Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

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  ¨

Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

INDEX

2

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

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

3

Table of Contents

CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

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

4

Table of Contents

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.

5

Table of Contents

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.

6

Table of Contents

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, 2004 and notes thereto included in the Company’s Form 10-K, filed with the Securities and Exchange Commission on March 16, 2005 (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 months ended March 31, 2005 and 2004 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.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements based on the fair value of the equity or liability instruments issued. Effective, January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all employee awards granted, modified, or settled after January 1, 2003. SFAS No. 123R will require the Company to apply fair value recognition provisions to all unvested equity awards as of the first annual reporting period starting after June 15, 2005, which is the Company’s fiscal year beginning January 1, 2006. The adoption of SFAS No. 123R is not expected to have a material effect on the Company’s results of operations or financial condition.

3. Receivable—Marketing and Reservation Fees

The marketing and reservation fees receivable at March 31, 2005 and December 31, 2004 was $31.0 million and $21.7 million, respectively. Depreciation and amortization expense attributable to marketing and reservation activities was $1.9 million and $2.5 million for the three months ended March 31, 2005 and 2004, respectively. Interest expense attributable to reservation activities was $0.2 million and $0.4 million for the three months ended March 31, 2005 and 2004, respectively.

4. Income Taxes

The income tax provisions for the three months March 31, 2005 and 2004 are based on the effective tax rates expected to be applicable for the corresponding full year periods. The 2005 and 2004 three-month rate of approximately 36.5% and 37.1%, respectively, differs from the statutory rates primarily due to foreign income earned, which is taxed at lower income tax rates than statutory U.S. income tax rates.

7

Table of Contents

On October 22, 2004, the American Jobs Creation Act of 2004 (“AJCA”) was signed into law. The AJCA includes a temporary incentive for United States multinational corporations to repatriate undistributed earnings of foreign subsidiaries by providing an 85 percent dividends received deduction for qualifying dividends from controlled foreign corporations, as defined in the AJCA, resulting in an effective tax cost of 5.25 percent on any such repatriated foreign earnings. The Company may elect to apply this provision to qualifying earnings repatriations in 2005. We have begun an evaluation of the effects of the repatriation provisions and expect to complete the analysis prior to the end of the third quarter 2005. The range of possible amounts that the Company is considering for repatriation under this provision is between zero and $22.3 million. The related potential range of income tax is between zero and $1.2 million.

We have estimated and accrued for certain tax assessments and the expected resolution of tax contingencies which arise in the course of our business. The ultimate outcome of these tax-related contingencies impact the determination of income tax expense and may not be resolved until several years after the related tax returns have been filed. Predicting the outcome of such tax assessments involves uncertainty; however, we believe that recorded tax liabilities adequately account for our analysis of probable outcomes.

5. Comprehensive Income

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

6. Capital Stock and Earnings Per Share

Stock Repurchase Program

During the three months ended March 31, 2005, the Company repurchased 0.2 million shares of its common stock at a total cost of $14.1 million, including 0.1 million at a total cost of $6.0 million from one of the Company’s largest shareholders. During the three months ended March 31, 2004, the Company repurchased 0.9 million shares of its common stock at a total cost of $39.1 million.

Restricted Stock

The following table is a summary of activity related to restricted stock grants to non-employee directors and key employees for the three months ended March 31,

The Company incurred compensation expense totaling $0.8 million and $0.5 million related to the vesting of restricted stock during the three months ended March 31, 2005 and 2004, respectively.

Stock Options

The Company received $4.9 million and $2.8 million in proceeds from the exercise of 0.3 million and 0.2 million employee stock options during the three months ended March 31, 2005 and 2004, respectively.

8

Table of Contents

The Company granted approximately 0.2 million options to officers of the Company at a fair value of approximately $3.6 million during the three months ended March 31, 2005. The fair value of each option granted was estimated on the grant date using the Black-Scholes option-pricing model with the following weighted average assumptions:

Dividends

In March 2005, the Company declared a cash dividend of $0.225 per share (or approximately $7.2 million in the aggregate), which was paid on April 22, 2005 to shareholders of record on April 8, 2005.

