SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
OR
COMMISSION FILE NO. 001-13393
CHOICE HOTELS INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of incorporation or
organization)
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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
CLASS
SHARES OUTSTANDINGAT SEPTEMBER 30, 2003
Common Stock, Par Value $0.01 per share
Preferred Stock Purchase Rights
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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
INDEX
PART I. FINANCIAL INFORMATION:
Item 1 – Financial Statements
Consolidated Statements of Income – For the three and nine months ended September 30, 2003 and September 30, 2002 (Unaudited)
Consolidated Balance Sheets – As of September 30, 2003 (Unaudited) and December 31, 2002
Consolidated Statements of Cash Flows – For the nine months ended September 30, 2003 and September 30, 2002 (Unaudited)
Notes to Consolidated Financial Statements
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3 – Quantitative and Qualitative Disclosures about Market Risk
Item 4 – Controls and Procedures
PART II. OTHER INFORMATION:
Item 1 – Legal Proceedings
Item 2 – Changes in Securities
Item 3 – Defaults Upon Senior Securities
Item 4 – Submission of Matters to a Vote of Security Holders
Item 5 – Other Information
Item 6 – Exhibits and Reports on Form 8-K
SIGNATURE
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PART I. FINANCIAL INFORMATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
REVENUES:
Royalty fees
Initial franchise and relicensing fees
Partner services
Marketing and reservation
Hotel operations
Other
Total revenues
OPERATING EXPENSES:
Selling, general and administrative
Depreciation and amortization
Total operating expenses
OPERATING INCOME
OTHER INCOME AND EXPENSES:
Interest expense
Interest and other investment income
Minority interest in net income of consolidated subsidiary
Total other income and expenses
INCOME BEFORE INCOME TAXES
INCOME TAXES
NET INCOME
WEIGHTED AVERAGE SHARES OUTSTANDING-BASIC
WEIGHTED AVERAGE SHARES OUTSTANDING-DILUTED
BASIC EARNINGS PER SHARE
DILUTED EARNINGS PER SHARE
The accompanying notes are an integral part of these consolidated statements of income.
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CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
ASSETS
CURRENT ASSETS
Cash and cash equivalents
Receivables (net of allowance for doubtful accounts of $6,658 and $6,035, respectively)
Other current assets
Total current assets
PROPERTY AND EQUIPMENT, AT COST, NET
GOODWILL
FRANCHISE RIGHTS, NET
RECEIVABLE – MARKETING AND RESERVATION FEES
NOTE RECEIVABLE FROM SUNBURST
OTHER ASSETS
Total assets
The accompanying notes are an integral part of these consolidated balance sheets.
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(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
LIABILITIES AND SHAREHOLDERS’ DEFICIT
CURRENT LIABILITIES
Current portion of long-term debt
Accounts payable
Accrued expenses and other
Income taxes payable
Total current liabilities
LONG-TERM DEBT
DEFERRED INCOME TAXES AND OTHER LIABILITIES
Total liabilities
Commitments and Contingencies
SHAREHOLDERS’ DEFICIT
Common stock, $.01 par value
Additional paid-in-capital
Accumulated other comprehensive income
Deferred compensation
Treasury stock
Retained earnings
Total shareholders’ deficit
Total liabilities and shareholders’ deficit
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED, IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for bad debts
Non-cash stock compensation
Non-cash interest and other investment income
Changes in assets and liabilities, net of acquisitions:
Receivables
Receivable – marketing and reservation fees, net
Current liabilities
Income taxes payable/receivable and other assets
Deferred income taxes and other liabilities
NET CASH PROVIDED BY OPERATING ACTIVITIES
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in property and equipment
Proceeds from disposition of property
Acquisition of Flag
Other items, net
NET CASH UTILIZED IN INVESTING ACTIVITIES
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt
Principal payments on long-term debt
Purchase of treasury stock
Proceeds from exercise of stock options
NET CASH UTILIZED IN FINANCING ACTIVITIES
Net change in cash and cash equivalents
Cash and cash equivalents at beginning of period
CASH AND CASH EQUIVALENTS AT END OF PERIOD
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash payments during the period for:
Income taxes, net of refunds
Interest
Non-cash investing activities:
Conversion of note receivable into Flag equity interest
Non-cash financing activities related to employee stock options exercised:
Income tax benefit realized
Treasury shares received for employee tax withholding obligations
Common shares surrendered in-lieu of exercise price
The accompanying notes are an integral part of these consolidated statements of cash flows.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 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, 2002 and notes thereto included in the Company’s Form 10-K, filed with the Securities and Exchange Commission on March 31, 2003 (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 reclassifications have been made to the Company’s consolidated balance sheet as of December 31, 2002 to conform with the current year presentation.
