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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NO. 1-11915
CHOICE HOTELS INTERNATIONAL, INC.
------------------------------------------------------------
(Exact name of registrant as specified in its charter)
DELAWARE 52-1209792
- ------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10750 COLUMBIA PIKE
SILVER SPRING, MD. 20901
---------------------------------------------------
(Address of principal executive offices)
(Zip Code)
(301) 592-5000
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(Registrant's telephone number, including area code)
-------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to such filing requirements
for the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
SHARES OUTSTANDING
CLASS AT OCTOBER 21, 2002
------------------- -------------------
Common Stock, $0.01
par value per share 37,142,106
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================================================================================
1
CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
INDEX
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PAGE NO.
--------
PART I. FINANCIAL INFORMATION:
Item 1 - Financial Statements
Consolidated Statements of Income - For the three and nine months ended September 30, 2002
and September 30, 2001 (Unaudited) 3
Consolidated Balance Sheets - As of September 30, 2002 (Unaudited) and December 31, 2001 4
Consolidated Statements of Cash Flows - For the nine months ended September 30, 2002
and September 30, 2001 (Unaudited) 6
Notes to Consolidated Financial Statements 7
Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 12
Item 3 - Quantitative and Qualitative Disclosures about Market Risk 15
Item 4 - Controls and Procedures 15
PART II. OTHER INFORMATION: 17
Item 1 - Legal Proceedings
Item 2 - Changes in Securities
Item 3 - Defaults Upon Senior Securities
Item 4 - Submission of Matters to a Vote of Security Holders
Item 5 - Other Information
Item 6 - Exhibits and Reports on Form 8-K
SIGNATURE 18
CERTIFICATIONS 19
2
PART I. FINANCIAL INFORMATION
CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
---------- ---------- ---------- ----------
REVENUES As revised As revised
(See Note 1) (See Note 1)
Royalty fees $ 46,349 $44,618 $108,588 $107,621
Initial franchise and relicensing fees 3,524 3,509 9,261 9,159
Partner services revenue 2,548 2,964 9,040 8,866
Marketing and reservation revenues 50,251 43,968 148,600 117,626
Hotel operations 920 793 2,529 2,498
Other revenue 1,438 1,327 3,234 3,624
-------- ------- -------- --------
Total revenues 105,030 97,179 281,252 249,394
-------- ------- -------- --------
OPERATING EXPENSES
Selling, general and administrative 14,681 14,014 42,084 41,707
Depreciation and amortization 2,692 3,060 8,217 8,952
Marketing and reservation expenses 50,251 43,968 148,600 117,626
Hotel operations 821 728 2,210 1,909
-------- ------- -------- --------
Total operating expenses 68,445 61,770 201,111 170,194
-------- ------- -------- --------
OPERATING INCOME 36,585 35,409 80,141 79,200
-------- ------- -------- --------
OTHER INCOME AND EXPENSES
Interest and other investment income (968) (1,079) (3,244) (3,293)
Interest expense 3,287 3,981 9,885 12,045
Equity in net losses of affiliates 438 11,653 438 14,574
Minority interest in net income of consolidated subsidiary 105 - 105 -
Write-off of deferred financing costs - - - 650
-------- ------- -------- --------
Total other income and expenses 2,862 14,555 7,184 23,976
-------- ------- -------- --------
INCOME BEFORE INCOME TAXES 33,723 20,854 72,957 55,224
INCOME TAXES 11,856 8,346 27,209 21,750
-------- ------- -------- --------
NET INCOME $ 21,867 $12,508 $ 45,748 $ 33,474
======== ======= ======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING-BASIC 39,035 42,853 40,036 44,214
-------- ------- -------- --------
WEIGHTED AVERAGE SHARES OUTSTANDING-DILUTED 39,755 43,583 40,786 44,598
-------- ------- -------- --------
BASIC EARNINGS PER SHARE $ 0.55 $ 0.29 $ 1.14 $ 0.76
======== ======= ======== ========
DILUTED EARNINGS PER SHARE $ 0.54 $ 0.29 $ 1.12 $ 0.75
======== ======= ======== ========
The accompanying notes are an integral part of these consolidated
statements of income.
3
CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
September 30, 2002 December 31, 2001
------------------ -----------------
(Unaudited)
ASSETS
- ------
CURRENT ASSETS
Cash and cash equivalents $ 15,211 $ 16,871
Receivables (net of allowance for doubtful accounts of $6,000 and $5,392,
respectively) 34,695 25,223
Income taxes receivable and other current assets 327 889
-------- --------
Total current assets 50,233 42,983
-------- --------
PROPERTY AND EQUIPMENT, NET 66,343 70,458
GOODWILL, NET 60,620 60,620
FRANCHISE RIGHTS, NET 36,880 36,257
RECEIVABLE FROM MARKETING AND RESERVATION FUNDS 53,336 49,358
OTHER ASSETS 18,365 22,443
NOTE RECEIVABLE FROM SUNBURST 42,490 39,059
-------- --------
Total assets $328,267 $321,178
======== ========
The accompanying notes are an integral part of these consolidated balance
sheets.
