-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QnSzK4XjvFU9UYDvUur579SO3Y+bUcvlhedNG7Gm1f2+e8Xx/67IjBi/z/5333F4 1hkA2Wfhi5KKG9xZs86bNQ== 0000928385-00-001015.txt : 20000331 0000928385-00-001015.hdr.sgml : 20000331 ACCESSION NUMBER: 0000928385-00-001015 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CHOICE HOTELS INTERNATIONAL INC /DE CENTRAL INDEX KEY: 0001046311 STANDARD INDUSTRIAL CLASSIFICATION: HOTELS & MOTELS [7011] IRS NUMBER: 521209792 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-13393 FILM NUMBER: 585537 BUSINESS ADDRESS: STREET 1: 10770 COLUMBIA PIKE CITY: SILVER SPRING STATE: MD ZIP: 60563 BUSINESS PHONE: 3015925000 MAIL ADDRESS: STREET 1: 10770 COLUMBIA PIKE CITY: SILVER SPRING STATE: MD ZIP: 60563 FORMER COMPANY: FORMER CONFORMED NAME: CHOICE HOTELS FRANCHISING INC DATE OF NAME CHANGE: 19971118 FORMER COMPANY: FORMER CONFORMED NAME: CHOICE HOTELS INTERNATIONAL INC/ DATE OF NAME CHANGE: 19971022 10-K 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 _____________________ FORM 10-K FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (Mark One) [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED, EFFECTIVE OCTOBER 7, 1996]. For the fiscal year ended December 31, 1999 ----------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]. For the transition period from ___________________ to ____________________ Commission file number 001-13393 ----------------- CHOICE HOTELS INTERNATIONAL, INC. -------------------------------------- (Exact Name of Registrant as Specified in Its Charter)
DELAWARE 52-1209792 - -------------------------------------------------------- -------------------- (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification No.) 10750 Columbia Pike, Silver Spring, Maryland 20901 - ------------------------------------------------------------- -------------- (Address of Principal Executive Offices) Zip Code Registrant's telephone number, including area code (301) 592-5000 --------------
Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered ------------------- --------------------------------------------- Common Stock, Par Value $.01 per share New York Stock Exchange - -------------------------------------- ---------------------------- Preferred Stock Purchase Rights New York Stock Exchange - ------------------------------- ---------------------------- Securities registered pursuant to Section 12(g) of the Act: - ------------------------------------------------------------------------------- (Title of Class) - ------------------------------------------------------------------------------- (Title of Class) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed in Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months as for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _X_ No ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K. [_] The aggregate market value of voting stock of Choice Hotels International, Inc. held by non-affiliates was $531,353,144 as of March 10, 2000 based upon a closing price of $16.375 per share. APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ___ No ___ (APPLICABLE ONLY TO CORPORATE REGISTRANTS) The number of shares outstanding of Choice Hotels International, Inc.'s Common Stock at March 10, 2000 was 53,408,415. DOCUMENTS INCORPORATED BY REFERENCE. PART I 1999 Annual Report to Stockholders Proxy Statement dated March 29, 2000 PART II 1999 Annual Report to Stockholders Proxy Statement dated March 29, 2000 PART III Proxy Statement dated March 29, 2000 2 PART I Forward-Looking Statements - -------------------------- Certain statements in this report that are not historical facts constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act. Words such as "believes," "anticipates," "expects," "intends," "estimates," "projects," and other similar expressions, which are predictions of or indicate future events and trends, typically identify forward-looking statements. 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 an 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 and construction of hotels; the cost and other effects of legal proceedings; and other risks described from time to time in our filings with the Securities and exchange Commission, including those set forth under the hearing "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. Item 1. Business Overview Choice Hotels International, Inc. (the "Company" or "Choice") is the world's second largest franchisor of hotel properties with 4,248 hotels open and operating in 35 countries at December 31, 1999. In addition, at December 31, 1999, we had 761 franchise properties currently under development representing a total of 64,095 rooms. Choice franchises lodging properties under one of our proprietary brand names (the "Choice brands"): Comfort(R), Quality(R), Clarion(R), Sleep(R), Rodeway(R), Econo Lodge(R) and MainStay(SM). We have over 2,300 franchisees in the franchise system with no single franchisee accounting for more than 5% of its royalty or total revenues. We franchise hotels in all 50 states, Puerto Rico and the District of Columbia and 34 additional countries, with 95% of its franchising revenue generated from hotels franchised in the United States. With recognized brands and a diverse and growing franchisee base, we believe we have a strong foundation for continued growth. Choice is a "pure-play" lodging franchisor with limited real estate exposure and low capital expenditure requirements. With a focus on hotel franchising versus ownership, we benefit from the economies of scale inherent in the franchising business. The fee and cost structure of our business provides significant opportunities to increase profits by increasing the number of franchise properties. We derive substantially all of our revenues from franchise fees which consist of an initial fee and ongoing royalty, marketing, and reservation fees that are based as a percentage of the franchisees' gross room revenues. The principal factors that affect our results are: (i) growth in the number of hotels under franchise; (ii) occupancies and room rates achieved by the hotels under franchise; (iii) the number and relative mix of franchised hotels; (iv) effective royalty rates achieved; and (v) our ability to manage costs. The number of rooms at franchised properties and occupancies and room rates at those properties significantly affect our results because royalty fees are based upon room revenues at franchised hotels. The variable overhead costs associated with franchise system growth are substantially less than incremental royalty fees generated from new franchisees, therefore we are able to capture a significant portion of these royalty fees as operating income. Continued growth of our franchise business should enable us to capture increasing benefits from the operating leverage in place which would improve operating margins. Our franchising operating margins(1) have improved from 50.9% as of May 31, 1995 to 64.6% as of December 31, 1999. We have also generated steady royalty fee income from our increasing franchisee base -- growing from $50.9 million for the year ended May 31, 1992 to $128.7 million for the year ended December 31, 1999. Earnings before interest, taxes, depreciation and amortization has grown from $32.2 million for the year ended May 31, 1992 to $101.8 million for the year end December 31, 1999. - --------------------- /1/ Franchising operating margin is calculated by deducting selling, general and administrative expenses from net franchising revenues. 3 Company History Prior to becoming a separate, publicly-held company on October 15, 1997 pursuant to the Company Spin-off (as defined below), the Company was known as Choice Hotels Franchising, Inc. and was a wholly-owned subsidiary of Choice Hotels International, Inc. ("Former Choice"). On October 15, 1997, Former Choice distributed to its stockholders its hotel franchising business (which had previously been primarily conducted by the Company) and its European hotel ownership and franchising business through a pro rata distribution to its stockholders of all of the stock of the Company (the "Company Spin-off"). At the time of the Company Spin-off, the Company changed its name to "Choice Hotels International, Inc.," and Former Choice changed its name to "Sunburst Hospitality Corporation." References herein to the Company's former parent corporation prior to the Company Spin-off are to "Former Choice," and reference to such corporation after the Company Spin-off are to "Sunburst." Prior to November 1996, Former Choice was a subsidiary of Manor Care, Inc. ("Manor Care") which, directly and through its subsidiaries, engaged in the hotel franchising business currently conducted by the Company as well as the ownership and management of hotels (together with the hotel franchising business, the "Lodging Business") and the health care business. On November 1, 1996, Manor Care separated the Lodging Business from its health care business through a pro rata distribution to the holders of Manor Care's common stock of all of the stock of Former Choice (the "Former Choice Spin-off"). In connection with the Former Choice Spin-off, the Company became a wholly-owned subsidiary of Former Choice and remained as such until consummation of the Company Spin-off. The Lodging Industry/1/ As of December 31, 1999, there were approximately 3.9 million hotel rooms in the United States in hotels/motels containing twenty or more rooms. Of those rooms, approximately 1.2 million rooms were not affiliated with a national or regional brand, while the remaining approximately 2.7 million rooms were affiliated with a brand either through franchise or the ownership/management of a national or regional chain. During the late 1980s, the industry added approximately 500,000 hotel rooms to its inventory due largely to a favorable hotel lending environment, the ability of hotel operators to regularly increase room rates and the deductibility of passive tax losses, which encouraged hotel development. As a result, the lodging industry saw an oversupply of rooms and a decrease in industry performance. The lodging industry in recent years has recovered, demonstrating strong performance, based on year-to-year increases in room revenues, average daily rates, revenue per available room ("RevPAR"), and lodging industry profitability. RevPAR is calculated by multiplying the percentage of occupied rooms by the average daily room rate realized. Since 1993, the lodging industry has been able to increase its average daily rate ("ADR") at a pace faster than the increase in the Consumer Price Index ("CPI"), a common measure of inflation published by the US Department of Labor. The following chart demonstrates the recent trends: - ----------------- /1/ Source: Smith Travel Research 4 The US Lodging Industry's Growth Trends Since 1995
Increases in Average Room Daily Increase Increase Revenue Per Revenue Room in ADR in CPI Available New Versus Occupancy Rates Versus Versus Room Profits Rooms Year Prior Year Rates (ADR) Prior Year Prior Year (RevPAR) (in billions) Added - ---- ------------- ---------- ------- ---------- ---------- ----------- ------------- ------ 1995......... 6.7% 65.1% $65.81 4.7% 2.9% $42.83 $ 8.5 64,000 1996......... 8.9% 65.0% $70.81 7.6% 2.9% $46.06 $12.5 101,000 1997......... 8.8% 64.5% $75.16 6.1% 1.9% $48.50 $17.0 128,000 1998......... 7.7% 64.0% $78.62 4.4% 2.3% $50.29 $22.0 143,000 1999......... 7.4% 63.3% $81.27 4.0% 2.7% $51.44 $23.0 143,148
We believe the lodging industry can be divided into three price categories: luxury or upscale, mid-scale and economy. Typically, the luxury category generally has room rates above $80 per night, the mid-scale category generally has room rates between $50 and $79 per night and the economy category generally has room rates less than $50 per night. Additionally, a new category has emerged of extended-stay hotels that primarily serve guests who stay at a hotel five consecutive nights. These hotels span the industry's three price categories. Service is a distinguishing characteristic in the lodging industry. Generally, there are three levels of service: full-service hotels (which offer food and beverage services, meeting rooms, room service and similar guest services); limited-service hotels (which offer amenities such as swimming pools, continental breakfast, or similar services); and all-suites hotels (which usually have limited public areas, but offer guests two rooms or one room with distinct areas, and which may or may not offer food and beverage services). The Company's Econo Lodge(R), Rodeway(R) and Sleep(R) brands compete primarily in the limited-service economy market; the Company's Comfort(R) and Quality(R) brands compete primarily in the limited-service middle-market. The Company's MainStaySM Suites brand competes primarily in the all-suites middle- market. The Company's Clarion(R) brand competes primarily in the full-service upscale market. New hotels opened in recent years typically have been hotels without on-premise food and beverage, as these hotels are less costly to develop, enjoy higher gross margins, and tend to have better access to financing. These hotels typically operate in the economy and mid-scale categories and are located in suburban or highway locations. From 1991 to 1999, the average room count in new hotels declined from 122 to 104 primarily because hotel developers found it difficult to obtain financing of more than $3 million from their primary lending sources (local banks and Small Business Administration-guaranteed loan programs). In recent years, operators of hotels not owned or managed by major lodging companies have increasingly joined national hotel franchise chains as a means of remaining competitive with hotels owned by or affiliated with national lodging companies. Because the costs of owning and operating a hotel are generally fixed, increases in revenues generated by affiliation with a franchise lodging chain can improve a hotel's financial performance. Of approximately 1,188 hotel properties that changed their affiliation in 1999, and 79% converted from independent status to affiliation with a chain or converted from one chain to another. A total of 379 independent properties switched to a franchise chain in 1999. 