Choice Hotels International, Inc. — Q3 2014 Form 10-Q
Reporting period: Three and nine months ended September 30, 2014; unaudited. Choice is primarily a hotel franchisor, with 6,386 hotels open and 516 in its development pipeline across the U.S. and more than 35 other countries and territories. Results are seasonal, and interim results may not indicate full-year performance.
Financial performance
Amounts are in millions except per-share data and operating statistics.
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Total revenue | $215.2 | $216.7 | $572.6 | $555.8 |
| Operating income | $67.0 | $63.2 | $168.3 | $155.1 |
| Operating margin | 31.1% | 29.2% | 29.4% | 27.9% |
| Continuing-operations income | $39.4 | $38.6 | $96.2 | $90.0 |
| Net income | $39.4 | $38.7 | $97.9 | $90.3 |
| Diluted EPS | $0.67 | $0.66 | $1.66 | $1.53 |
| Adjusted EBITDA (non-GAAP) | $69.3 | $65.5 | $175.2 | $161.8 |
Q3 total revenue declined 1%, although management’s non-GAAP franchising revenue, excluding marketing and reservation activity and SkyTouch, rose 8% to $99.4 million. For nine months, total revenue increased 3% and franchising revenue rose 8% to $263.3 million. The marketing and reservation revenue line is matched by related expense and is not a direct measure of franchising profitability.
- Franchise performance: Domestic RevPAR increased 8.8% in Q3 and 7.7% for nine months; domestic open rooms increased 0.9% year over year. Domestic royalty growth was partly offset by lower effective royalty rates. Nine-month international royalties declined 1%, primarily due to foreign exchange.
- Cash flow: Nine-month operating cash flow was $138.4 million versus $106.5 million. Investing used $5.3 million versus $29.8 million; financing used $56.1 million versus $48.1 million. Ending cash was $244.4 million, up from $167.8 million at year-end 2013.
- Liquidity: Current assets were $405.4 million and current liabilities $199.5 million at September 30. The filing reports $180.6 million of cash at foreign subsidiaries whose earnings are intended to remain reinvested abroad.
- Debt: Total debt was $786.7 million, down from $793.6 million at December 31, 2013; cash less debt was approximately negative $542.3 million. The company had $132.2 million outstanding on its term loan and no revolver borrowings. It reported compliance with credit-facility covenants and leverage ratios of 3.16x total, 0.53x secured, and 6.13x fixed-charge coverage.
- Capital returns: The quarterly dividend remained $0.185 per share; $32.8 million of dividends were paid in the first nine months. The company repurchased $18.4 million of shares under its program.
Material changes versus the prior period
- Q3 operating income rose $3.8 million, but SG&A increased 14% to $30.2 million, including higher SkyTouch investment. Net income rose modestly; a prior-year investment gain did not recur.
- Nine-month operating income increased $13.2 million and diluted EPS rose 8%. Growth reflected higher franchising revenue and lower interest expense, partly offset by increased SG&A and lower gains from employee-plan investments.
- Marketing and reservation system fees collected exceeded cumulative expenses by $39.9 million at September 30, compared with a $5.8 million advance asset at December 31, 2013. The company deferred excess fees under franchise agreements; this materially affected reported marketing and reservation revenue.
- The company sold three company-owned MainStay Suites hotels by June 30, 2014 and presented their results as discontinued operations. Nine-month discontinued-operations income included a $2.8 million disposal gain.
- Cash flow benefited from a $60.2 million net inflow from marketing and reservation activities, compared with $29.7 million in the prior-year period. This timing and franchise-system cash flow should be distinguished from recurring operating earnings.
Outlook, risks, and unusual items
- Management expected 2014 domestic hotel openings to decline slightly, from 340 in 2013 to 311, primarily reflecting fewer conversion openings. It also expected $60–$65 million of 2014 cash flow from marketing and reservation activities.
- Management forecast approximately $18 million of full-year 2014 SkyTouch SG&A expense in excess of revenue, and indicated annual investment of $20–$40 million in franchisee financing, equity support, and related development initiatives.
- Management expected approximately $43.5 million of regular dividends for 2014 at the then-current rate, subject to board approval and business conditions. Future dividends and buybacks are also subject to debt covenants.
- At September 30, the company had $16.3 million of conditional franchisee financing commitments, including $6.6 million expected within 12 months, and expected $20.9–$24.1 million of property-improvement financing, also subject to conditions. It had committed a further $2.2 million to joint ventures. Two hotel-related loan guarantees had maximum exposures of $4.5 million and $11.6 million, plus specified ancillary obligations.
- Significant control issue: Management concluded disclosure controls were ineffective at September 30 because of a material weakness in revenue-recognition controls. Royalty and certain marketing and reservation fees had historically been recorded one month in arrears, contrary to GAAP; management said this was material to interim periods and had revised prior interim reporting. Remediation was underway but was not yet considered complete pending testing.
- Other risks cited include lodging and economic conditions, franchise growth and retention, foreign exchange and international operations, technology and cybersecurity, litigation, and managing debt. Management said ongoing litigation was not expected to have a material adverse effect.
Important facts for investors to verify
- Review the amended/restated filings and reconciliations for the revenue-recognition timing correction, including its effect on each interim period and related receivables and marketing balances.
- Track remediation testing and whether the revenue-recognition material weakness is ultimately deemed resolved.
- Assess the sustainability of RevPAR and royalty growth against effective royalty-rate declines, slower franchise additions, terminations, and the development pipeline’s conversion into open hotels.
- Examine the quality and timing of operating cash flow, especially marketing-system cash surpluses, franchisee advances, and deferred fees that are contractually designated for system use.
- Monitor debt maturities, covenant headroom, dividend and repurchase capacity, and the availability of foreign-held cash for domestic needs.
- Evaluate potential funding and credit exposure from franchisee incentives, joint ventures, hotel guarantees, impaired notes receivable, and the expected SkyTouch investment.