4
CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
September 30, 2002 December 31, 2001
------------------ -----------------
(Unaudited)
LIABILITIES AND SHAREHOLDERS' DEFICIT
- -------------------------------------
CURRENT LIABILITIES
Current portion of long-term debt $ 26,438 $ 13,563
Accounts payable 26,877 24,724
Accrued expenses and other 28,032 30,054
Income taxes payable 15,858 2,836
---------- --------
Total current liabilities 97,205 71,177
---------- --------
LONG-TERM DEBT 274,809 267,733
DEFERRED INCOME TAXES ($46,452 and $35,159, respectively) AND
OTHER LIABILITIES
56,913 46,807
---------- --------
Total liabilities 428,927 385,717
---------- --------
SHAREHOLDERS' DEFICIT
Common stock, $.01 par value 384 420
Additional paid-in-capital 72,492 70,130
Accumulated other comprehensive income (loss) 141 (354)
Deferred compensation (2,082) (2,857)
Treasury stock (396,518) (311,053)
Retained earnings 224,923 179,175
---------- ---------
Total shareholders' deficit (100,660) (64,539)
---------- ---------
Total liabilities and shareholders' deficit $ 328,267 $ 321,178
========== =========
The accompanying notes are an integral part of these consolidated balance
sheets.
5
CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED, IN THOUSANDS)
Nine Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
CASH FLOWS FROM OPERATING ACTIVITIES: As revised
(See Note 1)
Net income $ 45,748 $ 33,474
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 8,217 8,952
Non-cash interest and other investment income (1,953) (3,168)
Provision for bad debts 653 195
Non-cash stock compensation and other charges 615 581
Minority interest in net income of consolidated subsidiary 105 -
Equity in net losses of affiliates 438 14,574
Write-off of deferred financing costs - 650
Changes in assets and liabilities, net of acquisitions:
Receivables (7,353) (4,665)
Receivable from marketing and reservation funds, net 5,071 23,729
Current liabilities (1,681) (2,338)
Income taxes payable/receivable and other assets 13,818 21,116
Deferred income taxes and other liabilities 10,995 (10,080)
---------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES 74,673 83,020
---------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in property and equipment (8,225) (10,308)
Acquisition of Flag (1,557) -
Other items, net (933) 248
Proceeds from Sunburst note - 101,954
---------- ---------
NET CASH (UTILIZED IN) PROVIDED BY INVESTING ACTIVITIES (10,715) 91,894
---------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt 271,071 606,692
Principal payments of long-term debt (251,168) (627,009)
Purchase of treasury stock (90,839) (175,224)
Proceeds from exercise of stock options 5,318 9,672
---------- ---------
NET CASH UTILIZED IN FINANCING ACTIVITIES (65,618) (185,869)
---------- ---------
Net change in cash and cash equivalents (1,660) (10,955)
Cash and cash equivalents at beginning of period 16,871 19,701
---------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 15,211 $ 8,746
========== =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash payments during the period for:
Income taxes, net of refunds $ 1,642 $ 11,190
Interest 9,541 12,572
Non-cash investing activities:
Properties assumed through the restructuring of Sunburst note $ - $ 1,475
Conversion of note receivable into Flag equity interest 1,061 -
Non-cash financing activities:
Income tax benefit realized from employee stock options exercised $ 1,399 $ 3,295
The accompanying notes are an integral part of these consolidated
statements of cash flows.
6
CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Company Information and Significant Accounting Policies
The accompanying unaudited consolidated financial statements of Choice
Hotels International, Inc. and subsidiaries (together the "Company") have been
prepared by the Company pursuant to the rules and regulations of the Securities
and Exchange Commission. In the opinion of management, all adjustments (which
include any normal recurring adjustments) considered necessary for a fair
presentation have been included. Certain information and footnote disclosures
normally included in financial statements presented in accordance with
accounting principles generally accepted in the United States of America have
been omitted. The 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, 2001 and notes thereto included in the Company's Form
10-K, dated March 26, 2002 (the "10-K"). Interim results are not necessarily
indicative of the entire year results because of seasonal and short-term
variations. All intercompany transactions and balances between Choice Hotels
International, Inc. and its subsidiaries have been eliminated in consolidation.
Certain reclassifications have been made to the prior year quarterly period
financial statements to conform to the current year presentation.
The Company revised its presentation of marketing and reservation fees
during the fourth quarter of 2001 to comply with Emerging Issues Task Force
("EITF") Issue 99-19 "Reporting Revenue Gross as a Principal versus Net as an
Agent." The Company had previously presented these fees net of related expenses
in its consolidated statements of income. EITF 99-19 requires that these fees be
recorded gross and accordingly, the Company has revised its financial statement
presentation for all periods presented. In addition, net advances and repayments
of marketing and reservation fees have been reclassified to present these
activities as cash flows from operating activities for all periods presented.
These revisions have no effect on the net income or total cash flows reported
during the periods presented.
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosures of contingent assets and liabilities at
the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
On September 25, 2002, the Company announced that it will expense the cost
of all stock options, beginning with options to be granted in the first quarter
of 2003. The accounting change, approved by the Company's Board of Directors,
reflects the Company's view that expensing stock options is the preferable way
to record employee compensation costs. The Company will adopt the fair value
based method of recording stock options in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation", which will affect any options granted on or after January 1,
2003.