5 The large franchise lodging chains, including the Company, generally provide a number of services to hotel operators to improve the financial performance of their properties including national reservation systems, marketing and advertising programs, and direct sales programs. The Company believes that national franchise chains with a larger number of hotels enjoy greater brand awareness among potential guests than those with fewer numbers of hotels, and that greater brand awareness can increase the desirability of a hotel to its potential guests. We believe that hotel operators choose lodging franchisors based primarily on the perceived value and quality of each franchisor's brand and its services, and the extent to which affiliation with that franchisor may increase the franchisee's reservations and profits. Franchise Business Economics of Franchise Business. The fee and cost structure of the Company's business provides significant opportunities for us to increase profits by increasing the number of franchised properties. As a hotel franchisor, we derive substantially all of our revenue from franchise fees. The Company's franchise fees consist of an initial fee and ongoing royalty, marketing and reservation fees which are based on a percentage of the franchisee's gross room revenues. The royalty portion of the franchise fee is intended to cover our operating expenses, such as expenses incurred in quality assurance, administrative support and other franchise services and to provide the Company with operating profits. The marketing and reservation portion of the franchise fee is intended to reimburse the Company for the expenses associated with providing such franchise services as the central reservation system and national marketing and media advertising. Much of the variable costs associated with our activities are reimbursed by the franchisees through the initial fees, and marketing and reservation fees. The royalty fees generated from franchisees more than cover the fixed costs of the business at its current level. The variable overhead costs associated with franchise system growth are substantially less than incremental royalty fees generated from new franchisees, therefore we are able to capture a significant portion of these royalty fees as operating income. Strategy. Our business strategy is designed to maximize the value of our extensive distribution channels (which include the hotels under franchise and the hotel guests) by expanding and enhancing those relationships. The strategy is effectuated through an emphasis on the following key components: (1) optimizing the brand portfolio, (2) strategically growing the franchise system, (3) leveraging the franchise system, (4) improving its and its franchisees' margins, (5) growing profitability internationally, and (6) pursuing complementary business opportunities. o Optimizing the Brand Portfolio. Each of our brands has particular attributes and strengths. Our strategy is to leverage the strengths of each brand for profit growth and for identifying new niches into which the Company may expand. This will be effectuated through a raising of the Company's brand standards strictly enforced through consumer-driven quality assurance. 6 o Increasing Market Penetration on a Strategic Basis. We are taking advantage of our regional structure to analyze key markets in the U.S. and, in conjunction with our franchisees, identifying the best opportunities for new development or conversion to one of our brands. o Expanding Partner Services Programs. There is significant opportunity to leverage its size by entering into arrangements with national and multi- national companies that want to gain exposure to our franchised hotels and to the millions of guests who patronize our franchised hotels each year. In practice, the guest enjoys brand-name products and services that help build guest loyalty and the franchisee benefits from competitively priced products. Vendor partners gain access to a critical mass of franchisees, which in turn generates residual income for us. o Improving Margins Through Increased Productivity. We address the competitiveness of our own and our franchisees' profitability by initiating revenue generating programs and improving cost productivity. A key component of this strategy is the roll out of the Company's proprietary property and yield management system "Profit Manager by Choice", which we believe will improve the RevPAR of our franchisees. This is supplemented by continued enforcement of our contracts (including licensee audits). o Growing Profitably Internationally. During the eleven fiscal years ended December 31, 1999, the number of properties (including those under construction) in our international franchise system increased to 1,290 properties with 97,565 rooms, from 81 properties with 8,330 rooms. Our international franchise system includes hotels in 39 countries outside the United States. We plan to continue to profitably grow our brands internationally through a strategic pursuit of joint ventures, master franchising agreements and brand specific area development agreements. o Pursuing Complementary Business Opportunities. Our acquisition strategy includes the potential purchase of lodging brands that would enhance the offerings we currently make to our franchisees and hotel consumers as well as the purchase or partnering with businesses that are complementary to our core business and unique operating skills. Franchise System Our franchise hotels operate under one of the Choice brand names: Comfort(R), Quality(R), Clarion(R), Sleep(R), Rodeway(R), Econo Lodge(R) and MainStaySM. The following table presents key statistics relative to our domestic franchise system over the three fiscal years ended May 31, 1997, for the seven- month period ended December 31, 1997 and for the three fiscal years ended December 31, 1999. Combined Domestic Franchise System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, --------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ----------------------------------------------------------------------------------- Number of properties, end of period..... 2,311 2,495 2,781 2,880 2,880 3,039 3,123 Number of rooms, end of period.......... 200,792 214,613 235,431 242,161 242,161 252,357 258,120 Royalty fees ($000)..................... $ 71,665 $ 82,239 $ 91,724 $ 65,271 $ 99,144 $109,240 $120,932 Average Royalty Rate(1)................. 3.2% 3.3% 3.4% 3.5% 3.5% 3.6% 3.7% Average occupancy percentage............ 63.8% 63.9% 62.6% 66.2% 62.3% 61.0% 60.5% Average daily room rate (ADR)........... $ 47.13 $ 49.49 $ 51.92 $ 54.97 $ 53.89 $ 56.23 $ 58.42 RevPAR(2)............................... $ 30.08 $ 31.60 $ 32.52 $ 36.39 $ 33.56 $ 34.30 $ 35.33
7 (1) Represents domestic royalty fees as a percentage of aggregate gross room revenues of all of the domestic Choice brand franchised hotels. (2) The Company's RevPAR figure for each fiscal year is an average of the RevPAR calculated for each month in the fiscal year. The Company calculates RevPAR each month based on information actually reported by franchisees on a timely basis to the Company. We have over 2,300 domestic franchisees and operate in all 50 states and the District of Columbia. Approximately 95% of the total royalty income is generated from domestic franchise operations. Consequently, our analysis of our franchise system is focused on the domestic operations. Currently, no master franchisee or other franchisee accounts for 5% or more of Choice's royalty revenues or total revenues. Sunburst is our largest franchisee with a portfolio of 83 hotels containing 11,266 rooms located in 25 states as of December 31, 1999. Brand Positioning Our brands offer consumers a wide range of choices from economy hotels to upscale, full service properties. Comfort. Our largest brand is Comfort. Comfort Inns offer rooms in the mid- scale without food and beverage category and is targeted to business and leisure travelers. Principal competitor brands include Baymont, Fairfield Inn, Hampton Inn, Holiday Express and LaQuinta. Comfort Suites offer business and leisure guests a large room with separate living and sleeping areas. This product competes in the upper portion of the midscale without food and beverage market against brands such as AmeriSuites, Hampton Inn and Suites and Spring Hill. At December 31, 1999, there were 1,584 Comfort Inn properties and 231 Comfort Suites properties with a total of 121,291, and 18,796 rooms, respectively, open and operating worldwide. An additional 330 Comfort Inn and Comfort Suites properties with a total of 25,713 rooms were under development. During 1999, we added 123 Comfort properties while terminating 47. Comfort properties are located in the United States and in Argentina, Australia, the Bahamas, Belgium, Brazil, Canada, Denmark, France, Germany, India, Italy, Jamaica, Japan, Lebanon, Norway, Portugal, Puerto Rico, Sweden, Switzerland, Thailand, Turks & Caicos, the United Kingdom and the United Arab Emirates. The following chart summarizes the Comfort system in the United States: Comfort Domestic System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period........ 1,015 1,129 1,255 1,304 1,304 1,394 1,470 Number of rooms, end of period............. 87,551 94,160 102,722 105,384 105,384 110,682 112,727 Royalty fees ($000s)....................... $37,635 $44,657 $ 50,758 $ 36,446 $ 55,261 $ 61,153 $ 68,177 Average occupancy percentage............... 69.5% 68.7% 67.2% 71.3% 66.6% 65.4% 64.8% Average daily room rate (ADR).............. $ 48.24 $ 51.13 $ 54.17 $ 57.15 $ 55.74 $ 58.19 $ 60.57 RevPAR..................................... $ 33.54 $ 35.11 $ 36.39 $ 40.75 $ 37.15 $ 38.03 $ 39.26
8 Sleep Inn. Established in 1988, Sleep Inn is a new-construction hotel brand in the lower portion of the mid-scale without food and beverage segment. Sleep Inns are targeted to the business and leisure traveler. Principal competitor brands include Fairfield Inn, Holiday Express, LaQuinta and Red Roof. At December 31, 1999 there were 228 Sleep Inn properties with a total of 17,523 rooms open and operating worldwide. An additional 156 properties with a total of 11,917 rooms were under development. During 1999, 35 Sleep Inn properties were added while 8 were terminated. The properties are located in the United States, Brazil, Canada and the Cayman Islands. The following chart summarizes the Sleep system in the United States: Sleep Domestic System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period...... 51 87 131 156 156 197 224 Number of rooms, end of period........... 3,672 6,396 9,635 11,538 11,538 14,924 17,199 Royalty fees ($000s)..................... $2,080 $2,108 $3,343 $ 2,630 $ 3,926 $ 5,337 $ 7,241 Average occupancy percentage............. 65.3% 65.5% 63.9% 66.5% 63.0% 62.0% 60.6% Average daily room rate (ADR)............ $41.89 $45.11 $48.11 $ 50.54 $ 49.41 $ 51.32 $ 53.91 RevPAR................................... $27.37 $29.56 $30.75 $ 33.60 $ 31.11 $ 31.82 $ 32.66
Quality. Certain Quality Inns, Quality Inns and Suites, and Quality Suites hotels compete in the midscale with food and beverage segment. Quality Inns, Quality Inns and Suites, and Quality Suites are targeted to business and leisure travelers. Principal competitor brands include Best Western, Holiday Inn, Howard Johnson and Ramada Inn. At December 31, 1999, there were 686 Quality Inn and Quality Inns and Suites properties with a total of 73,442 rooms, and 45 Quality Suites properties with a total of 17,352 rooms open worldwide. An additional 145 Quality Inn, Quality Inns and Suites and Quality Suites properties with a total of 15,573 rooms were under development. During 1999, a total of 46 Quality properties were added while 45 were terminated. Quality properties are located in the United States and in Argentina, Australia, Brazil, Canada, Chile, Costa Rica, the Czech Republic, Denmark, France, Germany, India, Indonesia, Ireland, Italy, Jamaica, Malaysia, New Zealand, Norway, Portugal, Russia, Sweden, Thailand, the United Kingdom and the United Arab Emirates. The following chart summarizes the Quality system in the United States: Quality Domestic System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period........ 341 362 409 419 419 430 431 Number of rooms, end of period............. 43,281 45,967 50,487 50,674 50,674 50,151 49,331 Royalty fees ($000s)....................... $15,632 $16,606 $17,623 $14,459 $18,488 $20,187 $21,034 Average occupancy percentage............... 63.1% 62.5% 61.3% 63.8 % 60.2% 58.9% 58.0% Average daily room rate (ADR).............. $ 50.94 $ 52.90 $ 54.61 $ 57.58 $ 56.79 $ 60.02 $ 61.89 RevPAR..................................... $ 32.16 $ 33.08 $ 33.46 $ 36.73 $ 34.19 $ 35.35 $ 35.90
9 Clarion. Clarion Inns, Clarion Hotels, Clarion Resorts and Clarion Suites hotels are full-service properties with on-premise food and beverage facilities and operate in the upscale category. Clarion properties are targeted to business and leisure travelers. Principal competitor brands include Crowne Plaza, Four Points by Sheraton, Radisson, Courtyard by Marriott and Doubletree. At December 31, 1999, there were 142 Clarion properties with a total of 22,519 rooms open and operating worldwide and an additional 32 properties with a total of 4,479 rooms under development. During 1999, 20 Clarion properties were added while 13 were terminated. The properties are located in the United States, Argentina, Australia, the Bahamas, Canada, Chile, France, Germany, Guatemala, Indonesia, Ireland, Italy, Japan, Norway, the United Kingdom and Uruguay. The following chart summarizes the Clarion system in the United States: Clarion Domestic System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period........ 63 75 92 96 96 105 112 Number of rooms, end of period............. 10,420 12,817 14,721 16,161 16,161 17,878 18,815 Royalty fees ($000s)....................... $ 2,995 $ 3,602 $ 4,081 $ 2,957 $ 5,061 $ 5,447 $ 6,491 Average occupancy percentage............... 63.7% 63.3% 63.3% 64.7 % 62.3% 60.5% 59.0% Average daily room rate (ADR).............. $ 63.71 $ 64.36 $ 67.76 $ 71.53 $ 70.67 $ 72.25 $ 74.17 RevPAR..................................... $ 40.58 $ 40.74 $ 42.86 $ 46.29 $ 44.05 $ 43.73 $ 43.74
Econo Lodge. Econo Lodge hotels operate in the economy category of the lodging industry. Econo Lodges are primarily targeted to senior citizens and rely to a large extent on strong roadside name recognition. Principal competitor brands include Days Inn, Motel 6, Ramada Limited, Red Carpet Inn, Super 8 and Travelodge. At December 31, 1999, there were 722 Econo Lodge properties with a total of 45,193 rooms open and operating in the United States and Canada, and an additional 54 properties with a total of 3,231 rooms under development in those two countries. During 1999, 57 Econo Lodge properties were added while 64 were terminated. The following chart summarizes the Econo Lodge system in the United States: Econo Lodge Domestic System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period......... 633 641 682 692 692 698 691 Number of rooms, end of period.............. 42,801 42,726 44,636 45,050 45,050 44,458 43,754 Royalty fees ($000s)........................ $12,021 $12,760 $13,288 $ 8,991 $13,687 $13,975 $14,313 Average occupancy percentage................ 57.5% 58.0% 56.4% 60.7 % 56.1% 54.3% 54.0% Average daily room rate (ADR)............... $ 38.31 $ 39.97 $ 41.33 $ 43.86 $ 42.35 $ 43.55 $ 45.01 RevPAR...................................... $ 22.04 $ 23.17 $ 23.30 $ 26.63 $ 23.75 $ 23.65 $ 24.32
