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 MARCH 31, 2011

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months.    Yes  x     No   ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   ¨

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 MARCH 31, 2011

Common Stock, Par Value $0.01 per share   59,807,015

 

 

 


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 months ended March 31, 2011 and March  31, 2010

     3   

Consolidated Balance Sheets—As of March 31, 2011 and December 31, 2010

     4   

Consolidated Statements of Cash Flows—For the three months ended March 31, 2011 and 2010

     5   

Notes to Consolidated Financial Statements

     6   

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

     25   

Item 3—Quantitative and Qualitative Disclosures About Market Risk

     40   

Item 4—Controls and Procedures

     40   

PART II. OTHER INFORMATION:

  

Item 1—Legal Proceedings

     41   

Item 1A—Risk Factors

     41   

Item 2—Unregistered Sales of Equity Securities and Use of Proceeds

     41   

Item 3—Defaults Upon Senior Securities

     41   

Item 4—(Removed and Reserved)

     42   

Item 5—Other Information

     42   

Item 6—Exhibits

     42   

SIGNATURES

     43   

 

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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
March  31,
 
     2011     2010  

REVENUES:

    

Royalty fees

   $ 44,240      $ 41,021   

Initial franchise and relicensing fees

     2,614        1,912   

Procurement services

     3,165        3,245   

Marketing and reservation

     62,967        58,840   

Hotel operations

     864        867   

Other

     1,431        1,536   
                

Total revenues

     115,281        107,421   
                

OPERATING EXPENSES:

    

Selling, general and administrative

     23,847        21,816   

Depreciation and amortization

     1,955        2,172   

Marketing and reservation

     62,967        58,840   

Hotel operations

     833        756   
                

Total operating expenses

     89,602        83,584   
                

Operating income

     25,679        23,837   
                

OTHER INCOME AND EXPENSES, NET:

    

Interest expense

     3,224        621   

Interest income

     (210     (60

Other gains and losses

     1,043        (1,017

Equity in net income of affiliates

     (301     (353
                

Total other income and expenses, net

     3,756        (809
                

Income before income taxes

     21,923        24,646   

Income taxes

     6,193        8,853   
                

Net income

     15,730      $ 15,793   
                

Basic earnings per share

   $ 0.26      $ 0.27   
                

Diluted earnings per share

   $ 0.26      $ 0.26   
                

Cash dividends declared per share

   $ 0.185      $ 0.185   
                

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

 

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED, IN THOUSANDS, EXCEPT SHARE AMOUNTS)

 

     March 31,
2011
    December 31,
2010
 
ASSETS     

Current assets

    

Cash and cash equivalents

   $ 76,405      $ 91,259   

Receivables (net of allowance for doubtful accounts of $10,251 and $9,159, respectively)

     48,279        47,638   

Deferred income taxes

     429        429   

Other current assets

     22,755        24,256   
                

Total current assets

     147,868        163,582   

Property and equipment, at cost, net

     54,296        55,662   

Goodwill

     66,042        66,041   

Franchise rights and other identifiable intangibles, net

     19,962        20,825   

Receivable – marketing and reservation fees

     54,719        42,507   

Investments, employee benefit plans, at fair value

     24,728        23,365   

Deferred income taxes

     24,460        24,435   

Other assets

     20,298        15,305   
                

Total assets

   $ 412,373      $ 411,722   
                
LIABILITIES AND SHAREHOLDERS’ DEFICIT     

Current liabilities

    

Accounts payable

   $ 38,730      $ 41,168   

Accrued expenses

     28,963        47,818   

Deferred revenue

     72,039        67,322   

Current portion of long-term debt

     508        420   

Deferred compensation and retirement plan obligations

     2,573        2,552   

Revolving credit facility

     0        200   

Income taxes payable

     6,928        5,778   
                

Total current liabilities

     149,741        165,258   
                

Long-term debt

     260,007        251,554   

Deferred compensation and retirement plan obligations

     34,660        35,707   

Other liabilities

     16,995        17,274   
                

Total liabilities

     461,403        469,793   
                

Commitments and Contingencies

    
SHAREHOLDERS’ DEFICIT     

Common stock, $0.01 par value, 160,000,000 shares authorized; 95,345,362 shares issued at March 31, 2011 and December 31, 2010 and 59,807,015 and 59,583,770 shares outstanding at March 31, 2011 and December 31, 2010, respectively

     598        596   

Additional paid-in capital

     92,019        92,774   

Accumulated other comprehensive loss

     (6,482     (7,192

Treasury stock (35,538,347 and 35,761,592 shares at March 31, 2011 and December 31, 2010, respectively), at cost

     (867,960     (872,306

Retained earnings

     732,795        728,057   
                

Total shareholders’ deficit

     (49,030     (58,071
                

Total liabilities and shareholders’ deficit

   $ 412,373      $ 411,722   
                

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

 

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED, IN THOUSANDS)

 

     Three Months Ended
March  31,
 
     2011     2010  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 15,730      $ 15,793   

Adjustments to reconcile net income to net cash provided (used) by operating activities:

    

Depreciation and amortization

     1,955        2,172   

Provision for bad debts

     778        856   

Non-cash stock compensation and other charges

     4,513        2,670   

Non-cash interest and other income

     (350     (987

Equity in net income of affiliates

     (301     (353

Changes in assets and liabilities, net of acquisitions:

    

Receivables

     (1,250     (435

Receivable – marketing and reservation fees, net

     (8,979     (10,909

Accounts payable

     (1,775     3,294   

Accrued expenses

     (18,931     (10,611

Income taxes payable/receivable

     1,182        4,667   

Deferred income taxes

     (12     (65

Deferred revenue

     4,709        9,138   

Other assets

     (1,147     (6,898

Other liabilities

     (1,339     (1,352
                

Net cash provided (used) by operating activities

     (5,217     6,980   
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Investment in property and equipment

     (1,835     (4,558

Equity method investments

     (1,600     0   

Acquisitions, net of cash acquired

     0        (466

Issuance of notes receivable

     (1,477     (534

Collections of notes receivable

     7        10   

Purchases of investments, employee benefit plans

     (897     (1,104

Proceeds from sale of investments, employee benefit plans

     310        522   

Other items, net

     (95     (124
                

Net cash used in investing activities

     (5,587     (6,254
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Net borrowings pursuant to revolving credit facilities

     7,900        16,200   

Repayments of long-term debt

     (5     0   

Purchase of treasury stock

     (2,207     (8,936

Dividends paid

     (10,950     (10,945

Excess tax benefits from stock-based compensation

     834        49   

Debt issuance costs

     (2,207     0   

Proceeds from exercise of stock options

     2,238        648   
                

Net cash used in financing activities

     (4,397     (2,984
                

Net change in cash and cash equivalents

     (15,201     (2,258

Effect of foreign exchange rate changes on cash and cash equivalents

     347        (19

Cash and cash equivalents at beginning of period

     91,259        67,870   
                

Cash and cash equivalents at end of period

     76,405      $ 65,593   
                

Supplemental disclosure of cash flow information:

    

Cash payments during the period for:

    

Income taxes, net of refunds

   $ 3,756      $ 3,748   

Interest

   $ 7,309      $ 646   

Non-cash investing and financing activities:

    

Declaration of dividends

   $ 10,992      $ 10,971   

Capital lease obligation

   $ 430      $ 0   

Issuance of restricted shares of common stock

   $ 7,452      $ 8,163   

Issuance of performance vested restricted stock units

   $ 0      $ 256   

Issuance of treasury stock to employee stock purchase plan

   $ 185      $ 151   

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 (“SEC”). 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 (“GAAP”) have been omitted. The year end balance sheet information was derived from audited financial statements, but does not include all disclosures required by GAAP. 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, 2010 and notes thereto included in the Company’s Form 10-K, filed with the SEC on March 1, 2011 (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 GAAP 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.

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 March 31, 2011 and December 31, 2010, $2.6 million and $2.8 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.

The Company maintains cash balances in domestic banks, which at times, may exceed the limits of amounts insured by the Federal Deposit Insurance Corporation. In addition, the Company also maintains cash balances in international banks which do not provide deposit insurance.

Recently Adopted Accounting Guidance

In September 2009, the Financial Accounting Standards Board (“FASB”) ratified Emerging Issues Task Force (“EITF”) Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables” (“EITF 08-1”). EITF 08-1 updates the current guidance pertaining to multiple-element revenue arrangements included in Accounting Standards Codification (“ASC”) Subtopic 605-25, which originated primarily from EITF 00-21, also titled “Revenue Arrangements with Multiple Deliverables.” EITF 08-1 was effective for annual reporting periods beginning January 1, 2011 for calendar year entities with earlier adoption permitted. The adoption of these provisions did not have a material impact on our consolidated financial statements.

In July 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-20, which updates the guidance in ASC Topic 310, Receivables, related to disclosures about the credit quality of financing receivables and the allowance for credit losses. The new disclosures require disaggregated information related to financing receivables and will include for each class of financing receivables, among other things: a roll forward for the allowance for credit losses, credit quality information, impaired loan information, modification information, non-accrual and past-due information. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. Disclosures of reporting period activity (i.e. allowance roll-forward) are required for interim and annual periods beginning after December 15, 2010. The Company has updated its disclosures as appropriate.

 

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2. Other Current Assets

Other current assets consist of the following:

 

     March 31,
2011
     December 31,
2010
 
     (In thousands)  

Land held for sale

   $ 8,103       $ 11,089   

Prepaid expenses

     8,782         8,070   

Notes receivable (See Note 3)

     3,950         3,966   

Other current assets

     1,920         1,131   
                 

Total

   $ 22,755       $ 24,256   
                 

Land held for sale represents the Company’s purchase of various parcels of real estate as part of its program to incent franchise development in top markets for certain brands. The Company has acquired this real estate with the intent to resell it to third-party developers for the construction of hotels operated under the Company’s brands. During the three months ended March 31, 2011, the Company determined that one parcel of land no longer met the criteria to be classified as a current asset held for sale since it was no longer probable that the parcel would be sold within one year. As a result, the Company has reclassified this land to other long-term assets on the Company’s consolidated balance sheet at the lower of its carrying amount or fair value. The Company has determined that the carrying amount of the land exceeded its estimated fair value by approximately $1.8 million based on comparable sales. As a result, the Company has reduced the carrying amount of the land to its estimated fair value and recognized a $1.8 million loss in other gains and losses in the consolidated statements of income.

