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Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-Q

 


 

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

 

For the quarterly period ended June 30, 2004

 

OR

 

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

 

For the transition period from              to              .

 

Commission file number 001-31906

 


 

HIGHLAND HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)

 


 

MARYLAND   57-1183293

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

 

8405 Greensboro Drive, Suite 500, McLean, Virginia 22102

 

Telephone Number (703) 336-4901

 


 

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 (or for such shorter period that the registrant was required to file such reports), 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 Securities Exchange Act of 1934).    Yes  ¨    No  x

 

As of August 4, 2004, there were 39,982,011 shares of the registrant’s common stock issued and outstanding.

 



Table of Contents

HIGHLAND HOSPITALITY CORPORATION

 

INDEX

 

          Page

     PART I     

Item 1.

   Financial Statements    3
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    15
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    23
Item 4.    Controls and Procedures    23

PART II

Item 1.    Legal Proceedings    24
Item 2.    Changes in Securities and Use of Proceeds    24
Item 3.    Defaults Upon Senior Securities    24
Item 4.    Submission of Matters to a Vote of Security Holders    24
Item 5.    Other Information    24
Item 6.    Exhibits and Reports on Form 8-K    25

 

2


Table of Contents

PART I

 

Item 1. Financial Statements

 

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

     June 30, 2004

    December 31, 2003

 
     (unaudited)        

ASSETS

                

Investment in hotel properties, net

   $ 256,210     $ 147,562  

Deposits on hotel property acquisitions

     11,950       —    

Cash and cash equivalents

     107,498       225,630  

Restricted cash

     3,377       —    

Accounts receivable, net

     5,968       2,917  

Prepaid expenses and other assets

     5,003       3,379  

Deposits on loan applications

     4,940       —    
    


 


Total assets

   $ 394,946     $ 379,488  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY

                

Mortgage loan

   $ 17,000     $ —    

Accounts payable and accrued expenses

     8,740       6,936  

Payable to affiliates

     316       8,832  

Dividends/distributions payable

     5,323       —    

Other liabilities

     631       —    
    


 


Total liabilities

     32,010       15,768  
    


 


Minority interest in operating partnership

     8,496       8,457  

Commitments and contingencies (Note 10)

                

Preferred stock, $.01 par value; 100,000,000 shares authorized; no shares issued and outstanding at June 30, 2004 and December 31, 2003

     —         —    

Common stock, $.01 par value; 500,000,000 shares authorized; 39,982,011 shares and 39,882,500 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively

     400       399  

Additional paid-in capital

     366,639       365,454  

Unearned compensation

     (7,486 )     (7,917 )

Accumulated deficit

     (5,113 )     (2,673 )
    


 


Total stockholders’ equity

     354,440       355,263  
    


 


Total liabilities and stockholders’ equity

   $ 394,946     $ 379,488  
    


 


 

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

 

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Table of Contents

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

AND PREDECESSOR STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

 

     Highland Hospitality
Three Months Ended
June 30, 2004


    The Predecessor
Three Months Ended
June 30, 2003


  Highland Hospitality
Six Months Ended
June 30, 2004


    The Predecessor
Six Months Ended
June 30, 2003


 

REVENUE

                              

Rooms

   $ 16,430     $ 1,795   $ 28,543     $ 2,823  

Food and beverage

     7,897       1,059     13,784       2,013  

Other

     927       55     1,661       112  
    


 

 


 


Total revenue

     25,254       2,909     43,988       4,948  
    


 

 


 


EXPENSES

                              

Hotel operating expenses:

                              

Rooms

     3,518       361     6,090       643  

Food and beverage

     5,740       605     10,488       1,491  

Other direct

     594       27     1,077       64  

Indirect

     8,688       1,079     15,826       2,077  
    


 

 


 


Total hotel operating expenses

     18,540       2,072     33,481       4,275  

Depreciation and amortization

     2,132       171     3,726       341  

Corporate general and administrative:

                              

Stock-based compensation

     884       —       1,590       —    

Other

     1,472       —       2,963       —    
    


 

 


 


Total operating expenses

     23,028       2,243     41,760       4,616  
    


 

 


 


Operating income

     2,226       666     2,228       332  

Interest income

     294       1     675       3  

Interest expense

     336       221     646       443  
    


 

 


 


Income (loss) before minority interest in operating partnership and income taxes

     2,184       446     2,257       (108 )

Minority interest in operating partnership

     (52 )     —       (66 )     —    

Income tax benefit

     26       —       567       —    
    


 

 


 


Net income (loss)

   $ 2,158     $ 446   $ 2,758     $ (108 )
    


 

 


 


Earnings per share:

                              

Basic

   $ 0.05           $ 0.07          

Diluted

   $ 0.05           $ 0.07          

 

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

 

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HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

AND PREDECESSOR STATEMENT OF CASH FLOWS

(in thousands)

(unaudited)

 

    

Highland Hospitality

Six Months Ended
June 30, 2004


   

The Predecessor

Six Months Ended

June 30, 2003


 

Cash flows from operating activities:

                

Net income (loss)

   $ 2,758     $ (108 )

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

                

Depreciation and amortization

     3,726       341  

Amortization of deferred financing costs

     —         18  

Minority interest in operating partnership

     66       —    

Stock-based compensation

     1,590       —    

Changes in assets and liabilities:

                

Accounts receivable, net

     (1,508 )     (228 )

Prepaid expenses and other assets

     (2,283 )     (163 )

Accounts payable and accrued expenses

     1,780       106  

Payable to affiliates

     (1,193 )     —    
    


 


Net cash provided by (used in) operating activities

     4,936       (34 )
    


 


Cash flows from investing activities:

                

Acquisition of hotel properties, net of cash acquired

     (100,013 )     —    

Deposits on hotel property acquisitions

     (11,950 )     —    

Acquisition of furniture, fixtures and equipment

     (585 )     —    

Additions to leasehold improvements and construction-in-progress

     (504 )     (122 )

Change in restricted cash

     (3,183 )     (46 )
    


 


Net cash used in investing activities

     (116,235 )     (168 )
    


 


Cash flows from financing activities:

                

Payment of issuance costs related to sale of common stock

     (1,893 )     —    

Deposits on loan applications

     (4,940 )     —    

Repayments on debt

     —         (91 )

Distributions to owners

     —         (389 )
    


 


Net cash used in financing activities

     (6,833 )     (480 )
    


 


Net decrease in cash

     (118,132 )     (682 )

Cash and cash equivalents, beginning of period

     225,630       1,719  
    


 


Cash and cash equivalents, end of period

   $ 107,498     $ 1,037  
    


 


Supplemental disclosure of cash flow information:

                

Cash paid for interest

   $ 646     $ 425  

Assumption of mortgage loan related to hotel acquisition

   $ 17,000       —    

Issuance of operating partnership units

   $ 125       —    

Issuance of restricted common stock

   $ 1,030       —    

Issuance of unrestricted common stock

   $ 129       —    

 

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

 

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Table of Contents

HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

1. Organization and Description of Business

 

Highland Hospitality Corporation (the “Company”) is a self-advised real estate investment trust (“REIT”) that was incorporated in Maryland in July 2003 to own upscale full-service, premium limited-service, and extended stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside the United States. The Company commenced operations on December 19, 2003 when it completed its initial public offering (“IPO”) and concurrently consummated the acquisition of three hotel properties (“initial properties”).

