Form 10-Q
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 SEPTEMBER 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 SEPTEMBER 30, 2007

Common Stock, Par Value $0.01 per share

  62,842,388

 



Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

INDEX

 

     PAGE NO.

PART I. FINANCIAL INFORMATION:

  

Item 1—Financial Statements (Unaudited)

   3

Consolidated Statements of Income—For the three and nine months ended September 30, 2007 and September 30, 2006

   3

Consolidated Balance Sheets—As of September 30, 2007 and December 31, 2006

   4

Consolidated Statements of Cash Flows—For the nine months ended September 30, 2007 and September 30, 2006

   5

Notes to Consolidated Financial Statements

   7

Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations

   23

Item 3—Quantitative and Qualitative Disclosures About Market Risk

   39

Item 4—Controls and Procedures

   39

PART II. OTHER INFORMATION:

  

Item 1—Legal Proceedings

   39

Item 1A –Risk Factors

   39

Item 2—Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities

   40

Item 3—Defaults Upon Senior Securities

   40

Item 4—Submission of Matters to a Vote of Security Holders

   40

Item 5—Other Information

   40

Item 6—Exhibits

   40
SIGNATURE    43

 

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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
September 30,
    Nine Months Ended
September 30,
 
     2007     2006     2007     2006  

REVENUES:

        

Royalty fees

   $ 73,219     $ 64,364     $ 175,723     $ 157,374  

Initial franchise and relicensing fees

     8,902       7,733       21,482       20,099  

Brand solutions

     3,622       3,171       12,603       10,853  

Marketing and reservation

     86,795       73,001       230,646       203,719  

Hotel operations

     1,196       1,182       3,485       3,342  

Other

     2,675       1,545       6,362       5,567  
                                

Total revenues

     176,409       150,996       450,301       400,954  
                                

OPERATING EXPENSES:

        

Selling, general and administrative

     24,230       20,279       73,735       60,796  

Depreciation and amortization

     2,158       2,344       6,410       7,335  

Marketing and reservation

     86,795       73,001       230,646       203,719  

Hotel operations

     867       820       2,402       2,365  
                                

Total operating expenses

     114,050       96,444       313,193       274,215  
                                

Operating income

     62,359       54,552       137,108       126,739  

OTHER INCOME AND EXPENSES, NET:

        

Interest expense

     3,992       3,207       10,206       11,291  

Interest and other investment income

     (534 )     (569 )     (2,856 )     (1,099 )

Equity in net income of affiliates

     (462 )     (349 )     (837 )     (737 )

Loss on extinguishment of debt

     —         —         —         342  
                                

Total other income and expenses, net

     2,996       2,289       6,513       9,797  
                                

Income before income taxes

     59,363       52,263       130,595       116,942  

Income taxes

     20,969       5,906       47,241       28,784  
                                

Net income

   $ 38,394     $ 46,357     $ 83,354     $ 88,158  
                                

Weighted average shares outstanding-basic

     63,556       65,668       64,929       65,272  
                                

Weighted average shares outstanding-diluted

     64,602       67,152       66,077       67,009  
                                

Basic earnings per share

   $ 0.60     $ 0.71     $ 1.28     $ 1.35  
                                

Diluted earnings per share

   $ 0.59     $ 0.69     $ 1.26     $ 1.32  
                                

Cash dividends declared per share

   $ 0.17     $ 0.15     $ 0.47     $ 0.41  
                                

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

 

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Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

 

ASSETS   

September 30,

2007

    December 31,
2006
 

Current assets

    

Cash and cash equivalents

   $ 47,354     $ 35,841  

Receivables (net of allowance for doubtful accounts of $4,584 and $3,937, respectively)

     54,110       41,694  

Deferred income taxes

     3,062       1,790  

Investments, employee benefit plans, at fair value

     3,384       —    

Other current assets

     12,046       7,757  
                

Total current assets

     119,956       87,082  

Property and equipment, at cost, net

     44,036       42,802  

Goodwill

     65,813       65,813  

Franchise rights and other identifiable intangibles, net

     33,016       35,509  

Receivable – marketing fees

     87       6,662  

Investments, employee benefit plans, at fair value

     34,425       31,529  

Deferred income taxes

     29,732       22,451  

Other assets

     10,756       11,461  
                

Total assets

   $ 337,821     $ 303,309  
                
LIABILITIES AND SHAREHOLDERS’ DEFICIT     

Current liabilities

    

Current portion of long-term debt

   $ 8,400     $ 146  

Accounts payable

     41,271       41,816  

Accrued expenses and other

     36,974       45,306  

Deferred revenue

     47,087       47,167  

Income taxes payable

     13,970       5,356  

Deferred compensation and retirement plan obligations

     3,384       —    
                

Total current liabilities

     151,086       139,791  

Long-term debt

     269,962       172,390  

Deferred compensation and retirement plan obligations

     42,290       40,101  

Other liabilities

     23,482       13,407  
                

Total liabilities

     486,820       365,689  
                

Commitments and contingencies

    
SHAREHOLDERS’ DEFICIT     

Common stock, $0.01 par value, 160,000,000 shares authorized; 95,345,362 shares issued at September 30, 2007 and December 31, 2006 and 62,842,388 and 66,355,553 shares outstanding at September 30, 2007 and December 31, 2006, respectively

     628       664  

Additional paid-in-capital

     83,373       81,689  

Accumulated other comprehensive income (loss)

     830       (772 )

Treasury stock (32,502,974 shares and 28,989,809 shares at September 30, 2007 and December 31, 2006, respectively), at cost

     (770,212 )     (627,311 )

Retained earnings

     536,382       483,350  
                

Total shareholders’ deficit

     (148,999 )     (62,380 )
                

Total liabilities and shareholders’ deficit

   $ 337,821     $ 303,309  
                

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

 

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Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED, IN THOUSANDS)

 

     Nine Months Ended
September 30,
 
     2007     2006  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 83,354     $ 88,158  

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

    

Depreciation and amortization

     6,410       7,335  

Provision for bad debts

     133       35  

Non-cash stock compensation and other charges

     9,164       8,250  

Non-cash interest and other income

     (1,599 )     (385 )

Loss on extinguishment of debt

     —         342  

Dividends received from equity method investees

     495       657  

Equity in net income of affiliates

     (837 )     (737 )

Changes in assets and liabilities, net of acquisitions:

    

Receivables

     (12,155 )     (8,149 )

Receivable – marketing and reservation fees, net

     17,248       18,585  

Accounts payable

     (551 )     (2,227 )

Accrued expenses and other

     (9,403 )     (17,237 )

Income taxes payable

     8,614       19,776  

Deferred income taxes

     (9,035 )     (12,319 )

Deferred revenue

     (80 )     7,142  

Other assets

     (435 )     476  

Other liabilities

     9,081       5,888  
                

Net cash provided by operating activities

     100,404       115,590  
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Investment in property and equipment

     (8,734 )     (5,281 )

Acquisitions, net of cash acquired

     (343 )     —    

Issuance of notes receivable

     (6,066 )     (1,780 )

Collections of notes receivable

     1,675       772  

Purchases of investments, employee benefit plans

     (7,128 )     (7,976 )

Proceeds from sale of investments, employee benefit plans

     2,703       2,885  

Other items, net

     (468 )     (859 )
                

Net cash used in investing activities

     (18,361 )     (12,239 )
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Principal payments of long-term debt

     (422 )     (109 )

Net borrowings (repayments) pursuant to revolving credit facility

     106,200       (86,500 )

Purchase of treasury stock

     (156,749 )     (1,326 )

Excess tax benefits from stock-based compensation

     4,870       12,550  

Debt issuance costs

     —         (477 )

Dividends paid

     (29,522 )     (25,494 )

Proceeds from exercise of stock options

     5,093       8,162  
                

Net cash used in financing activities

     (70,530 )     (93,194 )
                

Net change in cash and cash equivalents

     11,513       10,157  

Cash and cash equivalents at beginning of period

     35,841       16,921  
                

Cash and cash equivalents at end of period

   $ 47,354     $ 27,078  
                

Supplemental disclosure of cash flow information:

    

Cash payments during the period for:

    

Income taxes, net of refunds

   $ 42,608     $ 20,993  

Interest

   $ 8,614     $ 9,367  

 

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Table of Contents
     Nine Months Ended
September 30,
     2007    2006

Non-cash financing activities:

     

Declaration of dividends

   $ 30,235    $ 26,952

Issuance of restricted shares of common stock

   $ 6,343    $ 7,005

Issuance of treasury stock to employee stock purchase plan

   $ 604      343

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

 

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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 balance sheet information was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The Company believes the disclosures made are adequate to make the information presented not misleading. The consolidated financial statements should be read in conjunction with the consolidated financial statements for the year ended December 31, 2006 and notes thereto included in the Company’s Form 10-K, filed with the Securities and Exchange Commission on March 1, 2007 (the “10-K”). Interim results are not necessarily indicative of the entire year results because of seasonal variations. All intercompany transactions and balances between Choice Hotels International, Inc. and its subsidiaries have been eliminated in consolidation.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Certain amounts in the prior year’s financial statements have been reclassified to conform to the current year presentation with no effect on previously reported net income or shareholders’ deficit.

The Company revised its presentation of cash flows for the nine months ended September 30, 2006 related to dividends received from equity method investees. During the first nine months of 2006, the Company had presented these cash flows as investing activities on its consolidated statement of cash flows. Statement of Financial Accounting Standards (“SFAS”) No. 95, “Statement of Cash Flows” requires these dividends, which represent a return on investments, to be classified as operating cash flows. There was no effect on any other previously reported income statement or balance sheet amounts.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with a maturity of three months or less at the date of purchase to be cash equivalents. As of September 30, 2007 and December 31, 2006, $7.1 million and $7.8 million, respectively, of book overdrafts representing outstanding checks in excess of funds on deposit are included in accounts payable in the accompanying consolidated balance sheets.