2. Receivable from Marketing and Reservation Funds
The receivable from marketing and reservation funds at September 30, 2002
and December 31, 2001 was $53.3 million and $49.4 million, respectively.
Depreciation and amortization expense incurred by the marketing and reservation
funds was $3.2 million and $2.9 million for the three months ended September 30,
2002 and 2001, respectively, and $9.5 million and $8.7 million for the nine
months ended September 30, 2002 and 2001, respectively. Interest expense
incurred by the reservation fund was $0.3 million and $0.4 million for the three
months ended September 30, 2002 and 2001, respectively, and $1.1 million and
$1.5 million for the nine months ended September 30, 2002 and 2001,
respectively.
Under the terms of the Company's franchise agreements, the Company has the
legally enforceable right to assess and collect fees from its current
franchisees sufficient to pay for the marketing and reservation services the
Company has procured for the benefit of the franchise system, including fees to
reimburse the Company for past services rendered. The Company has the
contractual authority to require that the franchisees in the system at any given
point repay any deficits in the funds to reimburse the Company for any advance.
3. Restructuring Programs
During 2001, the Company recognized $5.9 million in restructuring charges.
The restructuring charges include severance and termination benefits for 64
employees (consisting of brand management and new hotels support, reservation
sales and administrative personnel and franchise sales and operations support),
the cancellation of preexisting contracts for termination of domestic leases and
exit costs related to the termination of a corporate hotel construction project.
The Company charged $1.8 million (comprised of termination benefits)
against the restructuring liability during the three months ended September 30,
2002 and $3.9 million (including $3.7 million of termination benefits) for the
nine months ended September 30,
7
2002. As of September 30, 2002, the remaining $0.7 million liability is recorded
in accrued expenses in the accompanying consolidated balance sheet. The
remaining $0.7 million, which is comprised of termination benefits, will be
substantially paid by March 2003.
During 2000, the Company recognized $5.6 million in restructuring charges.
The restructuring charges include severance and termination benefits for 176
employees (consisting of property and yield management system installers,
reservation agents and field service administrative support), the cancellation
of pre-existing international lease contracts, and the termination of its
internet initiative launched in 1999. As of September 30, 2002, the remaining
liability of $0.2 million is included in accrued expenses in the accompanying
consolidated balance sheet. The remaining liability will be paid in 2002.
4. Income Taxes
The income tax provisions for the three and nine month periods ended
September 30, 2002 and 2001 are based on the effective tax rates expected to be
applicable for the corresponding full year periods. The 2002 and 2001 nine month
rates of 37% and 39%, respectively, differ from the statutory rates primarily
because of state income taxes and certain federal and state income tax credits.
5. Comprehensive Income
Comprehensive income was $21.8 million and $12.5 million for the three
months ended September 30, 2002 and 2001, respectively, and $46.2 million and
$33.0 million for the nine months ended September 30, 2002 and 2001. The
differences between net income and comprehensive income include foreign currency
translation adjustments and unrealized gains and losses on available for sale
securities.
Three Months Ended Nine Months Ended
September 30, September 30,
(In thousands) 2002 2001 2002 2001
----------------------- -------------------
Net income $21,867 $12,508 $45,748 $33,474
Other comprehensive income, net of tax:
Unrealized gains (losses) on
marketable equity securities (32) (112) 48 (100)
Foreign currency translation
adjustments (28) 107 447 (419)
------- ------- ------- -------
Other comprehensive income (loss) (60) (5) 495 (519)
------- ------- ------- -------
Comprehensive income $21,807 $12,503 $46,243 $32,955
======= ======= ======= =======
6. Earnings Per Share
Basic earnings per share ("EPS") amounts are computed by dividing earnings
applicable to common shareholders by the weighted average number of common
shares outstanding. Diluted EPS amounts assume the issuance of common stock for
all potentially dilutive equivalents outstanding.
7. Acquisition of Flag Choice Hotels
On July 1, 2002, the Company acquired a controlling interest in Flag Choice
Hotels ("Flag") (the "Flag Transaction"). Flag, based in Melbourne, Australia,
is a franchisor of certain hotel brands in Australia, Papua New Guinea and Fiji.
The acquisition of a controlling interest in Flag gave the Company the ability
to control the Choice and Flag brands in Australia, Papua New Guinea and Fiji
and the Flag brand in New Zealand.
Pursuant to the Flag Transaction, the Company converted an existing $1.1
million convertible note due from Flag into an additional 15% of Flag's equity
(beyond the 15% equity interest held prior to the Flag Transaction) and
purchased an additional 25% of Flag's equity for approximately $1.6 million. As
of July 1, 2002, the Company's total ownership in Flag is 55%.