10 Rodeway. The Rodeway brand competes in the economy category and is primarily targeted to senior citizens. Principal competitor brands include Ho-Jo Inn, Ramada Limited, Red Roof Inn, Shoney's Inn, Super 8 and Motel 6. At December 31, 1999, there were 171 Rodeway Inn properties with a total of 10,991 rooms, open and operating in the United States and Canada, and an additional 23 properties with a total of 1,481 rooms under development in those two countries. During 1999, 10 Rodeway properties were added while 40 were terminated. The following chart summarizes the Rodeway system in the United States: Rodeway Domestic System
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period......... 208 201 217 209 209 196 166 Number of rooms, end of period.............. 13,067 12,547 13,509 12,997 12,997 12,447 10,613 Royalty Fees ($000s)........................ $ 2,302 $ 2,506 $ 2,631 $ 1,756 $ 2,671 $ 2,678 $ 2,552 Average occupancy percentage................ 50.5% 52.7% 52.7% 54.7 % 51.4% 50.1% 50.7% Average daily room rate (ADR)............... $ 38.93 $ 40.66 $ 41.15 $ 44.11 $ 43.15 $ 44.03 $ 45.57 RevPAR...................................... $ 19.64 $ 21.48 $ 21.68 $ 24.13 $ 22.20 $ 22.04 $ 23.09
MainStay Suites. MainStay Suites, our newest hotel brand, is a midscale extended-stay lodging product targeted to travelers who book hotel rooms for five nights or more. The first MainStay Suites hotel, which Sunburst owns and manages, opened in Plano, Texas, in November 1996. As of December 31, 1999, there were 29 open hotels with 2,681 rooms and an additional 21 properties with 1,701 rooms under development. During 1999, 10 MainStay Suites properties were added. The MainStaySM Suites brand is designed to fill the gap in the midscale category between existing upscale and economy extended-stay lodging products. Principal competitors brands include Candlewood Suites, Homestead Village, Sierra Suites and TownePlace Suites. International Franchise Operations Our international franchise operations are primarily conducted through master franchise arrangements. These agreements provide the master franchisee the right to develop Choice branded hotels in a specific geographic region, usually for a fee. The agreements govern the relationship between the Company and the master franchisee, who share the royalties generated by the underlying franchised hotels. At December 31, 1999, we had 1,125 franchise hotels open in 34 countries outside the United States. The following table illustrates the growth of our international franchise system over the three fiscal years ended May 31, 1997 for the seven-month period ended December 31, 1997 and the three fiscal years ended December 31, 1999. 11 Combined International Franchise System(1)
As of and for the As of and for the Seven Months Ended As of and for the Year Ended May 31, December 31, Year Ended December 31, ---------------------------------------------------------------------------------------- 1995 1996 1997 1997 1997 1998 1999 ---------------------------------------------------------------------------------------- Number of properties, end of period......... 524 557 563 605 605 632 1,125 Number of rooms, end of period.............. 44,877 46,843 47,603 50,639 50,639 53,095 80,134 Royalty fees ($000s)....................... $ 1,998 $ 1,586 $ 1,672 $ 958 $ 2,303 $ 4,902 $ 6,949
(1) Master franchise contracts do not currently require the reporting of operating statistics (e.g. average occupancy percentage and average daily room rate) of the underlying hotels, thus RevPAR is not calculated for foreign hotels. Europe. The Company is the second-largest international franchised hotel chain in Europe, with 394 hotels open in thirteen countries at December 31, 1999. 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 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. There is also a master franchise arrangement in Scandinavia that has 90 open properties as of December 31, 1999. Canada. Choice Hotels Canada is Canada's largest lodging organization with 226 properties open at December 31, 1999. Choice Hotels Canada is a joint venture, owned 50% by the Company and 50% by W-westmont, a subsidiary of Westmont Hospitality, which was formed in 1993 when W-westmont converted substantially all of its controlled hotels to Choice's brands and Choice contributed its operations in Canada to form Choice Hotels Canada. 12 Other International Relationships. The Company has master franchise arrangements with developers in various countries, including Australia, New Zealand, India and Brazil. At December 31, 1999, 541 hotels were open and operating under these master franchise arrangements (exclusive of Europe and Canada), generating annual royalty fees to the Company of approximately $2.5 million. In July 1998, the Company and Flag International Limited ("Flag"), Australia's largest lodging chain, formed a strategic alliance. Flag Choice Hotels, a wholly-owned subsidiary of Flag, acquired a 20-year master franchise from the Company. Under the agreement, a number of Flag properties were re- branded with Company brands which best serve their market segment. The agreement also provides the Company with the opportunity to acquire, within the first four years of the agreement, up to 30 percent of the equity of Flag Choice Hotels with proportionate board representation. Franchise Sales We have identified key market areas for hotel development based on supply/demand relationships and strategic objectives. Development opportunities are first offered; (i) to existing franchisees; and then to (ii) developers of hotels; (iii) owners of independent hotels and motels; (iv) owners of hotels affiliated with other franchisors' brands; and; (v) contractors who construct any of the foregoing. In considering hotels for conversion to one of the Choice brands, or sites for development of new hotels, We consider locations which are close to major highways, airports, tourist attractions and business centers that attract travelers. At December 31, 1999, we employed approximately 40 sales directors, each of whom is responsible for a particular region or geographic area. Sales directors contact potential franchisees directly and receive compensation based on sales generated. Franchise sales efforts emphasize the benefits of affiliating with one of the Choice brands, our commitment to improving RevPAR, our television, radio and print brand advertising campaigns, the Choice reservation system, our training and support systems, and our history of growth and profitability. Because the Choice brands cover a broad spectrum of the lodging marketplace, we are able to offer each prospective franchisee a brand that fits its needs, lessening the chances that the prospective franchisee would need to consider a competing franchise system. Because retention of existing franchisees is important to our growth strategy, we created a formal Impact Policy in 1992, which was revised in July 1999, which offers existing franchisees the right to object to a same-brand property within a 15 mile radius. The Impact Policy protects franchisees from the opening of a same-brand property within a specific distance, which can range from one to seven miles, depending upon the market in which the property is located. We believe that it is the only major franchise company to routinely offer such territorial protection to its franchisees. During fiscal 1999, Choice received 788 franchise applications, signed 473 franchise agreements and placed 301 new properties into operation in the United States under the Choice brands. Of those placed into operations, 184 were newly constructed hotels. By comparison, during the twelve month period ended December 31, 1998, we received 919 franchise applications, signed 619 franchise agreements and added 318 new properties into 13 operation in the U.S. An application received may not always result in a signed franchise agreement during the year received or at all due to an applicant being unable to obtain financing or because the Company and the applicant are unable to agree on the financial terms of the franchise agreement. In 1999, we continued to place great focus on enforcing quality standards. Terminations for properties that failed to meet quality assurance standards and contractual obligations were 217 properties (including properties not yet open) in 1999 and 258 properties (including properties not yet open) in 1998. Franchise Agreements Our standard franchise agreement grants a franchisee the right to non- exclusive use of our franchise system in the operation of a single hotel at a specified location, typically for a period of 20 years, with certain rights to each of the franchisor and franchisee to terminate the franchise agreement before the twentieth year. When the responsibility for development is sold to a master franchisee, that party has the responsibility to sell to local franchisees the Choice brands and the master franchisee generally must manage the delivery of necessary services (such as quality assurance, reservations and marketing) to support the franchised hotels in the master franchise area. The master franchisee collects the fees paid by the local franchisee and remits an agreed share to us. Master franchise agreements generally have a term of at least 10 years. We have only entered into master franchise agreements with respect to franchise hotels outside the United States. Either party to a franchise agreement, other than master franchise agreements, can terminate a franchise agreement prior to the conclusion of their term under certain circumstances, such as at certain anniversaries of the agreement or if a franchisee fails to bring properties into compliance with contractual quality standards within specified periods of time. Early termination options give us flexibility in eliminating or re-branding properties which become weak performers for reasons other than contractual failure by the franchisee. Master franchise agreements typically contain provisions permitting us to terminate the agreement for failure to meet a specified development schedule. Franchise fees vary among the different Choice brands, but generally are competitive with the industry average within their market group. Franchise fees usually have four components: an initial, one-time affiliation fee; a royalty fee; a marketing fee; and a reservation fee. Proceeds from the marketing fee and reservation fee are used exclusively to fund marketing programs and the Company's central reservation system, respectively. Most marketing fees support brand-specific marketing programs, although we occasionally contribute a portion of such fees to marketing programs designed to support all of the Choice brands. Royalty fees and affiliation fees are the principal sources of profits for us. The standard franchise agreements typically require our franchisees to pay the following fees: 14 Quoted Fees by Brand
Initial Fee On-Going Fees as a Percentage of Gross Room Revenues Per Room/ -------------------------------------------------------------------- Brand Minimum Royalty Fees Marketing Fees Reservation Fees ----- -------------- ---------------- -------------------- ---------------------- Comfort Inn.................... $300/$50,000 5.25% 2.1% 1.75% Comfort Suites................. $300/$50,000 5.25% 2.1% 1.75% Quality Inn.................... $300/$35,000 4.0% 2.1% 1.75% Quality Suites................. $300/$50,000 4.0% 2.1% 1.25% Sleep Inn...................... $300/$40,000 4.5% 2.1% 1.75% Clarion........................ $300/$40,000 3.75% 1.0% 1.25% Econo Lodge.................... $250/$25,000 4.0% 3.5%(1) -- MainStay Suites................ $300/$30,000 4.5% 2.5%(1) -- Rodeway........................ $250/$25,000 3.5% 1.25% 1.25%
- --------------------- (1) Fee includes both Marketing and Reservation Fees. For a description of the franchising agreements between the Company and Sunburst, see "Relationship Between the Company and Sunburst--Franchise Agreements," on the Proxy Statement dated March 29, 2000, incorporated herein by reference. We have increased our average royalty rate since fiscal year 1993, primarily by raising the quoted royalty fee for Comfort Inn franchisees to 5.25% of annual gross room revenues ("GRR") from 4.0% of GRR in 1993, and by increasing the number of higher royalty fee contracts in the franchise system. For the twelve months ended December 31, 1999, our average royalty rate for all Choice domestic brand hotels was 3.7%. We believe that our average royalty rate will continue to increase as new franchisees are added and as older franchise agreements expire, terminate or are amended. Franchise Operations Our operations are designed to improve RevPAR for our franchisees, as this is the measure of performance that most directly impacts franchisee profitability. We believe that by helping our franchisees to become more profitable we will enhance our ability to both retain our existing franchisees and attract new franchisees. The key aspects of our franchise operations are: Central Reservation System. On average, approximately 30.0% of the room nights booked at franchisees' properties are reserved through the toll-free telephone reservation system which we operate. Our reservation system consists of a computer reservation system known as CHOICE 2001, five reservation centers in North America and several international reservation centers run by us or our master franchisees. Operators trained on the CHOICE 2001 system can match each caller with a Choice-branded hotel meeting the caller's needs. It provides an instant data link to our franchised properties as well as to the Amadeus, Galileo, SABRE and Worldspan airline reservation systems that facilitates the reservation process for travel agents. We also offers our rooms for sale on our own proprietary Internet site as well as those of other travel companies. To define more sharply the market and image for each of our brands, we began advertising separate toll-free reservation numbers for all of our brands in fiscal year 1995, although we allow our reservation agents to cross-sell the Choice brands. If a room in the Choice 15 hotel brand requested by a customer is not available in the location or price range that the customer desires, the agent may offer the customer a room in another Choice-branded hotel that meets the customer's needs. Cross-selling enables Choice and its franchisees to capture additional business. On-line reports generated by the CHOICE 2001 system enable franchisees to analyze their reservation patterns over time. In addition, we provide a yield management product for our franchisees to allow them to improve the management of their mix of rates and occupancy based on current and forecasted demand on a property-by-property basis. We also market to our franchisees a property management product. Such products are designed to manage the financial and operations information of an individual hotel and improve its efficiency. Property Management System; Technical Services Program. Our proprietary property and yield management system, Profit Manager by Choice Hotels, is designed to help franchisees