Effective January 1, 2003, the Company adopted, in accordance with the prospective method prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” the fair value based method of accounting for stock option awards granted on or after January 1, 2003.
The Company’s stock option plans and related accounting policies are described more fully in the notes to consolidated financial statements in the 10-K. No compensation expense related to the Company’s stock option plans was reflected in net income for the three and nine months ended September 30, 2002, because the Company accounted for those options under APB Opinion No. 25 and all stock options granted under the Company’s plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 148 to all stock compensation for the three and nine months ended September 30, 2003 and 2002.
Net income, as reported
Stock-based employee compensation cost included in reported net income, net of related tax effects
Total stock-based employee compensation expense determined under fair value method for all awards, net of tax effects
Net income, pro forma
Earnings per share:
Basic-as reported
Basic-pro forma
Diluted-as reported
Diluted-pro forma
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The marketing and reservation fees receivable at September 30, 2003 and December 31, 2002 was $41.1 million and $44.9 million, respectively. Depreciation and amortization expense attributable to marketing and reservation activities was $2.9 million and $3.2 million for the three months ended September 30, 2003 and 2002, respectively, and $9.5 million for each of the nine month periods ended September 30, 2003 and 2002. For each of the three month periods ended September 30, 2003 and 2002, interest expense attributable to reservation activities was $0.3 million, and $0.9 million and $1.1 million for the nine months ended September 30, 2003 and 2002, respectively.
On September 4, 2003, the Company and Sunburst entered into an Amendment Agreement regarding certain terms of the $41.3 million note receivable from Sunburst (the “Note”). As an incentive for Sunburst to accelerate repayment of the Note, the Company agreed to modify the yield maintenance provisions of the Note. Pursuant to the Amendment Agreement, at any time prior to January 31, 2004, upon Sunburst’s irrevocable election to redeem the Note, Choice will amend the existing optional redemption provision to allow Sunburst to redeem the Note at a percentage of the principal amount equal to (i) 105.6875%, plus (ii) 2.84375% multiplied by the number of days prior to January 5, 2005 that redemption is made, divided by 365 days.
During 2002, the Company recognized restructuring charge expense of $1.6 million pursuant to SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The restructuring charge related to employee severance and termination benefits for 23 employees resulting from corporate realignment initiatives. The restructuring was initiated and completed in 2002. As of December 31, 2002, the remaining liability related to this restructuring totaled approximately $0.9 million and was included in accrued expenses and other liabilities in the accompanying consolidated balance sheet. The Company paid approximately $0.1 million and $0.9 million in cash related to this restructuring during the three and nine months ended September 30, 2003, respectively. The payments made during the three months ended September 30, 2003 satisfied the Company’s obligations related to the 2002 restructuring resulting in no liability remaining at September 30, 2003.
During 2001, the Company recognized restructuring charge expense of $5.9 million, pursuant to Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. The restructuring charge included $5.3 million related to a corporate realignment designed to increase strategic focus on delivering value-added services to franchisees, including centralizing the Company’s franchise service and sales operations, consolidating its brand management functions and realigning its call center operations. Of this $5.3 million, $5.1 million relates to severance and termination benefits for 64 employees (consisting of brand management and new hotels support, reservation sales and administrative personnel and franchise sales and operations support) and $0.2 million relates to the cancellation of pre-existing contracts for termination of domestic leases. The remaining $0.6 million of the $5.9 million is due to exit costs related to the termination of a corporate hotel construction project. As of December 31, 2002, the remaining liability related to this restructuring totaled approximately $0.6 million and was included in accrued expenses and other liabilities in the accompanying consolidated balance sheet. The Company paid approximately $0.5 million in cash related to this restructuring prior to June 30, 2003. As a result of these payments, the Company’s obligations related to the 2001 restructuring were satisfied and approximately $0.1 million was recorded as a reduction of selling, general and administrative expense in the accompanying consolidated statements of income for the nine months ended September 30, 2003, resulting in no liability remaining at September 30, 2003.