 

The IPO consisted of the sale of 30,000,000 shares of common stock at a price of $10 per share, resulting in gross proceeds of $300 million and net proceeds (after deducting underwriting discounts and offering expenses) of approximately $277 million. Concurrent with the IPO, the Company sold in private placement transactions an aggregate of 4,550,000 shares of common stock at a price per share equal to the IPO price, less an amount equal to the underwriting discount of $0.70 per share. The proceeds generated from the private placement transactions were approximately $42.3 million. On December 26, 2003, the Company sold an additional 4,500,000 shares of common stock at a price of $9.30 per share, net of the underwriting discount, as a result of the exercise of the underwriters’ over-allotment option, resulting in additional net proceeds of approximately $41.9 million. The total net proceeds generated from the IPO, the private placement transactions, and the exercise of the underwriters’ over-allotment option was approximately $361.2 million.

 

The Company contributed all of the net proceeds from the IPO, the private placement transactions, and the exercise of the underwriters’ over-allotment option to Highland Hospitality, L.P., a Delaware limited partnership (the “Operating Partnership”), in exchange for an approximate 98% general and limited partnership interest in the Operating Partnership. The Operating Partnership used approximately $61.9 million of the net proceeds from the Company, along with 967,211 units of limited partner interest, to acquire all of the equity interests in the entities that own or lease the initial properties.

 

On December 29, 2003, December 30, 2003, January 8, 2004, January 12, 2004, and May 10, 2004, the Operating Partnership completed the acquisition of five additional hotel properties for an aggregate purchase price of approximately $194.3 million, including the assumption of mortgage debt of $17 million. As of June 30, 2004, the Company owned eight hotel properties.

 

Substantially all of the Company’s assets are held by, and all of its operations are conducted through, the Operating Partnership. For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which is owned approximately 98% by the Company and approximately 2% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly-owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels under management contracts. HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

 

2. Summary of Significant Accounting Policies

 

Basis of Presentation—The Company consolidated financial statements presented herein include all of the accounts of Highland Hospitality Corporation as of and for the quarter and six months ended June 30, 2004. For the quarter and six months ended June 30, 2003, this report includes the financial statements of Portsmouth Hotel Associates, LLC (“PHA”), which was one of the three entities acquired by the Company concurrent with the completion of the IPO on December 19, 2003. PHA was owned 66.7% by Barceló Crestline Corporation (“Barceló Crestline”), which was the sponsor of the Company’s formation and IPO. PHA is considered the predecessor to the Company for accounting purposes. Securities and Exchange Commission regulations require the inclusion of predecessor financial information for the periods prior to the Company’s commencement of operations. The predecessor statements of operations and cash flows for the quarter and six months ended June 30, 2003 include the operations of PHA on its historical cost basis.

 

The information in these financial statements is unaudited but, in the opinion of management, reflects all adjustments necessary for a fair presentation of the results for the periods covered. All such adjustments are of a normal, recurring nature unless disclosed otherwise. These financial statements, including notes, have been prepared in accordance with the applicable rules of the Securities and Exchange Commission and do not include all of the

 

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Table of Contents

HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. Additional information is contained in the Highland Hospitality Corporation Form 10-K for the year ended December 31, 2003.

 

Principles of Consolidation—The accompanying Company financial statements include the accounts of Highland Hospitality Corporation and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

 

Cash and Cash Equivalents—The Company considers all highly-liquid investments with an original maturity of three months or less to be cash equivalents.

 

Restricted Cash—Restricted cash includes reserves for replacements of furniture, fixtures and equipment pursuant to certain requirements in the Company’s hotel management, franchise, and loan agreements.

 

Fair Value of Financial Instruments—The Company’s financial instruments include cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and a mortgage loan. Due to their short maturities, these financial instruments are carried at amounts that reasonably approximate fair value.

 

Investment in Hotel Properties—Investments in hotel properties are recorded at acquisition cost (except where interests were acquired from Barceló Crestline and recorded at Barceló Crestline’s historical cost basis), and allocated to land, property and equipment and identifiable intangible assets in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Replacements and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon the sale or retirement of a fixed asset, the cost and related accumulated depreciation are removed from the Company’s accounts and any resulting gain or loss is included in the statements of operations.

 

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 15 to 40 years for buildings and building improvements and three to ten years for furniture, fixtures and equipment. Leasehold improvements are amortized over the shorter of the lease term or the useful lives of the related assets.

 

The Company reviews its investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause a review include, but are not limited to, adverse changes in the demand for lodging at the properties due to declining national or local economic conditions and/or new hotel construction in markets where the hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying amount to the related hotel property’s estimated fair market value is recorded and an impairment loss recognized. No impairment losses have been recorded for the quarters and six months ended June 30, 2004 and 2003.

 

Minority Interest in Operating Partnership—Certain hotel properties have been acquired, in part, by the Operating Partnership through the issuance of limited partnership units of the Operating Partnership. The minority interest in the Operating Partnership is: (i) increased or decreased by the limited partners’ pro-rata share of the Operating Partnership’s net income or net loss, respectively; (ii) decreased by distributions; (iii) decreased by redemption of partnership units for the Company’s common stock; and (iv) adjusted to equal the net equity of the Operating Partnership multiplied by the limited partners’ ownership percentage immediately after each issuance of units of the Operating Partnership and/or the Company’s common stock through an adjustment to additional paid-in capital. Net income or net loss is allocated to the minority interest in the Operating Partnership based on the weighted average percentage ownership throughout the period.

 

Revenue Recognition—Revenues from operations of the hotels are recognized when the services are provided. Revenues consist of room sales, food and beverage sales, and other hotel department revenues, such as telephone and gift shop sales.

 

Deferred Financing Costs—Deferred financing costs are recorded at cost and consist of loan fees and other costs incurred in issuing debt. Amortization of deferred financing costs is computed using a method that approximates the effective interest method over the term of the related debt and is included in interest expense in the statements of operations.

 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

Income Taxes—The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. As a REIT, the Company generally will not be subject to federal income tax on that portion of its net income (loss) that does not relate to HHC TRS, the Company’s wholly-owned taxable REIT subsidiary. HHC TRS, which leases the Company’s hotels from the Operating Partnership, is subject to federal and state income taxes.

 

The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“SFAS 109”). Under SFAS 109, the Company accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Valuation allowances are provided if, based upon the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

 

PHA operated as a limited liability company and, as a result, was not subject to federal or state income taxation. Accordingly, no provision was made for federal or state income taxes in the predecessor financial statements.

 

Earnings (Loss) Per Share—Basic earnings (loss) per share is calculated by dividing net income (loss), less dividends on unvested restricted common stock, by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated by dividing net income (loss), less dividends on unvested restricted common stock, by the weighted average number of common shares outstanding during the period, plus other potentially dilutive securities, including unvested shares of restricted common stock. The outstanding Operating Partnership units (which may be converted to common shares) have been excluded from the diluted earnings (loss) per share calculation, as there would be no effect on reported diluted earnings (loss) per share.

 

Stock-based Compensation—The Company accounts for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation, as amended. For restricted stock awards, the Company records unearned compensation equal to the number of shares awarded multiplied by the average price of the Company’s common stock on the date of the award, less the purchase price for the stock, if any. Unearned compensation is amortized using the straight-line method over the period in which the restrictions lapse (i.e., vesting period). For unrestricted stock awards, the Company records compensation expense on the date of the award equal to the number of shares awarded multiplied by the average price of the Company’s common stock on the date of the award, less the purchase price for the stock, if any.

 

Comprehensive Income (Loss)—Comprehensive income (loss), as defined, includes all changes in equity (net assets) during a period from non-owner sources. The Company does not have any items of comprehensive income (loss) other than net income (loss).

