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CHH > SEC Filings for CHH > Form 10-Q on 12-Nov-2013All Recent SEC Filings




Quarterly Report


The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("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.

We are a hotel franchisor with franchise agreements representing 6,303 hotels open and 455 hotels under construction, awaiting conversion or approved for development as of September 30, 2013, with 502,663 rooms and 37,077 rooms, respectively, in 49 states, the District of Columbia and over 35 countries and territories outside the United States. Our brand names include Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Ascend Hotel Collection®, Sleep Inn®, Econo Lodge®, Rodeway Inn®, MainStay Suites®, Suburban Extended Stay Hotel®, and Cambria Suites® (collectively, the "Choice brands").
The Company's domestic franchising operations are conducted through direct franchising relationships while its international franchise operations are conducted through a combination of direct franchising and master franchising relationships. Master franchising relationships are governed by master franchising agreements which generally provide the master franchisee with the right to use our brands and sub-license the use of our brands in a specific geographic region, usually for a fee.
Our business philosophy has been to conduct direct franchising in those international markets where both franchising is an accepted business model and we believe our brands can achieve significant distribution. We elect to enter into master franchise agreements in those markets where direct franchising is currently not a prevalent or viable business model. When entering into master franchising relationships, we strive to select partners that have professional hotel and asset management capabilities together with the financial capacity to invest in building the Choice brands in their respective markets. Master franchising relationships typically provide lower revenues to the Company as the master franchisees are responsible for managing certain necessary services (such as training, quality assurance, reservations and marketing) to support the franchised hotels in the master franchise area and therefore retain a larger percentage of the hotel franchise fees to cover their expenses. In certain circumstances, the Company has and may continue to make equity investments in our master franchisees.
As a result of our use of master franchising relationships and international market conditions, total revenues from international franchising operations comprised 8% of our total revenues for the nine months ended September 30, 2013, while representing approximately 19% of hotels open at September 30, 2013. Therefore, our description of the franchise system is primarily focused on the domestic operations.
Our Company generates revenues, income and cash flows primarily from initial, relicensing and continuing royalty fees attributable to our franchise agreements. Revenues are also generated from qualified vendor arrangements, hotel operations and other sources. The hotel industry is seasonal in nature. For most hotels, demand is lower in December through March than during the remainder of the year. Our principal source of revenues is franchise fees based on the gross room revenues of our franchised properties. The Company's franchise fee revenues and operating income reflect the industry's seasonality and historically have been lower in the first quarter than in the second, third or fourth quarters.
With a focus on hotel franchising instead of ownership, we benefit from the economies of scale inherent in the franchising business. The fee and cost structure of our business provides opportunities to improve operating results by increasing the number of franchised hotel rooms and effective royalty rates of our franchise contracts resulting in increased initial fee and relicensing revenue, ongoing royalty fees and procurement services revenues. In addition, our operating results can also be improved through our company-wide efforts related to improving property level performance. The Company currently estimates, based on its current domestic portfolio of hotels under franchise, a 1% change in revenue per available room ("RevPAR") or rooms under franchise would increase or decrease annual domestic royalty revenues by approximately $2.4 million and a 1 basis point change in the Company's effective royalty rate would increase or decrease annual domestic royalties by approximately $0.6 million. In addition to these revenues, we also collect marketing and reservation system fees to support centralized marketing and reservation activities for the franchise system. As a lodging franchisor, the Company currently has relatively low capital expenditure requirements.
The principal factors that affect the Company's results are: the number and relative mix of franchised hotel rooms in the various hotel lodging price categories; growth in the number of hotel rooms under franchise; occupancy and room rates achieved by the hotels under franchise; the effective royalty rate achieved; the level of franchise sales and relicensing activity; and our ability to