The income tax provisions for the three and nine month periods ended September 30, 2003 and 2002 are based on the effective tax rates expected to be applicable for the corresponding full year periods. The 2003 and 2002 nine month rates of approximately 37% differ from the statutory rates primarily because of state income taxes and certain federal and state income tax credits.
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The differences between net income and comprehensive income are described in the following table.
Other Comprehensive income, net of tax:
Unrealized gains (losses) on marketable equity securities
Foreign currency translation
Amortization of deferred gain on hedge
Other comprehensive income (loss)
Comprehensive income
During the nine months ended September 30, 2003, the Company repurchased 1.8 million shares of its common stock at a total cost of $43.9 million including, 1.0 million shares at a total cost of $24.8 million from the Company’s largest shareholder, that shareholder’s affiliates and related parties. During the three months ended September 30, 2003, the Company did not repurchase any shares of its common stock.
The Company received $0.9 million and $4.4 million in proceeds from the exercise of 0.1 million and 0.3 million employee stock options during the three and nine months ended September 30, 2003, respectively.
Basic earnings per share (“EPS”) amounts are computed by dividing earnings applicable to common shareholders by the weighted average number of common shares outstanding. Diluted EPS amounts assume the issuance of common stock for all potentially dilutive equivalents outstanding.
On February 10, 2003, the Company acquired the remaining 45% equity interest (beyond the 55% interest acquired prior to December 31, 2002) in Flag Choice Hotels (“Flag”). As a result Flag became a wholly-owned subsidiary of the Company as of that date. Flag, based in Melbourne, Australia, is a franchisor of certain hotel brands in Australia, Papua New Guinea, Fiji and New Zealand. The acquisition of Flag gave the Company the ability to control the Choice and Flag brands in Australia, Papua New Guinea and Fiji and the Flag brand in New Zealand.
The Company accounted for the February 2003 acquisition in accordance with SFAS No. 141, “Business Combinations”. The excess of the purchase price over the net tangible assets acquired of approximately $1.2 million has been allocated to franchise rights and is being amortized over their estimated useful lives of 5 to 15 years.
The purchase price allocation is preliminary and further refinements may be made. The Company began consolidating the results of Flag on July 1, 2002. The pro forma results of operations as if the Flag transaction had been combined at the beginning of 2002 and 2003, would not be materially different from the Company’s reported results for those periods.
In April 2003, the Company entered into a new $10.0 million demand note with a maturity of April 2004. The new demand note includes customary financial and other covenants that require the maintenance of certain ratios identical to those included in the Company’s existing senior credit facility. Borrowings under the demand note bear interest at rates established at the time of borrowing based on prime minus 175 basis points. The Company had $2.1 million outstanding at September 30, 2003 under this demand note.
In May 2003, the Company extended the maturity of a $10.0 million revolving line of credit, originally obtained in August 2002, until May 2004. The Company had $5.1 million outstanding at September 30, 2003 under this line of credit.
The Company has a single reportable segment encompassing its franchising business. Franchising revenues are comprised of royalty fees, initial franchise and relicensing fees, partner services revenue, marketing and reservation fees and other. 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
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calculate franchising operating income. Corporate and other revenue consists of hotel operations. Except as described in Note 3, the Company does not allocate interest income, interest expense or income taxes to its franchising segment.
The following table presents the financial information for the Company’s franchising segment.
Revenues
Operating income (loss)
The Company is a defendant in a number of lawsuits arising in the ordinary course of business. In the opinion of management and the general counsel to the Company, 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 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 licensing agreements, (iv) financial institutions in credit facility arrangements, and (v) underwriters in debt or equity security issuances. In addition, these parties are also 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.
