Business context and reporting period
Choice Hotels International, Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2012. It is principally a hotel franchisor, with one reportable segment. At quarter-end, its system included 6,199 open hotels and 435 hotels in development, conversion or approval pipelines, across the United States and more than 35 other countries and territories.
Financial performance and liquidity
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $210.4m | $192.3m | $513.2m | $472.9m |
| Operating income | $65.3m | $62.4m | $147.9m | $133.2m |
| Net income | $44.4m | $42.3m | $96.2m | $85.6m |
| Diluted EPS | $0.76 | $0.71 | $1.65 | $1.43 |
| Operating cash flow | Not separately provided | Not separately provided | $121.3m | $105.9m |
Q3 reported operating margin was 31.0% versus 32.4%; total revenue includes marketing and reservation fees that are contractually matched by expenses, so this reported margin includes substantial pass-through activity. Royalty revenue rose 5% in Q3 and 7% for the nine months. Domestic RevPAR increased 5.6% in Q3 and 6.9% year to date; domestic room supply grew about 1% in both comparisons. Q3 domestic royalty growth also reflected a 1% increase in franchised rooms and a 5.6% RevPAR increase.
At September 30, cash and cash equivalents were $115.1m, current assets $214.7m and current liabilities $207.2m. Approximately $110.5m of cash was held by foreign subsidiaries and management said it did not intend to use it domestically; repatriation could trigger additional U.S. tax. Total debt was $819.0m, compared with $252.7m at year-end 2011. The company generated $121.3m from operations in the first nine months, spent $19.6m on investing activities and used $94.5m in financing activities. Shareholders’ deficit was $569.4m, primarily reflecting the large special dividend and treasury stock.
Material changes versus the prior comparable period
- Q3 total revenue increased 9%, operating income 5%, net income 5% and diluted EPS 7%. Nine-month total revenue increased 9%, operating income 11%, net income 12% and diluted EPS 15%.
- Q3 interest expense rose to $10.2m from $3.2m; for the nine months it was $16.8m versus $9.7m. The increases followed debt issuance used to fund the special dividend. Q3 included a $0.5m loss on extinguishment of debt.
- On August 23, 2012, the company paid a $10.41-per-share special dividend totaling approximately $600.7m, financed with new debt. It issued $400m of 5.75% senior notes due 2022 and entered a $350m secured credit facility, including a $150m term loan and $200m revolving tranche. At quarter-end, $150m was outstanding on the term loan and $16.7m on the revolver.
- Net cash provided by operating activities increased to $121.3m from $105.9m; marketing and reservation activities provided $20.8m of cash, compared with a $1.5m use in the prior-year period.
Outlook, commentary, risks and unusual items
Management expected approximately 260 new franchise units to open in 2012, compared with 256 in 2011. It cited restricted construction financing, competitive retention efforts and franchise terminations as constraints; the domestic development pipeline declined 16% year over year, including a 28% decline in new-construction pipeline units. Management expected annual investment of $20m–$40m in franchisee financing, guarantees, joint ventures and strategic real estate, subject to market conditions, while also anticipating continued dividends and share repurchases as business conditions permit. The filing does not provide formal earnings or EPS guidance.
The company reported compliance with its credit-facility covenants at September 30, 2012: total leverage ratio 3.58x, secured leverage ratio 0.74x and fixed-charge coverage ratio 9.54x. It warned that higher leverage may constrain financing, investment, dividends and repurchases, and that variable-rate debt exposes it to rising interest rates. The $166.8m of variable-rate debt had an effective rate of 2.8%; a hypothetical 10% rate change would change annual interest expense by about $0.5m. Other stated risks include economic and lodging-industry conditions, franchisee performance, brand appeal, technology and foreign-currency fluctuations.
Other items to note: the effective tax rate benefited from a nonrecurring $4.5m favorable adjustment related to foreign operations; the IRS was examining tax years 2007, 2009 and 2010, with no material adjustments reported as of the filing. The company had $46.2m receivable for cumulative marketing and reservation costs in excess of fees earned and reported it fully collectible, while noting recovery could be affected by franchisee revenue, room supply and system growth. It had $9.5m of total loan-loss reserves against $35.4m of notes receivable. Management expected to settle the terminated executive SERP by year-end 2012; the estimated obligation was approximately $12.0m, and the final settlement could produce a gain or loss. Commitments included a $25m remaining payment on a land purchase, franchisee financing and joint-venture commitments, and an expected minimum $67.6m of rent over the initial 10-year term of a planned headquarters lease. A subsequent October 9 guaranty supported 25% of an $18m hotel construction loan, along with completion and environmental guarantees. Management said routine litigation was not expected to have a material adverse effect.
Most important facts for investors to verify
- Whether post-dividend leverage and higher interest costs remain manageable under the credit-facility covenants, and how much revolving capacity is available.
- Whether the special-dividend-related increase in debt is supported by sustainable operating cash flow, particularly given the foreign cash balance is not intended for domestic use.
- Whether RevPAR gains, domestic franchise-room growth and the development pipeline translate into openings and recurring royalty growth despite financing constraints and terminations.
- Whether the $46.2m marketing and reservation receivable and franchisee notes receivable are ultimately recovered as expected.
- The final SERP settlement cost, land-purchase and headquarters-lease obligations, and any exposure under the subsequent hotel-loan guarantees.
- The persistence of the $4.5m favorable tax adjustment and the outcome of the IRS examinations.