 

Segment Information—Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”), requires public entities to report certain information about operating segments. Based on the guidance provided in SFAS 131, the Company has determined that its business is conducted in one reportable segment, hotel ownership.

 

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

 

Reclassifications—Certain reclassifications have been made to the predecessor financial statements to conform to the Company’s presentation.

 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

3. Acquisition of Hotel Properties

 

On January 8, 2004, the Company acquired the 238-room Hilton Tampa Westshore hotel located in Tampa, Florida for approximately $30.2 million, which included the assumption of mortgage debt that encumbers the hotel property of $17 million (see Note 5). On January 12, 2004, the Company acquired the 158-room Hilton Garden Inn Baltimore/Washington International (BWI) Airport hotel located in Linthicum, Maryland for approximately $22.7 million in cash. On May 10, 2004, the Company acquired the 491-room Dallas/Fort Worth Airport Marriott hotel located in Dallas/Fort Worth, Texas for approximately $59.5 million in cash. The allocation of the purchase prices to the acquired assets and liabilities based on their fair values was as follows (in thousands):

 

     Hilton Tampa
Westshore


    Hilton Garden Inn
BWI Airport


    Dallas/Fort Worth
Airport Marriott


 

Land and land improvements

   $ 2,753     $ 1,443     $ 5,998  

Buildings and leasehold improvements

     23,151       20,063       50,475  

Furniture, fixtures and equipment

     3,784       1,048       2,543  

Cash

     17       2       33  

Restricted cash

     194       —         —    

Accounts receivable, net

     315       83       1,145  

Prepaid assets and other assets

     211       72       221  

Accounts payable and accrued expenses

     (266 )     (24 )     (868 )

Mortgage loan

     (17,000 )     —         —    
    


 


 


Net assets acquired

   $ 13,159     $ 22,687     $ 59,547  
    


 


 


 

The results of operations for each of the hotel properties are included in the Company’s consolidated statements of operations from their respective acquisition dates. The following pro forma financial information presents the results of operations of the Company for the quarters and six months ended June 30, 2004 and 2003 as if the Hilton Tampa Westshore hotel, Hilton Garden Inn BWI Airport hotel, and Dallas/Fort Worth Airport Marriott hotel acquisitions, as well as the five hotel property acquisitions that occurred in December 2003, had taken place on January 1, 2003. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which would have actually occurred had the transactions taken place on January 1, 2003, or of future results of operations. No pro forma adjustments have been made for the Hilton Tampa Westshore hotel or the Hilton Garden Inn BWI Airport hotel for the six months ended June 30, 2004, as the acquisitions occurred near the beginning of the period (in thousands).

 

     (unaudited)    (unaudited)
     Quarter Ended June 30,

   Six Months Ended June 30,

     2004

   2003(1)

   2004

   2003(1)

Total revenue

   $ 28,116    $ 21,912    $ 53,609    $ 43,443

Total operating expenses

     25,252      19,885      49,048      39,848

Operating income

     2,864      2,027      4,561      3,595

Net income

     2,767      1,857      4,983      2,566

Earnings per share:

                           

Basic

   $ 0.07    $ 0.05    $ 0.13    $ 0.07

Diluted

   $ 0.07    $ 0.05    $ 0.13    $ 0.07

(1) The Sugar Land Marriott hotel and Hilton Garden Inn Virginia Beach hotel did not open for business until October 2003 and November 2003, respectively. Accordingly, the only activity included in the pro forma results for the quarter and six months ended June 30, 2003 related to these two hotels was pre-opening expenses of $0.2 million and $0.4 million, respectively.

 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

On June 25, 2004, the Company signed a definitive agreement to acquire four hotels from Wyndham International, Inc. for $227 million. The four hotels are the 510-room Hilton hotel in Parsippany, New Jersey, the 495-room Crowne Plaza Ravinia hotel in Atlanta, Georgia, the 360-room Wyndham Wind Watch hotel in Hauppauge, Long Island, New York, and the 322-room Tremont Boston – A Wyndham Historic hotel in Boston, Massachusetts.

 

On June 30, 2004, the Company signed a definitive agreement with a hotel developer to purchase upon completion the 210-room Courtyard Gaithersburg Washingtonian Center hotel in Gaithersburg, Maryland. The purchase price for the hotel property is $29 million. The Company was required to deposit $8 million in an escrow account, which amount will be credited against the purchase price at closing or returned to the Company should the hotel developer fail to satisfy its obligations under the definitive agreement. Construction of the hotel is scheduled to be completed in the fourth quarter 2005.

 

4. Investment in Hotel Properties

 

Investment in hotel properties as of June 30, 2004 and December 31, 2003 consisted of the following (in thousands):

 

     June 30, 2004

    December 31, 2003

 

Land and land improvements

   $ 22,590     $ 12,396  

Buildings and leasehold improvements

     219,884       126,287  

Furniture, fixtures and equipment

     19,416       11,265  

Construction-in-progress

     504       72  
    


 


       262,394       150,020  

Less: accumulated depreciation and amortization

     (6,184 )     (2,458 )
    


 


     $ 256,210     $ 147,562  
    


 


 

5. Mortgage Loan

 

In connection with the Hilton Tampa Westshore hotel acquisition, the Company assumed a $17 million mortgage loan that encumbers the hotel property. The loan agreement provides for monthly interest-only payments of approximately $0.1 million based on an interest rate of 7.9%. Principal payments will commence in August 2004 and will be based on a 25-year amortization period, less the number of months that have elapsed since July 1, 2004. Prepayment of the loan is not allowed without a prepayment penalty until January 1, 2005. The loan matures on July 1, 2005.

 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

6. Earnings Per Share

 

The following is a reconciliation of the amounts used in calculating basic and diluted earnings per share (in thousands, except share and per share data):

 

     Quarter Ended
June 30, 2004


    Six Months Ended
June 30, 2004


 

Numerator:

                

Net income

   $ 2,158     $ 2,758  

Less: dividends on unvested restricted common stock

     (116 )     (116 )
    


 


Net income after dividends on unvested restricted common stock

   $ 2,042     $ 2,642  
    


 


Denominator:

                

Weighted average number of common shares outstanding - basic

     39,084,890       39,082,449  

Effect of dilutive securities:

                

Unvested restricted common stock

     160,290       180,003  

Warrants

     50,598       95,612  
    


 


Weighted average number of common shares outstanding - diluted

     39,295,778       39,358,064  
    


 


Earnings per share:

                

Basic

   $ 0.05     $ 0.07  

Diluted

   $ 0.05     $ 0.07  

 

During the quarter ended March 31, 2004, the Company issued 87,500 shares of restricted common stock to certain employees, which did not require payments by the employees. Subject to continued employment with the Company, the restrictions on the employees’ shares lapse at the rate of one-third of the number of restricted shares per year commencing on the first anniversary of their issuance. The Company recorded unearned compensation of approximately $1 million and is amortizing the unearned compensation over the 36-month period commencing on the dates of the issuance.

 

In connection with the IPO, the Company granted to its underwriters, as partial consideration for their services, warrants representing the right to acquire 888,488 shares of common stock. The warrants are exercisable for a period of five years commencing December 19, 2003 at an exercise price of $10 per share.

 

7. Cash Distributions

 

On June 17, 2004, the Company’s board of directors declared a cash distribution to shareholders of the Company and partners of the Operating Partnership of record as of June 30, 2004. The cash distribution of $0.13 per common share and partnership unit was paid on July 15, 2004.

