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CHH > SEC Filings for CHH > Form 10-Q on 8-May-2014All 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 the consolidated financial condition and results of operations of Choice Hotels International, Inc. and its subsidiaries (together the "Company") contained in this report. 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 primarily a hotel franchisor with franchise agreements representing 6,364 hotels open and 493 hotels under construction, awaiting conversion or approved for development as of March 31, 2014, with 507,152 rooms and 39,163 rooms, respectively, in 50 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 strategy 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

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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 three months ended March 31, 2014, while representing approximately 18% of hotels open at March 31, 2014. 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 $2.5 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. 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 over time. 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

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existing hotels. This is intended to ensure 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 through 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 March 31, 2014, 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 March 31, 2014, 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. 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. During the three months ended March 31, 2014, we paid cash dividends totaling approximately $10.8 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 the present dividend rate and outstanding share count, we expect that aggregate annual regular dividends for 2014 would be approximately $43.6 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 increased 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 the establishment of this new division, the Company expects to incur costs in excess of revenues earned as it further develops SkyTouch's product offerings and invests in sales and marketing. During the year ended December 31, 2014, the Company expects to incur selling, general and administrative ("SG&A") expenses in excess of revenues by approximately $20 million.
Notwithstanding investments in SkyTouch and other alternative growth strategies, the Company expects to continue to return value to its shareholders over time 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.

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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.

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 and the SkyTouch division, 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. 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. SkyTouch operations are excluded from franchising revenues since those operations do not reflect the Company's core franchising business but represent an adjacent, complimentary line 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
                                                 Three Months Ended March 31,
                                                        (in thousands)
                                                   2014                 2013
Franchising Revenues:
Total Revenues                               $      147,283       $      135,916
   Marketing and reservation system revenues        (84,012 )            (76,440 )
   SkyTouch division                                    (53 )                  -
Franchising Revenues                         $       63,218       $       59,476

Adjusted EBITDA: We also utilize adjusted earnings before interest, taxes, depreciation and amortization ("Adjusted EBITDA") to analyze our results which reflects earnings from continuing operations excluding the impact of interest expense, interest income, provision for income taxes, depreciation and amortization, other (gains) and losses and equity earnings 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

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and the depreciation and amortization expense among companies. Additionally, Adjusted EBITDA is also utilized as a performance indicator as it excludes equity in earnings 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 March 31,
                                            (in thousands)
                                        2014               2013
Adjusted EBITDA:
Income from continuing operations $      17,331       $      15,556
Income taxes                              7,711               5,406
Interest expense                         10,171              10,770
Interest income                            (503 )              (644 )
Other (gains) and losses                    (59 )              (710 )
Equity in net loss of affiliates             35                 141
Depreciation and amortization             2,122               2,041
Adjusted EBITDA                   $      36,808       $      32,560

Operations Review
Comparison of Operating Results for the Three-Month Periods Ended March 31, 2014
and 2013

Summarized financial results for the three months ended March 31, 2014 and 2013
are as follows:
(in thousands, except per share amounts)                            2014           2013
Royalty fees                                                    $   51,681     $   49,736
Initial franchise and relicensing fees                               3,740          3,777
Procurement services                                                 4,778          3,950
Marketing and reservation                                           84,012         76,440
Other                                                                3,072          2,013
Total revenues                                                     147,283        135,916
Selling, general and administrative                                 26,463         26,916
Depreciation and amortization                                        2,122          2,041
Marketing and reservation                                           84,012         76,440
Total operating expenses                                           112,597        105,397
Operating income                                                    34,686         30,519
Interest expense                                                    10,171         10,770
Interest income                                                       (503 )         (644 )
Other (gains) and losses                                               (59 )         (710 )
Equity in net loss of affiliates                                        35            141
Total other income and expenses, net                                 9,644          9,557
Income from continuing operations before income taxes               25,042         20,962
Income taxes                                                         7,711          5,406
Income from continuing operations                                   17,331         15,556
Income (loss) from discontinued operations, net of income taxes      1,641            (33 )
Net income                                                      $   18,972     $   15,523