 

     Fair Value Measurements Using  
     ($ in millions)  

Description

   March 31, 2011      Quoted Prices in
Active Markets
for Identical
Assets

(Level 1)
     Significant
Other
Observable
Inputs

(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
     Total  Gains
(Losses)
 

Land held for sale(1)

   $ 1.3         —         $ 1.3         —         ($ 1.8
                                            

 

(1) 

Included in Other Assets

3. Notes Receivable and Allowance for Losses

The Company segregates its notes receivable for the purposes of evaluating allowances for credit losses between two categories: Mezzanine and Other Notes Receivable and Forgivable Notes Receivable. The Company utilizes the level of security it has in the various notes receivable as its primary credit quality indicator (i.e. senior, subordinated or unsecured) when determining the appropriate allowances for uncollectible loans within these categories.

The following table shows the composition of our notes receivable balances:

 

     March 31, 2011      December 31, 2010  
     ($ in thousands)      ($ in thousands)  

Credit Quality Indicator

   Forgivable
Notes
Receivable
     Mezzanine
& Other
Notes
Receivable
     Total      Forgivable
Notes
Receivable
     Mezzanine
& Other
Notes
Receivable
     Total  

Senior

   $ —         $ 3,872       $ 3,872       $ —         $ 3,846       $ 3,846   

Subordinated

     —           14,616         14,616         —           14,494         14,494   

Unsecured

     7,709         —           7,709         7,753         —           7,753   
                                                     

Total notes receivable

     7,709         18,488         26,197         7,753         18,340         26,093   
                                                     

Allowance for losses on non-impaired loans

     769         624         1,393         775         613         1,388   

Allowance for losses on receivables specifically evaluated for impairment

     —           8,638         8,638         —           8,638         8,638   
                                                     

Total loan reserves

     769         9,262         10,031         775         9,251         10,026   
                                                     

Net carrying value

   $ 6,940       $ 9,226       $ 16,166       $ 6,978       $ 9,089       $ 16,067   
                                                     

Current portion, net

   $ 109       $ 3,841       $ 3,950       $ 114       $ 3,852       $ 3,966   

Long-term portion, net

     6,831         5,385         12,216         6,864         5,237         12,101   
                                                     

Total

   $ 6,940       $ 9,226       $ 16,166       $ 6,978       $ 9,089       $ 16,067   
                                                     

 

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The Company classifies notes receivable due within one year as other current assets and notes receivable with a maturity greater than one year as other assets in the Company’s consolidated balance sheets.

The following table summarizes the activity related to the Company’s Forgivable Notes Receivable and Mezzanine and & Other Notes Receivable allowance for losses from December 31, 2010 through March 31, 2011:

 

     Forgivable
Notes
Receivable
    Mezzanine
& Other  Notes
Receivable
 
     (In thousands)  

Balance, December 31, 2010

   $ 775      $ 9,251   

Provisions

     58        11   

Recoveries

     2        —     

Write-offs

     —          —     

Other (1)

     (66     —     
                

Balance, March 31, 2011

   $ 769      $ 9,262   
                

 

(1) 

Consists of default rate assumption changes

Forgivable Notes Receivable

From time to time, the Company provides financing to franchisees for property improvements and other purposes in the form of forgivable promissory notes. The terms of the notes typically range from 3 to 10 years, bearing market interest rates, and are forgiven and amortized over that time period if the franchisee remains in the system in good standing. Franchisees are not required to repay the forgivable notes provided that the respective hotels remain in the system and in good standing throughout the term of their note. The Company fully reserves all defaulted notes in addition to recording a reserve on the estimated uncollectible portion of the remaining notes. For those notes not in default, the Company calculates an allowance for losses and determines the ultimate collectability on these forgivable notes based on the historical default rates for those unsecured notes that are not forgiven but are required to be repaid. The Company records bad debt expense in SG&A expenses in the accompanying consolidated statements of income in the quarter when the note is deemed uncollectible.

As of March 31, 2011 and December 31, 2010, the unamortized balance of these notes totaled $7.7 million and $7.8 million, respectively. The Company recorded an allowance for credit losses on these forgivable notes receivable of $0.8 million at both March 31, 2011 and December 31, 2010. Amortization expense included in the accompanying consolidated statements of income related to the notes was $0.5 million for both the three months ended March 31, 2011 and 2010. At March 31, 2011, the Company had commitments to extend an additional $6.6 million in forgivable notes receivable provided certain commitments are met by its franchisees, of which $3.2 is expected to be advanced in the next twelve months.

Mezzanine and Other Notes Receivable

The Company has provided financing to franchisees in support of the development of properties in key markets. These notes include non-interest bearing receivables as well as notes bearing market interest and are due upon maturity. Non-interest bearing notes are recorded net of their unamortized discounts. At March 31, 2011 and December 31, 2010, all discounts were fully amortized. Interest income associated with these note receivable is reflected in the accompanying consolidated statements of income under the caption of interest income.

The Company expects the owners to repay the loans in accordance with the loan agreements, or earlier as the hotels mature and capital markets permit. The Company estimates the collectability and records an allowance for loss on its mezzanine and other notes receivable when recording the receivables in the Company’s financial statements. These estimates are updated quarterly based on available information.

The Company considers a loan to be impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. The Company measures loan impairment based on the present value of expected future cash flows discounted at the loan’s original effective interest rate or the estimated fair value of the collateral. For impaired loans, the Company establishes a specific impairment reserve for the difference between the recorded investment in the loan and the present value of the expected future cash flows or the estimated fair value of the collateral. The Company applies its loan impairment policy individually to all mezzanine and other notes receivable in the portfolio and does not aggregate loans for the purpose of applying such policy. For impaired loans, the Company recognizes interest income on a cash basis. If it is likely that a loan will not be collected based on financial or other business indicators it is the Company’s policy to charge off these loans to SG&A expenses in the accompanying consolidated statements of income in the quarter when it is deemed uncollectible.

The Company assesses the collectability of its senior notes receivable by comparing the market value of the underlying assets to the carrying value of the outstanding notes. In addition, the Company evaluates the property’s operating performance, the borrower’s compliance with the terms of the loan and franchise agreements, and all related personal guarantees that have been provided by the borrower. For subordinated or unsecured receivables, the Company assesses the property’s operating performance, the subordinated equity available to the Company, the borrower’s compliance with the terms of loan and franchise agreements, and the related personal guarantees that have been provided by the borrower.

The Company considers loans to be past due and in default when payments are not made when due. Although the Company considers loans to be in default if payments are not received on the due date, the Company does not suspend the accrual of interest until those payments are more than 30 days past due. The Company applies payments received for loans on non-accrual status first to interest and then principal. The Company does not resume interest accrual until all delinquent payments are received.

Notes receivable totaling $10.8 million was determined to be impaired at both March 31, 2011 and December 31, 2010. The Company has recorded an $8.6 million allowance for credit losses on these impaired loans at both March 31, 2011 and December 31, 2010 resulting in a carrying value of $2.2 million. The Company did not recognize interest income on either the accrual or cash basis on its impaired loans during the periods ended March 31, 2011 and 2010. The Company had provided loan reserves on non-impaired loans total $0.6 million at both March 31, 2011 and December 31, 2010, respectively.

At March 31, 2011, the Company had a commitment to extend an additional. $0.4 million in mezzanine and other notes receivables provided certain conditions are met.

 

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Past due balances of mezzanine and other notes receivable by credit quality indicators are as follows:

 

     30-89 days
Past Due
     > 90 days
Past Due
     Total
Past Due
     Current      Total
Receivables
 
     ($ in thousands)  

As of March 31, 2011

              

Senior

   $ —         $ —         $ —         $ 3,872       $ 3,872   

Subordinated

     —           10,931         10,931         3,685         14,616   
                                            
   $ —         $ 10,931       $ 10,931       $ 7,557       $ 18,488   
                                            

As of December 31, 2010

              

Senior

   $ —         $ —         $ —         $ 3,846       $ 3,846   

Subordinated

     —           10,931         10,931         3,563         14,494   
                                            
   $ —         $ 10,931       $ 10,931       $ 7,409       $ 18,340   
                                            

4. Receivable – Marketing and Reservation Fees

The marketing fees receivable from cumulative marketing expenses incurred in excess of cumulative marketing fees earned at March 31, 2011 and December 31, 2010 was $21.5 million and $17.0 million, respectively. As of March 31, 2011 and December 31, 2010, the reservation fees receivable related to cumulative reservation expenses incurred in excess of cumulative reservation fees earned was $33.2 million and $25.5 million, respectively. Depreciation and amortization expense attributable to marketing and reservation activities for the three months ended March 31, 2011 and 2010 was $3.2 million and $2.7 million, respectively. Interest expense attributable to reservation activities was $1.0 million and $0.1 million for the three months ended March 31, 2011 and 2010, respectively.

The Company evaluates the receivable for marketing and reservation costs in excess of cumulative marketing and reservation fees earned on a periodic basis for collectability. The Company will record an allowance when, based on current information and events, it is probable that we will be unable to collect all amounts due for marketing and reservation activities according to the contractual terms of the franchise agreements. The receivables are considered to be uncollectible if the expected net, undiscounted cash flows from marketing and reservation activities are less than the carrying amount of the asset.