Prior to January 1, 2003, the Company entered into a $3.0 million letter of credit as support for construction and permanent financing of a Sleep Inn and a MainStay Suites, each located in Atlanta, Georgia. The letter of credit expires in December 2003.
On January 1, 2003, the Company adopted FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” in its entirety. Such Interpretation elaborates on the disclosures to be made by a guarantor about its obligations under certain guarantees issued. It also clarifies that a guarantor is required to recognize, at the inception of any guarantee issued or modified after December 31, 2002, a liability for the fair value of the obligation undertaken in issuing the guarantee. The impact of adopting this Interpretation was not material to the Company’s results of operations or financial position.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition and disclosure provisions of SFAS No. 148 are effective for financial statements for interim and fiscal years ending after December 15, 2002,
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with early application permitted for entities with a fiscal year ending prior to December 15, 2002. We adopted the disclosure provisions of SFAS No. 148 effective December 31, 2002 and the transition provisions effective January 1, 2003.
In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities – an Interpretation of “Accounting Research Bulletin” (“ARB”) No. 51”. This Interpretation clarifies the application of the majority voting interest requirement of ARB No. 51, “Consolidated Financial Statements”, to certain types of variable interest entities that do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The controlling financial interest may be achieved through arrangements that do not involve voting interests. Under FIN No. 46, if an entity is determined to be a variable interest entity, it must be consolidated by the enterprise that absorbs the majority of the entity’s expected losses if they occur, receives a majority of the entity’s expected residual returns if they occur, or both. We do not expect to consolidate any previously unconsolidated entities as a result of adopting FIN No. 46. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies to the first fiscal year or interim period ending after December 15, 2003, to variable interest entities in which an enterprise holds a variable interest that is acquired before February 1, 2003. The Company adopted the applicable provisions of FIN No. 46 on January 31, 2003 and will fully adopt FIN No. 46 in the fourth quarter of 2003. The impact of adopting the provisions of FIN No. 46 applicable to periods after September 30, 2003 are not expected to have a material impact on our results of operations or financial position.
On May 31, 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This standard addresses how certain financial instruments with characteristics of both liabilities and equity should be classified and measured. The provisions of SFAS No. 150 are effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, or our third quarter of 2003. The adoption of SFAS No. 150 does not have a material impact on the Company’s results of operations or financial position.
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Comparison of Operating Results for the Three Month Periods Ended September 30, 2003 and September 30, 2002
The Company recorded net income of $24.3 million, or $0.66 per diluted share, for the three months ended September 30, 2003, compared to net income for the same period of 2002 of $21.9 million, or $0.54 per diluted share. The increase in net income for the period is attributable to improved operating income resulting primarily from a $2.0 million increase in royalty fees, a $0.5 million increase in initial franchise and relicensing fees, and $0.4 million increase in revenues generated from partner services relationships.
Franchise Revenues
The Company’s revenues, excluding marketing and reservation fees and hotel operations, were $56.3 million and $53.9 million for the three months ended September 30, 2003 and 2002, respectively. Royalty revenue increased by $2.0 million to $48.3 million for the three months ended September 30, 2003, from $46.3 million during the corresponding period in 2002. The change primarily relates to increased domestic royalty revenue attributable to a net increase of 167 domestic units from the corresponding prior year period, coupled with a domestic effective royalty rate increase of 4 basis points, partially offset by a 0.8% decline in RevPAR. International royalty revenue for each of the three month periods ended September 30, 2003 and 2002 was approximately $2.3 million. Initial franchise and relicensing fee revenue increased $0.5 million, to $4.0 million for the three months ended September 30, 2003, from $3.5 million during the corresponding period in 2002. The increase in initial franchise and relicensing fee revenue is primarily attributable to an increase in the number of contracts executed to add new hotels to our system or to relicense existing hotels. The Company executed an aggregate of 168 new and relicensing hotel franchise contracts in the three months ended September 30, 2003 compared to 128 contracts in the same period of 2002. Revenues generated from partner services relationships increased 15.9%, to $3.0 million for the three months ended September 30, 2003, from $2.5 million during the corresponding period in 2002. Partner services revenue is generated from hotel industry vendors (who have been designated as preferred providers) based on the level of goods or services purchased by hotel owners and guests of the Company’s franchised hotels.
