FORM 10-Q for the Quarterly Period ending June 30, 2007
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 


FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NO. 001-13393

 


CHOICE HOTELS INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 


 

DELAWARE   52-1209792

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

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

 

CLASS

 

SHARES OUTSTANDING

AT JUNE 30, 2007

Common Stock, Par Value $0.01 per share   65,701,820

 



Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

INDEX

 

     PAGE NO.
PART I. FINANCIAL INFORMATION:   
Item 1—Financial Statements    3
Consolidated Statements of Income—For the three and six months ended June 30, 2007 (Unaudited) and June 30, 2006 (Unaudited)    3
Consolidated Balance Sheets—As of June 30, 2007 (Unaudited) and December 31, 2006    4
Consolidated Statements of Cash Flows—For the six months ended June 30, 2007 (Unaudited) and June 30, 2006 (Unaudited)    5
Notes to Consolidated Financial Statements (Unaudited)    6
Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations    21
Item 3—Quantitative and Qualitative Disclosures About Market Risk    33
Item 4—Controls and Procedures    33
PART II. OTHER INFORMATION:   
Item 1—Legal Proceedings    33
Item 1A –Risk Factors    34
Item 2—Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities    34
Item 3—Defaults Upon Senior Securities    34
Item 4—Submission of Matters to a Vote of Security Holders    34
Item 5—Other Information    34
Item 6—Exhibits    35
SIGNATURE    37

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2007     2006     2007     2006  
REVENUES:         

Royalty fees

   $ 59,176     $ 53,146     $ 102,504     $ 93,010  

Initial franchise and relicensing fees

     7,649       6,723       12,580       12,366  

Brand solutions

     5,995       4,900       8,981       7,682  

Marketing and reservation

     81,810       72,742       143,851       130,718  

Hotel operations

     1,193       1,180       2,289       2,160  

Other

     1,886       1,849       3,687       4,022  
                                

Total revenues

     157,709       140,540       273,892       249,958  
                                
OPERATING EXPENSES:         

Selling, general and administrative

     25,605       22,242       49,505       40,517  

Depreciation and amortization

     2,137       2,642       4,252       4,991  

Marketing and reservation

     81,810       72,742       143,851       130,718  

Hotel operations

     794       800       1,535       1,545  
                                

Total operating expenses

     110,346       98,426       199,143       177,771  
                                

Operating income

     47,363       42,114       74,749       72,187  

OTHER INCOME AND EXPENSES, NET:

        

Interest expense

     3,217       4,044       6,214       8,084  

Interest and other investment (income) loss

     (1,721 )     174       (2,322 )     (530 )

Equity in net income of affiliates

     (181 )     (130 )     (375 )     (388 )

Loss on extinguishment of debt

     —         342       —         342  
                                

Total other income and expenses, net

     1,315       4,430       3,517       7,508  
                                

Income before income taxes

     46,048       37,684       71,232       64,679  

Income taxes

     17,403       13,548       26,272       22,878  
                                

Net income

   $ 28,645     $ 24,136     $ 44,960     $ 41,801  
                                

Weighted average shares outstanding-basic

     65,475       65,356       65,627       65,070  
                                

Weighted average shares outstanding-diluted

     66,599       67,105       66,823       66,925  
                                

Basic earnings per share

   $ 0.44     $ 0.37     $ 0.69     $ 0.64  
                                

Diluted earnings per share

   $ 0.43     $ 0.36     $ 0.67     $ 0.62  
                                

Cash dividends declared per share

   $ 0.15     $ 0.13     $ 0.30     $ 0.26  
                                

The accompanying notes are an integral part of these consolidated financial statements.

 

3


Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

 

    

June 30,

2007

    December 31,
2006
 
     (Unaudited)        

Current assets

    

Cash and cash equivalents

   $ 47,330     $ 35,841  

Receivables (net of allowance for doubtful accounts of $3,629 and $3,937, respectively)

     45,995       41,694  

Deferred income taxes

     3,061       1,790  

Investments, employee benefit plans, at fair value

  

 

3,343

 

    —    

Other current assets

     11,745       7,757  
                

Total current assets

  

 

111,474

 

    87,082  

Property and equipment, at cost, net

     43,674       42,802  

Goodwill

     65,813       65,813  

Franchise rights and other identifiable intangibles, net

     33,677       35,509  

Receivable – marketing fees

     7,139       6,662  

Investments, employee benefit plans, at fair value

  

 

34,083

 

    31,529  

Deferred income taxes

     25,387       22,451  

Other assets

     10,797       11,461  
                

Total assets

   $ 332,044     $ 303,309  
                
LIABILITIES AND SHAREHOLDERS’ DEFICIT     

Current liabilities

    

Current portion of long-term debt

   $ —       $ 146  

Accounts payable

     41,545       41,816  

Accrued expenses and other

     33,071       45,306  

Deferred revenue

     48,984       47,167  

Income taxes payable

     17,936       5,356  

Deferred compensation and retirement plan obligations

  

 

3,343

 

    —    
                

Total current liabilities

  

 

144,879

 

    139,791  
                

Long-term debt

     199,146       172,390  

Deferred compensation and retirement plan obligations

  

 

41,543

 

    40,101  

Other liabilities

     18,329       13,407  
                

Total liabilities

     403,897       365,689  
                

Commitments and contingencies

    
SHAREHOLDERS’ DEFICIT     

Common stock, $0.01 par value

     657       664  

Additional paid-in-capital

     80,732       81,689  

Accumulated other comprehensive income (loss)

     378       (772 )

Treasury stock, at cost

     (662,192 )     (627,311 )

Retained earnings

     508,572       483,350  
                

Total shareholders’ deficit

     (71,853 )     (62,380 )
                

Total liabilities and shareholders’ deficit

   $ 332,044     $ 303,309  
                

The accompanying notes are an integral part of these consolidated financial statements.

 

4


Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED, IN THOUSANDS)

 

     Six Months Ended
June 30,
 
     2007     2006  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 44,960     $ 41,801  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     4,252       4,991  

Provision for bad debts

     (528 )     (127 )

Non-cash stock compensation and other charges

     6,891       5,550  

Non-cash interest and other income

     (1,598 )     (107 )

Loss on extinguishment of debt

     —         342  

Dividends received from equity method investees

     295       169  

Equity in net income of affiliates

     (375 )     (388 )

Changes in assets and liabilities, net of acquisitions:

    

Receivables

     (3,654 )     (3,414 )

Receivable – marketing and reservation fees, net

     1,731       670  

Accounts payable

     (277 )     8,404  

Accrued expenses and other

     (12,678 )     (7,549 )

Income taxes payable

     12,580       4,815  

Deferred income taxes

     (4,680 )     (1,912 )

Deferred revenue

     1,817       3,603  

Other assets

     (1,278 )     (420 )

Other liabilities

     9,688       6,200  
                

Net cash provided by operating activities

     57,146       62,628  
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Investment in property and equipment

     (5,786 )     (4,045 )

Acquisitions, net of cash acquired

     (343 )     —    

Issuance of notes receivable

     (3,255 )     (1,277 )

Collections of notes receivable

     469       359  

Purchases of investments, employee benefit plans

     (5,701 )     (5,784 )

Proceeds from sale of investments, employee benefit plans

     1,551       1,387  

Other items, net

     (359 )     (296 )
                

Net cash used in investing activities

     (13,424 )     (9,656 )
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Principal payments of long-term debt

     (422 )     (73 )

Net borrowings (repayments) pursuant to revolving credit facility

     27,000       (49,600 )

Purchase of treasury stock

     (47,341 )     (1,132 )

Excess tax benefits from stock-based compensation

     3,765       11,983  

Debt issuance costs

     —         (472 )

Dividends paid

     (19,751 )     (16,925 )

Proceeds from exercise of stock options

     4,516       7,984  
                

Net cash used in financing activities

     (32,233 )     (48,235 )
                

Net change in cash and cash equivalents

     11,489       4,737  

Cash and cash equivalents at beginning of period

     35,841       16,921  
                

Cash and cash equivalents at end of period

   $ 47,330     $ 21,658  
                

Supplemental disclosure of cash flow information:

    

Cash payments during the period for:

    

Income taxes, net of refunds

   $ 13,506     $ 7,734  

Interest

   $ 6,155     $ 8,115  

Non-cash financing activities:

    

Declaration of dividends

   $ 19,651     $ 17,059  

Issuance of restricted shares of common stock

   $ 5,935     $ 6,549  

Issuance of treasury stock to employee stock purchase plan

   $ 396       —    

The accompanying notes are an integral part of these consolidated financial statements.