 

8. Income Taxes

 

The components of income tax benefit for the six months ended June 30, 2004 are as follows (in thousands):

 

     Six Months Ended
June 30, 2004


 

Deferred:

        

Federal

   $ (487 )

State

     (80 )
    


Income tax benefit

   $ (567 )
    


 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

A reconciliation of the statutory federal income tax expense to the Company’s income tax benefit is as follows (in thousands):

 

     Six Months Ended
June 30, 2004


 

Statutory federal income tax expense

   $ 767  

Effect of non-taxable REIT income

     (1,281 )

State income tax benefit, net of federal benefit

     (53 )
    


Income tax benefit

   $ (567 )
    


 

As of June 30, 2004, the Company had a net deferred tax asset of $0.8 million, primarily due to past and current year’s tax net operating losses. These loss carryforwards will begin to expire in 2023 if not utilized by then. The Company believes that it is more likely than not that the net deferred tax asset will be realized and has determined that no valuation allowance is required.

 

9. Related Party Transactions

 

The third-party member, other than Barceló Crestline, of PHA and Sugar Land Hotel Associates, L.P. (one of the entities that the Company acquired on December 19, 2003) was the developer of the Sugar Land Marriott hotel. The Company issued 294,673 Operating Partnership units, including 13,492 units in June 2004, to the third-party member in exchange for its equity interests in the two entities. As of December 31, 2003 and June 30, 2004, included in payable to affiliates in the consolidated balance sheet was approximately $2.6 million and $0.3 million, respectively, for construction costs related to the Sugar Land Marriott hotel.

 

Six of the eight hotels that the Company owned as of June 30, 2004 operate under management agreements with Crestline Hotels & Resorts, Inc., which is a wholly-owned subsidiary of Barceló Crestline, each for a 10-year term. Crestline Hotels & Resorts receives a base management fee, and if the hotels meet and exceed certain thresholds, an incentive management fee. The base management fee for the hotels is generally between 2% and 3.5% of total gross revenues from the hotels. The incentive management fee, if any, for each hotel will be due annually in arrears within 105 days after the end of each fiscal year and will be equal to 15% of the amount by which operating profit for the fiscal year exceeds 11% of the Company’s capitalized investment in the hotel. Crestline Hotels & Resorts will not be entitled to receive any incentive fee in any fiscal year in which the operating profit of the hotel has not equaled at least 11% of the Company’s investment in the hotel. The management agreement places a cap on the total amount of combined base and incentive management fees paid to Crestline Hotels & Resorts at 4.5% of gross revenues for each fiscal year.

 

For the quarter and six months ended June 30, 2004, the Company paid Crestline Hotels & Resorts approximately $0.3 million and $0.6 million in management fees, respectively. For the quarter and six months ended June 30, 2003, PHA paid Crestline Hotels & Resorts approximately $0.06 million and $0.1 million in management fees, respectively.

 

10. Commitments and Contingencies

 

Ground and Building Leases—PHA leases the Portsmouth Renaissance hotel and adjoining conference center from the Industrial Development Authority of the City of Portsmouth pursuant to two separate lease agreements, each for an initial term of 50 years ending May 2049, with four ten-year renewal options and one nine-year renewal option. Base rent under the hotel lease is $0.05 million per year. Annual percentage rent is equal to 100% of available net cash flow after payment of all hotel operating expenses, the base rent, real estate and property taxes, insurance and a cumulative priority annual return to the lessee of approximately $2 million, up to $0.2 million, then 50% of any remaining net cash flow until the landlord has been paid percentage (and additional) rent of $10 million in aggregate, and thereafter 10% of net cash flow annually. If the Company sells or assigns the hotel lease to an unrelated party, an additional rent payment equal to 50% of the net sales proceeds in excess of the Company’s capital investment in the hotel and unpaid annual return of 15% on the investment will be due.

 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

Annual rent under the conference center lease is equal to the lesser of $0.075 million per year or the maximum amount of rent allowable under tax regulations so as to preserve the tax-exempt status of the Portsmouth Industrial Development Authority bonds issued in connection with the hotel and conference center.

 

The Company leases the conference center and parking facility adjoining the Sugar Land Marriott hotel from the Sugar Land Town Square Development Authority for a term of 99 years ending October 2102. The minimum rent is $1 per year, plus an incentive rent payment for the first 25 years of the term of the lease. If during any of those first 25 years, the Company’s cumulative internal rate of return on investment in the hotel exceeds 15%, then the Company will pay incentive rent in an amount equal to 36% of the net cash flow and/or net sale proceeds for the applicable year in excess of the amount of net cash flow and/or net sales proceeds that would be necessary to generate a cumulative internal rate of return of 15%.

 

Percentage and incentive rent is accrued when it becomes probable that the specified thresholds will be achieved. No percentage or incentive rent was owed in any period presented in the financial statements, as the thresholds were not met.

 

The Company leases a building adjacent to the Plaza San Antonio Marriott hotel from the City of San Antonio. The Company is in the second of four permitted ten-year renewal options, expiring in March 2008. Annual rent due under the lease agreement is approximately $0.07 million, adjusted annually for increases in the consumer price index (CPI).

 

Management Agreements—Six of the eight hotels that the Company owned at June 30, 2004 operate under management agreements with Crestline Hotels & Resorts, Inc., which is a wholly-owned subsidiary of Barceló Crestline, each for a 10-year term (see Note 9).

 

The Hyatt Regency Savannah hotel is managed by Hyatt Corporation. The hotel management agreement expires on December 31, 2011, but provides for two extension periods of ten years each, at the option of Hyatt Corporation. Hyatt Corporation receives a base management fee, payable on a monthly basis, equal to 4% of the hotel’s gross receipts. Hyatt Corporation is also eligible to receive an incentive fee, payable in monthly installments, equal to the amount by which 20% of the profit for a fiscal year exceeds the base fee for that fiscal year.

 

The Dallas/Fort Worth Airport Marriott hotel is managed by Marriott International, Inc. The hotel management agreement expires on December 29, 2032, including all renewal periods. Marriott International, Inc. receives a base management fee, payable on a monthly basis, equal to 3% of hotel revenues. Marriott International, Inc. is also eligible to receive an incentive management fee, payable in monthly installments, equal to the lesser of 40% of available cash flow or 20% of net house profit, as defined in the management agreement.

 

Franchise Agreements—As of June 30, 2004, six of the Company’s eight hotels operate under franchise licenses from national hotel companies. The Company’s management agreements with Hyatt Corporation and Marriott International, Inc. allow the Hyatt Regency Savannah hotel and Dallas/Fort Worth Airport Marriott hotel to operate under the Hyatt brand and Marriott brand, respectively. Of the six hotels’ franchise licenses, one expires in 2019, one expires in 2023, three expire in 2024, and one expires in 2032. Under the franchise agreements, the Company is required to pay a franchise fee generally between 4% and 5% of room revenues, plus additional fees that amount to between 3% and 4% of room revenues from the hotels.

 

Restricted Cash—Pursuant to its management, franchise and loan agreements, the Company is required to establish a property improvement fund for each hotel to cover the cost of replacements and renewals of furniture and fixtures at the hotels. Contributions to the property improvement fund are based on a percentage of gross revenues or receipts at each hotel. The Company is generally required to contribute between 3% and 5% of gross revenues each month over the term of the agreements.

 

Litigation—The Company is not involved in any material litigation nor, to its knowledge, is any material litigation threatened against the Company.

