Compound Annual Growth (In thousands, except percentages) 1996 1995 1994 1993 Rate Operating Results Revenues $266,625 $236,513 $222,561 $214,565 7.5% Operating income before property transactions 123,874 101,648 91,762 64,758 24.1% Operating income 128,841 103,590 92,388 66,103 24.9% Income before income taxes and extraordinary items 109,888 75,579 63,117 30,795 52.8% Net income 64,724 46,579 36,319 16,926 56.4% EBITDA (a) 152,831 117,027 104,544 77,456 25.4% Financial Position Total assets $631,965 $519,809 $413,308 $438,016 13.0% Current portion of long-term debt 288 278 533 1,052 (35.1)% Long-term debt (b) 243,682 229,479 188,725 172,326 12.2% Total equity 248,089 167,367 143,008 180,522 11.2% Cash Flows Provided by (used in) Operating activities $84,796 $77,835 $58,187 $54,343 Investing activities (98,119) (102,837) 1,571 (895) Financing activities Advances from (to) Parent - 14,840 (60,975) (51,367) Other 14,355 10,609 (219) (667) Capital expenditures 157,543 115,714 18,379 20,885 1996 1995 1994 1993 Financial Percentages and Ratios Operating margin before property transactions 46.5% 43.0% 41.2% 30.2% Operating margin 48.3% 43.8% 41.5% 30.8% Return on revenues 24.3% 18.5% 16.3% 7.9% Return on average invested capital 15.8% 14.5% 13.7% 8.0% Return on average equity 31.2% 28.2% 22.5% 8.6% Ratio of earnings to fixed charges 4.3 3.2 3.0 1.9 Current ratio 0.5 0.4 0.7 0.5 Ratio of book equity to total debt 1.0 0.7 0.8 1.0 Ratio of market equity to total debt 6.2 5.0 - - Ratio of EBITDA to interest paid 8.1 6.7 6.1 4.2 Ratio of debt to EBITDA 1.6 2.0 1.8 2.2 14 (a) EBITDA, consisting of income before extraordinary items plus interest, taxes, depreciation, amortization and cash distributions from nonconsolidated affiliates less earnings from nonconsolidated affiliates, is a supplemental financial measurement used by management, as well as by industry analysts, to evaluate Promus Hotel Corporation's operations. However, EBITDA should not be construed as an alternative to operating income (as an indicator of operating performance) or to cash flows from operating activities (as a measure of liquidity) as determined in accordance with generally accepted accounting principles. (b) Includes debt allocated to Promus Hotel Corporation by its Parent for periods prior to the Spin-Off. 15 PERFORMANCE STATISTICS Compound Compound Number of Hotels Annual Number of Rooms/Suites Annual ------------------------------ Growth --------------------------------- Growth 1996 1995 1994 Rate 1996 1995 1994 Rate - ----------------------------------------------------------------------------------------------------------------------------------- Embassy Suites Company owned 9 9 9 - 2,025 2,025 2,025 - Joint venture 22 23 23 (2.2)% 5,578 5,901 5,912 (2.9)% Management contract (a) 47 27 24 39.9 % 11,461 6,280 6,022 38.0 % Franchised 58 55 51 6.6 % 13,583 12,529 11,756 7.5 % - ----------------------------------------------------------------------------------------------------------------------------------- 136 114 107 12.7 % 32,647 26,735 25,715 12.7 % - ----------------------------------------------------------------------------------------------------------------------------------- Hampton Inn Company owned 12 14 15 (10.6)% 1,654 1,916 2,047 (10.1)% Joint venture 19 19 19 - 2,376 2,376 2,376 - Management contract 5 4 4 11.8 % 678 464 464 20.9 % Franchised 584 483 399 21.0 % 62,830 52,958 45,184 17.9 % - ----------------------------------------------------------------------------------------------------------------------------------- 620 520 437 19.1 % 67,538 57,714 50,071 16.1 % - --------------------------------------------------------------------------------------------------------------------------------- Homewood Suites Company owned 7 9 8 (6.5)% 800 1,024 932 (7.4)% Management contract 4 - - - 471 - - - Franchised 26 21 18 20.2 % 2,628 2,071 1,949 16.1 % - ----------------------------------------------------------------------------------------------------------------------------------- 37 30 26 19.3 % 3,899 3,095 2,881 16.3 % - ----------------------------------------------------------------------------------------------------------------------------------- Hampton Inn & Management Suites contract 1 - - - 127 - - - Franchised 15 5 - - 1,719 573 - - - ----------------------------------------------------------------------------------------------------------------------------------- 16 5 - - 1,846 573 - - - ----------------------------------------------------------------------------------------------------------------------------------- Total System Company owned 28 32 32 (6.5)% 4,479 4,965 5,004 (5.4)% Joint venture 41 42 42 (1.2)% 7,954 8,277 8,288 (2.0)% Management contract (a) 57 31 28 42.7 % 12,737 6,744 6,486 40.1 % Franchised 683 564 468 20.8 % 80,760 68,131 58,889 17.1 % - ----------------------------------------------------------------------------------------------------------------------------------- 809 669 570 19.1 % 105,930 88,117 78,667 16.0 % - ----------------------------------------------------------------------------------------------------------------------------------- Managed Franchised Total --------------------------------------------------------------------------------------------- 1996 1995 1996 1995 1996 1995 - ----------------------------------------------------------------------------------------------------------------------------------- Embassy Vacation Resort properties 2 1 1 1 3 2 Resort (b) Timeshare units 164 48 207 207 371 255 Timeshare intervals available 8,364 2,448 10,557 10,557 18,921 13,005 Timeshare intervals sold 3,098 1,523 1,426 281 4,524 1,804 - ----------------------------------------------------------------------------------------------------------------------------------- Compound Compound Comparable System Hotels(c) Annual Total System Hotels Annual ----------------------------- Growth ------------------------------------- Growth 1996 1995 1994 Rate 1996 1995 1994 Rate - ----------------------------------------------------------------------------------------------------------------------------------- Embassy Suites Occupancy 75.2% 74.6% 75.0% 0.1 % 73.6% 74.2% 74.9% (0.9)% ADR $108.22 $102.33 $96.66 5.8 % $107.36 $101.90 $97.28 5.1 % RevPAS 81.41 76.38 72.51 6.0 % 79.00 75.61 72.86 4.1 % - ----------------------------------------------------------------------------------------------------------------------------------- Hampton Inn Occupancy 73.6% 75.1% 75.0% (0.9)% 72.1% 73.7% 74.3% (1.5)% ADR $ 60.85 $ 56.90 $53.61 6.5 % $ 60.84 $ 56.97 $53.46 6.7 % RevPAR 44.78 42.75 40.23 5.5 % 43.85 42.01 39.74 5.0 % - ----------------------------------------------------------------------------------------------------------------------------------- Homewood Suites Occupancy 77.2% 78.5% 79.2% (1.3)% 73.2% 76.9% 78.1% (3.2)% ADR $ 88.57 $ 82.20 $76.12 7.9 % $ 90.40 $ 82.42 $76.38 8.8 % RevPAS 68.41 64.53 60.31 6.5 % 66.14 63.37 59.67 5.3 % - ----------------------------------------------------------------------------------------------------------------------------------- Hampton Inn & Occupancy - - - - 63.9% 59.4% - - Suites ADR - - - - $ 73.41 $ 70.13 - - RevPAS - - - - 46.89 41.65 - - - ----------------------------------------------------------------------------------------------------------------------------------- Total System Room Revenues Compound ------------------------------------------------------------- Annual (In thousands) 1996 1995 1994 Growth Rate - ------------------------------------------------------------------------------------------------------------------------- Hampton Inn $ 997,422 $ 823,247 $ 677,803 21.3% Embassy Suites 852,647 719,378 687,670 11.4% Homewood Suites 84,492 68,353 62,080 16.7% Hampton Inn & Suites 18,878 2,901 - - - ------------------------------------------------------------------------------------------------------------------------- $ 1,953,439 $ 1,613,879 $ 1,427,553 17.0% - ------------------------------------------------------------------------------------------------------------------------- (a) The December 31, 1995 numbers exclude four Crown Sterling Suites properties with 1,076 suites being managed by Promus, but not yet converted to the Embassy Suites brand. All 16 Crown Sterling Suites properties had been converted to the Embassy Suites brand and included in these numbers as of December 31, 1996. (b) 1996 includes a resort under construction in the pre-sales phase. (c) Excludes those hotels that had room additions or were not open for the entire three year reporting period. 17 FINANCIAL REVIEW HIGHLIGHTS Promus Hotel Corporation (Promus or the Company) achieved outstanding financial results in 1996, as net income increased 40.7%, from a pro forma $46.0 million in 1995 to $64.7 million in 1996. This performance resulted primarily from strong growth in system room revenues, from $1.6 billion in 1995 to $2.0 billion in 1996, which in turn generated a 27.2% year over year increase in franchise and management fees. The principal driver of this earnings growth was unit growth, as Promus added a record 143 new hotels to its systems in 1996. Another important contributor to financial performance was a significant increase in the number of hotels under Promus management, which increased 83.9% from 31 in 1995 to 57 in 1996. Growth in the franchise and management components of the Company's business led to an increase in the overall operating margin from 43.8% in 1995 to 48.3% in 1996, a higher margin than any of our direct competitors. Promus' continued focus on its high margin franchise business provides excellent results. During 1996, Promus also improved its financial position and performance statistics with return on average equity increasing from 28.2% to 31.2%, with an increase of 30.6% in EBITDA from $117.0 million in 1995 to $152.8 million in 1996, and EBITDA increasing to 8.1 times interest paid. Promus received an upgrade in its investment grade rating by Standard & Poor's to BBB+ in 1996. Since the Spin-Off, Promus has made significant capital investments to enhance its return to shareholders. Over the past two years, Promus invested $273.3 million to maintain product quality, foster growth and improve its expanding operations. Promus' results coupled with continued financial strength are evidence of the Company's commitment to be a financial performance leader in our industry and to creating value for our shareholders. MANAGEMENT'S DISCUSSION AND ANALYSIS Results of Operations On June 30, 1995, The Promus Companies Incorporated (Parent) completed the transfer of the operations, assets and liabilities of its hotel business (the Hotel Business), to a new publicly-traded entity, Promus Hotel Corporation. As approved by Parent's Board of Directors and stockholders on May 26, 1995, this entity was spun-off (the Spin-Off) from the Parent and its stock was distributed to Parent's stockholders on a one-for-two basis effective June 30, 1995 (the Distribution). Concurrent with the Distribution, Parent changed its name to Harrah's Entertainment, Inc. Through its wholly-owned subsidiary, Promus Hotels, Inc. (PHI), Promus owns, operates and franchises the Embassy Suites, Hampton Inn, Hampton Inn & Suites and Homewood Suites hotel brands primarily through three lines of business: franchise; hotel operations, including management contracts; and hotel real estate and joint venture investments. The Embassy Suites brand is an all-suite hotel brand that management believes comprises the largest all-suite upscale hotel system in the United States by number of hotel suites and system revenue. The Hampton Inn brand offers a limited-facility hotel for the value- conscious consumer and the Homewood Suites brand offers residential-style accommodations designed for the extended-stay traveler. The Hampton Inn & Suites brand is the newest Promus hotel brand which combines, in a single hotel, Hampton style rooms with two-room suites. The Company also operates and licenses an interval ownership system bearing the name Embassy Vacation Resort (EVR). Promus' primary focus is to develop, grow and support its franchise business for all brands. Promus brand hotels