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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

OR

COMMISSION FILE NO. 001-13393

CHOICE HOTELS INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

10750 COLUMBIA PIKE

SILVER SPRING, MD. 20901

(Address of principal executive offices)

(Zip Code)

(301) 592-5000

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

INDEX

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PART I. FINANCIAL INFORMATION

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

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

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

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

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

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

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED, IN THOUSANDS)

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

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CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Company Information and Significant Accounting Policies

The accompanying unaudited consolidated financial statements of Choice Hotels International, Inc. and subsidiaries (together the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (which include any normal recurring adjustments) considered necessary for a fair presentation have been included. Certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States of America have been omitted. The 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, 2003 and notes thereto included in the Company’s Form 10-K, filed with the Securities and Exchange Commission on March 15, 2004 (the “10-K”). Interim results are not necessarily indicative of the entire year results because of seasonal variations. All intercompany transactions and balances between Choice Hotels International, Inc. and its subsidiaries have been eliminated in consolidation.

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

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

2. Stock-Based Compensation

Effective January 1, 2003, the Company adopted, in accordance with the prospective method prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all employee awards granted, modified or settled on or after January 1, 2003.

The Company’s stock-based compensation plans and related accounting policies are described more fully in the notes to the consolidated financial statements included in the 10-K. No stock-based compensation cost is reflected in the accompanying consolidated statements of income related to the grant of stock options which occurred prior to January 1, 2003, because the Company accounted for those grants under APB Opinion No. 25 and all such stock options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Therefore, the cost related to stock-based employee compensation included in the determination of net income for the three and nine months ended September 30, 2004 and 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS 123. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.

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3. Receivable—Marketing and Reservation Fees

The marketing and reservation fees receivable at September 30, 2004 and December 31, 2003 was $21.3 million and $32.4 million, respectively. Depreciation and amortization expense attributable to marketing and reservation activities was $2.0 million and $2.9 million for the three months ended September 30, 2004 and 2003, respectively, and $7.2 million and $9.5 million for the nine months ended September 30, 2004 and 2003, respectively. Interest expense attributable to reservation activities was $0.4 million and $0.3 million for the three months ended September 30, 2004 and 2003, respectively, and $1.1 million and $0.9 million for the nine months ended September 30, 2004 and 2003, respectively.

4. Restructuring Programs

During 2002, the Company recognized restructuring charge expense of $1.6 million pursuant to SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The restructuring charge related to employee severance and termination benefits for 23 employees resulting from corporate realignment initiatives. The restructuring was initiated and completed in 2002. Approximately $0.3 million of the restructuring expense related to stock compensation for certain severed employees. The Company paid approximately $0.1 million and $0.9 million in cash related to this restructuring during the three and nine months ended September 30, 2003, respectively. Through December 31, 2003, the Company paid approximately $1.3 million in cash related to this restructuring. As a result of these payments, the Company’s obligations related to the 2002 restructuring were satisfied, resulting in no liability remaining at December 31, 2003.

During 2001, the Company recognized restructuring charge expense of $5.9 million pursuant to Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The restructuring charge included $5.3 million related to a corporate realignment designed to increase 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. Of this $5.3 million, $5.1 million related to 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) and $0.2 million related to the cancellation of pre-existing contracts for termination of domestic leases. The remaining $0.6 million of the $5.9 million was due to exit costs related to the termination of a corporate hotel construction project. Approximately $0.9 million of the restructuring expense related to stock compensation for certain severed employees. Through December 31, 2003, the Company paid approximately $4.9 million in cash related to this restructuring. During the six months ended June 30, 2003, the Company paid approximately $0.5 million in cash related to this restructuring. As a result of these payments, the Company’s obligations related to the 2001 restructuring were satisfied and approximately $0.1 million was recorded as a reduction of selling, general and administrative expense during the nine months ended September 30, 2003, resulting in no liability remaining at December 31, 2003.

5. Income Taxes

The income tax provisions for the three and nine months ended September 30, 2004 and 2003 are based on the effective tax rates expected to be applicable for the corresponding full year periods. The 2004 and 2003 nine-month rate of approximately 37% differs from the statutory rates primarily because of state income taxes and certain federal and state income tax credits.

6. Comprehensive Income

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

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7. Capital Stock and Earnings Per Share

During the nine months ended September 30, 2004, the Company repurchased 2.3 million shares of its common stock at a total cost of $101.3 million. During the three months ended September 30, 2004, the Company repurchased 0.4 million shares of its common stock at a total cost of $21.6 million.