maximize profitability and compete more effectively by managing their rooms inventory, rates and reservations. The Profit Manager system synchronizes each hotel's inventory with the CHOICE 2001 system, giving reservation sales agents last room sell capabilities at every hotel. Profit Manager includes a revenue management feature that calculates and suggests optimum rates and length of stays based on each hotel's past performance and projected occupancy. As of March 1, 2000, 1,812 hotels in the United States and Canada are using Profit Manager, with 925 of those hotels utilizing the revenue management function. Brand Name Marketing and Advertising. Our marketing and advertising programs are designed to heighten consumer awareness of the Choice brands. Marketing and advertising efforts are focused primarily in the United States and include national television and radio advertising, print advertising in consumer and trade media and promotional events, including joint marketing promotions with vendors and corporate partners. In fiscal year 1996, we began using brand- specific marketing and largely discontinued the strategy of advertising our multiple brands under the Choice umbrella. As a result, each brand has established a unique identity and now employs a more focused approach to its target audiences. Numerous marketing programs are conducted which target specific groups, including senior citizens, motorist club members, families, government and military employees, and meeting planners. Other marketing efforts include domestic and international trade show 16 programs, publication of group and tour rate directories, direct-mail programs, discounts to holders of preferred credit cards, centralized commissions for travel agents, fly-drive programs in conjunction with major airlines, and twice- yearly publication of a Travel and Vacation Directory. In 1998, we launched a program called Guest Privileges at four of our brands (Comfort, Clarion, Quality and Sleep) to attract/retain frequent travelers. Marketing and advertising programs are directed by our marketing department, which utilizes the services of independent advertising agencies. We also employ sales personnel at our Silver Spring, Maryland, headquarters and in our Phoenix, Arizona office. These sales personnel use telemarketing to target specific customer groups, such as potential corporate clients in areas where our franchised hotels are located, the motor coach market, and meeting planners. Most of these sales personnel sell reservations and services for all of the Choice brands. Our franchise service directors work with franchisees to maximize RevPAR. These directors advise franchisees on topics such as marketing their hotels, improving quality and maximizing the benefits offered by the Choice reservations system. Quality Assurance Programs. Consistent quality standards are critical to the success of a hotel franchise. We have established quality standards for all of our franchised brands which cover housekeeping, maintenance, brand identification and level of services offered. We inspect properties for compliance with our quality standards when application is made for admission to the franchise system. The compliance of existing franchisees with quality standards is monitored through scheduled and unannounced Quality Assurance Reviews conducted at least once per year at each property. Properties which fail to maintain a minimum score are reinspected on a more frequent basis until deficiencies are cured, or until such properties are terminated. To encourage compliance with quality standards, various brand-specific incentives are offered to franchisees who maintain consistent quality standards. We identify franchisees whose properties operate below minimum quality standards and assist them in complying with brand specifications. Franchisees who fail to improve on identified quality matters may be subject to consequences ranging from written warnings to termination of the franchisee's franchise agreement. During the twelve months ended December 31, 1999, 83 domestic properties were terminated for failure to maintain minimum quality assurance scores. Training. We maintain a training department which conducts mandatory training programs for all franchisees and their employees. Regularly scheduled regional and national training meetings are also conducted for both property-level staff and managers. Training programs teach franchisees how to take advantage of the Choice reservation system and marketing programs, and fundamental hotel operations such as housekeeping, maintenance, and inventory yield management. Training is conducted by a variety of methods, including group instruction seminars and video programs. We are developing an interactive computer-based training system that will train hotel employees at their own pace. Franchisees will be required to purchase hardware to operate the training system, and will use software developed by us. 17 Purchasing. The Company's product services department negotiates volume purchases of various products needed by franchisees to run their hotels, including furniture, fixtures, carpets and bathroom amenities. The department also helps to ensure consistency in such products across its exclusively new- construction brands, Sleep Inn and MainStaySM Suites brands. Sales to franchisees by the Company were approximately $3.9 million during the twelve months ended December 31, 1999. The group purchasing program utilizes our bulk purchases to obtain favorable pricing from third-party vendors for franchisees ordering similar products. We act as a clearinghouse between the franchisee and the vendor, and most orders are shipped directly to the franchisee. In the fourth quarter of 1998, the Company discontinued the group purchasing program as previously operated. Design and Construction. We maintain a design and construction department to assist franchisees in refurbishing, renovating, or constructing their properties prior to or after joining the system. Department personnel assist franchisees in meeting our brand specifications by providing technical expertise and cost- savings suggestions. Financial Assistance Programs. From time to time, we establish programs or help franchisees obtain financing through; (i) a wholly owned subsidiary; (ii) strategic partnerships with hotel lenders; and (iii) by referral to hotel lenders for hotel refinancing, acquisition, renovation and development. Some of the past programs include: (i) a Second Mortgage Financing program under which the Company offered second mortgage financing for the development and construction of Quality Inn, Quality Suites, Quality Inn and Suites, Main Stay Suites and Sleep Inns; (ii) an Econo Lodge exterior renovation program under which forgivable loans up to an amount of $17,500 per property were given to qualified Econo Lodge franchisees for standardized exterior renovation; and (iii) a "Construction to Permanent Financing" program under which Salomon Smith Barney together with Suburban Capital Markets Inc. offered $100 million in financing per year to qualified franchises and the Company guaranteed such loans with a maximum guarantee amount of $10 million. At December 31, 1999, loans outstanding under the above programs were $2.2 million, $4.2 million and $14.3 million, respectively, and the Company's guarantee covered $7.2 million in loans. Competition Competition among franchise lodging chains is intense, both in attracting potential franchisees to the system and in generating reservations for franchisees. We believe that hotel operators choose lodging franchisors based primarily on the perceived value and quality of each franchisor's brand and services, and the extent to which affiliation with that franchisor may increase the franchisee's reservations and profits. We believe that hotel operators select a franchisor in part based on the franchisor's reputation among other franchisees, and the success of its existing franchisees. 18 Choice is the second largest hotel franchisor in the world. The largest, Cendant Corporation (formerly HFS, Inc.), has over 6,100 franchised hotels. Bass Hotels & Resorts has 2,097, Promus/Hilton has 1,680, Marriott International, Inc. has 1,543, Accor has 1,127, Carlson Hospitality has 417, Starwood Hotels and Resorts has 354, and Hospitality International has 119. Our prospects for growth are largely dependent upon the ability of our franchisees to compete in the lodging market, since our franchise system revenues are based on franchisees' gross room revenues. The ability of a hotel to compete may be affected by a number of factors, including the location and quality of its property, the number and quality of competing properties nearby, its affiliation with a recognized name brand, and general regional and local economic conditions. The effect of local economic conditions on our results is substantially reduced by the geographic diversity of our franchised properties, which are located in all 50 states and in 34 other countries, as well as its range of products and room rates. Service Marks and Other Intellectual Property The service marks Quality, Comfort, Clarion, Sleep, Econo Lodge, Rodeway, MainStay and related marks and logos are material to our business. We, directly and through our franchisees, actively uses these marks. All of the material marks are registered with the United States Patent and Trademark Office. In addition, we have registered certain of our marks with the appropriate governmental agencies in over 100 countries where we are doing business or anticipate doing business in the foreseeable future. We seek to protect our brands and marks throughout the world, although the strength of legal protection available varies from country to country. Seasonality Our principal sources of revenues are franchise fees based on the gross room revenues of its franchised properties. We experience seasonal revenue patterns similar to those of the lodging industry in general. This seasonality can be expected to cause quarterly fluctuations in our revenues, profit margins and net income. Regulation Our franchisees are responsible for compliance with all laws and government regulations applicable to the hotels they own or operate. The lodging industry is subject to numerous federal, state and local government regulations, including those relating to the preparation and sale of food and beverage (such as health and liquor license laws), building and zoning requirements and laws governing employee relations, including minimum wage requirements, overtime, working conditions and work permit requirements. The Federal Trade Commission (the "FTC"), various states and certain other foreign jurisdictions (including France, Province of Alberta, Canada, and Mexico) regulate the sale of franchises. The FTC requires franchisors to make extensive disclosure to prospective 19 franchisees but does not require registration. A number of states in which our franchises operate require registration or disclosure in connection with franchise offers and sales. In addition, several states have "franchise relationship laws" or "business opportunity laws" that limit the ability of the franchisor to terminate franchise agreements or to withhold consent to the renewal or transfer of these agreements. While our franchising operations have not been materially adversely affected by such regulation, we cannot predict the effect of future regulation or legislation. Impact of Inflation and Other External Factors Our principal sources of revenues are franchise fees. Franchise fees can be impacted by external factors, including, in particular: the supply of hotel rooms within the lodging industry relative to the demand for rooms by travelers, and inflation. Although we believe industry-wide supply and demand for hotel rooms recently has been fairly balanced, any excess in supply that might develop in the future could unfavorably impact room revenues at our franchised hotels either by reducing the number of rooms reserved at such franchised properties or by restricting the rates hotel operators can charge for their rooms. In addition, an excess supply of hotel rooms may discourage potential franchisees from opening new hotels, reducing the franchise fees received by us. However, we benefit from an increasing supply of hotels as it serves to increase franchise fees. Although we believe that increases in the rate of inflation will generally result in comparable increases in hotel room rates, severe inflation could contribute to a slowing of the national economy. Such a slowdown could result in reduced travel by both business and leisure travelers, potentially resulting in less demand for hotel rooms, which could result in a temporary reduction in room rates and fewer room reservations, negatively impacting our revenues. A weak economy could also reduce demand for new hotels, negatively impacting the franchise fees received by us. Among the other unpredictable external factors which may affect our fee stream are wars, airline strikes, gasoline shortages and severe weather. Employees We employ domestically approximately 2,100 people as of December 31, 1999. None of our employees are represented by unions or covered by collective bargaining agreements. We consider our relations with our employees to be satisfactory. Item 2. Properties Our principal executive offices are located at 10750 Columbia Pike, Silver Spring, Maryland 20901. Prior to May, 1998, the offices were leased from Sunburst; they are currently leased from a third party. We own our reservation system offices in Phoenix, AZ and Minot, ND. In 1998, one of our subsidiaries acquired a call center in Grand Junction, CO, which we had previously leased. We also lease one additional reservation system office in Grand Junction, CO, pursuant to a lease that expires in 2000, and occupy additional space in Toronto, Canada, on a 20 month-to-month basis. In addition, we lease 12 sales offices across the United States. Management believes that its executive, reservation systems and sales offices are sufficient to meet its present needs and does not anticipate any difficulty in securing additional or alternative space, as needed, on terms acceptable to the Company. Item 3. Legal Proceedings The Company is not a party to any litigation, other than routine litigation incidental to its business. None of such litigation, either individually or in the aggregate, is expected to be material to the business, financial condition or results of operations of the Company. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1999. EXECUTIVE OFFICERS OF CHOICE HOTELS INTERNATIONAL, INC. The name, age, title, present principal occupation, business address and other material occupations, positions, offices and employment of each of the executive officers of the Company are set forth below. The business address of each executive officer is 10750 Columbia Pike, Silver Spring, Maryland 20901, unless otherwise indicated.