Land held for sale

In the second quarter of 2007, the Company acquired for resale 2.1 acres of undeveloped land in San Antonio, Texas at a cost of approximately $1.0 million. The Company concluded that the land qualified as land held for sale and has therefore recorded the land at its fair value as of September 30, 2007 in other current assets on the accompanying consolidated balance sheet.

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

The marketing fees receivable at September 30, 2007 and December 31, 2006 was $0.1 million and $6.7 million, respectively. As of September 30, 2007 and December 31, 2006, cumulative reservation fees collected exceeded expenses by $13.1 million and $8.4 million, respectively, and the excess has been reflected as a long-term liability in the accompanying consolidated balance sheets. Depreciation and amortization expense attributable to marketing and reservation activities was $2.0 million for both the three months ended September 30, 2007 and 2006, and $6.0 million and $5.9 million for the nine months ended September 30, 2007 and 2006, respectively. Interest expense attributable to reservation activities was $0.1 million and $0.2 million for the three months ended September 30, 2007 and 2006, respectively, and $0.4 million and $0.6 million for the nine months ended September 30, 2007 and 2006, respectively.

3. Income Taxes

The effective income tax rate of 36.2% for the nine months ended September 30, 2007 differs from the statutory rate due to foreign income earned, which is taxed at lower rates than statutory federal income tax rates; state income taxes; and certain federal and state income tax credits. The effective income tax rate of 24.6% for the nine months ended September 30, 2006 differs from the statutory rate due to the reversal of provisions for certain income tax contingencies, foreign income earned, which is taxed at lower rates than statutory federal income tax rates; state income taxes; and certain federal and state income tax credits.

 

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Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This pronouncement also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. As a result of the implementation of FIN 48, the Company increased its existing reserves for uncertain tax positions by $3.2 million with a corresponding net reduction to opening additional paid-in-capital and retained earnings.

As of January 1, 2007 and September 30, 2007, the Company had $8.2 million and $8.0 million, respectively of total unrecognized tax benefits of which approximately $5.1 million and $4.8 million, respectively would affect the effective tax rate if recognized. These unrecognized tax benefits relate principally to state tax filing positions and previously deducted expenses. The Company believes it is reasonably possible it will recognize tax benefits of up to $2.1 million within the next twelve months. This is related to the anticipated expiration of statutes of limitations of previously deducted expenses.

In many cases, the Company’s uncertain tax positions are related to tax years that remain subject to examination by the relevant tax authorities. The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state and foreign jurisdictions. The Company has substantially concluded all U.S. federal income tax matters for years through 2003. Substantially all material state and local and foreign income tax matters have been concluded for years through 2003. U.S. federal income tax returns for 2004 through 2006 are currently open for examination.

Estimated interest and penalties related to the underpayment of income taxes are classified as a component of income tax expense in the consolidated statements of income and totaled $0.1 million for the nine months ended September 30, 2007. During the three months ended September 30, 2007, the Company reversed $0.2 million of accrued interest and penalties related to the resolution of previously unrecognized tax benefits. Accrued interest and penalties were $1.1 million and $1.2 million as of January 1, 2007 and September 30, 2007, respectively.

We have estimated and accrued for certain tax assessments and the expected resolution of tax contingencies which arise in the course of our business. The ultimate outcome of these tax-related contingencies impact the determination of income tax expense and may not be resolved until several years after the related tax returns have been filed. Predicting the outcome of such tax assessments involves uncertainty and accordingly, actual results could differ from those estimates.

4. Comprehensive Income

The differences between net income and comprehensive income are described in the following table.

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 

(In thousands)

   2007     2006     2007     2006  

Net income

   $ 38,394     $ 46,357     $ 83,354     $ 88,158  

Other comprehensive income, net of tax:

        

Amortization of pension related costs, net of tax

        

Prior service costs

     6       —         20       —    

Actuarial loss

     9       —         29       —    

Curtailment and remeasurement, net of tax

     —         —         758       —    

Foreign currency translation adjustment, net

     454       (2 )     845       69  

Amortization of deferred gain on hedge, net

     (17 )     (17 )     (50 )     (50 )
                                

Other comprehensive income (loss)

     452       (19 )     1,602       19  
                                

Comprehensive income

   $ 38,846     $ 46,338     $ 84,956     $ 88,177  
                                

5. Capital Stock

Stock Options

The Company granted 0.2 million options to officers of the Company during both the nine months ended September 30, 2007 and 2006 at a fair value of approximately $2.6 million and $2.8 million, respectively. No options were granted during the three months ended September 30, 2007 and 2006. The stock options granted by the Company had an exercise price equal to the market price of the Company’s common stock on the date of grant. The fair value of the options granted was estimated on the grant date using the Black-Scholes option-pricing model with the following weighted average assumptions:

 

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     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 September 30, 2007 was $56.2 million and $48.7 million, respectively. The total intrinsic value of options exercised during the three months ended September 30, 2007 and 2006 was $1.6 million and $0.9 million, respectively, and $14.4 million and $41.5 million during the nine months ended September 30, 2007 and 2006, respectively.

The Company received $0.6 million and $5.1 million in proceeds from the exercise of approximately 0.1 million and 0.5 million employee stock options during the three and nine months ended September 30, 2007, respectively. During the three and nine months ended September 30, 2006, the Company received $0.2 million and $8.2 million in proceeds from the exercise of 0.02 million and 1.0 million employee stock options, respectively.

Restricted Stock

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

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2007    2006    2007    2006

Restricted share grants

     10,500      10,736      157,467      143,943

Weighted average grant date fair value per share

   $ 38.85    $ 42.50    $ 40.28    $ 48.67

Aggregate grant date fair value ($000)

   $ 408    $ 456    $ 6,343    $ 7,005

Restricted shares forfeited

     10,670      5,740      36,460      24,227

Vesting service period of shares granted

     4 years      4 years      4 years      4 years

Fair value of shares vested ($000)

   $ 357    $ 443    $ 5,794    $ 8,470

Compensation expense related to the fair value of these awards is recognized straight-line over the requisite service period on those restricted stock grants that ultimately vest. The fair value is measured by the average of the high and low market price of the Company’s common stock on the date of grant. Restricted stock awards in 2007 and 2006 vest ratably at 25 percent per year beginning with the first anniversary of the grant date.

Performance Vested Restricted Stock Units

The Company has granted performance vested restricted stock units (“PVRSU”) to certain officers. The vesting of these stock awards is contingent upon the Company achieving specified earnings per share targets at the end of specified performance periods and the employees’ continued employment. The performance conditions affect the number of shares that will ultimately vest. The range of possible stock-based award vesting is between 50% and 200% of the initial target. Under SFAS No. 123 (Revised), “Share-Based Payment” (“SFAS No. 123R”), compensation expense related to these awards will be recognized over the requisite period regardless of whether the performance targets have been met based on the Company’s estimate of the achievement of the performance target. The Company has currently estimated that between 100% and 130% of the various award targets will be achieved. The fair value is measured by the average of the high and low market price of the Company’s common stock on the date of grant. Compensation expense is recognized ratably over the requisite service period based on those PVRSUs that ultimately vest.

 

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

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2007    2006    2007    2006

Performance vested restricted stock units granted

   —        20,000      21,141      49,780

Weighted average grant date fair value per share

   —      $ 42.50    $ 40.75    $ 46.22

Aggregate grant date fair value ($000)

   —      $ 850    $ 862    $ 2,301

Requisite service period

   —        3-4 years      3 years      3-4 years

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

 

     Nine Months Ended September 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       157,467       40.28    21,141      40.75

Exercised/Vested

   (502,522 )     10.13       (142,299 )     29.20    —        —  

Forfeited/Expired

   (43,489 )     18.80       (36,460 )     32.89    —        —  
                                        

Outstanding at September 30, 2007

   2,525,105     $ 17.22    4.3 years    548,842     $ 32.76    70,921    $ 44.59
                                          

Options exercisable at September 30, 2007

   1,766,318     $ 11.31    3.5 years           
                            

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

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,

(in millions)

   2007    2006    2007    2006

Stock options

   $ 0.4    $ 0.8    $ 2.5    $ 3.2

Restricted stock

     1.4      1.4      4.4      3.9

Performance vested restricted stock units

     0.1      0.1      0.6      0.7
                           

Total

   $ 1.9    $ 2.3    $ 7.5    $ 7.8
                           

Income tax benefits

   $ 0.7    $ 0.9    $ 2.8    $ 2.9
                           

Stock-based compensation expense on stock option and performance vested restricted stock units made to a retirement eligible executive officer during the nine months ended September 30, 2007 and 2006 was recognized upon issuance of the grants rather than over the awards’ vesting periods since the terms of these grants provide that the awards will vest upon retirement of the employee. Compensation costs for stock options and performance vested restricted stock related to vesting upon retirement eligibility totaled $1.2 million and $1.3 million for the nine month periods ended September 30, 2007 and 2006, respectively.

Dividends

In September 2007, the Company’s board of directors approved an increase in the quarterly dividend rate from $0.15 to $0.17 per share (or approximately $10.6 million in the aggregate), which was paid on October 19, 2007 to shareholders of record on October 5, 2007. In May 2007, the Company declared a cash dividend of $0.15 per share (or approximately $9.8 million in the aggregate), which was paid on July 20, 2007 to shareholders of record on July 6, 2007. On February 12, 2007, the Company declared a cash dividend of $0.15 per share (or approximately $9.9 million in the aggregate), which was paid on April 20, 2007 to shareholders of record on April 5, 2007.