The Company received $1.3 million and $5.6 million in proceeds from the exercise of 0.1 million and 0.4 million employee stock options during the three and nine months ended September 30, 2004, respectively.

During the three and nine months ended September 30, 2004, the Company granted approximately 1,000 shares and 0.2 million shares, respectively, of restricted stock to certain employees and directors. The fair value of the restricted stock granted in the three and nine months ended September 30, 2004 was $0.1 million and $7.9 million, respectively.

In September 2004, the Company declared a cash dividend of $0.225 per share (or approximately $7.4 million in the aggregate) which was paid on October 22, 2004 to shareholders of record on October 8, 2004.

Basic earnings per share excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per share, assumes dilution and is computed based on the weighted-average number of common shares outstanding after consideration of the dilutive effect of stock options and unvested restricted stock.

8. Acquisition of Flag Choice Hotels

On February 10, 2003, the Company acquired the remaining 45% equity interest (beyond the 55% interest acquired prior to December 31, 2002) in Flag Choice Hotels (“Flag”). As a result Flag became a wholly owned subsidiary of the Company as of that date. Flag, based in Melbourne, Australia, is a franchisor of certain hotel brands in Australia, Papua New Guinea, Fiji and New Zealand. The acquisition of Flag (“Flag Transaction”) 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. In September 2003, our master franchise agreement with a third party that included the right to franchise the Choice brands in New Zealand was terminated. At that time, Flag obtained the rights to the Choice brands in New Zealand.

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 $4.3 million has been allocated to franchise rights and is being amortized over their estimated useful lives of 5 to 15 years.

9. Debt

In July 2004, the Company entered into a $265 million senior unsecured revolving credit facility (the “Revolver”) with a syndicate of lenders. The proceeds from the Revolver were used to refinance and terminate the revolving credit facility and term loan outstanding under the Company’s existing senior credit facility (the “Old Credit Facility”). The Revolver permits the Company to borrow, repay and reborrow revolving loans until the scheduled maturity date in July 2009. Borrowings pursuant to the Revolver bear interest, at one of several rates selected by the Company, based upon the credit rating of the Company and include LIBOR plus 62 ½ basis points to 125 basis points; prime rate; and prime rate minus 175 basis points. In addition, the Company has the option to request participating banks to bid on loan participation at lower rates than those contractually provided by the Revolver. The Revolver requires the Company to pay a commitment fee ranging, based upon the credit rating of the Company, between 12 ½ basis points and 25 basis points of the average daily-unused portion of the aggregate available commitment. The Revolver also provides for the issuance of letters of credit on behalf of the Company. The Revolver includes customary financial and other covenants that require the maintenance of certain ratios including maximum leverage and interest coverage. The Revolver restricts the Company’s ability to make certain investments, incur certain debt, and dispose of assets, among other restrictions.

The Company accounted for the refinancing of the Old Credit Facility in accordance with Emerging Issues Task Force (“EITF”) Issue No. 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” and EITF No. 98-14, “Debtor’s Accounting for Changes in Line-of-Credit or Revolving-Debt Arrangements.” Pursuant to these accounting pronouncements, the Company recorded a loss on extinguishment of debt of approximately $0.7 million.

As of September 30, 2004, in addition to the Revolver and senior notes, the Company had a line of credit with a bank providing up to an aggregate of $10 million of borrowings, which is due upon demand. The line of credit ranks pari-pasu (or equally) with the Company’s Revolver and includes customary financial and other covenants that require the maintenance of certain ratios identical to those included in the Company’s Revolver. Borrowings under the line of credit bear interest at rates established at the time of borrowing based on prime minus 175 basis points. As of September 30, 2004, approximately $8.6 million was outstanding pursuant to this line of credit.

10. Reportable Segment Information

The Company has a single reportable segment encompassing its franchising business. Revenues from the franchising business include royalty fees, initial franchise and relicensing fees, marketing and reservation fees, partner services revenue and other revenue. The Company is obligated under its franchise agreements to provide marketing and reservation services appropriate for the successful operation of its systems. These services do not represent separate reportable segments as their operations are directly related to the Company’s franchising business. The revenues received from franchisees that are used to pay for part of the Company’s central ongoing operations are included in franchising revenues and are offset by the related expenses paid for marketing and reservation activities to calculate franchising operating income. Corporate and other revenue consists of hotel operations. Except as described in Note 3, the Company does not allocate interest income, interest expense or income taxes to its franchising segment.