Earnings Per Share

The following table reconciles the number of shares used in the basic and diluted earnings per share calculations for the three months ended March 31,

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. The effect of dilutive securities is computed using the treasury stock method and average market prices during the period. At March 31, 2005, the Company excluded 177,692 anti-dilutive options from the computation of diluted earnings per share.

9

Table of Contents

7. Pension Plans

The Company sponsors an unfunded non-qualified defined benefit plan (“SERP”) for certain senior executives. No assets are held with respect to the plan; therefore benefits are funded as paid to participants. The Company accounts for the SERP in accordance with SFAS No. 87, “Employers Accounting for Pensions.” For both the three months ended March 31, 2005 and 2004, the Company recorded $0.2 million of expense related to the SERP which is included in selling, general and administrative expense in the accompanying consolidated statements of income. Based on the plan retirement age of 65 years old, no benefit payments are anticipated during the current fiscal year. The following table presents the components of net periodic benefit costs for the three months ended March 31, 2005 and 2004.

8. Debt

In July 2004, the Company entered into a $265 million senior unsecured revolving credit facility (the “Revolver”) with a syndicate of lenders. 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 March 31, 2005, the Company had $232.0 million of revolving loans outstanding pursuant to the Revolver.

In April 2005, the Company increased the available credit under the Revolver from $265 million to $350 million. The increase in the credit facility did not change any other terms of the Revolver.

As of March 31, 2005, 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 March 31, 2005, approximately $0.3 million was outstanding pursuant to this line of credit.

9. 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.

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

10

Table of Contents

10. 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 had 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. The letter of credit expired in April 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.

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

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

Overview

We are a hotel franchisor with franchise agreements representing 5,008 hotels open and 503 hotels under development as of March 31 2005, with 407,309 rooms and 39,246 rooms, respectively, in 49 states and more than 40 countries and territories outside the United States. Our brand names include Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, Econo Lodge, Rodeway Inn, MainStay Suites, Cambria Suites and Flag Hotels. Approximately 94% 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 to owners 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, quality assurance standards and endorsed vendor relationships. We believe that healthy brands that 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 that has generated substantial value for our shareholders. We have repurchased 32.8 million shares of common stock at a total cost of $676.8 million, or an average price of $20.65 per share since the program’s inception. Our cash flows from operations support our ability to complete the repurchase of approximately 1.6 million shares presently remaining under our current board of director’s authorization. Upon completion of the current authorization we will evaluate the propriety of additional share repurchases with our board of directors. In 2003, we initiated a cash dividend on our common stock. During the first quarter of 2005, we paid dividends totaling approximately $7.2 million and we presently expect to continue to pay dividends in the future. On March 3, 2005, our board of directors declared a cash dividend of $0.225 on outstanding common shares payable on April 22, 2005 to holders of record on April 8, 2005.

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

Results of Operation: Royalty fees, operating income, net income and diluted earnings per share represent key measurements of these value drivers. In the three months ended March 31, 2005, royalty fees revenue and operating income totaled approximately $33.6 million and $22.3 million, respectively, increases of approximately 10%

11

Table of Contents

and 18%, respectively, from the same period in 2004. Net income for the three months ended March 31, 2005 increased to $12.0 million, an increase of $1.4 million or 13.3% from 2004. Diluted earnings per share for the first quarter of 2005 was $0.36, a 20% improvement over 2004 resulting from increased net income and a reduction in the number of shares outstanding attributable to our share repurchase program. These measurements will continue to be a key management focus in 2005 and beyond.

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

Liquidity and Capital Resources: The Company generates significant cash flows from operations. In the first quarter of 2005 and 2004, net cash provided by operating activities was $16.9 million and $22.5 million, respectively. Since our business does not require significant reinvestment of capital, we utilize cash in ways that management believes provide the greatest returns to our shareholders, which include share repurchases and dividends. We believe the Company’s cash flow from operations and available financing capacity are sufficient to meet the expected future operating, investing and financing needs of the business.

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

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 March 31, 2005 and 2004

The Company recorded net income of $12.0 million for the three months ended March 31, 2005, an increase of $1.4 million from $10.6 million for the quarter ended March 31, 2004. The increase in net income for the year is primarily attributable to a $3.4 million improvement in operating income partially offset by an $1.4 million increase in other income and expenses. Operating income increased as a result of a $4.1 million increase in franchising 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.

