Exhibit 13.01
Table of Contents
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Management's Discussion & Analysis 26
Report of Independent Public Accountants 34
Consolidated Financial Statements 35
Notes to Consolidated Financial Statements 39
Board of Directors and Corporate Officers 54
Corporate Information 55
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
The Company is one of the largest hotel franchisors in the world with 4,248
hotels open and 761 hotels under development as of December 31, 1999
representing 338,254 rooms open and 64,095 rooms under development in 40
countries. The Company franchises hotels under the Comfort, Quality, Econo
Lodge, Sleep Inn, Clarion, Rodeway Inn and MainStay Suites brand names. The
Company has over 2,300 franchisees in the franchise system with no single
franchisee accounting for more than 5% of its royalty or total revenues. The
Company operates in all 50 states and the District of Columbia and 34 additional
countries with 95% of its franchising revenue derived from hotels franchised in
the United States.
The principal factors that affect the Company's results are: growth in the
number of hotels under franchise; occupancies and room rates achieved by the
hotels under franchise; the effective royalty rates achieved; the number and
relative mix of franchised hotels; and the Company's ability to manage costs.
The number of rooms at franchised properties and occupancies and room rates at
those properties significantly affect the Company's results because franchise
royalty fees are based upon room revenues at franchised hotels. The key industry
standard for measuring hotel operating performance is revenue per available room
(RevPAR), which is calculated by multiplying the percentage of occupied rooms by
the average daily room rate realized. The variable overhead costs associated
with franchise system growth are substantially less than incremental royalty
fees generated from new franchisees; therefore, the Company is able to capture a
significant portion of those royalty fees as operating income.
During 1997, the Company changed its fiscal year end from May 31 to December 31.
Accordingly, the following discussion includes a discussion of the results of
the seven months ended December 31, 1997, as compared to unaudited results from
the comparable seven-month period in 1996.
Comparison of Calendar Year 1999 Operating Results and Calendar Year 1998
Operating Results
The Company recorded net income of $57.2 million for the year ended December 31,
1999 ("Calendar 1999"), an increase of $1.9 million, compared to net income of
$55.3 million for the year ended December 31, 1998 ("Calendar 1998"). Net income
in Calendar 1998 included a $7.2 million extraordinary gain from the early
extinguishment of debt. The increase in net income for Calendar 1999 was
primarily attributable to an increase in the effective royalty rates achieved,
an increase in franchise revenue as a direct result of improvements in the
operating performance of hotels, and the addition of new franchised hotels to
the system. Lower net interest costs versus Calendar 1998 also contributed
favorably to the Calendar 1999 results.
Summarized financial results for the years ended December 31, 1999 and 1998 are
as follows:
(In thousands) 1999 1998
----------------------------
Revenues:
Royalty fees $ 128,653 $ 115,171
Initial franchise & relicensing fees 13,910 16,571
Partner services revenue 9,055 6,370
Other revenue 6,111 5,516
Product sales 3,871 20,748
European hotel operations -- 1,098
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Total revenues 161,600 165,474
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Operating Expenses:
Selling, general & administrative 55,860 52,948
Depreciation & amortization 8,023 6,753
Product cost of sales 3,883 19,532
European hotel operations -- 1,133
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Total operating expenses 67,766 80,366
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Operating income 93,834 85,108
Loss (gain) on sale of investments 68 (2,370)
Interest expense 19,387 19,133
Interest and dividend income (20,092) (14,055)
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Income before income taxes
and extraordinary item 94,471 82,400
Income taxes 37,316 34,327
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Net income before extraordinary item 57,155 48,073
Gain on early extinguishment of
debt, net of $4,732 of income taxes -- 7,232
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Net income $ 57,155 $ 55,305
----------------------------
Franchise Revenues: Management analyzes its business based on net franchise
revenue, which is total revenue excluding product sales and European hotel
operations, and franchise operating expenses which are reflected as selling,
general and administrative expenses.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
Net franchise revenues were $157.7 million for Calendar 1999 and $143.6 million
for Calendar 1998. Royalties increased $13.5 million to $128.7 million from
$115.2 million in Calendar 1998, an increase of 11.7 %. The increase in
royalties is attributable to a 2% increase in the number of domestic franchised
hotel rooms, an increase in the effective royalty rate of the domestic hotel
system to 3.7% from 3.6%, and an improvement in domestic RevPAR of 3.0%.
Domestic initial fee revenue generated from franchise contracts signed was $10.1
million down from $13.1 million in Calendar 1998. Total franchise agreements
signed in Calendar 1999 were 318, a decline from the 440 total agreements
executed in Calendar 1998. An increasingly competitive hotel franchising
environment, coupled with stricter hotel brand standards being enforced by the
Company contributed to the decline in the total franchise agreements signed in
the period. Revenues generated from partner service relationships increased to
$9.1 million from $6.4 million in Calendar 1998. Under the partner services
program, the Company generates revenue from hotel industry vendors (who have
been designated as preferred providers) based on the level of goods or services
purchased from the vendors by hotel owners and hotel guests who stay in the
Company's franchised hotels.
The number of domestic rooms on-line increased to 258,120 from 252,357, an
increase of 2% for the year ended December 31, 1999. For 1999, the total number
of domestic hotels online grew 3% to 3,123 from 3,039 for 1998. The total number
of international hotels on-line increased to 1,125 from 632, an increase of 78%
for the year ended December 31, 1999. International rooms on-line increased to
80,134 as of December 31, 1999 from 53,095, an increase of 51%. As of December
31, 1999, the Company had 596 franchised hotels with 46,664 rooms either in
design or under construction in its domestic system. The Company has an
additional 165 franchised hotels with 17,431 rooms under development in its
international system as of December 31, 1999.
Franchise Expenses: The cost to operate the franchising business is reflected in
selling, general and administrative expenses. Selling, general and
administrative expenses were $55.9 million for Calendar 1999, an increase of
$3.0 million from the Calendar 1998 total of $52.9 million. As a percentage of
net franchise revenues, selling, general and administrative expenses declined to
35.4% in Calendar 1999 from 36.8% in Calendar 1998. The improvement in the
franchising margins relates to the economies of scale generated from operating a
larger franchisee base and improvements in franchised hotel performance.
Marketing and Reservations: The Company's franchise agreements require the
payment of franchise fees which include marketing and reservation fees. These
fees, which are based on a percentage of the franchisees' gross room revenues,
are used exclusively to reimburse the Company for expenses associated with
providing such franchise services as central reservation and yield management
systems, national marketing and media advertising. The Company is contractually
obligated to expend the reservation and marketing fees it collects from
franchisees in accordance with the franchise agreements; as such, no income or
loss to the Company is generated. During the second quarter of 1998, the Company
changed its presentation of marketing and reservation fees such that the fees
collected and associated expenses are reported net. All prior periods have been
reclassified to conform to the new presentation.
The total marketing and reservation fees received by the Company (previously
reported as revenue) were $146.0 million and $127.4 million for the years ended
December 31, 1999 and December 31, 1998, respectively. Depreciation and
amortization charged to the marketing and reservation funds was $9.6 million and
$6.2 million for the years ended December 31, 1999 and December 31, 1998,
respectively. Interest expense incurred by the reservation fund was $3.3 million
and $1.8 million for the years ended December 31, 1999 and 1998, respectively.
Reservation fees and marketing fees not expended in the current year are carried
over to the next fiscal year and expended in accordance with the franchise
agreements. Shortfall amounts are similarly recovered in subsequent years.
Excess or shortfall amounts from the operation of these programs are recorded as
a payable or receivable from the particular fund. Under the terms of the
franchise agreements, the Company may advance capital as necessary to the
marketing and reservation funds and recover such advances through future fees.
As of December 31, 1999, the Company's balance sheet includes a receivable of
$37.7 million related to advances made to the marketing ($12.5 million) and
reservation ($25.2 million) funds. As of December 31, 1998, the Company's
balance sheet includes a receivable of $ 18.7 million related to advances made
to the marketing ($7.8 million) and reservation ($10.9 million) funds. The
Company has the ability under existing franchise agreements and expects to
recover these advances through future marketing and reservation fees.
Product Sales: The group purchasing program utilizes bulk purchases to obtain
favorable pricing from third party vendors for franchisees ordering similar
products. The Company acts as a clearinghouse between the franchisee and
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
the vendor, and orders are shipped directly to the franchisee. Sales made to
franchisees through the Company's group purchasing program declined $16.8
million to $3.9 million in Calendar 1999 from $20.7 million in Calendar 1998.
Similarly, product cost of sales decreased $15.6 million to $3.9 million from
Calendar 1998. In the fourth quarter of 1998, the Company discontinued this
group purchasing program as previously operated.
European Hotel Operations: In January 1998, Friendly Hotels, PLC ("Friendly")
acquired from the Company ten hotels in France, two in Germany and one in the
United Kingdom in exchange for $22.2 million in 5.75% convertible preferred
shares in Friendly.
Depreciation and Amortization: Depreciation and amortization increased to $8.0
million in Calendar 1999 from $6.8 million in Calendar 1998. This increase was
primarily attributable to new computer systems installations and corporate
office renovations.
Interest Expense and Interest and Dividend Income: Interest expense of $19.4
million in Calendar 1999 is up slightly from $19.1 million in Calendar 1998 due
to higher interest rates and increased debt financing. Included in Calendar 1999
and Calendar 1998 results is approximately $14.2 million and $10.4 million,
respectively, of interest income earned on the note receivable from Sunburst
Hospitality Corporation. The Company's investment in Friendly resulted in $2.2
million and $2.1 million in dividend income in Calendar 1999 and Calendar 1998,
respectively.
Extraordinary Item: During 1998, the Company recorded an extraordinary gain from
the early extinguishment of debt. The Company retired $13.7 million in debt and
removed related assets of $1.8 million from the consolidated balance sheets. The
extraordinary gain was $7.2 million, after income tax expense of $4.7 million,
or $0.12 per diluted share.
Comparison of Calendar Year 1998 Operating Results and Calendar Year 1997
Operating Results
The Company recorded net income of $55.3 million for the year ended December 31,
1998 ("Calendar 1998"), an increase of $16.6 million compared to net income of
$38.7 million for the year ended December 31, 1997 ("Calendar 1997"). The
increase in net income for Calendar 1998 was primarily attributable to an
increase in franchise revenue as a direct result of the addition of new
franchised hotels to the system, improvements in the operating performance of
hotels and an increase in the effective royalty rates achieved. Additionally, in
Calendar 1998 the Company recognized an extraordinary gain on early
extinguishment of debt of $7.2 million.