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

11. Commitments and Contingencies

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

The Company has a $3.0 million letter of credit issued as support for construction and permanent financing of a Sleep Inn and a MainStay Suites located in Atlanta, Georgia. No amounts were drawn against this letter of credit as of September 30, 2004. The letter of credit expires in March 2005.

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

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

The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand Choice Hotels International, Inc. and subsidiaries (together “the Company”). MD&A is provided as a supplement to—and should be read in conjunction with—our consolidated financial statements and the accompanying notes.

Overview

We are a hotel franchisor with franchise agreements representing 4,959 hotels open as of September 30, 2004, with 402,519 rooms in the United States and 40 other countries and territories. Our brand names include Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, Econo Lodge, Rodeway Inn, MainStay Suites and Flag Hotels. Approximately 95% of the Company’s revenues are derived from hotels franchised in the United States.

Our Company generates revenues, income and cash flows primarily from initial and continuing royalty fees attributable to our franchise agreements. Revenues are also generated from partner services endorsed vendor arrangements, hotel operations and other sources.

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

Our Company articulates its mission as a commitment to provide hotel franchises that strive to generate the highest return on investment. We have developed an operating system dedicated to our franchisees’ success: One that focuses on delivering guests to our franchised hotels and reducing costs for our hotel owners. More specifically, through our actions we strive every day to continuously improve our franchise offerings to create the highest return on investment of any hotel franchise.

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

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

Maximizing Financial Returns and Creating Value for Shareholders. Our capital allocation decisions, including capital structure and uses of capital, are intended to maximize our return on invested capital and create value for our shareholders. We believe our strong and predictable cash flows create a strong financial position that provides us a competitive advantage. Our business does not require significant capital to operate and grow, therefore, we can maintain a capital structure that generates high financial returns and use our excess cash flow to increase returns to our shareholders. We have returned value to our shareholders in two primary ways: share repurchases and dividends. In 1998, we instituted a share repurchase program which has generated substantial value for our shareholders. We have repurchased 31.8 million shares of common stock through November 5, 2004 at a total cost of $628 million, or an average price of $19.71 per share since the program’s inception. Our cash flows from operations support our ability to complete the repurchase of approximately 2.5 million shares presently remaining under our current board of directors’ authorization. Upon completion of the current authorization we will evaluate the propriety of additional share repurchases with our board of directors. In the fourth quarter of 2003, we initiated a cash dividend on our common stock. In September 2004, our board of directors declared our fourth quarterly cash dividend in the amount of $0.225 per outstanding share of common stock, which was paid on October 22, 2004 to holders of record on October 8, 2004. This dividend represents a 12.5% increase over the previous quarterly rate of $0.20 and raises the indicated annual divided rate on the Company’s common stock from $0.80 to $0.90 per share.

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

Results of Operations. Royalty fees, operating income, net income and diluted earnings per share represent key measurements of these value drivers. In the three months ended September 30, 2004, royalty fees revenue totaled approximately $51.8 million, a 7% increase from the same period in 2003. Operating income totaled $42.5 million in the third quarter of 2004, a 7% increase from 2003. Net income for the three months ended September 30, 2004 increased to $24.9 million, a 2% increase from 2003. Diluted earnings per share for the third quarter of 2004 were $0.73, an 11% improvement over 2003 resulting from increased net income and a reduction in

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the number of shares outstanding attributable to our share repurchase program. Net income and diluted earnings per share for the quarter ended September 30, 2004 included a loss on extinguishment of debt of approximately $0.7 million ($0.4 million, net of the related tax effect) related to the refinancing of the Company’s senior credit facility. Net income and diluted earnings per share for the quarter ended September 30, 2003 included approximately $1.2 million ($0.7 million, net of the related tax effect) of interest income attributable to a note receivable from Sunburst Hospitality Corporation (“Sunburst”), which was repaid to the Company in December 2003. These measurements will continue to be a key management focus in 2004 and beyond. Refer to MD&A heading “Operations Review” for additional analysis of our results.

Liquidity and Capital Resources. In the nine months ended September 30, 2004, net cash provided by operating activities was $75.2 million. Since our business does not require significant reinvestment of capital, we utilize cash in ways that management believes provides the greatest returns to our shareholders which include share repurchases and dividends. We believe the Company’s cash flows from operations and available financing capacity are sufficient to meet the expected future operating, investing and financing needs of the business.