 

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

 

11. Subsequent Events

 

On July 9, 2004, the Company completed a $67 million non-recourse financing secured by the Hyatt Regency Savannah hotel, Portsmouth Renaissance hotel and conference center, and Hilton Garden Inn BWI Airport hotel. The loan bears a fixed annual interest rate of 6.47% and matures on July 11, 2011. For the period from August 2004 through July 2005, the loan agreement provides for monthly interest-only payments. Principal payments will commence in August 2005 and will be based on a 25-year amortization period. The loan agreement contains standard provisions that require the loan servicer to maintain escrow accounts over the term of the loan for certain items, including hotel capital improvements, ground rent, real estate taxes and insurance. In addition, the loan agreement contains a restrictive provision that requires the loan servicer to retain in escrow excess cash flow from the encumbered hotel properties if net cash flow, as defined, for the trailing twelve months declines below a specified level.

 

On August 2, 2004, the Company acquired the 156-room Courtyard Savannah Historic District hotel in Savannah, Georgia and the 109-room Residence Inn Tampa Downtown hotel in Tampa, Florida for $38.5 million.

 

On August 3, 2004, the Company announced the signing of two separate definitive agreements to acquire the 299-room Omaha Marriott hotel in Omaha, Nebraska and the 283-room Radisson Mount Laurel hotel in Mount Laurel, New Jersey. The aggregate purchase price for the two hotels is $42.8 million.

 

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

 

Hotel results of operations are best explained by three key performance indicators: occupancy, average daily rate (“ADR”) and revenue per available room (“RevPAR”), which is room revenue divided by total number of room nights. RevPAR does not include food and beverage revenues or other ancillary revenues, such as telephone, parking or other guest services generated by the property.

 

Occupancy is a major driver of room revenue, as well as other revenue categories, such as food and beverage and telephone. ADR helps to drive room revenue as well; however, it does not have a direct effect on other revenue categories. Fluctuations in occupancy are accompanied by fluctuations in most categories of variable operating costs, such as utility costs and certain labor costs such as housekeeping, resulting in varying levels of hotel profitability. Increases in ADR typically result in higher hotel profitability since variable hotel expenses generally do not increase correspondingly. Thus, increases in RevPAR attributable to increases in occupancy are accompanied by increases in most categories of variable operating costs, while increases in RevPAR attributable to increases in ADR are accompanied by increases in limited categories of operating costs, such as management fees and franchise fees.

 

Executive Summary

 

We continued to see a recovery in the lodging industry in the second quarter 2004, evidenced by improvements in occupancy and ADR throughout the industry. Even in light of the improving conditions in our industry, we were pleased with the performance of our hotel portfolio in the second quarter 2004. RevPAR for our six hotels that were open for business in the second quarter 2004 and 2003 increased 6.8% (the Sugar Land Marriott hotel and Hilton Garden Inn Virginia Beach hotel did not open for business until October 2003 and November 2003, respectively). We expect the improvements in our industry and in the performance of our own hotel portfolio to continue for the remainder of 2004 and into 2005.

 

Since the end of the first quarter 2004, we have been active in the acquisitions market, allocating our capital to investments that we believe will maximize our returns and increase stockholders’ value over the long-term. On May 10, 2004, we acquired the 491-room Dallas/Fort Worth Airport Marriott hotel in Dallas/Fort Worth, Texas. On June 25, 2004, we signed a definitive agreement to acquire four hotel properties from Wyndham International, Inc., consisting of the 510-room Hilton hotel in Parsippany, New Jersey, the 495-room Crowne Plaza Ravinia hotel in Atlanta, Georgia, the 360-room Wyndham Wind Watch hotel in Hauppauge, Long Island, New York, and the 322-room Tremont Boston - A Wyndham Historic Hotel in Boston, Massachusetts. On August 2, 2004, we acquired the 156-room Courtyard Savannah Historic District hotel in Savannah, Georgia and the 109-room Residence Inn Tampa Downtown hotel in Tampa, Florida. On August 3, 2004, we announced the signing of definitive agreements to acquire three additional hotel properties, consisting of the 210-room Courtyard Gaithersburg Washingtonian Center hotel in Gaithersburg, Maryland, the 299-room Omaha Marriott hotel in Omaha, Nebraska, and the 283-room Radisson Mount Laurel hotel in Mount Laurel, New Jersey. These hotel acquisitions aggregate to 3,235 rooms, as compared to 1,725 rooms that we owned at the end of the first quarter 2004. All of these transactions are in-line with our strategy of investing our capital in upscale full-service hotels, premium limited-service, and extended stay properties in major convention, business, resort and airport markets. We believe that they come at an opportune time given the current and expected improvements in lodging industry fundamentals.

 

Over the next several quarters, while we continue to focus on acquisitions, we will also focus our attention on our existing hotel portfolio, including renovating and rebranding several hotels. Specifically, we plan to continue the renovations at the Plaza San Antonio Marriott hotel and the Hyatt Regency Savannah hotel; renovate the to-be-acquired Crowne Plaza Ravinia hotel; renovate and rebrand the to-be-acquired Radisson Mount Laurel hotel and Wyndham Wind Watch hotel; and rebrand the to-be-acquired Tremont Boston hotel.

 

Overview

 

Highland Hospitality Corporation is a self-advised REIT that was incorporated in July 2003 to own upscale full-service, premium limited-service, and extended stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside the United States. We commenced operations on December 19, 2003 when we completed our IPO and concurrently consummated the acquisition of three hotel properties.

 

The IPO consisted of the sale of 30,000,000 shares of common stock, resulting in net proceeds (after deducting underwriting discounts and offering expenses) of approximately $277 million. In conjunction with the IPO, we sold an additional 9,050,000 shares of common stock as a result of private placement transactions and the exercise of the underwriters’ over-allotment option, resulting in additional proceeds of approximately $84.2 million. The total net proceeds generated from the IPO, the private placement transactions, and the exercise of the underwriters’ over-allotment option were approximately $361.2 million.

 

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Our initial three hotel properties were acquired from entities that were partially owned by Barceló Crestline, which was the sponsor of our formation and IPO. We used approximately $61.9 million of net proceeds from the IPO and issued 967,211 units of our Operating Partnership to acquire all of the equity interests in the three entities. The equity interests in the three entities acquired from Barceló Crestline, as our sponsor, in exchange for Operating Partnership units have been accounted for as a reorganization of entities under common control and recorded at Barceló Crestline’s historical cost basis. The remaining equity interests in the three entities acquired from third parties have been accounted for as acquisitions of minority interests and recorded at fair value.

 

On December 29, 2003, December 30, 2003, January 8, 2004, January 12, 2004, and May 10, 2004, we completed the acquisition of five additional hotel properties for an aggregate purchase price of approximately $194.3 million, including the assumption of mortgage debt of $17 million. We have accounted for the acquisition of the five hotel properties under the purchase method of accounting, recording these hotels at their acquisition costs. As of June 30, 2004, we owned the following eight hotel properties:

 

Property


   Number of
Rooms


   Location

   Acquired

Portsmouth Renaissance and Conference Center

   250    Portsmouth, VA    December 19, 2003

Sugar Land Marriott and Conference Center

   300    Sugar Land, TX    December 19, 2003

Hilton Garden Inn Virginia Beach Town Center

   176    Virginia Beach, VA    December 19, 2003

Plaza San Antonio Marriott

   252    San Antonio, TX    December 29, 2003

Hyatt Regency Savannah

   351    Savannah, GA    December 30, 2003

Hilton Tampa Westshore

   238    Tampa, FL    January 8, 2004

Hilton Garden Inn BWI Airport

   158    Linthicum, MD    January 12, 2004

Dallas/Fort Worth Airport Marriott

   491    Dallas/Fort Worth, TX    May 10, 2004
    
         

Total number of rooms

   2,216          
    
         

 

Substantially all of our assets are held by, and all of our operations are conducted through our Operating Partnership. In order for us to qualify as a REIT, neither our company nor the Operating Partnership can operate hotels directly. Therefore, the Operating Partnership, which is owned approximately 98% by us and approximately 2% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly-owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels under management contracts. HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

 

The discussion below relates to Highland Hospitality Corporation as of and for the quarter and six months ended June 30, 2004. For the quarter and six months ended June 30, 2003, the discussion below relates to Portsmouth Hotel Associates, LLC, which was one of the three entities we acquired on December 19, 2003 and was partially owned by Barceló Crestline. Portsmouth Hotel Associates, LLC is considered the predecessor to Highland Hospitality Corporation for accounting purposes. Securities and Exchange Commission regulations require the inclusion of predecessor financial information for the periods prior to Highland Hospitality Corporation’s commencement of operations.