Summarized financial results for the years ended December 31, 1998 and 1997 are
as follows:
1998 1997
(In thousands) (unaudited)
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Revenues:
Royalty fees $ 115,171 $ 106,299
Initial franchise & relicensing fees 16,571 16,096
Partner services revenue 6,370 7,079
Other revenue 5,516 4,833
Product sales 20,748 23,806
European hotel operations 1,098 17,303
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Total revenues 165,474 175,416
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Operating Expenses:
Selling, general & administrative 52,948 50,782
Depreciation & amortization 6,753 9,173
Product cost of sales 19,532 22,769
European hotel operations 1,133 15,624
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Total operating expenses 80,366 98,348
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Operating income 85,108 77,068
Gain on sale of investments (2,370) --
Interest expense 19,133 13,295
Interest and dividend income (14,055) (2,503)
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Income before income taxes
and extraordinary item 82,400 66,276
Income taxes 34,327 27,604
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Net income before extraordinary item 48,073 38,672
Gain on early extinguishment of
debt, net of $4,732 of income taxes 7,232 --
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Net income $ 55,305 $ 38,672
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Franchise Revenues: Net franchise revenues were $143.6 million for Calendar 1998
and $134.3 million for Calendar 1997. Royalties increased $8.9 million to $115.2
million from $106.3 million in Calendar 1997, an increase of 8.4%. The increase
in royalties is attributable to a net increase of 159 franchised hotels during
the period representing an additional 10,196 rooms added to the system, an
improvement in domestic RevPAR of 2.3% and an increase in the effective royalty
rate of the domestic hotel system to 3.6% from 3.5%. Domestic initial fee
revenue generated from franchise contracts signed increased 4.0% to $13.1
million from $12.6 million in Calendar 1997. Total franchise agreements signed
in Calendar 1998 were 440, up 4.5% from the total contracts
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
signed in Calendar 1997 of 421. Revenues generated from partner service
relationships decreased to $6.4 million from $7.1 million in Calendar 1997.
The number of domestic rooms under development increased to 75,232 from 62,384,
an increase of 20.6% for the year ended December 31, 1998. The total number of
international hotels on-line increased to 632 from 605, an increase of 4.5% for
the year ended December 31, 1998. International rooms on-line increased to
53,095 as of December 31, 1998 from 50,639, an increase of 4.9%. The total
number of international hotels under development increased to 611 from 119 for
the year ended December 31, 1998. The number of international rooms under
development increased to 40,375 as of December 31, 1998 from 12,029 as of
December 31, 1997. These increases are primarily attributable to a strategic
alliance in June 1998 with Flag International Limited.
Franchise Expenses: Selling, general and administrative expenses were $52.9
million for Calendar 1998, an increase of $2.1 million from the Calendar 1997
total of $50.8 million. As a percentage of net franchise revenues, selling,
general and administrative expenses declined to 36.9% in Calendar 1998 from
37.8% in Calendar 1997. The improvement in the franchising margins relates to
the economies of scale generated from operating a larger franchisee base, cost
control initiatives, and improvements in franchised hotel performance.
Marketing and Reservations: The total marketing and reservation fees received by
the Company (previously reported as revenue) were $127.4 million and $110.2
million for the years ended December 31, 1998 and December 31, 1997,
respectively. Depreciation and amortization charged to the marketing and
reservation funds was $6.2 million and $2.9 million for the years ended December
31, 1998 and December 31, 1997, respectively. As of December 31, 1998 the
Company's balance sheet includes a receivable of $18.7 million related to
advances made to the marketing ($7.8 million) and reservation ($10.9 million)
funds. As of December 31, 1997, the Company's balance sheet includes a
receivable of $5.2 million related to advances made to the marketing fund and a
current liability in accounts payable of $4.5 million related to excess monies
in the reservation fund.
Product Sales: Sales made to franchisees through the Company's group purchasing
program declined $3.1 million to $20.7 million in Calendar 1998 from $23.8
million in Calendar 1997. Similarly, product cost of sales decreased $3.2
million (or 14.2%) from Calendar 1997. The product services margins increased
for the year ended December 31, 1998 to 5.9% from 4.4% in Calendar 1997.
Depreciation and Amortization: Depreciation and amortization decreased to $6.8
million in Calendar 1998 from $9.2 million in Calendar 1997. This decrease was
primarily attributable to the sale of the Company's European hotels.
Interest Expense and Interest and Dividend Income:
The increase in interest expense of $5.8 million in Calendar 1998 from $13.3
million in Calendar 1997 resulted from additional debt incurred in connection
with the Sunburst Distribution (as defined in the Notes to the Consolidated
Statements). Included in Calendar 1998 results is approximately $10.4 million of
interest income earned on the note receivable from Sunburst Hospitality
Corporation and $2.1 million in dividend income from the Company's investment in
Friendly.
Extraordinary Item: During 1998, the Company recorded an extraordinary gain from
the early extinguishment of debt. The Company retired $13.7 million in debt and
removed related assets of $1.8 million from the consolidated balance sheets. The
extraordinary gain was $7.2 million, after income tax expense of $4.7 million,
or $0.12 per diluted share.
Comparison of Seven Month Period Ended December 31,1997 Operating Results and
Seven Month Period Ending December 31,1996 Operating Results
The Company recorded net income of $27.3 million for the seven months ended
December 31, 1997, an increase of $4.0 million compared to net income of $23.3
million for the seven months ended December 31, 1996. The increase in net income
for the seven months ended December 31, 1997 was primarily attributable to an
increase in franchise revenue as a direct result of the addition of new
franchised hotels to the system, improvements in the operating performance of
hotels and an increase in the effective royalty rates achieved.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
Summarized financial results for the seven months ended December 31, 1997 and
1996 are as follows:
1997 1996
(In thousands) (unaudited)
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Revenues:
Royalty fees $ 70,308 $ 61,821
Initial franchise & relicensing fees 8,597 9,304
Partner services revenue 3,510 1,510
Other revenue 1,359 1,651
Product sales 13,524 14,717
European hotel operations 10,541 10,975
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Total revenue 107,839 99,978
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Operating Expenses:
Selling, general & administrative 29,454 28,132
Depreciation & amortization 3,977 3,153
Product cost of sales 13,031 13,481
European hotel operations 9,203 9,745
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Total operating expenses 55,665 54,511
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Operating income 52,174 45,467
Interest expense, net 5,791 5,784
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Income before income taxes 46,383 39,683
Income taxes 19,096 16,338
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Net income $ 27,287 $ 23,345
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Franchise Revenues: Net franchise revenues were $83.8 million for the seven
months ended December 31, 1997 and $74.3 million for the seven months ended
December 31, 1996. Royalties increased $8.5 million to $70.3 million from $61.8
million for the seven months ended December 31, 1996, an increase of 13.7%. The
increase in royalties is attributable to a net increase of 264 franchised hotels
during the period representing an additional 19,881 rooms added to the system,
an improvement in domestic RevPAR of 2.4% and an increase in the effective
royalty rate of the domestic hotel system to 3.5% from 3.4%. Domestic initial
fee revenue generated from franchise contracts signed declined to $6.4 million
from $7.8 million for the seven months ended December 31, 1997 as compared to
the seven months ended December 31, 1996. Total franchise agreements signed for
the seven months ended December 31, 1997 were 368, down 14.0% from the total
contracts signed during the seven months ended December 31, 1996 of 428. The
decline in initial fees is partly a result of the Company's sales force
reorganization and the resulting temporary displacement of the sales force. The
reorganization of the regional market management sales and support force was
completed in September 1997. Revenues generated from partner service
relationships increased to $3.5 million from $1.5 million for the seven months
ended December 31, 1996.
The number of domestic rooms under development as of December 31, 1997 increased
to 62,384 from 59,023 at December 31, 1996, an increase of 5.7%. The total
number of international hotels on-line increased to 605 from 548 at December 31,
1996, an increase of 10.4%. International rooms on-line increased 9.0% to 50,639
as of December 31, 1997 from 46,473 as of December 31, 1996. The total number of
international hotels under development decreased to 119 from 143, a decrease of
16.8% from December 31, 1996. The number of international rooms under
development decreased to 12,029 as of December 31, 1997 from 13,906 as of
December 31, 1996, a decrease of 13.5%.
Franchise Expenses: Selling, general and administrative expenses were $29.5
million for the seven months ended December 31, 1997, an increase of $1.3
million from the comparable period in 1996. The increase in selling, general and
administrative expenses was primarily due to additional personnel to support
company growth and new company initiatives. As a percentage of net franchise
revenues, selling, general and administrative expenses declined to 35.2% for the
seven months ended December 31, 1997 from 37.8% for the seven months ended
December 31, 1996. The improvement in the franchising margins relates to the
economies of scale generated from operating a larger franchisee base, cost
control initiatives and improvements in franchised hotel performance.
Marketing and Reservations: The total marketing and reservation fees received by
the Company (previously reported as revenue) were $72.3 million and $66.3
million for the seven months ended December 31, 1997 and December 31, 1996,
respectively. Depreciation and amortization charged to the marketing and
reservation funds was $2.2 million and $1.4 million for the seven months ended
December 31, 1997 and December 31, 1996, respectively.
Product Sales: Sales made to franchisees through the Company's group purchasing
program declined $1.2 million to $13.5 million for the seven months ended
December 31, 1997 from $14.7 million for the seven months ended December 31,
1996. Similarly, product cost of sales decreased $0.4 million (or 3.3%) for the
seven months ended December 31, 1997. The product services margins decreased for
the seven months ended December 31, 1997 to 3.6% from 8.4% for the seven months
ended December 31, 1996.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
Depreciation and Amortization: Depreciation and amortization increased to $4.0
million for the seven months ended December 31, 1997 from $3.2 million for the
seven months ended December 31, 1996. The increase was primarily due to capital
improvements to the Company's financial and billing information systems.
Liquidity and Capital Resources
Net cash provided by operating activities was $79.5 million for the year ended
December 31, 1999, an increase of $34.9 million from $44.6 million for the year
ended December 31, 1998. The improvement in cash provided was primarily due to
improvements in operating income and management of working capital. As of
December 31, 1999, the total long-term debt outstanding for the Company was $307
million.
Cash used in investing activities for the years ended December 31, 1999 and
1998, the seven months ended December 31, 1997 and the fiscal year ended May 31,
1997 was $50.5 million, $14.7 million, $149.7 million and $16.9 million,
respectively. Investment in property and equipment includes renovations to the
Company's corporate headquarters (including a fran-chisee learning and training
center) and installation of systemwide property and yield management systems.
During the years ended December 31, 1999 and 1998, the seven months ended
December 31, 1997 and the fiscal year ended May 31, 1997, capital expenditures
totaled $30.6 million, $17.5 million, $7.3 million and $10.6 million,
respectively. Capital expenditures in prior years include amounts for computer
hardware; financial, property and yield management, and reservation systems; and
European hotel capital improvements.
The Company made advances to the marketing and reservation funds totaling $15.1
million in Calendar 1999. The advances are associated with a system-wide
property and yield management systems implementation, the timing of expenditures
associated with specific brand initiatives of the marketing fund and the
recognition of costs and the timing of payments received from franchisees in
conjunction with the Company's frequency stay program. The Company has the
ability under existing franchise agreements and expects to recover these
advances through future marketing and reservation fees. The company expects
$15.0 to $20.0 million of increases in advances to the marketing and reservation
funds in Calendar 2000 due to the continued property and yield management
systems implementation and expenditures associated with specific brand
initiatives.
On October 15, 1997, the Company funded a $115 million, five year Subordinated
Term Note to Sunburst with an initial simple interest rate of 11% per annum. In
connection with the amendment of the strategic alliance agreement (as defined in
the Notes to the Consolidated Financial Statements), effective October 15, 2000
interest payable shall accrue at a rate of 11% per annum compounded daily. The
Company implemented this amendment prospectively beginning on January 1, 1999
and has recognized interest on the outstanding principal and accrued interest
amounts at an effective rate of 10.58%. The note is payable in full, along with
accrued interest, on October 15, 2002. Total interest accrued at December 31,
1999 and 1998 was $27.0 million and $12.8 million, respectively.