Pursuant to the Flag Transaction, the Company gave the seller the right to
"put" the remaining 45% equity interest in Flag to the Company for approximately
$1.1 million. The put right can be exercised between January 1, 2003 and June
30, 2007. The Company accounts for the put rights in accordance with SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities". SFAS 133
requires the recognition of all derivatives, except certain qualifying hedges,
as either assets or liabilities measured at fair value, with
8
changes in value reflected as current period income or loss unless specific
hedge accounting criteria are met. The fair value of the put rights was $0 at
July 1, 2002 and September 30, 2002, accordingly, there was no impact on
reported net income in the quarter ended September 30, 2002.
The Company also acquired the right to "call" the remaining 45% equity
interest in Flag from the seller for approximately $1.1 million. This right can
be exercised between July 1, 2004 and July 1, 2005. The Company determined that
the call right does not meet the definition of a derivative in SFAS 133.
The Company accounted for the Flag Transaction in accordance with SFAS No.
141, "Business Combinations". The excess of the purchase price over the net
tangible assets acquired of approximately $3.1 million has been allocated to
identifiable intangible assets as follows:
Estimated
Estimated Useful
Fair Value Lives
---------- -----
($000)
Trademarks/ Non-compete agreements $ 208 5 years
Franchise rights 2,951 5-15 years
------
$3,159
======
The purchase price allocation is preliminary and further refinements may be
made. The Company began consolidating the results of Flag on July 1, 2002. The
pro forma results of operations as if the Flag Transaction had been combined at
the beginning of 2001 and 2002, would not be materially different from the
Company's reported results for those periods.
8. Debt
In August 2002, the Company entered into a new $10.0 million revolving line
of credit with a maturity of August 2003. The new line of credit includes
customary financial and other covenants that require the maintenance of certain
ratios identical to those included in the Company's existing senior credit
facility. Borrowings under the line of credit bear interest at rates established
at the time of borrowing based on Prime minus 1.75% basis points. The Company
had $10.0 million outstanding at September 30, 2002 under this line of credit.
9. Reportable Segment Information
The Company has a single reportable segment encompassing its franchising
business. Franchising revenues are comprised of royalty fees, initial franchise
and relicensing fees, partner services revenue, marketing and reservation fees
and other. The Company is obligated under its franchise agreements to provide
marketing and reservation services appropriate for the successful operation of
its systems. These funds do not represent separate reportable segments as their
operations are directly related to the Company's franchising business. The
revenues received from franchisees that are used to pay for part of the
Company's central on-going operations are included in franchising revenues and
are offset by the related expenses paid from the marketing and reservation funds
to calculate franchising operating income. Corporate and other revenue consists
of hotel operations. 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 September 30, 2002 Three Months Ended September 30, 2001
Corporate & Corporate &
(In thousands) Franchising Other Consolidated Franchising Other Consolidated
-------------------------------------- ---------------------------------------
Revenues $104,110 $ 920 $105,030 $ 96,386 $ 793 $ 97,179
Operating income (loss) 46,750 (10,165) 36,585 43,091 (7,682) 35,409
Nine Months Ended September 30, 2002 Nine Months Ended September 30, 2001
Corporate & Corporate &
(In thousands) Franchising Other Consolidated Franchising Other Consolidated
-------------------------------------- ---------------------------------------
Revenues $278,723 $ 2,529 $281,252 $246,896 $ 2,498 $249,394
Operating income (loss) 109,705 (29,564) 80,141 110,305 (31,105) 79,200
9
10. Commitments and Contingencies
As of September 30, 2002, the Company's letter of credit with Friendly
Hotels PLC (currently known as C.H.E. Group PLC) ("Friendly") is (Pounds)2.7
million (approximately US $3.8 million). The Company extended its guarantee on
the letter of credit to July 22, 2003.
The Company is a defendant in a number of lawsuits arising in the ordinary
course of business. In the opinion of management and general counsel to the
Company, the ultimate outcome of such litigation will not have a material
adverse effect on the Company's business, financial position, results of
operations or cash flows.
The Company has a $3.0 million letter of credit issued as support for
construction and permanent financing of a Sleep Inn and MainStay Suites located
in Atlanta, Georgia. The letter of credit will expire in December 2003.
11. Impact of Recently Issued Accounting Standards
The Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets,"
on January 1, 2002, which updated accounting and reporting standards for the
amortization of goodwill and recognition of other intangible assets. SFAS No.
142 requires goodwill to be assessed on at least an annual basis for impairment
using a fair value basis. Because the Company operates in one reporting segment
in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information" and EITF 98-3, "Determining Whether a Nonmonetary
Transaction Involves Receipt of Productive Assets or of a Business", the fair
value of the Company's total assets are used to determine if goodwill may be
impaired. According to SFAS No. 142, quoted market prices in active markets are
the best evidence of fair value and shall be used as the basis for the
measurement if available. The Company is no longer required to record goodwill
amortization expense of approximately $2.0 million per year. Pursuant to the
requirements of SFAS No. 142, the Company will evaluate its goodwill and
intangibles for impairment on an annual basis and/or when events or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying amount. The Company's intangible assets were
determined to not be impaired during its 2002 annual assessment performed during
July 2002.