Name Age Position ---- --- -------- Stewart Bainum, Jr........................ 53 Chairman of the Board of Directors Charles A. Ledsinger, Jr.................. 50 Chief Executive Officer and President Steven T. Schultz......................... 53 Executive Vice President, Franchise Operations Thomas Mirgon............................. 43 Senior Vice President, Administration Bruno Geny................................ 40 Senior Vice President, International Michael J. DeSantis....................... 41 Senior Vice President, General Counsel and Secretary Joseph M. Squeri.......................... 34 Senior Vice President, Chief Financial Officer and Treasurer
Background of Executive Officers: Stewart Bainum, Jr., Chairman of the Board of the Company from March 1987 to November 1996 and since October 1997; Director of the Company since 1977; Chairman of the Board of Sunburst since November 1996; Chairman of the Board of Manor Care, Inc. since September, 1998; Chairman of the Board and Chief Executive Officer of Manor Care, Inc. from March 1987 to September, 1998; Chief Executive Officer of Manor Care, Inc. and its subsidiary ManorCare Health Services, Inc. ("MCHS") from March 1987 to September, 1998 and President from June 1989 to September, 1998; Vice Chairman of the Board of Vitalink Pharmacy Services, Inc. ("Vitalink") from December 1994 to September, 1998; Vice Chairman of the Board of Manor Care and subsidiaries from June 1982 to March 1987; Director of Manor Care from August 1981 to September 1998, of Vitalink from September 1991 to September, 1998, of MCHS from 1976 to September 1998; Chairman of the Board and Chief Executive Officer of 21 Vitalink from September 1991 to February 1995 and President and Chief Executive Officer from March 1987 to September 1991. Charles A. Ledsinger, Jr., President, Chief Executive Officer and Director of the Company since August, 1998; President and Chief Operating Officer of St. Joe Company from February 1998 to August 1998, Senior Vice President and Chief Financial Officer of St. Joe Company from May 1997 to February 1998; Senior Vice President and Chief Financial Officer of Harrah's Entertainment, Inc. from June 1995 to May 1997; Senior Vice President and Chief Financial Officer of Promus Companies Incorporated from August 1990 to June 1995. Director: FelCor Lodging Trust, Inc., Friendly's Ice Cream Corporation and TBC. Steven T. Schultz. Executive Vice President, Franchise Operations of the Company since May 1999; Executive Vice President and Chief Development Officer of La Quinta Inns, Inc. from 1997 to April 1999; Senior Vice President- Development of La Quinta Inns, Inc. from 1992 to 1997. Bruno Geny, Senior Vice President, International of the Company since November 1997; Executive Director, Mergers & Acquisitions of Union Bank Switzerland from July 1997 to November 1997; Executive Director, Mergers & Acquisitions of SBC Walberg from March 1992 to June 1997. Thomas Mirgon. Senior Vice President, Administration since April 1998; Senior Vice President, Human Resources of the Company from March 1997 to April 1998 and of Former Choice from March 1997 to October 1997; Vice President, Administration of Interim Services from August 1993 to February 1997; employed by Taco Bell Corp. from January 1986 to August 1993, last serving as Senior Director, Field Human Resources from February 1992 to August 1993. Michael J. DeSantis. Senior Vice President, General Counsel and Secretary of the Company since June 1997 and of Former Choice from June 1997 to October 1997; Senior Attorney for Former Choice from November 1996 to June 1997; Senior Attorney for Manor Care from January 1996 to October 1996; Vice President, Associate General Counsel and Assistant Secretary for Caterair International Corporation from April 1994 to December 1995; Assistant General Counsel of Caterair International from May 1990 to March 1994. Director: Friendly Hotels, plc. Joseph M. Squeri. Senior Vice President and Chief Financial Officer of the Company since June 1999; Treasurer of the Company since April 1998; Vice President, Finance and Controller of the Company from March 1997 to June 1999 and of Former Choice from March 1997 to October 1997; Director of Investment Funds, The Carlyle Group, from November 1994 to February 1997; various positions with Arthur Andersen LLP from July 1987 to November 1994, most recently as Manager. 22 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Prior to the Spin-off, the Company was a wholly-owned subsidiary of Former Choice. In the Spin-off, Former Choice distributed to its shareholders all of its interest in the Company on the basis of one share of Company common stock for each share of Former Choice common stock. The Spin-off resulted in approximately 60 million shares of Company common stock outstanding as of October 16, 1997. The shares of the Company's Common Stock are listed and traded on the New York Stock Exchange. The following table sets forth information on the high and low prices of the Company's Common Stock since October 16, 1997. QUARTERLY MARKET PRICE RANGE OF COMMON STOCK (Unaudited) Quarters Ended Market Price Per Share - ------------------------------------------------------------ High Low - ------------------------------------------------------------ FISCAL 1999 March $14 3/8 $12 5/6 June 19 3/4 13 3/16 September 17 1/2 15 1/8 December 17 3/16 13 11/16 FISCAL 1998 March $18 1/2 $14 5/16 June 18 7/16 12 September 14 7/16 11 5/8 December 13 5/16 9 5/8 FISCAL 1997(1) October 16 -- November 30 $18 $17 CALENDER 1997(1) October 16 - December 31 $18 $15 7/8 - ----------------- (1) On September 16, 1997, the Company changed its fiscal year end from May 31 to December 31. The Spinoff occurred on October 15, 1997, no trading occurred prior to that date. The Company paid no dividends during the twelve month period ended December 31, 1999. The Company does not anticipate the payment of any cash dividends on its common stock in the foreseeable future. Payment of dividends on Company common stock will also be subject to limitations as may be imposed by the Company's credit facilities from time to time. The declaration of dividends will be subject to 23 the discretion of the Board of Directors. As of March 10, 2000, there were 4,037 record holders of Company common stock. Item 6. Selected Financial Data. The required information is included on page 1 of the 1999 Annual Report and is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations. The required information is included on pages 26-33 of the 1999 Annual Report and is incorporated herein by reference. Item 7A. The Company is exposed to market risk from changes in interest rates and the impact of fluctuations in foreign currencies on the Company's foreign investments. The Company manages its exposure to this market risk through the monitoring of its available financing alternatives including in certain circumstances the use of derivative financial instruments. The Company's strategy to manage exposure to changes in interest rates and foreign currencies remains unchanged from 1997. Furthermore, the Company does not foresee any significant changes in exposure in these areas or in how such exposure is managed in the near future. At December 31, 1999 and 1998, the Company had $307.4 million and $279.2 million of debt outstanding at effective interest rates of 6.6% and 6.4%, respectively, after the impact of interest rate swaps is taken into account. A hypothetical change of 10% in the Company's effective interest rate from year-end 1999 levels would increase or decrease interest expense by $1.3 million. The Company will refinance the $150 million variable rate term loan as it amortizes throughout the expected maturity dates. Upon expiration of the Credit Facility in 2002, the Company expects to refinance its obligations. For more information related to the Company's use of interest rate instruments, see Long-Term Debt and Notes Payable, Interest Rate Hedges and Fair Value of Financial Instruments in the Notes to the Consolidated Financial Statements. The Company is also exposed to fluctuations in foreign currency relating to its preferred stock investment in Friendly Hotels, PLC which is denominated in British Pounds. The Company does not have any derivative financial instruments related to its foreign investments. Item 8. Financial Statements and Supplementary Data. The required information is included on page(s) 35-52 of the 1999 Annual Report and is incorporated herein by reference. See Item 14 for the Index to Financial Statements and Schedules. 24 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Directors and Executive Officers of the Registrant The required information on directors is included on pages 5-7 of the Proxy Statement dated March 29, 2000 and is incorporated herein by reference. The required information on executive officers is set forth in Part I of this Form 10-K under an unnumbered item captioned "Executive Officers of Choice Hotels International, Inc." Item 11. Executive Compensation. The required information is included on pages 11-14 of the Proxy Statement dated March 30, 2000 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management. The required information is included on pages 9-10 of the Proxy Statement dated March 29, 2000 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions. The required information is included on pages 20-25 of the Proxy Statement dated March 29, 2000 and is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) List of Documents Filed as Part of this Report 1. Financial Statements The following information is included on the corresponding pages of the 1999 Annual Report: Consolidated Statements of Income........................ p. 35 Consolidated Balance Sheets.............................. p. 36 Consolidated Statements ofShareholders' Equity and Comprehensive Income................................ p. 38 Consolidated Statements of Cash Flows.................... p. 37 Report of Independent Public Accountants................. p. 34 Notes to Consolidated Financial Statements............... pp. 39-52 25 2. Financial Statement Schedules The following reports are filed herewith. Report of Independent Public Accountants on Schedule..... Consent of Independent Public Accountants................ Schedule II: Valuation and Qualifying Accounts.......... All other schedules are not applicable. 3. Exhibits
Exhibit Number Description - ------- ----------- 3.01(a) Restated Certificate of Incorporation of Choice Hotels Franchising, Inc. 3.02(a) Amended and Restated Bylaws of Choice Hotels International, Inc. 4.01(c) Credit Agreement dated October 15, 1997 among Choice Hotels International, Inc., Chase Manhattan Bank, as Agent and certain Lenders 4.02(c) First Amendment to Credit Agreement dated February 13, 1998 among Choice Hotels International, Inc., Chase Manhattan Bank, as Agent, and certain Lenders. 4.03(j) Second Amendment to Credit Agreement, dated as of March 30, 1998 among Choice Hotels International, Inc., Chase Manhattan Bank, as agent, and certain Lenders. 4.04 (j) Third Amendment to Credit Agreement, dated as of April 9, 1998 among Choice Hotels International, Inc., Chase Manhattan Bank, as agent, and certain Lenders. 4.05(j) Fourth Amendment to Credit Agreement, dated as of December 16, 1998, among Choice Hotels International, Inc., Chase Manhattan Bank, as agent, and certain Lenders. 4.06(k) Fifth Amendment to Credit Agreement dated March 19, 1999 among Choice Hotels International, Inc., Chase Manhattan Bank as agent, and certain lenders. 4.07(h) Registration Agreement dated April 28, 1998 between Choice Hotels International, Inc. and Salomon Brothers, Inc., Bear Stearns & Co. Inc. and Lehman Brothers Inc. 4.08(h) Indenture dated as of May 4, 1998, by and among the Company, Quality Hotels Europe, Inc., QH Europe Partnership and Marine Midland Bank, as Trustee, with respect to the 7.125% Senior Notes due 2008 of the Company. 4.09(h) Specimen certificate of 7.125% Senior Note due 2008 (Original Note) (Attached as an exhibit to the Indenture set forth as Exhibit 4.08) 4.10(h) Specimen certificate of 7.125% Senior Note due 2008 (Exchange Note) (Attached as an exhibit to the Indenture set forth as Exhibit 4.08) 4.11(b) Guarantee Agreement dated October 15, 1997 between Quality Hotels Europe, Inc. and The Chase Manhattan Bank. 4.12(b) Supplement No. 1 to the guarantee Agreement dated April 28, 1998 among Choice Hotels International, Inc., Quality Hotels Europe, Inc., QH Europe Partnership and The Chase Manhattan Bank. 4.13(b) Indemnity, Subrogation and Contribution Agreement, dated April 28, 1998 among Choice Hotels International, Inc., Quality Hotels Europe, Inc., QH Europe Partnership and The Chase Manhattan Bank. 4.14(g) Rights Agreement, dated as of February 19, 1998, between Choice Hotels International, Inc. and ChaseMellon Shareholder Services, L.L.C., as Rights Agent. 10.01(l) Amended and Restated Employment Agreement between Choice Hotels International, Inc. and Charles A. Ledsinger, Jr. dated April 13, 1999. 10.02(d) Distribution Agreement dated as of October 15, 1997 by and between Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation) and Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.)