 

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In September 2006, the Company’s board of directors approved an increase in the quarterly dividend rate from $0.13 to $0.15 per share (or approximately $9.9 million in the aggregate), which was paid on October 20, 2006 to shareholders of record on October 6, 2006. In May 2006, the Company declared a cash dividend of $0.13 per share (or approximately $8.6 million in the aggregate), which was paid on July 21, 2006 to shareholders of record on July 7, 2006. In February 2006, the Company declared a cash dividend of $0.13 per share (or approximately $8.5 million in the aggregate), which was paid on April 21, 2006 to shareholders of record on April 7, 2006.

Stock Repurchase Program

During the three and nine months ended September 30, 2007, the Company purchased 2.9 million and 4.1 million shares of common stock under the share repurchase program at a total cost of $109.2 million and $155.2 million, respectively. The Company did not purchase any common stock during the three and nine months ended September 30, 2006 under the share repurchase program. In September 2007, the Company’s board of directors authorized an increase under the Company’s existing stock repurchase program to acquire up to an additional three million shares of its outstanding common stock and as a result, at September 30, 2007 the Company had 4.0 million shares remaining under the current board of directors’ authorization.

In addition, during the three and nine months ended September 30, 2007, the Company purchased 6,447 and 37,586 shares of common stock at a total cost of $0.2 million and $1.5 million, respectively, from employees to satisfy statutory minimum tax-withholding requirements from the vesting of restricted stock grants. During the three and nine months ended September 30, 2006, the Company purchased 1,172 and 27,966 shares of common stock at a total cost of $0.05 million and $1.3 million, respectively, to satisfy minimum tax-withholding requirements. These purchases were outside the share repurchase program initiated in September 1998.

6. Earnings Per Share

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

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,

(In thousands, except per share amounts)

   2007    2006    2007    2006

Computation of Basic Earnings Per Share:

           

Net income

   $ 38,394    $ 46,357    $ 83,354    $ 88,158
                           

Weighted average shares outstanding-basic

     63,556      65,668      64,929      65,272
                           

Basic earnings per share

   $ 0.60    $ 0.71    $ 1.28    $ 1.35
                           

Computation of Diluted Earnings Per Share:

           

Net income for diluted earnings per share

   $ 38,394    $ 46,357    $ 83,354    $ 88,158

Weighted average shares outstanding-basic

     63,556      65,668      64,929      65,272

Effect of Dilutive Securities:

           

Employee stock option and restricted stock plan

     1,046      1,484      1,148      1,737
                           

Weighted average shares outstanding-diluted

     64,602      67,152      66,077      67,009
                           

Diluted earnings per share

   $ 0.59    $ 0.69    $ 1.26    $ 1.32
                           

Basic earnings per share exclude dilution and are computed by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per share assumes dilution and is computed based on the weighted-average number of common shares outstanding after consideration of the dilutive effect of stock options and unvested restricted stock. The effect of dilutive securities is computed using the treasury stock method and average market prices during the period. At September 30, 2007 and 2006, PVRSUs totaling 70,921 and 49,780 were excluded from the computation since the performance conditions had not been met at the reporting date. In addition, the Company excluded 0.4 million anti-dilutive options from the computation of diluted earnings per share for both the three and nine months ended September 30, 2007 and 0.2 million for both the three and nine months ended September 30, 2006.

7. Pension Plans

The Company sponsors an unfunded non-qualified defined benefit plan (“SERP”) for certain senior executives. No assets are held with respect to the plan; therefore benefits are funded as paid to participants. Effective December 31, 2006, the Company began accounting for the SERP in accordance with SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). For the three and nine

 

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months ended September 30, 2007, the Company recorded $0.2 million and $1.0 million, respectively for the expenses related to the SERP which is included in selling, general and administrative expense in the accompanying consolidated statements of income. For the three and nine months ended September 30, 2006, the Company recorded $0.3 million and $0.9 million, respectively for the expenses related to the SERP. Based on the plan retirement age of 65 years old, no benefit payments are anticipated over the current year.

The following table presents the components of net periodic benefit costs for the three and nine months ended September 30, 2007 and 2006:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,

(In thousands)

   2007    2006    2007    2006

Components of net periodic pension cost:

           

Service cost

   $ 127    $ 169    $ 395    $ 508

Interest cost

     94      87      285      262

Amortization:

           

Prior service cost

     10      15      32      43

Loss

     13      19      46      57
                           
     244      290      758      870

Curtailment

     —        —        248      —  
                           

Net periodic pension cost

   $ 244    $ 290    $ 1,006    $ 870
                           

Curtailment

During the first quarter of 2007, the Company recognized a curtailment loss due to the termination of certain senior executive officers from the Company. The curtailment loss was equal to the unrecognized prior service costs attributed to these employees’ expected aggregate future services which totaled approximately $248,000. In addition, the monthly net periodic pension costs declined from approximately $106,000 to $82,000. The components of projected pension costs for the year ended December 31, 2007 are as follows:

 

     (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 nine months ended September 30, 2007:

 

     (In thousands)  

Projected benefit obligation, January 1, 2007

   $ 7,223  

Service cost

     395  

Interest cost

     285  

Remeasurement

     (962 )
        

Projected benefit obligation, September 30, 2007

   $ 6,941  
        

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

 

     (In thousands)  

Transition asset (obligation)

   $ —    

Prior service cost

     (605 )

Accumulated loss

     (1,106 )
        

Total

   $ (1,711 )
        

 

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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 September 30, 2007, the Company had $170 million of revolving loans outstanding pursuant to the Revolver. As of September 30, 2007, the Company was in compliance with all covenants under the Revolver.

In 1998, the Company completed a $100 million senior unsecured note offering (‘the Senior Notes’) at a discount of $0.6 million, bearing a coupon rate of 7.13% with an effective rate of 7.22%. The Senior Notes will mature on May 1, 2008, with interest on the Senior Notes paid semi-annually. The Senior Notes have been classified as a long-term liability at September 30, 2007, since the Company’s intention is to repay the Senior Notes upon maturity by utilizing the available capacity of the Revolver.

As of September 30, 2007, in addition to the Revolver and Senior Notes, the Company had a line of credit with a bank providing an aggregate of $10 million of borrowings, which is due upon demand. The line of credit ranks pari-pasu (or equally) with the Company’s Revolver and includes customary financial and other covenants that require the maintenance of certain ratios identical to those included in the Company’s Revolver. Borrowings under the line of credit bear interest rates established at the time of borrowing based on prime rate minus 175 basis points. As of September 30, 2007, the Company had $8.4 million outstanding pursuant to this line of credit.

In the second quarter of 2007, the Company repaid an outstanding note with a balance of $0.4 million by utilizing proceeds from the Revolver. The note had an original maturity date of January 1, 2009. The loan bore interest based on seventy percent of prime and required monthly principal and interest payments.

As of September 30, 2007, total debt outstanding for the Company was $278.4 million, of which $8.4 million was scheduled to mature in the twelve months ending September 30, 2008.

9. Condensed Consolidating Financial Statements

Effective July 14, 2006, the Company’s Senior Notes are guaranteed jointly, severally, fully and unconditionally by 7 wholly-owned domestic subsidiaries. There are no legal or regulatory restrictions on the payment of dividends to Choice Hotels International, Inc. from subsidiaries that do not guarantee the Senior Notes. As a result of these guarantee arrangements, the following condensed consolidating financial statements are presented. Investments in subsidiaries are accounted for under the equity method of accounting.

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Three Months Ended September 30, 2007

(Unaudited, In Thousands)

 

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

REVENUES:

          

Royalty fees

   $ 66,846     $ 20,660     $ 6,260     $ (20,547 )   $ 73,219  

Initial franchise and relicensing fees

     8,902       —         —         —         8,902  

Brand solutions

     3,622       —         —         —         3,622  

Marketing and reservation

     76,145       78,050       3,673       (71,073 )     86,795  

Other items, net

     2,675       1,196       —         —         3,871  
                                        

Total revenues

     158,190       99,906       9,933       (91,620 )     176,409  
                                        

OPERATING EXPENSES:

          

Selling, general and administrative

     21,533       21,074       2,170       (20,547 )     24,230  

Marketing and reservation

     79,636       74,824       3,408       (71,073 )     86,795  

Other items, net

     803       1,989       233       —         3,025  
                                        

Total operating expenses

     101,972       97,887       5,811       (91,620 )     114,050  
                                        

Operating income

     56,218       2,019       4,122       —         62,359  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     4,076       (116 )     32       —         3,992  

Other items, net

     (177 )     (109 )     (710 )     —         (996 )

Equity in earnings of consolidated subsidiaries

     (8,017 )     —         —         8,017       —    
                                        

Total other income and expenses, net

     (4,118 )     (225 )     (678 )     8,017       2,996  
                                        

Income before income taxes

     60,336       2,244       4,800       (8,017 )     59,363  

Income taxes

     21,942       (1,380 )     407       —         20,969  
                                        

Net income

   $ 38,394     $ 3,624     $ 4,393     $ (8,017 )   $ 38,394  
                                        

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Three Months Ended September 30, 2006

(Unaudited, In Thousands)

 

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

REVENUES:

          

