[May 08, 2013] CHOICE HOTELS INTERNATIONAL INC /DE - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis ("MD&A") is intended to help the reader understand Choice Hotels International, Inc. and subsidiaries (together the "Company"). MD&A is provided as a supplement to-and should be read in conjunction with-our consolidated financial statements and the accompanying notes. 31-------------------------------------------------------------------------------- Table of Contents Overview We are a hotel franchisor with franchise agreements representing 6,264 hotels open and 476 hotels under construction, awaiting conversion or approved for development as of March 31, 2013, with 500,376 rooms and 37,977 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 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 9% of our total revenues for the three months ended March 31, 2013, while representing approximately 19% of hotels open at March 31, 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 $2.5 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. 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 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 32-------------------------------------------------------------------------------- Table of Contents 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 value drivers: 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 March 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. The Company did not purchase any shares under the share repurchase program during the three months ended March 31, 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 March 31, 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. We expect to continue to pay dividends in the future, subject 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. 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. 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. 33-------------------------------------------------------------------------------- Table of Contents As a result of these investments in exploring growth alternatives, the Company recently announced the formation 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 $2.2 million in the first quarter of 2013, for business development, sales and marketing and continued software development. Notwithstanding investments in alternative growth strategies, the Company expects to continue to return value to its shareholders through a combination of share repurchases and dividends, subject to business performance, economic conditions, changes in income tax regulations and other factors. We believe these investments and value drivers, when properly implemented, will enhance our profitability, maximize our financial returns and continue to generate value for our shareholders. The ultimate measure of our success will be reflected in the items below. Results of Operation: Royalty fees, operating income, net income and diluted earnings per share ("EPS") represent key measurements of these value drivers. In the three months ended March 31, 2013, royalty fees revenue totaled $49.7 million, a 4% increase from the same period in 2012. Operating income totaled $30.5 million for the three months ended March 31, 2013, a $0.6 million or 2% decline from the same period in 2012. Net income for the three months ended March 31, 2013 decreased 22% from the same period of the prior year to $15.5 million. Diluted EPS for the quarter ended March 31, 2013 were $0.26 compared to $0.34 for the three months ended March 31, 2012. These measurements will continue to be a key management focus in 2013 and beyond. 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. 34-------------------------------------------------------------------------------- Table of Contents Operations Review Comparison of Operating Results for the Three-Month Periods Ended March 31, 2013 and 2012 Summarized financial results for the three months ended March 31, 2013 and 2012 are as follows: (in thousands, except per share amounts) 2013 2012 REVENUES: Royalty fees $ 49,736 $ 47,853 Initial franchise and relicensing fees 3,777 2,528 Procurement services 3,950 3,315 Marketing and reservation 76,440 70,929 Hotel operations 956 978 Other 2,013 3,566 Total revenues 136,872 129,169 OPERATING EXPENSES: Selling, general and administrative 26,916 24,349 Depreciation and amortization 2,175 2,017 Marketing and reservation 76,440 70,929 Hotel operations 875 809 Total operating expenses 106,406 98,104 Operating income 30,466 31,065 OTHER INCOME AND EXPENSES, NET: Interest expense 10,770 3,117 Interest income (644 ) (337 ) Other (gains) and losses (710 ) (2,003 ) Equity in net loss of affiliates 141 55 Total other income and expenses, net 9,557 832 Income before income taxes 20,909 30,233 Income taxes 5,386 10,236 Net income $ 15,523 $ 19,997 Diluted earnings per share $ 0.26 $ 0.34 On occasion, 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 and hotel operations rather than total revenues when analyzing the performance of the business. Marketing and reservation activities are excluded from revenues since the Company is required by its franchise agreements to use these 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 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. Hotel operations are excluded since they do not reflect the most accurate measure of the Company's core franchising business. This non-GAAP measure is a commonly used measure of performance in our industry and facilitates comparisons between the Company and its competitors. 35-------------------------------------------------------------------------------- Table of Contents Calculation of Franchising Revenues Three Months Ended March 31, ($ amounts in thousands) 2013 2012 Franchising Revenues: Total Revenues $ 136,872 $ 129,169 Adjustments: Marketing and reservation system revenues (76,440 ) (70,929 ) Hotel operations (956 ) (978 ) Franchising Revenues $ 59,476 $ 57,262 EBITDA: We also utilize earnings before interest, taxes, depreciation and amortization ("EBITDA") to analyze our results which reflects earnings excluding the impact of interest expense, provision for income taxes, depreciation and amortization other (gains) and losses and equity in net income (loss) of unconsolidated affiliates. We consider 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 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. 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. Calculation of EBITDA Three Months Ended March 31, ($ amounts in thousands) 2013 2012 EBITDA: Net income $ 15,523 $ 19,997 Income taxes 5,386 10,236 Interest expense 10,770 3,117 Interest income (644 ) (337 ) Other (gains) and losses (710 ) (2,003 ) Equity in net loss of affiliates 141 55 Depreciation and amortization 2,175 2,017 EBITDA $ 32,641 $ 33,082 The Company recorded EBITDA of $32.6 million for the three month period ended March 31, 2013, a $0.4 million or 1.3% decline from the same period of the prior year. The decline in EBITDA reflects a $2.6 million or 11% increase in selling, general and administrative ("SG&A") expense partially offset by a $2.2 million or 4% increase in the Company's franchising revenues for the three months ended March 31, 2013. The Company recorded net income of $15.5 million for the three month period ended March 31, 2013, a 22% decline from the $20.0 million recorded for the quarter ended March 31, 2012. The decrease in net income primarily reflects the decline in EBITDA as well as $7.7 million increase in interest expense resulting from the issuance of debt in July and August 2012 to finance the Company's $600.7 million special dividend paid on August 23, 2012. Furthermore, net income was impacted by a decline in other (gains) and losses resulting from a $0.7 million appreciation in the fair value of investments held in the Company's non-qualified employee benefit plans during the three months ended March 31, 2013 compared to a $2.0 million appreciation in the fair value of these investments in the same period of the prior year. Franchising Revenues: Franchising revenues were $59.5 million for the three months ended March 31, 2013 compared to $57.3 million for the three months ended March 31, 2012, an increase of 4%. The increase in franchising revenues is primarily due to 36-------------------------------------------------------------------------------- Table of Contents a 4% increase in royalty revenues, a $1.2 million increase in initial and relicensing fees, partially offset by a $1.6 million decline in other income. Domestic