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CHH > SEC Filings for CHH > Form 10-K on 3-Mar-2014All Recent SEC Filings




Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation.

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 its 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 primarily a hotel franchisor with franchise agreements representing 6,340 hotels open and 503 hotels under construction, awaiting conversion or approved for development as of December 31, 2013, with 506,058 rooms and 38,957 rooms, respectively, in 50 states, the District of Columbia and more than 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 scale. 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, revenues from international franchising operations comprised 8% of our total revenues in both 2013 and 2012 while representing approximately 18% and 19% of our franchise system hotels open at December 31, 2013 and 2012, respectively. 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 and relicensing fee 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. At December 31, 2013, the Company estimates, based on its current domestic portfolio of hotels under franchise, that a 1% change in revenue per available room ("RevPAR") or rooms under franchise would increase or decrease royalty revenues by approximately $2.5 million and a 1 basis point change in the Company's effective royalty rate would increase or decrease domestic royalties by

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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. The Company's hotel franchising business 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 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 and property management systems, 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 and increases the desirability of our brands to hotel owners and developers, 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 primarily through share repurchases, dividends or investing in growth opportunities. 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 December 31, 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. At December 31, 2013, we had approximately 1.4 million shares remaining under the current share repurchase authorization. We currently believe that our cash flows from operations will support our ability to complete the current board of directors repurchase authorization and 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

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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 year ended December 31, 2013, the Company paid cash dividends totaling approximately $32.8 million. We expect to continue to pay dividends in the future, subject to declaration by our board of directors as well as future business performance, economic conditions, changes in income tax regulations and other factors. Based on our present dividend rate and outstanding share count, we expect that aggregate annual regular dividends for 2014 would be approximately $43.1 million.
The Company also allocates capital to exploring 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 and include the following:
Our board of directors authorized a program which permits us to offer financing, investment and guaranty support to qualified franchisees as well as allows us 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 pursuant to this program opportunistically to promote growth of our emerging brands. The amount and timing of the investment in this program 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 per year and we generally expect to recycle these investments within a five year period.
In March 2013, the Company announced the launch of a new division, SkyTouch Technology ("SkyTouch"), which develops and markets cloud-based technology products for the hotel industry. In conjunction with this new division, the Company incurred selling, general and administrative ("SG&A") expenses of $11.5 million during the year ending December 31, 2013 primarily related 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. However, we may determine to utilize cash for acquisitions and other investments in the future. 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. Inflation: Inflation has been moderate in recent years and has not had a significant impact on our business.

Non-GAAP Financial Statement Measurements The Company utilizes certain measures which do not conform to generally accepted accounting principles accepted 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 measurements may be different from the calculations used by other companies and therefore comparability may be limited. We have included a reconciliation of these measures to the comparable GAAP measurement below as well as our reasons for reporting these non-GAAP measures.

Franchising Revenues: The Company utilizes franchising revenues, which exclude revenues from marketing and reservation system activities, 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 contractually required by its franchise agreements to use the fees collected for marketing and reservation activities; as such, no income or loss to the Company is generated. Cumulative marketing and reservation system fees not expended are recorded as a liability in 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 incurred in excess of fees collected for marketing and reservation activities are deferred and recorded as an asset in the Company's financial statements and recovered in future periods. Hotel operations reflect the Company's ownership of three MainStay Suites hotels. SkyTouch is a division of the Company that develops and markets cloud-based technology products, including inventory management, pricing and connectivity to third party channels, to hoteliers not under franchise agreements with the Company. Hotel and SkyTouch operations are excluded from franchising revenue since they do not reflect the Company's core franchising business but are adjacent, complimentary lines of business. 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
                                                  Year Ended December 31,
                                                 ($ amounts in thousands)
                                             2013          2012          2011
Total Revenues                            $ 724,307     $ 691,509     $ 638,793
Less Adjustments:
Marketing and reservation system revenues  (403,099 )    (384,784 )    (349,036 )
SkyTouch division                               (33 )           -             -
Hotel operations                             (4,774 )      (4,573 )      (4,356 )
Franchising Revenues                      $ 316,401     $ 302,152     $ 285,401

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 it excludes 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 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

                                           Year Ended December 31,
                                          ($ amounts in thousands)
                                      2013          2012          2011
Net Income                         $ 112,601     $ 120,687     $ 110,396
Income taxes                          44,317        48,481        47,661
Interest expense                      42,537        27,189        12,939
Interest income                       (2,547 )      (1,540 )      (1,306 )
Loss on extinguishment of debt             -           526             -
Other (gains) and losses              (1,780 )      (1,989 )       2,442
Equity in net income of affiliates      (634 )        (212 )        (269 )
Depreciation and amortization          9,469         8,226         8,024
Adjusted EBITDA                    $ 203,963     $ 201,368     $ 179,887