Financial results for the three months ended March 31, 2005 and 2004 are as follows:

12

Table of Contents

Management analyzes its 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 $41.2 million for the three months ended March 31, 2005 compared to $37.1 million for the quarter ended March 31, 2004. Royalty fees increased $2.9 million to $33.6 million from $30.7 million in 2004, an increase of 9.6%. The increase in royalties is attributable to a combination of factors including a 4.4% increase in the number of domestic franchised hotel rooms, a 5.5% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system to 4.08% from 4.02%. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise agreements increased 11.3% to $2.5 million for the three months ended March 31, 2005 from $2.2 million for the quarter ended March 31, 2004. The increase reflects 103 domestic franchise agreements executed in the first three months of 2005 compared to 81 agreements executed during the same period in 2004. Relicensing fees increased 58.5% to $1.8 million for the three months ended March 31, 2005 from $1.1 million for the quarter ended March 31, 2004. 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 declined from $0.7 million for the quarter ended March 31, 2004 to $0.6 million for the three months ended March 31, 2005, primarily as the result of reduced termination awards revenue, which are generated when franchises exit the system prior to contractually agreed-upon dates.

The number and changes in number of hotels and rooms on-line is important information when analyzing 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 and royalty fees. The number of domestic rooms on-line increased to 312,630 from 299,359, an increase of 4.4% for the three months ended March 31, 2005. For 2005, the total number of domestic hotels on-line grew 4.9% to 3,868 from 3,688 for 2004. International rooms on-line declined slightly to 94,679 as of March 31, 2005 from 94,879 as of March 31, 2004, a 0.2% decline. The total number of international hotels on-line also decreased from 1,166 to 1,140, a decline of 2.2% for the quarter ended March 31, 2005. As of March 31, 2005, the Company had 399 franchised hotels with 30,090 rooms either in design or under construction in its domestic system. The Company has an additional 104 franchised hotels with 9,156 rooms under development in its international system as of March 31, 2005.

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative expenses were $16.8 million for the three months ended March 31, 2005, an increase of $1.0 million from the three months ended March 31, 2004 total of $15.8 million. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 40.7% for the quarter ended March 31, 2005 compared to 42.6% for the same period in 2004. The decline is primarily due to our operating leverage since the variable operating costs associated with our franchising system growth are less than the incremental royalty fees generated from new franchisees. Franchising revenues increased approximately 11% while selling, general and administrative expenses increased only 6%.

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

Total marketing and reservation revenues were $49.1 million and $49.3 million for the three months ended March 31, 2005 and 2004, respectively. Depreciation and amortization attributable to marketing and reservation activities was $1.9 million and $2.5 million for the three months ended March 31, 2005 and 2004, respectively. Interest expense attributable to reservation activities was $0.2 million and $0.4 million for the quarters ended March 31, 2005 and 2004, respectively. Cash advances for marketing and reservation activities totaled approximately $7.4 million for the three months ended March 31, 2005. Marketing and reservation activities provided positive cash flow of $3.4 million for the three months ended March 31, 2004. As of March 31, 2005 and December 31, 2004, the Company’s balance sheet includes a receivable of $31.0 million and $21.7 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 reservations activities. The Company’s current franchisees are legally obligated to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue. The Company has no present intention to accelerate repayment of the deficit from current franchisees.

Other Income and Expenses: Interest expense increased to $3.6 million for the three months ended March 31, 2005 from $2.5 million for the same period of 2004 due to an increase in average borrowings outstanding and higher average interest rates. The Company’s weighted average interest rate as of March 31, 2005 was 4.66% compared to 4.06% as of March 31, 2004. Interest and other investment income for the quarter ended March 31, 2005 also reflects investment losses on assets held in non-qualified employee benefit plans versus investment income in the prior year period.

Income Taxes: The Company’s effective income tax provision rate was 36.5% for the three months ended March 31, 2005, a decrease of 60 basis points from the effective income tax provision rate of 37.1% for the quarter ended March 31, 2004. The reduction in the effective income tax provision rate resulted primarily from state income taxes and an increase in foreign income, which are both taxed at lower income tax rates than the statutory U.S. income tax rates.