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

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

Operations Review

Comparison of Operating Results for the Three Month Periods Ended September 30, 2004 and September 30, 2003

The Company recorded net income of $24.9 million for the three months ended September 30, 2004, an increase of $0.6 million from $24.3 million for the same period in 2003. The increase in net income for the period is primarily attributable to a $2.7 million improvement in operating income partially offset by a $2.3 million increase in other expenses, including a loss on extinguishment of debt of $0.7 million. Operating income increased as a result of a $4.8 million, or 9%, increase in franchise revenues (total revenues excluding marketing and reservation revenues and hotel operations) partially offset by an increase in selling, general and administrative expense. Net other income and expenses increased primarily as result of a $0.7 million loss on extinguishment of debt, a $1.2 million reduction of interest income attributable to the December 2003 repayment of a note receivable from Sunburst and reductions in investment income attributable to non-qualified employee benefit plan assets. As a result of the Sunburst note prepayment, no interest income related to this note will be realized in future periods.

Summarized financial results for the three months ended September 30, 2004 and 2003 are as follows:

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

Franchise Revenues: Franchise revenues were $61.1 million for the three months ended September 30, 2004 compared to $56.3 million for the three months ended September 30, 2003. Royalty fees increased $3.5 million to $51.8 million from $48.3 million in 2003, an increase of 7%. The increase in royalties is attributable to a combination of factors including a 5.1% increase in the number of domestic franchised hotel rooms, a 2.1% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system to 4.04 % from 4.03%. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise contracts was $3.1 million for the three months ended September 30, 2004 compared to $2.3 million for the three months ended September 30, 2003. The number of domestic franchise agreements executed in third quarter 2004 increased to 122, compared to 108 in 2003. Other revenues increased primarily as a result of increased termination awards revenue which are generated when franchises exit the system prior to contractually agreed-upon dates.

The number and changes in the number of hotels and rooms on-line is important information when analyzing our results because they are key indicators of our performance in executing our strategic priority of profitable growth. Increases in franchising revenues are heavily dependent upon our ability to sell additional hotel franchises because of the direct impact these sales have on our initial franchise fees and royalty fees. The number of domestic rooms on-line increased to 306,797 from 291,827, an increase of 5.1% during the twelve month period ended September 30, 2004. For the twelve month period ended September 30, 2004, the total number of domestic hotels on-line grew 5.4% to 3,796 from 3,601 as of September 30, 2003. International rooms on-line increased to 95,722 as of September 30, 2004 from 92,987 as of September 30, 2003. The total number of international hotels on-line decreased slightly to 1,163 from 1,172, for the twelve month period ended September 30, 2004. As of September 30, 2004, the Company had 397 franchised hotels with 30,776 rooms either in design or under construction in its domestic system. The Company had an additional 95 franchised hotels with 8,351 rooms under development in its international system as of September 30, 2004.

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative expenses were $16.4 million and $14.1 million for the three months ended September 30, 2004 and September 30, 2003, respectively. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total selling, general and administrative expenses were 26.8% for the three months ended September 30, 2004, compared to 25.0% for 2003. The increase in selling, general and administrative expense for third quarter 2004 reflects increased costs associated with franchise sales incentive compensation, costs related to retirement of a board member, adoption of the fair value method of accounting for stock compensation and increased professional fees related to Sarbanes-Oxley compliance efforts.

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

Total marketing and reservation revenues were $65.4 million and $48.6 million for the three months ended September 30, 2004 and 2003, respectively. Depreciation and amortization attributable to marketing and reservation activities was $2.0 million and $2.9 million for the three months ended September 30, 2004 and 2003, respectively. Interest expense attributable to reservation activities was $0.4 million and $0.3 million for the three months ended September 30, 2004 and 2003, respectively. As of September 30, 2004 and December 31, 2003, the Company’s balance sheet included a receivable of $21.3 million and $32.4 million, respectively, for marketing and reservation fees. This receivable is recorded as an asset in the financial statements as the Company has the contractual authority to require that the franchisees in the system at any given point repay the Company for any deficits related to marketing and reservation activities. The Company’s current franchisees are legally obliged to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue. The Company has no present intention to accelerate repayment of the deficit from current franchisees.