royalty fees for the three months ended March 31, 2013 increased $2.0 million to $44.3 million from $42.3 million in the three months ended March 31, 2012, an increase of 5%. The increase in royalties is attributable to a combination of factors including a 4.6% increase in RevPAR, a 0.8% increase in the number of domestic franchised hotel rooms and a 5 basis point increase in the effective royalty rate from 4.34% to 4.39%. System-wide RevPAR increased due to a combination of a 2.3% increase in average daily rates and a 100 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, 2013* 2012* Change Average Average Average Daily Daily Daily Rate Occupancy RevPAR Rate Occupancy RevPAR Rate Occupancy RevPAR Comfort Inn $ 76.30 47.5 % $ 36.24 $ 74.29 46.8 % $ 34.76 2.7 % 70 bps 4.3 % Comfort Suites 81.82 52.6 % 43.04 79.88 51.0 % 40.72 2.4 % 160 bps 5.7 % Sleep 69.07 47.6 % 32.85 66.39 45.0 % 29.90 4.0 % 260 bps 9.9 % Quality 64.20 42.2 % 27.08 63.39 40.8 % 25.87 1.3 % 140 bps 4.7 % Clarion 68.84 41.1 % 28.32 67.90 38.7 % 26.26 1.4 % 240 bps 7.8 % Econo Lodge 51.67 38.6 % 19.95 50.31 38.7 % 19.45 2.7 % (10 ) bps 2.6 % Rodeway 47.96 42.2 % 20.25 47.08 41.7 % 19.61 1.9 % 50 bps 3.3 % MainStay 68.55 57.0 % 39.05 64.60 61.8 % 39.94 6.1 % (480 ) bps (2.2 )% Suburban 40.90 63.4 % 25.94 39.15 62.5 % 24.47 4.5 % 90 bps 6.0 % Ascend Collection 113.87 56.1 % 63.84 104.02 52.0 % 54.11 9.5 % 410 bps 18.0 % Total $ 68.87 45.5 % $ 31.34 $ 67.32 44.5 % $ 29.95 2.3 % 100 bps 4.6 % ___________________ *Operating statistics represent hotel operations from December through February and exclude Cambria Suites. The number of domestic rooms on-line increased by 3,025 rooms or 0.8% to 395,902 as of March 31, 2013 from 392,877 as of March 31, 2012. The total number of domestic hotels on-line increased by 1.7% to 5,091 as of March 31, 2013 from 5,006 as of March 31, 2012. A summary of domestic hotels and rooms on-line at March 31, 2013 and 2012 by brand is as follows: March 31, 2013 March 31, 2012 Variance Hotels Rooms Hotels Rooms Hotels Rooms % % Comfort Inn 1,332 104,159 1,392 108,777 (60 ) (4,618 ) (4.3 )% (4.2 )% Comfort Suites 597 46,079 613 47,506 (16 ) (1,427 ) (2.6 )% (3.0 )% Sleep 382 27,685 394 28,564 (12 ) (879 ) (3.0 )% (3.1 )% Quality 1,172 99,090 1,054 91,942 118 7,148 11.2 % 7.8 % Clarion 190 27,268 188 27,550 2 (282 ) 1.1 % (1.0 )% Econo Lodge 811 49,244 797 49,254 14 (10 ) 1.8 % - % Rodeway 421 24,269 396 22,183 25 2,086 6.3 % 9.4 % MainStay 41 3,165 39 3,024 2 141 5.1 % 4.7 % Suburban 63 7,241 61 7,191 2 50 3.3 % 0.7 % Ascend Collection 63 5,481 53 4,671 10 810 18.9 % 17.3 % Cambria Suites 19 2,221 19 2,215 - 6 - % 0.3 % Total Domestic Franchises 5,091 395,902 5,006 392,877 85 3,025 1.7 % 0.8 % 37-------------------------------------------------------------------------------- Table of Contents Domestic hotels open and operating increased by 8 hotels during the three months ended March 31, 2013 compared to a net increase of 5 domestic hotels open and operating during the three months ended March 31, 2012. Gross domestic franchise additions increased from 39 for the three months ended March 31, 2012 to 62 for the same period of 2013. New construction hotels represented 8 of the gross domestic additions during three months ended March 31, 2013 compared to 5 hotels in the same period of the prior year. Gross domestic additions for conversion hotels during the three months ended March 31, 2013 increased by 20 to 54 from 34 for the three months ended March 31, 2012. The increase in franchise openings primarily reflects a 42% increase in the number of domestic franchise agreements executed during 2012 compared to the prior year. The Company expects the number of new franchise units that will open during 2013 to increase from 308 in 2012 to approximately 324 hotels. Although there has been an increase in the number of projected openings, new construction and conversion openings continue to be impacted by the restrictive lending environment, retention efforts implemented by other hotel brand companies and increased competition for existing hotels seeking a new brand affiliation. Net domestic franchise terminations increased from 34 in the three months ended March 31, 2012 to 54 for the three months ended March 31, 2013 primarily due to an increase in the number of terminations related to the removal of hotels for non-compliance with the Company's rules, regulations and standards as well as non-payment of franchise fees. International royalties decreased by $0.1 million or 1% from the first quarter of 2012 to $5.5 million for the same period of 2013 primarily due to RevPAR performance in the various countries in which we operate and foreign currency fluctuations. International available rooms increased 0.9% to 104,474 as of March 31, 2013 from 103,491 as of March 31, 2012. The total number of international hotels increased 0.4% from 1,168 as of March 31, 2012 to 1,173 as of March 31, 2013. New domestic franchise agreements executed in the three months ended March 31, 2013 totaled 83 representing 6,330 rooms compared to 64 agreements representing 4,658 rooms executed in the first quarter of 2012. During the first quarter of 2013, 10 of the executed agreements were for new construction hotel franchises representing 754 rooms compared to 7 contracts representing 443 rooms for the three months ended March 31, 2012. Conversion hotel executed franchise agreements totaled 73 representing 5,576 rooms for the three months ended March 31, 2013 compared to 57 agreements representing 4,215 rooms for the same period a year ago. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise agreements increased $0.6 million to $2.0 million for the three months ended March 31, 2013 from $1.4 million for the three months ended March 31, 2012. Domestic initial fee revenue increased approximately 44% due to a 30% increase in the number of new franchise agreements executed and an increase in amount of deferred revenue recognized in 2013 related to franchise agreements containing developer incentives that were executed in prior years. Revenues associated with agreements including incentives are deferred and recognized when the incentive criteria are met or the agreement is terminated, whichever comes first. A summary of executed domestic franchise agreements by brand for the three months ended March 31, 2013 and 2012 is as follows: Three Months Ended March 31, 2013 Three Months Ended March 31, 2012 % Change New New New Construction Conversion Total Construction Conversion Total Construction Conversion Total Comfort Inn 3 5 8 1 8 9 200 % (38 )% (11 )% Comfort Suites 2 2 4 1 2 3 100 % - % 33 % Sleep 1 - 1 3 - 3 (67 )% NM (67 )% Quality - 19 19 - 27 27 NM (30 )% (30 )% Clarion - 3 3 - 2 2 NM 50 % 50 % Econo Lodge - 8 8 - 4 4 NM 100 % 100 % Rodeway - 9 9 - 12 12 NM (25 )% (25 )% MainStay 1 - 1 - - - NM NM NM Suburban - 1 1 - - - NM NM NM Ascend Collection 2 26 28 1 2 3 100 % 1,200 % 833 % Cambria Suites 1 - 1 1 - 1 - % NM - % Total Domestic System 10 73 83 7 57 64 43% 28% 30% Relicensing fees include fees charged to the new owners of a franchised property whenever an ownership change occurs and the property remains in the franchise system as well as fees required to renew expiring franchise contracts. Domestic relicensing and renewal contracts increased from 49 in the first quarter of 2012 to 69 for the three months ended March 31, 38-------------------------------------------------------------------------------- Table of Contents 2013. As a result of the increase in contracts, domestic relicensing revenues increased $0.6 million or 52% from $1.0 million for the three months ended March 31, 2012 to $1.6 million for the three months ended March 31, 2013. As of March 31, 2013, the Company had 395 franchised hotels with 30,984 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 388 hotels and 31,190 rooms at March 31, 2012. The number of new construction franchised hotels in the Company's domestic pipeline declined 7% to 232 at March 31, 2013 from 250 at March 31, 2012. New construction hotels in the domestic pipeline have been negatively impacted by the limited availability of hotel construction financing. As a result, the ability of existing projects to obtain financing and commence construction has been significantly impacted and has resulted in the termination of franchise agreements related to hotels that have not yet opened. The number of conversion franchised hotels in the Company's domestic pipeline increased by 25 units or 18% from March 31, 