Royalty fees

   $ 59,840     $ 21,264     $ 4,694     $ (21,434 )   $ 64,364  

Initial franchise and relicensing fees

     7,733       —         —         —         7,733  

Brand solutions

     3,171       —         —         —         3,171  

Marketing and reservation

     61,978       63,196       2,154       (54,327 )     73,001  

Other items, net

     1,545       1,182       —         —         2,727  
                                        

Total revenues

     134,267       85,642       6,848       (75,761 )     150,996  
                                        

OPERATING EXPENSES:

          

Selling, general and administrative

     21,793       19,091       829       (21,434 )     20,279  

Marketing and reservation

     65,473       60,081       1,774       (54,327 )     73,001  

Other items, net

     802       2,171       191       —         3,164  
                                        

Total operating expenses

     88,068       81,343       2,794       (75,761 )     96,444  
                                        

Operating income

     46,199       4,299       4,054       —         54,552  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     3,427       (240 )     20       —         3,207  

Other items, net

     (102 )     (359 )     (457 )     —         (918 )

Equity in earnings of consolidated subsidiaries

     (7,884 )     —         —         7,884       —    
                                        

Total other income and expenses, net

     (4,559 )     (599 )     (437 )     7,884       2,289  
                                        

Income before income taxes

     50,758       4,898       4,491       (7,884 )     52,263  

Income taxes

     4,401       1,095       410       —         5,906  
                                        

Net income

   $ 46,357     $ 3,803     $ 4,081     $ (7,884 )   $ 46,357  
                                        

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Nine Months Ended September 30, 2007

(Unaudited, In Thousands)

 

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

REVENUES:

          

Royalty fees

   $ 159,261     $ 74,693     $ 16,415     $ (74,646 )   $ 175,723  

Initial franchise and relicensing fees

     21,482       —         —         —         21,482  

Brand solutions

     12,603       —         —         —         12,603  

Marketing and reservation

     199,275       211,629       10,598       (190,856 )     230,646  

Other items, net

     6,362       3,485       —         —         9,847  
                                        

Total revenues

     398,983       289,807       27,013       (265,502 )     450,301  
                                        

OPERATING EXPENSES:

          

Selling, general and administrative

     70,620       70,393       7,368       (74,646 )     73,735  

Marketing and reservation

     209,492       202,378       9,632       (190,856 )     230,646  

Other items, net

     2,403       5,632       777       —         8,812  
                                        

Total operating expenses

     282,515       278,403       17,777       (265,502 )     313,193  
                                        

Operating income

     116,468       11,404       9,236       —         137,108  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     10,581       (375 )     —         —         10,206  

Other items, net

     (344 )     (1,856 )     (1,493 )     —         (3,693 )

Equity in earnings of consolidated subsidiaries

     (19,125 )     —         —         19,125       —    
                                        

Total other income and expenses, net

     (8,888 )     (2,231 )     (1,493 )     19,125       6,513  
                                        

Income before income taxes

     125,356       13,635       10,729       (19,125 )     130,595  

Income taxes

     42,002       4,040       1,199       —         47,241  
                                        

Net income

   $ 83,354     $ 9,595     $ 9,530     $ (19,125 )   $ 83,354  
                                        

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Nine Months Ended September 30, 2006

(Unaudited, In Thousands)

 

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

REVENUES:

          

Royalty fees

   $ 145,745     $ 67,417     $ 12,456     $ (68,244 )   $ 157,374  

Initial franchise and relicensing fees

     20,099       —         —         —         20,099  

Brand solutions

     10,853       —         —         —         10,853  

Marketing and reservation

     173,098       187,338       6,078       (162,795 )     203,719  

Other items, net

     5,567       3,342       —         —         8,909  
                                        

Total revenues

     355,362       258,097       18,534       (231,039 )     400,954  
                                        

OPERATING EXPENSES:

          

Selling, general and administrative

     65,721       60,994       2,325       (68,244 )     60,796  

Marketing and reservation

     182,905       178,539       5,070       (162,795 )     203,719  

Other items, net

     2,395       6,739       566       —         9,700  
                                        

Total operating expenses

     251,021       246,272       7,961       (231,039 )     274,215  
                                        

Operating income

     104,341       11,825       10,573       —         126,739  

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     11,880       (628 )     39       —         11,291  

Other items, net

     130       (670 )     (954 )     —         (1,494 )

Equity in earnings of consolidated subsidiaries

     (18,314 )     —         —         18,314       —    
                                        

Total other income and expenses, net

     (6,304 )     (1,298 )     (915 )     18,314       9,797  
                                        

Income before income taxes

     110,645       13,123       11,488       (18,314 )     116,942  

Income taxes

     22,487       5,327       970       —         28,784  
                                        

Net income

   $ 88,158     $ 7,796     $ 10,518     $ (18,314 )   $ 88,158  
                                        

 

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Choice Hotels International, Inc.

Condensed Consolidating Balance Sheet

As of September 30, 2007

(Unaudited, In thousands)

 

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

ASSETS

            

Cash and cash equivalents

   $ 8,664     $ 382    $ 38,308    $ —       $ 47,354  

Receivables

     46,920       449      6,741      —         54,110  

Other current assets

     7,035       10,080      1,377      —         18,492  
                                      

Total current assets

     62,619       10,911      46,426      —         119,956  

Property and equipment, at cost, net

     17,156       26,155      725      —         44,036  

Goodwill

     60,620       5,193      —        —         65,813  

Franchise rights and other identifiable intangibles, net

     21,923       5,963      5,130      —         33,016  

Investments, employee benefit plans, at fair value

     —         34,425      —        —         34,425  

Investment in and advances to affiliates

     226,701       127,498      54,106      (408,305 )     —    

Receivable, marketing fees

     397       —        —        (310 )     87  

Deferred income taxes

     —         38,220      734      (9,222 )     29,732  

Other assets

     1,360       9,148      463      (215 )     10,756  
                                      

Total assets

   $ 390,776     $ 257,513    $ 107,584      (418,052 )   $ 337,821  
                                      

Current portion of long-term debt

   $ 8,400     $ —      $ —      $ —       $ 8,400  

Accounts payable

     9,037       27,985      4,249      —         41,271  

Accrued expenses and other

     16,085       19,447      1,442      —         36,974  

Deferred revenue

     5,253       41,834      —        —         47,087  

Deferred compensation & retirement plan obligations

     —         3,384      —        —         3,384  

Income taxes payable

     6,642       5,600      1,728      —         13,970  
                                      

Total current liabilities

     45,417       98,250      7,419      —         151,086  

Long-term debt

     269,962       —        —        —         269,962  

Deferred compensation & retirement plan obligations

     —         42,288      2      —         42,290  

Advances from affiliates

     192,889       6,110      55,599      (254,598 )     —    

Payable, marketing fees

     13,110       310      —        (310 )     13,110  

Deferred income taxes

     9,222       —        —        (9,222 )     —    

Other liabilities

     9,175       690      722      (215 )     10,372  
                                      

Total liabilities

     539,775       147,648      63,742      (264,345 )     486,820  
                                      

Total shareholders’ (deficit) equity

     (148,999 )     109,865      43,842      (153,707 )     (148,999 )
                                      

Total liabilities and shareholders’ deficit

   $ 390,776     $ 257,513      107,584    $ (418,052 )   $ 337,821  
                                      

 

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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) equity

     (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  
                                      

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2007

(Unaudited, In thousands)

 

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

Net cash provided from operating activities

   $ 81,769     $ 5,600     $ 13,035     —      $ 100,404  
                                     

CASH FLOWS FROM INVESTING ACTIVITIES:

           

Investment in property and equipment

     (3,619 )     (4,936 )     (179 )   —        (8,734 )

Acquisitions, net of cash acquired

     —         —         (343 )   —        (343 )

Issuance of notes receivable

     (5,337 )     (729 )     —       —        (6,066 )

Collection of notes receivable

     1,075       600       —       —        1,675  

Purchases of investments, employee benefit plans

     —         (7,128 )     —       —        (7,128 )

Proceeds from the sales of investments, employee benefit plans

     —         2,703       —       —        2,703  

Other items, net

     (402 )     (305 )     239     —        (468 )
                                     

Net cash used in investing activities

     (8,283 )     (9,795 )     (283 )   —        (18,361 )
                                     

CASH FLOWS FROM FINANCING ACTIVITIES:

           

Principal payments of long-term debt

     (422 )     —         —       —        (422 )

Net borrowings pursuant to revolving credit facility

     106,200       —         —       —        106,200  

Purchase of treasury stock

     (156,749 )     —         —       —        (156,749 )

Excess tax benefits from stock-based compensation

     506       4,364       —       —        4,870  

Dividends paid

     (29,522 )     —         —       —        (29,522 )

Proceeds from exercise of stock options

     5,093       —         —       —        5,093  
                                     

Net cash provided (used) in financing activities

     (74,894 )     4,364       —       —        (70,530 )
                                     

Net change in cash and cash equivalents

     (1,408 )     169       12,752     —        11,513  

Cash and cash equivalents at beginning of period

     10,072       213       25,556     —        35,841  
                                     

Cash and cash equivalents at end of period

   $ 8,664     $ 382     $ 38,308     —      $ 47,354  
                                     

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2006

(Unaudited, In thousands)

 

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

Net cash provided (used) from operating activities

   $ 104,061     $ (1,126 )   $ 12,655     —      $ 115,590  
                                     

CASH FLOWS FROM INVESTING ACTIVITIES:

           

Investment in property and equipment

     (3,304 )     (1,901 )     (76 )   —        (5,281 )

Issuance of notes receivable

     —         (1,780 )     —       —        (1,780 )

Purchases of investments, employee benefit plans

     —         (7,976 )     —       —        (7,976 )