The impact of the adoption of SFAS No. 142 on our net income, basic EPS and
diluted EPS for the three and nine months ended September 30, 2002 and 2001, as
if the adoption had taken place during the first quarter of 2001 is as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
(In thousands, except per share amounts) 2002 2001 2002 2001
------------------------- -----------------------
Reported net income $21,867 $12,508 $45,748 $33,474
Add back: Goodwill amortization - 463 - 1,436
------- ------- ------- -------
Adjusted net income $21,867 $12,971 $45,748 $34,910
======= ======= ======= =======
Basic earnings per share:
Reported net income $ 0.55 $ 0.29 $ 1.14 $ 0.76
Goodwill amortization - 0.01 - 0.03
------- ------- ------- -------
Adjusted basic earnings per share $ 0.55 $ 0.30 $ 1.14 $ 0.79
======= ======= ======= =======
Diluted earnings per share:
Reported net income $ 0.54 $ 0.29 $ 1.12 $ 0.75
Goodwill amortization - 0.01 - 0.03
------- ------- ------- -------
Adjusted diluted earnings per share $ 0.54 $ 0.30 $ 1.12 $ 0.78
======= ======= ======= =======
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinded three previously issued statements and
amended SFAS No. 13, "Accounting for Leases." The statement provides reporting
standards for debt extinguishments and provides accounting standards for certain
lease modifications that have economic effects similar to sale-leaseback
transactions. The statement is effective for certain lease transactions
occurring after May 15, 2002 and all other provisions of the statement shall be
effective for financial statements issued on or after May 15, 2002. Adoption of
this standard did not have any impact on the Company's financial position or
results of operations.
10
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which updates accounting and
reporting standards for personnel and operational restructurings. The Company
will be required to adopt SFAS No. 146 for exit, disposal or other restructuring
activities that are initiated after December 31, 2002, with early application
encouraged. The Company does not expect the adoption of SFAS No. 146 to have a
material effect on the Company's financial position or results of operations.
12. Subsequent Events
In October 2002, the Board of Directors granted the Company's management
authority to acquire up to an additional 5.0 million shares.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Comparison of Operating Results for the Three Month Periods Ended September 30,
2002 and September 30, 2001
The Company recorded net income of $21.9 million, or $0.54 per diluted
share, for the quarter ended September 30, 2002, compared to net income for the
same period of 2001 of $12.5 million, or $0.29 per diluted share. The increase
in net income for the period is primarily attributable to $11.7 million of
equity losses related to the Company's investment in Friendly recorded in the
three months ended September 30, 2001. There were no equity losses related to
Friendly in the three months ended September 30, 2002. Net income also increased
due to improved franchising margins resulting from a $1.7 million increase in
royalty fees compared to the three months ended September 30, 2001 partially
offset by increased payroll and insurance related costs; and a decrease in the
Company's effective tax rate primarily attributable to $0.8 million of federal
and state tax credits recorded in the third quarter of 2002. In addition,
goodwill amortization, which is not recorded in 2002 pursuant to SFAS No. 142,
"Goodwill and Other Intangible Assets," of $0.5 million was recorded during the
third quarter of 2001.
Franchise Revenues
Management analyzes its business based on "net franchise revenue," which is
total revenue excluding hotel operations and marketing and reservation revenues,
and franchise operating expenses which are reflected in selling, general and
administrative expenses.
The Company's franchise revenues were $53.9 million and $52.4 million for
the three months ended September 30, 2002 and 2001, respectively. Royalty
revenue increased by $1.7 million to $46.3 million for the three months ended
September 30, 2002, from $44.6 million during the corresponding period in 2001.
Approximately $0.8 million of the change relates to increased domestic royalty
revenue attributable to an increase of 138 domestic units from the corresponding
prior year period, coupled with a domestic effective royalty rate increase of 3
basis points, partially offset by a 2.4% decline in RevPAR. International
royalty revenue increased $0.9 million, primarily due to the consolidation of
Flag during the third quarter of 2002. Revenues generated from partner services
relationships decreased by 14.0% from $3.0 million in 2001 to $2.5 million in
2002 due to lower transactional revenues earned associated with reduced hotel
occupancy levels. Under the partner services program, the Company generates
revenue from hotel industry vendors (who have been designated as preferred
providers) based on the level of goods or services purchased by hotel owners and
guests of the Company's franchised hotels.
The total number of domestic hotels online increased to 3,434 from 3,296,
an increase of 4.2% for the twelve months ended September 30, 2002, as compared
to the corresponding prior year period. This represents an increase in the
number of rooms open of 4.1% from 268,176 as of September 30, 2001 to 279,135 as
of September 30, 2002. As of September 30, 2002, the Company had 358 hotels
under development in its domestic hotel system representing 27,902 rooms.
The total number of international hotels online was 1,188 as of September
30, 2002, compared to 1,199 as of the corresponding prior year period. The
decrease in international hotels online is primarily due to termination of
certain Flag properties for failure to comply with the Company's brand standards
or failure to formalize a franchise relationship. The total number of
international rooms was 90,940 as of September 30, 2002, compared to 89,997 as
of September 30, 2001. As of September 30, 2002, the Company had 149 franchised
hotels under development in its international hotel system representing 15,689
rooms.