 

Results of Operations

 

Highland Hospitality Corporation—Three months ended June 30, 2004

 

Revenues—Total revenue for the three months ended June 30, 2004 was $25.3 million, which includes rooms revenue of $16.4 million, food and beverage revenue of $7.9 million, and other revenue of $0.9 million. Average occupancy, ADR, and RevPAR for the three months ended June 30, 2004 were 73.4%, $122.44, and $89.85, respectively. Revenues for the quarter ended June 30, 2004 included the results of operations of seven hotel properties for the full quarter and the Dallas/Fort Worth Airport Marriott hotel from May 10, 2004 through June 30, 2004. Two of the hotels that we acquired on December 19, 2003 had just recently opened for business (October 2003 and November 2003) and ramp-up efforts continued in the quarter ended June 30, 2004. We expect RevPAR to improve at these two hotel properties as operations stabilize and the hotels establish themselves in the marketplace.

 

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Table of Contents

Included in the following table is a comparison of the key hotel operating statistics for our six hotel properties that were open and operating during the quarters ended June 30, 2004 and 2003. The Sugar Land Marriott hotel and Hilton Garden Inn Virginia Beach hotel did not open for business until October 2003 and November 2003, respectively, and thus have been excluded in the comparison. The hotel operating statistics for the six hotels for the quarter ended June 30, 2003 reflect the results of operations of the hotels under previous ownership.

 

     Quarter Ended June 30,

 
     2004

    2003

 

Occupancy %

     78.3 %     76.9 %

ADR

   $ 125.41     $ 119.60  

RevPAR

   $ 98.25     $ 92.02  

 

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the three months ended June 30, 2004 were $18.5 million. Direct hotel operating expenses included rooms expenses of $3.5 million, food and beverage expenses of $5.7 million, and other direct expenses of $0.6 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $8.7 million.

 

Depreciation and amortization—Depreciation and amortization expense for the three months ended June 30, 2004 was $2.1 million.

 

Corporate general and administrative—Total corporate general and administrative expenses for the three months ended June 30, 2004 were $2.4 million, which included non-cash stock-based compensation expense of $0.9 million.

 

Interest income—Interest income for the three months ended June 30, 2004 was $0.3 million.

 

Interest expense—Interest expense for the three months ended June 30, 2004 was $0.3 million, resulting from the mortgage loan assumed in the Hilton Tampa Westshore hotel acquisition.

 

Net income—Net income for the three months ended June 30, 2004 was $2.2 million, due to the items discussed above.

 

Highland Hospitality Corporation—Six months ended June 30, 2004

 

Revenues—Total revenue for the six months ended June 30, 2004 was $44.0 million, which includes rooms revenue of $28.5 million, food and beverage revenue of $13.8 million, and other revenue of $1.7 million. Average occupancy, ADR, and RevPAR for the six months ended June 30, 2004 were 70.8%, $119.92, and $84.94, respectively. Revenues for the six months ended June 30, 2004 included the results of operations of five hotel properties for the full six months and three hotel properties from their acquisition dates, January 8, 2004, January 12, 2004, and May 10, 2004, through June 30, 2004. Two of the hotels that we acquired on December 19, 2003 had just recently opened for business (October 2003 and November 2003) and ramp-up efforts continued in the six months ended June 30, 2004. We expect RevPAR to improve at these two hotel properties as operations stabilize and the hotels establish themselves in the marketplace.

 

Included in the following table is a comparison of the key hotel operating statistics for our six hotel properties that were open and operating during the six months ended June 30, 2004 and 2003. The Sugar Land Marriott hotel and Hilton Garden Inn Virginia Beach hotel did not open for business until October 2003 and November 2003, respectively, and thus have been excluded in the comparison. The hotel operating statistics for the six hotels for the six months ended June 30, 2003 reflect the results of operations of the hotels under previous ownership.

 

     Six Months Ended June 30,

 
     2004

    2003

 

Occupancy %

     76.6 %     76.1 %

ADR

   $ 123.49     $ 118.79  

RevPAR

   $ 94.53     $ 90.36  

 

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Table of Contents

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the six months ended June 30, 2004 were $33.5 million. Direct hotel operating expenses included rooms expenses of $6.1 million, food and beverage expenses of $10.5 million, and other direct expenses of $1.1 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $15.8 million.

 

Depreciation and amortization—Depreciation and amortization expense for the six months ended June 30, 2004 was $3.7 million.

 

Corporate general and administrative—Total corporate general and administrative expenses for the six months ended June 30, 2004 were $4.6 million, which included non-cash stock-based compensation expense of $1.6 million. Also included in corporate general and administrative expenses were $0.3 million of nonrecurring start-up costs related to our formation, such as IT consulting and corporate governance costs.

 

Interest income—Interest income for the six months ended June 30, 2004 was $0.7 million.

 

Interest expense—Interest expense for the six months ended June 30, 2004 was $0.6 million, resulting from the mortgage loan assumed in the Hilton Tampa Westshore hotel acquisition.

 

Income tax benefit—Income tax benefit for the six months ended June 30, 2004 was $0.6 million. The income tax benefit resulted from a taxable operating loss incurred by our TRS for the six months ended June 30, 2004. As of June 30, 2004, we had a net deferred tax asset of $0.8 million, primarily due to past and current year’s tax net operating losses. These loss carryforwards will begin to expire in 2023 if not utilized by then. We believe that it is more likely than not that the net deferred tax asset will be realized and have determined that no valuation allowance is required.

 

Net income—Net income for the six months ended June 30, 2004 was $2.8 million, due to the items discussed above.

 

Portsmouth Hotel Associates, LLC—Three months ended June 30, 2003

 

Revenue—Total revenue for the three months ended June 30, 2003 was $3.0 million, which includes rooms revenue of $1.8 million and food and beverage revenue of $1.1 million. Average occupancy, ADR, and RevPAR for the three months ended June 30, 2003 were 72.1%, $109.90, and $79.23, respectively.

 

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the three months ended June 30, 2003 were $2.1 million. Direct hotel operating expenses included rooms expenses of $0.4 million and food and beverage expenses of $0.6 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $1.1 million.

 

Depreciation and amortization—Depreciation and amortization expense for the three months ended June 30, 2003 was $0.2 million.

 

Interest expense—Interest expense for the three months ended June 30, 2003 was $0.2 million.

 

Net income—Net income for the three months ended June 30, 2003 was $0.4 million, due to the items discussed above.

 

Portsmouth Hotel Associates, LLC—Six months ended June 30, 2003

 

Revenue—Total revenue for the six months ended June 30, 2003 was $4.9 million, which includes rooms revenue of $2.8 million and food and beverage revenue of $2.0 million. Average occupancy, ADR, and RevPAR for the six months ended June 30, 2003 were 66.2%, $94.69, and $62.64, respectively.