are located in almost every state, the District of Columbia and five foreign countries. Promus charges each franchisee royalty fees of generally four percent of suite or room rentals. System-wide room revenues generated by Company owned hotels and reported by franchisees in 1996, 1995 and 1994 were $2.0 billion, $1.6 billion and $1.4 billion, respectively. In addition, Promus earns a licensing fee for new licenses granted to franchisees when the franchise is approved. Promus also receives franchise fees on net interval sales and on suite rental revenues related to EVR properties. [Description of graph contained in document] GROWTH IN FRANCHISE & MANAGEMENT FEES (IN THOUSANDS) 1994: $ 76,874 1995: $ 79,935 1996: $101,653 GROWTH IN RETURN ON AVERAGE EQUITY 1994: 22.5% 1995: 28.2% 1996: 31.2% 18 Promus Hotel Corporation Promus currently operates 128 Promus-brand hotels (including two EVR properties). Company operated properties include wholly-owned, partially owned through joint ventures and hotels managed for third parties. Promus has followed an asset strategy to own and manage a mix of Promus hotels that can impact profits and enhance its role as franchisor for its brands. Management fee income is based on a percentage of gross revenues, profits, or both, at the related managed property. The principal factors affecting Promus' results are: continued growth in the number of hotels; occupancy and room rates achieved by the hotel brands; number and relative mix of owned, managed and franchised hotels; and Promus' ability to manage costs. The number of rooms/suites at franchised and managed properties and revenue per available room/suite (RevPAR/S) significantly affect Promus' results because franchise royalty and management fees are based upon a percentage of rooms/suites revenues. Increases in franchise and management fee revenues have a favorable impact on Promus' operating margin due to minimal incremental costs associated with these incremental revenues. [Description of graph contained in document] GROWTH IN SYSTEM REVENUES (IN BILLIONS) 1994: $1.4 1995: $1.6 1996: $2.0 GROWTH IN NET INCOME (IN THOUSANDS) 1994: $36,319 1995: $46,579 1996: $64,724 Actual historical results of operations for all three years were as follows (in millions, except percentages and per share data): Percentage Increase - ------------------------------------------------------------------------------------------------------------------------------- 1996 1995 1994 96 vs 95 95 vs 94 - ------------------------------------------------------------------------------------------------------------------------------- Revenues $ 266.6 $ 236.5 $ 222.6 12.7% 6.2% Operating income before property transactions 123.9 101.6 91.8 21.9 10.7 Operating income 128.8 103.6 92.4 24.3 12.1 Net income 64.7 46.6 36.3 38.8 28.4 Earnings per share (a) 1.25 0.90 0.70 38.9% 28.6% Operating margin 48.3% 43.8% 41.5% 4.5pts 2.3pts (a) For purposes of computing earnings per share on a comparable basis, the weighted average shares outstanding for periods prior to the Spin-Off are assumed to be equal to the actual common and common equivalent shares outstanding on June 30, 1995. Because Promus began operations as a public company on July 1, 1995, year over year comparison of historical results is difficult. The most notable differences between years relate to the incremental stand-alone public company costs (incurred in the last six months of 1995 and all of 1996), and that prior to the Spin-Off, interest was allocated to Promus from Parent at Parent's higher overall borrowing rate. Results of operations on a pro forma basis were as follows (in millions, except percentages and per share data): Percentage Increase - ------------------------------------------------------------------------------------------------------------------------------- 1996 1995 1994 96 vs 95 95 vs 94 - ------------------------------------------------------------------------------------------------------------------------------- Revenues $ 266.6 $ 236.6 $ 224.1 12.7% 5.6% Operating income before property transactions 123.9 98.4 83.7 25.9 17.6 Operating income 128.8 100.4 84.4 28.3 19.0 Income before property transactions and extraordinary items, net of tax 61.8 42.1 32.0 46.8 31.6 Net income 64.7 46.0 32.4 40.7 42.0 Earnings per share (a) 1.25 0.89 0.63 40.4% 41.3% Operating margin before property transactions 46.5% 41.6% 37.3% 4.9pts 4.3pts Operating margin 48.3% 42.4% 37.7% 5.9pts 4.7pts (a) For purposes of computing earnings per share on a comparable basis, the weighted average shares outstanding for periods prior to the Spin-Off are assumed to be equal to the actual common and common equivalent shares outstanding on June 30, 1995. 19 [Description of graph contained in document] GROWTH IN PRO FORMA EPS 1994: $0.63 1995: $0.89 1996: $1.25 GROWTH IN PRO FORMA OPERATING MARGIN 1994: 37.7% 1995: 42.4% 1996: 48.3% The increases in revenues, operating income and operating margins are primarily a function of the approval and addition of new franchised hotels, additional management contracts (primarily in 1996 as a result of the FelCor Agreements--see Hotel Brand Development), system-wide increases in ADR and cost containment. The 1996 sales of three company owned hotels (a Hampton Inn and two Homewood Suites) and the 1995 sale of a Hampton Inn hotel impact year over year comparison. Additionally, a company owned Embassy Suites restaurant was leased to a third party in 1994 and a restaurant lease was terminated in 1995 which also impacts the year over year comparisons. Company owned hotel revenues for 1996 increased 3.4% or $4.5 million over 1995, while company owned hotel expenses increased only 1.6% or $1.3 million over the same period. For 1995, company owned hotel revenues increased approximately 4.0% or $5.0 million over 1994, while the related operating expenses actually decreased. Although comparable system occupancy rates generally decreased slightly overall in 1996, average daily rates (ADR) have consistently increased, resulting in higher RevPAR/S. On a comparable hotel basis (which excludes those hotels that had room additions or were not open for the entire three year reporting period), 1996 RevPAR/S increased 6.6%, 4.7% and 6.0% over 1995 at Embassy Suites, Hampton Inn and Homewood Suites hotels, respectively. Over the past three years, comparable hotels have posted two year compound annual growth rates in RevPAR/S of 6.0%, 5.5% and 6.5% for Embassy Suites, Hampton Inn and Homewood Suites hotels, respectively. Franchise and management fees increased 27.2% or $21.7 million over 1995. As of December 31, 1996, Promus' combined hotel system had grown to include 809 properties and 105,930 rooms/suites (not including EVR properties), representing 20.9% and 20.2% increases over December 31, 1995, respectively. System expansion plus continued year over year RevPAR/S increases have helped generate a compound annual growth rate in total system room revenues of 17.0% from 1994 to 1996. Due in large part to the acquisition and final conversion of the 16 Crown Sterling Suites hotel properties by FelCor in 1996 (see Hotel Brand Development), rooms under management contracts as of December 31, 1996 increased 88.9% over prior year. This continued unit growth in the franchise systems and the expansion of hotels under management contracts, coupled with the continued focus on rate growth and cost management, were the primary contributors to the Company's higher revenues, margins and operating income as compared to prior year. Property transactions for 1996 include gains on the sale of three company owned hotels to Equity Inns, Inc. (Equity) and Winston Hotels, Inc. (Winston) (see Hotel Brand Development), and the gain related to the sale of the Company's interest in an Embassy Suites joint venture hotel. For 1995, property transaction gains resulted primarily from the sale of a company owned Hampton Inn hotel to a franchisee, while in 1994 they were generated by the sale of a Hampton Inn hotel and the expiration of certain guarantees and contingencies that had caused a portion of prior years' gains to be deferred. In all years, these property transaction gains were partially offset by miscellaneous asset write-offs. Net income for 1996 and 1995 includes approximately $3.4 million and $2.1 million, respectively, of nonrecurring pretax operating income before property transactions from specific transactions related to the restructuring of two joint venture Embassy Suites hotels. Additionally, net income for 1994 includes approximately $4.2 million of pretax nonrecurring operating income before property transactions related primarily to franchise terminations and the release of certain contingencies. Excluding the impact of the nonrecurring items and property transactions discussed above, and extraordinary items, 1996 net income on a pro forma basis increased 46.4% over 1995, and 38.2% from 1994 to 1995. 20 Promus Hotel Corporation The following comparison of expenses and other items is based on pro forma results for 1995 and 1994 (in millions, except percentages): Percentage Increase/(Decrease) - ------------------------------------------------------------------------------------------------------------------------------- 1996 1995 1994 96 vs 95 95 vs 94 - ------------------------------------------------------------------------------------------------------------------------------- Interest expense, net of interest capitalized $ (29.0) $ (28.9) $ (29.6) 0.3 % (2.4)% Dividend income 5.7 0.5 - N/M N/M Interest and other income 4.4 2.6 1.5 69.2 % 73.3 % Extraordinary items, net of income tax - 2.8 - N/M N/M Effective tax rate 41.1% 42.1% 42.5% (1.0)pts (0.4)pts Interest expense was relatively flat year over year due primarily to a decrease in interest expense attributable to the Company's nonconsolidated subsidiaries, offset by increases in interest related to deferred compensation balances and the revolving credit facility. Although the interest rates obtained by the Company during 1996 were favorable to 1995 rates, average outstanding debt balances were higher. The decrease in nonconsolidated subsidiaries' interest expense resulted primarily from the joint venture restructurings described above as the properties' debt was replaced with additional equity investments. Also contributing to the decrease are the more favorable terms that have been secured on several other joint ventures' debt instruments over the past year. The decrease in interest expense from 1994 to 1995 was primarily attributable to lower rates of interest partially offset by higher average debt balances allocated to Promus from Parent before the Spin- Off and increases in interest attributable to deferred compensation balances. Dividend income in 1996 and 1995 relates to Promus' investments in three Real Estate Investment Trusts (REITs) (see Hotel Brand Development). Interest and other income has increased due primarily to increased mezzanine loans with franchisees and interest charged on Promus' investment in the franchise system. During 1995, two Embassy Suites hotels in which the Company has a 50 percent interest realized extraordinary gains related to the early payoff and forgiveness of a portion of their existing debt. The cash to fund the early debt payoffs was made available through additional capital contributions to the joint ventures of approximately $10 million from each of its partners. Promus' share of these nonconsolidated affiliates' gains, net of applicable income tax expense, was $2.8 million. The effective tax rate for all periods is higher than the federal statutory rate primarily due to state income taxes. Hotel Brand Development Overall There were 140 net hotels (17,813 rooms) added to the Promus hotel systems during 1996 compared with 99 (9,450 rooms) in 1995. This continued development growth is impressive considering that, per the latest available information provided by Smith Travel Research as of December 31, 1996, Promus hotel brands had a 3.0% share of the entire United States room supply and accounted for 12.7% of new rooms, excluding casino related hotel rooms, added to the market from ground-up