Financing cash flows relate primarily to the Company's borrowings under its
credit lines and treasury stock purchases. On October 15, 1997, the Company
entered into a five-year $300 million competitive advance and multi-currency
revolving credit facility. The credit facility provides for a term loan of $150
million and a revolving credit facility of $150 million, $50 million of which is
available in foreign currency borrowings. At the time of the Sunburst
Distribution, the Company borrowed $150 million under the term loan and $140
million under the revolving credit facility, the proceeds of which were used to
fund the $115 million Sunburst note and to refinance existing indebtedness. As
of December 31, 1999, the Company had $112.5 million of term loans outstanding
and $82 million of revolving loans. The term loan is payable over five years,
$32.5 million of which is due in 2000. The credit facility includes customary
financial and other covenants that require the maintenance of certain ratios
including maximum leverage, minimum net worth and interest coverage and restrict
the Company's ability to make certain investments, repurchase stock, incur debt
and dispose of assets. At the Company's option, the interest rate may be based
on LIBOR, a certificate of deposit rate or an alternate base rate (as defined)
plus a facility fee percentage. The rate is determined based on the Company's
consolidated leverage ratio at the time of borrowing.
On May 1, 1998, the Company completed a $100 million senior unsecured note
offering ("the Notes"), bearing a coupon rate of 7.13% with an effective rate of
7.22%. The Notes will mature on May 1, 2008, with interest on the Notes to be
paid semi-annually. The Company used the net proceeds from the offering of
approximately $99 million to repay amounts outstanding under the Company's $300
million competitive advance and multi-currency revolving credit facility.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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Choice Hotels International, Inc. and Subsidiaries
The Company has entered into an interest rate swap agreement with a notional
amount of $115 million at December 31, 1999, to fix certain of its variable rate
debt in order to reduce the Company's exposure to fluctuations in interest
rates. The interest rate differential to be paid or received on the interest
rate swap agreement is accrued as interest rates change and is recognized as an
adjustment to interest expense. At December 31, 1999, the interest rate swap
agreement had a remaining life of approximately two months with a fixed rate of
5.85% and a variable rate at December 31, 1999 of 6.12%.
As of December 31, 1999, the Company had repurchased 7.5 million shares of its
common stock at a total cost of $107.4 million. On February 7, 2000 the Company
received authorization from its Board of Directors to repurchase up to an
additional 5 million shares.
The Company believes that cash flows from operations and available financing
capacity are adequate to meet the expected operating, investing, financing and
debt service requirements for the business for the immediate future.
Year 2000 Compliance
The Company has materially remedied the Year 2000 computer problem shared by
virtually all companies and businesses. Initially, this Year 2000 problem was
associated with two-digit date codes used in many computer programs and embedded
chip systems. As an on-going effort, the Company continues to monitor its
systems as well as third party vendors and franchisees.
The Company's exposure to potential Year 2000 problems existed in two general
areas: technological operations in the sole control of the Company and
technological operations dependent in some way on one or more third parties.
With respect to the Company's internal systems, no material Year 2000 problems
have occurred. The Company previously conducted Year 2000 compliance testing on
all of its proprietary software, including its reservations and reservations
support systems, its franchise support system and its franchisee property
management support systems. Except for two DOS based systems, the proprietary
software is Year 2000 compliant. The DOS version of ChoiceLINKS is not Year 2000
compliant and the DOS version of the Company's property management system is
only compliant through December 31, 2000. The Company has communicated this to
franchisees using these systems and has recommended that they migrate to the
Windows based versions of these systems, which are Year 2000 compliant. As of
February 7, 2000, 100% have migrated to the Windows version of ChoiceLINKS and
100% have migrated to the Windows version of the Company's property management
system.
The Company's inventory of third party software, including PC operating systems
and word processing and other commercial software, did not disclose any material
compliance issues.
During 1999, the Company's Year 2000 Compliance Committee identified third party
vendors and service providers whose non-compliant systems could have a material
impact on the Company and undertook an assessment as to such parties' compliant
status. These parties included airline global distribution systems (GDS),
utility providers, telephone service providers, banks and data processing
services. The GDS companies, which provide databases through which travel agents
can book hotel rooms, have assured the Company in writing that they are
compliant and the Company conducted tests with three of the four major GDS
companies. As of February 7, 2000, no material Year 2000 problems have been
experienced with the GDS companies and other third parties. Throughout 2000, the
committee will continue to monitor all of its material vendors.
Costs of addressing potential Year 2000 problems have not been material to date.
The value of employee time devoted to testing and development has been
approximately $400,000 over the past two and one half years. Total costs for
replacement of hardware and operating systems were approximately $600,000 over
the past two and one half years. The replacements to date and on-going
replacements are being implemented primarily as part of the Company's ongoing
technology updating, rather than specifically for Year 2000 compliance reasons.
Year 2000 compliance costs have not had a material adverse impact on the
Company's financial position, results of operations or cash flows.
33
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
While the Company has not experienced any material non-compliance issues to
date, it is not in a position to guarantee the performance of others with
respect to their Year 2000 compliance or predict whether any of the assurances
that others provide regarding Year 2000 compliance may prove later to be
inaccurate or overly optimistic.
Impact of Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," which requires
recognition of the fair value of derivatives in the statement of financial
position, with changes in the fair value recognized either in earnings or as a
component of other comprehensive income dependent upon the hedging nature of the
derivative. Implementation of SFAS No. 133 is required for Fiscal 2001. SFAS No.
133 is not expected to have a material impact on the Company's earnings or other
comprehensive income.
Forward-Looking Statements
Certain statements contained in this annual report, including those in the
section entitled Management's Discussion and Analysis, contain forward-looking
information that involves risk and uncertainties. Forward-looking statements are
usually identified by the words "believes," "anticipates," "expects," intends,"
"estimates," "projects," and other similar expressions, which are predictions of
or indicate future events and trends. Such statements are subject to a number of
risks and uncertainties which could cause actual results to differ materially
from those projected, including: competition within each of our business
segments; business strategies and their intended results; the balance between
supply of and demand for hotel rooms; our ability to obtain new franchise
agreements; our ability to develop and maintain positive relations with current
and potential hotel owners; the effect of international, national and regional
economic conditions; the availability of capital to allow us and potential hotel
owners to fund investments; our ability, and that of other parties upon which
our business also rely, to modify or replace on a timely basis, their computer
software and other systems in order to function properly prior to, in and
beyond, the year 2000; and other risks described from time to time in our
filings with the Securities and Exchange Commission, including those set forth
under the heading "Risk Factors" in our Report on Form 10-Q for the Period ended
June 30, 1999. Given these uncertainties, you are cautioned not to place undue
reliance on such statements. We also undertake no obligation to publicly update
or revise any forward-looking statement to reflect current or future events or
circumstances.
34
- --------------------------------------------------------------------------------
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
To Choice Hotels International,Inc.
We have audited the accompanying consolidated balance sheets of Choice Hotels
International, Inc. and sub- sidiaries, as defined under "Background and Basis
of Presentation" in the Notes to Consolidated Financial Statements, as of
December 31, 1999 and 1998, and the related consolidated statements of income
and cash flows for the years ended December 31, 1999 and 1998, the seven months
ended December 31, 1997 and the fiscal year ended May 31, 1997, and the
consolidated statements of shareholders' equity and comprehensive income for the
period from October 15, 1997 (inception) to December 31, 1997 and the years
ended December 31, 1998 and 1999. These consolidated financial statements are
the responsibility of Choice Hotels International, Inc.'s management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. 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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Choice
Hotels International, Inc. and subsidiaries as of December 31, 1999 and 1998,
and the consolidated results of their operations and their consolidated cash
flows for the years ended December 31, 1999 and 1998, the seven months ended
December 31, 1997 and the fiscal year ended May 31, 1997, and the consolidated
statements of shareholders' equity and comprehensive income for the period from
October 15, 1997 (inception) to December 31, 1997 and the years ended December
31, 1998 and 1999, in conformity with accounting principles generally accepted
in the United States.
/s/ Arthur Andersen LLP
Vienna, Virginia
January 28, 2000
35
- --------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Seven months Fiscal year
Years ended ended ended
December 31, December 31, May 31,
(In thousands) 1999 1998 1997 1997
------------------------------------------------
Revenues
Royalty fees $128,653 $115,171 $ 70,308 $ 97,215
Initial franchise and relicensing fees 13,910 16,571 8,597 16,802
Partner services revenue 9,055 6,370 3,510 4,175
Other revenue 6,111 5,516 1,359 8,467
Product sales 3,871 20,748 13,524 23,643
European hotel operations -- 1,098 10,541 17,737
------------------------------------------------
Total revenues 161,600 165,474 107,839 168,039
Operating Expenses
Selling, general and administrative 55,860 52,948 29,454 51,102
Depreciation and amortization 8,023 6,753 3,977 7,643
Product cost of sales 3,883 19,532 13,031 22,766
European hotel operations -- 1,133 9,203 16,166
------------------------------------------------
Total operating expenses 67,766 80,366 55,665 97,677
------------------------------------------------
Operating income 93,834 85,108 52,174 70,362
------------------------------------------------
Other
Loss (gain) on sale of investments 68 (2,370) -- --
Interest on notes payable to Manor Care -- -- -- 7,083
Interest expense 19,387 19,133 8,788 4,647
Interest and dividend income (including interest
income on Sunburst Note of $14.2 million,
$10.4 million and $2.7 million for December 31,
1999, 1998 and 1997, respectively) (20,092) (14,055) (2,997) (943)
------------------------------------------------
Total other (637) 2,708 5,791 10,787
------------------------------------------------
Income before income taxes and extraordinary item 94,471 82,400 46,383 59,575
Income taxes 37,316 34,327 19,096 24,845
------------------------------------------------
Net income before extraordinary item 57,155 48,073 27,287 34,730
Gain on early extinguishment of debt (net of taxes of $4,732) -- 7,232 -- --
------------------------------------------------
Net income $ 57,155 $ 55,305 $ 27,287 $ 34,730
------------------------------------------------
Weighted average shares outstanding 54,859 58,717 59,798 62,680
------------------------------------------------
Diluted shares outstanding 55,667 59,548 61,300 62,680
------------------------------------------------
Basis EPS:
Income before extraordinary item $ 1.04 $ 0.82 $ 0.46 $ 0.55
Extraordinary item -- 0.12 -- --
------------------------------------------------
Net income $ 1.04 $ 0.94 $ 0.46 $ 0.55
------------------------------------------------
Diluted EPS:
Income before extraordinary item $ 1.03 $ 0.81 $ 0.45 $ 0.55
Extraordinary item -- 0.12 -- --
------------------------------------------------
Net income $ 1.03 $ 0.93 $ 0.45 $ 0.55
------------------------------------------------
See notes to consolidated statements.
