10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


 

FORM 10-K

 


 

(Mark One)

x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the year ended December 31, 2006

 

OR

 

¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

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 of

Incorporation or Organization)

 

(I.R.S. Employer

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 $0.01 per share   New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None

 


 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or 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 this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

 

Large accelerated filer  x   Accelerated filer  ¨   Non-accelerated filer  ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

 

The aggregate market value of common stock of Choice Hotels International, Inc. held by non-affiliates was $2,105,577,736 as of June 30, 2006 based upon a closing price of $60.60 per share.

 

The number of shares outstanding of Choice Hotels International, Inc.’s common stock at February 15, 2007 was 66,405,601.

 

DOCUMENTS INCORPORATED BY REFERENCE.

 

Certain portions of our definitive proxy statement, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than April 15, 2007 are incorporated by reference under Part III.

 



Table of Contents

CHOICE HOTELS INTERNATIONAL, INC.

Form 10-K

 

Table of Contents

 

              Page No.

Part I

             
   

Item 1.

  

Business.

   1
   

Item 1A.

  

Risk Factors.

   18
   

Item 1B.

  

Unresolved Staff Comments.

   24
   

Item 2.

  

Properties.

   24
   

Item 3.

  

Legal Proceedings.

   24
   

Item 4.

  

Submission of Matters to a Vote of Security Holders.

   24

Part II

             
   

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

   27
   

Item 6.

  

Selected Financial Data.

   29
   

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operation.

   29
   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk.

   50
   

Item 8.

  

Financial Statements and Supplementary Data.

   51
   

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

   98
   

Item 9A.

  

Controls and Procedures.

   98
   

Item 9B.

  

Other Information.

   98

Part III

             
   

Item 10.

  

Directors and Executive Officers of the Registrant.

   99
   

Item 11.

  

Executive Compensation.

   99
   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

   99
   

Item 13.

  

Certain Relationships and Related Transactions.

   99
   

Item 14.

  

Principal Accounting Fees and Services.

   99

Part IV

             
   

Item 15.

  

Exhibits, Financial Statement Schedules and Reports on Form 8-K.

   100
        

SIGNATURE

   103


Table of Contents

PART I

 

Throughout this report, we refer to Choice Hotels International, Inc., together with its subsidiaries as “we”, “us” or “the Company”.

 

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; 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 relationships with current and potential hotel owners; the effect of international, national and regional economic conditions and geopolitical events such as acts of god, acts of war, terrorism or epidemics; the availability of capital to allow potential hotel owners to fund investments in 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 in Item 1A “Risk Factors”. 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.

 

WHERE YOU CAN FIND MORE INFORMATION

 

We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Our SEC filings are available to the public over the internet at the SEC’s web site at http://www.sec.gov. Our SEC filings are also available free of charge on our website at http://www.choicehotels.com as soon as reasonably practicable following the time that they are filed with or furnished to the SEC. You may also read and copy any document we file with the SEC at its public reference room located at 100 F Street, NE Washington DC 20549. Please call the SEC at 1-800-SEC-0330 for further information on its public reference room.

 

Item 1.    Business.

 

Reference is made to the consolidated financial statements included in Item 8 of this annual report on Form 10-K for the financial information required to be included herein.

 

Overview

 

Choice Hotels International, Inc. and subsidiaries is one of the largest hotel franchisors in the world with 5,376 hotels open and 930 hotels under development as of December 31, 2006, representing 437,385 rooms open and 72,555 rooms under development in 49 states, the District of Columbia and more than 40 countries and territories outside the United States. Choice franchises lodging properties under the proprietary brand names (the “Choice brands”): Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Sleep Inn®, Econo Lodge®, Rodeway Inn®, MainStay Suites®, Suburban Extended Stay Hotel®, Cambria Suites™ and Flag Hotels®. We operate in a single reportable segment encompassing our franchising business.

 

The Company conducts its international franchise operations through a combination of direct franchising and master franchising which allow the use of our brands by third parties in foreign countries. The Company has made equity investments in certain non-domestic lodging franchise companies that conduct franchise operations for the Company’s brands under master franchising relationships. As a result of our use of master franchising relationships and international market conditions, total revenues from international franchising operations

 

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comprised only 6% and 5% of our total revenues in 2006 and 2005, respectively while representing approximately 22% of our franchise system hotels open at December 31, 2006 and 2005, respectively.

 

Our direct lodging property real estate exposure is limited to three company-owned MainStay Suites® hotels.

 

With a focus on hotel franchising instead of ownership, we benefit from the economies of scale inherent in the franchising business. The fee and cost structure of our business provides opportunities to improve operating results by increasing the number of franchised properties and effective royalty rates of our franchise contracts resulting in increased initial fee revenue; ongoing royalty fees and brand solutions (formerly known as partner services) revenues. In addition, our operating results can also be improved through our company wide efforts directed towards improving the property level performance of our franchisees. We also collect marketing and reservation fees to support centralized marketing and reservation activities for the franchise system. As a lodging franchisor, Choice has relatively low capital expenditure requirements.