Other Income and Expenses. Interest expense was $2.9 million for each of the three month periods ended September 30, 2004 and 2003. The Company’s weighted average interest rate as of September 30, 2004 was 4.17% compared to 3.54% as of September 30, 2003. Other income and expenses includes a loss on extinguishment of debt of approximately $0.7 million attributable to the refinancing of our senior credit facility during the third quarter. Interest and other investment income for the three months ended September 30, 2003 includes approximately $1.2 million of interest income earned on a note receivable from Sunburst which was repaid in December 2003.

Comparison of Operating Results for the Nine Month Periods Ended September 30, 2004 and September 30, 2003

The Company recorded net income of $54.0 million for the nine months ended September 30, 2004, an increase of $2.9 million from $51.1 million for the same period in 2003. The increase in net income for the period is primarily attributable to a $7.8 million improvement in operating income partially offset by a $4.1 million increase in net other income and expenses. Operating income increased as a result of an $11.3 million, or 8%, increase in franchise revenues (total revenues excluding marketing and reservation revenues and hotel operations) and a decrease in depreciation and amortization expense partially offset by an increase in selling, general and administrative expense. Net other income and expenses increased primarily as result of a $0.7 million loss on extinguishment of debt, a $3.5 million reduction of interest income attributable to the December 2003 repayment of a note receivable from Sunburst and reductions in investment income attributable to non-qualified employee benefit plan assets, partially offset by lower interest expense. As a result of the Sunburst note prepayment, no interest income related to this note will be realized in future periods.

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Summarized financial results for the nine months ended September 30, 2004 and 2003 are as follows:

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

Franchise Revenues: Franchise revenues were $150.0 million for the nine months ended September 30, 2004 compared to $138.7 million for the nine months ended September 30, 2003. Royalty fees increased $11.0 million to $124.2 million from $113.2 million in 2003, an increase of 10%. The increase in royalties is attributable to a combination of factors including a 5.1% increase in the number of domestic franchised hotel rooms, a 4.2% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system to 4.04 % from 4.00%. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise contracts increased 19% to $8.6 million for the nine months ended September 30, 2004 from $7.2 million for the nine months ended September 30, 2003. The increase resulted from the number of domestic franchise agreements executed in 2004 increasing to 354, compared to 294 in 2003. Relicensing fees increased 22% to $5.0 million for the nine months ended September 30, 2004 from $4.1 million for the nine months ended September 30, 2003. Relicensing fees are charged to the new property owner of a franchised property whenever an ownership change occurs and the property remains in the franchise system. Other revenues decreased primarily as a result of reduced termination awards revenue which are generated when franchises exit the system prior to contractually agreed-upon dates. Other revenues for the nine months ended September 30, 2003, included approximately $1.7 million of liquidated damages received from Sunburst for the termination of certain franchises.

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative expenses were $49.6 million for the nine months ended September 30, 2004 compared to $45.0 million for the same period in 2003. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total selling, general and administrative expenses were 33.1% for the nine months ended September 30, 2004, compared to 32.4% for 2003. The increase in selling, general and administrative expense reflects increased costs associated with increasing the size of the franchise sales team, franchise sales incentive compensation, costs related to retirement of a board member, adoption of the fair value method of accounting for stock compensation and increased professional fees and other costs related to Sarbanes-Oxley compliance efforts.

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

Total marketing and reservation revenues were $169.1 million and $149.6 million for the nine months ended September 30, 2004 and 2003, respectively. Depreciation and amortization attributable to marketing and reservation activities was $7.2 million and $9.5 million for the nine months ended September 30, 2004 and 2003, respectively. Interest expense attributable to reservation activities was $1.1 million and $0.9 million for the nine months ended September 30, 2004 and 2003, respectively. Marketing and reservation activities generated $18.2 million and $13.4 million of positive operating cash flow for the nine months ended September 30, 2004 and 2003, respectively. As of September 30, 2004 and December 31, 2003, the Company’s balance sheet included a receivable of $21.3 million and $32.4 million, respectively, for marketing and reservation fees. This receivable is recorded as an asset in the financial statements as the Company has the contractual authority to require that the franchisees in the system at any given point repay the Company for any deficits related to marketing and reservation activities. The Company’s current franchisees are legally obliged to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue. The Company has no present intention to accelerate repayment of the deficit from current franchisees.