36
- --------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
(In thousands) December 31, December 31,
Assets 1999 1998
---------------------------
Current assets
Cash and cash equivalents $ 11,850 $ 1,692
Receivables (net of allowance for doubtful
accounts of $6,203 and $8,082, respectively) 30,035 28,117
Income taxes receivable -- 5,427
Other current assets 37 425
---------------------------
Total current assets 41,922 35,661
Property and equipment, at cost, net 58,255 37,556
Goodwill, net 64,706 66,749
Franchise rights, net 43,101 44,981
Investment in Friendly Hotels 41,195 41,576
Advances to marketing and reservation funds 37,668 18,653
Other assets 35,958 25,200
Note receivable from Sunburst Hospitality 141,853 127,849
---------------------------
Total assets $ 464,658 $ 398,225
---------------------------
Liabilities and Shareholders' Equity
Current liabilities
Current portion of long-term debt $ 44,646 $ 28,846
Accounts payable 21,362 16,216
Accrued expenses 22,283 19,606
Income taxes payable 1,367 --
---------------------------
Total current liabilities 89,658 64,668
Long-term debt 262,710 250,364
Deferred income taxes ($30,648 and $19,569,
respectively) and other liabilities 46,674 26,683
---------------------------
Total liabilities 399,042 341,715
---------------------------
Shareholders' Equity
Common stock, $ .01 par value, 160,000,000
shares authorized; 53,833,911 and
56,726,917 shares issued and outstanding at
December 31, 1999 and 1998, respectively 614 607
Additional paid-in-capital 52,386 45,097
Accumulated other comprehensive income 1,205 2,112
Deferred compensation (1,937) (1,665)
Treasury stock (108,370) (54,204)
Retained earnings 121,718 64,563
---------------------------
Total shareholders' equity 65,616 56,510
---------------------------
Total liabilities and shareholders' equity $ 464,658 $ 398,225
---------------------------
See notes to consolidated financial statements.
37
- --------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Seven Months Fiscal Year
Years Ended Ended Ended
December 31, December 31, May 31,
1999 1998 1997 1997
- ----------------------------------------------------------------------------------------------------------------
(In thousands)
Cash Flows From Operating Activities
Net income $ 57,155 $ 55,305 $ 27,287 $ 34,730
Reconciliation of net income to net cash provided
by operating activities:
Depreciation and amortization 17,576 13,067 6,159 10,438
Provision for bad debts 588 1,473 2,274 2,238
Increase (decrease) in deferred income taxes and other 10,216 14,852 (4,828) 3,171
Non cash interest and dividend income (16,259) (12,364) (2,997) (943)
Gain on extinguishment of debt -- (11,964) -- --
Changes in assets and liabilities:
Receivables (4,006) (4,311) (10,606) (4,835)
Prepaid expenses and other current assets 1,355 (1,849) 2,403 1,615
Current liabilities 6,086 (6,180) 11,226 (2,145)
Income taxes payable/receivable 6,794 (3,411) 2,689 1,061
Other liabilities -- -- -- 175
------------------------------------------------------
Net cash provided by operating activities 79,505 44,618 33,607 45,505
------------------------------------------------------
Cash Flows From Investing Activities
Investment in property and equipment (30,633) (17,488) (7,329) (10,630)
Purchase of minority interest -- -- -- (2,494)
Repayments from/advances to Sunburst Hospitality -- 8,145 (25,066) --
Note receivable from Sunburst Hospitality -- -- (115,000) --
Advances to marketing and reservation funds, net (15,098) (4,154) (4,487) --
Other items, net (4,762) (1,225) 2,143 (3,804)
------------------------------------------------------
Net cash utilized in investing activities (50,493) (14,722) (149,739) (16,928)
------------------------------------------------------
Cash Flows From Financing Activities
Proceeds from mortgages and other long term debt 88,630 194,901 236,509 31,107
Principal payments of debt (59,458) (184,300) (78,851) (51,260)
Purchase of treasury stock (53,166) (54,015) (189) --
Cash transfers to Manor Care, net -- -- (35,222) (8,069)
Proceeds from issuance of common stock 5,140 4,928 -- --
------------------------------------------------------
Net cash (utilized in) provided by financing activities (18,854) (38,486) 122,247 (28,222)
------------------------------------------------------
Net change in cash and cash equivalents 10,158 (8,590) 6,115 355
Cash and cash equivalents at beginning of period 1,692 10,282 4,167 3,812
------------------------------------------------------
Cash and cash equivalents at end of period $ 11,850 $ 1,692 $ 10,282 $ 4,167
======================================================
See notes to consolidated statements.
38
- --------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
(In thousands, except share amounts)
Accumulated Other
Common Stock Additional Comprehensive Deferred Treasury
Shares Amount Paid-in-Capital Income (Loss) Compensation Stock
-------------------------------------------------------------------------------
Initial capitalization
October 15, 1997 59,767,716 $598 $ 48,064 $(8,662) $ -- $ --
Comprehensive income
Net income -- -- -- -- -- --
Other comprehensive income:
Foreign translation adjustments -- -- -- 346 -- --
Comprehensive income
Exercise of stock options/grants, net 71,876 -- (157) -- -- --
Treasury purchases (10,714) -- -- -- -- (189)
Transfers of net income to Sunburst
prior to the distribution -- -- -- -- -- --
-------------------------------------------------------------------------------
Balance as of December 31, 1997 59,828,878 $598 $ 47,907 $(8,316) $ -- $ (189)
-------------------------------------------------------------------------------
Comprehensive income
Net Income -- -- -- -- -- --
Other comprehensive income:
Foreign translation adjustments -- -- -- -- -- --
Unrealized gain on securities, net of
reclassification adjustment -- -- -- -- -- --
Other comprehensive income -- -- -- 10,428 -- --
Comprehensive income
Exercise of stock options/grants, net 667,227 7 5,058 -- -- --
Issuance of restricted stock 160,212 2 2,272 -- (2,274) --
Amortization of deferred compensation -- -- -- -- 609 --
Treasury purchases (3,929,400) -- -- -- -- (54,015)
Purchase of MainStay brand
from Sunburst -- -- (10,140) -- -- --
-------------------------------------------------------------------------------
Balance as of December 31, 1998 56,726,917 $607 $ 45,097 $ 2,112 $(1,665) $ (54,204)
-------------------------------------------------------------------------------
Comprehensive income
Net Income -- -- -- -- -- --
Other comprehensive income:
Foreign translation adjustments -- -- -- -- -- --
Unrealized loss on securities, net
of taxes, net of reclassification
adjustment -- -- -- -- -- --
Other comprehensive income -- -- -- (907) -- --
Comprehensive income
Exercise of stock options/grants, net 623,647 6 6,275 -- -- --
Issuance of restricted stock 70,260 1 1,014 -- (1,015) --
Amortization of deferred compensation -- -- -- -- 743 --
Treasury purchases (3,586,913) -- -- -- -- (54,166)
-------------------------------------------------------------------------------
Balance as of December 31, 1999 53,833,911 $614 $ 52,386 $ 1,205 $(1,937) $(108,370)
-------------------------------------------------------------------------------
Comprehensive Retained
Income Earnings Total
--------------------------------------
Initial capitalization
October 15, 1997 $ -- $ 40,000
Comprehensive income
Net income $ 27,287 27,287 27,287
Other comprehensive income:
Foreign translation adjustments 346 -- 346
---
Comprehensive income $ 27,633
========
Exercise of stock options/grants, net -- (157)
Treasury purchases -- (189)
Transfers of net income to Sunburst
prior to the distribution (18,029) (18,029)
--------------------------------------
Balance as of December 31, 1997 $ 9,258 $ 49,258
--------------------------------------
Comprehensive income
Net Income 55,305 55,305 55,305
Other comprehensive income:
Foreign translation adjustments 10,048 -- 10,048
Unrealized gain on securities, net of
reclassification adjustment 380 -- 380
---
Other comprehensive income 10,428 -- --
------
Comprehensive income $ 65,733
========
Exercise of stock options/grants, net -- 5,065
Issuance of restricted stock -- --
Amortization of deferred compensation -- 609
Treasury purchases -- (54,015)
Purchase of MainStay brand
from Sunburst -- (10,140)
--------------------------------------
Balance as of December 31, 1998 $ 64,563 $ 56,510
--------------------------------------
Comprehensive income
Net Income 57,155 57,155 57,155
Other comprehensive income:
Foreign translation adjustments (108) -- (108)
Unrealized loss on securities, net
of taxes, net of reclassification
adjustment (799) -- (799)
-----
Other comprehensive income (907) -- --
-----
Comprehensive income $ 56,248
========
Exercise of stock options/grants, net
-- 6,281
Issuance of restricted stock
-- --
Amortization of deferred compensation
-- 743
Treasury purchases -- (54,166)
--------------------------------------
Balance as of December 31, 1999 $121,718 $ 65,616
--------------------------------------
See notes to consolidated statements.
39
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Background and Basis of Presentation
On March 7, 1996, Manor Care, Inc. ("Manor Care") announced its intention to
proceed with the separation of its lodging business ("Choice Hotels Holdings,
Inc." or "Holdings") from its health care business via a spin-off of its lodging
business (the "Manor Care Distribution"). On September 30, 1996 the Board of
Directors of Manor Care declared a special dividend to its shareholders of one
share of common stock of Holdings for each share of Manor Care stock, and the
Board set the record date and the distribution date. The Manor Care Distribution
was made on November 1, 1996 to holders of record of Manor Care's common stock
on October 10, 1996. Choice Hotels International, Inc. (the "Company"), which
was a subsidiary of Manor Care became a wholly-owned subsidiary of Holdings.
The Manor Care Distribution separated the lodging and health care businesses of
Manor Care into two public corporations. The operations of Holdings consisted
principally of the hotel franchise operations and the owned and managed hotel
operations formerly conducted by Manor Care directly or through its subsidiaries
(the "Lodging Business").
On November 1, 1996, concurrent with the Manor Care Distribution, Holdings
changed its name from Choice Hotels Holdings, Inc. to Choice Hotels
International, Inc. ("CHI") and the Company changed its name to Choice Hotels
Franchising, Inc.
On April 29, 1997, CHI's Board of Directors announced its intention to separate
CHI's franchising business from its owned hotel business (referred to as the
"Sunburst Distribution"). On September 16, 1997, the Board of Directors and
shareholders of CHI approved the separation of the business via a spin-off of
the Company, along with CHI's European hotel and franchising operations, to its
shareholders. The Board set October 15, 1997 as the date of distribution and on
that date, CHI shareholders received one share in the Company (renamed "Choice
Hotels International, Inc." and referred to hereafter as the "Company") for
every share of CHI stock held on October 7, 1997 (the date of record).
Concurrent with the October 15, 1997 distribution date, CHI changed its name to
Sunburst Hospitality Corporation, (referred to hereafter as "Sunburst") and
effected a one-for-three reverse stock split of its common stock.
The Company is in the business of hotel franchising. As of December 31, 1999,
the Company had franchise agreements with 4,248 hotels open and 761 hotels under
development in 40 countries under the following brand names: Comfort, Quality,
Econo Lodge, Sleep, Clarion, Rodeway, and MainStay Suites.
The consolidated financial statements present the financial position, results of
operations and cash flows and equity of the Company as if it were formed as a
separate entity of its parent (Manor Care prior to Manor Care Distribution and
Sunburst prior to Sunburst Distribution) which conducted the hotel franchising
business and European hotel operations and as if the Company were a separate
company for all periods presented. The Parent's historical basis in the assets
and liabilities of the Company has been carried over to the consolidated
financial statements. All material intercompany transactions and balances
between the Company and its subsidiaries have been eliminated. Changes in the
investments and advances from parent represent the net income of the Company
plus the net change in transfers between the Company and Manor Care through
November 1, 1996 and Sunburst through October 15, 1997.
An analysis of the activity in the investments and advances from parent account
for the fiscal year ended May 31, 1997 and the period June 1, 1997 through
October 15, 1997 is as follows:
(In thousands)
--------------
Balance, May 31, 1996 $ 30,532
Transfers to Parent, net (8,069)
Net income 34,730
--------------
Balance, May 31, 1997 57,193
Transfers to Parent, net through
October 15, 1997 (35,222)
Net income from June 1, 1997
through October 15, 1997 18,029
Initial capitalization (40,000)
--------------
Balance, October 15, 1997 $ --
--------------
The average balance of the investments and advances from parent was $48.6
million and $43.9 million for the period June 1, 1997 through October 15, 1997
and the fiscal year ended May 31, 1997, respectively.