 

5


Table of Contents

CHOICE 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 condensed 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 six months ended June 30, 2006 related to dividends received from equity method investees. During the first six 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 June 30, 2007 and December 31, 2006, $6.6 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

During the three months ended June 30, 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 therefore has recorded the land at its fair value as of June 30, 2007 in other current assets on the accompanying consolidated balance sheet.

2. Marketing Fees Receivable & Cumulative Reservation Fees Collected in Excess of Expenses

The marketing fees receivable at June 30, 2007 and December 31, 2006 was $7.1 million and $6.7 million, respectively. As of June 30, 2007 and December 31, 2006, cumulative reservation fees collected exceeded expenses by $6.7 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 $1.9 million and $2.0 million for the three months ended June 30, 2007 and 2006, respectively, and $3.9 million for both the six months ended June 30, 2007 and 2006. Interest expense attributable to reservation activities was $0.1 million and $0.2 million for the three months ended June 30, 2007 and 2006, respectively, and $0.3 million and $0.4 million for the six months ended June 30, 2007 and 2006, respectively.

3. Income Taxes

The effective income tax rates for the 2007 and 2006 six-month periods ended June 30, of approximately 36.9% and 35.4%, respectively, differ 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.

Effective January 1, 2007, the Company adopted the provisions of 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 FASB Statement 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 June 30, 2007, the Company had $8.2 million and $9.0 million, respectively of total unrecognized tax benefits of which approximately $5.1 million and $5.5 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 $2.0 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 2002. Substantially all material state and local and foreign income tax matters have been concluded for years through 2002. U.S. federal income tax returns for 2003 through 2006 are currently open for examination.

 

6


Table of Contents

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 $0.2 million and $0.3 million for the three months and six months ended June 30, 2007, respectively. Accrued interest and penalties were $1.1 million and $1.4 million as of January 1, 2007 and June 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.

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 

(In thousands)

   2007     2006     2007     2006  

Net income

   $ 28,645     $ 24,136     $ 44,960     $ 41,801  

Other comprehensive income, net of tax:

        

Amortization of pension related costs, net of tax

        

Prior service costs

     7       —         14       —    

Actuarial loss

     7       —         20       —    

Curtailment and remeasurement, net of tax

     —         —         758       —    

Foreign currency translation adjustment, net

     319       101       391       71  

Amortization of deferred gain on hedge, net

     (16 )     (16 )     (33 )     (33 )
                                

Other comprehensive income

     317       85       1,150       38  
                                

Comprehensive income

   $ 28,962     $ 24,221     $ 46,110     $ 41,839  
                                

5. Capital Stock

Stock Options

The Company granted 0.2 million options to officers of the Company during both the six months ended June 30, 2007 and 2006 at a fair value of approximately $2.6 million and $2.8 million during the six months ended June 30, 2007 and 2006, respectively. The Company granted 45,000 options to officers of the Company at a fair value of approximately $0.5 million during the three months ended June 30, 2007. No options were granted during the three months ended June 30, 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:

 

     2007 Grants     2006 Grants  

Risk-free interest rate

     4.84 %     4.69 %

Expected volatility

     32.31 %     32.09 %

Expected life of stock option

     4.5 years       4.3 years  

Dividend yield

     1.49 %     1.07 %

Requisite service period

     4 years       4 years  

Contractual life

     7 years       7 years  

Weighted average fair value of options granted

   $ 12.15     $ 14.82  

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 June 30, 2007 was $60.0 million and $52.0 million, respectively. The total intrinsic value of options exercised during the three months ended June 30, 2007 and 2006 was $8.0 million and $25.3 million, respectively, and $12.7 million and $40.5 million during the six months ended June 30, 2007 and 2006, respectively.

The Company received $2.8 million and $4.5 million in proceeds from the exercise of 0.3 million and 0.4 million employee stock options during the three and six months ended June 30, 2007, respectively. During the three and six months ended June 30, 2006, the Company received $4.5 million and $8.0 million in proceeds from the exercise of 0.6 million and 1.0 million employee stock options, respectively.

 

7


Table of Contents

Restricted Stock

The following table is a summary of activity related to restricted stock grants:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2007    2006    2007    2006

Restricted share grants

     32,544      15,191      146,967      133,207

Weighted Average Grant Date Fair Value Per Share

   $ 38.12    $ 52.64    $ 40.39    $ 49.16

Aggregate Grant Date Fair Value ($000)

   $ 1,241    $ 800    $ 5,935    $ 6,549

Restricted Shares Forfeited

     7,693      13,513      25,790      18,487

Vesting Service Period of Shares Granted

     4 years      4 years      4 years      4 years

Fair Value of Shares Vested ($000)

   $ 463    $ 914    $ 5,437    $ 8,027

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

During the first quarter of 2007, the Company 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 100% and 130% of the 2007 and 2006 awards targets will be achieved, respectively. 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 PVRSU’s that ultimately vest. There were no grants of PVRSU’s during the three months ended June 30, 2007 and 2006.

The following table is a summary of activity related to PVRSU grants:

 

     Six Months Ended
June 30,
     2007    2006

Performance Vested Restricted Stock Units Granted

     21,141      29,780

Weighted Average Grant Date Fair Value Per Share

   $ 40.75    $ 48.72

Aggregate Grant Date Fair Value ($000)

   $ 862    $ 1,451

Requisite Service Period

     3 years      3 years

A summary of stock-based award activity as of June 30, 2007, and changes during the six months ended are presented below:

 

     Six Months Ended June 30, 2007
     Stock Options    Restricted Stock    Performance Vested
Restricted Stock Units
     Shares     Weighted
Average
Exercise
Price
   Weighted
Average
Contractual
Term
   Shares     Weighted
Average Grant
Date Fair Value
   Shares    Weighted
Average Grant
Date Fair Value

Outstanding at January 1, 2007

   2,860,159     $ 14.30       570,134     $ 29.81    49,780    $ 46.22

Granted

   210,957       40.21       146,967       40.39    21,141      40.75

Exercised/Vested

   (446,960 )     10.10       (132,632 )     28.84    —        —  

Forfeited/Expired

   (38,661 )     19.87       (25,790 )     30.58    —        —  
                                        

Outstanding at June 30, 2007

   2,585,495     $ 17.06    4.6 years    558,679     $ 32.78    70,921    $ 44.59
                                          

Options exercisable at June 30, 2007

   1,824,490     $ 11.28    3.8 years           
                            

 

8


Table of Contents

The components of the Company’s pretax stock-based compensation expense and associated income tax benefits are as follows for the three and six months ended June 30:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,

(in millions)

   2007    2006    2007    2006

Stock options

   $ 0.5    $ 0.8    $ 2.1    $ 2.4

Restricted stock

     1.5      1.3      3.0      2.5

Performance vested restricted stock units

     0.1      0.1      0.5      0.6
                           

Total

   $ 2.1    $ 2.2    $ 5.6    $ 5.5
                           

Income tax benefits

   $ 0.8    $ 0.8    $ 2.1    $ 2.1
                           

Stock-based compensation expense on stock option and performance vested restricted stock grants made to a retirement eligible executive officer during the six months ended June 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 six month periods ended June 30, 2007 and 2006, respectively.

Dividends

On May 1, 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.

On May 2, 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. On February 13, 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 six months ended June 30, 2007, the Company purchased 0.7 million and 1.2 million shares of common stock under the share repurchase program at a total cost of $28.3 million and $46.1 million, respectively. The Company did not purchase any common stock during the three and six months ended June 30, 2006 under the share repurchase program.

During the three and six months ended June 30, 2007, the Company purchased 2,160 and 31,139 shares of common stock at a total cost of $0.1 million and $1.3 million, respectively, from employees to satisfy statutory minimum tax-withholding requirements from the vesting of restricted stock grants. No shares were repurchased from employees to satisfy tax-withholding requirements during the three months ended June 30, 2006. During the six months ended June 30, 2006, the Company purchased 26,794 shares of common stock at a total cost of $1.1 million to satisfy statutory minimum tax-withholding requirements from the vesting of restricted stock grants. These purchases were outside the share repurchase program initiated in June 1998.

6. Earnings Per Share

The following table reconciles the number of shares used in the basic and diluted earnings per share calculations.