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Results of Operations
The Company recorded income from continuing operations of $17.3 million for the three month period ended March 31, 2014, a $1.8 million, or 11% increase from the same period of the prior year. The increase in income from continuing operations primarily reflects a $4.2 million increase in operating income partially offset by an increase in the Company's effective income tax rate from continuing operations from 25.8% for the three month period ended March 31, 2013 to 30.8% for the three month period ended March 31, 2014.
Operating income increased $4.2 million as the Company's franchising revenues increased by $3.7 million or 6.3% and SG&A expenses declined $0.5 million. Adjusted EBITDA for the three months ended March 31, 2014 increased $4.2 million or 13.0% to $36.8 million. The key drivers of these fluctuations are described in more detail below.
Franchising Revenues: Franchising revenues were $63.2 million for the three months ended March 31, 2014 compared to $59.5 million for the three months ended March 31, 2013, an increase of 6%. The increase in franchising revenues is primarily due to a $1.9 million or 4% increase in royalty revenues, a $0.8 million increase in procurement services revenues and a $1.1 million increase in other revenues.
Royalty Fees
Domestic royalty fees for the three months ended March 31, 2014 increased $2.2 million to $46.5 million, an increase of 5% compared to the three months ended March 31, 2013. The increase in royalties is attributable to a combination of factors including a 5.6% increase in RevPAR and a 1.6% increase in the number of domestic franchised hotel rooms open. These increases were partially offset by a 4 basis point decline in the effective royalty rate from 4.39% to 4.35%. System-wide RevPAR increased due to a combination of a 1.1% increase in average daily rates and a 200 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 March 31,    For the Three Months Ended March 31,
                             2014*                                  2013*                                  Change
               Average                                 Average                              Average
                Daily                                   Daily                                Daily
                 Rate       Occupancy     RevPAR        Rate       Occupancy     RevPAR       Rate       Occupancy      RevPAR
Comfort Inn  $    77.34         49.5 %   $ 38.25     $   76.30         47.5 %   $ 36.24       1.4  %     200     bps      5.5  %
Suites            83.59         54.5 %     45.52         81.82         52.6 %     43.04       2.2  %     190     bps      5.8  %
Sleep             70.05         49.8 %     34.90         69.07         47.6 %     32.85       1.4  %     220     bps      6.2  %
Quality           65.33         44.2 %     28.90         64.20         42.2 %     27.08       1.8  %     200     bps      6.7  %
Clarion           68.61         43.9 %     30.14         68.84         41.1 %     28.32      (0.3 )%     280     bps      6.4  %
Econo Lodge       51.49         40.2 %     20.70         51.67         38.6 %     19.95      (0.3 )%     160     bps      3.8  %
Rodeway           49.67         45.5 %     22.58         47.96         42.2 %     20.25       3.6  %     330     bps     11.5  %
MainStay          69.31         59.7 %     41.35         68.55         57.0 %     39.05       1.1  %     270     bps      5.9  %
Suburban          41.56         64.6 %     26.85         40.90         63.4 %     25.94       1.6  %     120     bps      3.5  %
Ascend Hotel
Collection       104.61         56.3 %     58.88        113.87         56.1 %     63.84      (8.1 )%      20     bps     (7.8 )%
Total        $    69.63         47.5 %   $ 33.09     $   68.87         45.5 %   $ 31.34       1.1  %     200     bps      5.6  %


*Operating statistics represent hotel operations from December through February 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 6,515 rooms or 1.6% to 402,417 as of March 31, 2014 from 395,902 as of March 31, 2013. The total number of domestic hotels on-line increased by 2.4% to 5,211 as of March 31, 2014 from 5,091 as of March 31, 2013.

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A summary of domestic hotels and rooms on-line at March 31, 2014 and 2013 by brand is as follows:

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