Franchise Expenses
The cost to operate the franchising business is reflected in selling,
general and administrative ("SG&A") expenses. SG&A expenses increased to $14.7
million from $14.0 million, an increase of $0.7 million for the three months
ended September 30, 2002, as compared to the corresponding prior period. As a
percentage of total net franchising revenues, total SG&A expenses were 27.3% for
the third quarter of 2002, compared to 26.7% for 2001. The increase is
substantially related to increased payroll and benefit costs, higher general
insurance costs compared to the corresponding prior year period, and the
consolidation of Flag during the third quarter of 2002.
Marketing and Reservations
The total marketing and reservation fees received by the Company were $50.3
million and $44.0 million for the three months ended September 30, 2002 and
2001, respectively. Depreciation and amortization expense incurred by the
marketing and reservation funds were $3.2 million and $2.9 million for the three
months ended September 30, 2002 and 2001, respectively. Interest expense
incurred by the reservation fund was $0.3 million and $0.4 million for the three
months ended September 30, 2002 and 2001, respectively. The Company's balance
sheet includes a receivable of $53.3 million related to advances made to the
marketing and
12
reservation funds as of September 30, 2002. Advances to the marketing and
reservation funds represent the legal obligation of the franchise system and the
Company has the legal right to demand repayment at any point.
Other
For the three months ended September 30, 2002 and September 30, 2001, the
Company recognized approximately $1.2 million and $1.1 million, respectively, of
interest income from its subordinated term note to Sunburst.
On July 1, 2002, the Company increased its ownership interest in Flag
Choice Hotels ("Flag") to 55% and obtained a controlling interest in Flag. The
results of Flag have been consolidated beginning on that date. The Company
recorded $0.4 million related to equity losses in Flag in the third quarter of
2002 as a result of the acquisition of the controlling interest. In addition,
during the third quarter of 2002, the Company recorded $0.1 million of minority
interest in the earnings of Flag.
The Company recorded an equity loss of $11.7 million for the three months
ended September 30, 2001, relating to changes in its equity investment in
Friendly. The loss was primarily due to adverse fixed asset valuation
adjustments due to a decline in economic conditions. The Company disposed of its
entire preferred and common equity interest in Friendly on March 20, 2002.
Comparison of Operating Results for the Nine Month Periods Ended September 30,
2002 and September 30, 2001
The Company reported net income of $45.7 million, or $1.12 per diluted
share, for the nine months ended September 30, 2002, compared to net income for
the same period of 2001 of $33.5 million, or $0.75 per diluted share. The
increase in net income for the period is primarily attributable to $14.6 million
of equity losses related to the Company's investment in Friendly for the nine
months ended September 30, 2001. There were no equity losses related to Friendly
in the nine-months ended September 30, 2002. Net income also increased due to
improved franchising margins resulting from a $1.0 million increase in royalty
and other franchising fees partially offset by increased SG&A costs; and a
decrease in the Company's effective tax rate primarily attributable to $0.8
million of federal and state tax credits recorded in the third quarter of 2002.
Interest expense decreased by $2.2 million due to lower average interest rates
for the period. In addition, goodwill amortization of $1.4 million recorded
during the first nine months of 2001 is not recorded in 2002 pursuant to SFAS
No. 142.
Franchise Revenues
The Company's franchise revenues were $130.1 million for the nine months
ended September 30, 2002 and $129.3 million for the nine months ended September
30, 2001, respectively. Royalty revenue increased by $1.0 million to $108.6
million for the nine months ended September 30, 2002, from $107.6 million during
the corresponding period in 2001. Approximately $0.8 million of the change
relates to increased domestic royalty revenue attributable to a 4.2% growth in
the number of hotels online and a 5 basis point increase in the overall
system-wide royalty rate, partially offset by a 4.9% decrease in domestic RevPAR
from 2001. International royalty revenue increased $0.2 million, due to the
consolidation of Flag during the third quarter of 2002, partially offset by
decreased international master fees received from European properties. Revenues
generated from partner services relationships increased 2.0% from $8.9 million
in 2001 to $9.0 million in 2002 due to revenues associated with incremental
hotel industry vendor programs in 2002.
Franchise Expenses
Selling, general and administrative ("SG&A") expenses increased to $42.1
million from $41.7 million, an increase of $0.4 million for the nine months
ended September 30, 2002, as compared to the corresponding prior period. As a
percentage of total net franchising revenues, total SG&A expenses remained
constant at 32.3% for each of the nine month periods ended September 30, 2002
and 2001, respectively.
Marketing and Reservations
The total marketing and reservation fees received by the Company were
$148.6 million and $117.6 million for the nine months ended September 30, 2002
and 2001, respectively. Depreciation and amortization expense incurred by the
marketing and reservation funds were $9.5 million and $8.7 million for the nine
months ended September 30, 2002 and 2001, respectively. Interest expense
incurred by the reservation fund was $1.1 million and $1.5 million for the nine
months ended September 30, 2002 and 2001, respectively. The Company's balance
sheet includes a receivable of $53.3 as of September 30, 2002. Advances to the
marketing and reservation funds represent the legal obligation of the franchise
system and the Company has the legal right to demand repayment at any point.