 

Our capital allocation decisions, including capital structure and uses of capital, are intended to maximize our return on invested capital and create value for our shareholders. We believe our strong and predictable cash flows create a strong financial position that provides us a competitive advantage. Our business does not require significant capital to operate and grow, therefore, we can maintain a capital structure that generates high financial returns and use our excess cash flow to increase returns to our shareholders. We have returned value to our shareholders in two primary ways: share repurchases and dividends. In 1998, we instituted a share repurchase program which has generated substantial value for our shareholders. Through December 31, 2006, we had repurchased 33.6 million shares (including 33.0 million prior to the two-for-one stock split effected in October 2005) of common stock at a total cost of $711.9 million since the program’s inception. Considering the effect of the two-for-one stock split, the Company had repurchased 66.6 million shares at an average price of $10.69 per share. Our cash flows from operations support our ability to complete the repurchase of approximately 5.1 million shares remaining as of December 31, 2006 under our current board of directors’ authorization. No shares were repurchased during 2006 under the current repurchase authorization. Subject to market and other conditions and upon completion of the current authorization, we will evaluate the propriety of additional share repurchases with our board of directors. In 2006, we paid cash dividends totaling approximately $35.4 million and we presently expect to continue to pay dividends in the future. Based on our present dividend rate and outstanding share count, aggregate annual dividends would be approximately $39.6 million.

 

The principal factors that affect the Company’s results are: the number and relative mix of franchised hotels; growth in the number of hotels under franchise; occupancy and room rates achieved by the hotels under franchise; the effective royalty rate achieved; and our ability to manage costs. The number of rooms at franchised properties and occupancy and room rates at those properties significantly affect the Company’s results because our 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. Our variable overhead costs associated with franchise system growth have historically been less than incremental royalty fees generated from new franchises. Accordingly, continued growth of our franchise business should enable us to realize benefits from the operating leverage in place and improve operating results.

 

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The Lodging Industry(1)

 

Companies participating in the lodging industry primarily do so through a combination of one or more of the three primary lodging industry activities: ownership, franchising and management. A company’s relative reliance on each of these activities determines which drivers most influence its profitability.

 

   

Ownership requires a substantial capital commitment and involves the most risk but offers high returns due to the owner’s ability to influence margins by driving RevPAR and managing operating expenses. The ownership model has a high fixed-cost structure that results in a high degree of financial leverage. As a result, profits escalate rapidly in a lodging up-cycle but erode quickly in a downturn as costs rarely fall as fast as revenue. Profits from an ownership model increase at a greater rate from RevPAR growth attributable to average daily rate (“ADR”) growth, than from occupancy gains since there are more incremental costs associated with higher guest volumes compared to higher pricing.

 

   

Franchisors license their brands to a hotel owner, giving the hotel the right to use the brand name, logo, operating practices, and reservations systems in exchange for a fee and an agreement to operate the hotel in accordance with the brand standards. Under a typical franchise agreement, the hotel pays the franchisor an initial fee, a percentage-of-revenue royalty fee and a marketing/reservation reimbursement. A franchisor’s revenues are dependent on the number of rooms in its system and the top-line performance of those hotels. Earnings drivers include RevPAR increases, unit growth and effective royalty rate improvement. Franchisors enjoy significant operating leverage in their business model since it costs little to add a new hotel franchise to an existing system. Franchisors normally benefit from higher industry supply growth, because the benefits of unit growth usually outweigh lower RevPAR resulting from excess supply. As a result, franchisors benefit from both RevPAR growth and supply increases which aids in reducing the impact of lodging industry economic cycles.

 

   

Management companies operate hotels for owners that do not have the expertise and/or the desire to self-manage. These companies collect management fees predominately based on revenues earned and/or profits generated. Similar to franchising activities, the key drivers of revenue based management fees are RevPAR and unit growth and similar to ownership activities, profit based fees are driven by improved hotel margins and RevPAR growth.

 

The lodging industry has historically experienced economic cycles reflected in positive and negative operating performance for various periods of time.

 

Positive cycles are characterized as periods of sustained occupancy growth. These cycles usually continue until the economy sustains a prolonged downturn, excess supply conditions exist or some external factor occurs such as war, terrorism or natural resource shortages. Recovery in the industry usually begins with an increase in occupancy followed by hoteliers increasing their room rates. As occupancies and rates continue to improve, growth stabilizes and demand begins to exceed room supply. These pressures result in increased hotel development.

 

The hotel industry posted positive and consistent RevPAR growth from the mid-1990’s until 2000 as the industry was able to increase its 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. However, due to the economic recession, which began to affect the lodging industry during 2001, coupled with the terrorist attacks of September 11, 2001, industry profits and RevPAR declined between 2001 and 2003. Nonetheless, the industry remained profitable through this period.

 

In 2004, the resumption of economic growth increased lodging demand and occupancy rates. This coupled with the relatively slow growth in hotel supply, allowed hotels to aggressively raise room rates during 2004. These factors resulted in annual RevPAR growth in 2004 for the first time since the year 2000. The lodging industry recovery continued in 2005 and 2006 with RevPAR increasing 8.3% and 7.6%, respectively.

 


(1)

 

Certain industry statistics included in this section, such as the number of hotel rooms, number of affiliated and non-affiliated rooms, US Lodging Industry Trends From 1997 – 2006, etc. were obtained from Smith Travel Research.