Proceeds from the sale of investments, employee benefit plans

     —         2,885       —       —        2,885  

Other items, net

     (210 )     343       (220 )   —        (87 )
                                     

Net cash used from investing activities

     (3,514 )     (8,429 )     (296 )   —        (12,239 )
                                     

CASH FLOWS FROM FINANCING ACTIVITIES:

           

Principal payment of long-term debt

     (109 )     —         —       —        (109 )

Net repayments pursuant to revolving credit facilities

     (86,500 )     —         —       —        (86,500 )

Purchase of treasury stock

     (1,326 )     —         —       —        (1,326 )

Excess tax benefits from stock-based compensation

     4,451       8,099       —       —        12,550  

Debt issuance costs

     (477 )     —         —       —        (477 )

Dividends paid

     (25,494 )     —         —       —        (25,494 )

Proceeds from exercise of stock options

     8,162       —         —       —        8,162  
                                     

Net cash provided (used) in financing activities

     (101,293 )     8,099       —       —        (93,194 )
                                     

Net change in cash and cash equivalents

     (746 )     (1,456 )     12,359     —        10,157  

Cash and cash equivalents at beginning of period

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

Cash and cash equivalents at end of period

   $ 5,102     $ 596     $ 21,380     —      $ 27,078  
                                     

10. Reportable Segment Information

The Company has a single reportable segment encompassing its franchising business. Revenues from the franchising business include royalty fees, initial franchise and relicensing fees, marketing and reservation fees, brand solutions revenue and other revenue. The Company is obligated under its franchise agreements to provide marketing and reservation services appropriate for the successful operation of its systems. These services do not represent separate reportable segments as their operations are directly related to the Company’s franchising business. The revenues received from franchisees that are used to pay for part of the Company’s central ongoing operations are included in franchising revenues and are offset by the related expenses paid for marketing and reservation activities to calculate franchising operating income. Corporate and other revenue consists of hotel operations. Except as described in Note 2, the Company does not allocate interest income, interest expense or income taxes to its franchising segment.

 

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

 

     Three Months Ended September 30, 2007    Three Months Ended September 30, 2006

(In thousands)

   Franchising    Corporate &
Other
    Consolidated    Franchising    Corporate &
Other
    Consolidated

Revenues

   $ 175,213    $ 1,196     $ 176,409    $ 149,814    $ 1,182     $ 150,996

Operating income (loss)

   $ 71,820    $ (9,461 )   $ 62,359    $ 64,838    $ (10,286 )   $ 54,552
     Nine Months Ended September 30, 2007    Nine Months Ended September 30, 2006

(In thousands)

   Franchising    Corporate &
Other
    Consolidated    Franchising    Corporate &
Other
    Consolidated

Revenues

   $ 446,816    $ 3,485     $ 450,301    $ 397,612    $ 3,342     $ 400,954

Operating income (loss)

   $ 169,791    $ (32,683 )   $ 137,108    $ 159,869    $ (33,130 )   $ 126,739

11. Commitments and Contingencies

The Company is a defendant in a number of lawsuits arising in the ordinary course of business. In the opinion of management and the Company’s legal counsel, the ultimate outcome of such litigation will not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.

In April 2007, two federal securities law class actions were filed in the United States District Court for the District of Colorado on behalf of persons who purchased the Company’s stock between April 25, 2006, and July 26, 2006. These substantially-similar lawsuits assert claims pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, against the Company, its current Vice Chairman and Chief Executive Officer, and its former Executive Vice President and Chief Financial Officer. These claims are related to the Company’s July 25, 2006 announcement of its results of operations for the second quarter of 2006.

Since the initial filings, the Company has filed a motion to transfer the litigation from Colorado to the United States District Court for the District of Maryland. Additionally, one plaintiff has petitioned the Court to be named lead plaintiff in the dispute. At this time, the Company has not responded to the complaints filed and is not required to do so until after a lead plaintiff is appointed and a consolidated complaint is filed. The Company believes that the allegations contained within these class action lawsuits are without merit and intends to vigorously defend the litigation.

The Company’s management does not expect that the outcome of any of its currently ongoing legal proceedings individually or collectively, will have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

In March 2006, the Company guaranteed $1 million of a bank loan funding a franchisee’s construction of a Cambria Suites in Green Bay, Wisconsin. The guaranty was scheduled to expire in September 2010. In February 2007, the Company was released from its obligations under the March 2006 guaranty, and subsequently, on May 3, 2007, issued a new $1 million guaranty for a bank loan funding the construction for the same franchisee’s Cambria Suites in Green Bay, Wisconsin. The guaranty expires in August 2010. The Company has received personal guarantees from several of the franchisee’s principal owners related to the repayment of any amounts paid by the Company under this guaranty.

In the ordinary course of business, the Company enters into numerous agreements that contain standard guarantees and indemnities whereby the Company indemnifies another party for breaches of representations and warranties. Such guarantees or indemnifications are granted under various agreements, including those governing (i) purchases or sales of assets or businesses, (ii) leases of real estate, (iii) licensing of trademarks, (iv) access to credit facilities, (v) issuances of debt or equity securities, and (vi) other operating agreements. The guarantees or indemnifications issued are for the benefit of the (i) buyers in sale agreements and sellers in purchase agreements, (ii) landlords in lease contracts, (iii) franchisees in franchise agreements, (iv) financial institutions in credit facility arrangements, and (v) underwriters in debt or equity security issuances. In addition, these parties may also be indemnified against any third party claim resulting from the transaction that is contemplated in the underlying agreement. While some of these guarantees extend only for the duration of the underlying agreement, many survive the expiration of the term of the agreement or extend into perpetuity (unless subject to a legal statute of limitations). There are no specific limitations on the maximum potential amount of future payments that the Company could be required to make under these guarantees, nor is the Company able to develop an estimate of the maximum potential amount of future payments to be made under these guarantees as the triggering events are not subject to predictability. With respect to certain of the aforementioned guarantees, such as indemnifications of landlords against third party claims for the use of real estate property leased by the Company, the Company maintains insurance coverage that mitigates any potential payments to be made.

 

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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 September 30, 2007, approximately $2.8 million of termination benefits remained of which $2.7 million is included in current liabilities and $0.1 million in other long-term liabilities in the Company’s consolidated financial statements.

13. Acquisition of Suburban Franchise Holding Company, Inc.

During 2005, the Company acquired 100% of the stock of Suburban Franchise Holding Company, Inc. (“Suburban”) and its wholly owned subsidiary, Suburban Franchise Systems, Inc. Beginning on the third anniversary of the closing, the merger provided for contingent cash payments of up to $5.0 million to be made upon the satisfaction of certain criteria. No liabilities had been previously recorded related to the contingent cash payments. During the three months ended September 30, 2007, the Company has determined that the performance conditions can no longer be satisfied and therefore the contingent consideration will not be earned.

14. Recently Issued Accounting Standards

In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements’” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the impact, if any, the adoption of this statement will have on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”) which provides reporting entities an option to report certain financial instruments and other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective as of the beginning of a reporting entity’s first fiscal year beginning after November 15, 2007. We are currently evaluating the impact, if any, the adoption of this statement will have on our consolidated financial statements.

 

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 5,533 hotels open and 954 hotels under development as of September 30, 2007, with 450,280 rooms and 76,823 rooms, respectively, in 49 states, the District of Columbia and 39 countries and territories outside the United States. Our brand names include Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Sleep Inn®, Econo Lodge®, Rodeway Inn® , MainStay Suites®, Suburban Extended Stay Hotel®, Cambria Suites™ and Flag Hotels®.

The Company conducts its international franchise operations through a combination of direct franchising and master franchising arrangements (which allow the use of our brands by third parties in foreign countries). The Company has made equity investments in certain non-domestic lodging franchise companies that conduct franchise operations for the Company’s brands under master franchising relationships. As a result of our use of master franchising relationships and international market conditions, total revenues from international operations comprised only 7% of our total revenues for the nine months ended September 30, 2007 while representing approximately 21% of hotels open at September 30, 2007.

During 2006, the Company acquired 100% of the stock of Choice Hotels Franchise GmbH (“CHG”). CHG was a wholly owned subsidiary of one of the Company’s master franchisees, The Real Hotel Company PLC (“RHC”), formerly known as CHE Hotel Group PLC. Under the master franchise agreement with RHC, CHG franchised hotels under the Company’s brands in Austria, Germany, Italy, Czech Republic and portions of Switzerland. As a result of this acquisition, the master franchise agreement between the Company and RHC covering these countries terminated. The results of CHG have been consolidated with the Company since October 30, 2006.

During 2006, the Company acquired RHC’s assets, including franchise contracts, related to its franchising of hotels under the Company’s brands in France, Belgium, Portugal, Spain and portions of Switzerland. As a result of the acquisition, the master franchise agreement between the Company and RHC covering these countries terminated and the Company commenced direct franchising operations in these countries on November 30, 2006.

 

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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 qualified vendor arrangements, hotel operations and other sources. The hotel industry is seasonal in nature. For most hotels, demand is lower in December through March than during the remainder of the year. Our principal source of revenues is franchise fees based on the gross room revenues of our franchised properties. The Company’s franchise fee revenues and operating income reflect the industry’s seasonality and historically have been lower in the first quarter than in the second, third or fourth quarters.

With a focus on hotel franchising instead of ownership, we benefit from the economies of scale inherent in the franchising business. The fee and cost structure of our business provides opportunities to improve operating results by increasing the number of franchised properties and effective royalty rates of our franchise contracts resulting in increased initial fee revenue; ongoing royalty fees and brand solutions revenues. In addition, our operating results can also be improved through our company wide efforts related to improving property level performance. In addition to these revenues, we also collect marketing and reservation fees to support centralized marketing and reservation activities for the franchise system. As a lodging franchisor, the Company has relatively low capital expenditure requirements.