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manage costs. The number of rooms at franchised properties and occupancy and room rates at those properties significantly affect the Company's results because our fees are based upon room revenues at franchised hotels. The key industry standard for measuring hotel-operating performance is RevPAR, which is calculated by multiplying the percentage of occupied rooms by the average daily room rate realized. Our variable overhead costs associated with franchise system growth of our established brands have historically been less than incremental royalty fees generated from new franchises. Accordingly, continued growth of our franchise business should enable us to realize benefits from the operating leverage in place and improve operating results.
We are required by our franchise agreements to use the marketing and reservation system fees we collect for system-wide marketing and reservation activities. These expenditures, which include advertising costs and costs to maintain our central reservations system, help to enhance awareness and increase consumer preference for our brands. Greater awareness and preference promotes long-term growth in business delivery to our franchisees, which ultimately increases franchise fees earned by the Company.
Our Company articulates its mission as a commitment to our franchisees' profitability by providing our franchisees with hotel franchises that strive to generate the highest return on investment of any hotel franchise. We have developed an operating system dedicated to our franchisees' success that focuses on delivering guests to our franchised hotels and reducing costs for our hotel owners.
We believe that executing our strategic priorities creates value for our shareholders. Our Company focuses on two key goals:
Profitable Growth. Our success is dependent on improving the performance of our hotels, increasing our system size by selling additional hotel franchises, effective royalty rate improvement and maintaining a disciplined cost structure. We attempt to improve our franchisees' revenues and overall profitability by providing a variety of products and services designed to increase business delivery to and/or reduce operating and development costs for our franchisees. These products and services include national marketing campaigns, a central reservation system, property and yield management systems, quality assurance standards and qualified vendor relationships. We believe that healthy brands, which deliver a compelling return on investment for franchisees, will enable us to sell additional hotel franchises and raise royalty rates. We have established multiple brands that meet the needs of many types of guests, and can be developed at various price points and applied to both new and existing hotels. This ensures that we have brands suitable for creating growth in a variety of market conditions. Improving the performance of the hotels under franchise, growing the system through additional franchise sales and improving franchise agreement pricing while maintaining a disciplined cost structure are the keys to profitable growth.
Maximizing Financial Returns and Creating Value for Shareholders. Our capital allocation decisions, including capital structure and uses of capital, are intended to maximize our return on invested capital and create value for our shareholders. We believe our strong and predictable cash flows create a strong financial position that provides us a competitive advantage. Currently, our business does not require significant capital to operate and grow. Therefore, we can maintain a capital structure that generates high financial returns and use our excess cash flow to increase returns to our shareholders.
Historically, we have returned value to our shareholders in two primary ways:
share repurchases and dividends. In 1998, we instituted a share repurchase program which has generated substantial value for our shareholders. Since the program's inception through September 30, 2013, we have repurchased 45.3 million shares (including 33.0 million prior to the two-for-one stock split effected in October 2005) of common stock at a total cost of $1.1 billion. Considering the effect of the two-for-one stock split, the Company has repurchased 78.3 million shares at an average price of $13.89 per share. The Company did not purchase any shares under the share repurchase program during the nine months ended September 30, 2013. We currently believe that our cash flows from operations will support our ability to complete the current board of directors repurchase authorization of approximately 1.4 million shares remaining as of September 30, 2013. Upon completion of the current authorization, our board of directors will evaluate the advisability of additional share repurchases.
The Company commenced paying quarterly dividends in 2004 and in 2012 the Company elected to pay a special cash dividend totaling approximately $600 million. The Company currently maintains the payment of a quarterly dividend on its common shares outstanding of $0.185 per share, however the declaration of future dividends are subject to the discretion of the board of directors. In the fourth quarter of 2012, the Company's board of directors elected to pay prior to December 31, 2012 the regular quarterly dividend initially scheduled to be paid in the first quarter of 2013. As a result, the Company did not pay a regular quarterly dividend during the first quarter of 2013. During the nine months ended September 30, 2013, we paid cash dividends totaling approximately $22.0 million. We expect to continue to pay dividends in the future, subject to declaration by our board of directors as well as to future business performance, economic conditions, changes in income tax regulations and other factors. Based on the present dividend rate and outstanding share count, we expect that aggregate annual regular dividends for 2013, excluding the first quarter payment which was paid to shareholders in December 2012, would be approximately $32.8 million.