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,

(In thousands, except per share amounts)

   2007    2006    2007    2006

Computation of Basic Earnings Per Share:

           

Net Income

   $ 28,645    $ 24,136    $ 44,960    $ 41,801
                           

Weighted average shares outstanding-basic

     65,475      65,356      65,627      65,070
                           

Basic earnings per share

   $ 0.44    $ 0.37    $ 0.69    $ 0.64
                           

Computation of Diluted Earnings Per Share:

           

Net income for diluted earnings per share

   $ 28,645    $ 24,136    $ 44,960    $ 41,801

Weighted average shares outstanding-basic

     65,475      65,356      65,627      65,070

Effect of Dilutive Securities:

           

Employee stock option and restricted stock plan

     1,124      1,749      1,196      1,855
                           

Weighted average shares outstanding-diluted

     66,599      67,105      66,823      66,925
                           

Diluted earnings per share

   $ 0.43    $ 0.36    $ 0.67    $ 0.62
                           

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. However, at June 30, 2007 and 2006, PVRSUs totaling 70,921 and 29,780 were excluded from the computation since the performance conditions had not been met at the reporting date. In addition, at June 30, 2007, the Company excluded 0.4 million anti-dilutive options from the computation of diluted earnings per share for the three and six months ended June 30, 2007. There were no anti-dilutive options at June 30, 2006.

 

9


Table of Contents

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 six months ended June 30, 2007, the Company recorded $0.2 million and $0.8 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 six months ended June 30, 2006, the Company recorded $0.3 million and $0.6 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 six months ended June 30, 2007 and 2006:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,

(In thousands)

   2007    2006    2007    2006

Components of net periodic pension cost:

           

Service cost

   $ 128    $ 170    $ 268    $ 339

Interest cost

     94      87      191      175

Amortization:

           

Prior service cost

     10      14      22      28

Loss

     13      19      33      38
                           
     245      290      514      580

Curtailment

     —        —        248      —  
                           

Net periodic pension cost

   $ 245    $ 290    $ 762    $ 580
                           

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 Company recognized a curtailment loss 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:

 

     (In thousands)

Service cost

   $ 523

Interest cost

     379

Amortization

  

Prior service cost

     43

Loss

     58
      
     1,003

Curtailment loss

     248
      

Net periodic pension cost

   $ 1,251
      

The following is a reconciliation of the changes in the projected benefit obligation for the six months ended June 30, 2007:

 

     (In thousands)  

Projected benefit obligation, January 1, 2007

   $ 7,223  

Service cost

     268  

Interest cost

     191  

Remeasurement

     (962 )
        

Projected benefit obligation, June 30, 2007

   $ 6,720  
        

The amounts in accumulated other comprehensive income that have not yet been recognized as components of net periodic benefit costs at June 30, 2007 are as follows:

 

     (In thousands)  

Transition asset (obligation)

   $ —    

Prior service cost

     (615 )

Accumulated loss

     (1,119 )
        

Total

   $ (1,734 )
        

 

10


Table of Contents

8. 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 June 30, 2007, the Company had $99.2 million of revolving loans outstanding pursuant to the Revolver. As of June 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 June 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 June 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 June 30, 2007, the Company had no amounts 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 June 30, 2007, total debt outstanding for the Company was $199.1 million.

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.

 

11


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Three Months Ended June 30, 2007

(Unaudited, In Thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Royalty fees

   $ 53,716     $ 26,707     $ 5,516     $ (26,763 )   $ 59,176  

Initial franchise and relicensing fees

     7,649       —         —         —         7,649  

Brand solutions

     5,995       —         —         —         5,995  

Marketing and reservation

     71,311       68,297       3,653       (61,451 )     81,810  

Other items, net

     1,886       1,193       —         —         3,079  
                                        

Total revenues

     140,557       96,197       9,169       (88,214 )     157,709  

OPERATING EXPENSES:

          

Selling, general and administrative

     25,335       24,060       2,973       (26,763 )     25,605  

Marketing and reservation

     75,120       64,980       3,161       (61,451 )     81,810  

Other items, net

     794       1,865       272       —         2,931  
                                        

Total operating expenses

     101,249       90,905       6,406       (88,214 )     110,346  

Operating income

     39,308       5,292       2,763       —         47,363  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     3,383       (134 )     (32 )     —         3,217  

Other items, net

     (107 )     (1,395 )     (400 )     —         (1,902 )

Equity in earnings of consolidated subsidiaries

     (5,558 )     —         —         5,558       —    
                                        

Total other income and expenses, net

     (2,282 )     (1,529 )     (432 )     5,558       1,315  
                                        

Income before income taxes

     41,590       6,821       3,195       (5,558 )     46,048  

Income taxes

     12,945       3,846       612       —         17,403  
                                        

Net income

   $ 28,645     $ 2,975     $ 2,583     $ (5,558 )   $ 28,645  
                                        

 

12


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Three Months Ended June 30, 2006

(Unaudited, In Thousands) 

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations     Consolidated

REVENUES:

          

Royalty fees

   $ 49,347     $ 23,983     $ 3,630     $ (23,814 )   $ 53,146

Initial franchise and relicensing fees

     6.723       —         —         —         6,723

Brand solutions

     4,900       —         —         —         4,900

Marketing and reservation

     63,203       60,362       2,395       (53,218 )     72,742

Other items, net

     1,849       1,180       —         —         3,029
                                      

Total revenues

     126,022       85,525       6,025       (77,032 )     140,540

OPERATING EXPENSES:

          

Selling, general and administrative

     23,949       21,766       761       (24,234 )     22,242

Marketing and reservation

     66,156       57,524       1,860       (52,798 )     72,742

Other items, net

     798       2,456       188       —         3,442
                                      

Total operating expenses

     90,903       81,746       2,809       (77,032 )     98,426

Operating income

     35,119       3,779       3,216       —         42,114

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     4,236       (201 )     9       —         4,044

Other items, net

     282       301       (197 )     —         386

Equity in earnings of consolidated subsidiaries

     (5,438 )     —         —         5,438       —  
                                      

Total other income and expenses, net

     (920 )     100       (188 )     5,438       4,430
                                      

Income before income taxes

     36,039       3,679       3,404       (5,438 )     37,684

Income taxes

     11,903       1,377       268       —         13,548
                                      

Net income

   $ 24,136     $ 2,302     $ 3,136     $ (5,438 )   $ 24,136
                                      

 

13


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Six Months Ended June 30, 2007

(Unaudited, In Thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Royalty fees

   $ 92,415     $ 54,033     $ 10,155     $ (54,099 )   $ 102,504  

Initial franchise and relicensing fees

     12,580       —         —         —         12,580  

Brand solutions

     8,981       —         —         —         8,981  

Marketing and reservation

     123,130       133,579       6,925       (119,783 )     143,851  

Other items, net

     3,687       2,289       —         —         5,976  
                                        

Total revenues

     240,793       189,901       17,080       (173,882 )     273,892  

OPERATING EXPENSES:

          

Selling, general and administrative

     49,087       49,319       5,198       (54,099 )     49,505  

Marketing and reservation

     129,856       127,554       6,224       (119,783 )     143,851  

Other items, net

     1,600       3,643       544       —         5,787  
                                        

Total operating expenses

     180,543       180,516       11,966       (173,882 )     199,143  

Operating income

     60,250       9,385       5,114       —         74,749  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     6,505       (259 )     (32 )     —         6,214  

Other items, net

     (167 )     (1,747 )     (783 )     —         (2,697 )

Equity in earnings of consolidated subsidiaries

     (11,108 )     —         —         11,108       —    
                                        

Total other income and expenses, net

     (4,770 )     (2,006 )     (815 )     11,108       3,517  
                                        

Income before income taxes

     65,020       11,391       5,929       (11,108 )     71,232  

Income taxes

     20,060       5,420       792       —         26,272  
                                        

Net income

   $ 44,960     $ 5,971     $ 5,137     $ (11,108 )   $ 44,960  
                                        

 

14


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Six Months Ended June 30, 2006

(Unaudited, In Thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Royalty fees

   $ 85,905     $ 46,223     $ 7,132     $ (46,250 )   $ 93,010  

Initial franchise and relicensing fees

     12,366       —         —         —         12,366  

Brand solutions

     7,682       —         —         —         7,682  

Marketing and reservation

     111,122       124,134       4,299       (108,837 )     130,718  

Other items, net

     4,022       2,160       —         —         6,182  
                                        

Total revenues

     221,097       172,517       11,431       (155,087 )     249,958  

OPERATING EXPENSES:

          

Selling, general and administrative

     43,725       41,840       1,577       (46,625 )     40,517  

Marketing and reservation

     117,241       118,458       3,481       (108,462 )     130,718  

Other items, net

     1,594       4,567       375       —         6,536  
                                        

Total operating expenses

     162,560       164,865       5,433       (155,087 )     177,771  

Operating income

     58,537       7,652       5,998       —         72,187  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     8,453       (388 )     19       —         8,084  