construction during 1996. The acquisition and final conversion of the Crown Sterling Suites hotels to the Embassy Suites brand was the primary reason for the brand adding 22 hotels and 5,912 suites in 1996, representing 19.3% and 22.1% increases over 1995, respectively. The Hampton Inn, Hampton Inn & Suites and Homewood Suites brands together added a net 118 hotels and 11,901 rooms in 1996, representing 21.3% and 19.4% increases over 1995, respectively. Promus increased its development pipeline at year end 1996 by 20.2% to 351 properties either in the design or construction phase. As of December 31, 1996, 145 properties were under construction (excluding EVR properties), 141 of which will operate under franchise licenses: 95 Hampton Inn hotels; 12 Embassy Suites hotels; 17 Homewood Suites hotels and 17 Hampton Inn & Suites hotels. The 145 properties will add nearly 16,000 rooms or suites to the Promus hotel system. The remaining 206 hotels in the pipeline were approved and in the design phase at December 31, 1996, although construction had not yet begun. Homewood Suites and Hampton Inn & Suites Brand Development Promus' internal development plans over the next several years will be focused on growing the newer and therefore less mature Homewood Suites and Hampton Inn & Suites hotel brands. During 1996, Promus opened eight Homewood Suites hotels and eleven Hampton Inn & Suites hotels. Of the 206 hotels in the design phase at December 31, 1996, 29 were Homewood Suites and another 29 were Hampton Inn & Suites. The Company plans to follow its overall strategy of growing these brands through franchise and management contracts, but recognizes some franchisees' difficulty in obtaining conventional financing for such projects. As a result, the Company has initiated several programs designed to bridge the gap between the financing that is currently available and the equity required by the prospective owners. During 1996, Promus entered into strategic development alliances with Equity and Winston whereby Promus will invest up to $15.0 million in the common stock of both the Equity and Winston REITs as they purchase existing or to be constructed 21 FINANCIAL REVIEW (Continued) Promus hotels from the Company. Promus currently plans to build approximately seven to ten Homewood Suites and/or Hampton Inn & Suites properties per year at an average cost of $7-10 million per property. Of those hotels built each year, several are expected to be offered for sale to Equity and Winston at Promus' cost of construction. Promus will receive 20-year license agreements and 10-year management contracts for all hotels developed or purchased pursuant to these alliances. During 1996, two existing company owned properties were sold to Equity and one to Winston for cash proceeds of $25.5 million. Additionally, two hotels were developed for and sold to Equity at Promus' cost of construction. As a result of these property sales, Promus has invested $7.1 million and $1.5 million in the common stock of the Equity and Winston REITs, respectively. Based on the market value of that common stock as of December 31, 1996, Promus recorded an unrealized gain of $1.1 million (before tax) directly to stockholders' equity. Promus has also developed a mezzanine financing program. Under the program, Promus provides conservatively underwritten secondary financing to franchisees. A minimum of 20 percent equity is required by the borrower, and the investment must meet certain defined underwriting criteria. The terms of the first mortgage and the mezzanine financing must be acceptable to Promus and the first mortgage lender, with whom Promus will enter into an inter- creditor agreement. Promus provided $6.9 million in mezzanine loans during 1996, and anticipates providing an additional $16.0 million in mezzanine loans during 1997. Additionally, $2.8 million was repaid during the year. Outstanding loans bear interest at rates ranging from 10.0% to 10.25%. Embassy Suites Brand Development In May 1995, Promus entered into a Subscription Agreement with FelCor Suite Hotels, Inc. and FelCor Suites Limited Partnership (FelCor) whereby Promus purchased $25.0 million in FelCor limited partnership interests to help fund the partnership's acquisition of all-suite upscale hotels converted to the Embassy Suites brand. In September 1995, Promus entered into a second agreement with FelCor in connection with FelCor's agreement to acquire the Crown Sterling Suites hotel chain. FelCor has converted 16 of the Crown Sterling Suites hotels acquired (over 4,000 suites) to the Embassy Suites brand. In consideration, Promus made a $50.0 million investment in FelCor common stock and has guaranteed repayment of up to $25.0 million of a third party loan advanced to FelCor. Hotels converted to the Embassy Suites brand under these agreements operate under 20-year license agreements, and 10-year management contracts have been awarded to Promus. Subject to some restrictions, the limited partnership interests may be converted to shares of FelCor common stock on a one-for-one basis and the common stock may be sold on the open market. As of December 31, 1996, FelCor had acquired 24 all-suite hotel properties (including 16 Crown Sterling Suites hotels) under these agreements. Of the eight non-Crown Sterling Suites hotels acquired, five had been Embassy Suites hotels before their acquisition, and two of those five were already being managed by Promus. Based on the market value of FelCor common stock as of December 31, 1996, Promus has recorded an unrealized gain of $26.7 million (before tax) directly to stockholders' equity. This unrealized gain, as well as the unrealized gain on the Equity and Winston common stock investments, will change with increases or decreases in the market value of the common stock; however, no earnings impact will be realized until the stock is actually sold. Including the properties acquired pursuant to these agreements, FelCor owned or had an interest in 40 Embassy Suites hotels as of December 31, 1996, which represents 4.9% and 9.3% of all Promus brand hotels and hotel rooms, respectively. Those 40 hotels contributed approximately 10.6% of total system revenues and 11.4% of the Company's franchise and management fee revenue for 1996. Subsequent to year end, FelCor acquired an ownership interest in an additional eight Embassy Suites hotels that are already managed by Promus. Promus has also entered into an agreement with Remington Hotel Corporation and Nomura Asset Capital Corporation to develop ten Embassy Suites hotels that will incorporate a new 150-200 suite prototype design. Promus will provide a portion of the total project capital through a form of mezzanine financing. Investments pursuant to this agreement are expected to total approximately $6.0 million in 1997. The Company has two managed and one franchised EVR properties. The resort at Poipu Point on the Hawaiian island of Kauai was converted to the EVR brand and has 207 suites. The resort in Orlando, Florida, which is under construction, has 102 suites open and will add an additional 268 suites over the next four years. Construction is underway on the resort in South Lake Tahoe, California, which will add 210 suites over the next five years. Sales of timeshare intervals are underway at all three resorts. Promus has entered into a five-year joint venture development agreement with Vistana Development, Ltd. (Vistana) to acquire, develop, manage and market vacation ownership resorts in North America under Promus brand names. Vistana will serve as managing partner and project developer, and will market the timeshare units. Promus will serve as franchisor and manager of these joint venture properties. Promus will own a 50 percent interest in each project. Capital Spending Investment in Franchise System Promus made additional investments in its franchise system infrastructure during 1996 relating primarily to the addition of new system hotels, enhancements made to the systems already in place at existing hotels and the construction of a new reser- 22 Promus Hotel Corporation vation call center in Tampa, Florida. During 1996, the Company invested approximately $15.0 million and plans to spend an additional $7.0 million in 1997 on franchise system expansion and enhancements. Other Ongoing refurbishment of Promus' existing company owned hotel properties to maintain the quality standards set for those properties will continue in 1997 at an estimated annual cost of approximately $12 million. During 1996, $10.6 million in costs were incurred for hotel refurbishment. During 1996, Promus incurred $12.7 million in costs to renovate its corporate headquarters. An additional $3 million is estimated to be spent on the renovation in 1997. Cash necessary to finance projects currently under development, as well as additional projects to be developed by Promus, will be made available from operating cash flows, the Promus Facility (see Liquidity and Capital Resources), joint venture partners, specific project financing, sales of existing hotel assets and, if necessary, Promus debt and equity offerings. Promus' capital expenditures totaled $157.5 million during 1996. The Company expects to spend approximately $150 million during 1997 to fund hotel and EVR development, to refurbish existing facilities, for investments in the common stock of Equity and Winston, for hotel business systems, to make advances under mezzanine loan agreements and for other corporate related projects. However, some of these expenditures are expected to be offset by the receipt of proceeds from additional hotel sales to Equity and Winston. Liquidity and Capital Resources The accompanying financial statements, for periods before the Spin-Off, represent the portion of Parent's historical revenues, expenses, assets, liabilities and cash flows associated with the Hotel Business. The 1995 and 1994 year to date results of operations and cash flows do not provide accurate indications of Promus' future results as a separate corporation. The most significant items that will affect liquidity and capital resources as a result of the Spin-Off are incremental costs associated with operating as a stand alone company, a decrease in the Company's average borrowing rate, and Promus' payment of state and federal income taxes and interest expense subsequent to the Distribution (Parent historically paid both). Cash flows from operating activities were $84.8 million, $77.8 million and $58.2 million in 1996, 1995 and 1994, respectively. Year over year comparisons are difficult due primarily to the fact that prior to the Spin-Off, income taxes and interest expense were assumed to be paid in the period incurred. If those amounts had also been paid in the year they were incurred subsequent to the Spin-Off, cash flows from operating activities would have been $92.8 million, $73.5 million and $58.2 million in 1996, 1995 and 1994, respectively, resulting in increases over the prior year of 26.3% in both 1996 and 1995, respectively. [Description of graph contained in document] GROWTH IN EBITDA (IN THOUSANDS) 1994: $104,544 1995: $117,027 1996: $152,831 Earnings before interest, taxes, depreciation and amortization plus cash distributions from nonconsolidated affiliates less earnings from nonconsolidated affiliates (EBITDA) is a supplemental financial measurement used by management as well as by industry analysts to evaluate operations. It should not be construed as an alternative to operating income (as an indicator of operating performance) or to cash flows from operating activities (as a measure of liquidity) as determined in accordance with generally accepted accounting principles. A comparison of EBITDA and the related margins is as follows (dollars in millions): Percentage Increase - ------------------------------------------------------------------------------------------------------------------------------- 1996 1995 1994 96 vs 95 95 vs 94 - ------------------------------------------------------------------------------------------------------------------------------- EBITDA $ 152.8 $ 117.0 $ 104.5 30.6% 12.0% EBITDA margin 57.3% 49.5% 47.0% 7.8pts 2.5pts EBITDA to interest paid 8.1x 6.7x 6.1x 1.4pts 0.6pts On December 31, 1996, the Company had a working capital deficit of $27.8 million, which is a $3.6 million improvement over the deficit at December 31, 1995. The working capital deficit results primarily from Promus' cash management program whereby all excess cash is used to pay down amounts outstanding under the Promus Facility. Therefore, the Company does not believe that the current ratio is an appropriate measure of its short-term liquidity without considering availability under the Promus Facility. 