Choice Hotels International, Inc. — 2010 Q3 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2010. Unaudited consolidated results; financial amounts below are in millions unless otherwise stated.
Business context
Choice is primarily a hotel franchisor, operating brands in the United States and internationally. At quarter-end, its franchise agreements covered 6,091 open hotels and 638 hotels in the development pipeline. International operations represented about 19% of open hotels but 7% of revenue.
Financial performance
- Third quarter: Revenue was $183.8 million, up 10.7% year over year; operating income was $54.9 million, up 14.0%; net income was $40.5 million, up 23.4%; diluted EPS was $0.68 versus $0.55.
- First nine months: Revenue was $441.1 million, up 4.2%; operating income was $122.3 million, up 7.3%; net income was $83.3 million, up 11.6%; diluted EPS was $1.40 versus $1.24.
- Core franchising revenue, a company-defined non-GAAP measure excluding marketing and reservation revenue and hotel operations, rose 7% to $79.9 million in Q3 and 2% to $195.9 million for nine months. Marketing and reservation revenue is contractually spent on those services and does not generate income or loss.
- Operating margin on reported revenue was approximately 29.9% in Q3 (29.0% in 2009) and 27.7% for nine months (26.9% in 2009).
- Cash flow: Nine-month operating cash flow was $108.2 million, compared with $80.0 million. Capital expenditures were $17.7 million versus $7.5 million; operating cash flow less capital expenditures was approximately $90.6 million. Cash and equivalents were $79.5 million at September 30.
- Debt and liquidity: Total debt was $258.5 million, including $249.4 million of senior notes and $6.6 million drawn on the revolving facility. Current assets of $165.2 million were below current liabilities of $176.7 million; the current ratio was approximately 0.93. Cash less total debt was approximately negative $179.0 million. About $76 million of cash was held by foreign subsidiaries and intended to remain reinvested overseas.
- The company declared a quarterly dividend of $0.185 per share. Nine-month dividends paid were $32.9 million; share repurchases cost $8.7 million under the program.
Changes versus prior period
- Q3 domestic royalty revenue increased 9%, supported by 7.4% RevPAR growth, 0.7% growth in domestic franchised rooms, and a higher effective royalty rate (4.30% versus 4.23%). Occupancy rose 420 basis points while average daily rates were approximately flat.
- For the first nine months, domestic RevPAR increased 0.5%: occupancy improved 110 basis points, partly offset by a 1.7% decline in average daily rates. Domestic royalties increased 2.9%.
- Franchise development remained weak: domestic net additions were 45 for nine months versus 174 a year earlier, while the domestic pipeline declined 27% to 545 hotels. Management attributed the slowdown to economic conditions and limited hotel financing.
- SG&A declined 7% for nine months to $67.8 million. Initial franchise and relicensing revenue fell, as did procurement services revenue; royalty growth offset these declines.
- The effective tax rate declined to 26.4% for Q3 from 35.0%, and to 31.6% for nine months from 35.9%. Management attributed the 2010 rates principally to a $3.3 million prior-period deferred-tax-asset adjustment, partly offset by $1.6 million related to identified prior-period tax positions, plus $1.7 million of additional federal tax benefits identified in the quarter.
Debt, outlook, risks, and unusual items
- In August, Choice issued $250 million of 5.7% coupon senior notes due 2020 (effective interest rate 6.19%), using net proceeds primarily to repay revolving borrowings and for general corporate purposes. The revolving facility matures in June 2011; $6.6 million was outstanding at quarter-end. The company reported covenant compliance, with leverage of about 1.5x against a 3.25x maximum.
- A forward-starting interest-rate swap was settled for $8.7 million when the notes were issued. The effective loss was recorded in other comprehensive income and is to be amortized as interest expense over the debt term; less than $0.1 million of ineffectiveness was expensed immediately.
- Management expected approximately 325 domestic hotel openings in 2010, down from 442 in 2009, and anticipated continued below-pre-recession franchise agreement activity while financing remained constrained. It cautioned that prolonged credit-market disruption could materially harm results. The filing provides no specific earnings or revenue guidance.
- Management expected annual investment of $20–$40 million in franchisee financing, guarantees, and real estate programs, subject to market conditions; approximately $18.9 million had been invested in the first nine months, of which $5 million was repaid. Marketing and reservation activities were expected to use $8–$12 million of cash in 2010.
- Marketing and reservation fee receivables totaled $46.1 million, up from $33.9 million at year-end, and depend on future collections from franchisees. Notes receivable, net, were $12.6 million; $10.8 million of mezzanine and other notes were identified as impaired, with an $8.6 million allowance against those impaired loans.
- One-time employee termination charges were $1.6 million for nine months, with $3.2 million of termination benefits unpaid at quarter-end. Management expected $2.6 million to be paid within 12 months. Two $1 million franchisee loan guarantees and a conditional $3.5 million land purchase commitment were disclosed. Management said ordinary-course lawsuits were not expected individually to have a material adverse effect; Part II reports no legal proceedings.
- Key risks include lodging demand and room-rate changes, hotel supply, franchisee performance and development, access to financing, brand competitiveness, technology, foreign currency exposure, debt management, and collectability of marketing/reservation advances and franchisee loans.
Important facts for investors to verify
- Whether RevPAR, royalty rates, and room growth continue to support royalty revenue as the development pipeline and new openings contract.
- How much of the $46.1 million marketing and reservation receivable is collectible, and whether its growth creates additional cash demands.
- Franchisee loan exposure, impairment assumptions, and the terms and funding of the remaining committed advances.
- Cash availability and restrictions: approximately $76 million was held overseas, while current liabilities exceeded current assets.
- The effect of the 2020 notes’ higher borrowing cost, the revolving facility’s June 2011 maturity, and continued dividends, repurchases, and development-program spending on liquidity.
- The sustainability of earnings growth given tax adjustments and investment-related gains, and the status of the expected 2010 hotel openings and development investments.