Reclassifications
Certain reclassifications have been made to the prior year consolidated
financial statements to conform to the current year presentation.
40
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Significant Accounting Policies
Fiscal Year
During October 1997, the Company changed its fiscal year from a May 31 year end
to a December 31 year end.
Consolidation Policy
The consolidated financial statements include Choice Hotels International, Inc.
and its subsidiaries. All significant inter-company accounts and transactions
have been eliminated in consolidation.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with a maturity of
three months or less at the date of purchase to be cash equivalents.
Capitalization Policies
Major renovations and replacements are capitalized to appropriate property and
equipment accounts. Upon sale or retirement of property, the cost and related
accumulated depreciation are eliminated from the accounts and the related gain
or loss is taken into income. Maintenance, repairs and minor replacements are
charged to expense.
Impairment Policy
The Company evaluates the recoverability of long lived assets, including
franchise rights and goodwill, whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable.
Recoverability is measured based on net, undiscounted expected cash flows.
Assets are considered to be impaired if the net, undiscounted expected cash
flows are less than the carrying amount of the assets. Impairment charges are
recorded based upon the difference between the carrying value of the asset and
the expected net cash flows, discounted at an appropriate interest rate.
Deferred Financing Costs
Debt financing costs are deferred and amortized, using the interest method, over
the term of the related debt.
Investment Policy
The Company accounts for its investments in common stock in accordance with
Statements of Financial Accounting Standards ("SFAS") No. 115 "Accounting for
Certain Investments in Debt and Equity Securities" and SFAS No. 130 "Reporting
Comprehensive Income." The Company accounts for its investment in unincorporated
joint ventures in accordance with Accounting Principles Board Opinion ("APB")
No. 18 "The Equity Method of Accounting for Investments in Common Stock."
Use of Estimates
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, disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from these estimates.
Property and Equipment
The components of property and equipment in the consolidated balance sheets are:
December 31,
(In thousands) 1999 1998
------------------------
Land $ 1,227 $ 1,603
Facilities in progress 1,838 1,600
Building and improvements 18,458 8,023
Furniture, fixtures and equipment 60,629 40,486
------------------------
82,152 51,712
Less: Accumulated depreciation (23,897) (14,156)
------------------------
$ 58,255 $ 37,556
------------------------
Depreciation has been computed for financial reporting purposes using the
straight-line method. A summary of the ranges of estimated useful lives upon
which depreciation rates have been based follows:
Building and improvements 10-40 years
Furniture, fixtures and equipment 3-20 years
Goodwill
Goodwill primarily represents an allocation of the excess purchase price of the
stock of the Company over the recorded minority interest. Goodwill is amortized
on a straight-line basis over 40 years. Such amortization amounted to $2.0
million, $2.0 million, $1.1 million, and $1.9 million for the years ended
December 31, 1999 and 1998, the seven months ended December 31, 1997, and the
fiscal year ended May 31, 1997, respectively. Goodwill is net of accumulated
amortization of $10.1 million and $8.1 million at December 31, 1999 and 1998,
respectively.
Franchise Rights
Franchise rights are intangible assets and represent an allocation in purchase
accounting for the value of long-term franchise contracts. The majority of the
balance results from the Econo Lodge and Rodeway acquisitions made in fiscal
year 1991. Franchise rights acquired are amortized over an average life of 15
years. Amortization expense for the years
41
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
ended December 31, 1999 and 1998, the seven months ended December 31, 1997 and
the fiscal year ended May 31, 1997 amounted to $4.3 million, $3.8 million, $1.7
million and $2.9 million, respectively. Franchise rights are net of accumulated
amortization of $23.0 million and $18.7 million at December 31, 1999 and 1998,
respectively.
The Company periodically assesses the amortization lives of its franchise
rights. Effective January 1, 1998, the Company changed its estimate of the
useful life of Econo Lodge franchise rights to a 17 year period and Rodeway
franchise rights to a 3 year period to more closely match the remaining
estimated contract lives of franchise contracts acquired in 1991. The effect of
this change in estimate was to increase depreciation and amortization expense by
approximately $900,000 and decrease net income by $0.01 per dilutive share for
the years ended December 31, 1999 and 1998.
Investment in Friendly Hotels
On May 31, 1996, the Company invested approximately $17.1 million in the capital
stock of Friendly Hotels, PLC ("Friendly"). In exchange for the $17.1 million
investment, the Company received 750,000 shares of common stock and 10 million
newly issued immediately convertible preferred shares. In addition, the Company
granted to Friendly a Master Franchise Agreement for the United Kingdom and
Ireland in exchange for 333,333 additional shares of common stock. The preferred
shares carry a 5.75% dividend payable in cash or in stock, at the Company's
option. The dividend accrues annually with the first dividend paid on the
earlier of the third anniversary of completion or on a conversion date. As a
condition to the investment, the Company has the right to appoint three
directors to the board of Friendly. Given the Company's ability to exercise
significant influence over the operations of Friendly, the equity method of
accounting is applied.
In January 1998, Friendly acquired European hotels owned by the Company for
$26.2 million in convertible preferred shares and cash. In exchange for 10
hotels in France, two in Germany and one in the United Kingdom, the Company
received $22.2 million in new unlisted 5.75% convertible preferred shares in
Friendly at par, convertible for one new Friendly ordinary share for every 150p
nominal of the preferred convertible shares.
In 1998, the Company granted Friendly the master franchise rights for Choice's
Comfort, Quality and Clarion brand hotels throughout Europe (with the exception
of Scandinavia) for a 10 year period. In exchange, the Company will receive from
Friendly $8.0 million, payable in eight equal annual installments. The master
franchise payment is being recognized over the life of the agreement.
The Company recognized $2.2 million, $2.1 million, $0.6 million and $0.9 million
in preferred dividend income from the Friendly investment for the years ended
December 31, 1999 and 1998, the seven months ended December 31, 1997 and the
fiscal year ended May 31, 1997, respectively. As of December 31, 1999 and 1998,
accrued but unpaid preferred dividends were $5.8 million and $3.7 million,
respectively. The Company also recognized $2.2 million and $1.4 million in
royalty revenue from Friendly for the years ended December 31, 1999 and 1998,
respectively.
The Company owned approximately 5.3%, 5.2% and 4.95% of Friendly's outstanding
ordinary shares at December 31, 1999, 1998 and 1997, respectively. The fair
market value of the ordinary shares at December 31, 1999 and 1998 was $2.0
million and $1.9 million, respectively. Summarized unaudited balance sheet data
for Friendly is as follows:
(Unaudited)
December 31,
(In thousands) 1999 1998
---------------------------
Current assets $ 43,616 $ 52,197
Non-current assets 207,299 237,654
Current liabilities 49,622 60,696
Non-current liabilities 91,984 85,919
Redeemable preferred stock 37,800 31,558
Shareholders' equity 174,382 205,880
Summarized unaudited income statement data for Friendly is as follows:
(Unaudited)
December 31,
(In thousands) 1999 1998 1997
----------------------------------------
Net revenues $ 150,332 $130,028 $100,970
Gross profit 84,852 73,447 60,184
Income from continuing
operations 8,809 12,778 11,956
Net (loss) income
after preferred dividends (4,113) 18,984 7,684
42
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Revenue Recognition
The Company enters into numerous franchise agreements committing to provide
franchisees with various marketing services, a centralized reservation system
and limited rights to utilize the Company's registered tradenames. These
agreements are typically for a period of twenty years, with certain rights to
the franchisee to terminate after five, 10, or 15 years. Initial franchise fees
are recognized upon sale because the initial franchise fee is non-refundable and
the Company has no continuing obligations related to the franchisee. Royalty
fees, primarily based on gross room revenues of each franchisee, are recorded
when earned. Reserves for uncollectible accounts are charged to bad debt expense
and included in selling, general and administrative expenses in the accompanying
consolidated statements of income.
The Company's franchise agreements require the payment of franchise fees which
include marketing and reservation fees. These fees, which are based on a
percentage of the franchisees' gross room revenues, are used exclusively to
reimburse the Company for expenses associated with providing such franchise
services as central reservation systems, property and yield management systems,
national marketing, and media advertising. The Company is contractually
obligated to expend the reservation and marketing fees it collects from
franchisees in accordance with the franchise agreements; as such, no income or
loss to the Company is generated. During the second quarter of 1998, the Company
changed its presentation of marketing and reservation fees such that the fees
collected and associated expenses are reported net. All prior periods have been
reclassified to conform to the new presentation.
The total marketing and reservation fees received by the Company (previously
reported as revenue) for the years ended December 31, 1999 and 1998, the seven
months ended December 31, 1997, and the fiscal year ended May 31, 1997 amounted
to $146.0 million, $127.4 million, $72.3 million, and $104.2 million,
respectively. Depreciation and amortization charged to the marketing and
reservation funds for the years ended December 31, 1999 and 1998, the seven
months ended December 31, 1997, and the fiscal year ended May 31, 1997 amounted
to $9.6 million, $6.2 million, $2.2 million, and $2.8 million, respectively.
Under the terms of the franchise agreements reservation fees and marketing fees
not expended in the current year are carried over to the next fiscal year and
expended in accordance with the franchise agreements. Shortfall amounts are
similarly recovered in subsequent years. Excess or shortfall amounts from the
operation of these programs are recorded as a payable or receivable,
respectively, from the particular fund. As of December 31, 1999 and 1998, the
Company's balance sheet includes advances to marketing and reservation funds of
$37.7 million and $18.7 million, respectively. The advances made are composed of
1999 and 1998 marketing ($12.5 million and $7.8 million, respectively) and 1999
and 1998 reservation ($25.2 million and $10.9 million, respectively) funds. The
Company has the ability under existing franchise agreements and expects to
recover these advances through future marketing and reservation fees.
Transactions with Sunburst
Subsequent to the Manor Care Distribution, the Company participated in a cash
concentration system with Sunburst and as such maintained no significant cash
balances or banking relationships. Substantially all cash received by the
Company was immediately deposited in and combined with Sunburst's corporate
funds through its cash management system. Similarly, operating expenses, capital
expenditures and other cash requirements of the Company have been paid by
Sunburst and charged to the Company. The net result of all of these intercompany
transactions were reflected in Investments and advances from Parent.
As part of the Sunburst Distribution, Sunburst and the Company have entered into
a strategic alliance agreement. Among other things, the agreement provides for:
(i) a right of first refusal to the Company to franchise any lodging properties
to be acquired or developed by Sunburst; (ii) certain commitments by Sunburst
for the development of Sleep Inn and MainStay Suites hotels; (iii) continued
cooperation of both parties with respect to matters of mutual interest, such as
new product and concept testing; (iv) continued cooperation with respect to
third party vendor arrangements; and (v) certain limitations on competition in
each others' line of business. The strategic alliance agreement extends for a
term of 20 years with mutual rights of termination on the fifth, 10th and 15th
anniversaries. In December 1998, the parties amended the strategic alliance
agreement: (i) to eliminate Sunburst's option to acquire the MainStay Suites
brand; (ii) to amend Sunburst's development commitments; and (iii) to provide
certain global amendments to Sunburst's franchise agreements.