The total number of domestic hotels online increased to 3,601 from 3,434 as of September 30, 2003 and 2002, respectively, an increase of 4.9%. This represents an increase in the number of rooms open of 4.5% from 279,135 as of September 30, 2002 to 291,827 as of September 30, 2003. As of September 30, 2003, the Company had 338 hotels under development in its domestic hotel system representing 26,059 rooms.
The total number of international hotels online was 1,172 as of September 30, 2003, compared to 1,188 as of the corresponding prior year period. The total number of international rooms was 92,987 as of September 30, 2003, compared to 90,940 as of September 30, 2002. As of September 30, 2003, the Company had 88 franchised hotels under development in its international hotel system representing 9,358 rooms.
Franchise Expenses
The cost to operate the franchising business is reflected in selling, general and administrative (“SG&A”) expenses. SG&A expenses decreased to $14.1 million from $14.7 million, a decrease of $0.6 million for the three months ended September 30, 2003, as compared to the corresponding prior period. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 25.1% for the third quarter of 2003, compared to 27.3% for 2002.
Marketing and Reservations
Marketing and reservation fees and expenses recognized by the Company were $48.6 million and $50.3 million for the three months ended September 30, 2003 and 2002, respectively. Marketing and reservation expenses decreased as a result of the timing of advertising, sales promotions and telecommunications costs. Depreciation and amortization expense attributable to marketing and reservation activities was $2.9 million and $3.2 million for the three months ended September 30, 2003 and 2002, respectively. For each of the three month periods ended September 30, 2003 and 2002, interest expense attributable to reservation activities was $0.3 million. The Company’s balance sheet includes a receivable of $41.1 million and $44.9 million for marketing and reservation activities as of September 30, 2003 and December 31, 2002, respectively. The Company expects the marketing and reservation receivable to be between $37.0 million and $38.5 million at December 31, 2003.
For each of the three month periods ended September 30, 2003 and 2002, the Company recognized $1.2 million of interest income from its subordinated term note to Sunburst.
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On February 10, 2003, the Company acquired the remaining 45% equity interest (beyond the 55% interest acquired prior to December 31, 2002) in Flag Choice Hotels (“Flag”) for approximately $1.2 million. As a result Flag became a wholly-owned subsidiary of the Company as of that date. Flag, based in Melbourne, Australia, is a franchisor of certain hotel brands in Australia, Papua New Guinea, Fiji and New Zealand. The acquisition of Flag gave the Company the ability to control the Choice and Flag brands in Australia, Papua New Guinea and Fiji and the Flag brand in New Zealand. The Company began consolidating the results of Flag on July 1, 2002.
Comparison of Operating Results for the Nine Month Periods Ended September 30, 2003 and September 30, 2002
The Company recorded net income of $51.1 million, or $1.38 per diluted share, for the nine months ended September 30, 2003, compared to net income for the same period of 2002 of $45.7 million, or $1.12 per diluted share. The increase in net income for the period is attributable to improved operating income resulting primarily from a $4.6 million increase in royalty fees, a $2.0 million increase in initial franchise and relicensing fees, and $1.3 million in other revenue primarily attributable to termination awards and service charges compared to the nine months ended September 30, 2002 partially offset by increased costs including compensation expense related to the Company’s adoption of the fair value method of accounting for stock options on January 1, 2003, convention and key customer marketing activities and the consolidation of Flag.