2012 to 163 hotels at March 31, 2013 due to higher franchise sales for the Company's Ascend Collection brand. The Company had an additional 81 franchised hotels with 6,993 rooms under construction, awaiting conversion or approved for development in its international system as of March 31, 2013 compared to 83 hotels and 7,020 rooms at March 31, 2012. While the Company's hotel pipeline provides a strong platform for growth, a hotel in the pipeline does not always result in an open and operating hotel due to various factors. A summary of the domestic franchised hotels under construction, awaiting conversion or approved for development at March 31, 2013 and 2012 by brand is as follows: Variance March 31, 2013 March 31, 2012 Units Units Conversion New Construction Total New New Conversion Construction Total Conversion Construction Total Units % Units % Units % Comfort Inn 30 49 79 28 44 72 2 7 % 5 11 % 7 10 % Comfort Suites 2 67 69 3 83 86 (1 ) (33 )% (16 ) (19 )% (17 ) (20 )% Sleep 1 44 45 1 44 45 - - % - - % - - % Quality 35 2 37 40 4 44 (5 ) (13 )% (2 ) (50 )% (7 ) (16 )% Clarion 9 - 9 12 1 13 (3 ) (25 )% (1 ) (100 )% (4 ) (31 )% Econo Lodge 23 - 23 18 2 20 5 28 % (2 ) (100 )% 3 15 % Rodeway 30 - 30 25 1 26 5 20 % (1 ) (100 )% 4 15 % MainStay - 25 25 2 22 24 (2 ) (100 )% 3 14 % 1 4 % Suburban 3 12 15 2 16 18 1 50 % (4 ) (25 )% (3 ) (17 )% Ascend Collection 30 9 39 7 4 11 23 329 % 5 125 % 28 255 % Cambria Suites - 24 24 - 29 29 - NM (5 ) (17 )% (5 ) (17 )% 163 232 395 138 250 388 25 18 % (18 ) (7 )% 7 2 % Selling, General and Administrative Expenses: The cost to operate the franchising business is reflected in SG&A on the consolidated statements of income. SG&A expenses were $26.9 million for the three months ended March 31, 2013, an increase of $2.6 million or 11% from the three months ended March 31, 2012. SG&A for the three months ended March 31, 2013 increased from the prior year primarily due to a $2.2 million increase in alternative growth spending primarily related to the launch of the Company's new SkyTouch Technology division, a $0.8 million increase in rent expense related to the relocation of the Company's corporate headquarters and a $0.4 million increase in variable franchise sales compensation due to a 30% increase in domestic franchise agreements. SG&A expense for the three months ended March 31, 2012 included approximately $1.5 million related to a litigation settlement with a former franchisee. SG&A, excluding these items, increased by approximately 3.5%. Marketing and Reservations: The Company's franchise agreements require the payment of franchise fees, which include marketing and reservation system fees. The fees, which are primarily based on a percentage of the franchisees' gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing and media advertising. The Company is contractually obligated to expend the marketing and reservation system fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated. 39-------------------------------------------------------------------------------- Table of Contents Total marketing and reservation system revenues increased 8% from $70.9 million for the three months ended March 31, 2012 to $76.4 million for the three months ended March 31, 2013. The increase in revenues was primarily due to improved system fees resulting from system growth and RevPAR increases and increasing revenues from the Choice Privileges loyalty program resulting from the growth in program membership. Depreciation and amortization attributable to marketing and reservation activities was $4.0 million and $3.5 million for the three months ended March 31, 2013 and 2012, respectively. Interest expense attributable to marketing and reservation activities was approximately $0.9 million and $1.2 million for the three months ended March 31, 2013 and 2012, respectively. As of March 31, 2013 and December 31, 2012, the Company's balance sheet includes a receivable of $51.3 million and $42.2 million, respectively from cumulative marketing and reservation expenses incurred in excess of cumulative marketing and reservations system fee revenues earned. During the three months ended March 31, 2013, the Company expended $9.1 million of marketing and reservation expenses in excess of revenues earned. As a result, these expenses in excess of revenue earned were added to the outstanding marketing and reservation receivable. The increase in the receivable primarily reflects the timing of various marketing programs and the seasonality of the Company's revenues. This receivable is recorded as an asset in the financial statements as the Company has the contractual authority to require that the franchisees in the system at any given point repay the Company for any deficits related to marketing and reservation activities. The Company's current franchisees are legally obligated to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue and whether or not they joined the system following the deficit's occurrence. The Company has no present intention to accelerate repayment of the deficit from current franchisees. Conversely, cumulative marketing and reservation system revenues not expended are recorded as a payable in the financial statements and are carried over to the next fiscal year and expended in accordance with the franchise agreements. Our ability to recover these receivables may be adversely impacted by certain factors, including, among others, declines in the ability of our franchisees to generate revenues at properties they franchise from us, lower than expected franchise system growth of certain brands and/or lower than expected international franchise system growth. An extended period of occupancy or room rate declines or a decline in the number of hotel rooms in our franchise system could result in the generation of insufficient funds to recover marketing and reservation advances as well as meet the ongoing marketing and reservation needs of the overall system. Other Income and Expenses, Net: Other income and expenses, net increased from an expense of $0.8 million during the three months ended March 31, 2012 to an expense of $9.6 million for the three months ended March 31, 2013 primarily due to the following items: Interest expense increased $7.7 million for the three months ended March 31, 2013 to $10.8 million due to the issuance of the Company's $400 million senior notes due in 2022 with an effective rate of 5.94% on June 27, 2012 as well as the $350 million senior secured credit facility entered into by the Company on July 25, 2012. The Company utilized the proceeds from these debt issuances to pay a special cash dividend on August 23, 2012 totaling approximately $600.7 million to common shareholders. Other gains and losses decreased from a gain of $2.0 million for the three months ended March 31, 2012 to a gain of $0.7 million for the three months ended March 31, 2013 primarily due to fluctuations in the fair value of investments held in the Company's non-qualified employee benefit plans. As discussed in the accompanying critical accounting policies, the Company sponsors two non-qualified retirement and savings plans: the Non-Qualified Plan and the EDCP plan. The fair value of the Non-Qualified Plan investments increased by $0.6 million during the three months ended March 31, 2013 compared to an increase of $0.9 million during the three months ended March 31, 2012. The fair value of the Company's investments held in the EDCP plan increased by $0.1 million during the three months ended March 31, 2013 compared to an increase in fair value of $1.1 million during the same period of the prior year. The Company accounts for the EDCP Plan and Non-Qualified Plan in accordance with accounting for deferred compensation arrangements when investments are held in a rabbi trust and invested. Therefore, the Company also recognizes compensation expense or benefits in SG&A related to changes in the fair value of investments held in the Non-Qualified Plan and a portion of the investments held in the EDCP Plan, excluding investments in the Company's stock. As a result, during the three months ended March 31, 2013 and 2012, the Company's SG&A expense was increased by $1.0 million for both periods. Income Taxes: The effective income tax rates were 25.8% and 33.9% for the three months ended March 31, 2013 and 2012, respectively. The effective income tax rate for the three months ended March 31, 2013 and 2012 were lower than the U.S federal income tax rate of 35% due to the recurring impact of foreign operations, partially