5. Other Assets

Other assets consist of the following:

 

     March 31,
2011
     December 31,
2010
 
     (In thousands)  

Notes receivable (see Note 3)

   $ 12,216       $ 12,101   

Deferred financing fees

     3,886         2,102   

Equity method investments

     2,170         251   

Other

     2,026         851   
                 

Total

   $ 20,298       $ 15,305   
                 

 

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6. Deferred Revenue

Deferred revenue consists of the following:

 

     March 31,
2011
     December 31,
2010
 
     (In thousands)  

Loyalty programs

   $ 61,548       $ 61,604   

Initial, relicensing and franchise fees

     4,178         4,631   

Procurement service fees

     2,065         1,052   

Other

     4,248         35   
                 

Total

   $ 72,039       $ 67,322   
                 

7. Debt

Debt consists of the following at:

 

     December 31,  
   March 31,
2011
     December 31,
2010
 
   (In thousands)  

$300 million senior unsecured revolving credit facility with an effective interest rate of 1.72% at March 31, 2011

   $ 8,100      $ —     

$250 million senior notes with an effective interest rate of 6.19% at March 31, 2011 and December 31, 2010

     249,395        249,379   

$350 million senior unsecured revolving credit facility with an effective interest rate of 0.675% at December 31, 2010

     —           200   

Capital lease obligations due 2016 with an effective interest rate of 4.66% at March 31, 2011 and December 31, 2010

     2,968        2,538   

Other notes payable

     52        57   
                 

Total debt

   $ 260,515       $ 252,174   

Less current portion

     508         620   
                 

Total long-term debt

   $ 260,007       $ 251,554   
                 

On February 24, 2011, the Company entered into a new $300 million senior unsecured revolving credit agreement (the “Revolver”) with Wells Fargo Bank, National Association, as administrative agent and a syndicate of lenders. Simultaneously with the closing of the Revolver, the $350 million unsecured revolving credit agreement dated as of June 2006 (the “Old Revolver”) was terminated. The Revolver provides for a $300 million unsecured revolving credit facility with a final maturity date on February 24, 2016. Up to $30 million of borrowings under the Revolver may be used for letters of credit and up to $20 million of borrowings under the Revolver may be used for swing-line loans.

The Revolver is unconditionally guaranteed, jointly and severally, on a senior unsecured basis by all of the Company’s subsidiaries that currently guaranty the obligations under the Company’s Indenture governing the terms of its 5.70% senior notes due 2020.

The Company may at any time prior to the final maturity date increase the amount of the Revolver by up to an additional $150 million to the extent that any one or more lenders commit to being a lender for the additional amount and certain other customary conditions are met.

The Company may elect to have borrowings under the Revolver bear interest at (i) a base rate plus a margin ranging from 5 to 80 basis points based on the Company’s credit rating or (ii) LIBOR plus a margin ranging from 105 to 180 basis points based on the Company’s credit rating. In addition, the Revolver requires the Company to pay a quarterly facility fee on the

 

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full amount of the commitments under the Revolver (regardless of usage) ranging from 20 to 45 basis points based upon the credit rating of the Company.

The Revolver requires that the Company and its restricted subsidiaries comply with various covenants, including with respect to restrictions on liens, incurring indebtedness, making investments and effecting mergers and/or asset sales. In addition, the Revolver imposes financial maintenance covenants requiring the Company to maintain a total leverage ratio of not more than 3.5 to 1.0 and an interest coverage ratio of at least 3.5 to 1.0. The Revolver includes customary events of default, the occurrence of which, following any applicable cure period, would permit the lenders to, among other things, declare the principal, accrued interest and other obligations of the Company under the Revolver to be immediately due and payable.

The proceeds of the Revolver are used for general corporate purposes, including working capital, debt repayment, stock repurchases, dividends, investments and other permitted uses.

Debt issuance costs incurred in connection with the Revolver totaled $2.4 million and are being amortized, on a straight-line basis, which is not materially different than the effective interest method, through the maturity of the Revolver. Amortization of these costs is included in interest expense in the accompanying statements of income.

On August 25, 2010, the Company completed a $250 million senior unsecured note offering (“the Senior Notes”) at a discount of $0.6 million, bearing a coupon of 5.7% with an effective rate of 6.19%. The Senior Notes will mature on August 28, 2020, with interest on the Senior Notes to be paid semi-annually on February 28th and August 28th. The Company used the net proceeds from the offering, after deducting underwriting discounts and other offering expenses, to repay outstanding borrowings under the Old Revolver and other general corporate purposes. The Company’s Senior Notes are guaranteed jointly, severally, fully and unconditionally by eight 100%-owned domestic subsidiaries.

8. Pension Plan

The Company sponsors an unfunded non-qualified defined benefit plan (“SERP”) for certain senior executives. No assets are held with respect to the SERP, therefore benefits are funded as paid to participants. For the three months ended March 31, 2011 and 2010, the Company recorded $0.1 million and $0.1 million, respectively for expenses related to the SERP which are included in SG&A expense in the accompanying consolidated statement of income. Benefit payments totaling $0.4 million are currently scheduled to be remitted within the next twelve months.

The following table presents the components of net periodic benefit costs for the three months ended March 31, 2011 and 2010:

 

     Three Months Ended
March 31,
 
(In thousands)    2011      2010  

Components of net periodic pension cost:

     

Interest cost

     135         135   
                 

Net periodic pension cost

   $ 135       $ 135   
                 

The 2011 monthly net periodic pension costs are approximately $0.5 million. The components of projected pension costs for the year ended December 31, 2011 are as follows:

 

(in thousands)       

Components of net periodic pension cost:

  

Interest cost

   $ 541   
        

Net periodic pension cost

   $ 541   
        

 

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The following is a reconciliation of the changes in the projected benefit obligation for the three months ended March 31, 2011:

 

(in thousands)       

Projected benefit obligation, December 31, 2010

   $ 10,034   

Interest cost

     135  

Actuarial loss

     16   

Benefit payments

     (111 )
        

Projected benefit obligation, March 31, 2011

   $ 10,074   
        

The amounts in accumulated other comprehensive income (loss) that have not yet been recognized as components of net periodic benefit costs at March 31, 2011 are as follows:

 

(in thousands)       

Transition asset (obligation)

   $ —     

Prior service cost

     —     

Accumulated loss

     (657
        

Total

   $ (657
        

9. Non-Qualified Retirement, Savings and Investment Plans

The Company sponsors two non-qualified retirement savings and investment plans for certain employees and senior executives. Employee and Company contributions are maintained in separate irrevocable trusts. Legally, the assets of the trusts remain those of the Company; however, access to the trusts’ assets is severely restricted. The trusts’ cannot be revoked by the Company or an acquirer, but the assets are subject to the claims of the Company’s general creditors. The participants do not have the right to assign or transfer contractual rights in the trusts.

In 2002, the Company adopted the Choice Hotels International, Inc. Executive Deferred Compensation Plan (“EDCP”) which became effective January 1, 2003. Under the EDCP, certain executive officers may defer a portion of their salary into an irrevocable trust. Prior to January 1, 2010, participants could elect an investment return of either the annual yield of the Moody’s Average Corporate Bond Rate Yield Index plus 300 basis points, or a return based on a selection of available diversified investment options. Effective January 1, 2010, the Moody’s Average Corporate Bond Rate Yield Index plus 300 basis points is no longer an investment option for salary deferrals made on compensation earned after December 31, 2010. As of March 31, 2011 and December 31, 2010, the Company recorded a deferred compensation liability of $16.1 million and $17.6 million, respectively related to these deferrals and credited investment returns. Compensation expense is recorded in SG&A expense on the Company’s consolidated statements of income based on the change in the deferred compensation obligation related to earnings credited to participants as well as changes in the fair value of diversified investments. Compensation expense recorded in SG&A for the three months ended March 31, 2011 and 2010 were $0.3 million and $0.2 million, respectively.

The Company has invested the employee salary deferrals in diversified long-term investments which are intended to provide investment returns that partially offset the earnings credited to the participants. The diversified investments held in the trusts totaled $14.6 million and $13.6 million as of March 31, 2011 and December 31, 2010, respectively, and are recorded at their fair value, based on quoted market prices. These investments are considered trading securities and therefore the changes in the fair value of the diversified assets is included in other gains and losses in the accompanying statements of income. The Company recorded investment gains during the three months ended March 31, 2011 and 2010 of $0.4 million and $0.5 million, respectively.

In 1997, the Company adopted the Choice Hotels International, Inc. Nonqualified Retirement Savings and Investment Plan (“Non-Qualified Plan”). The Non-Qualified Plan allows certain employees who do not participate in the EDCP to defer a portion of their salary and invest these amounts in a selection of available diversified investment options. As of March 31, 2011 and December 31, 2010, the Company had recorded a deferred compensation liability of $11.1 million and $10.6 million, respectively related to these deferrals. Compensation expense is recorded in SG&A expense on the Company’s consolidated statements of income based on the change in the deferred compensation obligation related to earnings credited to participants as well as changes in the fair value of diversified investments. The net increase in compensation expense recorded in SG&A for the three months ended March 31, 2011 and 2010 was $0.4 million for both periods.

 

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The diversified investments held in the trusts were $10.2 million and $9.7 million as of March 31, 2011 and December 31, 2010, respectively, and are recorded at their fair value, based on quoted market prices. These investments are considered trading securities and therefore the changes in the fair value of the diversified assets is included in other gains and losses in the accompanying statements of income. The Company recorded investment gains during the three months ended March 31, 2011 and 2010 of $0.3 million for both periods. In addition, the Non-Qualified Plan held shares of the Company’s common stock with a market value of $0.9 million at both March 31, 2011 and December 31, 2010.

10. Fair Value Measurements

The Company estimates the fair value of our financial instruments utilizing a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. There have been no significant transfers into or out of Level 1 or Level 2 inputs during the three months ended March 31, 2011. The following summarizes the three levels of inputs, as well as the assets that the Company values using those levels of inputs.