23 FINANCIAL REVIEW (Continued) During 1995 the Company entered into the Promus Facility which consists of two agreements, the significant terms of which are as follows: Total Maturity Interest Facility Facility Date Rate Fees - --------------------------------------------------------------------------------------------------------------------------------- Base Rate, as defined, or 0.10% of the total facility Five-Year Revolver $300,000,000 November 1, 2001 LIBOR +22.5 basis points Base Rate, as defined, or 0.08% of the total facility Extendible Revolver $ 50,000,000 June 4, 1997 LIBOR +24.5 basis points The Extendible Revolver is a 364-day facility with annual renewals and may be converted into a two-year term loan with equal amortizing payments over such two-year period. Facility fees and interest on Base Rate loans are paid quarterly. The agreements contain a tiered scale for facility fees and the applicable LIBOR spread (current rates for both reflected above) that is based on the more favorable of Promus' current credit rating (recently upgraded by Standard & Poor's to BBB+) or the leverage ratio, as defined. They also contain provisions that restrict certain investments, limit the Company's ability to incur additional indebtedness and pay dividends, and require that certain performance ratios be maintained. As of December 31, 1996 and 1995, Promus was in compliance with all such covenants. The Five-Year Revolver includes a sublimit for letters of credit of $20.0 million. At December 31, 1996, approximately $12.4 million in letters of credit were outstanding under this agreement (related primarily to the Company's self-insurance reserves). There was approximately $94.5 million of availability under the Promus Facility as of December 31, 1996. The remaining borrowing capacity available under the Promus Facility is available for working capital, hotel development and other general corporate purposes. Both the Extendible Revolver and the Five-Year Revolver are unsecured. As of December 31, 1996, Promus was a party to several interest rate swap agreements that bear a total notional amount of $100.0 million. The effect of the swap agreements was to convert a portion of the Company's variable rate debt under the Promus Facility to a fixed rate of interest. The weighted average effective fixed rate pursuant to the agreements, which expire between December 1998 and March 2000, was approximately 7.2% at December 31, 1996. The Company has filed a shelf registration for up to $300 million in debt securities with the Securities and Exchange Commission. The securities issuable under the registration statement may be offered from time to time in one or more series, in amounts, at prices and on terms to be determined at the time of the offerings. Relationship With Parent For the purpose of governing certain of the ongoing relationships between Promus and Parent after the Distribution and to provide mechanisms for an orderly transition, Parent and Promus have entered into various agreements and adopted policies to govern their future relationship. Management believes that the agreements are fair to both parties and contain terms comparable to those which would have been reached in arm's-length negotiations with unaffiliated parties (although comparisons are difficult with respect to certain agreements that relate to the specific circumstances of the Distribution). Tax Sharing Agreement In connection with the Spin-Off, Promus and Parent entered into a tax sharing agreement that defines each company's rights and obligations with respect to deficiencies and refunds of federal, state and other income or franchise taxes relating to Promus' business for tax years prior to the Distribution and with respect to certain tax attributes of Promus after the Distribution. In general, with respect to periods ending on or before December 31, 1995, Parent is responsible for (i) filing federal tax returns for Parent and Promus for the periods such companies were members of the same consolidated group, and (ii) paying the taxes relating to such returns (to include any subsequent adjustments resulting from the redetermination of such tax liabilities by the applicable taxing authorities; Promus will reimburse Parent for the portion of such adjustments relating to the Hotel Business). Promus is responsible for filing returns and paying taxes for periods beginning after the Spin-Off. Effects of Inflation and Current Economic Condition Generally, Promus has not experienced any significant negative effect on its hotels and food and beverage operations because of inflation. To date, Promus has been able to increase rates and prices and thereby pass on the effects of inflationary cost increases. Although competitive conditions may limit the industry's future ability to raise room rates at the rate of inflation, management believes that each of its hotel brands has rate growth potential in excess of the inflation rate. Promus will continue to emphasize cost containment and productivity improvement programs. Inflation tends to increase the underlying value of Promus' real estate and management and franchise contracts. Although significant growth in the general economy is not expected for 1997, moderate but stable growth is anticipated in the hotel industry, as demand is increasing at a greater rate than supply. Promus hotel brands lead the industry in the percentage of guests who intend to make return visits, and in guest satisfaction, due largely to the 100% Satisfaction Guarantee offered unconditionally throughout the entire Promus hotel system. 24 Promus Hotel Corporation MANAGEMENT'S REPORT ON FINANCIAL STATEMENTS Promus is responsible for preparing the financial statements and related information appearing in this report. Management believes that the financial statements present fairly its financial position, its results of operations and its cash flows in conformity with generally accepted accounting principles. In preparing its financial statements, Promus is required to include amounts based on estimates and judgments which it believes are reasonable under the circumstances. Promus maintains accounting and other control systems designed to provide reasonable assurance that financial records are reliable for purposes of preparing financial statements and that assets are properly accounted for and safeguarded. Compliance with these systems and controls is reviewed through a program of audits by an internal auditing staff. Limitations exist in any internal control system, recognizing that the system's cost should not exceed the benefits derived. The Board of Directors pursues its responsibility for Promus' financial statements through its Audit Committee, which is composed solely of directors who are not officers or employees of Promus. The Audit Committee meets from time to time with the independent public accountants, management and the internal auditors. Promus' internal auditors report directly to, and the independent public accountants have access to, the Audit Committee, with and without the presence of management representatives. Michael D. Rose Chairman of the Board Jeffery M. Jarvis Vice President, Controller & Chief Accounting Officer REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Promus Hotel Corporation: We have audited the accompanying consolidated balance sheets of Promus Hotel Corporation (a Delaware corporation) and subsidiaries (Promus) as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years ended December 31, 1996. These financial statements are the responsibility of Promus' management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Promus as of December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the three years ended December 31, 1996, in conformity with generally accepted accounting principles. [Arthur Andersen LLP] Memphis, Tennessee February 5, 1997 25 CONSOLIDATED BALANCE SHEETS As of December 31 (In thousands, except share amounts) 1996 1995 --------- --------- ASSETS Current assets Cash and cash equivalents $ 3,700 $ 2,668 Receivables, including notes receivable of $264 and $497, less allowance for doubtful accounts of $1,180 and $1,172 18,307 14,837 Deferred income taxes (Note 6) 932 3,492 Prepayments and other (Note 3) 7,626 2,429 --------- --------- Total current assets 30,565 23,426 --------- --------- Land, buildings, furniture and equipment Land 56,231 60,818 Buildings and improvements 255,495 259,224 Furniture, fixtures and equipment 127,346 107,139 --------- --------- 439,072 427,181 Less: accumulated depreciation (118,659) (101,534) --------- --------- 320,413 325,647 Investments in and advances to nonconsolidated affiliates (Note 11) 186,766 90,506 Investment in franchise system 48,750 37,899 Deferred costs and other 45,471 42,331 --------- --------- $ 631,965 $ 519,809 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payable $ 20,753 $ 18,202 Accrued expenses (Note 3) 37,361 36,371 Current portion of long-term debt (Note 4) 288 278 --------- --------- Total current liabilities 58,402 54,851 --------- --------- Long-term debt (Note 4) 243,682 229,479 Deferred credits and other 40,834 36,282 Deferred income taxes (Note 6) 40,958 31,830 --------- --------- 383,876 352,442 --------- --------- Commitments and contingencies (Notes 5 through 7) Stockholders' equity (Note 9) Common stock, $0.10 par value, 360,000,000 shares authorized, 51,399,117 and 51,371,152 shares outstanding, net of 5,698 and 2,626 shares held in treasury 5,140 5,137 Capital surplus 136,513 136,057 Retained earnings 90,073 25,349 Deferred compensation related to restricted stock (Note 8) (598) (998) Unrealized gain on marketable equity securities, net of related deferred tax liability of $10,844 and $1,165 16,961 1,822 --------- --------- 248,089 167,367 --------- --------- $ 631,965 $ 519,809 ========= ========= The accompanying notes are an integral part of these consolidated balance sheets. 26 Promus Hotel Corporation CONSOLIDATED STATEMENTS OF INCOME For the years ended December 31 (In thousands) 1996 1995 1994 -------- -------- -------- Revenues Company owned hotels Rooms $121,000 $116,094 $110,205 Food and beverage 6,353 7,180 8,001 Other 7,190 6,805 6,879 Franchise and management fees 101,653 79,935 76,874 Other 30,429 26,499 20,602 -------- -------- -------- Total revenues 266,625 236,513 222,561 -------- -------- -------- Operating expenses Company owned hotels Rooms 58,823 56,228 56,952 Food and beverage 5,982 6,832 7,760 Other 12,452 12,946 12,547 Other operating expenses 26,182 24,111 26,764 Depreciation expense 22,246 20,890 18,829 Corporate expense 17,066 13,858 7,947 -------- -------- -------- Total operating expenses 142,751 134,865 130,799 -------- -------- -------- Operating income before property transactions 123,874 101,648 91,762 Property transactions 4,967 1,942 626 -------- -------- -------- Operating income 128,841 103,590 92,388 Interest expense, net of interest capitalized (Notes 4 and 11) (29,016) (31,138) (30,759) Dividend income 5,713 547 - Interest and other income 4,350 2,580 1,488 -------- -------- -------- Income before income taxes and extraordinary items 109,888 75,579 63,117 Provision for income taxes (Note 6) (45,164) (31,819) (26,798) -------- -------- -------- Income before extraordinary items 64,724 43,760 36,319 Extraordinary items, net of income tax of $1,635 (Note 10) - 2,819 - -------- -------- -------- Net income $ 64,724 $ 46,579 $ 36,319 ======== ======== ======== Earnings per share $1.25 (a) (a) ======== ======== ======== (a) Not applicable; see Note 2 (Earnings Per Share). The accompanying notes are an integral part of these consolidated financial statements. 