Other items, net

     232       (311 )     (497 )     —         (576 )

Equity in earnings of consolidated subsidiaries

     (10,035 )     —         —         10,035       —    
                                        

Total other income and expenses, net

     (1,350 )     (699 )     (478 )     10,035       7,508  
                                        

Income before income taxes

     59,887       8,351       6,476       (10,035 )     64,679  

Income taxes

     18,086       4,232       560       —         22,878  
                                        

Net income

   $ 41,801     $ 4,119     $ 5,916     $ (10,035 )   $ 41,801  
                                        

 

15


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Balance Sheet

As of June 30, 2007

(Unaudited, In thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
   Non-Guarantor
Subsidiaries
   Eliminations     Consolidated  

ASSETS

            

Cash and cash equivalents

   $ 9,595     $ 546    $ 37,189    $ —       $ 47,330  

Receivables

     40,734       760      4,501      —         45,995  

Other current assets

     7,927    

 

8,935

     1,287      —         18,149  
                                      

Total current assets

     58,256    

 

10,241

     42,977      —         111,474  

Property and equipment, at cost, net

     16,504       26,437      733      —         43,674  

Goodwill

     60,620       5,193      —        —         65,813  

Franchise rights and other identifiable intangibles, net

     22,469       6,118      5,090      —         33,677  

Investments, employee benefit plans, at fair value

     —         34,083      —        —         34,083  

Investment in and advances to affiliates

     211,018       123,252      48,553      (382,823 )     —    

Receivable, marketing fees

     7,449       —        —        (310 )     7,139  

Deferred income taxes

     —         37,807      731      (13,151 )     25,387  

Other assets

     1,233       9,410      434      (280 )     10,797  
                                      

Total assets

   $ 377,549     $ 252,541    $ 98,518    $ (396,564 )   $ 332,044  
                                      

Accounts payable

   $ 8,890     $ 28,627    $ 4,028      —       $ 41,545  

Accrued expenses and other

     14,556       17,049      1,466      —         33,071  

Deferred revenue

     7,214       41,770      —        —         48,984  

Deferred compensation & retirement plan obligations

     —      

 

3,343

     —        —         3,343  

Income taxes payable

     8,810       7,476      1,650      —         17,936  
                                      

Total current liabilities

     39,470    

 

98,265

     7,144      —         144,879  

Long-term debt

     199,146       —        —        —         199,146  

Deferred compensation & retirement plan obligations

     —      

 

41,541

     2      —      

 

41,543

 

Advances from affiliates

     180,610       6,011      49,261      (235,882 )     —    

Payable, marketing fees

     —         310      —        (310 )     —    

Deferred income taxes

     13,151       —        —        (13,151 )     —    

Other liabilities

     17,025       839      745      (280 )     18,329  
                                      

Total liabilities

     449,402       146,966      57,152      (249,623 )     403,897  
                                      

Total shareholders’ deficit

     (71,853 )     105,575      41,366      (146,941 )     (71,853 )
                                      

Total liabilities and shareholders’ deficit

   $ 377,549     $ 252,541    $ 98,518    $ (396,564 )   $ 332,044  
                                      

 

16


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Balance Sheet

As of December 31, 2006

(In thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
   Non-Guarantor
Subsidiaries
   Eliminations     Consolidated  

ASSETS

            

Cash and cash equivalents

   $ 10,072     $ 213    $ 25,556    $ —       $ 35,841  

Receivables

     35,885       358      5,451      —         41,694  

Other current assets

     9,317       7,489      645      (7,904 )     9,547  
                                      

Total current assets

     55,274       8,060      31,652      (7,904 )     87,082  

Property and equipment, at cost, net

     17,270       24,793      739      —         42,802  

Goodwill

     60,620       5,193      —        —         65,813  

Franchise rights and other identifiable intangibles, net

     23,885       6,427      5,197      —         35,509  

Investments, employee benefit plans, at fair value

     —         31,529      —        —         31,529  

Investment in and advances to affiliates

     184,223       129,728      47,947      (361,898 )     —    

Receivable, marketing fees

     6,972       —        —        (310 )     6,662  

Deferred income taxes

     —         33,842      728      (12,119 )     22,451  

Other assets

     1,055       10,170      236      —         11,461  
                                      

Total assets

   $ 349,299     $ 249,742    $ 86,499    $ (382,231 )   $ 303,309  
                                      

LIABILITIES AND SHAREHOLDERS’ DEFICIT

            

Current portion of long-term debt

   $ 146     $ —      $ —      $ —       $ 146  

Accounts payable

     9,503       28,735      3,578      —         41,816  

Accrued expenses and other

     14,988       28,617      1,701      —         45,306  

Deferred revenue

     7,485       39,622      60      —         47,167  

Income taxes payable

     —         11,587      1,673      (7,904 )     5,356  
                                      

Total current liabilities

     32,122       108,561      7,012      (7,904 )     139,791  

Long-term debt

     172,390       —        —        —         172,390  

Deferred compensation & retirement plan obligations

     —         40,099      2      —         40,101  

Advances from affiliates

     182,114       5,609      41,032      (228,755 )     —    

Payable, marketing fees

     —         310      —        (310 )     —    

Deferred income taxes

     12,119       —        —        (12,119 )     —    

Other liabilities

     12,934       —        473      —         13,407  
                                      

Total liabilities

     411,679       154,579      48,519      (249,088 )     365,689  
                                      

Total shareholders’ deficit

     (62,380 )     95,163      37,980      (133,143 )     (62,380 )
                                      

Total liabilities and shareholders’ deficit

   $ 349,299     $ 249,742    $ 86,499    $ (382,231 )   $ 303,309  
                                      

 

17


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Statement of Cash Flows

For the Six Months Ended June 30, 2007

(Unaudited, In thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations    Consolidated  

Net Cash Provided from Operating Activities

   $ 40,352     $ 4,831     $ 11,963     —      $ 57,146  
                                     

Cash Flows From Investing Activities

           

Investment in property and equipment

     (1,689 )     (3,973 )     (124 )   —        (5,786 )

Acquisitions, net of cash acquired

     —         —         (343 )   —        (343 )

Issuance of notes receivable

     (3,038 )     (217 )     —       —        (3,255 )

Collection of notes receivable

     75       394       —       —        469  

Purchases of investments, employee benefit plans

     —         (5,701 )     —       —        (5,701 )

Proceeds from the sales of investments, employee benefit plans

     —         1,551       —       —        1,551  

Other items, net

     (225 )     (271 )     137     —        (359 )
                                     

Net Cash Used in Investing Activities

     (4,877 )     (8,217 )     (330 )   —        (13,424 )
                                     

Cash Flows from Financing Activities

           

Principal payments of long-term debt

     (422 )     —         —       —        (422 )

Net borrowings pursuant to revolving credit facility

     27,000       —         —       —        27,000  

Purchase of treasury stock

     (47,341 )     —         —       —        (47,341 )

Excess tax benefits from stock-based compensation

     46       3,719       —       —        3,765  

Dividends paid

     (19,751 )     —         —       —        (19,751 )

Proceeds from exercise of stock options

     4,516       —         —       —        4,516  
                                     

Net Cash Provided (Used) from Financing Activities

     (35,952 )     3,719       —       —        (32,233 )
                                     

Net change in cash and cash equivalents

     (477 )     333       11,633     —        11,489  

Cash and cash equivalents at beginning of period

     10,072       213       25,556     —        35,841  
                                     

Cash and Cash Equivalents at End of Period

   $ 9,595     $ 546     $ 37,189     —      $ 47,330  
                                     

 

18


Table of Contents

Choice Hotels International, Inc.