Operations Review
Comparison of 2013 and 2012 Operating Results

Summarized financial results for the years ended December 31, 2013 and 2012 are
as follows:
                                           2013           2012
                                          (In thousands, except
                                           per share amounts)
Royalty fees                           $   267,229     $ 260,782
Initial franchise and relicensing fees      18,686        14,203
Procurement services                        20,668        17,962
Marketing and reservation                  403,099       384,784
Hotel operations                             4,774         4,573
Other                                        9,851         9,205
Total revenues                             724,307       691,509
Selling, general and administrative        113,567       101,852
Depreciation and amortization                9,469         8,226
Marketing and reservation                  403,099       384,784
Hotel operations                             3,678         3,505
Total operating expenses                   529,813       498,367
Operating income                           194,494       193,142
Interest expense                            42,537        27,189
Interest income                             (2,547 )      (1,540 )
Loss on extinguishment of debt                   -           526
Other (gains) and losses                    (1,780 )      (1,989 )
Equity in net income of affiliates            (634 )        (212 )
Total other income and expenses, net        37,576        23,974
Income before income taxes                 156,918       169,168
Income taxes                                44,317        48,481
Net income                             $   112,601     $ 120,687
Diluted earnings per share             $      1.91     $    2.07

The Company recorded net income of $112.6 million for the year ended December 31, 2013, an $8.1 million or 7% decline from the year ended December 31, 2012. The decline in net income for the year ended December 31, 2013 primarily reflects a $15.3 million increase in interest expense resulting from the issuance of debt in June and July of 2012 to finance the Company's $600.7 million special dividend paid on August 23, 2012, partially offset by a $1.4 million increase in operating income, a $0.5 million loss on extinguishment of debt incurred in the prior year as a result of refinancing the Company's $300 million revolving credit facility and a decline in the Company's effective income tax rate from 28.7% in 2012 to 28.2% in the current year.
Operating income increased $1.4 million as the Company's franchising revenues increased by a $14.2 million or 5% but were partially offset by an $11.7 million or 12% increase in SG&A expenses and a $1.2 million increase in depreciation and amortization expenses. Adjusted EBITDA for the year ended December 31, 2013 increased $2.6 million or 1% to $204.0 million. The key drivers of these fluctuations are described in more detail below.

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Franchising Revenues: Franchising revenues were $316.4 million for the year ended December 31, 2013 compared to $302.2 million for the year ended December 31, 2012, a 5% increase. The increase in franchising revenues is primarily due to a $6.4 million or 2% increase in royalty revenues, a $4.5 million increase in initial franchise and relicensing fees and a $2.7 million or 15% increase in procurement services fees. Royalty Fees
Domestic royalty fees for the year ended December 31, 2013 increased $6.8 million to $242.5 million from $235.7 million in 2012, an increase of 3%. The increase in domestic royalties is attributable to a combination of factors including a 3.0% increase in domestic RevPAR and a 1.1% increase in the number of domestic franchised hotel rooms. The Company's effective royalty rate of the domestic hotel system for 2013 remained unchanged at 4.33% from 2012. System-wide RevPAR increased due to an 80 basis point increase in occupancy rates and a 1.6% increase in average daily rates.
A summary of the Company's domestic franchised hotels operating information for the years ending December 31, 2013 and 2012 is as follows:

                            2013*                                      2012*                                   Change
              Average                                    Average                                   Average
             Daily Rate     Occupancy      RevPAR       Daily Rate     Occupancy      RevPAR      Daily Rate    Occupancy    RevPAR
Inn        $      83.21         59.9 %   $  49.87     $      81.55         59.4 %   $  48.42          2.0 %        50 bps     3.0%
Suites            86.89         62.8 %      54.53            85.47         61.7 %      52.74          1.7 %       110 bps     3.4%
Sleep             74.35         58.5 %      43.46            72.40         56.3 %      40.77          2.7 %       220 bps     6.6%
Quality           70.19         53.0 %      37.17            69.46         51.6 %      35.85          1.1 %       140 bps     3.7%
Clarion           75.20         50.9 %      38.30            74.94         49.4 %      37.03          0.3 %       150 bps     3.4%
Lodge             56.56         48.7 %      27.52            55.78         48.5 %      27.05          1.4 %        20 bps     1.7%
Rodeway           54.25         51.6 %      27.96            53.36         50.8 %      27.13          1.7 %        80 bps     3.1%
MainStay          72.46         68.0 %      49.27            69.34         70.4 %      48.81          4.5 %     (240) bps     0.9%
Suburban          42.67         70.1 %      29.91            41.61         69.7 %      29.01          2.5 %        40 bps     3.1%
Collection       120.97         64.3 %      77.82           113.33         64.4 %      72.94          6.7 %      (10) bps     6.7%
Total      $      74.76         56.3 %   $  42.08     $      73.60         55.5 %   $  40.84          1.6 %        80 bps     3.0%


* Operating statistics represent hotel operations from December through November 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 to 400,585 rooms as of December 31, 2013 from 396,102 as of December 31, 2012 an increase of 4,483 rooms or 1.1%. The total number of domestic hotels on-line increased by 97 units . . .
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