offset by state taxes. The effective income tax rate for the three months ended March 31, 2013 was further reduced by settlements of unrecognized tax positions and by legislation retroactively extending the U.S. controlled foreign corporation look-through rule. 40-------------------------------------------------------------------------------- Table of Contents Diluted EPS: Diluted EPS decreased 24% to $0.26 for the three months ended March 31, 2013 from $0.34 for the same period of the prior year. The decrease in diluted EPS primarily reflects the items discussed above. Liquidity and Capital Resources Operating Activities During the three months ended March 31, 2013, net cash provided by operating activities totaled $1.9 million compared to $4.4 million during the three months ended March 31, 2012. The decrease in cash flows from operating activities primarily reflects a decline in EBITDA and the timing of working capital items. Net cash advanced to marketing and reservation activities totaled $4.1 million during the three months ended March 31, 2013 compared to $6.2 million during the three months ended March 31, 2012. The improvement in cash flows from marketing and reservation activities primarily reflects an improvement in marketing and reservation system fees resulting from domestic system size expansion and RevPAR performance and improved financial performance of the Company's loyalty program. Based on the current economic conditions, the Company expects marketing and reservation activities to provide cash flows from operations ranging between $12 million and $17 million in 2013. Investing Activities Cash utilized for investing activities totaled $13.8 million and $1.5 million for the three months ended March 31, 2013 and 2012, respectively. The increase in cash utilized for investing activities for the three months ended March 31, 2013 primarily reflect an increase in capital expenditures. The increase in capital expenditures were partially offset by a decline in the proceeds from the sale of investments held in trust related to the Company's deferred compensation plans during the three months ended March 31, 2013. During the three months ended March 31, 2013 and 2012, the Company sold investments totaling $3.9 million and $8.7 million, respectively and utilized the proceeds to reimburse the Company for participant distributions made on behalf of the trust in prior years. The decline in proceeds from the sale of investments primarily reflects the timing of employee terminations and their deferred compensation distribution elections. During the three months ended March 31, 2013 and 2012, capital expenditures totaled $13.6 million and $3.1 million, respectively. The increase in capital expenditures for 2013 primarily reflect tenant improvements related to the relocation of the Company's corporate headquarters. The Company occasionally provides financing to franchisees for property improvements, hotel development efforts and other purposes. During the three months ended March 31, 2013 and 2012, the Company advanced $1.7 million and $3.7 million, respectively, for these purposes. At March 31, 2013, the Company had commitments to extend an additional $11.3 million for these purposes provided certain conditions are met by its franchisees, of which $6.5 million is expected to be advanced in the next twelve months. During the three months ended March 31, 2013 and 2012, the Company invested $1.0 million and $2.6 million, respectively in joint ventures accounted for under the equity method of accounting. The Company's investment in these joint ventures primarily pertain to ventures that either support the Company's efforts to increase business delivery to its franchisees or promote growth of our emerging brands. Our board of directors previously authorized us to enter into a program which permits us to offer financing, investment 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. At March 31, 2013 and December 31, 2012, the Company had approximately $68.8 million and $68.3 million, respectively invested under this program. Over the next several years, we expect to continue to deploy capital opportunistically pursuant to this program to promote growth of our emerging brands. Our current expectation is that our annual investment in this program will range from $20 million to $40 million per year however, the amount and timing of the investment in this program will be dependent on market and other conditions. Financing Activities Financing cash flows relate primarily to the Company's borrowings, treasury stock purchases and dividends. 41-------------------------------------------------------------------------------- Table of Contents Debt Senior Unsecured Notes due 2022 On June 27, 2012 the Company issued unsecured notes with a principal amount of $400 million ("the 2012 Senior Notes") at par, bearing a coupon of 5.75% with an effective rate of 5.94%. The 2012 Senior Notes will mature on July 1, 2022, with interest to be paid semi-annually on January 1st and July 1st. The Company utilized the net proceeds of this offering, after deducting underwriting discounts and commissions and other offering expenses, together with a portion of the proceeds of a new credit facility, to pay a special cash dividend totaling approximately $600.7 million paid to shareholders on August 23, 2012. The Company's 2012 Senior Notes are guaranteed jointly, severally, fully and unconditionally, subject to certain customary limitations by eight 100%-owned domestic subsidiaries. The Company may redeem the 2012 Senior Notes at its option at a redemption price equal to the greater of (a) 100% of the principal amount of the notes to be redeemed and (b) the sum of the present values of the remaining scheduled principal and interest payments from the redemption date to the date of maturity discounted to the redemption date on a semi-annual basis at the Treasury rate, plus 50 basis points. Senior Unsecured Notes due 2020 On August 25, 2010, the Company completed a $250 million senior unsecured note offering ("the 2010 Senior Notes") at a discount of $0.6 million, bearing a coupon of 5.7% with an effective rate of 6.19%. The 2010 Senior Notes will mature on August 28, 2020, with interest on the 2010 Senior Notes to be paid semi-annually on February 28th and August 28th. The Company used the net proceeds from the offering, after deducting underwriting discounts and other offering expenses, to repay outstanding borrowings and other general corporate purposes. The Company's 2010 Senior Notes are guaranteed jointly, severally, fully and unconditionally, subject to certain customary limitations, by eight 100%-owned domestic subsidiaries. The Company may redeem the 2010 Senior Notes at its option at a redemption price equal to the greater of (a) 100% of the principal amount of the notes to be redeemed and (b) the sum of the present values of the remaining scheduled principal and interest payments from the redemption date to the date of maturity discounted to the redemption date on a semi-annual basis at the Treasury rate, plus 45 basis points. Senior Credit Facility On July 25, 2012, the Company entered into a $350 million senior secured credit facility, comprised of a $200 million revolving credit tranche ("the New Revolver") and a $150 million term loan tranche (the "Term Loan") with Deutsche Bank AG New York Branch, as administrative agent, Wells Fargo Bank, National Association, as administrative agent, and a syndication of lenders (the "New Credit Facility"). The New Credit Facility has a final maturity date of July 25, 2016, subject to an optional one-year extension, provided certain conditions are met. Up to $25 million of the borrowings under the New Revolver may be used for letters of credit, up to $10 million of borrowings under the New Revolver may be used for swing-line loans and up to $35 million of borrowings under the New Revolver may be used for alternative currency loans. The Term Loan requires quarterly amortization payments (a) during the first two years, in equal installments aggregating 5% of the original principal amount of the Term Loan per year, (b) during the second two years, in equal installments aggregating 7.5% of the original principal amount of the Term Loan per year, and (c) during the one-year extension period (if exercised), equal installments aggregating 10% of the original principal amount of the Term Loan. The Company utilized the proceeds from the Term Loan and borrowings from the New