Condensed Consolidating Statement of Cash Flows

For the Six Months Ended June 30, 2006

(Unaudited, In thousands)

 

     Choice Hotels
International, Inc.
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations    Consolidated  

Net Cash Provided (Used) from Operating Activities

   $ 58,192     $ (2,387 )   $ 6,823     —      $ 62,628  
                                     

Cash Flows From Investing Activities

           

Investment in property and equipment

     (2,633 )     (1,361 )     (51 )   —        (4,045 )

Issuance of notes receivable

     —         (1,277 )     —       —        (1,277 )

Collections of notes receivable

     —         359       —       —        359  

Purchases of investments, employee benefit plans

     —         (5,784 )     —       —        (5,784 )

Proceeds from the sale of investments, employee benefit plans

     —         1,387       —       —        1,387  

Other items, net

     (132 )     (591 )     427     —        (296 )
                                     

Net Cash Provided (Used) from Investing Activities

     (2,765 )     (7,267 )     376     —        (9,656 )
                                     

Cash Flows from Financing Activities

           

Principal payment of long-term debt

     (73 )     —         —       —        (73 )

Net repayments pursuant to revolving credit facilities

     (49,600 )     —         —       —        (49,600 )

Purchase of treasury stock

     (1,132 )     —         —       —        (1,132 )

Excess tax benefits from stock-based compensation

     3,965       8,018       —       —        11,983  

Debt issuance costs

     (472 )     —         —       —        (472 )

Dividends paid

     (16,925 )     —         —       —        (16,925 )

Proceeds from exercise of stock options

     7,984       —         —       —        7,984  
                                     

Net Cash Provided (Used) in Financing Activities

     (56,253 )     8,018       —       —        (48,235 )
                                     

Net change in cash and cash equivalents

     (826 )     (1,636 )     7,199     —        4,737  

Cash and cash equivalents at beginning of period

     5,848       2,052       9,021     —        16,921  
                                     

Cash and Cash Equivalents at End of Period

   $ 5,022     $ 416     $ 16,220     —      $ 21,658  
                                     

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.

The following table presents the financial information for the Company’s franchising segment:

 

     Three Months Ended June 30, 2007    Three Months Ended June 30, 2006

(In thousands)

   Franchising    Corporate &
Other
    Consolidated    Franchising    Corporate &
Other
    Consolidated

Revenues

   $ 156,516    $ 1,193     $ 157,709    $ 139,360    $ 1,180     $ 140,540

Operating income (loss)

   $ 58,400    $ (11,037 )   $ 47,363    $ 54,665    $ (12,551 )   $ 42,114
     Six Months Ended June 30, 2007    Six Months Ended June 30, 2006

(In thousands)

   Franchising    Corporate &
Other
    Consolidated    Franchising    Corporate &
Other
    Consolidated

Revenues

   $ 271,603    $ 2,289     $ 273,892    $ 247,798    $ 2,160     $ 249,958

Operating income (loss)

   $ 97,971    $ (23,222 )   $ 74,749    $ 95,031    $ (22,844 )   $ 72,187

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 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 April 2007, two punitive 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.

 

19


Table of Contents

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 June 2010. In the second quarter of 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 licensing 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.

12. 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 June 30, 2007, approximately $3.1 million of termination benefits remained of which $2.9 million is included in current liabilities and $0.2 million in other long-term liabilities in the Company’s consolidated financial statements.

13. 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.

14. Subsequent Event

Subsequent to June 30, 2007 through August 9, 2007, the Company repurchased an additional 1.3 million shares of its common stock at a total cost of $50.5 million.

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. At June 30, 2007, no liabilities had been recorded related to the contingent cash payments. Subsequent to June 30, 2007, the Company has determined that the performance conditions can no longer be satisfied and therefore the contingent consideration will not be earned.

 

20


Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 5,474 hotels open and 943 hotels under development as of June 30, 2007, with 445,826 rooms and 75,747 rooms, respectively, in 49 states, the District of Columbia and 38 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 six months ended June 30, 2007 while representing approximately 21% of hotels open at June 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.

Our 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 endorsed 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 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 endorsed 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 June 30, 2007, we

 

21


Table of Contents

have repurchased 34.8 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 $758 million since the program’s inception. Considering the effect of the two-for-one stock split, the Company has repurchased 67.8 million shares at an average price of $11.17 per share through June 30, 2007. At June 30, 2007, the Company had 3.9 million shares remaining under our current board of directors’ authorization. The Company expects to continue to return value to its 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 six months ended June 30, 2007, we paid cash dividends totaling approximately $9.9 million and $19.8 million, respectively and we presently expect to continue to pay dividends in the future. On May 1, 2007, our board of directors declared a cash dividend of $0.15 on outstanding common shares payable on July 20, 2007 to shareholders of record on July 6, 2007. Based on our present dividend rate and outstanding share count, aggregate annual dividends would be approximately $39.3 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 June 30, 2007, royalty fees revenue totaled $59.2 million, an 11% increase from the same period in 2006. Operating income totaled $47.4 million for the three months ended June 30, 2007, a $5.2 million or 12% increase from the same period in 2006. Net income for the three months ended June 30, 2007 increased $4.5 million to $28.6 million, a 19% increase from the second quarter of 2006. Diluted earnings per share for the second quarter of 2007 were $0.43 compared to $0.36 for the second quarter of 2006, a 19% improvement resulting primarily from increased net income. 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 six months ended June 30, 2007 and 2006, net cash provided by operating activities was $57.1 million and $62.6 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.

 

22


Table of Contents

Operations Review

Comparison of Operating Results for the Three-Month Periods Ended June 30, 2007 and June 30, 2006

The Company recorded net income of $28.6 million for the three months ended June 30, 2007, an increase of $4.5 million, or 19% from $24.1 million for the quarter ended June 30, 2006. The increase in net income for the three months ended June 30, 2007 is primarily attributable to a $5.2 million increase in operating income, a $0.8 million decline in interest expense, a $1.9 million increase in interest and other investment income, offset by an increase in the effective income tax rate to 37.8% from 36.0%.The effective income tax rate increased primarily due to a decline in the proportion of foreign income earned over the prior year period, which is taxed at lower rates than statutory U.S. income tax rates. Operating income increased as a result of an $8.1 million, or 12% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) partially offset by a $3.4 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. The $3.1 million decline in net other income and expenses was primarily related to investment gains on assets held in the Company’s non-qualified employee benefit plans and an $0.8 million decline in interest expense due to lower average debt balances.

Summarized financial results for the three months ended June 30, 2007 and 2006 are as follows:

 

(in thousands, except per share amounts)    2007     2006  

REVENUES:

    

Royalty fees

   $ 59,176     $ 53,146  

Initial franchise and relicensing fees

     7,649       6,723  

Brand solutions

     5,995       4,900  

Marketing and reservation

     81,810       72,742  

Hotel operations

     1,193       1,180  

Other

     1,886       1,849  
                

Total revenues

     157,709       140,540  
                

OPERATING EXPENSES:

    

Selling, general and administrative

     25,605       22,242  

Depreciation and amortization

     2,137       2,642  

Marketing and reservation

     81,810       72,742  

Hotel operations

     794       800  
                

Total operating expenses

     110,346       98,426  
                

Operating income

     47,363       42,114  
                

OTHER INCOME AND EXPENSES, NET:

    

Interest expense

     3,217       4,044  

Interest and other investment (income) loss

     (1,721 )     174  

Equity in net income of affiliates

     (181 )     (130 )

Loss on extinguishment of debt

     —         342  
                

Total other income and expenses, net

     1,315       4,430  
                

Income before income taxes

     46,048       37,684  

Income taxes

     17,403       13,548  
                

Net income

   $ 28,645       24,136  
                

Weighted average shares outstanding – diluted

     66,599       67,105  
                

Diluted earnings per share

   $ 0.43     $ 0.36  
                

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 $74.7 million for the three months ended June 30, 2007 compared to $66.6 million for the three months ended June 30, 2006. The growth in franchising revenues is primarily due to an 11% increase in royalty revenues, a 14% increase in initial franchise and relicensing fees and a 22% increase in brand solutions revenues.

Domestic royalty fees increased $4.3 million to $53.9 million from $49.6 million in the three months ended June 30, 2007, an increase of 8.7%. The increase in royalties is attributable to a combination of factors including a 4.2% increase in the number of domestic franchised hotel rooms, a 3.3% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system from 4.10% to 4.14%. System-wide RevPAR increases resulted primarily from average daily rate (“ADR”) increases of 4.4% over the prior year offset by a 60 basis point decline in occupancy rates.