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Our board of directors previously authorized us to enter into a program which permits us to offer investment, financing and guaranty support to qualified franchisees as well as to acquire and resell real estate to incent franchise development for certain brands in strategic markets. Recent market conditions have resulted in an increase in opportunities to incentivize development under this program and as a result over the next several years, we expect to deploy capital opportunistically pursuant to this program to promote growth of our emerging brands. The amount and timing of the investment will be dependent on market and other conditions. Our current expectation is that our annual investment in this program will range from $20 million to $40 million and we generally expect to recycle these investments within a five year period. In addition, the Company may allocate capital to exploring additional growth opportunities in business areas that are adjacent or complementary to our core hotel franchising business, which leverage our core competencies and are additive to our franchising business model. The timing and amount of these investments are subject to market and other conditions.
In March 2013, the Company announced the launch of its newest division, SkyTouch Technology ("SkyTouch"), which develops and markets cloud-based technology products for the hotel industry. In conjunction with this new division, the Company expects to incur operating expenses ranging between $12 million and $14 million during the full year ending December 31, 2013, of which the Company has incurred approximately $8.8 million during the nine months ended September 30, 2013. These expenses primarily relate to business development, sales and marketing and continued software development.
Notwithstanding investments in SkyTouch and other alternative growth strategies, the Company expects to continue to return value to its shareholders through a combination of share repurchases and dividends, subject to the discretion of our board of directors as well as to business performance, economic conditions, changes in income tax regulations and other factors.
We believe these investments and strategic priorities, when properly implemented, will enhance our profitability, maximize our financial returns and continue to generate value for our shareholders. The ultimate measure of our success will be reflected in the items below.
Results of Operation: Royalty fees, operating income, net income and diluted earnings per share ("EPS") represent key measurements of these value drivers. These measurements are primarily driven by the operations of our franchise system and therefore our analysis of the Company's operations is primarily focused on the size, performance and potential growth of the franchise system as well as our variable overhead costs.
Refer to MD&A heading "Operations Review" for additional analysis of our results.
Liquidity and Capital Resources: Historically, the Company has generated significant cash flows from operations. Since our business does not currently require significant reinvestment of capital, we typically utilize cash in ways that management believes provide the greatest returns to our shareholders, which include share repurchases and dividends. We believe the Company's cash flow from operations and available financing capacity is sufficient to meet the expected future operating, investing, and financing needs of the business.
Refer to MD&A heading "Liquidity and Capital Resources" for additional analysis.

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Operations Review
Comparison of Operating Results for the Three-Month Periods Ended September 30,
2013 and 2012

Summarized financial results for the three months ended September 30, 2013 and
2012 are as follows:
(in thousands, except per share amounts)    2013         2012
Royalty fees                             $ 83,107     $ 80,845
Initial franchise and relicensing fees      4,650        3,247
Procurement services                        4,708        3,839
Marketing and reservation                 126,296      119,062
Hotel operations                            1,310        1,238
Other                                       3,091        2,182
Total revenues                            223,162      210,413
Selling, general and administrative        26,982       23,170
Depreciation and amortization               2,379        1,995
Marketing and reservation                 126,296      119,062
Hotel operations                              956          933
Total operating expenses                  156,613      145,160
Operating income                           66,549       65,253
Interest expense                           10,757       10,166
Interest income                              (676 )       (425 )
Loss on extinguishment of debt                  -          526
Other (gains) and losses                     (703 )       (511 )
Equity in net income of affiliates           (421 )       (171 )
Total other income and expenses, net        8,957        9,585
Income before income taxes                 57,592       55,668
Income taxes                               16,080       11,291
Net income                               $ 41,512     $ 44,377
Diluted earnings per share               $   0.70     $   0.76