27 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the years ended December 31 (Note 9) Deferred Compensation Unrealized Related to Gain on Common Stock Restricted Marketable Parent ---------------- Capital Retained Stock Equity Company (In thousands) Shares Amount Surplus Earnings (Note 8) Securities Investment Total ------ ------ ------- -------- ------------ ---------- ---------- -------- Balance--December 31, 1993 - $ - $ - $ - $ - $ - $ 180,522 $180,522 Net income - - - - - - 36,319 36,319 Intercompany activity with Parent - - - - - - (73,833) (73,833) ------- ------ ------- -------- ------------ ---------- ---------- -------- Balance--December 31, 1994 - - - - - - 143,008 143,008 Net income--January 1, 1995 through June 30, 1995 - - - - - - 21,230 21,230 Intercompany activity with Parent--January 1, 1995 through June 30, 1995 - - - - - - (24,656) (24,656) Spin-Off of the Company (Note 1) 51,352 5,135 135,801 - (1,354) - (139,582) - Shares issued under incentive compensation plan 8 1 174 - (175) - - - ------- ------ ------- -------- ------------ ---------- --------- -------- Balance--June 30, 1995 51,360 5,136 135,975 - (1,529) - - 139,582 Net income--July 1, 1995 through December 31, 1995 - - - 25,349 - - - 25,349 Net shares issued under incentive compensation plans, including income tax benefit of $97 11 1 82 - 531 - - 614 Unrealized gain on marketable equity securities, net of related deferred tax liability of $1,165 - - - - - 1,822 - 1,822 ------- ------ ------- -------- ------------ ---------- --------- -------- Balance--December 31, 1995 51,371 5,137 136,057 25,349 (998) 1,822 - 167,367 Net income - - - 64,724 - - - 64,724 Net shares issued under incentive compensation plans, including income tax benefit of $130 28 3 456 - 400 - - 859 Unrealized gain on marketable equity securities, net of related deferred tax liability of $9,679 - - - - - 15,139 - 15,139 ------- ------ -------- -------- ---------- ---------- ---------- -------- Balance--December 31, 1996 51,399 $5,140 $136,513 $90,073 $ (598) $16,961 $ - $248,089 ======= ====== ======== ======== ========== ========== ========== ======== The accompanying notes are an integral part of these consolidated financial statements. 28 Promus Hotel Corporation CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31 (Note 12) (In thousands) 1996 1995 1994 -------- --------- -------- Cash flows from operating activities Net income $ 64,724 $ 46,579 $ 36,319 Adjustments to reconcile net income to cash flows from operating activities Extraordinary items - (4,454) - Depreciation and amortization 24,942 24,063 21,226 Other noncash items (4,869) (2,217) (2,762) Equity in earnings and distributions from nonconsolidated affiliates 807 (61) 2,969 Net gains from property transactions (3,107) (2,159) (280) Net change in long-term accounts 4,826 2,089 5,637 Net change in working capital accounts (2,527) 13,995 (4,922) -------- --------- -------- Cash flows provided by operating activities 84,796 77,835 58,187 -------- --------- -------- Cash flows from investing activities Land, buildings, furniture and equipment additions (56,301) (55,872) (13,626) Proceeds from property transactions 43,537 7,843 19,164 Investments in and advances to nonconsolidated affiliates (76,835) (47,832) (1,657) Advances under Mezzanine loan agreements (6,887) (7,899) (1,000) Repayments under Mezzanine loan agreements 2,750 1,500 - Proceeds from sale of equity investments 2,224 - - Net investment in franchise system (17,520) (4,111) (2,096) Recovery of investment in franchise system 6,703 4,249 3,507 Other 4,210 (715) (2,721) -------- --------- -------- Cash flows (used in) provided by investing activities (98,119) (102,837) 1,571 -------- --------- -------- Cash flows from financing activities Net borrowings under revolving credit facility 14,500 10,600 - Debt retirements (286) (284) (219) Advances from (to) Parent - 14,840 (60,975) Other 141 293 - -------- --------- -------- Cash flows provided by (used in) financing activities 14,355 25,449 (61,194) -------- --------- -------- Net increase (decrease) in cash and cash equivalents 1,032 447 (1,436) Cash and cash equivalents, beginning of year 2,668 2,221 3,657 -------- --------- -------- Cash and cash equivalents, end of year $ 3,700 $ 2,668 $ 2,221 ======== ========= ======== The accompanying notes are an integral part of these consolidated financial statements. 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996 NOTE 1--BASIS OF PRESENTATION AND ORGANIZATION On June 30, 1995, The Promus Companies Incorporated (Parent) completed the transfer of the operations, assets and liabilities of its hotel business (the Hotel Business), to a new publicly-traded entity, Promus Hotel Corporation (Promus or the Company). As approved by Parent's Board of Directors and stockholders on May 26, 1995, this entity was spun-off (the Spin-Off) from the Parent and its stock was distributed to Parent's stockholders on a one-for-two basis effective June 30, 1995 (the Distribution). Concurrent with the Distribution, Parent changed its name to Harrah's Entertainment, Inc. Through its wholly-owned subsidiary (Promus Hotels, Inc.), Promus owns, operates and franchises the Embassy Suites, Hampton Inn, Hampton Inn & Suites, and Homewood Suites hotel brands primarily through three lines of business: franchise; hotel operations, including management contracts; and hotel real estate and joint venture investments. The Embassy Suites brand is a full- service hotel brand that management believes comprises the largest all-suite upscale hotel system in the United States by number of suites and system revenue. The Hampton Inn brand is a limited-service hotel for the value- conscious consumer and the Homewood Suites brand offers residential-style accommodations designed for the extended stay traveler. The Hampton Inn & Suites brand is the newest Promus hotel brand that combines, in a single hotel, Hampton style rooms with two-room suites. The Company also operates and licenses an interval ownership system bearing the name Embassy Vacation Resort (EVR). Promus' primary focus is to develop, grow and support its franchise business for all brands. Promus hotel brands are located in virtually every state, the District of Columbia and five foreign countries. Promus charges each franchisee royalty fees of generally four percent of suite or room rentals. System-wide room revenues generated by company owned hotels and reported by franchisees in 1996, 1995 and 1994 were $2.0 billion, $1.6 billion and $1.4 billion, respectively. In addition, Promus earns a licensing fee for new licenses granted to franchisees when the franchise is approved. Promus also receives franchise fees on net interval sales and on suite revenue related to EVR properties. Promus currently operates more than 125 Promus-brand hotels. Company operated properties include wholly-owned, partially owned through joint ventures and hotels managed for third parties. Promus has followed an asset strategy to own and manage a mix of Promus hotels that can impact profits and enhance its role as franchisor. Management fee income is based on a percentage of gross revenues, profits, or both at the related managed property. NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The accompanying financial statements for periods before the Spin-Off, represent the portion of Parent's historical revenues, expenses, assets, liabilities and cash flows associated with the Hotel Business. The preparation of these financial statements required the use of certain estimates by management in determining the Company's assets, liabilities, revenues and expenses. All significant intercompany accounts and transactions have been eliminated. Investments in 50% or less owned companies and joint ventures over which Promus has the ability to exercise significant influence are accounted for using the equity method. Promus reflects its share of income before interest expense and extraordinary gain of these nonconsolidated affiliates in revenues - -other. Promus' proportionate share of interest expense and extraordinary gain of such nonconsolidated affiliates is included in interest expense and extraordinary items, respectively, in the consolidated statements of income (see Note 11 for combined summarized financial information regarding these nonconsolidated affiliates). Management believes Promus' inclusion of its proportionate share of the interest expense of its equity investees in interest expense is the preferable presentation due to the nature of its equity investments. Cash Equivalents Cash equivalents are highly liquid investments with a maturity of less than three months and are stated at the lesser of cost or market. Land, Buildings, Furniture and Equipment Land, buildings, furniture and equipment are stated at cost. Land includes land held for future development or disposition which totaled $7.4 million and $9.6 million at December 31, 1996 and 1995, respectively. Improvements and extraordinary repairs that extend the life of the asset are capitalized. Maintenance and repairs are expensed as incurred. Construction in progress, which is reflected in buildings and improvements in the accompanying consolidated balance sheets, was $32.2 million and $20.2 million at December 31, 1996 and 1995, respectively. Interest expense is capitalized on constructed assets at Promus' overall weighted average borrowing rate. The Company capitalized interest of $1.6 million and $1.4 million in 1996 and 1995, respectively. No material amounts of capitalized interest were recorded during 1994. 30 Promus Hotel Corporation Depreciation expense is calculated using the straight-line method over the estimated useful life of the assets or over the related lease term, as follows: Buildings and improvements 10 to 40 years Furniture, fixtures and equipment 2 to 15 years Investment in Franchise System Promus' investment in franchise system includes the costs for computer systems to operate the centralized marketing and reservation center and a property management system that interacts with several operational software packages which are available to each Promus franchised hotel. Promus is reimbursed for these costs by the respective brand system fund over their estimated useful lives. Generally, the owner of each hotel, including Promus' company owned hotels, contributes 3.5 to 4.0 percent of suite or room revenues to its brand's fund. Revenue Recognition Room revenue represents revenue derived from the rental of rooms and suites for hotels majority owned by Promus. Food and beverage revenues represent revenues from company owned restaurants and lounges. Amortization Deferred management and franchise contract costs are amortized on a straight-line basis over the term of the related contract, generally 10 to 20 years. Deferred finance charges are amortized over the term of the related debt agreement (see Note 4). Property Transactions Property transactions include gains and losses from asset sales, including sales of joint venture equity interests, write-downs of assets to net realizable value and the ongoing costs of Promus' asset management staff. The operations of properties sold are included in the financial statements through the date of sale. Treasury Stock Shares of Promus' common stock held in treasury are reflected in the consolidated balance sheets and consolidated statements of stockholders' equity as if they were retired. Earnings Per Share Earnings per share is computed by dividing net income by the number of weighted average common shares outstanding during the year, including common stock equivalents. Earnings per share for 1996, 1995 and 1994, respectively, were $1.25, $0.90 and $0.70. For purposes of computing earnings per share on a comparable basis, the weighted average shares outstanding for periods prior to the Spin-Off are assumed to be equal to the actual common and common equivalent shares outstanding on June 30, 1995. Reclassifications Certain amounts for prior years have been reclassified to conform with the presentation for 1996. Other The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. NOTE 3--DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS Prepayments and other consisted of the following (in thousands): 1996 1995 ------- ------- Prepayments $ 6,811 $ 1,557 Other current assets 598 666 Supplies 217 206 ------- ------- $ 7,626 $ 2,429 ------- ------- Accrued expenses consisted of the following (in thousands): 1996 1995 ------- ------- Self-insurance reserves $16,051 $ 8,934 Payroll and other compensation 9,321 7,424 Taxes, other than income taxes 4,217 3,658 Deposits and customer funds 2,906 4,794 Income taxes - 4,290 Other 4,866 7,271 ------- ------- $37,361 $36,371 ======= ======= NOTE 4--LONG-TERM DEBT Parent Debt Allocation The Company's financial position, and its results of operations prior to June 30, 1995, reflects all indebtedness, together with related interest expense, specifically identified with Promus entities, as well as a pro rata portion of Parent's historical corporate debt balance, unamortized deferred finance charges and interest expense. Allocations of those amounts to Promus from Parent were based on the percentage of Parent's historical corporate debt that was expected to be retired using proceeds from Promus' $350 million bank credit facility (the Promus Facility). Parent's corporate interest expense, including amortization of deferred finance costs allocated to Promus before the Spin-Off, was $10.5 million (which represents interest through June 30, 1995). 