 

23


Table of Contents

A summary of the Company’s domestic franchised hotels operating information is as follows:

 

    

For the Three Months Ended

June 30, 2007

  

For the Three Months Ended

June 30, 2006

   Change  
     Average Daily
Rate
   Occupancy     RevPAR    Average Daily
Rate
   Occupancy     RevPAR    Average Daily
Rate
    Occupancy
    RevPAR  

Comfort Inn

   $ 75.62    63.9 %   $ 48.29    $ 71.84    64.0 %   $ 45.97    5.3 %   -10 bps   5.0 %

Comfort Suites

     87.54    67.8 %     59.36      83.04    69.5 %     57.72    5.4 %   -170 bps   2.8 %

Sleep

     69.74    65.4 %     45.63      66.69    65.2 %     43.47    4.6 %   20 bps   5.0 %
                                                          

Midscale without
Food & Beverage

     77.32    64.9 %     50.18      73.42    65.2 %     47.90    5.3 %   -30 bps   4.8 %
                                                          

Quality

     68.96    55.4 %     38.19      66.18    56.5 %     37.36    4.2 %   -110 bps   2.2 %

Clarion

     80.13    53.1 %     42.51      77.77    53.5 %     41.63    3.0 %   -40 bps   2.1 %
                                                          

Midscale with
Food & Beverage

     71.58    54.8 %     39.24      69.01    55.7 %     38.44    3.7 %   -90 bps   2.1 %
                                                          

Econo Lodge

     52.85    48.4 %     25.55      52.09    47.5 %     24.75    1.5 %   90 bps   3.2 %

Rodeway

     51.47    46.1 %     23.71      49.98    44.5 %     22.23    3.0 %   160 bps   6.7 %
                                                          

Economy

     52.56    47.8 %     25.14      51.72    47.0 %     24.29    1.6 %   80 bps   3.5 %
                                                          

MainStay

     69.53    69.7 %     48.43      67.43    70.3 %     47.39    3.1 %   -60 bps   2.2 %

Suburban

     40.39    70.7 %     28.56      38.95    76.8 %     29.91    3.7 %   -610 bps   -4.5 %
                                                          

Extended Stay

     46.65    70.5 %     32.88      44.05    75.5 %     33.27    5.9 %   -500 bps   -1.2 %
                                                          

Total

   $ 70.98    59.1 %   $ 41.92    $ 67.98    59.7 %   $ 40.58    4.4 %   -60 bps   3.3 %
                                                          

The number of domestic rooms on-line increased to 346,712 as of June 30, 2007 from 332,656 as of June 30, 2006, an increase of 4.2%. The total number of domestic hotels on-line grew 5.1% to 4,326 as of June 30, 2007 from 4,116 as of June 30, 2006. A summary of the domestic hotels and rooms on-line at June 30, 2007 and 2006 by brand is as follows:

 

     June 30, 2007    June 30, 2006    Variance  
     Hotels    Rooms    Hotels    Rooms    Hotels     Rooms     %     %  

Comfort Inn

   1,424    111,230    1,411    110,440    13     790     0.9 %   0.7 %

Comfort Suites

   453    35,494    417    32,786    36     2,708     8.6 %   8.3 %

Sleep

   340    25,338    320    24,133    20     1,205     6.3 %   5.0 %
                                            

Midscale without Food & Beverage

   2,217    172,062    2,148    167,359    69     4,703     3.2 %   2.8 %
                                            

Quality

   783    75,840    692    68,407    91     7,433     13.2 %   10.9 %

Clarion

   161    23,378    157    23,262    4     116     2.5 %   0.5 %
                                            

Midscale with Food & Beverage

   944    99,218    849    91,669    95     7,549     11.2 %   8.2 %
                                            

Econo Lodge

   819    49,882    825    50,673    (6 )   (791 )   -0.7 %   -1.6 %

Rodeway

   256    15,412    203    12,469    53     2,943     26.1 %   23.6 %
                                            

Economy

   1,075    65,294    1,028    63,142    47     2,152     4.6 %   3.4 %
                                            

MainStay

   29    2,166    27    2,047    2     119     7.4 %   5.8 %

Suburban

   60    7,853    64    8,439    (4 )   (586 )   -6.3 %   -6.9 %
                                            

Extended Stay

   89    10,019    91    10,486    (2 )   (467 )   -2.2 %   -4.5 %
                                            

Cambria Suites

   1    119    —      —      1     119     NM     NM  
                                            

Total Domestic Franchises

   4,326    346,712    4,116    332,656    210     14,056     5.1 %   4.2 %
                                            

International rooms on-line increased to 99,114 as of June 30, 2007 from 98,818 as of June 30, 2006. The total number of international hotels on-line decreased from 1,168 as of June 30, 2006 to 1,148 as of June 30, 2007.

As of June 30, 2007, the Company had 858 franchised domestic hotels with 67,740 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 687 hotels and 53,765 rooms at June 30, 2006. The number of new construction franchised hotels in the Company’s domestic pipeline increased 24% to 611 at June 30, 2007 from 494 at June 30, 2006. The Company had an additional 85 franchised hotels with 8,007 rooms under development in its international system as of June 30, 2007 compared to 65 hotels and 5,993 rooms at June 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.

 

24


Table of Contents

A summary of the domestic franchised hotels under construction, awaiting conversion or approved for development at June 30, 2007 and 2006 by brand is as follows:

 

    

June 30, 2007

Units

  

June 30, 2006

Units

   Variance  
         Conversion     New Construction     Total  
   Conversion    New
Construction
   Total    Conversion    New
Construction
   Total    Units     %     Units     %     Units     %  

Comfort Inn

   42    121    163    40    101    141    2     5 %   20     20 %   22     16 %

Comfort Suites

   3    240    243    4    202    206    (1 )   (25 )%   38     19 %   37     18 %

Sleep Inn

   —      108    108    —      85    85    —       NM     23     27 %   23     27 %
                                                                  

Midscale without
Food & Beverage

   45    469    514    44    388    432    1     2 %   81     21 %   82     19 %
                                                                  

Quality

   68    11    79    55    14    69    13     24 %   (3 )   -21 %   10     14 %

Clarion

   23    7    30    18    4    22    5     28 %   3     75 %   8     36 %
                                                                  

Midscale with
Food & Beverage

   91    18    109    73    18    91    18     25 %   —       0 %   18     20 %
                                                                  

Econo Lodge

   44    4    48    24    6    30    20     83 %   (2 )   -33 %   18     60 %

Rodeway

   61    1    62    50    1    51    11     22 %   —       0 %   11     22 %
                                                                  

Economy

   105    5    110    74    7    81    31     42 %   (2 )   -29 %   29     36 %
                                                                  

MainStay

   1    33    34    1    35    36    —       0 %   (2 )   -6 %   (2 )   -6 %

Suburban

   5    30    35    1    18    19    4     400 %   12     67 %   16     84 %
                                                                  

Extended Stay

   6    63    69    2    53    55    4     200 %   10     19 %   14     25 %
                                                                  

Cambria Suites

   —      56    56    —      28    28    —       NM     28     100 %   28     100 %
                                                                  
   247    611    858    193    494    687    54     28 %   117     24 %   171     25 %
                                                                  

There were 72 net domestic franchise additions during the three months ended June 30, 2007 compared to 46 net franchise additions during the three months ended June 30, 2006. Gross domestic franchise additions increased from 114 for the three months ended June 30, 2006 to 122 for the same period of 2007. Net franchise terminations decreased to 50 from 68 for the three months ended June 30, 2007. The Company continues to execute its strategy to replace franchised hotels that do not meet our brand standards or are underperforming in their market. As the competition gets stronger and more focused on limited service franchising, the Company will continue to focus on improving its system hotels and utilizing the domestic hotels under development as a strong platform for continued system growth.

International royalties increased $1.7 million or 47% from $3.6 million in the second quarter of 2006 to $5.3 million for the same period of 2007 primarily due to the commencement of direct franchising operations in continental Europe which contributed $1.1 million of additional royalties.

New domestic franchise agreements executed in the three months ended June 30, 2007 totaled 176 representing 14,493 rooms compared to 155 agreements representing 12,956 rooms executed in the second quarter of 2006. During the second quarter of 2007, 68 of the executed agreements were for new construction hotel franchises, representing 5,570 rooms, compared to 58 contracts, representing 4,320 rooms for the same period a year ago. Conversion hotel franchise executed contracts totaled 108 representing 8,923 rooms for three months ended June 30, 2007 compared to 97 agreements representing 8,636 rooms from the same period a year ago. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise agreements increased 30% to $4.8 million for the three months ended June 30, 2007 from $3.7 million for the three months ended June 30, 2006. Higher revenues than the prior year resulted primarily from 21 additional executed agreements.