The Company’s revenues, excluding marketing and reservation fees and hotel operations, were $138.7 million and $130.1 million for the nine months ended September 30, 2003 and 2002, respectively. Royalty revenue increased by $4.6 million to $113.2 million for the nine months ended September 30, 2003, from $108.6 million during the corresponding period in 2002. Approximately $2.3 million of the change relates to increased domestic royalty revenue attributable to a net increase of 167 domestic units from the corresponding prior year period, coupled with a domestic effective royalty rate increase of 2 basis points, partially offset by a 1.9% decline in RevPAR. International royalty revenue increased $2.3 million, primarily due to the consolidation of Flag beginning on July 1, 2003. Initial franchise and relicensing fee revenue increased $2.0 million, to $11.3 million for the nine months ended September 30, 2003, from $9.3 million during the corresponding period in 2002. The increase in initial franchise and relicensing fee revenue is primarily attributable to an increase in the number of contracts executed to add new hotels to our system or to relicense existing hotels. The Company executed an aggregate of 432 new and relicensing hotel franchise contracts in the nine months ended September 30, 2003 compared to 313 contracts in the same period of 2002. Revenues generated from partner services relationships increased 6.7%, to $9.6 million for the nine months ended September 30, 2003, from $9.0 million during the corresponding period in 2002. The increase in partner services revenue is primarily attributable to the addition of new strategic partner endorsed vendors and from the usage of guest services programs available to franchisees.
The cost to operate the franchising business is reflected in SG&A expenses. SG&A expenses increased to $45.0 million from $42.1 million, an increase of $2.9 million for the nine months ended September 30, 2003, as compared to the corresponding prior period. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 32.5% for the nine months ended September 30, 2003, compared to 32.3% for 2002. The increase is primarily related to the consolidation of Flag beginning on July 1, 2002 and increases in other costs including insurance, convention, stock and other employee compensation arrangements.
Marketing and reservation fees and expenses recognized by the Company were $149.5 million and $148.6 million for the nine months ended September 30, 2003 and 2002, respectively. Marketing and reservation fees increased as a result of increased levels of national marketing and reservations activities. Depreciation and amortization expense attributable to marketing and reservation activities were $9.5 million for each of the nine month periods ended September 30, 2003 and 2002. Interest expense attributable to reservation activities was $0.9 million and $1.1 million for the nine months ended September 30, 2003 and 2002, respectively.
For the nine months ended September 30, 2003 and 2002, the Company recognized $3.5 million and $3.4 million, respectively, of interest income from its subordinated term note to Sunburst.
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LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $82.0 million for the nine months ended September 30, 2003, an increase of $7.3 million from $74.7 million for 2002. The increase is primarily due to increases in operating income and in cash inflows from marketing and reservation activities during the nine months ended September 30, 2003, as compared to the corresponding prior year period.
At September 30, 2003, the total long-term debt outstanding for the Company was $280.1 million, $27.5 million of which matures in the next twelve months. The Company presently expects to refinance principal maturities of its outstanding debt using the revolving line of credit available pursuant to the Company’s current Credit Facility. Prior to expiration of the Credit Facility in 2006, the Company expects to refinance its obligations. As of September 30, 2003, subject to covenant compliance, the Company had approximately $76.8 million available for borrowing under existing credit facilities.
Net cash inflows were $13.4 million related to marketing and reservation activities during the nine months ended September 30, 2003. The Company expects marketing and reservation activities to generate positive cash flows between $17.5 and $20.5 million for the year ended December 31, 2003. The Company expects the marketing and reservation receivable to be between $37.0 million and $38.5 million at December 31, 2003.
The Company expects capital expenditures to range between $11.0 and $15.0 million for the year ended December 31, 2003.
During the nine months ended September 30, 2003, the Company repurchased 1.8 million shares of its common stock at a total cost of $43.9 million including 1.0 million shares at a total cost of $24.8 million from the Company’s largest shareholder, that shareholder’s affiliates and related parties. At September 30, 2003, the Company had approximately 35.7 million shares of common stock outstanding.
The Company received $0.9 million and $4.4 million in proceeds from the exercise of 0.1 million and 0.3 million employee stock options during the three months and nine months ended September 30, 2003, respectively.
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On August 13, 2003, the Company indicated its intention to initiate a cash dividend on its common stock. The plan approved by the Company’s Board of Directors anticipates an initial quarterly dividend of $0.20, or $0.80 per share annually. The first quarterly dividend is expected to be declared late in the fourth quarter of 2003 and paid early in the first quarter of 2004. The actual declaration of dividends, and the setting of record and payment dates, is subject to final determination by the Board each quarter after its review of the Company’s financial performance.