 

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The following chart demonstrates these trends:

 

US Lodging Industry Trends — 1997 - 2006

 

Year


   Occupancy
Rates


   

Average

Daily

Room

Rates

(ADR)


   Increase
in ADR
Versus
Prior
Year


    Increase
in CPI
Versus
Prior
Year


   

Revenue Per

Available

Room

(RevPAR)


  

Profits

(in billions)


  

New

Rooms

Added
(Gross)


1997

   64.5 %   $ 75.16    6.1 %   1.9 %   $ 48.50    $ 17.0    128,000

1998

   64.0 %   $ 78.62    4.6 %   2.3 %   $ 50.29    $ 22.0    143,000

1999

   63.3 %   $ 81.27    3.4 %   2.7 %   $ 51.44    $ 23.0    143,148

2000

   63.5 %   $ 85.24    4.9 %   3.4 %   $ 54.13    $ 24.0    121,476

2001

   60.1 %   $ 84.85    -0.5 %   2.9 %   $ 50.99    $ 16.7    101,279

2002

   59.2 %   $ 83.15    -2.0 %   1.6 %   $ 49.22    $ 16.1    86,366

2003

   59.1 %   $ 83.19    0.1 %   2.3 %   $ 49.20    $ 15.0    65,876

2004

   61.3 %   $ 86.41    3.9 %   2.7 %   $ 52.93    $ 17.0    55,245

2005

   63.1 %   $ 90.84    5.1 %   3.4 %   $ 57.34    $ 21.0    65,900

2006

   63.4 %   $ 97.31    7.1 %   3.2 %   $ 61.69    $ 26.3    73,308

 

Hotel room supply growth is cyclical as hotel construction responds to interest rates, construction and material supply conditions, capital availability and industry fundamentals. Historically, the industry added hotel rooms to its inventory through new construction due largely to a favorable lending environment that encouraged hotel development. This resulted in an over supply of rooms which, coupled with the decrease in industry performance between 2001 and 2003, led to reduced hotel development since that time.

 

During 2005, year-over-year new hotel construction increased for the first time since 1999 with 65,900 rooms added to the industry and again in 2006 with an additional 73,308 rooms. However, the volume of new room additions still lags the pre-2001 economic recession levels. Despite rising interest rates and construction costs, some economic forecasters have predicted a continuing rise in the supply of hotel rooms to meet demand.

 

As a franchisor, we are well positioned in any stage of the lodging cycle. We benefit from both the RevPAR gains typically experienced in the early stage of recovery, as our revenues are based on our franchisees’ gross room revenues, and the supply growth normally occurring in the later stages as we increase our portfolio size.

 

During lodging cycle downturns, we benefit from the conversion of independent and other hotel chain affiliates into our system in an effort to improve their performance.

 

Hotels are broadly segmented into two categories: full-service and limited service. Full-service hotels generally offer food and beverage (F&B) facilities and/or meeting facilities. Limited-service hotels, usually offer only rooms, although some offer modest F&B (e.g. breakfast buffets) and/or small meeting rooms. Full-service hotels are generally larger, command higher room rates, and generate higher profits, although overall operating margins are normally lower because F&B is a lower-margin business.

 

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The lodging industry can be further divided into chain scale segments or groupings of generally competitive brands as follows:

 

Chain Scale


  

Brand Examples


  

Room

Count


   % of
Total


   

Avg.

Hotel
Room Size


Luxury

   Four Seasons, Ritz Carlton    78,410    1.8 %   311

Upper Upscale

   Marriott, Hilton, Sheraton    544,601    12.1 %   384

Upscale

   Hilton Garden Inn, Courtyard, Residence Inn    407,234    9.0 %   154

Midscale w/ F&B

   Quality, Clarion, Holiday Inn, Best Western, Ramada    540,974    12.0 %   118
         
  

 

Sub-Total Full Service

   1,571,219    34.9 %   176
         
  

 

Midscale w/o F&B

   Comfort, La Quinta, Baymont Inn, Hampton Inn    682,661    15.1 %   87

Economy

   Econo Lodge, Days Inn, Super 8, Red Roof Inn    741,560    16.5 %   77
         
  

 

Sub-Total Limited Service

   1,424,221    31.6 %   82
         
  

 

Independents

   1,509,165    33.5 %   66
         
  

 

Total All Hotels

   4,504,605    100 %   92
         
  

 

 

Source: Smith Travel Research (December 2006)

 

According to Smith Travel Research, Choice branded system-wide market share as of December 31, 2006 in the United States has increased 107 basis points to 7.5% of total industry rooms since 2002. The total number of domestic hotel rooms has increased at an annual rate of less than 1% per annum during these same 4 years.

 

Independent 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. Over the past 16 years, the industry has seen a significant movement of hotels from independent to chain affiliation, with affiliated hotels increasing from 46% of the market in 1990 to 67% of the market in 2006. Because a significant portion of 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.

 

The large franchise lodging chains, including us, generally provide a number of services to hotel operators to improve the financial performance of their properties including central reservation systems, marketing and advertising programs, direct sales programs, training and education programs, property systems, revenue enhancement services, creating relationships with vendors to streamline purchasing processes and make lower cost products available. We believe that national franchise chains with a large number of hotels enjoy greater brand awareness among potential guests than those with fewer 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 hotel operator profitability.