13
Other
For the nine months ended September 30, 2002 and September 30, 2001, the
Company recognized $3.4 million and $3.2 million, respectively, of interest
income from its subordinated term note to Sunburst.
On July 1, 2002, the Company increased its ownership interest in Flag
Choice Hotels ("Flag") to 55% and obtained a controlling interest in Flag. The
results of Flag have been consolidated beginning on that date. The Company
recorded $0.4 million related to equity losses in Flag in the third quarter of
2002 as a result of the acquisition of the controlling interest. In addition,
during the third quarter of 2002, the Company recorded $0.1 million of minority
interest income in the earnings of Flag.
The Company recorded an equity loss on its investment in Friendly of $14.6
million for the nine months ended September 30, 2001, relating to changes in its
equity investment in Friendly. The loss was primarily due to adverse fixed asset
valuation adjustments due to a decline in economic conditions. The Company
disposed of its entire preferred and common equity interest in Friendly on March
20, 2002.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $74.7 million for the nine
months ended September 30, 2002, a decrease of $8.3 million from $83.0 million
for 2001. Repayments from the marketing and reservation funds, net of
depreciation and amortization related to the funds, decreased during 2002 to
$5.1 million, as compared to $23.7 million during the corresponding prior year
period. The decrease is due to the timing of advertising costs incurred
associated with the marketing fund. Also contributing to the decrease in net
cash received from operations was a reduction in current income taxes payable at
September 30, 2002, as compared to the corresponding prior year period.
Partially offsetting these reductions in operating cash flows were increases in
deferred income taxes of $21.1 million for the nine months ended September 30,
2002, which are primarily associated with the disposition of the Friendly equity
interest.
In August 2002, the Company entered into a new $10.0 million revolving line
of credit with a maturity of August 2003. The new line of credit includes
customary financial and other covenants that require the maintenance of certain
ratios identical to those included in the Company's existing senior credit
facility. Borrowings under the line of credit bear interest at rates established
at the time of borrowing based on Prime minus 1.75% basis points. The Company
had $10.0 million outstanding at September 30, 2002 under this line of credit.
At September 30, 2002, the total long-term debt outstanding for the Company was
$301.2 million, $26.4 million of which matures in the next twelve months.
The Company realigned its corporate structure in November 2001 to increase
its strategic focus on delivering value-added services to franchisees, including
centralizing the Company's franchise service and sales operations, consolidating
its brand management functions and realigning its call center operations. The
Company charged $1.8 million against the 2001 restructuring liability during the
three months ended September 30, 2002 and $3.9 million for the nine months ended
September 30, 2002. The Company expects the remaining $0.7 million liability to
be substantially paid by March 2003. The Company also implemented a
corporate-wide reorganization during 2000 to provide improved service and
support to the Company's franchisees and to create a more competitive overhead
structure. As of September 30, 2002, the Company maintains a $0.2 million
liability in accrued expenses in the accompanying consolidated balance sheet for
the 2000 reorganization related to severance benefits and international lease
agreements. The remaining liability will be paid in 2002.
The Company had net cash repayments of $5.1 million from the marketing and
reservation funds during the nine months ended September 30, 2002. The Company
has the right to recoup these advances as outlined in its franchise agreements
and expects to continue to recover the advances through future marketing and
reservation fees. The Company expects a positive net cash flow from the
marketing and reservation funds to approximate $13.0 million for the year ended
December 31, 2002. The receivable from the marketing and reservation funds is
expected to approximate $49.0 million at December 31, 2002.
In October 2002, the Board of Directors granted the Company's management
authority to acquire up to an additional 5.0 million shares.
During the first nine months of 2002, the Company repurchased 4.0 million
shares of its common stock at a total cost of $90.8 million. During and through
October 21, 2002, the Company repurchased an additional 1.3 million shares at a
total cost of $27.8 million, which completed the share repurchase program
previously authorized by its Board of Directors. At October 21, 2002, the
Company has approximately 37.1 million shares outstanding.
The Company believes that cash flows from operations and available
financing capacity is adequate to meet the expected operating, investing and
financing requirements for the business for the immediate future.
14
New Accounting Pronouncements and Changes in Accounting
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinded three previously issued statements and
amended SFAS No. 13, "Accounting for Leases." The statement provides reporting
standards for debt extinguishments and provides accounting standards for certain
lease modifications that have economic effects similar to sale-leaseback
transactions. The statement is effective for certain lease transactions
occurring after May 15, 2002 and all other provisions of the statement shall be
effective for financial statements issued on or after May 15, 2002. Adoption of
this standard did not have any impact on the Company's financial position or
results of operations.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which updates accounting and
reporting standards for personnel and operational restructurings. The Company
will be required to adopt SFAS No. 146 for exit, disposal or other restructuring
activities that are initiated after December 31, 2002, with early application
encouraged. The Company does not expect the adoption of SFAS No. 146 to have a
material effect on the Company's financial position or results of operations.