26 10.03(d) Employee Benefits Administration Agreement dated as of October 15, 1997 by and between Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation) and Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.) 10.04(d) Tax Administration Agreement dated as of October 15, 1997 by and between Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation) and Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc. 10.05(d) Tax Sharing Agreement dated as of October 15, 1997 by and between Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation) and Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.) 10.09(d) Employee Benefits Allocation Agreement dated as of October 15, 1997 by and between Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation) and Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.) 10.10(d) Strategic Alliance Agreement dated as of October 15, 1997 by and between Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation) and Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.) 10.11(d) Omnibus Amendment and Guaranty dated as of October 15, 1997 by and among Choice Hotels International, Inc. (renamed Sunburst Hospitality Corporation), Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.) and Manor Care, Inc. 10.12(d) Amended and Restated Employment Agreement dated as of October 15, 1997 by and between Choice Hotels Franchising, Inc. (renamed Choice Hotels International, Inc.) and Stewart Bainum, Jr. 10.13(l) Amended and Restated Employment Agreement dated April 13, 1999 by and between Choice Hotels International, Inc. and Thomas Mirgon 10.14(j) Omnibus Amendment Agreement dated December 28, 1998 between Choice Hotels International, Inc. and Sunburst Hospitality Corporation. 10.15 * Second Omnibus Amendment Agreement dated February 29, 2000 between Choice Hotels International, Inc. and Sunburst Hospitality Corporation. 10.16(f) Choice Hotels International, Inc. Non-Employee Director Stock Option and Deferred Compensation Stock Purchase Plan. 10.17(f) Choice Hotels International, Inc. 1997 Non-Employee Director Stock Compensation Plan. 10.18(f) Choice Hotels International, Inc. 1997 Long-Term Incentive Plan. 10.20(l) Second Amended and Restated Employment Agreement dated April 13, 1999 between Choice Hotels International, Inc. and Michael J. DeSantis. 10.22(j) Commercial Lease dated May 29, 1998 among Columbia Pike I, LLC and Colesville Road, LLC (each an assignee of Manor Care, Inc.) and Choice Hotels International, Inc. 10.23(l) Employment Agreement dated May 13, 1999 between Choice Hotels International, Inc. and Steven T. Schultz. 10.24(l) Employment Agreement dated June 3, 1999 between Choice Hotels International, Inc. and Joseph M. Squeri. 13.01 * Annual Report to Shareholders 21.01 * Subsidiaries of Choice Hotels International, Inc. 23.01 * Consent of Arthur Andersen LLP 27.01 * Financial Data Schedule
- ------------------ * Filed herewith (a) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Registration Statement on Form S-4, filed August 31, 1998 (Reg. No. 333-62543). (b) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Amendment No. 1 to Registration Statement on Form S-4, filed October 14, 1998 (Reg. No. 333-62543). 27 (c) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Transitional Report on Form 10-K dated June 1, 1997, to December 31, 1997, filed on March 31, 1998. (d) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Current Report on Form 8-K dated October 15, 1997, filed on October 29, 1997. (e) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Current Report on Form 8-K dated October 15, 1997, filed on December 16, 1997. (f) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Registration Statement filed on Form S- 8, filed on December 2, 1997 (Reg. No. 333-41357). (g) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Current Report on Form 8-K dated February 19, 1998, filed on March 11, 1998. (h) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Quarterly Report on Form 10-Q filed for the quarterly period ended March 31, 1998, filed on May 15, 1998. (i) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Quarterly Report on Form 10-Q filed for the quarter ended June 30, 1998, filed on August 11, 1998. (j) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1998, filed on March 30, 1999. (k) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Quarterly Report on Form 10-Q for the quarter ended March 31, 1999, filed on May 4, 1999. (l) Incorporated by reference to the identical document filed as an exhibit to Choice Hotels International, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, filed on August 16, 1999. (b) No reports on Form 8-K were filed during the last quarter of the fiscal year ended December 31, 1999. 28 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CHOICE HOTELS INTERNATIONAL, INC. By: /s/ Charles A. Ledsinger, Jr. --------------------------------------- Charles A. Ledsinger, Jr. President and Chief Executive Officer Dated: March 30, 2000 29 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /s/ Stewart Bainum, Jr. Chairman, Director March 30, 2000 - ------------------------------------ Stewart Bainum, Jr. /s/ Charles P. Ledsinger, Jr. President, Chief Executive March 30, 2000 - ------------------------------------ Officer & Director Charles P. Ledsinger, Jr. /s/ Barbara Bainum Director March 30, 2000 - ------------------------------------ Barbara Bainum /s/ James H. Rempe Director March 30, 2000 - ------------------------------------ James H. Rempe /s/ Larry R. Levitan Director March 30, 2000 - ------------------------------------ Larry R. Levitan /s/ William L. Jews Director March 30, 2000 - ------------------------------------ William L. Jews /s/ Gerald W. Petitt Director March 30, 2000 - ------------------------------------ Gerald W. Petitt /s/ Raymond E. Schultz Director March 30, 2000 - ------------------------------------ Raymond E. Schultz /s/ Jerry E. Robertson Director March 30, 2000 - ------------------------------------ Jerry E. Robertson /s/ Joseph M. Squeri Senior Vice President and March 30, 2000 - ------------------------------------ Chief Financial Officer Joseph M. Squeri
30 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Choice Hotels International, Inc.: We have audited in accordance with auditing standards generally accepted in the United States, the consolidated financial statements included in Choice Hotels International, Inc.'s ("the Company") annual report to shareholders incorporated by reference in this Form 10-K, and have issued our opinion thereon dated January 28, 2000. Our audit was made for the purpose of forming an opinion on those consolidated financial statements taken as a whole. The schedule listed in the index under Item 14(a)2 is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Arthur Andersen LLP Vienna, Virginia January 28, 2000 31 CHOICE HOTELS INTERNATIONAL, INC. AND SUBSIDIARIES SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (In thousands of dollars)
Balance at Charges to Balance at Beginning of Profit End Description Period and Loss Write-offs Of Period ----------- ------ -------- ---------- ---------- Year ended December 31, 1999 Allowance for doubtful accounts $8,082 $ 588 $(2,467) $6,203 ====== ====== ======= ====== Year ended December 31, 1998 Allowance for doubtful accounts $7,608 $1,473 $ (999) $8,082 ====== ====== ======= ====== Seven months ended December 31, 1997 Allowance for doubtful accounts $6,159 $2,274 $ (825) $7,608 ====== ====== ======= ====== Year ended May 31, 1997 Allowance for doubtful accounts $4,515 $2,238 $ (594) $6,159 ====== ====== ======= ======
32 EX-10.15 2 EXHIBIT 10.15 EXHIBIT 10.15 SECOND OMNIBUS AMENDMENT AGREEMENT THIS SECOND OMNIBUS AMENDMENT AGREEMENT (this "Agreement") is made this 29th day of February, 2000 by and between CHOICE HOTELS INTERNATIONAL, INC., a Delaware corporation ("Choice"), and SUNBURST HOSPITALITY CORPORATION, a Delaware corporation ("Sunburst"). WHEREAS, in connection with the spin-off of Choice by Sunburst (the "Spin-off"), Choice and Sunburst entered into a Strategic Alliance Agreement (the "Strategic Alliance Agreement") dated October 15, 1997 pursuant to which, among other things, the parameters of the operating relationship between Choice and Sunburst with regard to matters of mutual interest are set forth; WHEREAS, in connection with the Spin-off, Choice and Sunburst also entered into a Noncompetition Agreement dated October 15, 1997 (the "Noncompetition Agreement"); WHEREAS, in connection with the Spin-off, Choice and Sunburst entered into a Distribution Agreement dated October 15, 1997 pursuant to which, among other things, Choice agreed to loan to Sunburst $115,000,000 which was evidenced by a subordinated note (the "Term Note") with an aggregate principal amount of $115,000,000 and a maturity date of five years; WHEREAS, the Strategic Alliance Agreement contains a form of Franchising Agreement (the "Franchising Agreement") as Exhibit A to be entered --------- into by and between Choice and Sunburst whenever Choice is to brand any hotel or lodging property of any kind that Sunburst develops or acquires and intends to franchise during the term of the Strategic Alliance Agreement; WHEREAS, Choice and Sunburst have entered into numerous franchising agreements substantially in the form of the Franchising Agreement; WHEREAS, Choice and Sunburst entered into an Omnibus Amendment Agreement (the "First Omnibus Amendment Agreement" and, together with this Agreement, the Strategic Alliance -2- Agreement, the Noncompetition Agreement, the Term Note and the franchising agreements entered into between Franchising and Realco prior to, on or after the date hereof, the "Transaction Documents") dated December 28, 1998, pursuant to which, among other things, Choice and Sunburst agreed to amend the Strategic Alliance Agreement, the Term Note and the aforementioned franchising agreements; WHEREAS, Choice and Sunburst desire to further amend the Strategic Alliance Agreement, the aforementioned franchising agreements and the Term Note; and WHEREAS, Choice and Sunburst desire to terminate the Noncompetition Agreement; NOW, THEREFORE, Choice and Sunburst agree as follows: ARTICLE ONE AMENDMENTS TO STRATEGIC ALLIANCE AGREEMENT AND FRANCHISING AGREEMENTS Section 1.1. Definitions. Any capitalized term used within this ----------- Article One and not defined within this Agreement, will have the meaning ascribed to such term in the Strategic Alliance Agreement. Section 1.2. Term. Section 2.1 of the Strategic Alliance Agreement ---- is hereby amended and restated as follows: This Agreement shall go into effect on the date of the Distribution (the "Effective Date") and shall continue in force until October 15, 2002 (the "Expiration Date"), except for Section 7.2 and Sections 1.6 and 1.7 of the Second Omnibus Amendment Agreement which shall survive so long as any franchising agreements between Realco and Franchising are in effect. This Agreement may be renewed upon the mutual consent of the Parties. -3- Section 1.3. Elimination of Right to First Refusal in Strategic -------------------------------------------------- Alliance Agreement. The Strategic Alliance Agreement is hereby amended such - ------------------ that Sections 3.2, 3.3, 3.4, 3.5 and 3.6 are deleted in their entirety and the following new Section 3.2 is hereby inserted as follows: 3.2 Until the Expiration Date, Realco shall give Franchising written notice at least fourteen days prior to executing a franchise application with a third party with respect to the franchising of a hotel or lodging property. Such written notice shall include a summary term sheet of the proposed arrangement with the third party. Franchising shall have the opportunity to present Realco with a plan to brand the hotel or lodging property with one of its brands provided that Realco shall have no obligation to enter into an agreement with Franchising to use any of its brands on the hotel or lodging property. Section 1.4. Development. Section 4 of the Strategic Alliance ----------- Agreement is hereby amended and restated in its entirety as follows: 4. Development ----------- 4.1. Realco and Franchising are currently in the midst of a program under which Realco has developed the twenty-one MainStay Suite Hotels listed on Appendix I to the Second Omnibus Amendment Agreement and which ---------- are franchised by Franchising. Realco agrees that it will continue to develop at least four additional MainStay Suite Hotels so that it will have opened and continue to operate no fewer than a total of twenty-five MainStay Suite Hotels prior to the Expiration Date (the "MainStay Quota"). For purposes of Sections 4.1 and 4.2, the following shall be included in the MainStay Quota notwithstanding Realco's transfer of such hotels prior to the Expiration Date: (a) The three MainStay Suites properties (the "Put Call Properties") which are subject to a Put Call Agreement between Realco and Franchising; -4- (b) The two MainStay Suites properties identified in Appendix III to ------------ the Second Omnibus Amendment Agreement; and (c) Any MainStay Suite property sold, transferred or conveyed by Realco if such property is relicensed by the new owner or transferee as a MainStay Suites under market terms acceptable to Franchising. 