million increase in operating income. Operating income increased as a result of an $11.6 million, or 15% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) partially offset by a $4.0 million increase in selling, general and administrative expenses. The increase in selling, general and administration expenses was partially due to the commencement of direct franchising operations in continental Europe.
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Table of ContentsSummarized financial results for the three months ended September 30, 2007 and 2006 are as follows:
Management analyzes its business based on franchising revenues, which is total revenues excluding marketing and reservation revenues and hotel operations, and franchise operating expenses that are reflected as selling, general and administrative expenses. Franchising Revenues: Franchising revenues were $88.4 million for the three months ended September 30, 2007 compared to $76.8 million for the three months ended September 30, 2006. The growth in franchising revenues is primarily due to a 14% increase in royalty revenues, a 15% increase in initial franchise and relicensing fees and a 73% increase in other income. Domestic royalty fees increased $7.2 million to $67.2 million from $60.0 million in the three months ended September 30, 2007, an increase of 12%. The increase in royalties is attributable to a combination of factors including a 4.4% increase in the number of domestic franchised hotel rooms, a 5.6% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system from 4.07% to 4.12%. System-wide RevPAR increases resulted primarily from average daily rate (“ADR”) increases of 5.4% over the prior year and a 10 basis point increase in occupancy rates.
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Table of ContentsA summary of the Company’s domestic franchised hotels operating information is as follows:
The number of domestic rooms on-line increased to 350,701 as of September 30, 2007 from 335,884 as of September 30, 2006, an increase of 4.4%. The total number of domestic hotels on-line grew 5.7% to 4,396 as of September 30, 2007 from 4,157 as of September 30, 2006. A summary of the domestic hotels and rooms on-line at September 30, 2007 and 2006 by brand is as follows:
International rooms on-line increased to 99,579 as of September 30, 2007 from 98,811 as of September 30, 2006. The total number of international hotels on-line decreased from 1,171 as of September 30, 2006 to 1,137 as of September 30, 2007.
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Table of ContentsAs of September 30, 2007, the Company had 872 franchised domestic hotels with 68,853 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 736 hotels and 57,117 rooms at September 30, 2006. The number of new construction franchised hotels in the Company’s domestic pipeline increased 27% to 642 at September 30, 2007 from 507 at September 30, 2006. The Company had an additional 82 franchised hotels with 7,970 rooms under development in its international system as of September 30, 2007 compared to 72 hotels and 6,462 rooms at September 30, 2006. While the Company’s hotel pipeline provides a strong platform for growth, a hotel in the pipeline does not always result in an open and operating hotel due to various factors. A summary of the domestic franchised hotels under construction, awaiting conversion or approved for development at September 30, 2007 and 2006 by brand is as follows:
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