On September 25, 2002, the Company announced that it will expense the cost
of all stock options, beginning with options to be granted in the first quarter
of 2003. The accounting change, approved by the Company's Board of Directors,
reflects the Company's view that expensing stock options is the preferable way
to record employee compensation costs. The Company will adopt the fair value
based method of recording stock options in accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation", which will affect any options granted
on or after January 1, 2003.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this quarterly report, including those in
the section entitled Management's Discussion and Analysis of Financial Condition
and Results of Operations, that are not historical facts constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act. Words such as "believes," "anticipates," "expects,"
"intends," "estimates," "projects," and other similar expressions, which are
predictions of or indicate future events and trends, typically identify
forward-looking statements. Such statements are subject to a number of risks and
uncertainties which could cause actual results to differ materially from those
projected, including: competition within each of our business segments; business
strategies and their intended results; the balance between supply of and demand
for hotel rooms; our ability to obtain new franchise agreements; our ability to
develop and maintain positive relations with current and potential hotel owners;
the effect of international, national and regional economic conditions; the
availability of capital to allow us and potential hotel owners to fund
investments and construction of hotels; the cost and other effects of legal
proceedings; and other risks described from time to time in our filings with the
Securities and Exchange Commission, including those set forth under the heading
"Risk Factors" in our Report on Form 10-Q for the period ended September 30,
2001. Given these uncertainties, you are cautioned not to place undue reliance
on such statements. We also undertake no obligation to publicly update or revise
any forward-looking statement to reflect current or future events or
circumstances.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk from changes in interest rates and
the impact of fluctuations in foreign currencies on the Company's foreign
investments and revenues. The Company manages its exposure to this market risk
through the monitoring of its available financing alternatives including in
certain circumstances the use of derivative financial instruments. The Company's
strategy to manage exposure to changes in interest rates and foreign currencies
remains unchanged from 1997. Furthermore, the Company does not foresee any
significant changes in exposure in these areas or in how such exposure is
managed in the near future.
At September 30, 2002 and December 31, 2001, the Company had $301.2 million
and $281.3 million of debt outstanding at an effective interest rate of 4.4% and
4.9%, respectively. A hypothetical change of 10% in the Company's effective
interest rate from quarter-end September 30, 2002 levels would increase or
decrease interest expense by $0.6 million. The Company expects to refinance the
$106.3 million variable rate term loan balance remaining at September 30, 2002,
as it amortizes throughout the maturity dates using the Company's current Credit
Facility. Upon expiration of the Credit Facility in 2006, the Company expects to
refinance its obligations. For more information related to the Company's use of
interest rate instruments, see Long-Term Debt and Fair Value of Financial
Instruments in the Notes to the Consolidated Financial Statements in the
Company's December 31, 2001 Form 10-K.
ITEM 4. CONTROLS AND PROCEDURES
The Company formed a Disclosure Review Committee whose membership includes
the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), among
others. The Disclosure Review Committee's procedures are considered by the CEO
and
15
CFO in performing their evaluations of the Company's disclosure controls and
procedures and in assessing the accuracy and completeness of the Company's
disclosures.
As of October 25, 2002, an evaluation was performed under the supervision
and with the participation of the Company's CEO and CFO, of the effectiveness of
the design and operation of the Company's disclosure controls and procedures.
Based on that evaluation, the Company's management, including the CEO and CFO,
concluded that the Company's disclosure controls and procedures were effective
as of October 25, 2002. There have been no significant changes in the Company's
internal controls or in other factors that could significantly affect internal
controls subsequent to October 25, 2002.
16
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Incorporated by reference to the description of legal proceedings in the
"Commitments and Contingencies" footnote in the financial statements set forth
in Part I. "Financial Information".
ITEM 2. CHANGES IN SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
None.
(b) Reports on Form 8-K
None.
17
SIGNATURE
Pursuant to the requirements of the Securities Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
CHOICE HOTELS INTERNATIONAL, INC.
Date: October 30, 2002 /s/ Joseph M. Squeri
---------------- --------------------------------
By: Joseph M. Squeri
Sr. VP, Development and
Chief Financial Officer
18
WRITTEN STATEMENT
OF
CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
The undersigned hereby certify that the Quarterly Report on Form 10-Q for
the quarter ended September 30, 2002 filed by Choice Hotels International, Inc.
with the Securities and Exchange Commission fully complies with the requirements
of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that
information contained in the report fairly presents, in all material respects,
the financial condition and results of operations of the issuer.
Dated: October 30, 2002 /s/ Charles A. Ledsinger, Jr.
---------------- -------------------------------------
Charles A. Ledsinger, Jr.
President and Chief Executive Officer
Dated: October 30, 2002 /s/ Joseph M. Squeri
---------------- ---------------------------------------
Joseph M. Squeri
Sr. VP, Development and Chief Financial
Officer
19
I, Charles A. Ledsinger, Jr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Choice Hotels
International, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Dated: October 30, 2002 /s/ Charles A. Ledsinger, Jr.
---------------- ------------------------------
Charles A. Ledsinger, Jr.
President and Chief Executive Officer
20
I, Joseph M. Squeri, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Choice Hotels
International, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Dated: October 30, 2002 /s/ Joseph M. Squeri
---------------- ---------------------------------------
Joseph M. Squeri
Sr. VP, Development and Chief Financial
Officer
21