4.2. Until the MainStay Suite Hotels subject to the MainStay Quota are Developed(as defined below), expenditures by Realco (or any of its subsidiaries or affiliates) of cash or other assets, or agreements, understandings or commitments for the same (whether binding, contingent, conditional or otherwise), in connection with or related to the development of any hotel or lodging property other than a MainStay Suite Hotel, including without limitation, by way of acquisition of any property or any capital stock (but excluding a stock for stock acquisition or merger) or assets of any person or entity that directly or indirectly owns, operates or manages a hotel or lodging property (collectively, "Hotels Expenditures") shall not exceed the aggregate amount spent by Realco in connection with or related to the development of MainStay Suite Hotels (collectively, "MainStay Expenditures"). The ratio of Hotel Expenditures to MainStay Expenditures shall be measured on a bi-annual, cumulative aggregate basis. Within thirty days after the end of such bi-annual period, Realco will deliver to Franchising a statement detailing (i) all Hotel Expenditures made by Realco during such period, (ii) all MainStay Expenditures made by Realco during such period, and (iii) outstanding agreements, understandings and commitments for the same. "Developed" shall mean either: (i) that, on or before April 15, 2001, three of the remaining four MainStay Suites to be built to satisfy the MainStay Quota are open and operating and the fourth has commenced construction; or (ii), if the conditions of clause (i) are not satisfied, then all four of the remain- -5- ing MainStay Suites to be built to satisfy the MainStay Quota are open and operating. Section 1.5. Dispute and MainStay Brand Issues Resolution. The -------------------------------------------- Strategic Alliance Agreement is hereby amended by retitling Section 7 as "Dispute and Brand Issue Resolution" and amending and restating Sections 7.1 and 7.2 in their entitety as follows: 7.1. Realco and Franchising agree to use their commercially reasonable best efforts to address the brand issues identified on Appendix -------- II to the Second Omnibus Amendment Agreement within the time frames set -- forth therein. Realco and Franchising agree to use their commercially reasonable best efforts to have their respective designated representatives meet once every two weeks for six months from February 15, 2000 to discuss ongoing matters with respect to the MainStay Suite Hotel brand. At the end of the initial six month period, either party may require such bi-weekly meetings to continue for an additional six month period and then once a month for the following year. The representatives shall be the Executive Vice President, Franchise Operations and the Senior Vice President, Marketing for Franchising and the Chief Executive Officer for Realco. 7.2. Arbitration. Notwithstanding anything contained in the ----------- Transaction Documents to the contrary, any claim arising out of or related to any of the Transaction Documents, which has not been resolved by mutual agreement of the parties after a written notice of the claim by the complaining party to the other party and a forty-five (45) day negotiation period in which the Parties try to resolve the claim, shall be finally settled by arbitration. Such arbitration shall be conducted in Bethesda, Maryland in accordance with the Commercial Rules of the American Arbitration Association then in effect, as modified or supplemented herein, or as the parties mutually agree otherwise. Notwithstanding the rules of the arbitral body, the Parties hereto agree (a) that any arbitration shall be presided over by a single arbitrator, who shall have been ad- -6- mitted to the practice of law, and be in good standing or on retirement status in any of the fifty United States or the District of Columbia and have experience in hotel franchise matters, (b) that the arbitrator shall base his decision on the facts as presented into evidence, and (c) that the arbitrator shall prepare a written memorandum of decision setting forth the findings of fact and conclusions of law. The arbitrator shall be selected by the Parties. If they cannot agree on such selection within a thirty (30) day period, they shall ask the American Arbitration Association to appoint an arbitrator. The decision of the arbitrator shall be final, and judgment may be entered upon it in accordance with the applicable law in any court having jurisdiction. Any claim for relief made pursuant to this Agreement shall be made within one (1) year from the date upon which the claim arose. All costs of the arbitration shall be borne by the Party determined to be the losing Party by the arbitrator. For purposes of determining the prevailing and losing Party, the arbitrator may consider offers of settlement by either Party, or both of them. The Circuit Court of Montgomery County, Maryland shall have exclusive jurisdiction to enforce this arbitration provision, for injunctive relief in and of arbitration and for enforcement of any arbitration award. Section 1.6. Liquidated Damages Provision in Franchising Agreements. ------------------------------------------------------ Notwithstanding Section 3.1 of the Strategic Alliance Agreement and with reference to Section 1.3 of the First Omnibus Amendment Agreement, as long as Sunburst has not defaulted under the Term Note: (a) Notwithstanding the terms of any and all franchising agreements entered into prior to, on or after the date hereof by and between Choice and Sunburst (or any of their respective predecessors or affiliates) related to the twenty-five MainStay Suite Hotels subject to the MainStay Quota, Sunburst agrees that it shall not reflag any such MainStay Suite Hotel, through a sale or otherwise (except as provided in the Put Call Agreement), or seek termination of any such franchising agreement or fail to -7- enter into a franchising agreement for any such hotels or allow any other brand to be flagged to any such hotel prior to October 15, 2002; provided, however, Sunburst may: (i) reflag, or permit the reflagging of, -------- -------- up to two of the properties so identified on Appendix III to the Second ------------ Omnibus Amendment Agreement during such three year period or thereafter; and (ii) sell, transfer or convey any such MainStay Suites hotel if such property is relicensed by the new owner or transferee as a MainStay Suites under market terms acceptable to Choice. Upon an event specified in clause (i) or (ii) of the preceding sentence, Choice shall terminate the respective franchise agreements and waive any claim for damages against Sunburst caused by such reflagging, sale, transfer or termination including the obligation to pay liquidated damages. After October 15, 2002, Sunburst may reflag, or permit the reflagging of, any MainStay Suite Hotels and terminate any such franchising agreement and Choice shall waive any claim against Sunburst for damages caused by such reflagging or termination, including liquidated damages, if (x) Sunburst gives thirty days prior written notice to Choice and (y) Sunburst pays Choice $100,000 as a termination fee for each MainStay Suites Hotel, other than the two properties referred to in clause (i) above, that is to be reflagged or for which the franchising agreement is to be terminated. Choice and Sunburst acknowledge that if any or all of the Put Call Properties are transferred pursuant to the Put Call Agreement, that Choice shall terminate the respective franchise agreements and shall waive any claim against Sunburst for damages, including liquidated damages. Choice and Sunburst agree that irreparable damage would occur in the event any of the provisions of this Section 1.6(a) were not performed in accordance with the terms hereof and that Choice's remedy at law for any breach of Sunburst's obligations hereunder would be inadequate. Sunburst agrees and consents that temporary and permanent injunctive relief may be granted in any proceeding which may be brought to enforce any provision hereof without the necessity of proof of actual damage. -8- (b) Choice and Sunburst acknowledge that the reference in Section 1.3 of the First Omnibus Amendment Agreement to the liquidated damages provision applicable to Sleep Inn franchise agreements is intended as a termination fee such that Sunburst has the right at any time on or after February 29, 2000 to terminate any such Sleep Inn franchise agreements upon payment to Choice of $100,000 per agreement and Choice shall waive any claim against Sunburst for damages caused by such termination, including liquidated damages. (c) Choice and Sunburst acknowledge that pursuant to Section 1.3 of the First Omnibus Amendment Agreement, if Sunburst reflags a hotel or lodging property that is neither a Sleep Inn nor MainStay Suite Hotel and that hotel or lodging property is not sold by Sunburst within three years from the date it was flagged with a non-Choice brand, then on such third anniversary Sunburst shall pay Choice $100,000 in liquidated damages for each such reflagged hotel or lodging property and Choice shall waive any claim against Sunburst for damages caused by such reflagging, including liquidated damages. Section 1.7. Franchise Fee Credits. Notwithstanding anything --------------------- contained in any MainStay Suites franchising agreements entered into prior to, on or after the date hereof by and between Choice and Sunburst (or any of their respective predecessors or affiliates) Section 4 of each franchising agreement is hereby amended to add new subsections as follows: (h) On the date hereof Franchising shall establish an account to serve as a mechanism for administering the Shortfall Balance, as defined in and pursuant to this Section 4. The initial amount credited to the Shortfall Balance on the date hereof shall be $2,142,887 (the "Shortfall Amount"), which represents the amount by which an agreed upon target Cumulative EBITDA for the MainStay Suites hotels subject to the MainStay Quota (excluding the Put Call Properties) for the period from October 1, 1996 through December 31, 1999 exceeds the actual Cumulative EBITDA for such period. -9- (i) For each year beginning January 1, 2001 until the Shortfall Freeze Date (as defined below), the Shortfall Balance shall be adjusted (an "Adjustment") by 50% of the amount, if any, by which the Target Cumulative EBITDA (as set forth on Appendix IV) for the preceding year exceeds the ----------- actual Cumulative EBITDA for the MainStay Suites Hotels subject to the MainStay Quota (exclusive of the Put Call Properties) for such year as finally determined pursuant to clause (j) below. Each year, on or prior to February 15 of such year, Realco shall determine the actual Cumulative EBITDA for the preceding year in a manner consistent with the calculation of the Target Cumulative EBITDA and whether an Adjustment is warranted and shall deliver written notice thereof to Franchising together with the monthly operating statements for each applicable hotel. From and after the earlier of February 28, 2010 and the first year in which no Adjustment is required pursuant to this clause (h) (the "Shortfall Freeze Date"), no further Adjustments shall be determined pursuant to this paragraph and the Shortfall Balance shall thereafter never be increased. (j) The Shortfall Balance, if any, shall be applied by Realco as a credit against royalty, reservation and marketing fees ("Fees") payable to Franchising as follows: (1) First, to Fees payable pursuant to the franchise agreements related to the MainStay Suites Hotels subject to the MainStay Quota for each month prior to the tenth anniversary of the date of each such franchise agreement. The Fee credit shall be applied no later than the fifteenth day of each month against Fees payable as of the last day of the preceding month; and (2) Second, to Fees payable pursuant to franchise agreements for MainStay Suite Hotels other -10- than those referred to in (i)(1) above or for any brand developed by Franchising after the date hereof. The Fee credit shall be applied no later than the fifteenth day of each month against Fees payable as of the last day of the preceding month. The Shortfall Balance shall immediately be reduced by the amounts used as Fee credits pursuant to this section. Any remainder of the Shortfall Balance shall carry forward until used. (k) Franchising or its representatives shall have the right to review and audit the books and records of Realco for the purposes of determining the Shortfall Amount and the Fees payable in any particular month. If Franchising agrees with the Shortfall Amount determined by Realco, then that amount shall be deemed finally determined. In the event Franchising disagrees with the Shortfall Amount or the Fees payable as determined by Realco, then Franchising shall so notify Realco in writing within 10 days of receipt of notice from Realco of the Shortfall Amount. If Franchising and Realco are unable to agree in good faith by the tenth day of any month, then Franchising shall, within 10 days from its delivery of the notice to Realco, retain a firm of independent accountants to determine the Shortfall Amount and/or the Fees payable. The accountant shall deliver its determination no later than the last day of such month. The cost of such accountants shall be borne by Franchising unless the accountant's determination of the Shortfall Amount and/or Fees payable deviates by 5% or more from the amount determined by Realco, in which case Realco shall bear the cost. If Franchising and Realco agree with the accountants determination of the Shortfall Amount