Level 1: Quoted prices in active markets for identical assets and liabilities. The Company’s Level 1 assets consist of marketable securities (primarily mutual funds) held in the Company’s EDCP and Non-Qualified Plan deferred compensation plans.

Level 2: Observable inputs, other than quoted prices in active markets for identical assets and liabilities, such as quoted prices for similar assets and liabilities; quoted prices in markets that are not active; or other inputs that are observable. The Company’s Level 2 assets consist of money market funds held in the Company’s EDCP and Non-Qualified Plan deferred compensation plans and those recorded in cash and cash equivalents.

Level 3: Unobservable inputs, supported by little or no market data available, where the reporting entity is required to develop its own assumptions to determine the fair value of the instrument. The Company does not currently have any assets whose fair value was determined using Level 3 inputs.

 

     Fair Value Measurements at
Reporting Date Using
 
     Total      Level 1      Level 2      Level 3  

Assets (in thousands)

           

As of March 31, 2011

           

Money market funds, included in cash and cash equivalents

   $ 10,001       $ —         $ 10,001       $ —     

Mutual funds(1)

     22,183         22,183         —           —     

Money market funds(1)

     2,545         —           2,545         —     
                                   
   $ 34,729       $ 22,183       $ 12,546       $ —     
                                   

As of December 31, 2010

           

Money market funds, included in cash and cash equivalents

   $ 10,001       $ —         $ 10,001       $ —     

Mutual funds(1)

     20,917         20,917         —           —     

Money market funds(1)

     2,448         —           2,448         —     
                                   
   $ 33,366       $ 20,917       $ 12,449       $ —     
                                   

 

(1) 

Included in Investments, employee benefit plans, fair value on the consolidated balance sheets.

The Company believes that the fair values of its current assets and current liabilities approximate their reported carrying amounts due to the short-term nature of these items. In addition, the interest rates of the Company’s Revolver adjust frequently based on current market rates; accordingly its carrying amount approximates fair value.

The Company estimates the fair value of its senior notes, using quoted market prices. At March 31, 2011, the senior notes had an approximate fair value of $245.2 million.

11. Income Taxes

The effective income tax rate was 28.2% and 35.9% for the three months ended March 31, 2011 and March 31, 2010, respectively.

The effective income tax rates for the three months ended March 31, 2011 differed from the U.S. federal statutory rate of 35% primarily due to a $1.4 million adjustment that reduced current federal taxes payable. The Company believes that this

 

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adjustment is not material to its financial statements for prior annual or interim periods, the three months ended March 31, 2011 or the Company’s expected annual results for the year ended December 31, 2011. The rate was also impacted by the effect of foreign operations, partially offset by state income taxes.

12. Share-Based Compensation and Capital Stock

Stock Options

The Company granted 0.2 million options to certain employees of the Company at fair value of $2.1 million during the three months ended March 31, 2011 and 0.2 million options with a fair value of $2.5 million during the three months ended March 31, 2010. 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:

 

     2011 Grants     2010 Grants  

Risk-free interest rate

     2.10     2.18

Expected volatility

     39.51     41.92

Expected life of stock option

     4.4 years        4.4 years   

Dividend yield

     1.79     2.27

Requisite service period

     4 years        4 years   

Contractual life

     7 years        7 years   

Weighted average fair value of options granted

   $ 12.42      $ 9.98   

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. Historical volatility is calculated based on a period that corresponds to the expected life of the stock option. 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 March 31, 2011 was $12.1 million and $7.3 million, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2011 and 2010 was approximately $1.7 million and $0.8 million, respectively.

The Company received approximately $2.2 million and $0.6 million in proceeds from the exercise of approximately 0.1 million and 0.04 million employee stock options during the three month periods ended March 31, 2011 and 2010, respectively.

Restricted Stock

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

 

     Three Months Ended
March 31,
 
     2011      2010  

Restricted share grants

     180,645         250,390   

Weighted average grant date fair value per share

   $ 41.25       $ 32.60   

Aggregate grant date fair value ($000)

   $ 7,452       $ 8,163   

Restricted shares forfeited

     5,806         8,194   

Vesting service period of shares granted

     3-4 years         3-4 years   

Grant date fair value of shares vested ($000)

   $ 4,831       $ 4,406   

Compensation expense related to the fair value of these awards is recognized straight-line over the requisite service period based on those restricted stock grants that ultimately vest. The fair value of grants is measured by the market price of the Company’s stock on the date of grant. Restricted stock awards generally vest ratably over the service period beginning with the first anniversary of the grant date.

 

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Performance Vested Restricted Stock Units

The Company has granted performance vested restricted stock units (“PVRSU”) to certain employees. The vesting of these stock awards is contingent upon the Company achieving performance 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 0% and 200% of the initial target. If a minimum of 50% of the performance target is not attained then no awards will vest under the terms of the PVRSU agreements. Compensation expense related to these awards will be recognized over the requisite service period regardless of whether the performance targets have been met based on the Company’s estimate of the achievement of the various performance targets. The Company has currently estimated that between 0% and 100% of the various award targets will be achieved. The fair value is measured by the 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.

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

 

     Three Months Ended
March 31,
 
     2011      2010  

Performance vested restricted stock units granted at target

     25,036        33,517  

Weighted average grant date fair value per share

   $ 41.25      $ 32.60  

Aggregate grant date fair value ($000)

   $ 1,033      $ 1,093  

Stock units forfeited

     39,070        9,650  

Requisite service period

     3 years        3 years  

During the three months ended March 31, 2011, no PVRSU grants vested. PVRSU grants totaling 39,070 units were forfeited since the Company did not achieve the minimum performance conditions contained in the stock awards. During the three months ended March 31, 2010, PVRSU grants totaling 10,880 vested at a fair value of $0.3 million. These PVRSU grants were initially granted at a target of 15,541 units; however, since the Company achieved only 70% of the targeted performance during the three months ended March 31, 2010, 4,989 units were forfeited since the performance targets of the applicable PVRSU grant were not achieved.

A summary of stock-based award activity as of March 31, 2011 and changes during the three months ended are presented below:

 

    Three Months Ended March 31, 2011  
    Stock Options     Restricted Stock     Performance Vested
Restricted  Stock Units
 
    Shares     Weighted
Average
Exercise
Price
    Weighted
Average
Remaining
Contractual

Term
    Shares     Weighted
Average
Grant Date
Fair Value
    Shares     Weighted
Average
Grant Date
Fair Value
 

Outstanding at January 1, 2011

    1,732,674      $ 31.43          592,131      $ 31.81        127,912      $ 33.43   

Granted

    166,306        41.25          180,645        41.25        25,036        41.25   

Exercised/Vested

    (98,936     22.62          (151,016     31.99        —          —     

Forfeited/Expired

    (26,212     29.55          (5,806     31.26        (39,070     31.85   
                                                 

Outstanding at March 31, 2011

    1,773,832      $ 32.87        5.0 years        615,954      $ 34.54        113,878      $ 35.70   
                                                       

Options exercisable at March 31, 2011

    966,264      $ 32.48        4.5 years           
                               

 

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The components of the Company’s pretax stock-based compensation expense and associated income tax benefits are as follows for the three months ended March 31, 2011 and 2010:

 

     Three Months Ended
March 31,
 

(in millions)

   2011      2010  

Stock options

   $ 0.6       $ 0.6   

Restricted stock

     1.7         1.7   

Performance vested restricted stock units

     0.1         0.1   
                 

Total

   $ 2.4       $ 2.4   
                 

Income tax benefits

   $ 0.9       $ 0.9   
                 

Dividends

On February 21, 2011, the Company’s board of directors declared a cash dividend of $0.185 per share (or approximately $11.0 million in the aggregate), which was paid on April 15, 2011 to shareholders of record as of April 1, 2011.

On February 16, 2010, the Company’s board of directors declared a quarterly cash dividend of $0.185 per share (or approximately $11.0 million in the aggregate), which was paid on April 16, 2010 to shareholders of record as of April 5, 2010.

Stock Repurchase Program

No shares of common stock were purchased by the Company under the share repurchase program during the three months ended March 31, 2011. During the three months ended March 31, 2010, the Company purchased 0.2 million of shares of common stock under the share repurchase program at a total cost of $6.9 million.

During the three months ended March 31, 2011 and 2010, the Company redeemed 55,295 and 65,133 shares of common stock at a total cost of approximately $2.2 million and $2.1 million, respectively, from employees to satisfy statutory minimum tax requirements from the vesting of restricted stock and PVRSU grants. These redemptions were outside the share repurchase program initiated in March 1998.

13. Comprehensive Income

The components of accumulated other comprehensive income (loss) is as follows:

 

(In thousands)    March 31,
2011
    December 31,
2010
 

Foreign currency translation adjustments

   $ 2,045      $ 1,540   

Deferred loss on cash flow hedge

     (8,116     (8,331

Changes in pension benefit obligation recognized in other comprehensive income (loss)

     (411     (401
                

Total accumulated other comprehensive income (loss)

   $ (6,482   $ (7,192
                

 

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

 

     Three Months Ended
March 31,
 
(In thousands)    2011     2010  

Net income

   $ 15,730      $ 15,793   

Other comprehensive income, net of tax:

    

Amortization of loss on cash flow hedge

     215        —     

Foreign currency translation adjustment, net

     505        6   

Actuarial pension loss, net of tax

     (10     —     
                

Other comprehensive income, net of tax

     710        6   
                

Comprehensive income

   $ 16,440      $ 15,799   
                

14. Earnings Per Share

The computation of basic and diluted earnings per common share is as follows:

 

     Three Months Ended
March 31,
 
(In thousands, except per share amounts)    2011     2010  

Computation of Basic Earnings Per Share:

    

Net income

   $ 15,730      $ 15,793   

Income allocated to participating securities

     (156     (157
                

Net income available to common shareholders

   $ 15,574      $ 15,636   
                

Weighted average common shares outstanding – basic

     59,081        58,924   
                

Basic earnings per share

   $ 0.26      $ 0.27   
                

Computation of Diluted Earnings Per Share:

    

Net income

   $ 15,730      $ 15,793   

Income allocated to participating securities

     (156     (157
                

Net income available to common shareholders

   $ 15,574      $ 15,636   
                

Weighted average common shares outstanding – basic

     59,081        58,924   

Diluted effect of stock options and PVRSUs

     151        86   
                

Weighted average shares outstanding-diluted

     59,232        59,010   
                

Diluted earnings per share

   $ 0.26      $ 0.26   
                

The Company’s unvested restricted shares contain rights to receive non-forfeitable dividends, and thus are participating securities requiring the two-class method of computing earnings per share (“EPS”). The calculation of EPS for common stock shown above excludes the income attributable to the unvested restricted share awards from the numerator and excludes the dilutive impact of those awards from the denominator.