The principal factors that affect the Company’s results are: the number and relative mix of franchised hotels; growth in the number of hotels and hotel rooms under franchise; occupancy and room rates achieved by the hotels under franchise; the effective royalty rate achieved; and our ability to manage costs. The number of rooms at franchised properties and occupancy and room rates at those properties significantly affect the Company’s results because our fees are based upon room revenues at franchised hotels. The key industry standard for measuring hotel-operating performance is revenue per available room (“RevPAR”), which is calculated by multiplying the percentage of occupied rooms by the average daily room rate realized. Our variable overhead costs associated with franchise system growth have historically been less than incremental royalty fees generated from new franchises. Accordingly, continued growth of our franchise business should enable us to realize benefits from the operating leverage in place and improve operating results.

We are contractually required by our franchise agreements to use the marketing and reservation fees we collect for system-wide marketing and reservation activities. These expenditures, which include advertising costs and costs to maintain our central reservations system, help to enhance awareness and increase consumer preference for our brands. Greater awareness and preference promotes long-term growth in business delivery to our franchisees, which ultimately increases franchise fees earned by the Company.

Our Company articulates its mission as a commitment to our customers’ profitability by providing our customers with hotel franchises that generate the highest return on investment of any hotel franchise. We have developed an operating system dedicated to our franchisees’ success that focuses on delivering guests to our franchised hotels and reducing costs for our hotel owners. We strive every day to continuously improve our franchise offerings to enhance our customers’ profitability and create the highest return on investment of any hotel franchise.

We believe that executing our strategic priorities creates value. Our Company focuses on two key value drivers:

Profitable Growth. Our success is dependent on improving the performance of our hotels, increasing our system size by selling additional hotel franchises and effective royalty rate improvement. We attempt to improve our franchisees’ revenues and overall profitability by providing a variety of products and services designed to increase business delivery to and/or reduce operating and development costs for our franchisees. These products and services include national marketing campaigns, a central reservation system, property and yield management systems, quality assurance standards and qualified vendor relationships. We believe that healthy brands, which deliver a compelling return on investment for franchisees, will enable us to sell additional hotel franchises and raise royalty rates. We have established multiple brands that meet the needs of many types of guests, and can be developed at various price points and applied to both new and existing hotels. This ensures that we have brands suitable for creating growth in a variety of market conditions. Improving the performance of the hotels under franchise, growing the system through additional franchise sales and improving franchise agreement pricing while maintaining a disciplined cost structure are the keys to profitable growth.

Maximizing Financial Returns and Creating Value for Shareholders. Our capital allocation decisions, including capital structure and uses of capital, are intended to maximize our return on invested capital and create value for our shareholders. We believe our strong and predictable cash flows create a strong financial position that provides us a competitive advantage. Our business does not require significant capital to operate and grow, therefore, we can maintain a capital structure that generates high financial returns and use our excess cash flow to increase returns to our shareholders. We have returned value to our shareholders in two primary ways: share repurchases and dividends. In 1998, we instituted a share repurchase program which has generated substantial value for our shareholders. Through September 30, 2007, we have repurchased 37.8 million shares (including 33.0 million prior to the two-for-one stock split effected in October 2005) of common stock at a total cost of $867.1 million since the program’s inception. Considering the effect of the two-for-one stock split, the Company has repurchased 70.8 million shares at an average price of $12.26 per share through September 30, 2007. In September 2007, the Company’s board of directors authorized an increase under the Company’s existing stock repurchase program to acquire up to an additional three million shares of its outstanding common stock. At September 30, 2007 the Company had 4.0 million shares remaining under the current board of directors’ authorization. The Company expects to continue to return value to

 

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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 nine months ended September 30, 2007, we paid cash dividends totaling approximately $9.8 million and $29.5 million, respectively, and we presently expect to continue to pay dividends in the future. On September 11, 2007, our board of directors declared a cash dividend of $0.17 on outstanding common shares payable on October 19, 2007 to shareholders of record on October 5, 2007. Based on our present dividend rate and outstanding share count, aggregate annual dividends would be approximately $40.2 million.

We believe these value drivers, when properly implemented, will enhance our profitability, maximize our financial returns and continue to generate value for our shareholders. The ultimate measure of our success will be reflected in the items below.

Results of Operation: Royalty fees, operating income, net income and diluted earnings per share (“EPS”) represent key measurements of these value drivers. In the three months ended September 30, 2007, royalty fees revenue totaled $73.2 million, a 14% increase from the same period in 2006. Operating income totaled $62.4 million for the three months ended September 30, 2007, a $7.8 million or 14% increase from the same period in 2006. Net income and diluted earnings per share declined 17% and 14%, respectively from the same period of the prior year primarily due to the resolution of income tax contingencies during third quarter of 2006 totaling $12.8 million or $0.19 per share compared to $0.7 million or $0.01 per share for the same period of 2007. These measurements will continue to be a key management focus in 2007 and beyond.

Refer to MD&A heading “Operations Review” for additional analysis of our results.

Liquidity and Capital Resources: The Company generates significant cash flows from operations. In the nine months ended September 30, 2007 and 2006, net cash provided by operating activities was $100.4 million and $115.6 million, respectively. Since our business does not require significant reinvestment of capital, we utilize cash in ways that management believes provide the greatest returns to our shareholders, which include share repurchases and dividends. We believe the Company’s cash flow from operations and available financing capacity are sufficient to meet the expected future operating, investing and financing needs of the business.

Refer to MD&A heading “Liquidity and Capital Resources” for additional analysis.

Operations Review

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

The Company recorded net income of $38.4 million for the three months ended September 30, 2007, an $8.0 million, or 17% decline from the $46.4 million for the quarter ended September 30, 2006. The decline in net income for the three months ended September 30, 2007 is primarily attributable to the resolution of income tax contingencies totaling $12.8 million during the three months ended September 30, 2006 which resulted in an effective income tax rate of 11.3% compared to 35.3% for the current year period. The increase in the Company’s effective income tax rate was partially offset by a $7.8 million increase in operating income. Operating income increased as a result of an $11.6 million, or 15% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) partially offset by a $4.0 million increase in selling, general and administrative expenses. The increase in selling, general and administration expenses was partially due to the commencement of direct franchising operations in continental Europe.

 

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

 

(in thousands, except per share amounts)    2007     2006  

REVENUES:

    

Royalty fees

   $ 73,219     $ 64,364  

Initial franchise and relicensing fees

     8,902       7,733  

Brand solutions

     3,622       3,171  

Marketing and reservation

     86,795       73,001  

Hotel operations

     1,196       1,182  

Other

     2,675       1,545  
                

Total revenues

     176,409       150,996  
                

OPERATING EXPENSES:

    

Selling, general and administrative

     24,230       20,279  

Depreciation and amortization

     2,158       2,344  

Marketing and reservation

     86,795       73,001  

Hotel operations

     867       820  
                

Total operating expenses

     114,050       96,444  
                

Operating income

     62,359       54,552  
                

OTHER INCOME AND EXPENSES, NET:

    

Interest expense

     3,992       3,207  

Interest and other investment income

     (534 )     (569 )

Equity in net income of affiliates

     (462 )     (349 )
                

Total other income and expenses, net

     2,996       2,289  
                

Income before income taxes

     59,363       52,263  

Income taxes

     20,969       5,906  
                

Net income

   $ 38,394     $ 46,357  
                

Weighted average shares outstanding – diluted

     64,602       67,152  
                

Diluted earnings per share

   $ 0.59     $ 0.69  
                

Management analyzes its business based on franchising revenues, which is total revenues excluding marketing and reservation revenues and hotel operations, and franchise operating expenses that are reflected as selling, general and administrative expenses.

Franchising Revenues: Franchising revenues were $88.4 million for the three months ended September 30, 2007 compared to $76.8 million for the three months ended September 30, 2006. The growth in franchising revenues is primarily due to a 14% increase in royalty revenues, a 15% increase in initial franchise and relicensing fees and a 73% increase in other income.

Domestic royalty fees increased $7.2 million to $67.2 million from $60.0 million in the three months ended September 30, 2007, an increase of 12%. The increase in royalties is attributable to a combination of factors including a 4.4% increase in the number of domestic franchised hotel rooms, a 5.6% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system from 4.07% to 4.12%. System-wide RevPAR increases resulted primarily from average daily rate (“ADR”) increases of 5.4% over the prior year and a 10 basis point increase in occupancy rates.