and/or the Fees payable, then that amount shall be deemed finally determined. If Franchising or Realco disagree with the accountants determination, then the parties shall settle the disagreement and the Shortfall Amount and/or the Fees payable shall be finally determined in accordance with the dispute resolution mechanism set forth in the Strategic Alliance Agreement, as amended. Realco agrees that it shall cooperate with -11- Franchising and the accountant and provide them reasonable access to its books records and employees in connection with their review of the Shortfall Amount and/or the Fees payable. Section 1.8. Elimination of Right to First Refusal in Franchising ---------------------------------------------------- Agreements. Notwithstanding anything contained in any franchising agreements - ---------- entered into prior to, on or after the date hereof by and between Choice and Sunburst (or any of their respective predecessors or affiliates), the provision regarding the right of first refusal contained in each franchising agreement is hereby deleted in its entirety. ARTICLE TWO AMENDMENTS TO TERM NOTE Section 2.1. Definitions. Any defined term used within this Article ----------- Two and not defined within this Agreement shall have the meaning ascribed to such term in the Term Note (as amended). Section 2.2. Asset Sale Proceeds. Section 1.6 of the Term Note is ------------------- hereby amended by deleting the section in its entirety and replacing it with the following: Within fourteen (14) calendar days after the consummation of an Asset Sale involving the Put Call Properties, the Payor will pay to the Payee by wire transfer to the bank account designated by the Payee such aggregate principal amount of this Note as equals one hundred percent (100%) of the Asset Sale Proceeds. Section 2.3. Event of Default. Section 2 of the Term Note is hereby ---------------- amended by adding the following after paragraph 2(e): (f) A Change of Control of the Payor. For purposes of this paragraph, a "Change of Control" shall mean: -12- 1. Any "person" as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (other than (i) the Payor, (ii) any trustee or other fiduciary holding securities under an employee benefit plan of the Payor, (iii) any corporations owned, directly or indirectly, by the stockholders of the Payor in substantially the same proportions as their ownership of stock of the Payor, or(iv) Stewart Bainum, his wife, their lineal descendants and their spouses (so long as they remain spouses) and the estate of any of the foregoing persons, and any partnership, trust, corporation or other entity to the extent shares of common stock (or their equivalent) are considered to be beneficially owned by any of the persons or estates referred to in the foregoing provisions of this subsection or any transferee thereof) becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act)), directly or indirectly, of securities of the Payor representing 20% or more of the combined voting power of the Payor's then outstanding voting securities. 2. Individuals constituting the Board of Directors of the Payor on the date of this Agreement and the successors of such individuals ("Continuing Directors") cease to constitute a majority of the Board. For this purpose, a director shall be a successor if and only if he or she was nominated by a Board (or a Nominating Committee thereof) on which individuals constituting the Board on February 29, 2000 and their successors (determined by prior application of this sentence) constituted a majority; 3. The stockholders of the Payor approve a plan of merger or consolidation ("Combination") with any other corporation or legal person, other than a Combination which would result in stockholders of the Payor immediately prior to the Combination owning, immediately thereafter, more than sixty-five percent (65%) of the combined voting power of either the surviving entity or the entity owning directly or indirectly all of the common stock, or its equivalent, of the surviving entity; provided, how- -13- ever, that if stockholder approval is not required for such Combination, the Change in Control shall occur upon the consummation of such Combination; 4. The Payor or an affiliate of the Payor engages in a "Rule 13e-3 transaction" as defined in the Securities and Exchange Act of 1934, as amended. 5. The stockholders of the Payor approve a plan of liquidation of the Payor or an agreement for the sale or disposition (including through a sale/leaseback) by the Payor of more than 50% of the Payor's stock and/or assets, or accept a tender offer for more than 50% of the Payor's stock (or any transaction having a similar effect); provided, however, that if stockholder approval is not required for such transaction, the Change in Control shall occur upon consummation of such transaction. Section 2 shall be further amended by adding the following paragraph immediately preceding the last paragraph of Section 2: If an Event of Default specified in Section 2(f) shall have occurred and be continuing, Payee may, at its option, by written notice to Payor and to Chase, declare the entire principal amount of this Note and the interest accrued thereon to be due and payable. Section 2.4. Representation of Payor. Section 6 of the Term Note is ----------------------- amended by adding the following new provision: 6.10. Representation and Warranty of Payor. The Payor hereby ------------------------------------ represents and warrants that the Lenders have consented to and approved the amendments to the Note contained in the Omnibus Amendment Agreement dated December 28, 1998 (as amended herein) and the Second Omnibus Amendment Agreement dated February 29, 2000. The Payor further represents and warrants that the Lenders have waived any default or event of default under the Credit Agreement or any other Senior Debt Document that may arise as a result -14- of any payment under this Note in accordance with its terms, including without limitation pursuant to Section 1.6 hereof. Section 2.5. Covenant of Payor. Section 3.2 of the Term Note is ----------------- amended by adding the following new provision: Payor further covenants and agrees that for so long as any indebtedness evidenced by this Note remains outstanding, Payor will not, without the written consent of Payee, enter into any agreement that restricts or prohibits any payment by Payor to Payee under the terms of this Note. ARTICLE THREE NONCOMPETITION AGREEMENT Section 3.1. Termination. The Noncompetition Agreement is hereby ----------- terminated and shall from and after the date hereof be of no further force or effect. ARTICLE FOUR MISCELLANEOUS PROVISIONS Section 4.1. Conflicts. In the event of any conflict between the --------- terms of this Agreement and the terms of the Strategic Alliance Agreement, any franchising agreement entered into by and between Choice and Sunburst referred to in this Agreement, the Term Note, the Noncompetition Agreement, the First Omnibus Amendment Agreement and any other documents related thereto and executed by one or more parties hereto in connection with any of the aforementioned agreements, the terms and provisions of this Agreement shall control. Section 4.2. Agreements Remain in Effect. The Strategic Alliance --------------------------- Agreement, any franchising agreement en- -15- tered into by and between Choice and Sunburst referred to in this Agreement, the First Omnibus Amendment Agreement and the Term Note shall remain fully effective and are changed only as specifically provided herein and shall bind the parties to each in all respects as originally contemplated. Section 4.3. Counterparts. This Agreement may be executed in one or ------------ more counterparts, all of which taken together shall constitute one instrument. Section 4.4. Board Approval. This Agreement has been approved by -------------- the Board of Directors of both Choice and Sunburst. IN WITNESS WHEREOF, intending to be legally bound hereby, the parties hereto have executed this Agreement as of the day and year first written above. CHOICE HOTELS INTERNATIONAL, INC. /S/ Joseph M. Squeri - -------------------------- Name: Joseph M. Squeri Title: Senior Vice President SUNBURST HOSPITALITY CORPORATION /s/ Donald J. Landry - ---------------------------- Name: Donald J. Landry Title: President EX-13.01 3 EXHIBIT 13.01 Exhibit 13.01 Table of Contents - -------------------------------------------------------------------------------- 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 26 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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 ---------------------------- Total revenues 161,600 165,474 ---------------------------- 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 ---------------------------- Total operating expenses 67,766 80,366 ---------------------------- 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) ---------------------------- Income before income taxes and extraordinary item 94,471 82,400 Income taxes 37,316 34,327 ---------------------------- Net income before extraordinary item 57,155 48,073 Gain on early extinguishment of debt, net of $4,732 of income taxes -- 7,232 ---------------------------- 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. 27 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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 28 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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) ---------------------------- 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 ---------------------------- Total revenues 165,474 175,416 ---------------------------- 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 ---------------------------- Total operating expenses 80,366 98,348 ---------------------------- 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) ---------------------------- Income before income taxes and extraordinary item 82,400 66,276 Income taxes 34,327 27,604 ---------------------------- Net income before extraordinary item 48,073 38,672 Gain on early extinguishment of debt, net of $4,732 of income taxes 7,232 -- ---------------------------- Net income $ 55,305 $ 38,672 ---------------------------- 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 29 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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. 30 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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) ---------------------------- 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 ---------------------------- Total revenue 107,839 99,978 ---------------------------- 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 ---------------------------- Total operating expenses 55,665 54,511 ---------------------------- Operating income 52,174 45,467 Interest expense, net 5,791 5,784 ---------------------------- Income before income taxes 46,383 39,683 Income taxes 19,096 16,338 ---------------------------- Net income $ 27,287 $ 23,345 ---------------------------- 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. 31 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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. 32 - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS - -------------------------------------------------------------------------------- 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 - -------------------------------------------------------------------------------- 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 EX-21.01 4 EXHIBIT 21.01 Exhibit 21.01 SUBSIDIARIES Choice Capital Corp. (Lending subsidiary) Choice Hotels Australia Pty. Ltd. (90% owned) Choice Hotels Canada Inc. (50% owned) Choice Hotels del Plata Choice Hotels Brazil (Cayman) Ltd. (10%) Choice Hotels International Asia Pacific Pty. Ltd. Choice Hotels Australia Pty. Ltd. Choice Hotels International Foundation, Inc. Choice Hotels International Services Corp. Choice Hotels Japan, Inc. (Formerly Quality Hotels Japan, Inc.) Choice Hotels Limited Choice Hotels Systems, Inc. Choice Hotels Thailand (Del.) Inc. Quality Hotels Europe, Inc. Quality Hotels and Resorts, Inc. Schuyler Properties Ltd. (Bahamian) EX-23.01 5 EXHIBIT 23.01 Exhibit 23.01 ------------ Consent of Independent Public Accountants As independent public accountants, we hereby consent to the incorporation of our reports incorporated by reference into or included in this Form 10-K, into the Company's previously filed Registration Statements File No. 333-36819, No. 333-41355, No. 333-41357 and No. 333-67737. Arthur Andersen LLP Vienna, Virginia March 30, 2000 EX-27 6 EXHIBIT 27
5 This schedule contains summary financial information extracted from the Consolidated Balance Sheets, the Consolidated Statements of Income and the Consolidated Statements of Cash Flows and is qualified in its entirety by reference to such financial statements. 12-MOS DEC-31-1999 JAN-01-1999 DEC-31-1999 $11,850 0 36,238 6,203 6 41,922 82,152 23,897 464,658 89,658 262,710 0 0 614 65,002 464,658 0 161,600 0 67,766 0 588 (637) 94,471 37,316 57,155 0 0 0 57,155 1.04 1.03 (1) This schedule contains summary financial information extracted from the Consolidated Balance Sheets, the Consolidated Statements of Income and the Consolidated Statements of Cash Flows and is qualified in its entirety by reference to such financial statements.
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