At both March 31, 2011 and 2010, the Company had 1.8 million outstanding stock options. Stock options are included in the diluted earnings per share calculation using the treasury stock method and average market prices during the period, unless the stock options would be anti-dilutive. For the three months ended March 31, 2011 and 2010, the Company excluded 0.4 million and 0.7 million of anti-dilutive stock options from the diluted earnings per share calculation, respectively.

PVRSUs are also included in the diluted earnings per share calculation assuming the performance conditions have been met at the reporting date. However, at March 31, 2011 and 2010, PVRSUs totaling 113,878 and 131,372, respectively were excluded from the computation since the performance conditions had not been met.

 

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15. Condensed Consolidating Financial Statements

Effective August 2010, the Company’s Senior Notes are guaranteed jointly, severally, fully and unconditionally by eight 100%-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 the guarantee arrangements, the following condensed consolidating financial statements are presented. Investments in subsidiaries are accounted for under the equity method of accounting.

Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Three Months Ended March 31, 2011

(Unaudited, in Thousands)

 

     Parent     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Royalty fees

   $ 38,501      $ 27,107      $ 6,667      $ (28,035   $ 44,240   

Initial franchise and relicensing fees

     2,614        —          —          —          2,614   

Procurement services

     3,165        —          —          —          3,165   

Marketing and reservation

     50,171        68,794        3,901        (59,899     62,967   

Other items, net

     1,247        864        184       —          2,295   
                                        

Total revenues

     95,698        96,765        10,752        (87,934     115,281   
                                        

OPERATING EXPENSES:

          

Selling, general and administrative

     56,872        23,871        4,408        (61,304     23,847   

Marketing and reservation

     19,503        66,055        4,039        (26,630     62,967   

Other items, net

     708        1,864        216        —          2,788   
                                        

Total operating expenses

     77,083        91,790        8,663        (87,934     89,602   
                                        

Operating income

     18,615        4,975        2,089        —          25,679   

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     4,173        (951     2        —          3,224   

Equity in earnings of consolidated subsidiaries

     (5,073     —          —          5,073       —     

Other items, net

     (198     (723     1,453        —          532   
                                        

Total other income and expenses, net

     (1,098     (1,674     1,455        5,073        3,756   
                                        

Income before income taxes

     19,713        6,649        634        (5,073     21,923   

Income taxes (benefit)

     3,983        2,534        (324     —          6,193   
                                        

Net income

   $ 15,730      $ 4,115      $ 958      $ (5,073   $ 15,730   
                                        

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Income

For the Three Months Ended March 31, 2010

(Unaudited, in Thousands)

 

     Parent     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Royalty fees

   $ 35,852      $ 24,298      $ 6,399      $ (25,528   $ 41,021   

Initial franchise and relicensing fees

     1,912        —          —          —          1,912   

Procurement services

     3,245        —          —          —          3,245   

Marketing and reservation

     47,980        65,123        3,447        (57,710     58,840   

Other items, net

     1,424        867        112        —          2,403   
                                        

Total revenues

     90,413        90,288        9,958        (83,238     107,421   
                                        

OPERATING EXPENSES:

          

Selling, general and administrative

     21,734        21,855        3,755        (25,528     21,816   

Marketing and reservation

     50,203        62,706        3,641        (57,710     58,840   

Other items, net

     984        1,745        199        —          2,928   
                                        

Total operating expenses

     72,921        86,306        7,595        (83,238     83,584   
                                        

Operating income

     17,492        3,982        2,363        —          23,837   

OTHER INCOME AND EXPENSES, NET:

          

Interest expense

     704        (84     1        —          621   

Equity earnings of consolidated subsidiaries

     (5,389     —          —          5,389       —     

Other items, net

     (61     (789     (580     —          (1,430 )
                                        

Total other income and expenses, net

     (4,746     (873     (579     5,389        (809
                                        

Income before income taxes

     22,238        4,855        2,942        (5,389     24,646   

Income taxes

     6,445        2,051        357        —          8,853   
                                        

Net income

   $ 15,793      $ 2,804      $ 2,585      $ (5,389   $ 15,793   
                                        

 

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Choice Hotels International, Inc.

Condensed Consolidating Balance Sheet

As of March 31, 2011

(Unaudited, in thousands)

 

     Parent     Guarantor
Subsidiaries
     Non-Guarantor
Subsidiaries
     Eliminations     Consolidated  

ASSETS

            

Cash and cash equivalents

   $ 3,847      $ 259       $ 72,299         —        $ 76,405   

Receivables

     40,822        1,449         6,008         —          48,279   

Other current assets

     5,485        18,970         3,580         (4,851     23,184   
                                          

Total current assets

     50,154        20,678         81,887         (4,851     147,868   

Property and equipment, at cost, net

     10,500        42,444         1,352         —          54,296   

Goodwill

     60,620        5,193         229         —          66,042   

Franchise rights and other identifiable intangibles, net

     12,708        3,797         3,457         —          19,962   

Receivable – marketing and reservation fees

     54,719       —           —           —          54,719   

Investment in and advances to affiliates

     261,787        197,685         6,508         (465,980     —     

Investments, employee benefit plans, at fair value

     —          24,728         —           —          24,728   

Deferred income taxes

     4,572        19,751         137         —          24,460   

Other assets

     9,271        7,201         3,826         —          20,298   
                                          

Total assets

   $ 464,331      $ 321,477       $ 97,396       $ (470,831   $ 412,373   
                                          

LIABILITIES AND SHAREHOLDERS’ DEFICIT

            

Accounts payable

   $ 8,867      $ 25,484       $ 4,379       $ —        $ 38,730   

Accrued expenses

     13,805        13,922         1,236         —          28,963   

Deferred revenue

     10,913        60,235         891         —          72,039   

Current portion of long-term debt

     —          494         14         —          508   

Income taxes payable

     9,579        —           1,546         (4,197     6,928   

Other current liabilities

     —          3,227         —           (654     2,573   
                                          

Total current liabilities

     43,164        103,362         8,066         (4,851     149,741   

Long-term debt

     257,495        2,476         36         —          260,007   

Deferred compensation & retirement plan obligations

     —          34,654         6         —          34,660   

Advances from affiliates

     203,544        505         12,411         (216,460     —     

Other liabilities

     9,158        7,794         43         —          16,995   
                                          

Total liabilities

     513,361        148,791         20,562         (221,311     461,403   
                                          

Total shareholders’ (deficit) equity

     (49,030     172,686         76,834         (249,520     (49,030
                                          

Total liabilities and shareholders’ deficit

   $ 464,331      $ 321,477       $ 97,396       $ (470,831   $ 412,373   
                                          

 

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Choice Hotels International, Inc.

Condensed Consolidating Balance Sheet

As of December 31, 2010

(In Thousands)

 

     Parent     Guarantor
Subsidiaries
     Non-Guarantor
Subsidiaries
     Eliminations     Consolidated  

ASSETS

            

Cash and cash equivalents

   $ 4,849      $ 18,659       $ 67,751       $ —        $ 91,259   

Receivables

     40,160        2,055         5,423         —          47,638   

Other current assets

     5,193        19,616         6,444         (6,568 )     24,685   
                                          

Total current assets

     50,202        40,330         79,618         (6,568 )     163,582   

Property and equipment, at cost, net

     11,586        42,678         1,398         —          55,662   

Goodwill

     60,620        5,193         228        —          66,041   

Franchise rights and other identifiable intangibles, net

     13,315        3,953         3,557         —          20,825   

Investments, employee benefit plans, at fair value

     —          23,365         —           —          23,365   

Investment in and advances to affiliates

     251,245        186,045         7,338         (444,628 )     —     

Receivable, marketing and reservation fees

     42,507        —           —           —          42,507   

Deferred income taxes

     4,560        19,745         130         —          24,435   

Other assets

     7,339        7,366         600         —          15,305   
                                          

Total assets

   $ 441,374      $ 328,675       $ 92,869       $ (451,196 )   $ 411,722   
                                          

LIABILITIES AND SHAREHOLDERS’ DEFICIT

            

Accounts payable

   $ 5,700      $ 31,475       $ 3,993         —        $ 41,168   

Accrued expenses

     19,257        26,890         1,671         —          47,818   

Deferred revenue

     14,070        52,256         996         —          67,322   

Revolving credit facility

     200        —           —           —          200   

Current portion of long-term debt

     —          403        17        —          420   

Income taxes payable

     9,395        —           2,297         (5,914 )     5,778   

Other current liabilities

     —          3,206         —           (654 )     2,552   
                                          

Total current liabilities

     48,622        114,230         8,974         (6,568 )     165,258   

Long-term debt

     249,379        2,137        38         —          251,554   

Deferred compensation & retirement plan obligations

     —          35,707         —           —          35,707   

Advances from affiliates

     192,077        1,097         10,137         (203,311 )     —     

Other liabilities

     9,367        7,880         27         —          17,274   
                                          

Total liabilities

     499,445        161,051         19,176         (209,879 )     469,793   
                                          

Total shareholders’ (deficit) equity

     (58,071 )     167,624         73,693         (241,317 )     (58,071 )
                                          