In connection with the Sunburst Distribution, the Company borrowed $115 million
under its Credit Facility in order to fund a Subordinated Term Note to Sunburst.
The Subordinated Term Note of $115 million accrues interest monthly at an
initial simple rate of 11% per annum through October 14, 2000. In connection
with the amendment of the strategic alliance agreement discussed above,
effective October 15, 2000 interest shall accrue at a rate of 11% per
43
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
annum compounded daily. On January 1, 1999, the Company began recognizing
interest on the outstanding principal and accrued interest amounts at an
effective rate of 10.58%. The note is payable in full, along with accrued
interest, on October 15, 2002. Total interest accrued as of December 31, 1999
and 1998 was $27.0 million and $12.8 million, respectively.
For purposes of providing an orderly transition after the Sunburst Distribution,
Sunburst and the Company entered into various agreements, including, among
others, a Distribution Agreement, a Tax Sharing Agreement, a Corporate Services
Agreement and an Employee Benefits Allocation Agreement. Effective as of October
15, 1997, these agreements provide, among other things, that Sunburst: (i) will
receive human resources for certain corporate and support services, such as
accounting, tax and computer systems support; (ii) will provide to the Company
certain services including asset management, and payables processing; (iii) will
adjust outstanding options to purchase shares of Company common stock held by
Company employees, Sunburst employees, and employees of Manor Care; (iv) is
responsible for filing and paying the related taxes on consolidated federal tax
returns and consolidated or combined state tax returns for itself and any of its
affiliates (including the Company) for the periods of time that the affiliates
were members of the consolidated group; (v) will be reimbursed by the Company
for the portion of income taxes paid that relate to the Company and its
subsidiaries; and (vi) guarantees that the Company will, at the date of
distribution, have a specified minimum level of net worth. These agreements were
to extend for a maximum period of 30 months from the Distribution date or until
such time as the Company and Sunburst have arranged to provide such services
in-house or through another unrelated provider of such services. As of March 31,
1999, all services provided by each party under the Corporate Services
Agreement, except for human resources and tax services provided by the Company,
were terminated. As of December 31, 1999, the human resources and tax services
provided by the Company, were terminated. Costs associated with the Corporate
Services Agreement as well as costs of services provided by Sunburst to the
Company or provided by the Company to Sunburst have been allocated between the
entity providing the services and the entity receiving the services in the
accompanying financial statements. As a result, future administrative and
corporate expenses are expected to vary from historical results. However, the
Company has estimated that general and administrative expenses incurred annually
will not materially change.
During the periods presented, Sunburst operated substantially all of its hotels
pursuant to franchise agreements with the Company. Total fees paid to the
Company included in the accompanying consolidated financial statements for
franchising royalty, marketing and reservation fees were $9.1 million and $11.2
million for the years ended December 31, 1999 and 1998, respectively, $6.2
million for the seven months ended December 31, 1997, and $9.5 million for the
fiscal year ended May 31, 1997.
In accordance with the Sunburst Distribution Agreement, the Company agreed to
assume and pay certain liabilities of Sunburst, subject to the Company
maintaining a minimum net worth of $40 million, at the date of Distribution. As
of December 31, 1997, the Company reflected a $25 million receivable due from
Sunburst on the consolidated balance sheet. In 1998, net payments of
approximately $8 million were collected from Sunburst in cash. On December 28,
1998, the Company and Sunburst amended the strategic alliance agreement entered
into in connection with the Sunburst Distribution. As part of that amendment,
the Company exchanged the remaining $17 million balance in return for, among
other things, the exclusive rights to the MainStay Suites brand from Sunburst.
The $17 million, net of income taxes of approximately $7 million, was recorded
as an adjustment to additional paid-in-capital as it represents an adjustment to
the accounting for the Sunburst Distribution.
44
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Accrued Expenses
Accrued expenses were as follows as of December 31:
(In thousands) 1999 1998
---------------------------
Accrued salaries & benefits $12,813 $10,611
Accrued interest 2,911 3,302
Other 6,559 5,693
---------------------------
Total $22,283 $19,606
---------------------------
Long-Term Debt and Notes Payable
As of December 31, debt consisted of the following:
(In thousands) 1999 1998
---------------------------
$300 million competitive advance
and multi-currency revolving
credit facility with an average rate
of 6.81% and 5.91% at December
31, 1999 and 1998, respectively $194,500 $172,000
$100 million senior note offering
with an average rate of 7.22% at
December 31, 1999 and 1998 99,382 99,382
$15 million line of credit with a rate
of 6.90% and 6.10% at December
31, 1999 and 1998 12,000 6,200
Other notes with an average rate
of 5.90% and 5.85% at December
31, 1999 and 1998 1,474 1,628
---------------------------
Total indebtedness $307,356 $279,210
---------------------------
Maturities of debt as of December 31, 1999 were as follows:
Year (In thousands)
2000 $ 44,646
2001 42,646
2002 119,646
2003 146
2004 146
Thereafter 100,126
-----------
Total $307,356
-----------
On October 15, 1997, the Company entered into a $300 million competitive advance
and multi-currency revolving credit facility (the "Credit Facility") provided by
a group of 13 banks. The Credit Facility provides for a term loan of $150
million and a revolving credit facility of $150 million, $50 million of which is
available for borrowings in foreign currencies. The Credit Facility includes
customary financial and other covenants that require the maintenance of certain
ratios including maximum leverage, minimum net worth and interest coverage and
restricts the Company's ability to make certain investments, repurchase stock,
incur debt and dispose of assets. The term loan ($112.5 million of which is
outstanding at December 31, 1999) is payable over five years, $32.5 million of
which is due in 2000. Borrowings under the facility are, at the option of the
borrower, at one of several rates including LIBOR plus 20.0 to 87.5 basis
points, based upon a defined financial ratio and the loan type. In addition, the
Company has the option to request participating banks to bid on loan
participation at lower rates than those contractually provided by the facility.
The Credit Facility requires the Company to pay annual fees of 1/10 of 1% to 1/3
of 1%, based upon a defined financial ratio of the total loan commitment. The
Credit Facility will terminate on October 15, 2002.
On May 1, 1998, the Company issued $100 million of senior unsecured notes (the
"Notes") at a discount of $0.6 million, bearing a coupon rate of 7.13% with an
effective rate of 7.22%. The Notes will mature on May 1, 2008, with interest on
the Notes to be paid semi-annually. The Company used the net proceeds from the
offering of approximately $99 million to repay amounts outstanding under the
Company's Credit Facility.
During April 1999, the Company renewed its $15 million revolving line of credit
in order to finance short term working capital requirements and other short term
general corporate goals. The line of credit is due to expire on April 30, 2000
and bears interest at 6.90%. Interest accrues monthly on the outstanding
balance. The line of credit contains essentially the same covenants as the
Credit Facility and is prepayable without penalty.
Cash paid for interest was $19.4 million, $19.2 million, $7.9 million and $11.6
million for the years ended December 31, 1999 and 1998, the seven months ended
December 31, 1997, and the fiscal year ended May 31, 1997, respectively.
Interest Rate Hedges
The Company has entered into an interest rate swap agreement with a notional
amount of $115 million at December 31, 1999 to fix certain of its variable rate
debt in order to reduce the Company's exposure to fluctuations in interest
rates. The interest rate differential to be paid or received on the interest
rate swap agreement is accrued as interest rates change and is recognized as an
adjustment to interest expense. As of December 31, 1999, the interest rate swap
agreement has a life of two months with a fixed rate of 5.85% and variable rate
of 6.12%. As of December 31, 1999 and 1998, the interest rate swap agreements
45
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
have a fair market valuation of approximately $0.1 million and $(2.8) million,
respectively.
Foreign Operations
The Company accounts for foreign currency translation in accordance with SFAS
No. 52, "Foreign Currency Translation." Revenues generated by foreign operations
for the years ended December 31, 1999 and 1998, the seven months ended December
31, 1997 and the fiscal year ended May 31, 1997 were $6.9 million, exclusive of
$2.5 million of foreign dividends; $5.8 million, exclusive of $2.1 million of
foreign dividends; $16.2 million, exclusive of $0.6 million of foreign
dividends; and $27.5 million, exclusive of $0.9 million of foreign dividends,
respectively. The Company's foreign operations had net income (loss) of $1.0
million, $0.0 million, $0.5 million, and $(3.1 million) for the years ended
December 31, 1999 and 1998, the seven months ended December 31, 1997 and the
fiscal year ended May 31, 1997.
Pension, Profit Sharing and Incentive Plans
Bonuses accrued for key executives of the Company under incentive compensation
plans were $1.0 million and $0.8 million at December 31, 1999 and 1998,
respectively.
During 1999 and 1998, employees of the Company participated in 401(k) retirement
plans sponsored by the Company. For the years ended December 31, 1999 and 1998,
the Company recorded compensation expense of $1.3 million and $1.2 million,
respectively, related to the plans. Prior to the Manor Care Distribution and
Sunburst Distribution, employees participated in retirement plans sponsored by
Manor Care and Sunburst. Costs allocated to the Company under those plans were
based on the size of its payroll relative to the sponsor's payroll. Costs
allocated to the Company were approximately $1.2 million and $1.4 million for
the seven months ended December 31, 1997 and the fiscal year ended May 31, 1997,
respectively.
- --------------------------------------------------------------------------------
Income Taxes
The Company was included in the consolidated federal income tax returns of Manor
Care and Sunburst prior to October 15, 1997. Subsequent to October 15, 1997, the
Company is required to make its own filings. The income tax provision included
in these consolidated financial statements reflects the historical income tax
provision and temporary differences attributable to the operations of the
Company on a separate return basis. Deferred taxes are recorded for the tax
effect of temporary differences between book and tax income.
Income before income taxes were derived from the following:
Years ended Seven months Fiscal year
December 31, ended December 31, ended May 31,
(In thousands) 1999 1998 1997 1997
---------------------------------------------------------
Income before income taxes and extraordinary item:
Domestic operations $92,058 $82,400 $ 45,866 $ 62,641
Foreign operations 2,413 -- 517 (3,066)
---------------------------------------------------------
Income before income taxes and extraordinary item $94,471 $82,400 $ 46,383 $ 59,575
---------------------------------------------------------
The provisions for income taxes follow:
Current tax expense
Federal $22,038 $15,918 $ 15,946 $ 18,208
State 2,723 3,482 3,475 3,950
Foreign 1,422 2 -- --
Deferred tax (benefit) expense
Federal 10,515 12,420 (223) 2,293
State 618 2,505 (102) 394
---------------------------------------------------------
$37,316 $34,327 $ 19,096 $ 24,845
---------------------------------------------------------
Deferred tax assets (liabilities) are comprised of the following:
December 31,
(In thousands) 1999 1998
---------------------------
Depreciation and amortization $(16,582) $(16,013)
Prepaid expenses (17,542) (3,975)
Other (6,175) (5,316)
---------------------------
Gross deferred tax liabilities (40,299) (25,304)
---------------------------
Foreign operations 223 2,211
Accrued expenses 9,112 5,035
Net operating losses 99 187
Other 3,979 1,860
---------------------------
Gross deferred tax assets 13,413 9,293
---------------------------
Net deferred tax liability $(26,886) $(16,011)
---------------------------
46
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
A reconciliation of income tax expense at the statutory rate to income tax
expense included in the accompanying consolidated statements of income follows:
Years ended Seven months Fiscal year
December 31, ended December 31, ended May 31,
(In thousands, except Federal income tax rate) 1999 1998 1997 1997
------------------------------------------------------------
Federal income tax rate 35% 35% 35% 35%
Federal taxes at statutory rate $33,065 $28,856 $16,234 $20,853
State income taxes, net of federal tax benefit 2,172 3,892 2,192 2,824
Other 2,079 1,579 670 1,168
------------------------------------------------------------
Income tax expense $37,316 $34,327 $19,096 $24,845
------------------------------------------------------------
Cash paid for state income taxes was $2.3 million, $3.4 million, $0.2 million
and $1.3 million for the years ended December 31, 1999 and 1998, the seven
months ended December 31, 1997 and the fiscal year ended May 31, 1997,
respectively. Federal income taxes were paid by Manor Care for the period ending
October 31, 1996. Federal income taxes were paid by Sunburst for the period
beginning November 1, 1996 through October 15, 1997. The Company paid $15.5
million, $18.9 million, and $9.1 million for the years ended December 31, 1999
and 1998 and for the seven months ended December 31, 1997, respectively.