Revolver, together with the net proceeds from the Company's recently issued senior notes offering, to pay a special cash dividend of approximately $600.7 million in the aggregate to the Company's stockholders on August 23, 2012. The New Credit Facility is unconditionally guaranteed, jointly and severally, by certain of the Company's domestic subsidiaries. The subsidiary guarantors currently include all subsidiaries that guarantee the obligations under the Company's Indenture governing the terms of its 2010 and 2012 Senior Notes. The New Credit Facility is secured by first priority pledges of (i) 100% of the ownership interests in certain domestic subsidiaries owned by the Company and the guarantors, (ii) 65% of the ownership interests in (a) Choice Netherlands Antilles N.V. ("Choice NV"), the top-tier foreign holding company of the Company's foreign subsidiaries, and (b) the domestic subsidiary that owns Choice NV and (iii) all presently existing and future domestic franchise agreements (the "Franchise Agreements") between the Company and individual franchisees, but only to the extent that the Franchise Agreements may be pledged without violating any law of the relevant jurisdiction or conflicting with any existing contractual obligation of the Company or the applicable franchisee. At the time that the maximum total leverage ratio is required to be no greater than 4.00 to 1.00 (beginning of year 4 of the New Credit Facility), the security interest in the Franchise Agreements will be released. 42-------------------------------------------------------------------------------- Table of Contents The Company may at any time prior to the final maturity date increase the amount of the New Credit Facility by up to an additional $100 million to the extent that any one or more lenders commit to being a lender for the additional amount and certain other customary conditions are met. Such additional amounts may take the form of an increased revolver or term loan. The Company may elect to have borrowings under the New Credit Facility bear interest at a rate equal to (i) LIBOR, plus a margin ranging from 200 to 425 basis points based on the Company's total leverage ratio or (ii) a base rate plus a margin ranging from 100 to 325 basis points based on the Company's total leverage ratio. The New Credit Facility requires the Company to pay a fee on the undrawn portion of the New Revolver, calculated based on the average daily unused amount of the New Revolver multiplied by 0.30% per annum. The Company may reduce the New Revolver commitment and/or prepay the Term Loan in whole or in part at any time without penalty, subject to reimbursement of customary breakage costs, if any. Any Term Loan prepayments made by the Company shall be applied to reduce the scheduled amortization payments in direct order of maturity. Additionally, the New Credit Facility requires that the Company and its restricted subsidiaries comply with various covenants, including with respect to restrictions on liens, incurring indebtedness, making investments, paying dividends or repurchasing stock, and effecting mergers and/or asset sales. With respect to dividends, the Company may not make any payments if there is an existing event of default or if the payment would create an event of default. In addition, if the Company's total leverage ratio exceeds 4.5 to 1.0, the Company is generally restricted from paying aggregate dividends in excess of $50 million during any calendar year. The New Credit Facility also imposes financial maintenance covenants requiring the Company to maintain: • a total leverage ratio of not more than 5.75 to 1.00 in year 1, 5.00 to 1.00 in year 2, 4.50 to 1.00 in year 3 and 4.00 to 1.00 thereafter,• a maximum secured leverage ratio of not more than 2.50 to 1.00 in year 1, 2.25 to 1.00 in year 2, 2.00 to 1.00 in year 3 and 1.75 to 1.00 thereafter, and • a minimum fixed charge coverage ratio of not less than 2.00 to 1.00 in years 1 and 2, 2.25 to 1.00 in year 3 and 2.50 to 1.00 thereafter. At March 31, 2013, the Company maintained a total leverage ratio of approximately 3.72x, a maximum secured leverage ratio of 0.95x and a minimum fixed charge coverage ratio of approximately 6.53x. At March 31, 2013, the Company was in compliance with all covenants under the New Credit Facility. The New Credit Facility includes customary events of default, the occurrence of which, following any applicable cure period, would permit the lenders to, among other things, declare the principal, accrued interest and other obligations of the Company under the New Credit Facility to be immediately due and payable. At March 31, 2013, the Company had $144.4 million and $75.0 million outstanding under the Term Loan and New Revolver, respectively. At December 31, 2012, the Company had $146.3 million and $57.0 million outstanding under the Term Loan and New Revolver, respectively. In connection with the entry into the New Credit Facility, the Company's $300 million senior unsecured revolving credit agreement, dated as of February 24, 2011, among the Company, Wells Fargo Bank, National Association, as administrative agent, and a syndicate of lenders (the "Old Credit Facility"), was terminated and replaced by the New Credit Facility. The Old Credit Facility permitted the Company to borrow, repay and re-borrow revolving loans until the scheduled maturity date of February 24, 2016. In addition, the Old Credit Facility bore interest, at the Company's election, at either (i) a base rate plus a margin ranging from 5 to 80 basis points based on the Company's credit rating or (ii) LIBOR plus a margin ranging from 105 to 180 basis points based on the Company's credit rating. The Old Credit Facility also required the Company to pay a quarterly facility fee on the full amount of the commitments under the Old Credit Facility (regardless of usage) ranging from 20 to 45 basis points based upon the credit rating of the Company. Dividends 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. We expect to continue to pay dividends in the future, subject 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 43-------------------------------------------------------------------------------- Table of Contents 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. Share Repurchases 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 March 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. No shares were repurchased under the share repurchase program during the three months ended March 31, 2013. As of March 31, 2013, the Company had approximately 1.4 million shares remaining under the board of directors share repurchase authorization and we currently believe that our cash flows from operations will support our ability to complete the current authorization. Upon completion of the current authorization, our board of directors will evaluate the advisability of additional share repurchases. Other items Approximately $134.7 million of the Company's cash and cash equivalents at March 31, 2013 pertains to undistributed earnings of the Company's consolidated foreign subsidiaries. Since the Company's intent is for such earnings to be reinvested by the foreign subsidiaries, the Company has not provided additional U.S. income taxes on these amounts. While the Company has no intention to utilize these cash and cash equivalents in its domestic operations, any change to this policy would result in the Company incurring additional U.S. income taxes on any amounts utilized domestically. During the three months ended March 31, 2013, the Company recorded one-time employee termination charges totaling $0.8 million in SG&A and marketing and reservation expenses. These charges related to salary and benefits continuation payments for employees separating from service with the Company. At March 31, 2013, the Company had approximately $0.3 million of these salary and benefits continuation payments remaining to be remitted. During the three months ended March 31, 2013, the Company remitted an additional $1.8 million of termination benefits related to employee termination charges recorded in prior periods and had approximately $1.7 million of these benefits remaining to be paid. At March 31, 2013, total termination benefits of approximately $2.0 million remained to be paid and the Company expects $2.0 million of these benefits to be paid in the next twelve months. In addition, the Company expects to satisfy approximately $2.4 million of deferred compensation and retirement plan obligations during the next twelve