 

Choice’s Franchising Business

 

Choice operates primarily as a hotel franchisor offering 10 brands. Our Clarion® and Quality® brands compete primarily in the full service midscale with food and beverage segment; our Comfort Inn®, Comfort Suites®, and Sleep Inn® brands compete primarily in the limited service midscale without food & beverage segment; MainStay Suites® and Suburban Extended Stay Hotel® compete primarily in the extended stay segment and our Econo Lodge® and Rodeway Inn® brands compete primarily in the economy segment. In January 2005, we introduced a new brand, Cambria Suites®, which will compete in the upscale segment. As a result of our acquisition of Suburban Franchise Holding Company, Inc., the Suburban Extended Stay Hotel® brand was added to our portfolio on September 28, 2005.

 

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Economics of Franchising Business. The fee and cost structure of our business provides opportunities for us to improve operating results by increasing the number of franchised properties, improving property level RevPAR performance and increasing the effective royalty rates of our franchise contracts. As a hotel franchisor, we derive our revenue from various franchise fees. Our franchise fees consist primarily of an initial fee and ongoing royalty, marketing and reservation fees that are typically based on a percentage of the franchisee’s gross room revenues. The initial fee and on-going royalty portion of the franchise fees are intended to cover our operating expenses, such as expenses incurred in business development, quality assurance, administrative support and other franchise services and to provide us with operating profits. The marketing and reservation fees are used exclusively for the expenses associated with marketing and media advertising and providing such franchise services as the central reservation system.

 

Our fee stream depends on the number of rooms in our system, the gross room revenues generated by our franchisees and effective royalty rates. We enjoy significant operating leverage since the variable operating costs associated with our franchise system growth have historically been less than incremental royalty fees generated from new franchisees. Our business is well positioned in the lodging industry since we benefit from both RevPAR growth and new hotel construction.

 

Our various brand offerings position us well within the lodging industry. Our Cambria Suites®, Comfort Inn®, Comfort Suites®, Sleep Inn®, Suburban Extended Stay Hotel® and MainStay Suites® are primarily new build brands which offer hotel developers an array of choices in the upscale, midscale and extended stay segments during periods of supply growth, while our Clarion® , Quality® , Econo Lodge® and Rodeway Inn® brands offer conversion opportunities to independent operators who desire to affiliate with a brand and take advantage of the services a franchisor has to offer.

 

Strategy. Our Company’s mission is a commitment to our customer’s profitability by providing our customers with hotel franchises that strive to generate the highest return on investment of any hotel franchise. Our business strategy is to create franchise system growth by leveraging Choice’s large and well-known hotel brands, franchise sales capabilities, effective marketing and reservation delivery efforts, RevPAR enhancing services and technology, and financial strength created by our significant free cash flow. We believe our brands’ growth will be driven by our ability to create a compelling return on investment for franchisees. Our strategic objective is to improve our franchisee’s profitability by providing services, which increase business delivery, reduce hotel operating and development costs, and/or improve guest satisfaction. Specific elements of our strategy include: build strong brands, deliver exceptional services, reach more consumers and leverage size, scale and distribution that reduce costs for hotel owners.

 

Build Strong Brands. Each of our brands has particular attributes and strengths, including awareness with both consumers and developers. Our strategy is to utilize the strengths of each brand for unit growth, RevPAR gains and royalty rate improvement that create revenue growth. We believe brand consistency, quality and guest satisfaction are critical in improving brand performance and building strong brands.

 

We have multiple brands that are positioned to meet the needs of many types of guests, and can be developed at various price points and applied to both new and existing hotels. This ensures that we have brands suitable for creating unit growth in various types of markets, with various types of customers, and during both industry contraction and growth cycles. During times of lower industry supply growth and tighter capital markets, we can target conversions of existing non-Choice affiliated hotels seeking the awareness and proven performance provided by our brands. During periods of strong industry supply growth, we expect a greater portion of our unit growth to come from our new construction brands. We believe that a large number of markets can still support our hotel brands, and the growth potential for our brands as well as new brands we may introduce remains strong.

 

We believe each of our brands appeals to targeted hotel owners and guests because of unique brand standards, service levels and pricing.

 

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Deliver Exceptional Services. We provide a combination of services and technological products to help our franchisees improve performance. We have approximately 70 field services staff members located nationwide that help franchisees improve RevPAR performance and guest satisfaction. In addition, we provide our franchisees with technology products designed to improve property level performance. These services and products promote revenue gains for franchisees and translate into both higher royalties for Choice and improved returns for owners, leading to further unit growth by making Choice brands attractive to franchisees. We develop our services based on customer needs and focus on activities that generate high return on investment for our customers.

 

Reach More Consumers. We believe hotel owners value the large volume of guests we deliver through corporate and brand marketing, reservation systems, key account sales, and Choice’s principal loyalty program, Choice Privileges®. Our strategy is to maximize the effectiveness of these activities in delivering both leisure and business travelers to Choice-branded hotels.