The Company utilizes certain measures which do not conform to generally accepted accounting principles in the United States ("GAAP") when analyzing and discussing its results with the investment community. This information should not be considered as an alternative to any measure of performance as promulgated under GAAP. The Company's calculation of these measures may be different from the calculations used by other companies and therefore comparability may be limited. We have included below a reconciliation of the measures utilized during this period to the comparable GAAP measures as well as our reason for reporting these non-GAAP measures.
Franchising Revenues: The Company utilizes franchising revenues which exclude marketing and reservation system revenues, revenues from the SkyTouch Division and hotel operations rather than total revenues when analyzing the performance of the business. Marketing and reservation activities are excluded from franchising revenues since the Company is required by its franchise agreements to use these fees collected for marketing and reservation activities; as such, no net income or loss to the Company is generated. Cumulative marketing and reservation system fees not expended are recorded as a payable on the Company's financial statements and are carried over to the next fiscal year and expended in accordance with the franchise agreements. Cumulative marketing and reservation expenditures in excess of fees collected for marketing and reservation activities are recorded as a receivable on the Company's financial statements and recovered in future periods. Hotel operations reflect the company's ownership of three MainStay Suites hotels. SkyTouch Technology is a division of the Company that develops and markets cloud-based technology products to help industry-wide hoteliers, not under franchise agreements with the Company, improve their efficiency and profitability. Hotel and SkyTouch Technology operations are excluded from franchising revenue since they do not reflect the company's core franchising business but are adjacent, complimentary lines of business.

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This non-GAAP measure is a commonly used measure of performance in our industry and facilitates comparisons between the Company and its competitors.

Calculation of Franchising Revenues
                                                Three Months Ended September 30,
                                                    ($ amounts in thousands)
                                                    2013                 2012
Franchising Revenues:
Total Revenues                               $       223,162       $       210,413
   Marketing and reservation system revenues        (126,296 )            (119,062 )
   SkyTouch Division                                     (13 )                   -
   Hotel operations                                   (1,310 )              (1,238 )
Franchising Revenues                         $        95,543       $        90,113

Adjusted EBITDA: We also utilize adjusted earnings before interest, taxes, depreciation and amortization ("Adjusted EBITDA") to analyze our results which reflects earnings excluding the impact of interest expense, interest income, loss on extinguishment of debt, provision for income taxes, depreciation and amortization, other (gains) and losses and equity in net income of unconsolidated affiliates. We consider Adjusted EBITDA to be an indicator of operating performance because we use it to measure our ability to service debt, fund capital expenditures, and expand our business. We also use Adjusted EBITDA, as do analysts, lenders, investors and others, to evaluate companies because they exclude certain items that can vary widely across different industries or among companies within the same industry. For example, interest expense can be dependent on a company's capital structure, debt levels and credit ratings. Accordingly, the impact of interest expense on earnings can vary significantly among companies. The tax positions of companies can also vary because of their differing abilities to take advantage of tax benefits and because of the tax policies of the jurisdictions in which they operate. As a result, effective tax rates and provision for income taxes can vary considerably among companies. Adjusted EBITDA also excludes depreciation and amortization because companies utilize productive assets of different ages and use different methods of both acquiring and depreciating productive assets. These differences can result in considerable variability in the relative costs of productive assets and the depreciation and amortization expense among companies. Additionally, Adjusted EBITDA is also utilized as a performance indicator as it excludes equity in net (income) loss of unconsolidated affiliates and other (gains) and losses which primarily reflect the performance of investments held in the Company's non-qualified retirement, savings and investment plans which can vary widely from period to period based on market conditions.

Calculation of Adjusted EBITDA
                                      Three Months Ended September 30,
                                          ($ amounts in thousands)
                                          2013                 2012
Adjusted EBITDA:
Net income                         $        41,512       $        44,377
Income taxes                                16,080                11,291
Interest expense                            10,757                10,166
Interest income                               (676 )                (425 )
Other (gains) and losses                      (703 )                (511 )
Loss on the extinguishment of debt               -                   526
Equity in net income of affiliates            (421 )                (171 )
Depreciation and amortization                2,379                 1,995
Adjusted EBITDA                    $        68,928       $        67,248

