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CHH > SEC Filings for CHH > Form 10-Q on 8-Nov-2016All 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 primarily a hotel franchisor with franchise agreements representing 6,419 hotels open and 745 hotels under construction, awaiting conversion or approved for development as of September 30, 2016, with 509,152 rooms and 61,417 rooms, respectively, in 50 states, the District of Columbia and over 40 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 hotel & 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 is 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, total revenues from international franchising operations comprised 6% of our total revenues for the nine months ended September 30, 2016, while representing approximately 18% of our franchise system hotels open as of September 30, 2016. Therefore, our description of the franchise system is primarily focused on the domestic operations.

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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 and other sources. The hotel industry is seasonal in nature. For most hotels, demand is lower from November through February 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 reflect the industry's seasonality and historically have been lower in the first and fourth quarters than in the second or third 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 $3.0 million and a 1 basis point change in the Company's effective royalty rate would increase or decrease annual domestic royalties by approximately $0.7 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 or the number of rooms 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, maintaining a guest loyalty program, 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 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

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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, our board of directors instituted a share repurchase program which has generated substantial value for our shareholders. Since the program's inception through September 30, 2016, we have repurchased 48.7 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 $1.3 billion. Considering the effect of the two-for-one stock split, the Company has repurchased 81.7 million shares at an average price of $15.37 per share. The Company purchased 0.6 million shares of common stock under the share repurchase program during the nine months ended September 30, 2016 at a total cost of $28.6 million. At September 30, 2016, we had approximately 1.1 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 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; however, the declaration of future dividends is subject to the discretion of the board of directors. During the fourth quarter of 2015, the Company's board of directors announced a 5% increase to the quarterly cash dividend rate to $0.205 per common share outstanding. The projected annual dividend in 2016 is $0.82 per common share outstanding. During the nine months ended September 30, 2016, we paid cash dividends totaling approximately $34.7 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 including limitations in the Company's credit facility. Based on the present dividend rate and outstanding share count, we expect that aggregate annual regular dividends for 2016 would be approximately $46.2 million. The Company also allocates capital to 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. 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 and we generally expect to recycle these investments within a five-year period.

In March 2013, the Company announced the launch of SkyTouch Technology ("SkyTouch"), a new division of the Company that develops and markets cloud-based technology products for the hotel industry. Since inception, the Company has made significant investments in the division, including investments in product development and sales efforts to expand its customer base. As a result, the division has incurred costs in excess of revenues in each year of its existence and is projected to continue to incur costs in excess of revenues through the year ended December 31, 2016. For the nine months ended September 30, 2016, the division had an operating loss of approximately $12.7 million. At this time, the Company believes that its operation of the SkyTouch division beginning in 2017 will not require the same pace of investment as compared to past periods, and as a result, the Company expects that revenues generated by the SkyTouch division will approximate its selling, general and administration expenses for the year ended December 31, 2017.

As with many new technology businesses, the Company from time to time evaluates strategic alternatives with respect to the SkyTouch division. However, no transaction is imminent and there can be no assurance that future evaluation of strategic alternatives, if any, would result in a transaction.

In August 2015, the Company completed the acquisition of a company that provides software as a service solutions for vacation rental management companies. This business provides central reservations systems, property management systems and integrated software applications including point-of-sale. The transaction has been accounted for using the acquisition method of accounting and accordingly, assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. The results of this business have been consolidated with the Company since August 2015.
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.

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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 Operations: 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 hotel franchise system and therefore, our analysis of the Company's operations is primarily focused on the size, performance and potential growth of the hotel franchise system as well as our variable overhead costs. Since our hotel franchising activities represent more than 99% of total revenues, our discussion of our results from operations primarily relate to our hotel franchising activities. Refer to MD&A heading "Operations Review" for additional analysis of our results.
Inflation: Inflation has been moderate in recent years and has not had a significant impact on our business.
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.
Hotel Franchising Revenues: The Company utilizes hotel franchising revenues, which exclude revenues from marketing and reservation system activities, the SkyTouch Technology division, a recently acquired operation that provides software as a service solutions to vacation rental management companies, and revenue generated from the ownership of an office building that is leased to a third-party, rather than total revenues when analyzing the performance of the business. Marketing and reservation activities are excluded from hotel 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 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 and our vacation rental technology solutions provider operations are excluded from hotel franchising revenues since those operations do not reflect the Company's core hotel franchising business but represent adjacent, complementary 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 Hotel Franchising Revenues
                                                Three Months Ended September 30,           Nine Months Ended September 30,
                                                                              (in thousands)
                                                    2016                 2015                 2016                 2015

Total Revenues                               $       267,577       $       241,526     $       716,446       $       648,927
   Marketing and reservation system revenues        (152,018 )            (134,463 )          (412,193 )            (366,298 )
   Non-hotel franchising activities                   (2,424 )              (1,459 )            (6,521 )              (2,473 )
Hotel Franchising Revenues                   $       113,135       $       105,604     $       297,732       $       280,156

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Operations Review
Comparison of Operating Results for the Three-Month Periods Ended September 30,
2016 and 2015