Total liabilities and shareholders’ deficit

   $ 441,374      $ 328,675       $ 92,869       $ (451,196 )   $ 411,722   
                                          

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Cash Flows

For the Three Months ended March 31, 2011

(Unaudited, in thousands)

 

     Parent     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations      Consolidated  

Net cash provided (used) from operating activities

   $ 4,590      $ (15,659   $ 5,852        —         $ (5,217
                                         

CASH FLOWS FROM INVESTING ACTIVITIES:

           

Investment in property and equipment

     (205     (1,601     (29     —           (1,835

Equity method investments

     —          —          (1,600     —           (1,600

Issuance of notes receivable

     (49     (1,406     (22     —           (1,477

Collection of notes receivable

     —          7        —          —           7   

Purchases of investments, employee benefit plans

     —          (897     —          —           (897

Proceeds from the sales of investments, employee benefit plans

     —          310        —          —           310   

Other items, net

     (113     13        5        —           (95
                                         

Net cash provided (used) in investing activities

     (367     (3,574     (1,646     —           (5,587
                                         

CASH FLOWS FROM FINANCING ACTIVITIES:

           

Net borrowings pursuant to revolving credit facilities

     7,900        —          —          —           7,900   

Repayments of long-term debt

     —          —          (5     —           (5

Purchase of treasury stock

     (2,207     —          —          —           (2,207

Debt issuance costs

     (2,207     —          —          —           (2,207

Excess tax benefits from stock-based compensation

     1        833        —          —           834   

Dividends paid

     (10,950     —          —          —           (10,950

Proceeds from exercise of stock options

     2,238        —          —          —           2,238   
                                         

Net cash provided (used) in financing activities

     (5,225     833        (5     —           (4,397
                                         

Net change in cash and cash equivalents

     (1,002     (18,400     4,201        —           (15,201

Effect of foreign exchange rate changes on cash and cash equivalents

     —          —          347        —           347   

Cash and cash equivalents at beginning of period

     4,849        18,659        67,751        —           91,259   
                                         

Cash and cash equivalents at end of period

   $ 3,847      $ 259      $ 72,299        —         $ 76,405   
                                         

 

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Choice Hotels International, Inc.

Condensed Consolidating Statement of Cash Flows

For the Three Months ended March 31, 2010

(Unaudited, in thousands)

 

     Parent     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminations      Consolidated  

Net cash provided (used) from operating activities

   $ 4,108      $ 4,088      $ (1,216     —         $ 6,980   
                                         

CASH FLOWS FROM INVESTING ACTIVITIES:

           

Investment in property and equipment

     (1,167     (3,320     (71     —           (4,558

Acquisitions, net of cash acquired

     —          —          (466 )     —           (466

Issuance of notes receivable

     (213     (321     —          —           (534

Collection of notes receivable

     —          10        —          —           10   

Purchases of investments, employee benefit plans

     —          (1,104     —          —           (1,104

Proceeds from the sales of investments, employee benefit plans

     —          522        —          —           522   

Other items, net

     (124     —          —          —           (124
                                         

Net cash used in investing activities

     (1,504     (4,213     (537     —           (6,254
                                         

CASH FLOWS FROM FINANCING ACTIVITIES:

           

Net borrowings pursuant to revolving credit facility

     16,200        —          —          —           16,200   

Purchase of treasury stock

     (8,936     —          —          —           (8,936

Excess tax benefits from stock-based compensation

     —          49       —          —           49   

Dividends paid

     (10,945     —          —          —           (10,945

Proceeds from exercise of stock options

     648        —          —          —           648   
                                         

Net cash (used in) provided by financing activities

     (3,033     49        —          —           (2,984
                                         

Net change in cash and cash equivalents

     (429     (76     (1,753     —           (2,258

Effect of foreign exchange rate changes on cash and cash equivalents

     —          —          (19     —           (19

Cash and cash equivalents at beginning of period

     4,281        303        63,286        —           67,870   
                                         

Cash and cash equivalents at end of period

   $ 3,852      $ 227      $ 61,514        —         $ 65,593   
                                         

16. 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 system fees, procurement services revenue and other revenue. The Company is obligated under its franchise agreements to provide marketing and reservation services appropriate for the 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 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 4, the Company does not allocate interest income, interest expense or income taxes to its franchising segment.

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

 

     Three Months Ended March 31, 2011      Three Months Ended March 31, 2010  

(In thousands)

   Franchising      Corporate &
Other
    Consolidated      Franchising      Corporate &
Other
    Consolidated  

Revenues

   $ 114,417       $ 864      $ 115,281       $ 106,554       $ 867      $ 107,421   

Operating income (loss)

   $ 36,077       $ (10,398   $ 25,679       $ 33,068       $ (9,231   $ 23,837   

Income (loss) before income taxes

   $ 34,611       $ (12,688   $ 21,923       $ 33,421       $ (8,775   $ 24,646   

 

 

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17. 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 any such lawsuit individually will not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.

In June 2008, the Company guaranteed $1 million of a bank loan funding a franchisee’s construction of a Cambria Suites in Columbus, Ohio. The guaranty will terminate on the earlier of (i) the repayment of all outstanding obligations under the bank loan that it supports (the current initial loan term runs through June 2013), or (ii) when the franchisee achieves certain debt service coverage ratios outlined in the underlying bank loan agreement. The Company has received a pledge of an equity interest in the entity constructing the property as well as personal guarantees from several of the franchisee’s principal owners related to the repayment of any amounts the Company may be required to pay under this guaranty.

In July 2008, the Company guaranteed $1 million of a bank loan funding a franchisee’s construction of a Cambria Suites in Noblesville, Indiana. The guaranty will terminate on the earlier of (i) the repayment of all outstanding obligations under the bank loan that it supports (the current initial loan term runs through September 2011), or (ii) when the franchisee achieves certain debt service coverage ratios outlined in the underlying bank loan agreement. The Company has received a pledge of an equity interest in the entity constructing the property as well as personal guarantees from several of the franchisee’s principal owners related to the repayment of any amounts the Company may be required to pay under this guaranty.

The Company occasionally provides financing to franchisees for property improvements, hotel development efforts and other purposes. At March 31, 2011, the Company had commitments to extend an additional $7.0 million for these purposes provided certain conditions are met by its franchisees, of which $3.6 million is expected to be advanced in the next twelve months.

The Company has invested $1.6 million in a joint venture and has a commitment to invest an additional $3.4 million which is expected to be funded completely in 2011.

In the ordinary course of business, the Company enters into numerous agreements that contain standard indemnities whereby the Company indemnifies another party for breaches of representations and warranties. Such 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) certain operating agreements. The indemnifications issued are for the benefit of the (i) buyers in sale agreements and sellers in purchase agreements, (ii) landlords in lease contracts, (iii) franchisees in licensing agreements, (iv) financial institutions in credit facility arrangements, (v) underwriters in debt or equity security issuances and (vi) parties under certain operating agreements. In addition, these parties are also generally indemnified against any third party claim resulting from the transaction that is contemplated in the underlying agreement. While some of these indemnities 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 indemnities, nor is the Company able to develop an estimate of the maximum potential amount of future payments to be made under these indemnifications as the triggering events are not subject to predictability. With respect to certain of the aforementioned indemnities, 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 potential liability.

18. Termination Charges

During three months ended March 31, 2011, the Company recorded one-time employee termination charges totaling $0.3 million in SG&A and marketing and reservation expenses. These charges related to salary and benefits continuation payments for employees separating from service with the Company. At March 31, 2011, the Company had approximately $0.2 million of these salary and benefits continuation payments remaining to be remitted. During the three months ended March 31, 2011, the Company remitted $1.9 million of termination benefits related to employee termination charges recorded in prior periods and had approximately $2.1 million of these benefits remaining to be paid.

At March 31, 2011 and December 31, 2010, approximately $2.4 million and $4.0 million of termination benefits remained and were included in current and noncurrent liabilities in the Company’s consolidated financial statements. The Company expects $2.0 million of benefits to be paid in the next twelve months.

19. Subsequent Events

On May 5, 2011, the Company’s Board of Directors declared a quarterly cash dividend of $0.185 per share of common stock. The dividend is payable on July 15, 2011 to shareholders of record as of July 1, 2011. Based on the Company’s share count at March 31, 2011, the total dividends to be paid is approximately $11 million.

 

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

The following 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 6,128 hotels open and 606 hotels under construction, awaiting conversion or approved for development as of March 31, 2011, with 492,733 rooms and 49,908 rooms, respectively, in 49 states, the District of Columbia and over 40 countries and territories outside the United States. Our brand names include Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Ascend Collection®, Sleep Inn®, Econo Lodge®, Rodeway Inn®, MainStay Suites®, Suburban Extended Stay Hotel®, and Cambria Suites® (collectively, the “Choice brands”).

The Company conducts its international franchise operations through a combination of direct franchising and master franchising relationships. Master franchising relationships allow the use of our brands by third parties in foreign countries. These relationships are governed by master franchising agreements which generally provide the master franchise with the right to use our brands in a specific geographic region, usually for a fee. As a result of our use of master franchising relationships and international market conditions, total revenues from international franchising operations comprised only 10% and 9% of our total revenues for the three months ended March 31, 2011 and 2010, while representing approximately 19% of hotels open at both March 31, 2011 and 2010.