Income tax expense for the three months ended March 31, 2005 and 2004 includes approximately $0.3 million and $0.6 million, respectively of provisions for income tax contingencies. Depending upon the outcome of certain income tax contingencies during 2005, up to $6.5 million of income tax benefits may be reflected in our 2005 results of operations from the reversal of reserves.

Net income for the three months ended March 31, 2005 increased by 13.3% to $12.0 million, and diluted earnings per share increased 20% to $0.36 in 2005 from $0.30 reported for the same period of 2004. A portion of the increase in diluted earnings per share is attributable to stock repurchases made by the Company in 2005 and prior years.

Liquidity and Capital Resources

Net cash provided by operating activities was $16.9 million and $22.5 million for the three months ended March 31, 2005 and 2004, respectively. The decline primarily reflects decreases in cash flows from marketing and reservation activities partially offset by improvements in operating income.

Net cash advances related to marketing and reservation activities totaled $7.4 million during the three months ended March 31, 2005, compared to net repayments of $3.4 million during the three months ended March 31, 2004. The decline in cash flows from marketing and reservation activities is attributable to an increase in advertising and promotional costs during the year. The Company expects marketing and reservation activities to generate positive cash flows of between $18 million and $20 million in 2005.

Cash used in investing activities for the three months ended March 31, 2005 and 2004, was $4.5 and $4.4 million, respectively. As a lodging franchisor, Choice has relatively low capital expenditure requirements. During the quarter ended March 31, 2005 and 2004, capital expenditures totaled $3.0 million and $1.6 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.

13

Table of Contents

Financing cash flows relate primarily to the Company’s borrowings under its credit lines, treasury stock purchases and dividends. In July 2004, the Company entered into a $265 million senior unsecured revolving credit facility (the “Revolver”) with a syndicate of lenders. 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 ^1/2 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. On February 28, 2005, Standard & Poor’s Rating Services raised its rating of the Company’s debt from BBB- to BBB. This rating and any other ratings by other rating organizations may be subject to revision or withdrawal at any time by the assigning rating organization. Each rating should be evaluated independently of any other rating. The Revolver requires the Company to pay a commitment fee ranging, based upon the credit rating of the Company, between 12 ^1/2 basis points and 25 basis points of the average daily-unused portion of the aggregate available commitment. The Revolver also provides for the issuances 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. As of March 31, 2005 the Company was in compliance with all covenants under the Revolver. The Revolver restricts the Company’s ability to make certain investments, incur certain debt, and dispose of assets, among other restrictions. As of March 31, 2005, the Company had $232.0 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 April 2005, the Company increased the available credit under the Revolver from $265 million to $350 million. The increase in the credit facility did not change any other terms of the Revolver.

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 Notes contain a call provision that would require the Company to pay a premium if the Notes were redeemed prior to their maturity.

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. Borrowings under the line of credit bear interest at rates established at the time of the borrowings based on prime minus 175 basis points. As of March 31, 2005, $0.3 million was outstanding pursuant to this line of credit.

As of March 31, 2005, the total long-term debt outstanding for the Company was $332.8 million, of which $0.4 million was scheduled to mature in the next twelve months ending March 31, 2006.

Through March 31, 2005, the Company had purchased 0.2 million shares of its common stock under its share repurchase program at a total cost of $13.5 million. At March 31, 2005, the Company had approximately 32.5 million shares of common stock outstanding. As of March 31, 2005, the Company had remaining authorization to purchase up to 1.6 million shares. Subsequent to March 31, 2005 through May 5, 2005, the Company repurchased an additional 11,600 shares of its common stock at a total cost of $0.7 million.

In the fourth quarter of 2003, the Company initiated a cash dividend on its common stock. In September 2004, the Company’s board of directors increased the quarterly dividend rate to $0.225, a 12.5% increase from the previous quarterly rate of $0.20. This increase raises the annual dividend rate on the Company’s common stock from $0.80 to $0.90 per share. Dividends paid in the first quarter of 2005 were approximately $7.2 million and we expect dividends in 2005 to be approximately $29 million assuming the existing share count and dividend rate, subject to declaration by our board of directors.

The Company expects to continue to return value to its shareholders through a combination of share repurchases and dividends. Market conditions and our financial performance will dictate the amounts and allocation between these vehicles.

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, 2004 included in our Annual Report on Form 10-K.

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.