Results of Operations
The Company recorded net income of $41.5 million for the three month period ended September 30, 2013, a 6% decline from the $44.4 million recorded for the quarter ended September 30, 2012. The decrease in net income primarily reflects the increase in the Company's effective income tax rate from 20.3% for the three month period ended September 30, 2012 to 27.9% for the current quarter. The effective income tax rate for the three months ended September 30, 2012 reflected a non-recurring

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favorable adjustment of $4.5 million related to foreign operations. Income before income taxes increased $1.9 million or 3% from the prior year quarter to $57.6 million primarily due to a $1.3 million or 2% increase in operating income.
The increase in operating income primarily reflects an increase in Adjusted EBITDA which increased $1.7 million or 2.5% to $68.9 million for the three month period ended September 30, 2013. The increase in Adjusted EBITDA reflects a $5.4 million or 6% increase in the Company's franchising revenues for the three months ended September 30, 2013 partially offset by a $3.8 million or 16% increase in selling, general and administrative expense ("SG&A"). Franchising Revenues: Franchising revenues were $95.5 million for the three months ended September 30, 2013 compared to $90.1 million for the three months ended September 30, 2012, an increase of 6%. The increase in franchising revenues is primarily due to a $2.3 million or 3% increase in royalty revenues, a $1.4 million increase in initial franchise and relicensing fees, a $0.9 million increase in procurement services revenues and a $0.9 million increase in other revenues.
Royalty Fees
Domestic royalty fees for the three months ended September 30, 2013 increased $2.3 million to $76.7 million, an increase of 3% compared to the three months ended September 30, 2012. The increase in royalties is attributable to a combination of factors including a 3.0% increase in RevPAR, a 0.7% increase in the number of domestic franchised hotel rooms open and a 1 basis point increase in the effective royalty rate from 4.29% to 4.30%. System-wide RevPAR increased due to a combination of a 1.9% increase in average daily rates and a 70 basis point increase in occupancy rates.
A summary of the Company's domestic franchised hotels operating information is as follows:

            For the Three Months Ended September   For the Three Months Ended September
                         30, 2013*                              30, 2012*                              Change
              Average                                Average                              Average
               Daily                                  Daily                                Daily
               Rate       Occupancy     RevPAR        Rate       Occupancy     RevPAR       Rate      Occupancy    RevPAR
Comfort Inn $   89.49         70.8 %   $ 63.35     $   87.58         70.2 %   $ 61.46        2.2 %      60   bps     3.1 %
Suites          91.36         71.2 %     65.05         89.69         70.2 %     62.93        1.9 %     100   bps     3.4 %
Sleep           78.45         66.8 %     52.38         76.09         64.8 %     49.32        3.1 %     200   bps     6.2 %
Quality         75.81         62.5 %     47.36         75.02         61.2 %     45.88        1.1 %     130   bps     3.2 %
Clarion         81.27         59.7 %     48.50         79.73         58.7 %     46.82        1.9 %     100   bps     3.6 %
Econo Lodge     61.76         58.1 %     35.88         60.60         57.7 %     34.97        1.9 %      40   bps     2.6 %
Rodeway         60.78         60.8 %     36.97         59.62         60.8 %     36.23        1.9 %       -   bps     2.0 %
MainStay        76.91         75.2 %     57.82         73.17         76.5 %     55.96        5.1 %    (130 ) bps     3.3 %
Suburban        43.79         73.1 %     32.02         42.62         75.1 %     32.03        2.7 %    (200 ) bps       - %
Collection     125.54         71.6 %     89.86        115.98         71.4 %     82.77        8.2 %      20   bps     8.6 %
Total       $   80.14         65.7 %   $ 52.63     $   78.63         65.0 %   $ 51.09        1.9 %      70   bps     3.0 %


*Operating statistics represent hotel operations from June through August and exclude Cambria Suites since the operating statistics are not representative of a stabilized brand which the Company defines as having at least 25 units open and operating for a twelve month period.
The number of domestic rooms on-line increased by 2,676 rooms or 0.7% to 396,663 as of September 30, 2013 from 393,987 as of September 30, 2012. The total number of domestic hotels on-line increased by 2.0% to 5,134 as of September 30, 2013 from 5,034 as of September 30, 2012.

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