 

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

 

    

For the Three Months Ended

September 30, 2007

  

For the Three Months Ended

September 30, 2006

   Change  
    

Average Daily

Rate

   Occupancy     RevPAR   

Average Daily

Rate

   Occupancy     RevPAR   

Average Daily

Rate

    Occupancy    RevPAR  

Comfort Inn

   $ 82.60    73.2 %   $ 60.51    $ 78.25    72.6 %   $ 56.79    5.6 %   60bps    6.6 %

Comfort Suites

     90.64    72.7 %     65.88      86.19    73.3 %     63.22    5.2 %   (60)bps    4.2 %

Sleep

     73.09    70.8 %     51.72      69.80    69.6 %     48.61    4.7 %   120bps    6.4 %
                                                         

Midscale without Food & Beverage

     82.93    72.8 %     60.35      78.67    72.3 %     56.88    5.4 %   50bps    6.1 %
                                                         

Quality

     76.08    63.7 %     48.47      71.73    64.7 %     46.42    6.1 %   (100)bps    4.4 %

Clarion

     85.09    60.0 %     51.05      82.51    57.1 %     47.14    3.1 %   290bps    8.3 %
                                                         

Midscale with Food & Beverage

     78.10    62.8 %     49.08      74.19    62.8 %     46.60    5.3 %   —      5.3 %
                                                         

Econo Lodge

     59.07    56.3 %     33.24      57.22    56.1 %     32.11    3.2 %   20bps    3.5 %

Rodeway

     58.55    57.3 %     33.52      57.14    54.9 %     31.38    2.5 %   240bps    6.8 %
                                                         

Economy

     58.95    56.5 %     33.31      57.20    55.9 %     31.96    3.1 %   60bps    4.2 %
                                                         

MainStay

     73.34    75.3 %     55.26      68.86    77.1 %     53.12    6.5 %   (180)bps    4.0 %

Suburban

     40.89    70.3 %     28.76      38.95    75.4 %     29.36    5.0 %   (510)bps    (2.0) %
                                                         

Extended Stay

     49.27    71.6 %     35.26      44.89    75.7 %     34.00    9.8 %   (410)bps    3.7 %
                                                         

Total

   $ 76.90    66.9 %   $ 51.43    $ 72.96    66.8 %   $ 48.72    5.4 %   10bps    5.6 %
                                                         

The number of domestic rooms on-line increased to 350,701 as of September 30, 2007 from 335,884 as of September 30, 2006, an increase of 4.4%. The total number of domestic hotels on-line grew 5.7% to 4,396 as of September 30, 2007 from 4,157 as of September 30, 2006. A summary of the domestic hotels and rooms on-line at September 30, 2007 and 2006 by brand is as follows:

 

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

Comfort Inn

   1,429    111,505    1,411    110,525    18     980     1.3 %   0.9 %

Comfort Suites

   470    36,688    427    33,573    43     3,115     10.1 %   9.3 %

Sleep

   345    25,617    327    24,609    18     1,008     5.5 %   4.1 %
                                            

Midscale without Food & Beverage

   2,244    173,810    2,165    168,707    79     5,103     3.6 %   3.0 %
                                            

Quality

   804    77,515    709    69,699    95     7,816     13.4 %   11.2 %

Clarion

   166    23,685    160    23,733    6     (48 )   3.8 %   (0.2 )%
                                            

Midscale with Food & Beverage

   970    101,200    869    93,432    101     7,768     11.6 %   8.3 %
                                            

Econo Lodge

   824    50,273    815    50,013    9     260     1.1 %   0.5 %

Rodeway

   275    16,342    217    13,245    58     3,097     26.7 %   23.4 %
                                            

Economy

   1,099    66,615    1,032    63,258    67     3,357     6.5 %   5.3 %
                                            

MainStay

   29    2,166    27    2,046    2     120     7.4 %   5.9 %

Suburban

   52    6,691    64    8,441    (12 )   (1,750 )   (18.8 )%   (20.7 )%
                                            

Extended Stay

   81    8,857    91    10,487    (10 )   (1,630 )   (11.0 )%   (15.5 )%
                                            

Cambria Suites

   2    219    —      —      2     219     NM     NM  
                                            

Total Domestic Franchises

   4,396    350,701    4,157    335,884    239     14,817     5.7 %   4.4 %
                                            

International rooms on-line increased to 99,579 as of September 30, 2007 from 98,811 as of September 30, 2006. The total number of international hotels on-line decreased from 1,171 as of September 30, 2006 to 1,137 as of September 30, 2007.

 

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As of September 30, 2007, the Company had 872 franchised domestic hotels with 68,853 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 736 hotels and 57,117 rooms at September 30, 2006. The number of new construction franchised hotels in the Company’s domestic pipeline increased 27% to 642 at September 30, 2007 from 507 at September 30, 2006. The Company had an additional 82 franchised hotels with 7,970 rooms under development in its international system as of September 30, 2007 compared to 72 hotels and 6,462 rooms at September 30, 2006. While the Company’s hotel pipeline provides a strong platform for growth, a hotel in the pipeline does not always result in an open and operating hotel due to various factors.

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

 

    

September 30, 2007

Units

  

September 30, 2006

Units

   Variance  
         Conversion     New Construction     Total  
   Conversion   

New

Construction

   Total    Conversion   

New

Construction

   Total    Units     %     Units     %     Units     %  

Comfort Inn

   41    121    162    50    108    158    (9 )   (18 )%   13     12 %   4     3 %

Comfort Suites

   1    258    259    5    197    202    (4 )   (80 )%   61     31 %   57     28 %

Sleep Inn

   —      113    113    —      95    95    —       NM     18     19 %   18     19 %
                                                                  

Midscale without Food & Beverage

   42    492    534    55    400    455    (13 )   (24 )%   92     23 %   79     17 %
                                                                  

Quality

   61    12    73    67    11    78    (6 )   (9 )%   1     9 %   (5 )   (6 )%

Clarion

   23    7    30    14    4    18    9     64 %   3     75 %   12     67 %
                                                                  

Midscale with Food & Beverage

   84    19    103    81    15    96    3     4 %   4     27 %   7     7 %
                                                                  

Econo Lodge

   45    4    49    32    5    37    13     41 %   (1 )   (20 )%   12     32 %

Rodeway

   52    3    55    56    2    58    (4 )   (7 )%   1     50 %   (3 )   (5 )%
                                                                  

Economy

   97    7    104    88    7    95    9     10 %   —       0 %   9     9 %
                                                                  

MainStay

   1    36    37    1    33    34    —       0 %   3     9 %   3     9 %

Suburban

   6    31    37    4    19    23    2     50 %   12     63 %   14     61 %
                                                                  

Extended Stay

   7    67    74    5    52    57    2     40 %   15     29 %   17     30 %
                                                                  

Cambria Suites

   —      57    57    —      33    33    —       NM     24     73 %   24     73 %
                                                                  
   230    642    872    229    507    736    1     0 %   135     27 %   136     18 %
                                                                  

There were 70 net domestic franchise additions during the three months ended September 30, 2007 compared to 41 net franchise additions during the three months ended September 30, 2006. Gross domestic franchise additions increased from 85 for the three months ended September 30, 2006 to 118 for the same period of 2007. Net franchise terminations increased to 48 from 44 for the three months ended September 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 40% from $4.3 million in the third quarter of 2006 to $6.0 million for the same period of 2007 primarily due to the commencement of direct franchising operations in continental Europe which contributed $1.0 million of additional royalties.

New domestic franchise agreements executed in the three months ended September 30, 2007 totaled 182 representing 14,372 rooms compared to 178 agreements representing 13,321 rooms executed in the third quarter of 2006. During the third quarter of 2007, 83 of the 182 executed agreements were for new construction hotel franchises, representing 6,357 rooms, compared to 56 contracts, representing 4,202 rooms for the same period a year ago. Conversion hotel franchise executed contracts totaled 99 representing 8,015 rooms for three months ended September 30, 2007 compared to 122 agreements representing 9,119 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 approximately 14% to $5.3 million for the three months ended September 30, 2007 from $4.7 million for the three months ended September 30, 2006.

 

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

 

    

For the Three Months Ended

September 30, 2007

  

For the Three Months Ended

September 30, 2006

   % Change  
    

New

Construction

   Conversion    Total   

New

Construction

   Conversion    Total   

New

Construction

    Conversion     Total  

Comfort Inn

   10    12    22    14    25    39    (29 )%   (52 )%   (44 )%

Comfort Suites

   38    1    39    14    1    15    171 %   0 %   160 %

Sleep

   17    —      17    17    1    18    0 %   (100 )%   (6 )%
                                                

Midscale without Food & Beverage

   65    13    78    45    27    72    44 %   (52 )%   8 %
                                                

Quality

   2    33    35    —      43    43    NM     (23 )%   (19 )%

Clarion

   1    7    8    —      4    4    NM     75 %   100 %
                                                

Midscale with Food & Beverage

   3    40    43    —      47    47    NM     (15 )%   (9 )%
                                                

Econo Lodge

   1    22    23    —      20    20    NM     10 %   15 %

Rodeway

   2    23    25    1    25    26    100 %   (8 )%   (4 )%
                                                

Economy

   3    45    48    1    45    46    200 %   0 %   4 %
                                                

MainStay

   6    —      6    2    —      2    200 %   NM     200 %

Suburban

   3    1    4    3    3    6    0 %   (67 )%   (33 )%
                                                

Extended Stay

   9    1    10    5    3    8    80 %   (67 )%   25 %
                                                

Cambria Suites

   3    —      3    5    —      5    (40 )%   NM     (40 )%
                                                

Total Domestic System

   83    99    182    56    122    178    48 %   (19 )%   2 %
                                                

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 September 30, 2007, relicensings increased 17% to 123 for the three months ended September 30, 2007 from 105 in the third quarter of 2006. The increase in relicensing contracts resulted in an increase in fees of approximately 17% to $3.6 million for the three months ended September 30, 2007 from $3.1 million for the three months ended September 30, 2006.

Other income increased $1.1 million or 73% to $2.7 million for the three months ended September 30, 2007 primarily due to higher 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 $24.2 million for the three months ended September 30, 2007, an increase of $4.0 million from the three months ended September 30, 2006. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 27.4% for the three months ended September 30, 2007 compared to 26.4% for the three months ended September 30, 2006. Expenses as a percentage of franchise revenues increased primarily due to an additional $0.9 million in expenses related to the commencement of direct franchising operations in continental Europe.

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.