Capital Stock
In 1999, the Company granted key employees and non-employee directors 70,260
restricted shares of common stock with a value of $1.0 million on the grant
date. The restricted stock vests over a three to five year period with 11,016
shares of the restricted stock vesting over a three year period, 32,180 shares
vesting over a four year period and 27,064 shares vesting over a five year
period. In 1998, the Company granted key employees and non-employee directors
160,212 restricted shares of common stock with a value of $2.3 million on the
grant date. These restricted shares vest over a one to five year period with
22,665 shares of the restricted stock vesting over a one year period, 78,547
shares vesting over a three year period, 40,250 shares vesting over a four year
period, and 18,750 shares vesting over a five year period. A total of 46,275
shares of restricted stock were forfeited in 1999 and 1998.
On February 19, 1998, the Board of Directors adopted a shareholder rights plan
under which a dividend of one preferred stock purchase right was distributed for
each outstanding share of the Company's common stock to shareholders of record
on April 3, 1998. Each right will entitle the holder to buy 1/100th of a share
of a newly issued series of a junior participating preferred stock of the
Company at an exercise price of $75 per share. The rights will be exercisable,
subject to certain exceptions, 10 days after a person or a group acquires
beneficial ownership of 10% or more of the Company's common stock. Shares owned
by a person or group on February 19, 1998, and held continuously thereafter are
exempt for purposes of determining beneficial ownership under the rights plan.
The rights will be non-voting and will expire on January 31, 2008, unless
exercised or previously redeemed by the Company for $.001 each. If the Company
is involved in a merger or certain other business combinations not approved by
the Board of Directors, each right will entitle its holder, other than the
acquiring person or group, to purchase common stock of either the Company or the
acquiror or having a value of twice the exercise price of the right.
The Company has stock option plans for which it is authorized to grant options
to purchase up to 7.1 million shares of the Company's common stock, of which 0.8
million shares remain available for grant. Stock options may be granted to
officers, key employees and non-employee directors with an exercise price not
less than the fair market value of the common stock on the date of grant. In
connection with the Sunburst Distribution, the outstanding options held by
current and former employees of the Company were redenominated in stock of the
newly separated companies and the number and exercise prices of the options were
adjusted based on the relative trading prices of the common stock of the two
companies in order to retain the intrinsic value of the options.
47
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
A summary of the option activity under the above plans is as follows as of
December 31, 1999 and 1998:
1999 1998
---------------------------------------------------------------
Fixed Options Shares Weighted-Option Shares Weighted-Option
(000) Price (000) Price
---------------------------------------------------------------
Outstanding at beginning of year 3,969,309 $10.13 4,167,045 $ 8.62
Granted 732,372 13.19 933,263 13.37
Exercised (695,228) 7.06 (738,318) 4.75
Cancelled (99,127) 12.85 (392,681) 11.88
-------- ----- --------- -----
Outstanding at end of year 3,907,326 $11.19 3,969,309 $10.13
---------------------------------------------------------------
Options exercisable at year end 1,727,748 1,813,541
Weighted-average fair value of
options granted during the year $ 6.20 $ 7.81
---------------------------------------------------------------
The following table summarizes information about stock options outstanding at
December 31, 1999:
Options Outstanding Options Exercisable
- ------------------------------------------------------------------------------------------------------------------
Range of Number Weighted-Average Weighted Number Weighted
Exercise Prices Outstanding at Remaining Average Exercisable at Average
12/31/99 Contractual Life Exercise Price 12/31/99 Exercise Price
- ------------------------------------------------------------------------------------------------------------------
$ 3.01 to 5.00 480,992 1.6 years $4.01 452,363 $3.95
5.00 to 9.00 388,412 3.7 years 7.03 271,387 6.89
9.00 to 13.00 2,033,777 7.8 years 12.11 721,093 11.59
13.00 to 17.65 1,004,145 8.1 years 14.36 282,905 13.97
- ------------------------------------------------------------------------------------------------------------------
3,907,326 1,727,748
- ------------------------------------------------------------------------------------------------------------------
SFAS No. 123, "Accounting for Stock-Based Compensation," requires companies to
provide additional disclosures about employee stock-based compensation plans
based on a fair value based method of accounting. As permitted by this
accounting standard, the Company continues to account for these plans under APB
Opinion 25, under which no compensation cost has been recognized.
For purposes of the proforma disclosure, compensation cost for the Company's
stock option plan was determined based on the fair value at the grant dates for
awards under those plans consistent with the method of SFAS No. 123. The fair
value of each option grant has been estimated on the date of grant using an
option-pricing model with the following weighted average assumptions used for
grants in 1999 and 1998:
1999 1998
---------------------------------
Risk-free interest rate 6.45% 4.70%
Volatility 38.0% 36.7%
Expected Lives 10 years 10 years
Dividend Yield 0% 0%
If options had been reported as compensation expense based on their fair value,
pro forma net income would have been $56.4 million and $54.0 million for the
years ended December 31, 1999 and December 31, 1998, and pro forma diluted
earnings per share would have been $1.01 and $0.90, respectively. Since this
methodology has not been applied to options granted prior to the Sunburst
distribution date, the resulting pro forma compensation cost is not likely to be
representative of that to be expected in future years.
Comprehensive Income
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income," which establishes new rules for the reporting and display
of comprehensive income and its components; however, the adoption of SFAS No.
130 had no impact on the Company's net income or shareholders' equity. SFAS No.
130 requires unrealized gains or losses on the Company's available-for-sale
securities and the foreign currency translation adjustments, which prior to
adoption were reported separately in shareholders' equity, to be included in
other comprehensive income. Prior year financial statements have been
reclassified to conform to the requirements of SFAS No. 130.
48
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
The components of total accumulated other comprehensive income in the
consolidated balance sheets are as follows:
December 31,
(In thousands) 1999 1998 1997
----------------------------------------------
Unrealized losses on securities available for sale $ (419) $ 380 $ --
Foreign currency translation adjustments 1,624 1,732 (8,316)
----------------------------------------------
Total accumulated other comprehensive income (loss) $ 1,205 $2,112 $(8,316)
----------------------------------------------
The related income tax effect allocated to each component of other comprehensive
income (loss) is as follows:
Amount Before Income Tax Amount Net
(In thousands) Taxes (Expense)/Benefit of Taxes
----------------------------------------------
Calendar year 1999
Net unrealized losses $(1,024) $ 225 $ (799)
Foreign currency translation adjustments, net (108) -- (108)
----------------------------------------------
Total other comprehensive income $(1,132) $ 225 $ (907)
----------------------------------------------
Calendar year 1998
Net unrealized gains $ 585 $(205) $ 380
Foreign currency translation adjustments, net 10,048 -- 10,048
----------------------------------------------
Total other comprehensive income $10,633 $(205) $10,428
----------------------------------------------
Fiscal year 1997
Foreign currency translation adjustments, net $(1,298) $ -- $(1,298)
----------------------------------------------
Total other comprehensive income $(1,298) $ -- $(1,298)
----------------------------------------------
Below represents the detail of other comprehensive income:
1999 1998
------------------------------
Foreign currency translation adjustments $ (108) $ 1,916
Plus: reclassification of loss on
liquidation of foreign subsidiaries -- 8,132
------------------------------
Foreign currency translation
adjustments, net $ (108) $10,048
------------------------------
Unrealized holding gains arising during
the period, net $ 601 $ 380
Less: reclassification adjustments for
gains included in net income (1,400) --
------------------------------
Net unrealized holding losses arising
during the period $ (799) $ 380
------------------------------
Earnings Per Share
The Company adopted SFAS No. 128, "Earnings Per Share," in 1997. The following
table illustrates the reconciliation of the earnings and number of shares used
in the basic and diluted earnings per share calculations.
Years ended
December 31,
(In millions, except per share amounts) 1999 1998
-----------------------
Computation of Basic Earnings Per Share:
Net income $57.2 $55.3
Weighted average shares outstanding 54.9 58.7
Basic earnings per share $1.04 $0.94
Computation of Diluted Earnings Per Share:
Net income for diluted earnings per share $57.2 $55.3
Weighted average shares outstanding 54.9 58.7
Effect of Dilutive Securities:
Employee stock option plan 0.8 0.8
-----------------------
Shares for diluted earnings per share 55.7 59.5
-----------------------
Diluted earning per share $1.03 $0.93
49
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
The effect of dilutive securities is computed using the treasury stock method
and average market prices during the period. In 1999 and 1998, the Company
excluded 206,031 and 497,864, respectively, anti-dilutive options from the
computation of diluted earnings per share.
The weighted average number of common shares outstanding is based on the
Company's weighted average number of outstanding common shares for the period
October 15, 1997 through December 31, 1999, Sunburst's weighted average number
of outstanding common shares for the period November 1, 1996 through October 15,
1997 and Manor Care's weighted average number of outstanding common shares prior
to November 1, 1996.
Leases
Rental expense under non-cancelable operating leases was approximately $5.5
million, $1.7 million, $181,000 and $171,000 for the years ended December 31,
1999 and 1998, the seven months ended December 31, 1997 and the fiscal year
ended May 31, 1997, respectively. The Company paid office rent of $51,662,
$977,500 and $1.1 million to Sunburst for the years ended December 31, 1999 and
1998 and the seven months ended December 31, 1997 based on the portion of total
space occupied by the Company. Future minimum lease payments are as follows:
Year (In thousands)
2000 $ 3,606
2001 3,374
2002 3,332
2003 3,259
2004 3,347
Thereafter 30,610
-----------
Total $47,528
-----------
During 1998, the Company recorded an extraordinary gain from the early
extinguishment of debt associated with a capitalized lease obligation. The
Company retired $13.7 million in debt and removed related assets of $1.8 million
from the consolidated balance sheets. Accordingly, an extraordinary gain of $7.2
million was recognized, after income tax expense of $4.7 million, or $0.12 per
diluted share.
Prior to May 31, 1998, the Company was a guarantor of Sunburst's obligations
under leases between Sunburst and Manor Care. Additionally, Sunburst and Choice
had entered into a sublease agreement with respect to the Company's principal
executive offices. On May 31, 1998, the Company and Manor Care entered into a
new lease for the Silver Spring, Maryland corporate headquarters and the
Company's guarantees of Sunburst lease obligations and the sublease were
cancelled. The new lease has a fifteen year term and was subsequently assigned
from Manor Care to an unrelated party.