Our Company generates revenues, income and cash flows primarily from initial, relicensing and continuing royalty fees attributable to our franchise agreements. Revenues are also generated from 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 hotel rooms and effective royalty rates of our franchise contracts resulting in increased initial fee and relicensing revenue, ongoing royalty fees and procurement services revenues. In addition, our operating results can also be improved through our company-wide efforts related to improving property level performance. The Company currently estimates that based on its current domestic portfolio of hotels under franchise that a 1% change in revenue per available room (“RevPAR”) or rooms under franchise would increase or decrease annual domestic royalty revenues by approximately $2.2 million and a 1 basis point change in the Company’s effective royalty rate would increase or decrease annual domestic royalties by approximately $0.5 million. In addition to these revenues, we also collect marketing and reservation system fees to support centralized marketing and reservation activities for the franchise system. As a lodging franchisor, the Company currently has relatively low capital expenditure requirements.

The principal factors that affect the Company’s results are: the number and relative mix of franchised hotel rooms; growth in the number of hotel rooms under franchise; occupancy and room rates achieved by the hotels under franchise; the effective royalty rate achieved; the level of franchise sales and relicensing activity; 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 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 system 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 franchisees’ profitability by providing them with hotel franchises that strive to generate the highest return on investment of any hotel franchise. We have developed an operating

 

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system dedicated to our franchisees’ success that focuses on delivering guests to our franchised hotels and reducing costs for our hotel owners.

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

Profitable Growth. We believe our success is dependent on improving the performance of our hotels, increasing our system size by selling additional hotel franchises, effective royalty rate improvement and maintaining a disciplined cost structure. 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. Currently, 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.

Historically, 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. During the three months ended March 31, 2011, the Company repurchased no shares of its common stock under the share repurchase program. Since the program’s inception through March 31, 2011, we have repurchased 43.2 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 $1.0 billion. Considering the effect of the two-for-one stock split, the Company has repurchased 76.2 million shares at an average price of $13.35 per share. We currently believe that our cash flows from operations will support our ability to complete the current board of directors repurchase authorization of approximately 3.6 million shares remaining as of March 31, 2011. Upon completion of the current authorization, our board of directors will evaluate the advisability of additional share repurchases.

During the three months ended March 31, 2011, we paid cash dividends totaling approximately $11.0 million and we presently expect to continue to pay dividends in the future, subject to future business performance, economic conditions, changes in income tax regulations and other factors. Based on our present dividend rate and outstanding share count, aggregate annual dividends for 2011 would be approximately $44.0 million.

Our board of directors previously authorized us to enter into programs which permit us to offer investment, financing and guaranty support to qualified franchisees as well as to acquire and resell real estate to incent franchise development for certain brands in top markets. Recent market conditions have resulted in an increase in opportunities to incentivize development under these programs.

Over the next several years, we expect to deploy capital opportunistically pursuant to these programs to promote growth of our emerging brands. The amount and timing of the investment in these programs will be dependent on market and other conditions. Our current expectation is that our annual investment in these programs will range from $20 million to $40 million. Notwithstanding these programs, the company expects to continue to return value to its shareholders through a combination of share repurchases and dividends, subject to business performance, economic conditions, changes in income tax regulations and other factors.

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 March 31, 2011, royalty fees revenue totaled $44.2 million, an 8% increase from the same period in 2010. Operating income totaled $25.7 million for the three months ended March 31, 2011, a $1.8 million or 8% increase from the same period in 2010. Net income decreased $0.1 million from the same period of the prior year to $15.7 million. Diluted earnings per share for the quarter ended March 31, 2011 were $0.26 compared to

 

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$0.26 for the three months ended March 31, 2010. These measurements will continue to be a key management focus in 2011 and beyond.

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

Liquidity and Capital Resources: Historically, the Company has generated significant cash flows from operations. Since our business does not currently 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 is 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 March 31, 2011 and 2010

The Company recorded net income of $15.7 million for the three month period ended March 31, 2011, a $0.1 million decrease from the $15.8 million for the quarter ended March 31, 2010. The decrease in net income for the three months ended March 31, 2011, is primarily attributable to the Company recording a $1.8 million loss on assets held for sale as well as an increase in effective borrowing rates due to the issuance of fixed rate long-term debt in August 2010. The increases in these items were partially offset by an 8% increase in operating income and a lower effective income tax rate compared to the prior year period.

Summarized financial results for the three months ended March 31, 2011 and 2010 are as follows:

 

(in thousands, except per share amounts)    2011     2010  

REVENUES:

    

Royalty fees

   $ 44,240      $ 41,021   

Initial franchise and relicensing fees

     2,614        1,912   

Procurement services

     3,165        3,245   

Marketing and reservation

     62,967        58,840   

Hotel operations

     864        867   

Other

     1,431        1,536   
                

Total revenues

     115,281        107,421   
                

OPERATING EXPENSES:

    

Selling, general and administrative

     23,847        21,816   

Depreciation and amortization

     1,955        2,172   

Marketing and reservation

     62,967        58,840   

Hotel operations

     833        756   
                

Total operating expenses

     89,602        83,584   
                

Operating income

     25,679        23,837   
                

OTHER INCOME AND EXPENSES, NET:

    

Interest expense

     3,224        621   

Interest income

     (210     (60

Other gains and losses

     1,043        (1,017

Equity in net income of affiliates

     (301     (353
                

Total other income and expenses, net

     3,756        (809
                

Income before income taxes

     21,923        24,646   

Income taxes

     6,193        8,853   
                

Net income

   $ 15,730      $ 15,793   
                

Diluted earnings per share

   $ 0.26      $ 0.26   
                

The Company utilizes certain measures such as adjusted net income, adjusted diluted EPS, adjusted selling, general and administrative (“SG&A”) expense, adjusted operating income and franchising revenues which do not conform to generally accepted accounting principles in the United States (“GAAP”) when analyzing and discussing its results with the investment community. This information should not be considered as an alternative to any measure of performance as promulgated under

 

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GAAP, such as net income, diluted EPS, SG&A, operating income and total revenues. The Company’s calculation of these measurements may be different from the calculations used by other companies and therefore comparability may be limited. We have included below a reconciliation of these measures to the comparable GAAP measurement as well as our reason for reporting these non-GAAP measures.

Franchising Revenues: The Company utilizes franchising revenues which exclude marketing and reservation system revenues and hotel operations rather than total revenues when analyzing the performance of the business. Marketing and reservation activities are excluded from revenues since the Company is contractually required by its franchise agreements to use these fees collected for marketing and reservation activities; as such, no income or loss to the Company is generated. Cumulative marketing and reservation system fees not expended are recorded as a payable on the Company’s financial statements and are carried over to the next fiscal year and expended in accordance with the franchise agreements. Cumulative marketing and reservation expenditures in excess of fees collected for marketing and reservation activities are recorded as a receivable on the Company’s financial statements. Hotel operations are excluded since they do not reflect the most accurate measure of the Company’s core franchising business. This non-GAAP measure is a commonly used measure of performance in our industry and facilitates comparisons between the Company and its competitors.

Calculation of Franchising Revenues

 

     Three Months Ended March 31,  
     ($ amounts in thousands)  
     2011     2010  

Franchising Revenues:

    

Total Revenues

   $ 115,281      $ 107,421   

Adjustments:

    

Marketing and reservation system revenues

     (62,967     (58,840

Hotel operations

     (864     (867
                

Franchising Revenues

   $ 51,450      $ 47,714   
                

Adjusted Net Income, Adjusted Diluted EPS, Adjusted SG&A and Adjusted Operating Income: We also use adjusted net income, adjusted diluted EPS, adjusted SG&A and adjusted operating income all of which exclude employee termination benefits for the three months ended March 31, 2011 and 2010. Adjusted net income and adjusted diluted EPS for the three months ended March 31, 2011 also exclude a $1.8 million loss on assets held for sale resulting from the Company reducing the carrying amount of a parcel of land held for sale to its estimated fair value. The Company utilizes these non-GAAP measures to enable investors to perform meaningful comparisons of past, present and future operating results and as a means to emphasize the results of on-going operations.

Calculation of Adjusted Operating Income

 

     Three Months Ended March 31,  
     ($ amounts in thousands)  
     2011      2010  

Operating Income

   $ 25,679       $ 23,837   

Adjustments:

     

Employee termination benefits

     70         352   
                 

Adjusted Operating Income

   $ 25,749       $ 24,189   
                 

 

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Calculation of Adjusted SG&A

 

     Three Months Ended March 31,  
     ($ amounts in thousands)  
     2011     2010  

SG&A

   $ 23,847      $ 21,816   

Adjustments:

    

Employee termination benefits

     (70     (352
                

Adjusted SG&A

   $ 23,777      $ 21,464   
                

Calculation of Adjusted Net Income and Adjusted Diluted EPS

 

     Three Months Ended March 31,  
     (In thousands, except per share amounts)  
     2011      2010  

Net Income

   $ 15,730       $ 15,793   

Adjustments, net of tax:

     

Loss on land held for sale

     1,111         —     

Employee termination benefits

     44         220   
                 

Adjusted Net Income

   $ 16,885       $ 16,013   
                 

Weighted average shares outstanding – diluted

     59,825         59,600   

Diluted EPS

   $ 0.26       $ 0.26   

Adjustments:

     

Loss on land held for sale

     0.02         —     

Employee termination benefits

     —           0.01   
                 

Adjusted Diluted EPS

   $ 0.28       $ 0.27   
                 

The Company recorded adjusted net income of $16.9 million for the three months ended March 31, 2011 a $0.9 million increase compared to an adjusted net income of $16.0 million for the three months ended March 31, 2010. The increase in adjusted net income for the three months ended March 31, 2011 is primarily attributable to a $1.6 million increase in adjusted operating income and a lower effective income tax rate, partially offset by $2.6 million increase in interest expense due to the issuance of $250 million of senior notes in August 2010 which carry a higher effective interest rate than the Company’s revolving credit facility. Adjusted operating income increased $1.6 million as the Company’s franchising revenues for the three months ended March 31, 2011 increased $3.7 million or 8% from the same period of the prior year partially offset by a $2.3 million increase adjusted SG&A expenses.