 

Choice will continue to increase awareness of its brands through its multi-branded national marketing campaign which features re-imaged signs, our “We’ll See You There” tagline and our loyalty program promotions. This campaign is intended to generate the most compelling message in the midscale and economy segments and utilize Choice’s significant size to create even greater awareness for our brands. Local and regional co-op marketing campaigns will continue to leverage the national marketing programs to drive business to Choice properties at a local level. We expect our efforts at marketing directly to guests will continue to be enhanced through the use of our customer relationship management technology. Our continued focus on overall brand quality coupled with our marketing initiatives is designed to stimulate room demand for our franchised hotels through improved guest awareness and satisfaction.

 

Our central reservations system is a critical technology used to deliver guests to our franchisees through multiple channels, including our call centers and proprietary websites, and global distribution systems (e.g., SABRE, Amadeus, and internet distribution sites). We believe our well-known brands, combined with our relationships with many internet distribution web sites benefits our franchisees, by facilitating increased rate and reservations delivery, and reducing costs and operational complexity.

 

Leverage Size, Scale and Distribution. We continually focus on identifying methods for utilizing the significant number of hotels in our system to reduce costs and increase returns for our franchisees. For example, we create relationships with vendors to: (i) make low-cost products available to our franchisees; (ii) streamline the purchasing process; and (iii) maintain brand standards and consistency. We plan to expand this business and identify new methods for decreasing hotel-operating costs by increasing penetration internally and enhancing our existing vendor relationships and/or creating new vendor relationships. We believe our efforts to leverage Choice’s size, scale and distribution benefit the Company by enhancing brand quality and consistency, improving our franchisees returns and satisfaction, and creating brand solutions revenues.

 

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Franchise System

 

Our franchises operate domestically under one of nine Choice brand names: Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Sleep Inn®, Econo Lodge®, Rodeway Inn®, MainStay Suites® and Suburban Extended Stay Hotel®. The following table presents key statistics related to our domestic franchise system over the five years ended December 31, 2006.

 

COMBINED DOMESTIC FRANCHISE SYSTEM

 

     As of and For the Year Ended December 31,

 
     2002

    2003

    2004

    2005

    2006

 

Number of properties, end of period

     3,482       3,636       3,834       4,048       4,211  

Number of rooms, end of period

     282,423       294,268       309,586       329,353       339,441  

Royalty fees ($000)

   $ 135,381     $ 141,150     $ 155,915     $ 175,588     $ 194,333  

Average royalty rate(1),(3)

     3.97 %     4.01 %     4.04 %     4.08 %     4.10 %

Average occupancy percentage(3)

     55.6 %     54.7 %     56.6 %     57.6 %     58.0 %

Average daily room rate (ADR)(3)

   $ 61.96     $ 62.53     $ 63.56     $ 66.24     $ 69.71  

Revenue per available room (RevPAR)(2),(3)

   $ 34.48     $ 34.21     $ 35.95     $ 38.15     $ 40.46  

(1)

 

Represents domestic royalty fees as a percentage of aggregate gross room revenues of all domestic Choice brand franchised hotels except for Suburban Extended Stay Hotel® acquired on September 28, 2005.

(2)

 

The Company calculates RevPAR based on information reported to the Company on a timely basis by franchisees.

(3)

 

Statistics exclude the results of the Suburban Extended Stay Hotel® chain acquired on September 28, 2005 since comparable pre-acquisition data is not available.

 

The Company conducts its international franchise operations through a combination of direct franchising and master franchising which allow the use of our brands by third parties in foreign countries. The Company has made equity investments in certain non-domestic lodging franchise companies that conduct franchise operations for the Company’s brands under master franchising relationships. As a result of our use of master franchising relationships and international market conditions, total revenues from international franchising operations comprised only 6% and 5% of our total revenues in 2006 and 2005, respectively while representing approximately 22% of our franchise system hotels open at December 31, 2006 and 2005, respectively. Consequently, our description of our franchise system is primarily focused on the domestic operations. Currently, no individual franchisee or international master franchisee accounts for 2% or more of Choice’s royalty revenues or total revenues.

 

Brand Positioning

 

Our brands offer consumers and developers a wide range of choices from economy hotels to lower upscale, full service properties. Our domestic brands are as follows:

 

Cambria Suites: Cambria Suites is an upscale select service hotel chain with an upscale image and distinctive styling. Cambria offers well-appointed suites that emulate the “best of a modern home.” In-room amenities include luxury bedding, stereo with CD player, cordless phone and mini-refrigerator with microwave. Principal competitor brands include Marriott Courtyard and Hilton Garden Inn. The Cambria Suites brand was launched in January 2005.

 

Comfort Inn: Comfort Inn hotels operate in the mid-scale without food and beverage segment. One of the original brands in the limited service segment, Comfort has built a reputation for consistent high-value accommodations for both business and leisure travelers. Principal competitor brands include Holiday Inn Express, Fairfield Inn and Country Inn & Suites.

 

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Comfort Suites: Comfort Suites hotels operate in the upper portion of the mid-scale without food and beverage segment. Established in 1986 as an extension of the highly regarded Comfort Inn brand, Comfort Suites feature oversized, comfortable rooms at mid-priced rates. The brand competes with Hampton Inn, Holiday Inn Express, Fairfield Inn and Country Inn & Suites.