 

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Total marketing and reservations revenues were $86.8 million and $73.0 million for the three months ended September 30, 2007 and 2006, respectively. Depreciation and amortization attributable to marketing and reservation activities were $2.0 million for the both the three month periods ended September 30, 2007 and 2006. Interest expense attributable to reservation activities was $0.1 million and $0.2 million for the three months ended September 30, 2007 and 2006, respectively. Marketing and reservations activities generated $17.2 million and $18.6 million of positive operating cash flow for the nine months ended September 30, 2007 and 2006, respectively. As of September 30, 2007 and December 31, 2006, the Company’s balance sheet includes a receivable of $0.1 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 $13.1 million and $8.4 million at September 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, increased $0.7 million to an expense of $3.0 million for the three months ended September 30, 2007 from $2.3 million for the same period in 2006. Interest expense increased $0.8 million from $3.2 million to $4.0 million for the three months ended September 30, 2007. Interest expense increased due to higher outstanding borrowings and average interest rates on the Company’s variable rate debt. The Company’s weighted average interest rate as of September 30, 2007 was 6.09% compared to 6.47% as of September 30, 2006.

Income Taxes: The Company’s effective income tax provision rate was 35.3% for the three months ended September 30, 2007, an increase from the effective income tax provision rate of 11.3% for the three months ended September 30, 2006. The effective income tax rate for 2006 was lower than the statutory rate primarily due to the resolution of certain income tax contingencies totaling $12.8 million during the three months ended September 30, 2006 compared to $0.7 million during the same period of 2007. Depending upon the outcome of certain income tax contingencies up to an additional $0.3 million of additional income tax benefits may be reflected in our fourth quarter 2007 results of operations from the resolution of tax contingency reserves.

Net income for the three months ended September 30, 2007 decreased by 17% to $38.4 million, and diluted earnings per share decreased 14% to $0.59 for the three months ended September 30, 2007 from $0.69 reported for the three months ended September 30, 2006.

Comparison of Operating Results for the Nine-Month Periods Ended September 30, 2007 and September 30, 2006

The Company recorded net income of $83.4 million for the nine months ended September 30, 2007, a decrease of $4.8 million, or 5% from $88.2 million for the nine months ended September 30, 2006. The decline in net income for the nine months ended September 30, 2007 is primarily attributable to the resolution of income tax contingencies totaling $12.6 million during the nine months ended September 30, 2006 compared to $0.3 million for the nine months ended September 30, 2007 which resulted in an effective income tax rate of 24.6% compared to 36.2% for the current year period. The increase in the Company’s effective income tax rate was partially offset by a $10.4 million increase in operating income, a $1.1 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 $22.3 million, or 11% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) partially offset by a $12.9 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 $3.3 million decline in net other income and expenses was primarily related to a decline in interest expense of $1.1 million due to lower average debt outstanding and a $1.2 million increase in investment gains on assets held in the Company’s non-qualified employee benefit plans.

 

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Table of Contents

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

 

(in thousands, except per share amounts)    2007     2006  

REVENUES:

    

Royalty fees

   $ 175,723     $ 157,374  

Initial franchise and relicensing fees

     21,482       20,099  

Brand solutions

     12,603       10,853  

Marketing and reservation

     230,646       203,719  

Hotel operations

     3,485       3,342  

Other

     6,362       5,567  
                

Total revenues

     450,301       400,954  
                

OPERATING EXPENSES:

    

Selling, general and administrative

     73,735       60,796  

Depreciation and amortization

     6,410       7,335  

Marketing and reservation

     230,646       203,719  

Hotel operations

     2,402       2,365  
                

Total operating expenses

     313,193       274,215  
                

Operating income

     137,108       126,739  
                

OTHER INCOME AND EXPENSES, NET:

    

Interest expense

     10,206       11,291  

Interest and other investment income

     (2,856 )     (1,099 )

Equity in net income of affiliates

     (837 )     (737 )

Loss on extinguishment of debt

     —         342  
                

Total other income and expenses, net

     6,513       9,797  
                

Income before income taxes

     130,595       116,942  

Income taxes

     47,241       28,784  
                

Net income

   $ 83,354     $ 88,158  
                

Weighted average shares outstanding – diluted

     66,077       67,009  
                

Diluted earnings per share

   $ 1.26     $ 1.32  
                

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 $216.2 million for the nine months ended September 30, 2007 compared to $193.9 million for the nine months ended September 30, 2006. The growth in franchising revenues is primarily due to a 12% increase in royalty revenues, a 16% increase in brand solutions revenues and a 14% increase in other income.

Domestic royalty fees increased $13.6 million to $160.0 million from $146.4 million in the nine months ended September 30, 2007, an increase of 9.3%. The increase in royalties is attributable to a combination of factors including a 4.4% increase in the number of domestic franchised hotel rooms, a 3.8% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system from 4.08% to 4.13%. System-wide RevPAR increases resulted primarily from average daily rate increases of 4.7% over the prior year partially offset by a 50 basis point decline in occupancy rates.

 

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

 

    

For the Nine Months Ended

September 30, 2007

  

For the Nine Months Ended

September 30, 2006

   Change  
    

Average Daily

Rate

   Occupancy     RevPAR   

Average Daily

Rate

   Occupancy     RevPAR   

Average Daily

Rate

    Occupancy    RevPAR  

Comfort Inn

   $ 77.04    62.9 %   $ 48.45    $ 73.06    62.9 %   $ 45.92    5.4 %   0bps    5.5 %

Comfort Suites

     87.54    66.0 %     57.74      83.12    67.4 %     55.99    5.3 %   (140)bps    3.1 %

Sleep

     69.53    62.8 %     43.69      66.58    62.3 %     41.48    4.4 %   50bps    5.3 %
                                                         

Midscale without Food & Beverage

     78.20    63.5 %     49.67      74.22    63.7 %     47.25    5.4 %   (20)bps    5.1 %
                                                         

Quality

     70.45    54.5 %     38.37      67.27    55.6 %     37.40    4.7 %   (110)bps    2.6 %

Clarion

     80.39    51.5 %     41.38      79.18    51.2 %     40.56    1.5 %   30bps    2.0 %
                                                         

Midscale with Food & Beverage

     72.76    53.7 %     39.10      70.10    54.5 %     38.20    3.8 %   (80)bps    2.4 %
                                                         

Econo Lodge

     54.43    48.1 %     26.17      53.21    47.7 %     25.38    2.3 %   40bps    3.1 %

Rodeway

     53.63    47.9 %     25.68      52.32    46.7 %     24.44    2.5 %   120bps    5.1 %
                                                         

Economy

     54.25    48.0 %     26.06      53.05    47.5 %     25.20    2.3 %   50bps    3.4 %
                                                         

MainStay

     69.91    67.8 %     47.38      67.39    68.2 %     45.97    3.7 %   (40)bps    3.1 %

Suburban

     39.98    68.1 %     27.23      38.34    73.9 %     28.32    4.3 %   (580)bps    (3.8) %
                                                         

Extended Stay

     46.69    68.0 %     31.76      43.61    72.8 %     31.73    7.1 %   (480)bps    0.1 %
                                                         

Total

   $ 72.04    58.0 %   $ 41.80    $ 68.81    58.5 %   $ 40.28    4.7 %   (50)bps    3.8 %
                                                         

Net domestic franchise additions during the nine months ended September 30, 2007 were 185 compared with 109 for the same period a year ago. Gross domestic franchise additions increased from 271 for the nine months ended September 30, 2006 to 333 for the same period of 2007. Net franchise terminations declined from 162 to 148 for the nine months ended September 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 $4.7 million or 43% from $11.0 million for the nine months ended September 30, 2006 to $15.7 million for the same period of 2007 primarily due to the commencement of direct franchising operations in continental Europe which contributed $2.8 million of additional royalties.

New domestic franchise agreements executed in the first nine months of 2007 totaled 469 representing 37,965 rooms compared to 453 agreements representing 36,969 rooms executed in the same period in 2006. During the first nine months of 2007, 192 of the executed agreements were for new construction hotel franchises, representing 15,258 rooms, compared to 162 contracts, representing 12,539 rooms for the same period a year ago. Conversion hotel franchise executed contracts totaled 277 representing 22,707 rooms for nine months ended September 30, 2007 compared to 291 agreements representing 24,430 rooms for the nine months ended September 30, 2006. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise agreements increased 12% to $12.9 million for the nine months ended September 30, 2007 from $11.5 million for the nine months ended September 30, 2006.

 

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

 

    

For the Nine Months Ended

September 30, 2007

  

For the Nine Months Ended

September 30, 2006

   % Change  
    

New

Construction

   Conversion    Total   

New

Construction

   Conversion    Total   

New

Construction

    Conversion     Total  

Comfort Inn

   26    32    58    38    43    81    (32 )%   (26 )%   (28 )%

Comfort Suites

   78    4    82    55    3    58    42 %   33 %   41 %

Sleep

   33    1    34    27    1    28    22 %   0 %   21 %
                                                

Midscale without Food & Beverage

   137    37    174    120    47    167    14 %   (21 )%   4 %
                                                

Quality

   7    96    103    5    100    105    40 %   (4 )%   (2 )%

Clarion

   5    28    33    1    22    23    400 %   27 %   43 %
                                                

Midscale with Food & Beverage

   12    124    136    6    122    128    100 %   2 %   6 %
                                                

Econo Lodge

   3    50    53    —      43    43    NM     16 %   23 %

Rodeway

   2    62    64    2    73    75    0 %   (15 )%   (15 )%
                                                

Economy

   5    112    117    2    116    118    150 %   (3 )%   (1 )%
                                                

MainStay

   10    1    11