 

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the six months ended June 30, 2003 were $4.3 million. Direct hotel operating expenses included rooms expenses of $0.6 million and

 

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food and beverage expenses of $1.5 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $2.1 million.

 

Depreciation and amortization—Depreciation and amortization expense for the six months ended June 30, 2003 was $0.3 million.

 

Interest expense—Interest expense for the six months ended June 30, 2003 was $0.4 million.

 

Net loss—Net loss for the six months ended June 30, 2003 was $(0.1) million, due to the items discussed above.

 

Non-GAAP Financial Measures

 

Funds from operations—Funds from operations, or FFO, is defined as net income (loss), plus real estate related depreciation and amortization. Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, most industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Accordingly, we believe that FFO is a useful financial performance measure for investors and management because it provides another indication of our performance prior to deduction of real estate related depreciation and amortization. The calculation of FFO may vary from entity to entity, and as such, the presentation of FFO by us may not be comparable to FFO reported by other REITs. The following is a reconciliation between net income (loss) and FFO (in thousands):

 

    

Highland Hospitality
Quarter Ended

June 30, 2004


   The Predecessor
Quarter Ended
June 30, 2003


   Highland Hospitality
Six Months Ended
June 30, 2004


   The Predecessor
Six Months Ended
June 30, 2003


 

Net income (loss)

   $ 2,158    $ 446    $ 2,758    $ (108 )

Add: Depreciation and amortization

     2,132      171      3,726      341  
    

  

  

  


Funds from operations

   $ 4,290    $ 617    $ 6,484    $ 233  
    

  

  

  


 

EBITDA—EBITDA is defined as net income (loss) before interest, income taxes, depreciation and amortization. We believe it is a useful financial performance measure for investors and management because it provides an indication of the operating performance of our hotel properties and is not impacted by the capital structure of the REIT. The following is a reconciliation between net income (loss) and EBITDA (in thousands):

 

    

Highland Hospitality
Quarter Ended

June 30, 2004


    The Predecessor
Quarter Ended
June 30, 2003


    Highland Hospitality
Six Months Ended
June 30, 2004


    The Predecessor
Six Months Ended
June 30, 2003


 

Net income (loss)

   $ 2,158     $ 446     $ 2,758     $ (108 )

Add: Depreciation and amortization

     2,132       171       3,726       341  

Interest expense

     336       221       646       443  

Less: Interest income

     (294 )     (1 )     (675 )     (3 )

Income tax benefit

     (26 )     —         (567 )     —    
    


 


 


 


EBITDA

   $ 4,306     $ 837     $ 5,888     $ 673  
    


 


 


 


 

Neither FFO nor EBITDA represent cash generated from operating activities as determined by accounting principles generally accepted in the United States of America (“GAAP”) and neither should be considered as an alternative to GAAP net income, as an indication of our financial performance, or to cash flow from operating activities as determined by GAAP, as a measure of liquidity. In addition, FFO and EBITDA are not indicative of funds available to fund cash needs, including the ability to make cash distributions.

 

Liquidity and Capital Resources

 

Cash flows from operations for the six months ended June 30, 2004 were $4.9 million. For the six months ended June 30, 2004, we used $95.4 million to acquire the Hilton Tampa Westshore hotel, Hilton Garden Inn BWI Airport

 

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hotel, and Dallas/Fort Worth Airport Marriott hotel. In addition, $4.6 million was used to reduce liabilities that were outstanding as of December 31, 2003 related to our hotel acquisitions in December 2003. As of June 30, 2004, $12.0 million was held in escrow accounts for potential hotel property acquisitions.

 

For the six months ended June 30, 2004, $1.9 million was used to reduce liabilities incurred in connection with our initial public offering on December 19, 2003. As of June 30, 2004, $4.9 million was held in escrow accounts for loan application and rate-lock deposits related to financing agreements that we are negotiating. As of June 30, 2004, we had cash and cash equivalents of approximately $107.5 million, not including amounts held in escrow on our behalf. We intend to use the remaining proceeds from the IPO, the underwriters’ exercise of their over-allotment option, and the private placement transactions to invest in additional hotel properties as suitable opportunities arise.

 

We expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under an anticipated credit facility. We believe that net cash provided by operations will be adequate to fund operating requirements, including planned renovations, pay interest on borrowings, and fund dividends in accordance with the REIT requirements of the federal income tax laws.

 

In July 2004, we completed a $67 million non-recourse financing secured by three of our hotel properties. The loan bears a fixed annual interest rate of 6.47% and matures on July 11, 2011. We intend to incur additional indebtedness to supplement our investment capital. While our charter does not limit the amount of debt we can incur, to maintain flexibility to respond to industry conditions and opportunities, we intend to maintain target debt levels of 40-50% of historical asset cost. We are currently in negotiations with several financial institutions to obtain additional long-term fixed rate non-recourse property mortgage debt, as well as a revolving credit or term loan facility. We anticipate that these financings will be completed during the third quarter 2004.

 

Capital Expenditures

 

We will maintain each hotel in good repair and condition and in conformity with applicable laws and regulations and in accordance with the franchisor’s standards and the agreed upon requirements in our management agreements. The cost of all such routine maintenance, repairs and alterations will be paid out of a property improvement fund, which will be funded by a portion of hotel gross revenues. Routine repairs and maintenance will be administered by the management company. However, we have approval rights over capital expenditures. In the remainder of 2004 and first quarter 2005, we plan to spend approximately $13 million on renovations at the Hyatt Regency Savannah and Plaza San Antonio Marriott hotels.

 

Contractual Obligations

 

The following table sets forth our contractual obligations as of June 30, 2004, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands). There were no other off-balance sheet arrangements at June 30, 2004.

 

     Payments Due by Period

Contractual Obligations (2)


   Total

   Less Than
One Year


   One to
Three Years


   Three to
Five Years


   More Than
Five Years


Ground and building leases (1)

   $ 5,863    $ 191    $ 382    $ 300    $ 4,990

Mortgage loan, including interest

     18,335      1,561      16,774      —        —  
    

  

  

  

  

     $ 24,198    $ 1,752    $ 17,156    $ 300    $ 4,990
    

  

  

  

  


(1) Included in the table are the base rent payments (i.e., minimum lease payments) due under the ground and building lease agreements for the Portsmouth Renaissance hotel and adjoining conference center and the conference center and parking facility adjoining the Sugar Land Marriott hotel. The lease agreements provide for base rent payments each year and additional rent payments once we have exceeded a specified return on our original investment. Additional rent payments are not included in the table due to the uncertainty of the timing and amount of the payments in the future. However, we do not expect to make additional rent payments over the next five years.
(2) On June 25, 2004 and June 30, 2004, we signed two separate definitive agreements to acquire five hotel properties for an aggregate purchase price of $256 million. We expect to finance the acquisitions through a combination of non-recourse property mortgage debt and the use of our remaining IPO proceeds.

 

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Inflation

 

Operators of hotels, in general, possess the ability to adjust room rates daily to mitigate the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates.

 

Seasonality

 

Demand in the lodging industry is affected by recurring seasonal patterns. For non-resort properties, demand is generally lower in the winter months due to decreased travel and higher in the spring and summer months during the peak travel season. We expect that our operations will generally reflect non-resort seasonality patterns. Accordingly, we expect that we will have lower revenue, operating income and cash flow in the first and fourth quarters and higher revenue, operating income and cash flow in the second and third quarters. These general trends are, however, expected to be greatly influenced by overall economic cycles.