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Promus Facility The Promus Facility consists of a $300 million revolving credit arrangement which matures on November 1, 2001 (the Five-Year Revolver) and a $50 million annually extendible revolving credit facility (the Extendible Revolver). The Extendible Revolver is convertible into a two-year term loan with equal amortizing payments over such two-year period. Interest on the drawn portion of the Promus Facility is, at the option of the Company, equal to either (i) the Base Rate, as defined, or (ii) LIBOR plus the applicable spread, which was approximately 6.8% (including the LIBOR spread, facility fees and the impact of interest rate swaps) on a weighted average basis for 1996. Both agreements incorporate a tiered scale that defines the applicable LIBOR spread and a facility fee based upon the more favorable of the Company's current debt rating or leverage ratio, as defined. Currently, LIBOR spread on the Five-Year Revolver and the Extendible Revolver is 0.225% and 0.245%, respectively, and the facility fee required on the total amount of the Five-Year Revolver and the Extendible Revolver is 0.10% and 0.08%, respectively. Both the Extendible Revolver and the Five-Year Revolver are unsecured. The Promus Facility contains provisions that restrict certain investments, limit the Company's ability to incur additional indebtedness and pay dividends, and require that certain performance ratios be maintained. As of December 31, 1996 and 1995, Promus was in compliance with all such covenants. The Five-Year Revolver also provides a sublimit for letters of credit of $20 million. At December 31, 1996, approximately $12.4 million in letters of credit were outstanding under this agreement. As of December 31, Promus' indebtedness consisted of the following (in thousands): 1996 1995 -------- -------- Amounts outstanding under the Promus Facility $243,100 $228,600 Notes payable and other- unsecured, 13%, maturities to 1999 564 776 Mortgages, 8.0%-8.75%, maturities to 2005 243 271 Capital lease obligations, 8.2%-13.4%, maturities to 1999 63 110 -------- -------- 243,970 229,757 Current portion of long-term debt (288) (278) -------- -------- $243,682 $229,479 ======== ======== Aggregate annual maturities of long-term debt subsequent to December 31, 1996 were: 1997, $288,000; 1998, $330,000; 1999, $92,000; 2000, $36,000; 2001, $243,139,000, and $85,000 thereafter. Interest Rate Agreements As of December 31, 1996, Promus was a party to several interest rate swap agreements that help the Company manage the relative mix of its debt between fixed and variable rate instruments. These agreements effectively modify the interest characteristics of its outstanding debt without an exchange of the underlying principal amount. Pursuant to the agreements, Promus receives a variable interest rate tied to LIBOR in exchange for its payments at a fixed interest rate. The fixed rates to be paid by Promus are summarized in the following table: Next Quarterly Notional Amount Swap Rate Variable Rate (All Associated with Paid Effective Rate Adjustment Swap Promus Facility) (Fixed) at December 31 Date Maturity - ------------------------------------------------------------------------------ $50.0 million 6.99% 7.315% 03/20/1997 03/20/2000 $12.5 million 6.92% 7.245% 03/17/1997 12/15/1998 $12.5 million 6.68% 7.005% 03/17/1997 12/15/1999 $12.5 million 6.74% 7.065% 01/22/1997 01/22/1999 $12.5 million 6.52% 6.845% 01/22/1997 01/24/2000 The differences to be paid or received under the terms of the interest rate swap agreements described above are accrued as an adjustment to interest expense for the related debt. Changes in the effective interest rates to be paid by Promus pursuant to the terms of its interest rate agreements will have a corresponding effect on its future cash flows. These agreements contain a credit risk that the counterparties may be unable to meet the terms of the agreements. Promus minimizes that risk by evaluating the creditworthiness of its counterparties, which are limited to major banks and financial institutions, and does not anticipate nonperformance by the counterparties. Fair Market Value Because the terms of the Promus Facility provide that borrowings outstanding under those agreements bear interest at current market rates, management believes that the related liabilities reflected in the accompanying consolidated balance sheets as of December 31, 1996 and 1995, approximate fair market value. The fair market value of the Company's other material financial instruments as of December 31, 1996 and 1995, were as follows (in thousands): 1996 1995 ------ ------ Interest rate agreements (used for hedging purposes) Carrying value $ 92 $ 55 Market value 2,123 5,056 The amount reflected as the "carrying value" of the interest rate agreements represents the accrual balance as of the date reported. The "market value" of the interest rate agreements represents the estimated amount, considering the prevailing interest rates, that Promus would pay to terminate the agreements as of the date reported. 32 Promus Hotel Corporation NOTE 5--COMMITMENTS AND CONTINGENCIES Contractual Commitments Promus is liable under certain lease agreements pursuant to which it has assigned the direct obligation to third party interests. Additionally, Promus manages certain hotels for others under agreements that provide for payments or loans to the hotel owners if stipulated levels of financial performance are not maintained. The Company has also provided guarantees for certain loans related to joint venture investments. Management believes the likelihood is remote that material payments will be required under these agreements. Promus' estimated maximum exposure under such agreements is approximately $38.1 million over the next 30 years. FelCor Agreements In May 1995, Promus entered into a Subscription Agreement with FelCor Suite Hotels, Inc. and FelCor Suites Limited Partnership (FelCor) whereby Promus purchased $25 million in FelCor limited partnership interests to help fund the partnership's acquisition of all-suite upscale hotels converted to the Embassy Suites brand. In September 1995, Promus entered into a second agreement with FelCor in connection with FelCor's agreement to acquire the Crown Sterling Suites hotel chain. FelCor has converted 16 of the Crown Sterling Suites hotels they acquired (over 4,000 suites) to the Embassy Suites brand. In consideration, Promus made a $50 million investment in FelCor common stock and has guaranteed repayment of up to $25 million of a third party loan advanced to FelCor. Hotels converted to the Embassy Suites brand under these agreements operate under 20-year license agreements, and 10-year management contracts have been awarded to Promus. Subject to some restrictions, the limited partnership interests may be converted to shares of FelCor common stock on a one-for-one basis and the common stock may be sold on the open market. FelCor owns or had an interest in 40 Embassy Suites hotels as of December 31, 1996, which represents 4.9% and 9.3% of all Promus brand hotels and hotel rooms, respectively. Those 40 hotels contributed approximately 10.6% of total system revenues and 11.4% of the Company's franchise and management fee revenue for 1996. Subsequent to year end, FelCor acquired an ownership interest in an additional eight Embassy Suites hotels that are already managed by Promus. Equity Inns and Winston Agreements During 1996, Promus entered into strategic development alliances with Equity Inns, Inc. (Equity) and Winston Hotels, Inc. (Winston) whereby Promus will invest up to $15 million in the common stock of both Equity and Winston as they purchase existing or to be constructed Promus hotels from the Company. Promus will receive 20-year license agreements and 10-year management contracts for all hotels developed or purchased pursuant to these alliances. As of December 31, 1996, Promus had invested $7.1 million and $1.5 million in the common stock of Equity and Winston, respectively. Litigation The Company is a party to various inquiries, administrative proceedings and litigation relating to contracts, sales of property and other matters arising in the normal course of business. While any proceeding or litigation has an element of uncertainty, management believes that the final outcome of these matters will not have a materially adverse effect upon Promus' consolidated financial position or its results of operations. Employment and Severance Agreements Promus has severance agreements with 15 senior officers of the Company that provide for a payment of 2.99 times the average annual cash compensation (salary and bonus) paid to each such executive for the five preceding calendar years, including such compensation paid during service with Parent, as well as accelerated payment of any compensation or awards payable to such executive under any Promus incentive compensation or stock option plan if the executive is terminated subsequent to a change in control of Promus, as defined. The maximum amount of compensation that would be payable under all agreements, if a change in control occurred and if such executives were terminated, as of December 31, 1996, would be approximately $24.4 million. Self-Insurance Reserves Promus self-insures various levels of general liability, workers' compensation and employee medical coverage. All self-insurance reserves include accruals of estimated settlements for known claims, as well as accruals of actuarial estimates of incurred but not reported claims. These estimates are based on historical information along with certain assumptions about future events. Changes in assumptions for such things as medical costs and legal expenses, as well as changes in actual experience, could cause these estimates to change significantly in the near term. NOTE 6--INCOME TAXES Income tax expense attributable to income before income taxes and extraordinary items consisted of the following (in thousands): 1996 1995 1994 ------- ------- ------- Current Federal $35,553 $22,252 $25,396 State 6,442 2,889 1,154 Deferred Federal 3,068 3,004 248 State 101 3,674 - ------- ------- ------- $45,164 $31,819 $26,798 ======= ======= ======= In addition to taxes provided for income before income taxes and extraordinary items, Promus provided $1.6 million for extraordinary items during 1995 and $9.7 million and $1.2 million for unrealized gains on marketable equity securities in 1996 and 1995, respectively. The differences between the statutory federal 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) income tax rate and the effective tax rate expressed as a percentage of income before income taxes were as follows: 1996 1995 1994 ----- ----- ----- Statutory tax rate 35.0% 35.0% 35.0% Increases in tax resulting from State taxes, net of federal tax benefit 3.8 5.6 1.8 Other 2.3 1.5 5.7 ----- ----- ----- 41.1% 42.1% 42.5% ===== ===== ===== Components of Promus' net deferred tax liability included in the consolidated balance sheets were as follows (in thousands): 1996 1995 -------- -------- Deferred tax assets Compensation $ 5,250 $ 4,581 Deferred income 4,300 4,760 Bad debt reserve 848 703 Self-insurance reserves 418 562 Other 601 1,565 -------- -------- 11,417 12,171 -------- -------- Deferred tax liabilities Investments in nonconsolidated affiliates (24,649) (14,430) Property and equipment (24,204) (23,896) Franchise system fund prepayments (1,921) (1,333) Basis difference in other assets (669) (850) -------- -------- (51,443) (40,509) -------- -------- Net deferred tax liability $(40,026) $(28,338) ======== ======== Tax Sharing Agreement In connection with the Spin-Off, Promus and Parent entered into a tax sharing agreement that defines each company's rights and obligations with respect to deficiencies and refunds of federal, state and other income or franchise taxes relating to Promus' business for tax years prior to the Distribution and with respect to certain tax attributes of Promus after the Distribution. In general, with respect to periods ending on or before December 31, 1995, Parent is responsible for (i) filing federal tax returns for Parent and Promus for the periods such companies were members of the same consolidated group, and (ii) paying taxes relating to such returns (to include any subsequent adjustments resulting from the redetermination of such tax liabilities by the applicable taxing authorities; Promus will reimburse Parent for the portion of such adjustments relating to the Hotel Business). Promus is responsible for filing returns and paying taxes for periods beginning after the Spin-Off. NOTE 7--LEASES Promus leases both real estate and equipment used in its operations through operating and capital leases. Leases which transfer substantially all benefits and risks incidental to ownership of the property are capitalized. In addition to minimum rentals, many leases provide for contingent rents based on percentages of revenue. The average remaining term for operating leases, which generally contain renewal options, extends approximately 11 years. The costs of leased assets are amortized over periods not in excess of the lease terms. Rental expense associated with operating leases included in the consolidated statements of income was as follows (in thousands): 1996 1995 1994 ------ ------ ------ Noncancelable rental expense Minimum $1,904 $3,828 $2,400 Contingent 1,987 852 740 Other 1,011 863 790 ------ ------ ------ $4,902 $5,543 $3,930 ====== ====== ====== The future minimum rental commitments as of December 31, 1996, were as follows (in thousands): Noncancelable Operating Leases ---------------- 1997 $ 1,523 1998 1,167 1999 1,010 2000 1,010 2001 1,010 Thereafter 12,050 ------- $17,770 ======= Minimum rental commitments exclude contingent rentals, which may be paid under certain leases based on a percentage of revenues in excess of specified amounts. NOTE 8--EMPLOYEE BENEFIT PLANS Savings and Retirement Plan Promus has a defined contribution savings and retirement plan (S&RP) in which participating employees may elect to make pre-tax and after-tax contributions of up to 16 percent of their eligible earnings, the first six percent of which Promus will match fully. Amounts contributed to the plan are invested in one or more investment funds, at the participant's option. Participants become vested in Promus' matching contributions over seven years of credited service, including any previous credited service under Parent's plan. In November 1996, Promus reduced the vesting period for the S&RP participants to two years. Promus recognized contribution expense related to the Promus S&RP of $1.1 million and $0.4 million in 1996 and 1995, respectively. 34 Promus Hotel Corporation Restricted Stock Promus has a restricted stock plan (RSP) under which executives and key employees may be awarded shares of Promus' common stock. Shares granted under the Promus RSP are restricted as to transfer, are subject to forfeiture prior to vesting and will generally vest evenly over periods from two to four years. The deferred compensation expense is amortized over the vesting period. This expense totaled $0.3 million and $0.5 million in 1996 and 1995, respectively. Stock Option Plan Under the Promus 1995 Stock Option Plan (SOP), the Company may grant options to its employees not to exceed 3,600,000 shares of common stock. The exercise price of each option equals the market price of Promus stock on the date of grant. Options generally vest over a four year period and have an expiration date ten years after grant. Promus applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations in accounting for the SOP. Accordingly, no compensation cost has been recognized in the statements of income for this stock option plan. In accordance with Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," Promus has estimated the fair value of each option grant using the Black-Scholes option-pricing model. Concurrent with the Spin-Off, options were issued by Promus to replace Parent's options being held by Promus management. These replacement options were issued with identical remaining terms and conditions as the Parent options. The following weighted average assumptions were used for the replacement options and additional grants in 1995 and 1996, respectively: expected volatility of 30 percent; risk-free interest rates of 5.9%, 6.2% and 6.0%; expected lives of 4.5, 5.3 and 5.0; and no dividends. Had compensation cost for the SOP awards been determined based on their fair value at the grant dates, Promus' net income and earnings per share would have been reduced to the pro forma amounts indicated below (in thousands, except earnings per share): 1996 1995 ------- ------- Net income As reported $64,724 $46,579 Pro forma 60,108 42,425 Earnings per share As reported $1.25 $0.90 Pro forma 1.16 0.82 A summary of stock option transactions since the Spin-Off is as follows: Options Outstanding --------------------------- Common Stock Weighted Average Available for Price Number Grant ---------------- ------ ------------ Replacement options-- June 30, 1995 $16.82 1,238,839 2,361,161 Granted 24.47 711,150 (711,150) Exercised 4.12 (13,763) - Canceled 24.14 (24,171) 24,171 ------ --------- --------- Balance--December 31, 1995 19.66 1,912,055 1,674,182 Granted 31.33 803,492 (803,492) Exercised 12.65 (30,223) - Canceled 23.81 (107,985) 107,985 ------ --------- --------- Balance--December 31, 1996 $23.21 2,577,339 978,675 ====== ========= ========= Options exercisable at December 31, 1995 $ 6.59 262,660 1996 12.11 540,421 The weighted average fair value of options granted based on the Black- Scholes option-pricing model for the replacement options granted in 1995, all other 1995 grants and all 1996 option grants were $12.28, $9.39 and $11.59, respectively. The following table summarizes information about options outstanding at December 31, 1996: Options Outstanding Options Exercisable -------------------------------------------------- --------------------------------- Number Number Outstanding at Weighted Average Exercisable at December 31, Remaining Weighted Average December 31, Weighted Average Range of Exercise Prices 1996 Contractual Life Exercise Price 1996 Exercise Price - ------------------------ -------------- ---------------- ---------------- -------------- ---------------- $ 2.41 to $ 6.76 299,429 4.4 $ 4.85 254,691 $ 4.73 $ 9.62 to $19.45 405,875 7.0 14.61 168,559 12.72 $21.87 to $25.63 982,998 8.6 24.83 71,779 25.63 $27.19 to $32.13 889,037 9.4 31.53 45,392 29.87 --------- ---- ------ ------- ------ 2,577,339 8.1 $23.21 540,421 $12.11 ========= ==== ====== ======= ====== 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Deferred Compensation Plans Promus has deferred compensation plans under which certain employees may defer a portion of their compensation. Amounts deposited into these plans are unsecured and earn interest at rates approved by the Human Resources Committee of the Board of Directors. In connection with the administration of the executive deferred compensation plan, company owned life insurance policies insuring the lives of certain directors, officers and key employees have been purchased. As of December 31, 1996 and 1995, the total liability under these plans was $11.2 million and $8.4 million, and the related cash surrender value of life insurance policies was $12.1 million and $11.3 million, respectively. Stock Incentive Plan The Company established the Promus 1996 Non-Management Directors Stock Incentive Plan under which (i) directors will automatically receive each May 1, August 1, November 1 and February 1, in lieu of cash payments, shares of Promus common stock based upon one-half of the meeting and retainer fees earned and the fair market value of Promus common stock and (ii) may elect to receive the remaining one-half of compensation due in the form of a cash payment or as Promus common stock. Shares issued under the plan are restricted as to transfer for at least six months after the date of grant. NOTE 9--STOCKHOLDERS' EQUITY In addition to its common stock, the Company has the following classes of stock authorized but unissued: Preferred stock, $100 par value, 150,000 shares authorized Special stock--Series A, $1.125 par value, 5,000,000 shares authorized One special right is attached to each outstanding share of common stock. These rights entitle the holders to purchase, under certain conditions, units consisting of fractional shares of Special stock--Series A at a purchase price of $120 per unit, subject to adjustment. The rights also, under certain conditions, entitle the holders to purchase $240 worth of common stock for $120. These rights expire on May 1, 2005, unless Promus decides to redeem them earlier at $0.01 per right or upon the occurrence of certain other events. NOTE 10--EXTRAORDINARY ITEMS During 1995, two Embassy Suites hotels, in which the Company has a 50 percent interest, realized extraordinary gains related to the early payoff and forgiveness of a portion of their existing debt. Promus' share of these nonconsolidated affiliates' gains was $2.8 million, net of income tax expense of $1.6 million. There were no extraordinary items reported in 1996 or 1994. NOTE 11--NONCONSOLIDATED AFFILIATES Combined summarized balance sheet information and income statements of nonconsolidated affiliates which Promus accounted for using the equity method as of December 31, 1996 and 1995, and for the three fiscal years ended December 31, 1996, were as follows (in thousands): 1996 1995 1994 -------- -------- -------- Combined Summarized Balance Sheet Information Current assets $ 31,236 $ 33,578 Land, buildings and equipment, net 313,741 366,624 Other assets 24,276 18,435 -------- -------- Total assets 369,253 418,637 -------- -------- Current portion of long- term debt 25,540 187,339 Other current liabilities 9,906 13,059 Long-term debt 239,061 86,292 Other liabilities 1,530 1,696 -------- -------- Total liabilities 276,037 288,386 -------- -------- Net assets $ 93,216 $130,251 ======== ======== Combined Summarized Income Statements Revenues $158,722 $157,748 $157,686 ======== ======== ======== Operating income $ 40,839 $ 35,161 $ 32,240 ======== ======== ======== Net income $ 28,165 $ 16,438 $ 5,221 ======== ======== ======== Promus' share of its nonconsolidated affiliates' combined net income is reflected in the accompanying consolidated statements of income as follows (in thousands): 1996 1995 1994 -------- -------- -------- Pre-interest operating income (included in revenues--other) $ 23,059 $ 19,569 $ 18,077 ======== ======== ======== Interest expense (included in interest expense) $(11,218) $(12,899) $(12,749) ======== ======== ======== Extraordinary gain on forgiveness of debt (included in extraordinary items, net) $ - $ 4,454 $ - ======== ======== ======== 36 Promus Hotel Corporation The components of investments