 

25


Table of Contents

A summary of executed domestic franchise agreements by brand for the three months ended June 30, 2007 and 2006 is as follows:

 

     For the Three Months Ended
June 30, 2007
  

For the Three Months Ended

June 30, 2006

   % Change  
     New
Construction
   Conversion    Total    New
Construction
   Conversion    Total    New
Construction
    Conversion     Total  

Comfort Inn

   11    17    28    9    5    14    22 %   240 %   100 %

Comfort Suites

   26    2    28    29    2    31    -10 %   0 %   -10 %

Sleep

   8    1    9    7    —      7    14 %   NM     29 %
                                                

Midscale without Food & Beverage

   45    20    65    45    7    52    0 %   186 %   25 %
                                                

Quality

   4    28    32    3    32    35    33 %   -13 %   -9  %

Clarion

   2    15    17    —      9    9    NM     67 %   89 %
                                                

Midscale with Food & Beverage

   6    43    49    3    41    44    100 %   5 %   11 %
                                                

Econo Lodge

   1    15    16    —      14    14    NM     7 %   14 %

Rodeway

   —      28    28    1    33    34    -100 %   -15 %   -18 %
                                                

Economy

   1    43    44    1    47    48    0 %   -9 %   -8 %
                                                

MainStay

   4    1    5    1    —      1    300 %   NM     400 %

Suburban

   3    1    4    3    2    5    0 %   -50 %   -20 %
                                                

Extended Stay

   7    2    9    4    2    6    75 %   0 %   50 %
                                                

Cambria Suites

   9    —      9    5    —      5    80 %   NM     80 %
                                                

Total Domestic System

   68    108    176    58    97    155    17 %   11 %   14 %
                                                

Relicensing fees are charged to the new property owner of a franchised property whenever an ownership change occurs and the property remains in the franchise system. During the three months ended June 30, 2007, relicensings increased 5% to 96 for the three months ended June 30, 2007 from 91 in the second quarter of 2006. Despite the increase in relicensing contracts, fees declined 3% to $2.9 million for the three months ended June 30, 2007 from $3.0 million for the three months ended June 30, 2006 primarily due to lower average fees earned per contract.

Brand solutions revenue increased $1.1 million or 22% to $6.0 million resulting primarily from increased vendor sponsorships of our annual franchisee convention.

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were $25.6 million for the three months ended June 30, 2007, an increase of $3.4 million from the three months ended June 30, 2006. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 34.3% for the three months ended June 30, 2007 compared to 33.4% for the three months ended June 30, 2006. Expenses as a percentage of franchise revenues increased primarily due to an additional $0.7 million in expenses related to the commencement of direct franchising operations in continental Europe.

Depreciation and Amortization: Expenses declined $0.5 million to $2.1 million for the three months ended June 30, 2007 due to the acceleration of depreciation in the prior year period resulting from the renovation and replacement of furniture, fixtures and equipment at two of the Company-owned MainStay Suites.

Marketing and Reservations: The Company’s franchise agreements require the payment of franchise fees, which include marketing and reservation fees. The fees, which are based on a percentage of the franchisees’ gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing and media advertising. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated.

Total marketing and reservations revenues were $81.8 million and $72.7 million for the three months ended June 30, 2007 and 2006, respectively. Depreciation and amortization attributable to marketing and reservation activities were $1.9 and $2.0 million for the three months ended June 30, 2007 and 2006, respectively. Interest expense attributable to reservation activities was $0.1 million and $0.2 million for the three months ended June 30, 2007 and 2006, respectively. Marketing and reservations activities generated $1.7 million and $0.7 million of positive operating cash flow for the six months ended June 30, 2007 and 2006, respectively. As of June 30, 2007 and December 31, 2006, the Company’s balance sheet includes a receivable of $7.1 million and $6.7 million, respectively resulting from the cumulative marketing expenses incurred in excess of accumulated marketing fees earned. These receivables are recorded as assets in the financial statements as the Company has the contractual authority to require that the franchisees in the system at any given point repay the Company for any deficits related to marketing and reservation activities. The Company’s current franchisees are legally obligated to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue. The Company has no present intention to accelerate repayment of the deficit from current franchisees. A payable has been recorded in the Company’s balance sheet within other long-term liabilities related to cumulative reservation fee revenues received in excess of reservation fee expenses incurred totaling $6.7 million and $8.4 million at June 30, 2007 and December 31, 2006, respectively. Cumulative reservation and marketing fees not expended are recorded as a payable on the financial statements and are carried over to the next fiscal year and expended in accordance with the franchise agreements.

Other Income and Expenses, Net: Other income and expenses, net, decreased $3.1 million to an expense of $1.3 million for the three months ended June 30, 2007 from $4.4 million for the same period in 2006. This decline resulted primarily from a $1.4 million increase in the fair value of investments held in non-qualified employee benefit plans versus a $0.3 million decline in the value of these investments in the prior year period. In addition, interest expense declined $0.8 million from $4.0 million to $3.2 million for the three months ended June 30, 2007. Interest expense declined due to lower outstanding borrowings on the Company’s variable rate debt partially offset by higher average interest rates. The Company’s weighted average interest rate as of June 30, 2007 was 6.42% compared to 6.34% as of June 30, 2006.

Income Taxes: The Company’s effective income tax provision rate was 37.8% for the three months ended June 30, 2007, an increase of 180 bps from the effective income tax provision rate of 36.0% for the three months ended June 30, 2006. The effective income tax rate increased primarily due to a decline in the proportion of foreign income earned over the prior year period, which is taxed at lower rates than statutory federal income tax rates. Depending upon the outcome of certain income

 

26


Table of Contents

tax contingencies during 2007 up to $2.0 million of additional income tax benefits may be reflected in our 2007 results of operations from the resolution of tax contingency reserves.

Net income for the three months ended June 30, 2007 increased by 19% to $28.6 million, and diluted earnings per share increased 19% to $0.43 for the three months ended June 30, 2007 from $0.36 reported for the three months ended June 30, 2006.

Comparison of Operating Results for the Six-Month Periods Ended June 30, 2007 and June 30, 2006

The Company recorded net income of $45.0 million for the six months ended June 30, 2007, an increase of $3.2 million, or 8% from $41.8 million for the six months ended June 30, 2006. The increase in net income for the six months ended June 30, 2007 is primarily attributable to a $2.6 million increase in operating income, a $1.9 million decline in interest expense and a $1.8 million increase in interest and other investment income. Operating income increased as a result of a $10.7 million, or 9% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) partially offset by a $9.0 million increase in selling, general and administrative expenses. The increase in selling, general and administration expenses was primarily due to executive termination benefits of $3.7 million incurred during the first quarter of 2007 as well as the commencement of direct franchising operations in continental Europe. The $4.0 million decline in net other income and expenses was primarily related to investment gains on assets held in the Company’s non-qualified employee benefit plans and a decline in interest expense due to lower average debt outstanding.

Summarized financial results for the six months ended June 30, 2007 and 2006 are as follows:

 

(in thousands, except per share amounts)    2007     2006  

REVENUES:

    

Royalty fees

   $ 102,504     $ 93,010  

Initial franchise and relicensing fees

     12,580       12,366  

Brand solutions

     8,981       7,682  

Marketing and reservation

     143,851       130,718  

Hotel operations

     2,289       2,160  

Other

     3,687       4,022  
                

Total revenues

     273,892       249,958  
                

OPERATING EXPENSES:

    

Selling, general and administrative

     49,505       40,517  

Depreciation and amortization

     4,252       4,991  

Marketing and reservation

     143,851       130,718  

Hotel operations

     1,535       1,545  
                

Total operating expenses

     199,143       177,771  
                

Operating income

     74,749       72,187  
                

OTHER INCOME AND EXPENSES, NET:

    

Interest expense

     6,214       8,084  

Interest and other investment income

     (2,322 )     (530 )

Equity in net income of affiliates

     (375 )     (388 )

Loss on the extinguishment of debt

     —         342  
                

Total other income and expenses, net

     3,517       7,508  
                

Income before income taxes

     71,232       64,679  

Income taxes

     26,272       22,878  
                

Net income

   $ 44,960     $ 41,801  
                

Weighted average shares outstanding – diluted

     66,823       66,925  
                

Diluted earnings per share

   $ 0.67     $ 0.62  
                

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 $127.8 million for the six months ended June 30, 2007 compared to $117.1 million for the six months ended June 30, 2006. The growth in franchising revenues is primarily due to a 10% and 17% increase in royalty and brand solutions revenues, respectively.

Domestic royalty fees increased $6.4 million to $92.8 million from $86.4 million in the six months ended June 30, 2007, an increase of 7.4%. The increase in royalties is attributable to a combination of factors including a 4.2% increase in the number of domestic franchised hotel rooms, a 2.6% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system from 4.09% to 4.14%. System-wide RevPAR increases resulted primarily from average daily rate increases of 4.1% over the prior year offset by an 80 basis point decline in occupancy rates.