 

Critical Accounting Policies

 

We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our financial statements:

 

Investment in Hotel Properties—Investments in hotel properties are stated at acquisition cost (except where interests are acquired from Barceló Crestline) and allocated to land, property and equipment and identifiable intangible assets at fair value in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Property and equipment are recorded at current replacement cost for similar capacity and allocated to buildings, improvements, furniture, fixtures and equipment based on cost segregation studies performed by management and independent third parties. Property and equipment are depreciated using the straight-line method over an estimated useful life of 15 to 40 years for buildings and improvements and three to ten years for furniture and equipment. Identifiable intangible assets are typically contracts, including lease agreements and franchise agreements, which are recorded at fair value. Above-market and below-market contract values are based on the present value of the difference between contractual amounts to be paid pursuant to the contracts acquired and our estimate of the fair market contract rates for corresponding contracts measured over a period equal to the remaining non-cancelable term of the contract. Contracts acquired which are at market do not have significant value. An existing franchise agreement is typically terminated at the time of acquisition and a new franchise agreement is entered into based on then current market terms. Intangible assets are amortized using the straight-line method over the remaining non-cancelable term of the related agreements. In making estimates of fair values for purposes of allocating purchase price, we may utilize a number of sources that may be obtained in connection with the acquisition or financing of a property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired.

 

We review our investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the investments in hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to, adverse changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of an investment in a hotel property exceed the hotel’s carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying value to the estimated fair market value is recorded and an impairment loss recognized.

 

Stock-based Compensation—We account for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation, as amended. For restricted stock awards, we record unearned compensation equal to the number of shares awarded multiplied by the average price of our common stock on the date of the award, less the purchase price for the stock, if any. Unearned compensation is amortized using the straight-line method over the period in which the restrictions lapse (i.e., vesting period). For unrestricted stock awards, we record compensation expense on the date of the award equal to the number of shares awarded multiplied by the average price of our common stock on the date of the award, less the purchase price for the stock, if any.

 

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Revenue Recognition—Hotel revenues, including room, food and beverage, and other hotel revenues, are recognized as the related services are provided.

 

Income Taxes—We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRSs, we have not recorded a valuation allowance to reduce our net deferred tax asset as of June 30, 2004. Should our estimate of future taxable income be less than expected, we would record an adjustment to the net deferred tax asset in the period such determination was made.

 

New Accounting Pronouncements

 

FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51, as amended (“FIN 46R”), requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The adoption of FIN 46R did not have a material impact on our results of operations, financial position, or cash flows.

 

Statement of Financial Accounting Standards No. 150 (“SFAS 150”), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of these financial instruments were classified as equity. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period after June 15, 2003. However, in October 2003, the FASB elected to indefinitely defer implementation of certain provisions of SFAS 150 relating to limited-life subsidiaries created before November 5, 2003. The adoption of SFAS 150 did not have a material impact on our results of operations, financial position, or cash flows.

 

Forward-Looking Statements

 

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and as such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words, such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative. All statements regarding our expected financial position, business and financing plans are forward-looking statements. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to:

 

  United States economic conditions generally and the real estate market and the lodging industry specifically;

 

  management and performance of our hotels;

 

  our plans for renovation of our hotels;

 

  our financing plans;

 

  supply and demand for hotel rooms in our current and proposed market areas;

 

  our ability to acquire additional properties and the risk that potential acquisitions may not perform in accordance with expectations;

 

  legislative/regulatory changes, including changes to laws governing taxation of real estate investment trusts; and

 

  our competition.

 

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These risks and uncertainties should be considered in evaluating any forward-looking statement contained in this report or incorporated by reference herein. All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section. We undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

As of June 30, 2004, we did not have any significant financial instruments that were exposed to market risk. Our financial instruments included cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and a mortgage loan. Due to their short maturities, these financial instruments are carried at amounts that reasonably approximate fair value.

 

Item 4. Controls and Procedures

 

The Chief Executive Officer and Chief Financial Officer of Highland Hospitality Corporation have evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act, and have concluded that as of the end of the period covered by this report, Highland Hospitality Corporation’s disclosure controls and procedures were effective.

 

There was no change in Highland Hospitality Corporation’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Highland Hospitality Corporation’s most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, Highland Hospitality Corporation’s internal control over financial reporting.

 

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PART II

 

Item 1. Legal Proceedings

 

We are not involved in any material litigation nor, to our knowledge, is any material litigation threatened against us.

 

Item 2. Changes in Securities and Use of Proceeds

 

The shares of common stock that we sold in our initial public offering were registered under the Securities Act of 1933, as amended, on a Form S-11 Registration Statement (SEC File No. 333-108671) that was declared effective by the Securities and Exchange Commission on December 15, 2003. The aggregate net proceeds to us from the offering were approximately $318.9 million after deducting approximately $24.1 million in underwriting discounts and approximately $2 million in other expenses incurred in connection with the offering.

 

We used approximately $239 million of the net proceeds to purchase our initial portfolio of eight hotels. We intend to use the remaining net proceeds to acquire additional hotel properties and for general corporate purposes. Pending the use of the proceeds, as described above, we will invest any remaining proceeds in short-term, investment-grade, interest-bearing securities.

 

Item 3. Defaults Upon Senior Securities

 

Not applicable.

 

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

 

(a)-(c) The 2004 annual meeting of stockholders of the Company was held on May 25, 2004. The following matters were voted upon at the meeting:

 

  (i) The following individuals were elected directors of the Company for terms expiring in 2005:

 

     Votes For

   Votes Withheld

Bruce D. Wardinski

   33,260,661    1,920,154

James L. Francis

   33,259,161    1,921,654

Francisco L. Borges

   33,768,629    1,412,186

W. Reeder Glass

   33,259,661    1,921,154

Craig E. Lambert

   33,766,529    1,414,286

Thomas A. Natelli

   33,765,529    1,415,286

Margaret A. Sheehan

   33,811,629    1,369,186

William L. Wilson

   33,807,029    1,373,786

 

  (ii) Approval of the Company’s 2003 Omnibus Stock Incentive Plan:

 

Votes For


  

Votes Against


  

Votes Abstained


  

Broker Non-Votes


25,754,985

   1,553,288    34,094    7,838,448

 

Item 5. Other Information

 

None.

 

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Item 6. Exhibits and Reports on Form 8-K

 

  (a) Exhibits

 

The following exhibits are filed as part of this Form 10-Q:

 

Exhibit

Number


 

Description of Exhibit


31.1   Certification of President and Chief Executive Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2   Certification of Chief Financial Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1   Certification of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2   Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

  (b) Reports on Form 8-K

 

The Company filed the following reports on Form 8-K during the quarter ended June 30, 2004:

 

Date

 

Items Reported On


May 5, 2004  

Item 12—Results of Operations and Financial Condition

 

On May 5, 2004, Highland Hospitality Corporation issued a press release announcing

its results for the quarter ended March 31, 2004.

May 10, 2004  

Item 2—Acquisition or Disposition of Assets

Item 7—Financial Statements and Exhibits

 

On May 10, 2004, Highland Hospitality Corporation issued a press release announcing

the acquisition of the Dallas/Fort Worth Airport Marriott hotel.

 

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SIGNATURE

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

    HIGHLAND HOSPITALITY CORPORATION

Date: August 5, 2004

 

By:

 

/s/ Douglas W. Vicari


       

Douglas W. Vicari

Executive Vice President, Chief Financial Officer

and Treasurer (Principal Financial and Accounting Officer)

 

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