The Company believes that cash flows from operations and available financing capacity is adequate to meet the expected operating, investing and financing requirements for the business for the immediate future.
New Accounting Pronouncements
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition and disclosure provisions of SFAS No. 148 are effective for financial statements for interim and fiscal years ending after December 15, 2002, with early application permitted for entities with a fiscal year ending prior to December 15, 2002. We adopted the disclosure provisions of SFAS No. 148 effective December 31, 2002 and the transition provisions effective January 1, 2003.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this quarterly report, including those in the section entitled Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not historical facts constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act. Words such as “believes,” “anticipates,” “expects,” “intends,” “estimates,” “projects,” and other similar expressions, which are predictions of or indicate future events and trends, typically identify forward-
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looking statements. Such statements are subject to a number of risks and uncertainties which could cause actual results to differ materially from those projected, including: competition within each of our business segments; business strategies and their intended results; the balance between supply of and demand for hotel rooms; our ability to obtain new franchise agreements; our ability to develop and maintain positive relations with current and potential hotel owners; the effect of international, national and regional economic conditions and geopolitical events such as acts of god, acts of war, terrorism or epidemics; the availability of capital to allow us and potential hotel owners to fund investments and construction of hotels; the cost and other effects of legal proceedings; and other risks described from time to time in our filings with the Securities and Exchange Commission, including those set forth under the heading “Risk Factors” in our Report on Form 10-Q for the period ended March 31, 2003. Given these uncertainties, you are cautioned not to place undue reliance on such statements. We also undertake no obligation to publicly update or revise any forward-looking statement to reflect current or future events or circumstances.
The Company is exposed to market risk from changes in interest rates and the impact of fluctuations in foreign currencies on the Company’s foreign investments and revenues. The Company manages its exposure to this market risk through the monitoring of its available financing alternatives including in certain circumstances the potential use of derivative financial instruments. The Company’s strategy to manage exposure to changes in interest rates and foreign currencies remains unchanged from 1997. Furthermore, the Company does not foresee any significant changes in exposure in these areas or in how such exposure is managed in the near future.
At September 30, 2003 and December 31, 2002, the Company had $280.1 million and $307.8 million of debt outstanding at a weighted average effective interest rate of 4.0% and 4.2%, respectively. A hypothetical change of 10% in the Company’s effective interest rate from September 30, 2003 levels would increase or decrease annual interest expense by $0.4 million. The Company expects to refinance the $86.3 million variable rate term loan balance remaining at September 30, 2003, as the principal amortizes using the revolving line of credit available pursuant to the Company’s current Credit Facility. Prior to expiration of the Credit Facility in 2006, the Company expects to refinance its obligations.
The Company does not presently have any derivative financial instruments.
The Company formed a Disclosure Review Committee whose membership includes the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), among others. The Disclosure Review Committee’s procedures are considered by the CEO and CFO in performing their evaluations of the Company’s disclosure controls and procedures and in assessing the accuracy and completeness of the Company’s disclosures.
As of November 12, 2003, an evaluation was performed under the supervision and with the participation of the Company’s CEO and CFO, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of November 12, 2003. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to November 12, 2003.
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PART II. OTHER INFORMATION
Incorporated by reference to the description of legal proceedings in the “Commitments and Contingencies” footnote in the financial statements set forth in Part I. “Financial Information”.
None.
Exhibit Number and Description
The Company filed a report on Form 8-K, dated September 5, 2003, reporting that an Amendment Agreement had been executed regarding the Company’s $41.3 million note receivable from Sunburst Hospitality Corporation.
The Company filed a report on Form 8-K, dated August 13, 2003, announcing its intention to initiate payment of a cash dividend on its common stock.
The Company filed a report on Form 8-K, dated July 23, 2003, reporting that a press release had been issued reporting the Company’s earnings for the quarter ended June 30, 2003.
The Company filed a report on Form 8-K, dated July 17, 2003, reporting that a press release had been issued announcing earnings guidance for the quarter ended June 30, 2003.
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Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ Joseph M. Squeri
By:
Joseph M. Squeri
Senior Vice President, Development and Chief Financial Officer
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