 

27


Table of Contents

A summary of the Company’s domestic franchised hotels operating information is as follows:

 

    

For the Six Months Ended

June 30, 2007

  

For the Six Months Ended

June 30, 2006

   Change  
     Average Daily
Rate
   Occupancy     RevPAR    Average Daily
Rate
   Occupancy     RevPAR    Average Daily
Rate
    Occupancy
    RevPAR  

Comfort Inn

   $ 73.42    57.6 %   $ 42.29    $ 69.76    57.9 %   $ 40.40    5.2 %   -30 bps   4.7 %

Comfort Suites

     85.64    62.4 %     53.45      81.30    64.3 %     52.24    5.3 %   -190 bps   2.3 %

Sleep

     67.32    58.7 %     39.55      64.64    58.6 %     37.87    4.1 %   10 bps   4.4 %
                                                          

Midscale without
Food & Beverage

     75.19    58.8 %     44.18      71.46    59.2 %     42.34    5.2 %   -40 bps   4.3 %
                                                          

Quality

     66.62    49.6 %     33.03      64.26    50.8 %     32.63    3.7 %   -120 bps   1.2 %

Clarion

     77.42    47.2 %     36.57      77.11    48.1 %     37.11    0.4 %   -90 bps   -1.5 %
                                                          

Midscale with
Food & Beverage

     69.18    49.0 %     33.90      67.39    50.1 %     33.77    2.7 %   -110 bps   0.4 %
                                                          

Econo Lodge

     51.36    43.9 %     22.52      50.52    43.3 %     21.89    1.7 %   60 bps   2.9 %

Rodeway

     49.87    42.6 %     21.23      48.57    41.9 %     20.33    2.7 %   70 bps   4.4 %
                                                          

Economy

     51.04    43.6 %     22.24      50.18    43.1 %     21.61    1.7 %   50 bps   2.9 %
                                                          

MainStay

     67.91    64.0 %     43.47      66.48    63.7 %     42.33    2.2 %   30 bps   2.7 %

Suburban

     39.58    67.2 %     26.59      38.02    73.1 %     27.79    4.1 %   -590 bps   -4.3 %
                                                          

Extended Stay

     45.47    66.5 %     30.23      42.93    71.3 %     30.60    5.9 %   -480 bps   -1.2 %
                                                          

Total

   $ 68.89    53.5 %   $ 36.83    $ 66.16    54.3 %   $ 35.90    4.1 %   -80 bps   2.6 %
                                                          

Net domestic franchise additions during the six months ended June 30, 2007 were 115 compared with 68 for the same period a year ago. Gross domestic franchise additions increased from 186 for the six months ended June 30, 2006 to 215 for the same period of 2007. Net franchise terminations declined from 118 to 100 for the six months ended June 30, 2007. The Company continues to execute its strategy to replace franchised hotels that do not meet our brand standards or are underperforming in their market. As the competition gets stronger and more focused on limited service franchising, the Company will continue to focus on improving its system hotels and utilizing the domestic hotels under development as a strong platform for continued system growth.

International royalties increased $3.1 million or 47% from $6.6 million for the six months ended June 30, 2006 to $9.7 million for the same period of 2007 primarily due to the commencement of direct franchising operations in continental Europe which contributed $1.8 million of additional royalties.

New domestic franchise agreements executed in the first six months of 2007 totaled 287 representing 23,593 rooms compared to 275 agreements representing 23,648 rooms executed in the same period in 2006. During the first six months of 2007, 109 of the executed agreements were for new construction hotel franchises, representing 8,890 rooms, compared to 106 contracts, representing 8,337 rooms for the same period a year ago. Conversion hotel franchise executed contracts totaled 178 representing 14,703 rooms for six months ended June 30, 2007 compared to 169 agreements representing 15,311 rooms. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise agreements increased 10% to $7.5 million for the six months ended June 30, 2007 from $6.8 million for the six months ended June 30, 2006.

 

28


Table of Contents

A summary of executed domestic franchise agreements by brand for the six months ended June 30, 2007 and 2006 is as follows:

 

    

For the Six Months Ended

June 30, 2007

  

For the Six Months Ended

June 30, 2006

   % Change  
     New
Construction
   Conversion    Total    New
Construction
   Conversion    Total    New
Construction
    Conversion     Total  

Comfort Inn

   16    20    36    24    18    42    -33 %   11 %   -14 %

Comfort Suites

   40    3    43    41    2    43    -2 %   50 %   0 %

Sleep

   16    1    17    10    —      10    60 %   NM     70 %
                                                

Midscale without Food & Beverage

   72    24    96    75    20    95    -4 %   20 %   1 %
                                                

Quality

   5    63    68    5    57    62    0 %   11 %   10 %

Clarion

   4    21    25    1    18    19    300 %   17 %   32 %
                                                

Midscale with Food & Beverage

   9    84    93    6    75    81    50 %   12 %   15 %
                                                

Econo Lodge

   2    28    30    —      23    23    NM     22 %   30 %

Rodeway

   —      39    39    1    48    49    -100 %   -19 %   -20 %
                                                

Economy

   2    67    69    1    71    72    100 %   -6 %   -4 %
                                                

MainStay

   4    1    5    3    1    4    33 %   0 %   25 %

Suburban

   7    2    9    6    2    8    17 %   0 %   13 %
                                                

Extended Stay

   11    3    14    9    3    12    22 %   0 %   17 %
                                                

Cambria Suites

   15    —      15    15    —      15    0 %   NM     0 %
                                                

Total Domestic System

   109    178    287    106    169    275    3 %   5 %   4 %
                                                

Relicensing fees declined 11% to $5.0 million for the six months ended June 30, 2007 from $5.6 million for the six months ended June 30, 2006. Relicensing fees are charged to the new property owner of a franchised property whenever an ownership change occurs and the property remains in the franchise system. During the six months ended June 30, 2007, relicensings decreased 9% to 158 for the six months ended June 30, 2007 from 173 for the same period of 2006.

Brand solutions revenue increased $1.3 million or 17% to $9.0 million resulting primarily from increased vendor sponsorships of our annual franchisee convention.

Other income declined $0.3 million to $3.7 million for the six months ended June 30, 2007 primarily due to lower liquidated damage collections related to the early termination of franchise agreements.

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were $49.5 million for the six months ended June 30, 2007, an increase of $9.0 million from the six months ended June 30, 2006. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 38.8% for the six months ended June 30, 2007 compared to 34.6% for the six months ended June 30, 2006. Expenses increased primarily due to $3.7 million in termination benefits recorded related to the termination of certain executive officers and an additional $1.6 million in expenses related to the commencement of direct franchising operations in continental Europe.

Depreciation and Amortization: Expenses declined $0.7 million to $4.3 million for the six months ended June 30, 2007 due to the acceleration of depreciation in the prior year period resulting from the renovation and replacement of furniture, fixtures and equipment at two of the Company-owned MainStay Suites.

Marketing and Reservations: The Company’s franchise agreements require the payment of franchise fees, which include marketing and reservation fees. The fees, which are based on a percentage of the franchisees’ gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing and media advertising. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated.

Total marketing and reservations revenues were $143.9 million and $130.7 million for the six months ended June 30, 2007 and 2006, respectively. Depreciation and amortization attributable to marketing and reservation activities was $3.9 million for both the six months ended June 30, 2007 and 2006, respectively. Interest expense attributable to reservation activities was $0.3 million and $0.4 million for the six months ended June 30, 2007 and 2006, respectively.

Other Income and Expenses, Net: Other income and expenses, net, decreased $4.0 million to an expense of $3.5 million for the six months ended June 30, 2007 from $7.5 million for the same period in 2006. This decline resulted primarily from a $1.7 million increase in the fair value of investments held in non-qualified employee benefit plans versus a $0.3 million appreciation in value of these investments in the prior year period. In addition, interest expense declined $1.9 million from $8.1 million to $6.2 million. Interest expense declined due to lower outstanding borrowings on the Company’s variable rate debt partially offset by higher average interest rates. The Company’s weighted average interest rate as of June 30, 2007 was 6.42% compared to 6.34% as of June 30, 2006.

Income Taxes: The Company’s effective income tax provision rate was 36.9% for the six months ended June 30, 2007, an increase of 150 bps from the effective income tax provision rate of 35.4% for the six months ended June 30, 2006. The effective income tax rate increased primarily due to a decline in the proportion of foreign income earned over the prior year period, which is taxed at lower rates than statutory federal income tax rates. Depending upon the outcome of certain income tax contingencies during 2007 up to $2.0 million of additional income tax benefits may be reflected in our 2007 results of operations from the resolution of tax contingency reserves.

Net income for the six months ended June 30, 2007 increased by 8% to $45.0 million, and diluted earnings per share increased 8% to $0.67 for the six months ended

 

29


Table of Contents

June 30, 2007 from $0.62 reported for the six months ended June 30, 2006.