 

Sleep Inn: Sleep Inn is a new construction brand that operates in the mid-scale without food & beverage category. Sleep delivers one of the most consistent product offerings in the segment, which targets both business and leisure travelers. Sleep competes with Baymont, Amerihost, La Quinta and Fairfield Inn.

 

Quality: Quality Inn hotels have offered efficient and personable service and clean accommodations since 1968 in the midscale segment. Amenities and services typically include complimentary continental breakfast, “Quality Sleeper” by Serta mattresses, swimming pools and/or exercise rooms, free USA today or Wall Street Journal newspaper and meeting or event space. Principal competitor brands include Best Western, Ramada, Howard Johnson and Holiday Inn.

 

Clarion: Clarion hotels are full-service hotels competing in the mid-scale hotel category. The brand offers upscale lodging at an affordable price. Providing a full spectrum of superior facilities and amenities, which include restaurant, conference or banquet facilities, 24-hour business center, swimming pool or exercise room, guest laundry, room service and bell service. Principal competitor brands include Sheraton Four Points, Holiday Inn Select, Radisson and Doubletree.

 

MainStay Suites: MainStay Suites hotels compete in the mid-scale extended stay category. Complete with a residential feel and value-added amenities, the MainStay brand is designed as a more practical lodging option for guests whose stays are longer than just a few nights. Typically, longer hotel stays involve relocation, training, or temporary job assignments. All MainStay guests suites feature fully equipped kitchens with a two-burner range, dishes, utensils, dishwasher, sink with disposal, microwave, and full size refrigerator. All suites include a sleeper sofa, comfortable work area with ergonomic chair and large walk-in closets. MainStay competes directly with Studio Plus, TownePlace Suites, Sierra Suites, and Candlewood Suites.

 

Suburban Extended Stay Hotel: Suburban Extended Stay Hotel suites are built with today’s value-conscious extended stay guest in mind. All suites provide full kitchens, internet connections, and access to on-site laundry facilities. Suburban’s “just what you need” philosophy matches attractive weekly pricing with weekly housekeeping to provide extended stay guests with the all-suite accommodations they want without the cost of services they do not need. Principal competitor brands include Intown Suites and Sun Suites.

 

Econo Lodge: Econo Lodge is a leading economy segment chain, which offers clean, attractive lodging for value-oriented travelers. Breakfast by Econo Lodge, free local calls, and free premium channels are just some of the amenities that position Econo Lodge as a great value in the economy segment. Principal competitor brands are Days Inn, Super 8, Motel 6, and Travelodge.

 

Rodeway Inn: Rodeway Inn is a leading budget segment chain, which offers clean, affordable lodging for savings-oriented travelers. With Always Fresh…Rodeway® breakfast and a free newspaper, Rodeway is well positioned to offer savings for the budget-minded traveler. Principal competitor brands are Best Value Inn, Knights Inn and Budget Host.

 

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The following table presents key statistics related to the domestic system for each of our brands that is currently operational over the five years ended December 31, 2006.

 

     As of and For the Year Ended December 31,

 
     2002

    2003

    2004

    2005

    2006

 

COMFORT DOMESTIC SYSTEM

                                        

Number of properties, end of period

     1,707       1,783       1,821       1,839       1,848  

Number of rooms, end of period

     134,326       140,416       143,007       143,849       144,853  

Royalty fees ($000)

   $ 81,390     $ 85,998     $ 94,801     $ 106,603     $ 116,832  

Average occupancy percentage

     59.7 %     58.8 %     60.9 %     62.7 %     63.9 %

Average daily room rate (ADR)

   $ 65.18     $ 65.92     $ 67.34     $ 70.85     $ 75.46  

RevPAR

   $ 38.93     $ 38.79     $ 41.04     $ 44.40     $ 48.25  

QUALITY DOMESTIC SYSTEM

                                        

Number of properties, end of period

     455       508       576       660       736  

Number of rooms, end of period

     48,472       52,766       58,785       66,316       72,054  

Royalty fees ($000)

   $ 19,658     $ 20,221     $ 22,821     $ 25,855     $ 29,220  

Average occupancy percentage

     52.0 %     51.6 %     54.1 %     54.6 %     55.3 %

Average daily room rate (ADR)

   $ 63.82     $ 64.19     $ 63.62     $ 64.86     $ 66.89  

RevPAR

   $ 33.16     $ 33.14     $ 34.41     $ 35.41     $ 37.01  

CLARION DOMESTIC SYSTEM

                                        

Number of properties, end of period

     132       138       158       153       162  

Number of rooms, end of period

     20,006       20,737       23,652       23,554       23,945  

Royalty fees ($000)

   $ 7,479     $ 7,534     $ 8,375     $ 9,385     $ 9,531  

Average occupancy percentage

     51.8 %     49.2 %     51.1 %     52.5 %     51.2 %

Average daily room rate (ADR)

   $ 73.88     $ 72.27     $ 72.37     $ 74.62     $ 78.98  

RevPAR

   $ 38.26     $ 35.55     $ 36.97     $ 39.15     $ 40.41  

SLEEP DOMESTIC SYSTEM

                                        

Number of properties, end of period

     301       309       311       319       327  

Number of rooms, end of period

     23,061       23,678       23,766       24,205       24,575  

Royalty fees ($000)