Other Income and Expenses. Interest expense of $8.3 million for the nine months ended September 30, 2004 is down $0.7 million from $9.0 million in the nine months ended September 30, 2003 due primarily to lower average debt balances during 2004 partially offset by higher effective interest rates on our variable rate credit facilities. The Company’s weighted average interest rate as of September 30, 2004 was 4.17% compared to 3.54% as of September 30, 2003. Other income and expenses includes a loss on extinguishment of debt of approximately $0.7 million attributable to the refinancing of our senior credit facility during the third quarter. Interest and other investment income for the nine months ended September 30, 2003 includes approximately $3.5 million of interest income earned on a note receivable from Sunburst which was repaid in December 2003.

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Liquidity and Capital Resources

Net cash provided by operating activities was $75.2 million and $81.7 million for the nine months ended September 30, 2004 and September 30, 2003, respectively. The decrease is attributable to improvements in operating results and cash flows from marketing and reservation activities offset by higher payments related to income taxes.

During 2002 and 2001, the Company realigned its corporate structure to increase its strategic focus on delivering value-added services and support 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 recorded a $1.6 million restructuring charge in 2002 of which approximately $0.9 million and $0.4 million was paid in 2003 and 2002, respectively. Approximately $0.3 million of the expense was related to stock compensation for terminated employees and was credited directly to additional paid-in capital. The restructuring was initiated and completed in 2002. The Company recorded a $5.9 million restructuring charge in 2001 of which approximately $0.9 million of the expense was related to stock compensation for terminated employees and was credited directly to additional paid-in capital. Through December 31, 2002 the Company paid $4.4 million and during 2003 the Company paid an additional $0.5 million related to this restructuring. As a result of these payments, the Company’s obligations related to the 2001 restructuring were satisfied and approximately $0.1 million was recorded as a reduction of selling, general and administrative expense during the nine months ended September 30, 2003. As of December 31, 2003, the Company’s obligations related to the 2002 and 2001 restructurings were satisfied resulting in no liability remaining at December 31, 2003. During the nine months ended September 30, 2003, the Company paid approximately $0.9 million and $0.5 million related to the 2002 and 2001 restructurings, respectively.

Net cash repayments related to marketing and reservation activities totaled $18.2 million during the nine months ended September 30, 2004 compared to net repayments of $13.4 million during the nine months ended September 30, 2003. The improvement in cash flows attributable to marketing and reservation activities is attributable to cost reductions from restructured operations and growth in fees from operations. The Company expects marketing and reservation activities to generate positive cash flows between $19.0 million and $22.0 million in 2004.

Cash used in investing activities for the nine months ended September 30, 2004 and 2003, was $9.3 million and $11.1 million, respectively. During the nine months ended September 30, 2004 and 2003 capital expenditures totaled $4.3 million and $7.1 million, respectively. Capital expenditures include the installation of system-wide property and yield management systems, upgrades to financial and reservation systems, computer hardware and renovations to the Company’s corporate headquarters.

Financing cash flows relate primarily to the Company’s borrowings under its credit lines, treasury stock purchases and dividends. In June 2001, the Company entered into a five-year $265 million competitive advance and multi-currency credit facility (“Old Credit Facility”). The Old Credit Facility provided for a term loan of $115 million and a revolving credit facility of $150 million. The term loan was scheduled to partially amortize over the three years ending June 30, 2006. The unamortized balance of the term loan and all outstanding revolving loans were scheduled to mature in June 2006. Borrowings under the Old Credit Facility bore interest at one of several rates, at the option of the Company, including LIBOR plus .60% to 2.0%, based upon the credit rating of the Company and the loan type. The Old Credit Facility required the Company to pay annual fees ranging, based upon the credit rating of the Company, between 1/15 of 1% to 1/2 of 1% of the aggregate available commitment under the revolving credit facility.

In July 2004, the Company entered into a $265 million senior unsecured revolving credit facility (the “Revolver”) with a syndicate of lenders. The proceeds from the Revolver were used to refinance and terminate the revolving credit facility and term loan outstanding under the Company’s Old Credit Facility. The Revolver permits the Company to borrow, repay and reborrow revolving loans until the scheduled maturity date in July 2009. Borrowings pursuant to the Revolver bear interest, at one of several rates selected by the Company, based upon the credit rating of the Company and include LIBOR plus 62 ½ basis points to 125 basis points; prime rate; and prime rate minus 175 basis points. In addition, the Company has the option to request participating banks to bid on loan participation at lower rates than those contractually provided by the Revolver. The Revolver requires the Company to pay a commitment fee ranging, based upon the credit rating of the Company, between 12 ½ basis points and 25 basis points of the average daily-unused portion of the aggregate available commitment. The Revolver also provides for the issuance of letters of credit on behalf of the Company. The Revolver includes customary financial and other covenants that require the maintenance of certain ratios including maximum leverage and interest coverage. The Revolver restricts the Company’s ability to make certain investments, incur certain debt, and dispose of assets, among other restrictions. As of September 30, 2004, the Company had $199.0 million of revolving loans outstanding pursuant to the Revolver.