months. The Company believes that cash flows from operations and available financing capacity are adequate to meet the expected future operating, investing and financing needs of the business. Off Balance Sheet Arrangements On October 9, 2012, the Company entered into a limited payment guaranty with regards to a developer's $18.0 million bank loan for the construction of a Cambria Suites in White Plains, New York. Under the terms of the limited guaranty, the Company has agreed to guarantee 25% of the outstanding principal balance and accrued and unpaid interest, as well as any unpaid expenses incurred by the lender. The limited guaranty shall remain in effect until the maximum amount guaranteed by the Company is paid in full. In addition to the limited guaranty, the Company entered into an agreement in which the Company guarantees the completion of the construction of the hotel and an environmental indemnity agreement which indemnifies the lending institution from and against any damages relating to or arising out of possible environmental contamination issues with regards to the Cambria Suites property. Critical Accounting Policies Our accounting policies comply with principles generally accepted in the United States. We have described below those policies that we believe are critical or require the use of complex judgment or significant estimates in their application. Additional discussion of these policies is included in Note 1 to our consolidated financial statements as of and for the year ended December 31, 2012 included in our Annual Report on Form 10-K. Revenue Recognition. We recognize continuing franchise fees, including royalty, marketing and reservations system fees, when earned and receivable from our franchisees. Franchise fees are typically based on a percentage of gross room revenues of each franchisee. Our estimate of the allowance for uncollectible royalty fees is charged to SG&A expense and our estimate of the allowance for uncollectible marketing and reservation fees is charged to marketing and reservation expenses. 44-------------------------------------------------------------------------------- Table of Contents Initial franchise and relicensing fees are recognized, in most instances, in the period the related franchise agreement is executed because the initial franchise and relicensing fees are non-refundable and the Company is not required to provide initial services to the franchisee prior to hotel opening. We defer the initial franchise and relicensing fee revenue related to franchise agreements which include incentives until the incentive criteria are met or the agreement is terminated, whichever occurs first. The Company may also enter into master development agreements ("MDAs") with developers that grant limited exclusive development rights and preferential franchise agreement terms for one-time, non-refundable fees. When these fees are not contingent upon the number of agreements executed under the MDA, the Company recognizes the up-front fees over the MDA's contractual life. Fees that are contingent upon the execution of franchise agreements under the MDA are recognized upon execution of the franchise agreement. The Company recognizes procurement services revenues from qualified vendors when the services are performed or the product delivered, evidence of an arrangement exists, the fee is fixed and determinable and collectibility is probable. We defer the recognition of procurement services revenues related to certain upfront fees and recognize them over a period corresponding to the Company's estimate of the life of the arrangement. Marketing and Reservation Revenues and Expenses. The Company's franchise agreements require the payment of certain marketing and reservation system fees, which are used exclusively by the Company for expenses associated with providing franchise services such as national marketing, media advertising, central reservation systems and technology services. The Company is contractually obligated to expend the marketing and reservation system fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated. In accordance with our contracts, we include in marketing and reservation expenses an allocation of costs for certain activities, such as human resources, facilities, legal, accounting, etc., required to carry out marketing and reservation activities. The Company records marketing and reservation system revenues and expenses on a gross basis since the Company is the primary obligor in the arrangement, maintains the credit risk, establishes the price and nature of the marketing or reservation services and retains discretion in supplier selection. In addition, net advances to and repayments from the franchise system for marketing and reservation activities are presented as cash flows from operating activities. Marketing and reservation system fees not expended in the current year are carried over to the next fiscal year and expended in accordance with the franchise agreements. Shortfall amounts are similarly recovered in subsequent years. Cumulative excess or shortfall amounts from the operation of these programs are recorded as a marketing and reservation system fee payable or receivable. Under the terms of the franchise agreements, the Company may advance capital as necessary for marketing and reservation activities and recover such advances through future fees. Our current assessment is that the credit risk associated with the marketing and reservation system fees receivable is mitigated due to our contractual right to recover these amounts from a large geographically dispersed group of franchisees. However, our ability to recover these receivables may be adversely impacted by certain factors, including, among others, declines in the ability of our franchisees to generate revenues at properties they franchise from us, lower than expected franchise system growth of certain brands and/or lower than expected international franchise system growth. An extended period of occupancy or room rate declines or a decline in the number of hotel rooms in our franchise system could result in the generation of insufficient funds to recover marketing and reservation advances as well as meet the ongoing marketing and reservation needs of the overall system. The Company evaluates the receivable for marketing and reservation costs in excess of cumulative marketing and reservation system revnues earned on a periodic basis for collectibility. The Company will record an allowance when, based on current information and events, it is probable that we will be unable to collect all amounts due for marketing and reservation activities according to the contractual terms of the franchise agreements. The receivables are considered to be uncollectible if the expected net, undiscounted cash flows from marketing and reservation activities are less than the carrying amount of the asset. Choice Privileges is our frequent guest incentive marketing program. Choice Privileges enables members to earn points based on their spending levels with our franchisees and, to a lesser degree, through participation in affiliated partners' programs, such as those offered by credit card companies. The points, which we accumulate and track on the members' behalf, may be redeemed for free accommodations or other benefits. We provide Choice Privileges as a marketing program to franchised hotels and collect a percentage of program members' room revenue from franchises to operate the program. Revenues are deferred in an amount equal to the estimated fair value of the future redemption obligation. A third-party actuary estimates the eventual redemption rates and point values using various actuarial methods. These judgmental factors determine the required liability attributable to outstanding points. Upon redemption of points, the Company recognizes the previously deferred revenue as well as the corresponding expense relating to the cost of the awards redeemed. Revenues in excess of the estimated future redemption obligation are recognized when earned 45-------------------------------------------------------------------------------- Table of Contents to reimburse the Company for costs incurred to operate the program, including administrative costs, marketing, promotion and performing member services. Costs to operate the program, excluding estimated redemption values, are expensed when incurred. Valuation of Intangibles and Long-Lived Assets The Company evaluates the potential impairment of property and