Franchising Revenues: Franchising revenues were $51.5 million for the three months ended March 31, 2011 compared to $47.7 million for the three months ended March 31, 2010. The increase in franchising revenues is primarily due to an 8% increase in royalty revenues and a 37% increase in initial franchise and relicensing fees.

Domestic royalty fees for the three months ended March 31, 2011 increased $2.7 million to $38.7 million from $36.0 million in the three months ended March 31, 2010, an increase of 7%. The increase in royalties is attributable to a combination of factors including a 5.5% increase in RevPAR, a 0.8% increase in the number of domestic franchised hotel rooms and an increase in the effective royalty rate of the domestic hotel system from 4.32% to 4.35%. System-wide RevPAR increased due to a 190 basis point increase in occupancy and a 0.7% increase in average daily rates.

 

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

 

     For the Three Months Ended
March 31, 2011*
     For the Three Months Ended
March 31, 2010*
     Change  
     Average
Daily
Rate
     Occupancy     RevPAR      Average
Daily
Rate
     Occupancy     RevPAR      Average
Daily
Rate
    Occupancy      RevPAR  

Comfort Inn

   $ 72.21         44.3   $ 32.00       $ 71.02         42.8   $ 30.36         1.7     150 bps         5.4 %

Comfort Suites

     79.08         47.0     37.18         79.21         43.7     34.64         (0.2 %)      330 bps         7.3

Sleep

     64.94         42.2     27.43         64.76         41.2     26.67         0.3     100 bps         2.8

Quality

     61.58         38.6     23.80         61.59         37.0     22.77         (0.0 %)      160 bps         4.5

Clarion

     67.72         36.6     24.75         69.45         33.6     23.32         (2.5 %)      300 bps         6.1

Econo Lodge

     49.61         37.3     18.49         49.58         35.6     17.65         0.1     170 bps         4.8 %

Rodeway

     45.77         38.6     17.65         45.44         36.3     16.51         0.7     230 bps         6.9

MainStay

     60.97         53.9     32.85         63.11         52.1     32.86         (3.4 %)      180 bps         (0.0 %)

Suburban

     38.29         60.7     23.24         37.22         58.8     21.89         2.9     190 bps         6.2 %

Ascend Collection

     98.46         49.9     49.09         97.33         42.3     41.21         1.2     760 bps         19.1 %
                                                                             

Total

   $ 65.69         42.0   $ 27.58       $ 65.22         40.1   $ 26.13         0.7     190 bps         5.5 %
                                                                             

 

* Operating statistics represent hotel operations from December through February

The number of domestic rooms on-line increased to 390,407 as of March 31, 2011 from 387,246 as of March 31, 2010, an increase of 0.8%. The total number of domestic hotels on-line grew 1.3% to 4,970 as of March 31, 2011 from 4,905 as of March 31, 2010.

A summary of domestic hotels and rooms on-line at March 31, 2011 and 2010 by brand is as follows:

 

     March 31, 2011      March 31, 2010      Variance  
     Hotels      Rooms      Hotels      Rooms      Hotels     Rooms     %     %  

Comfort Inn

     1,422         110,932         1,445         113,266         (23     (2,334     (1.6 %)      (2.1 %) 

Comfort Suites

     621         48,096         620         48,180         1        (84     0.2     (0.2 %) 

Sleep

     397         28,895         389         28,377         8        518        2.1     1.8

Quality

     1,015         88,967         976         88,394         39        573        4.0     0.6

Clarion

     192         28,259         168         24,336         24        3,923        14.3     16.1

Econo Lodge

     779         48,245         786         48,519         (7     (274     (0.9 %)      (0.6 %) 

Rodeway

     381         20,940         373         21,118         8        (178     2.1     (0.8 %) 

MainStay

     38         2,943         36         2,797         2        146        5.6     5.2

Suburban

     63         7,543         62         7,474         1        69        1.6     0.9

Ascend Collection

     42         3,259         30         2,459         12        800        40.0     32.5

Cambria Suites

     20         2,328         20         2,326         —          2        0.0     0.1
                                                                    

Total Domestic Franchises

     4,970         390,407         4,905         387,246         65        3,161        1.3     0.8
                                                                    

International available rooms increased 2.3% to 102,326 as of March 31, 2011 from 100,018 as of March 31, 2010. The total number of international hotels increased 2.8% from 1,127 as of March 31, 2010 to 1,158 as of March 31, 2011.

As of March 31, 2011, the Company had 508 franchised hotels with 41,475 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 657 hotels and 52,483 rooms at March 31, 2010. The number of new construction franchised hotels in the Company’s domestic pipeline decreased 27% to 352 at March 31, 2011 from 482 at March 31, 2010. The number of conversion franchised hotels in the Company’s domestic pipeline declined by 19 units or 11% from March 31, 2010 to 156 hotels at March 31, 2011. The domestic system hotels under construction, awaiting conversion or approved for development declined 23% from the prior year primarily due to the decline in new executed franchise agreements over the trailing twelve months due to the current economic environment coupled with the opening of 291 franchised units over the twelve months ending March 31, 2011. The Company had an additional 98 franchised hotels with 8,433 rooms under construction, awaiting conversion or approved for development in its international system as of March 31, 2011 compared to 102 hotels and 8,221 rooms at March 31, 2010. While the Company’s hotel pipeline provides a

 

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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 March 31, 2011 and 2010 by brand is as follows:

 

                                               Variance  
     March 31, 2011
Units
     March 31, 2010
Units
     Conversion     New Construction     Total  
     Conversion      New
Construction
     Total      Conversion      New
Construction
     Total      Units     %     Units     %     Units     %  

Comfort Inn

     31         58         89         43         81         124         (12     (28 %)      (23     (28 %)      (35     (28 %) 

Comfort Suites

     3        117         120         —           154         154         3        NM        (37     (24 %)      (34     (22 %) 

Sleep Inn

     —           70         70         1         115         116         (1     (100 %)      (45     (39 %)      (46     (40 %) 

Quality

     47         6         53         39         13         52         8        21     (7     (54 %)      1        2

Clarion

     20         2         22         16         6         22         4        25     (4     (67 %)      —          0

Econo Lodge

     35         2         37         39         4         43         (4     (10 %)      (2     (50 %)      (6     (14 %) 

Rodeway

     14         2         16         33         3         36         (19     (58 %)      (1     (33 %)      (20     (56 %) 

MainStay

     2        39         41         —           39         39         2        NM        —          0     2        5

Suburban

     —           20         20         —           26         26         —          NM        (6     (23 %)      (6     (23 %) 

Ascend Collection

     4         4         8         4         4         8         —          0     —          0     —          0

Cambria Suites

     —           32         32         —           37         37         —          NM        (5     (14 %)      (5     (14 %) 
                                                                                                      

Total

     156         352         508         175         482         657         (19     (11 %)      (130     (27 %)      (149     (23 %) 
                                                                                                      

Domestic hotels open and operating declined by 23 hotels during the three months ended March 31, 2011 compared to a decline of one domestic hotel open and operating during the three months ended March 31, 2010. Gross domestic franchise additions declined from 78 for the three months ended March 31, 2010 to 42 for the same period of 2011. New construction hotels represented 4 of the gross domestic additions during three months ended March 31, 2011 compared to 28 hotels in the same period of the prior year. Gross domestic additions for conversion hotels during the three months ended March 31, 2011 declined by 12 to 38 hotels from 50 hotels in the same period of the prior year. The decline in new hotel openings in the current period reflects the lack of new hotel construction financing, a decline in the real estate market for hotel transactions and retention efforts implemented by other hotel brand companies have negatively impacted the Company’s pipeline of new franchises. The Company expects the number of new franchise additions that will open during 2011 to decline from 327 in 2010 to approximately 277 hotels. This decline is expected to be driven by new construction hotels which are projected to decline by 48 hotels from 78 in 2010 to 30 hotels in 2011 due to the impact the tight credit markets have had on the number of new construction franchise agreements executed in 2009 and 2010 as well as the availability of capital to commence construction on existing projects.

Net domestic franchise terminations declined from 79 in the three months ended March 31, 2010 to 65 for the three months ended March 31, 2011 primarily due to fewer terminations related to the removal of hotels related to the non-payment of franchise fees.

International royalties increased by $0.6 million or 12% from $5.0 million in the first quarter of 2010 to $5.6 million for the same period of 2011 primarily due to foreign currency fluctuations and global RevPAR increases.

New domestic franchise agreements executed in the three months ended March 31, 2011 totaled 56 representing 5,158 rooms compared to 55 agreements representing 4,511 rooms executed in the first quarter of 2010. During the first quarter of 2011, 6 of the executed agreements were for new construction hotel franchises representing 572 rooms compared to 10 contracts representing 709 rooms for the same period a year ago. Conversion hotel executed franchise agreements totaled 50 representing 4,586 rooms for the three months ended March 31, 2011 compared to 45 agreements representing 3,802 rooms for 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 69% to $2.2 million for the three months ended March 31, 2011 from $1.3 million for the three months ended March 31, 2010. Initial fee revenue increased $0.9 million from the same period of the prior year despite executing approximately the same number of new franchise agreements in both periods due to an increase in average initial fees and the recognition of revenue during 2011 related to franchise agreements containing developer incentives executed in prior periods. Revenues associated with agreements including incentives are deferred and recognized when the incentive criteria are met or the agreement is terminated, whichever occurs first.

 

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A summary of executed domestic franchise agreements by brand for the three months ended March 31, 2011 and 2010 is as follows:

 

     For the Three Months Ended
March 31, 2011
     For the Three Months Ended
March 31, 2010
     % Change  
     New
Construction
     Conversion      Total      New
Construction
     Conversion      Total      New
Construction
    Conversion     Total  

Comfort Inn

     2         7         9         1         8         9         100     (13 %)      0

Comfort Suites

     —           2         2         2         —           2         (100 %)      NM        0

Sleep

     2         —           2         2         —           2         0     NM        0

Quality

     —           24         24         1         11         12         (100 %)      118