in and advances to nonconsolidated affiliates as of December 31 were as follows (in thousands): 1996 1995 -------- ------- At market $111,859 $33,016 At equity 64,217 39,868 At cost 10,690 17,622 -------- ------- $186,766 $90,506 ======== ======= Certain Promus joint venture investments have been reduced below zero due to Promus' intention to fund its share of operating losses in the future, if needed. The total amount of these negative investments included in deferred credits and other liabilities in the consolidated balance sheets was $3.8 million and $5.2 million at December 31, 1996 and 1995, respectively. NOTE 12--SUPPLEMENTAL CASH FLOW INFORMATION The increase (decrease) in cash and cash equivalents due to the changes in long-term and working capital accounts was as follows (in thousands): 1996 1995 1994 ------- ------- ------- Long-term accounts Deferred costs and other assets $ (649) $(2,508) $(1,155) Deferred credits and other long-term liabilities 5,475 4,597 6,792 ------- ------- ------- Net change in long- term accounts $ 4,826 $ 2,089 $ 5,637 ======= ======= ======= Working capital accounts Accrued expenses $ 4,112 $ 9,725 $ 744 Accounts payable 2,549 7,824 (4,410) Receivables (3,864) (3,206) (859) Prepayments and other (5,324) (348) (397) ------- ------- ------- Net change in working capital accounts $(2,527) $13,995 $(4,922) ======= ======= ======= Supplemental Disclosure of Noncash Investing and Financing Activities Concurrent with the Spin-Off, the historical assets and liabilities of the Hotel Business were transferred to Promus by Parent, and the issuance of Promus common stock was completed in connection with the Distribution. These noncash transactions have been excluded from the consolidated statements of cash flows. Supplemental Disclosure of Cash Paid for Interest and Taxes The following table reconciles Promus' interest expense, net of interest capitalized, to cash paid for interest (in thousands): 1996 1995 1994 -------- -------- -------- Interest expense, net of amount capitalized (Note 4) $ 29,016 $ 31,138 $ 30,759 Adjustments to reconcile to cash paid for interest: Promus' share of interest expense of nonconsolidated affiliates (Note 11) (11,218) (12,899) (12,749) Capitalized interest 1,614 1,428 - Net change in accruals 192 (1,117) - Amortization of deferred finance charges (605) (785) (733) Net amortization of discounts and premiums - (8) (45) Other (154) (246) (143) -------- -------- -------- Cash paid for interest $ 18,845 $ 17,511 $ 17,089 ======== ======== ======== Cash paid for income taxes $ 49,842 $ 15,075 $ - ======== ======== ======== For purposes of this presentation, interest expense allocated to Promus by Parent is assumed to have been paid in the year allocated. Parent was responsible for the payment of Promus' income taxes for periods prior to the Spin-Off (Note 6). 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 13--SUMMARIZED FINANCIAL INFORMATION Promus Hotels, Inc. (PHI) is a wholly-owned subsidiary of Promus and the primary entity through which the operations of Promus are conducted. PHI is also Promus' principal asset. Summarized financial information for PHI, prepared on the same basis as Promus, as of and for the years ended December 31, is as follows (in thousands): 1996 1995 1994 -------- ------- ------ ASSETS Current assets $ 29,397 $ 23,246 Land, buildings and equipment, net 320,413 325,647 Other assets 269,626 169,961 -------- -------- 619,436 518,854 -------- -------- LIABILITIES Current liabilities 50,561 54,851 Long-term debt 243,682 229,479 Other liabilities 81,621 68,112 -------- -------- 375,864 352,442 -------- -------- Net assets $243,572 $166,412 ======== ======== Revenues $266,625 $236,513 $222,561 ======== ======== ======== Operating income $129,496 $104,137 $ 92,388 ======== ======== ======== Net income $ 65,124 $ 46,895 $ 36,319 ======== ======== ======== NOTE 14--RELATIONSHIP BETWEEN PROMUS AND PARENT AFTER THE DISTRIBUTION To govern certain ongoing relationships after the distribution, Promus and Parent entered into various agreements and adopted certain policies. Management believes the agreements are fair to both parties and contain terms comparable to those which would have been reached in arm's-length negotiations with unaffiliated parties (although comparisons are difficult with respect to certain agreements that relate to the specific circumstances of this transaction). 38 Promus Hotel Corporation QUARTERLY RESULTS OF OPERATIONS (Unaudited) (In thousands, except per share amounts) First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal Year -------------- -------------- ------------- -------------- ----------- 1996 Revenues $62,162 $69,393 $72,784 $62,286 $266,625 Operating income 27,230 36,051 37,982 27,578 128,841 Net income 12,749 18,136 19,692 14,147 64,724 Earnings per share (a) 0.25 0.35 0.38 0.27 1.25 Weighted average shares outstanding 51,577 51,685 51,712 51,779 51,690 1995 Revenues $56,487 $61,524 $61,653 $56,849 $236,513 Operating income 24,645 27,725 31,380 19,840 103,590 Net income 9,604 11,626 15,761 9,588 46,579 Pro forma earnings per share (a)(b) 0.19 0.23 0.31 0.19 0.90 Weighted average shares outstanding (b) 51,573 51,573 51,570 51,579 51,569 (a) The sum of the quarterly per share amounts may not equal the annual amount reported, as per share amounts are computed independently for each quarter while the full year is based on the annual weighted average common and common equivalent shares outstanding. (b) For purposes of computing pro forma earnings per share on a comparable basis, the weighted average shares outstanding for periods prior to the Spin-Off are assumed to be equal to the actual common and common equivalent shares outstanding on June 30, 1995. SELECTED FINANCIAL DATA (In thousands) 1996 1995 1994 1993 1992 --------- --------- ------- --------- -------- Operating results Revenues $266,625 $236,513 $222,561 $214,565 $206,513 Operating income before property transactions 123,874 101,648 91,762 64,758 49,610 Operating income 128,841 103,590 92,388 66,103 43,897 Income before income taxes and extraordinary items 109,888 75,579 63,117 30,795 3,242 Net income 64,724 46,579 36,319 16,926 6,361 Total assets 631,965 519,809 413,308 438,016 506,111 Long-term debt (a) 243,682 229,479 188,725 172,326 216,386 (a) Includes debt allocated to Promus Hotel Corporation by its Parent for periods prior to the Spin-Off. 39 INVESTOR INFORMATION Stock Listings Promus Hotel Corporation common stock trades on the New York Stock Exchange under the ticker symbol PRH. The stock is also listed on the Chicago, Philadelphia, and Pacific regional stock exchanges. Annual Meeting Date Promus Hotel Corporation will conduct its 1997 Annual Meeting of stockholders on April 23, 1997, 11 a.m. (CDT) at the Embassy Hall, Embassy Suites Hotel, 1022 South Shady Grove Road, Memphis, Tennessee. Shareholder Account Assistance For address changes, account consolidation, registration changes, lost stock certificates, and other shareholder services, contact: Continental Stock Transfer & Trust Company, 2 Broadway, New York, NY 10004, or call 800-509-5586. Investor Relations Financial community information requests should be directed to: Gregg A. Swearingen, Director, Investor Relations, 755 Crossover Lane, Memphis, TN 38117, or call (901) 374-5468, or fax (901) 374-5464. Form 10-K A shareholder may receive without charge a copy of the Form 10-K Annual Report filed with the Securities and Exchange Commission by writing to Investor Relations or by calling (901) 374-5468. Corporate Communications All media inquiries or requests for copies of this report should be directed to: John C. Hawkins, Director, Corporate Communications, 755 Crossover Lane, Memphis, TN 38117 or call (901) 374-5529. Corporate Headquarters 755 Crossover Lane Memphis, TN 38117 (901)-374-5000 Auditors Arthur Andersen LLP 165 Madison Avenue Memphis, TN 38103 Reservation Information Guests wishing to make reservations at our properties may do so by calling the following toll-free numbers: Embassy Suites Hotels 1-800-EMBASSY Hampton Inn Hotels 1-800-HAMPTON Hampton Inn & Suites Hotels 1-800-HAMPTON Homewood Suites Hotels 1-800-CALL HOME Embassy Vacation Resort Properties 1-800-EMBASSY Internet Communications A company overview, financial highlights, statistical data, operating philosophy, and reservations information can be found on the World Wide Web at http://www.promus-hotel.com. Trademarks The following trademarks are used in this report to identify products and services of Promus Hotel Corporation, its subsidiaries, and affiliates: Promus,-Registered Trademark- Embassy Suites,-Registered Trademark- Embassy Vacation Resort,-Registered Trademark- Hampton Inn,-Registered Trademark- Hampton Inn & Suites,-Registered Trademark- Hampton Vacation Resort,-Registered Trademark- Homewood Suites,-Registered Trademark- and 1-800-CALL HOME.-Registered Trademark- 40 DIRECTORS AND OFFICERS Board of Directors Michael D. Rose(2) Chairman of the Board Promus Hotel Corporation Memphis, Tennessee Director since April 1995 U. Bertram Ellis, Jr.(1),(4) Chairman, Chief Executive Officer & Director IXL Holdings, Inc. Atlanta, Georgia Director since June 1995 Debra J. Fields(1) Co-Chairman Mrs. Fields, Inc. Salt Lake City, Utah Director since June 1995 Christopher W. Hart(1) President, Spire Group, Inc. Brookline, Massachusetts Director since June 1995 C. Warren Neel(2),(3),(4) Dean, College of Business Administration University of Tennessee Knoxville, Tennessee Director since June 1995 Ben C. Peternell(2),(3),(4) Senior Vice President Human Resources & Communications Harrah s Entertainment, Inc. Memphis, Tennessee Director since April 1995 Michael I. Roth(1) Chairman of the Board & Chief Executive Officer Mutual of New York New York, New York Director since June 1995 Raymond E. Schultz(2) President & Chief Executive Officer Promus Hotel Corporation Memphis, Tennessee Director since April 1995 Jay Stein(3),(4) Chairman of the Board & Chief Executive Officer Stein Mart, Inc. Jacksonville, Florida Director since June 1995 David C. Sullivan Executive Vice President & Chief Operating Officer Promus Hotel Corporation Memphis, Tennessee Director since April 1995 Ronald Terry(2),(3),(4) Former Chairman of the Board First Tennessee National Corporation Memphis, Tennessee Director since June 1995 (1) Audit Committee (2) Executive Committee (3) Human Resources Committee (4) Strategic Planning Committee Corporate Executive Officers Michael D. Rose Chairman of the Board Raymond E. Schultz President & Chief Executive Officer David C. Sullivan Executive Vice President & Chief Operating Officer Donald H. Dempsey Senior Vice President & Chief Financial Officer Thomas L. Keltner Senior Vice President, Development Ralph B. Lake Senior Vice President, General Counsel & Secretary Mark C. Wells Senior Vice President, Franchise Services Other Corporate Officers Darryl J. Arbor Vice President, Internal Audit Donald A. Balash Vice President, Corporate Tax Carol G. Champion Vice President & Treasurer Vincent C. Ciaramitaro Vice President, Financial Services Patricia R. Ferguson Vice President, Human Resources M. Ronald Halpern Vice President & Deputy General Counsel James T. Harvey Vice President, Information Technology Jeffery M. Jarvis Vice President & Corporate Controller Division Officers Edwin F. Ansbro Vice President, Development-West/Mexico/Latin America Lorna E. Brown-Ray Vice President, Training & Communications Robert S. Davis Vice President, Embassy Vacation Resort Philip K. Cordell Vice President, Hotel Performance Services H. Nadine Greenwood Assistant Secretary Kevin W. Kern Assistant Secretary Donald M. Kolodz Vice President, Reservations Robert A. Lulloff Vice President, Design & Construction R. Bryan Mulroy Vice President, Hotels Controller Else W. O'Malley Vice President, Development-Parent Company Stevan D. Porter Vice President, Operations-Embassy Suites Thomas P. Powell Vice President, Development-East/Caribbean Frederick G. Schultz Vice President, Operations- Hampton Inn/Homewood Suites M. Davis Smith Vice President, Development-Central Jules S. Sowder Vice President, Marketing