14

Table of Contents

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 funds 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 dispersed group of franchisees.

Choice Privileges is our frequent guest incentive marketing program. Choice Privileges enables members to earn points based on their spending levels at participating brands and, to a lesser degree, through participation in affiliated partners’ programs, such as those offered by credit card companies. The points may be redeemed for free accommodations or other benefits. Points cannot be redeemed for cash.

The Company collects a percentage of program members’ room revenue from participating franchises. Revenues are deferred equal to the fair value of the future redemption obligation. A third-party actuary estimates the eventual redemption rates and point values using various actuarial methods. These judgmental factors determine the required liability for outstanding points. Upon redemption of the points, the Company recognizes the previously deferred revenue as well as the corresponding expense relating to the cost of the awards redeemed. Revenues in excess of the estimated future redemption obligation are recognized when earned to reimburse the Company for costs incurred to operate the program, including administrative costs, marketing, promotion and performing member services. Costs to operate the program, excluding estimated redemption values, are expensed when incurred.

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 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 months ended March 31, 2005 and 2004 is set forth in Note 2 to our consolidated financial statements.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements based on the fair value of the equity or liability instruments issued. Effective, January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all employee awards granted, modified, or settled after January 1, 2003. SFAS No. 123R will require the Company to apply fair value recognition provisions to all unvested equity awards as of the first annual reporting period starting after June 15, 2005, which is the Company’s fiscal year beginning January 1, 2006. The adoption of SFAS No. 123R is not expected to have a material effect on the Company’s results of operations or financial condition.

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.

The Company does not provide additional United States income taxes on undistributed earnings of consolidated foreign subsidiaries included in retained earnings. Such earnings could become taxable upon the sale or liquidation of these foreign subsidiaries or upon dividend repatriation. The Company’s intent is for such earnings to be reinvested by the subsidiaries or to be repatriated only when required for domestic business operations, tax or cash reasons. On October 22, 2004, the American Jobs Creation Act of 2004 (“AJCA”) was signed into law. The AJCA includes a temporary incentive for United States multinational corporations to repatriate accumulated income of foreign subsidiaries by providing an 85 percent dividends received deduction for qualifying dividends from controlled foreign corporations. Our income tax expense does not reflect the impact of the AJCA. We have begun an evaluation of the effects of the repatriation provisions and expect to complete the analysis prior to the end of the third quarter 2005.

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

15

Table of Contents

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, 2004. 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 March 31, 2005 and December 31, 2004, the Company had $332.8 million and $328.7 million of debt outstanding at an effective interest rate of 4.7% and 4.6%, respectively. A hypothetical change of 10% in the Company’s effective interest rate from March 31, 2005 levels would increase or decrease annual interest expense by $0.8 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.

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 CEO and CFO consider the disclosure review committee’s procedures 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 March 31, 2005.

There has been no change in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2005 that materially affected, or is reasonably likely to materially affect the Company’s internal controls over financial reporting.

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. UNREGISTERED SALES OF EQUITY SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

Issuer Purchases of Equity Securities

The following table sets forth purchases of Choice Hotels International, Inc. common stock made by the Company during the three months ended March 31, 2005.

During the three months ended March 31, 2005, the Company purchased 8,746 shares of common stock from employees to satisfy tax-withholding requirements from the vesting of restricted stock grants. These purchases were outside the share repurchase program initiated in June 1998.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

16

Table of Contents

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

(a) Exhibits

Exhibit Number and Description

17

Table of Contents

18

Table of Contents

(b) Reports on Form 8-K

The Company filed a report on Form 8-K, dated February 16, 2005 reporting that press releases had been issued reporting the Company’s earnings for the quarter and year ended December 31, 2004 and that the Company had entered into an amendment of its Rights Agreement (“the Agreement”) that accelerated the Final Expiration Date (as such term is determined in the Agreement) to February 14, 2005.

The Company filed a report on Form 8-K on March 10, 2005 reporting that on March 9, 2005 it had entered into an agreement to repurchase 100,000 shares of its common stock from the Bruce Bainum Declaration of Trust, Dated March 13, 1997, Bruce Bainum, Trustee. The Company also furnished information regarding a presentation made to potential investors on March 10, 2005.

19

Table of Contents

SIGNATURE

Pursuant to the requirements 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.

20