The proceeds from the Revolver are used for general corporate purposes, including working capital, debt repayment, stock repurchases and investments.

In 1998, the Company completed a $100 million senior unsecured note offering (“the Notes”), bearing a coupon rate of 7.13% with an effective rate of 7.22%. The Notes will mature on May 1, 2008, with interest on the Notes to be paid semi-annually. The Company used the net proceeds from the offering of approximately $99 million to repay amounts outstanding under the Company’s previous credit facility.

The Company has a line of credit with a bank providing up to an aggregate of $10 million of borrowings which is due upon demand. The line of credit ranks pari-pasu (or equally) with the Revolver and includes customary financial and other covenants that require the maintenance of certain ratios identical to those included in the Company’s Revolver. Borrowings under the line of credit bear interest at rates established at the time of borrowing based on prime minus 175 basis points. As of September 30, 2004, approximately $8.6 million was outstanding pursuant to this line of credit.

As of September 30, 2004, total long-term debt outstanding for the Company was $308.1 million, of which $8.7 million was scheduled to mature in the twelve months ended September 30, 2005.

Through September 30, 2004, the Company had repurchased 31.6 million shares of its common stock at a total cost of $616 million, including 2.3 million shares at a cost of $101.3 million during the nine months ended September 30, 2004. Through November 5, 2004, the Company had repurchased 31.8 million shares of its common stock at a total cost of $628 million. At September 30, 2004, the Company had approximately 33.0 million shares of common stock outstanding.

In the fourth quarter of 2003, we initiated a cash dividend on our common stock. In September 2004, our board of directors declared our fourth quarterly cash dividend in the amount of $0.225 on outstanding shares of common stock which was paid on October 22, 2004 to holders of record on October 8, 2004. This dividend represents a 12.5% increase over the previous quarterly rate of $0.20 and raises the indicated annual divided rate on the Company’s common stock from $0.80 to $0.90 per share. Dividends paid in 2004 were approximately $27.5 million.

The Company believes that cash flows from operations and available financing capacity are adequate to meet expected future operating, investing and financing needs of the business.

Critical Accounting Policies

Our accounting policies comply with principles generally accepted in the United States. We have described below those policies that we believe are critical and require the use of complex judgment or significant estimates in their application. Additional discussion of these policies is included in Note 1 to our consolidated financial statements as of and for the year ended December 31, 2003 included in our Annual Report on Form 10-K.

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Revenue Recognition.

We recognize continuing franchise fees, including royalty, marketing and reservations fees, when earned and receivable from our franchisees. Franchise fees are typically based on a percentage of gross room revenues of each franchisee. Our estimate of the allowance for uncollectible royalty fees is charged to selling, general and administrative expense.

Initial franchise and relicensing fees are recognized, in most instances, in the period the related franchise agreement is executed because the initial franchise fee is non-refundable and the Company has no continuing obligations related to the franchisee. We defer the initial franchise fee revenue related to franchise agreements which include incentives until the incentive criteria are met or the agreement is terminated, whichever occurs first.

We account for partner services revenues from endorsed vendors in accordance with Staff Accounting Bulletin No. 104, (“SAB 104”) “Revenue Recognition.” SAB 104 provides guidance on the recognition, presentation and disclosure of revenue in financial statements. Pursuant to SAB 104, the Company recognizes partner services revenues when the services are performed or the product delivered, evidence of an arrangement exists, the fee is fixed and determinable and collectibility is probable. We defer the recognition of partner services revenues related to certain upfront fees and recognize them over a period corresponding to the Company’s estimate of the life of the arrangement.

Marketing and Reservation Revenues and Expenses.