   $ 10,258     $ 10,856     $ 12,387     $ 13,862     $ 15,384  

Average occupancy percentage

     56.8 %     57.5 %     59.5 %     61.0 %     62.4 %

Average daily room rate (ADR)

   $ 57.36     $ 58.01     $ 59.50     $ 62.52     $ 66.44  

RevPAR

   $ 32.57     $ 33.33     $ 35.42     $ 38.16     $ 41.43  

MAINSTAY DOMESTIC SYSTEM

                                        

Number of properties, end of period

     40       26       27       27       29  

Number of rooms, end of period

     3,445       2,063       2,150       2,047       2,183  

Royalty fees ($000)

   $ 970     $ 980     $ 1,163     $ 1,375     $ 1,459  

Average occupancy percentage

     67.9 %     62.9 %     62.2 %     65.7 %     69.4 %

Average daily room rate (ADR)

   $ 61.50     $ 61.50     $ 61.09     $ 64.76     $ 67.26  

RevPAR

   $ 41.77     $ 38.70     $ 37.97     $ 42.54     $ 46.66  

ECONO LODGE DOMESTIC SYSTEM

                                        

Number of properties, end of period

     715       734       781       805       816  

Number of rooms, end of period

     44,522       45,420       48,301       49,763       49,679  

Royalty fees ($000)

   $ 13,664     $ 13,644     $ 14,255     $ 15,509     $ 16,467  

Average occupancy percentage

     49.4 %     47.5 %     48.2 %     48.2 %     47.7 %

Average daily room rate (ADR)

   $ 47.36     $ 47.88     $ 48.92     $ 50.95     $ 53.09  

RevPAR

   $ 23.38     $ 22.76     $ 23.57     $ 24.56     $ 25.31  

RODEWAY DOMESTIC SYSTEM

                                        

Number of properties, end of period

     132       138       160       180       233  

Number of rooms, end of period

     8,591       9,188       9,925       11,051       14,168  

Royalty fees ($000)

   $ 1,962     $ 1,917     $ 2,114     $ 2,256     $ 2,467  

Average occupancy percentage

     45.5 %     44.8 %     48.7 %     46.7 %     45.8 %

Average daily room rate (ADR)

   $ 49.00     $ 49.84     $ 52.33     $ 49.91     $ 51.66  

RevPAR

   $ 22.29     $ 22.32     $ 25.49     $ 23.31     $ 23.66  

SUBURBAN DOMESTIC SYSTEM

                                        

Number of properties, end of period

     —         —         —         65       60  

Number of rooms, end of period

     —         —         —         8,568       7,984  

Royalty fees ($000)

     —         —         —       $ 743 (2)   $ 2,973  

Average occupancy percentage

     —         —         —         —   (1)     72.4 %

Average daily room rate (ADR)

     —         —         —         —   (1)   $ 38.30  

RevPAR

     —         —         —         —   (1)   $ 27.73  

(1)

 

Statistics for average occupancy percentage, ADR and RevPAR for the year ended December 31, 2005 have been excluded since comparable pre-acquisition data is not available.

(2)

 

Royalty fees include results of Suburban operations from September 28, 2005 through December 31, 2006.

 

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International Franchise Operations

 

The Company conducts its international franchise operations through a combination of direct franchising and master franchising which allow the use of our brands by third parties in foreign countries. The Company has made equity investments in certain non-domestic lodging franchise companies that conduct franchise operations for the Company’s brands under master franchising relationships. The use of our brands by third parties in foreign countries are governed by master franchising agreements which generally provide the master franchisee with the right to use our brands in a specific geographic region, usually for a fee.

 

In some territories outside the United States hotel franchising is less prevalent, and many markets are served primarily by independent operators. We believe that chain affiliation will increase in certain international markets as local economies grow and hotel owners seek the economies of centralized reservations systems and marketing programs.

 

As of December 31, 2006, we had 1,165 franchise hotels open and operating in more than 40 countries and territories outside of the United States. The following chart summarizes our franchise system outside of the United States.

 

COMBINED INTERNATIONAL FRANCHISE SYSTEM(1)

 

     As of and For the Year Ended December 31,

     2002

   2003

   2004

   2005

   2006

Number of properties, end of period

     1,182      1,174      1,143      1,162      1,165

Number of rooms, end of period

     91,299      94,350      94,220      97,703      97,944

Royalty fees ($000)

   $ 6,335    $ 9,237    $ 10,071    $ 10,971    $ 16,183

(1)

 

Reporting of operating statistics (e.g. average occupancy percentage and average daily room rate) of international franchisees is not required by all master franchise contracts, thus these statistics and RevPAR are not presented for international franchisees.

 

Scandinavia. We conduct our operations in Denmark, Norway, Sweden, Finland and Lithuania through our relationship with Choice Hotels Scandinavia (“CHS”). As of December 31, 2006, CHS had 145 open properties. The master franchise agreement with CHS expires in November 2014, but may be terminated in November 2009 by either CHS or Choice.