Summarized financial results for the three months ended September 30, 2016 and
2015 are as follows:
(in thousands)                            2016         2015
Royalty fees                           $ 96,114     $ 89,929
Initial franchise and relicensing fees    6,284        6,170
Procurement services                      7,615        6,271
Marketing and reservation system        152,018      134,463
Other                                     5,546        4,693
Total revenues                          267,577      241,526
Selling, general and administrative      34,357       30,152
Depreciation and amortization             2,986        3,108
Marketing and reservation system        152,018      134,463
Total operating expenses                189,361      167,723
Gain on sale of assets, net                 402            -
Operating income                         78,618       73,803
Interest expense                         11,150       10,821
Interest income                            (836 )       (359 )
Other (gains) losses                       (746 )      1,402
Equity in net income of affiliates       (1,150 )       (329 )
Total other income and expenses, net      8,418       11,535
Income before income taxes               70,200       62,268
Income taxes                             22,635       20,849
Net income                             $ 47,565     $ 41,419

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Results of Operations
The Company recorded income before income taxes of $70.2 million for the three month period ended September 30, 2016, a $7.9 million, or 13% increase from the same period of the prior year. The increase in income before income taxes primarily reflects a $4.8 million increase in operating income, a $0.5 million increase in interest income, an increase of $2.1 million in other gains and losses, and a $0.8 million increase in equity in income of affiliates, partially offset by a $0.3 million increase in interest expense.
Operating income increased $4.8 million primarily due to a $7.5 million or 7% increase in the Company's hotel franchising revenues, a $0.4 million gain on sale of assets, and an increase of $1.0 million in non-hotel franchising revenues, offset by a $4.2 million or 14% increase in selling, general, and administrative expenses. The key drivers of these fluctuations are described in more detail below.
Hotel Franchising Revenues
Hotel franchising revenues were $113.1 million for the three months ended September 30, 2016 compared to $105.6 million for the three months ended September 30, 2015, an increase of $7.5 million or 7%. The increase in hotel franchising revenues is primarily due to a $6.2 million or 7% increase in royalty revenues and a $1.3 million or 21% increase in procurement services revenues.
Royalty Fees
Domestic royalty fees for the three months ended September 30, 2016 increased $6.0 million to $90.7 million, an increase of 7% compared to the three months ended September 30, 2015. The increase in royalties is primarily attributable to a 4.5% increase in RevPAR and an increase in the effective royalty rate. System-wide RevPAR increased due to a 3.4% increase in average daily rates, accompanied by a 70 basis point increase in occupancy rates. The Company's effective royalty rate for the domestic hotel system increased from 4.27% for the three months ended September 30, 2015 to 4.39% for the three months ended September 30, 2016. The increase in the effective royalty rate is attributable to improved royalty rate pricing on recently executed domestic franchise agreements as well as annual contractual royalty rate increases contained in existing franchise agreements.
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, 2016*                              30, 2015*                              Change
              Average                                 Average                              Average
               Daily                                   Daily                                Daily
                Rate       Occupancy     RevPAR        Rate       Occupancy     RevPAR       Rate      Occupancy     RevPAR
Comfort Inn $   100.02         73.4 %   $ 73.41     $   96.35         73.2 %   $ 70.54       3.8  %      20   bps     4.1  %
Suites          100.95         74.6 %     75.35         98.06         73.2 %     71.79       2.9  %     140   bps     5.0  %
Sleep            86.59         70.6 %     61.15         84.44         69.1 %     58.31       2.5  %     150   bps     4.9  %
Quality          84.31         66.4 %     55.96         80.80         65.3 %     52.79       4.3  %     110   bps     6.0  %
Clarion          88.98         66.4 %     59.08         85.46         63.9 %     54.61       4.1  %     250   bps     8.2  %
Econo Lodge      67.44         60.9 %     41.08         65.32         60.1 %     39.27       3.2  %      80   bps     4.6  %
Rodeway          69.72         62.3 %     43.45         66.00         63.7 %     42.02       5.6  %    (140 ) bps     3.4  %
MainStay         79.91         71.5 %     57.13         81.26         71.8 %     58.36      (1.7 )%     (30 ) bps    (2.1 )%
Suburban         51.09         78.2 %     39.96         48.77         78.1 %     38.09       4.8  %      10   bps     4.9  %
Collection      138.97         63.0 %     87.50        134.88         60.1 %     81.07       3.0  %     290   bps     7.9  %
Total       $    88.27         68.4 %   $ 60.39     $   85.38         67.7 %   $ 57.80       3.4  %      70   bps     4.5  %


*Operating statistics exclude Cambria hotel & 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 0.3% to 398,207 as of September 30, 2016, from 396,932 as of September 30, 2015. The total number of domestic hotels on-line increased by 0.9% to 5,275 as of September 30, 2016, from

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5,226 as of September 30, 2015. Our unit growth has outpaced the growth in our rooms primarily due to the Company's multi-year strategy to rejuvenate the Comfort family of brands by terminating or repositioning under-performing hotels that no longer meet the Comfort brand standards. Hotels terminated from the Comfort brand family may be repositioned to a more suitable brand within the Company's family of brands or exit our franchise system. As a result of this strategy our unit growth has been driven primarily by brands with lower average room counts than the Comfort family of brands. A summary of domestic hotels and rooms on-line at September 30, 2016 and 2015 by brand is as follows:

                    September 30, 2016          September 30, 2015                        Variance
                    Hotels         Rooms        Hotels         Rooms      Hotels     Rooms         %           %
Comfort Inn        1,126          87,346       1,188          92,029        (62 )   (4,683 )     (5.2 )%     (5.1 )%
. . .
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