Related Party Transactions
During 1998, the Company entered into an interest free bridge loan agreement
with a Company executive approximating $754,000, which is reflected as a
receivable at December 31, 1998. The bridge loan was repaid in March 1999.
Reportable Segment Information
The Company has a single reportable segment encompassing its franchising
business. Franchising revenues are comprised of royalty fees, initial franchise
and relicensing fees, and partner services revenue and other. Marketing and
reservation fees and expenses are excluded from reportable segment information
as such fees and associated expenses are reported net. Corporate and other
revenue consists of product sales and European hotel operations. The Company
does not allocate interest income, interest expense or income taxes to its
franchising segment.
The following table presents the financial information for the
50
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Year ended December 31, 1999
(In thousands) Franchising Corporate & Other Consolidated
-----------------------------------------------
Revenues $157,729 $ 3,871 $161,600
Operating income (loss) 124,293 (30,459) 93,834
Depreciation and amortization 730 7,293 8,023
Capital expenditures 16,515 14,118 30,633
Total assets 248,028 216,630 464,658
Year ended December 31, 1998
Franchising Corporate & Other Consolidated
-----------------------------------------------
Revenues $143,628 $ 21,846 $165,474
Operating income (loss) 113,175 (28,067) 85,108
Depreciation and amortization 221 6,532 6,753
Capital expenditures 15,500 1,988 17,488
Total assets 208,096 190,129 398,225
Seven months ended December 31, 1997
Franchising Corporate & Other Consolidated
-----------------------------------------------
Revenues $ 83,774 $ 24,065 $107,839
Operating income (loss) 67,889 (15,715) 52,174
Depreciation and amortization 24 3,953 3,977
Capital expenditures 5,535 1,794 7,329
Total assets 182,210 204,185 386,395
Fiscal year ended May 31, 1997
Franchising Corporate & Other Consolidated
-----------------------------------------------
Revenues $126,659 $ 41,380 $168,039
Operating income (loss) 92,774 (22,412) 70,362
Depreciation and amortization 331 7,312 7,643
Capital expenditures 7,727 2,903 10,630
Total assets 165,766 55,707 221,473
Company's franchising segment.
The Company's international operations had revenues of $6.9 million, $5.8
million, $16.2 million and $27.5 million for the years ended December 31, 1999
and 1998, the seven months ended December 31, 1997 and the fiscal year ended May
31, 1997, respectively. Long-lived assets related to international operations
were $20.6 million and $16.4 million as of December 31, 1999 and 1998,
respectively. All other long-lived assets of the Company are associated with
domestic activities. In addition, the Company had a $41.2 million and $41.6
million investment in Friendly as of December 31, 1999 and 1998, respectively.
Commitments and Contingencies
The Company is a defendant in a number of lawsuits arising in the ordinary
course of business. In the opinion of management and general counsel to the
Company, the ultimate outcome of such litigation will not have a material
adverse effect on the Company's business, financial position, results of
operations or cash flows.
Fair Value of Financial Instruments
The balance sheet carrying amount of cash and cash equivalents and receivables
approximate fair value due to the short term nature of these items. Long-term
debt consists of bank loans and senior notes. Interest rates on bank loans
adjust frequently based on current market rates; accordingly, the carrying
amount of bank loans is equivalent to fair value.
The Note Receivable from Sunburst has an approximate fair value of $135.0
million and $127.5 million at December 31, 1999 and 1998, respectively, based on
its current yield to maturity. The $100 million unsecured senior notes have an
approximate fair value at December 31, 1999 and 1998 of $93.9 million and $97.6
million, respectively, based on their
51
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
current yield to maturity.
Impact of Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," which requires
recognition of the fair value of derivatives in the statement of financial
position, with changes in the fair value recognized either in earnings or as a
component of other comprehensive income dependent upon the hedging nature of the
derivative. Implementation of SFAS No. 133 is required for Fiscal 2001. SFAS No.
133 will not have a material impact on the Company's earnings or other
comprehensive income.
Selected Quarterly Financial Data - (Unaudited)
(In thousands, except per share data)
- --------------------------------------------------------------------------------------------------------------------
Total
1999 First Second Third Fourth Year
- --------------------------------------------------------------------------------------------------------------------
Revenues $30,805 $39,763 $48,016 $43,016 $161,600
Operating income 16,166 24,198 30,206 23,264 93,834
Income before income taxes 17,272 24,280 30,381 22,538 94,471
Net income 10,277 14,531 18,338 14,009 57,155
Per basic share:
Net income $ 0.18 $ 0.26 $ 0.34 $ 0.26 $ 1.04
Per diluted share:
Net income $ 0.18 $ 0.26 $ 0.33 $ 0.26 $ 1.03
Total
1998 First Second Third Fourth Year
- --------------------------------------------------------------------------------------------------------------------
Revenues $ 33,171 $ 44,436 $ 46,731 $ 41,136 $ 165,474
Operating income 14,133 23,519 26,736 20,720 85,108
Income before income taxes and extraordinary item 13,961 22,258 25,224 20,957 82,400
Net income before extraordinary item 8,146 12,988 14,718 12,221 48,073
Net income 8,146 12,988 21,950 12,221 55,305
Per basic share:
Net income before extraordinary item $ 0.14 $ 0.22 $ 0.25 $ 0.21 $ 0.82
Extraordinary item $ 0.00 $ 0.00 $ 0.12 $ 0.00 $ 0.12
Net income $ 0.14 $ 0.22 $ 0.37 $ 0.21 $ 0.94
Per diluted share:
Net income before extraordinary item $ 0.13 $ 0.22 $ 0.25 $ 0.21 $ 0.81
Extraordinary item $ 0.00 $ 0.00 $ 0.12 $ 0.00 $ 0.12
Net income $ 0.13 $ 0.22 $ 0.37 $ 0.21 $ 0.93
52
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Choice Hotels International, Inc. and Subsidiaries
Subsequent Event (Unaudited)
In February 2000, the Company and Sunburst entered into a second amendment of
the strategic alliance agreement which had the effect of: (i) finalizing
outstanding operational issues with respect to the MainStay brand; (ii)
modifying the royalty payment schedule payable by Sunburst to the Company on the
MainStay portfolio; and (iii) ensuring that Sunburst keeps at least 20 MainStay
hotels in the franchise system for the period ending October 2002.
In addition, the parties entered into a put call agreement related to three
MainStay properties in Pittsburgh, Pennsylvania, Greenville, South Carolina, and
Brentwood, Tennessee for a period ending June 30, 2000. During this period, the
Company can "call" any property for purchase at Sunburst's original cost
(approximately $15 million) and at the end of this period Sunburst may "put" any
property at such cost.
Management believes that entering into these agreements will have the effect of
solidifying the strategic relationship, particularly with respect to development
of MainStay hotels, and ensure that Sunburst will complete its development quota
of 25 MainStay hotels.
54
Board of Directors & Corporate Officers
- --------------------------------------------------------------------------------
Board Of Directors
Stewart Bainum, Jr.
Chairman of the Board:
. Manor Care Inc.
. Sunburst Hospitality Corporation
Barbara Bainum
President, Secretary and Director:
. Commonweal Foundation
Secretary and Director:
. Realty Investment Company
William L. Jews
President and Chief Executive Officer:
. CareFirst BlueCross BlueShield
Director:
. Crown Central Petroleum Corp.
. Ryland Group, Inc.
Charles A. Ledsinger, Jr.
President and Chief Executive Officer:
. Choice Hotels International
Director:
. FelCor Lodging Trust, Inc.
. Friendly's Ice Cream Corporation
. TBC Corporation
Larry R. Levitan
Retired Managing Partner:
. Andersen Consulting's Worldwide Communications Industry Group
Gerald W. Pettit
President & Chief Executive Officer:
. Creative Hotel Associates LLC
James H. Rempe
Retired Senior Vice President,
General Counsel & Secretary:
. Manor Care Inc.
Jerry E. Robertson, Ph.D.
Retired Executive Vice President:
. 3M Life Sciences Sector and Corporate Services
Director:
. Coherent Inc.
. Steris Corp.
Raymond E. Schultz
Chairman:
. RES Investments, L.L.C.
Director:
. Equity Inns, Inc.
. TBC Corporation
Stewart Bainum
Chairman Emeritus
Corporate Executive Officers
Stewart Bainum, Jr.
Chairman of the Board
Charles A. Ledsinger, Jr.
President and Chief Executive Officer
Steven T. Schultz
Executive Vice President, Franchise Operations
Michael J. DeSantis
Senior Vice President, General Counsel and Secretary
Bruno Geny
Senior Vice President, International
Thomas Mirgon
Senior Vice President, Administration
Joseph M. Squeri
Senior Vice President, Chief Financial Officer and Treasurer
Corporate Officers
Eric Bauer
Vice President, Strategy and Business Development
Brendan M. Ebbs
Senior Vice President, Franchise Operations
Daniel Rothfeld
Vice President, Partner Services
Kevin M. Rooney
Associate General Counsel and Assistant Secretary
William Weatherford
Senior Vice President, Franchise
Operations
Market Area Vice
Presidents
Brendan M. Ebbs
Senior Vice President, Franchise Operations, Northeast Market Area
William Weatherford
Senior Vice President, Franchise Operations, Southeast Market Area
Michael Barnard
Vice President, Franchise Operations, West Market Area
Gary Decatur
Vice President, Franchise Operations, North Central Market Area
Brent Russell
Vice President, Franchise Operations, South Central Market Area
Brand Management
Michael Cothran
Vice President & Brand Manager Rodeway Inn
Peter Jordan
Vice President & Brand Manager Quality
Donald Kolodz
Vice President & Brand Manager Clarion
Dan Shoen
Vice President & Brand Manager Comfort
Tim Shuy
Vice President & Brand Manager Econo Lodge & MainStay Suites
55
C o r p o r a t e I n f o r m a t i o n
- --------------------------------------------------------------------------------
Stock Listing
Choice Hotels International common stock trades on the New York Stock Exchange
under the ticker symbol CHH.
Transfer Agent & Registrar
ChaseMellon
Shareholder Services LLC
Overpeck Centre
85 Challenger Road
Ridgefield, NJ 07660
www.chasemellon.com
Independent Auditors
Arthur Andersen LLP
Vienna, Virginia
Annual Meeting Date
Choice Hotels International will hold its Annual Meeting of Stockholders on
Wednesday, May 3, 2000, at 9 a.m. in The Chesapeake Room of the Learning Center,
10720 Columbia Pike, Silver Spring, Maryland.
Form 10-K
A stockholder may receive without charge a copy of the Form 10-K Annual Report
filed with the Securities and Exchange Commission by written request to the
Corporate Secretary at the corporate headquarters.
Corporate Headquarters
Choice Hotels International
10750 Columbia Pike
Silver Spring, MD 20901
General Inquiries:
(301) 592-5000
Franchise Sales:
(800) 547-0007
Investor Inquiries:
(301) 592-5026
e-mail: investor_relations@choicehotels.com
Media Relations:
(301) 592-5032
Corporate Web Site:
www.choicehotels.com
[LOGO]
(C)2000 Choice Hotels International, Inc.
Quality, Comfort, Clarion, Sleep Inn, Econo Lodge, Rodeway Inn and MainStay are
registered trademarks, service marks and trade names owned by Choice Hotels
International, Inc. Choice Hotels also owns and uses common law marks, including
Guest Privileges and Profit Manager.
Design: Choice Graphic Design & Corporate Identity
Principal Photographer: Cameron Davidson
Printer: GraphTec