equipment and other long-lived assets, including franchise rights and other definite-lived intangibles, on an annual basis or whenever an event or other circumstances indicates that we may not be able to recover the carrying value of the asset. Recoverability is measured based on net, undiscounted expected cash flows. Assets are considered to be impaired if the net, undiscounted expected cash flows are less than the carrying amount of the assets. Impairment charges are recorded based upon the difference between the carrying value and the fair value of the asset. Significant management judgment is involved in developing these projections, and they include inherent uncertainties. If different projections are used in the current period, the balances for non-current assets could be materially impacted. Furthermore, if management uses different projections or if different conditions occur in future periods, future-operating results could be materially impacted. The Company evaluates the impairment of goodwill and trademarks with indefinite lives on an annual basis, or during the year if an event or other circumstance indicates that we may not be able to recover the carrying amount of the asset. In evaluating these assets for impairment, the Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount. If we conclude that it is not more likely than not that the fair value of the reporting unit is less than its carrying value, then no further testing is required. If the conclusion is that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then a two-step impairment test is performed. Since the Company has one reporting unit, the fair value of the Company's net assets is used to determine if goodwill may be impaired. Indefinite life trademarks are considered to be impaired if the net, undiscounted expected cash flows associated with the trademark are less than their carrying amount. Loan Loss Reserves The Company segregates its notes receivable for the purposes of evaluating allowances for credit losses between two categories: Mezzanine and Other Notes Receivable and Forgivable Notes Receivable. The Company utilizes the level of security it has in the various notes receivable as its primary credit quality indicator (i.e. senior, subordinated or unsecured) when determining the appropriate allowances for uncollectible loans within these categories. Mezzanine and Other Notes Receivables The Company has provided financing to franchisees in support of the development of properties in strategic markets. The Company expects the owners to repay the loans in accordance with the loan agreements, or earlier as the hotels mature and capital markets permit. The Company estimates the collectibility and records an allowance for loss on its mezzanine and other notes receivable when recording the receivables in the Company's financial statements. These estimates are updated quarterly based on available information. The Company considers a loan to be impaired when, based on current information and events, it is probable that it will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. The Company measures loan impairment based on the present value of expected future cash flows discounted at the loan's original effective interest rate or the estimated fair value of the collateral. For impaired loans, the Company establishes a specific impairment reserve for the difference between the recorded investment in the loan and the present value of the expected future cash flows or the estimated fair value of the collateral. The Company applies its loan impairment policy individually to all mezzanine and other notes receivable in the portfolio and does not aggregate loans for the purpose of applying such policy. For impaired loans, the Company recognizes interest income on a cash basis. If it is likely that a loan will not be collected based on financial or other business indicators it is the Company's policy to charge off these loans to SG&A expenses in the accompanying consolidated statements of income in the quarter when it is deemed uncollectible. Recoveries of impaired loans are recorded as a reduction of SG&A expenses in the quarter received. The Company assesses the collectibility of its senior notes receivable by comparing the market value of the underlying assets to the carrying value of the outstanding notes. In addition, the Company evaluates the property's operating performance, the borrower's compliance with the terms of the loan and franchise agreements, and all related personal guarantees that have been provided by the borrower. For subordinated or unsecured receivables, the Company assesses the property's operating performance, the subordinated equity available to the Company, the borrower's compliance with the terms of loan and franchise agreements, and the related personal guarantees that have been provided by the borrower. 46-------------------------------------------------------------------------------- Table of Contents The Company considers loans to be past due and in default when payments are not made when due. Although the Company considers loans to be in default if payments are not received on the due date, the Company does not suspend the accrual of interest until those payments are more than 30 days past due. The Company applies payments received for loans on non-accrual status first to interest and then principal. The Company does not resume interest accrual until all delinquent payments are received. Forgivable Notes Receivable In certain instances, the Company may provide financing to franchisees for property improvements and other purposes in the form of forgivable promissory notes which bear interest at market rates. Under these promissory notes, the franchisee promises to repay the principal sum together with interest upon maturity unless certain conditions are met throughout the term of the promissory note. The principal sum and related interest are forgiven ratably over the term of the promissory note if the franchisee remains in the system in good standing. If during the term of the promissory note, the franchisee exits our franchise system or is not operating their franchise in accordance with our quality or credit standards, the Company may declare a default under the promissory note and commence collection efforts with respect to the full amount of the then-current outstanding principal and interest. In accordance with the terms of the promissory notes, the initial principal sum and related interest are ratably reduced over the term of the loan on each anniversary date until the outstanding amounts are reduced to zero as long as the franchisee remains within the franchise system and operates in accordance with our quality and brand standards. As a result, the amounts recorded as an asset on the Company's consolidated balance sheet are also ratably reduced since the amounts forgiven no longer represent probable future economic benefits to the Company. The Company records the reduction of its recorded assets through amortization and marketing and reservation system expenses on its consolidated statements of income. The Company fully reserves all defaulted notes in addition to recording a reserve on the estimated uncollectible portion of the remaining notes. For those notes not in default, the Company calculates an allowance for losses and determines the ultimate collectibility on these forgivable notes based on the historical default rates for those unsecured notes that are not forgiven but are required to be repaid. The Company records bad debt expense in SG&A and marketing and reservation system expenses in the accompanying consolidated statements of income in the quarter when the note is deemed uncollectible. Stock Compensation. The Company's policy is to recognize compensation cost related to share-based payment transactions in the financial statements based on the fair value of the equity or liability instruments issued. Compensation expense related to the fair value of share-based awards is recognized over the requisite service period based on an estimate of those awards that will ultimately vest. The Company estimates the share-based compensation expense for awards that will ultimately vest upon inception of the grant and adjusts the estimate of share-based compensation for those awards with performance and/or service requirements that will not be satisfied so that compensation cost is recognized only for awards that ultimately vest. Income Taxes. Income taxes are recorded using the asset and liability method of accounting for income taxes. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets if it is more likely than not such assets will be unrealized. Deferred U.S. income taxes have not been recorded for temporary differences related to investments in certain foreign subsidiaries and corporate affiliates. The temporary differences consist primarily of undistributed earnings that are considered permanently reinvested in operations outside the U.S. If management's intentions change in the future, deferred taxes may need to be provided. With respect to uncertain income tax positions, a tax liability is recorded in full when management determines that the position does not meet the more likely than not threshold of being sustained on examination. A tax liability may also be recognized for a position that meets the more likely than not threshold, based upon management's assessment of the position's probable settlement value. The Company records interest and penalties on unrecognized tax benefits in the provision for income taxes. Pension, Profit Sharing and Incentive Plans The Company sponsors two non-qualified retirement savings and investment plans for certain employees and senior executives. Employee and Company contributions are maintained in separate irrevocable trusts. Legally, the assets of the trusts remain those of the Company; however, access to the trusts' assets is severely restricted. The trusts' cannot be revoked by the Company or an acquirer, but the assets are subject to the claims of the Company's general creditors. The participants do not have the right to assign or transfer contractual rights in the trusts. 47-------------------------------------------------------------------------------- Table of Contents In 2002, the Company adopted the Choice Hotels International, Inc. Executive Deferred Compensation Plan ("EDCP") which became effective January 1, 2003. Under the EDCP, certain executive officers may defer a portion of their salary into an irrevocable trust. Prior to January 1, 2010, participants could elect an investment return of either the annual yield of the Moody's Average Corporate Bond Rate Yield Index plus 300 basis points, or a return based on a selection of available diversified investment options. Effective January 1, 2010, the Moody's Average Corporate Bond Rate Yield Index plus 300 basis points is no longer an investment option for salary deferrals made on compensation earned after December 31, 2009. The Company recorded current and long-term deferred compensation liabilities of $10.1 million and $11.7 million, as of March 31, 2013 and December 31, 2012, respectively, related to these deferrals and credited investment returns. Compensation expense is recorded in SG&A expense on the Company's consolidated statements of income based on the change in the deferred compensation obligation related to earnings credited to participants as well as changes in the fair value of diversified investments. Compensation expense recorded in SG&A for the three months ended March 31, 2013 and 2012 was $0.3 million and $0.4 million, respectively. In addition, the EDCP Plan held shares of the Company's common stock with a market value of $0.2 million and $0.1 million at March 31, 2013 and December 31, 2012, respectively which were recorded as a component of shareholders' deficit. The Company has invested the employee salary deferrals in diversified long-term investments which are intended to provide investment returns that partially offset the earnings credited to the participants. The diversified investments held in the trusts totaled $3.4 million and $6.0 million as of March 31, 2013 and December 31, 2012, respectively, and are recorded at their fair value, based on quoted market prices. At March 31, 2013, the Company expects $0.4 million of the assets held in the trusts to be distributed to participants during the next twelve months. These investments are considered trading securities and therefore the changes in the fair value of the diversified assets is included in other gains and losses in the accompanying consolidated statements of income. The Company recorded investment gains during the three months ended March 31, 2013 and 2012 of approximately $0.1 million and $1.1 million, respectively. In 1997, the Company adopted the Choice Hotels International, Inc. Non-Qualified Retirement Savings and Investment Plan ("Non-Qualified Plan"). The Non-Qualified Plan allows certain employees who do not participate in the EDCP to defer a portion of their salary and invest these amounts in a selection of available diversified investment options. As of March 31, 2013 and December 31, 2012, the Company had recorded a deferred compensation liability of $12.2 million and $11.2 million, respectively, related to these deferrals. Compensation expense is recorded in SG&A expense on the Company's consolidated statements of income based on the change in the deferred compensation obligation related to earnings credited to participants as well as changes in the fair value of diversified investments. The net increase in compensation expense recorded in SG&A for the three months ended March 31, 2013 and 2012 was $0.8 million and 0.9 million, respectively. The diversified investments held in the trusts were $10.9 million and $10.2 million as of March 31, 2013 and December 31, 2012, respectively, and are recorded at their fair value, based on quoted market prices. These investments are considered trading securities and therefore the changes in the fair value of the diversified assets is included in other gains and losses in the accompanying consolidated statements of income. The Company recorded investment gains during the three months ended March 31, 2013 and 2012 of approximately $0.6 million and $0.9 million, respectively. In addition, the Non-Qualified Plan held shares of the Company's common stock with a market value of $1.2 million and $1.0 million at March 31, 2013 and December 31, 2012, respectively, which are recorded as a component of shareholders' deficit. New Accounting Standards See Footnote No. 1 of the Notes to our Financial Statements for information related to our adoption of new accounting standards in 2013 and for information on our anticipated adoption of recently issued accounting standards. FORWARD-LOOKING STATEMENTS Certain matters discussed in this quarterly report constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Generally, our use of words such as "expect," "estimate," "believe," "anticipate,", "should", "will," "forecast," "plan"," project," "assume" or similar words of futurity identify such forward-looking statements. These forward-looking statements are based on management's current beliefs, assumptions and expectations regarding future events, which in turn are based on information currently available to management. Such statements may relate to projections of the Company's revenue, earnings and other financial and operational measures, Company debt levels, ability to repay outstanding indebtedness, payment of dividends, and future operations, among other matters. We caution you not to place undue reliance on any such forward-looking statements. Forward-looking statements do not guarantee future performance and involve known and unknown risks, uncertainties and other factors. Several factors could cause actual results, performance or achievements of the Company to differ materially from those expressed in or contemplated by the forward-looking statements. Such risks include, but are not limited to, changes to general, 48-------------------------------------------------------------------------------- Table of Contents domestic and foreign economic conditions; operating risks common in the lodging and franchising industries; changes to the desirability of our brands as viewed by hotel operators and customers; changes to the terms or termination of our contracts with franchisees; our ability to keep pace with improvements in technology utilized for reservations systems and other operating systems; fluctuations in the supply and demand for hotels rooms; the level of acceptance of alternative growth strategies we may implement; the outcome of litigation; and our ability to effectively manage our indebtedness. These and other risk factors are discussed in detail in the Risk Factors section of the Company's Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission on February 28, 2013. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. [ Back To TMCnet.com's Homepage ]