The Company’s franchise agreements require the payment of franchise fees, including marketing and reservation fees, which are used exclusively by the Company for expenses associated with providing services such as national marketing, media advertising, central reservation systems and technology services. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees to provide these types of services in accordance with the franchise agreements; as such, no income or loss to the Company is generated. In accordance with our contracts, we include in marketing and reservation expenses an allocation of costs for certain activities, such as human resources, legal, accounting, etc., required to carry out marketing and reservation activities.

The Company records marketing and reservation revenues and expenses in accordance with Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” which requires that these revenues and expenses be recorded gross. In addition, net advances to and repayments from the franchise system for marketing and reservation activities are presented as cash flows from operating activities.

Reservation fees and marketing fees not expended in the current year are carried over to the next fiscal year and expended in accordance with the franchise agreements. Shortfall amounts are similarly recovered in subsequent years. Cumulative excess or shortfall amounts from the operation of these programs are recorded as a marketing or reservation fee payable or receivable. Under the terms of the franchise agreements, the Company may advance capital as necessary for marketing and reservation activities and recover such advances through future fees. Our current assessment is that the credit risk associated with the marketing and reservation fee receivable is mitigated due to our contractual right to recover these amounts from a large geographically disperse group of franchisees.

Impairment Policy.

We evaluate the fair value of goodwill to assess potential impairments on an annual basis, or during the year if an event or other circumstance indicates that we may not be able to recover the carrying amount of the asset. We evaluate impairment of goodwill by comparing the fair value of our net assets with the carrying amount of goodwill. We evaluate the potential impairment of property and equipment and other long-lived assets, including franchise rights whenever an event or other circumstance indicates that we may not be able to recover the carrying value of the asset. Our evaluation is based upon future cash flow projections. These projections reflect management’s best assumptions and estimates. Significant management judgment is involved in developing these projections, and they include inherent uncertainties. If different projections had been used in the current period, the balances for noncurrent assets

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could have been materially impacted. Furthermore, if management uses different projections or if different conditions occur in future periods, future operating results could be materially impacted. The Company reviews outstanding notes receivable on a periodic basis to ensure that each is fully collectible by reviewing the financial condition of its debtors. If the Company concludes that it will be unable to collect all amounts due, the Company will record an impairment charge.

Stock Compensation.

Effective January 1, 2003, the Company adopted, in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” the fair value based method of accounting for stock option awards granted on or after January 1, 2003. No compensation expense related to the grant of stock options under the Company’s stock compensation plans was reflected in net income for any years ended on or before December 31, 2002 because the Company accounted for grants in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and all stock options granted in those years had an exercise price equal to the market value of the underlying common stock on the date of grant. The effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 148 to all stock compensation for the three and nine months ended September 30, 2004 and 2003 is set forth in Note 2 to our consolidated financial statements.

Income Taxes.

Our income tax expense and related balance sheet amounts involve significant management estimates and judgments. Judgments regarding realization of deferred tax assets and the ultimate outcome of tax-related contingencies represent key items involved in the determination of income tax expense and related balance sheet accounts.

Deferred tax assets represent items to be used as a tax deduction or credit in future tax returns for which we have already properly recorded the tax benefit in our income statement. Realization of our deferred tax assets reflects our tax planning strategies. We establish valuation allowances for deferred tax assets that we do not believe will be realized.

Tax assessments and resolution of tax contingencies may arise several years after tax returns have been filed. Predicting the outcome of such tax assessments involves uncertainty; however, we believe that recorded tax liabilities adequately account for our analysis of probable outcomes.

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 Operation, 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 and geopolitical events such as acts of god, acts of war, terrorism or epidemics; 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-K for the year ended December 31, 2003. 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 operations. The Company manages its exposure to these market risks through the monitoring of its available financing alternatives including in certain circumstances the use of derivative financial instruments. 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, 2004 and December 31, 2003, the Company had $308.1 million and $246.7 million of debt outstanding at an effective interest rate of 4.2% and 4.3%, respectively. A hypothetical change of 10% in the Company’s effective interest rate from September 30, 2004 levels would increase or decrease annual interest expense by $0.6 million. Prior to scheduled maturities, the Company expects to refinance its long-term debt obligations.

The Company does not presently have any derivative financial instruments.

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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 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.

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 September 30, 2004.

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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, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

(e) Issuer Purchases of Equity Securities

The following table sets forth purchases of Choice Hotels International, Inc. common stock made by the Company during the nine months ended September 30, 2004, pursuant to a share repurchase program initiated in June 1998.