 

Continental Europe. During the fourth quarter of 2006, the Company acquired from C.H.E. Group PLC (“CHE”) the franchising operations conducted by CHE in the European countries of Austria, Germany, Italy, the Czech Republic, Switzerland, France, Belgium, Portugal and Spain and simultaneously the master franchise agreement between Choice and CHE covering these countries was terminated and we began direct franchising operations in these countries.

 

United Kingdom. The master franchise agreement with CHE remains in place with respect to operations in the United Kingdom and Ireland. The master franchise agreement for these countries with CHE expires in January 2008, subject to certain renewal rights of CHE. At December 31, 2006, CHE had 113 properties open and operating in the United Kingdom and Ireland.

 

Canada. We conduct our operations in Canada through Choice Hotels Canada, Inc. (“CHC”) a joint venture owned 50% by us and 50% by InnVest Real Estate Investment Trust. CHC is one of the largest lodging organizations in Canada with 266 franchised properties open and operating as of December 31, 2006.

 

Australasia. The Company conducts direct franchising operations in Australia, American Samoa, Fiji, New Caledonia, Singapore, New Zealand and Papua New Guinea through a wholly owned subsidiary, Choice Hotels Australasia Pty. Ltd. (“CHA”). As of December 31, 2006, CHA had 291 franchised properties open under the Choice brands and 2 franchised hotels under the Flag brand in Australia, American Samoa, New Zealand, New Caledonia and Papua New Guinea. CHA is in the process of converting all remaining Flag branded franchises to the Company’s other brands and expects to complete this conversion during 2008.

 

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Mexico. During 2004, we established a wholly owned subsidiary Choice Hotels Mexico S. de R.L. de C.V. (“CHM”) to begin franchising operations in Mexico. CHM is focused on establishing Clarion®, Quality® and Comfort® brands through conversions of high quality unbranded hotels in Mexico. At December 31, 2006, CHM had 12 properties open and operating.

 

Other International Relationships. We have various master franchise and area representative arrangements in place with local hotel management and franchising companies doing business in South America, India, Central America, Japan and Indonesia. In addition, the Company has direct franchise relationships with properties in Malaysia, China, and Lebanon.

 

The following table summarizes Choice’s non-domestic franchise system as of December 31, 2006:

 

     Comfort

   Quality

   Clarion

   Sleep

   Econo Lodge

   Rodeway

   Flag

   Total

American Samoa

         1                1

Australia

   167    73    11                251

Austria

      1                   1

Belgium

   1                      1

China

   1                      1

Czech Republic

   1    1    1                3

France

   90    27    1                118

Germany

   23    20    5                48

Italy

   3    5    3                11

Lebanon

      1                   1

Malaysia

      2                   2

Mexico

   5    7                   12

New Caledonia

      1                   1

New Zealand

   13    13    5             2    33

Papua New Guinea

   1    4                   5

Portugal

   5    3    1                9

Singapore

      1    1                2

Spain

   5    2    2                9

Switzerland

   4    1                   5
    
  
  
  
  
  
  
  

Direct Franchise Agreements

   319    162    31             2    514
    
  
  
  
  
  
  
  

Brazil

   22    19    3    4             48

Canada*

   144    60    10    3    44    5       266

Costa Rica

      1    1    1             3

Denmark

   6    5    5                16

Dominican Republic

      1    1                2

El Salvador

   4    1                   5

Finland

   1    1    1                3

Guatemala

         1                1

Honduras

         2                2

Indonesia

   1    4                   5

India*

   11    13    1                25

Ireland

   4    8    8                20

Japan

   26    3       7             36

Lithuania

      1                   1

Norway

   9    38    21                68

Sweden

   10    27    20                57

United Kingdom

   34    48    5    6             93
    
  
  
  
  
  
  
  

Master Franchise Agreements

   272    230    79    21    44    5       651
    
  
  
  
  
  
  
  

Total Number of Properties

   591    392    110    21    44    5    2    1,165
    
  
  
  
  
  
  
  

*   The Company has made equity investments in these master franchisors.

 

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The following table presents key worldwide system size statistics as of and for the year ended December 31, 2006.

 

     Open and Operational

   Under Development

     Additions  

     Repositionings  

      Terminations  

 
       Hotels  

     Rooms  

     Hotels  

     Rooms  

       

Comfort

   2,439    184,716    438    32,801    130    (20 )   (89 )

Quality

   1,128    112,173    114    10,283    124    19     (71 )

Clarion

   272    37,237    24    2,668    41    3     (35 )

Sleep Inn

   348    26,582    127    8,967    25    (1 )   (11 )

MainStay Suites

   29    2,183    33    2,739    2    —       —    

Econo Lodge

   860    52,005    52    3,374    78    —       (66 )

Rodeway Inn

   238    14,420    70    4,229    64    8     (19 )

Suburban

   60    7,984    29    2,375    5    —       (10 )

Cambria Suites

   —      —      43    5,119    —      —       —    

Flag Hotels

   2    85    —      —      —      (9 )   (2 )
    
  
  
  
  
  

 

Totals

   5,376    437,385    930    72,555    469    —       (303 )
    
  
  
  
  
  

 

 

Franchise Sales

 

Brand growth is important to our business model. We have identified key market areas, for certain brands, for hotel development based on supply/demand relationships and our strategic objectives. Development opportunities are typically offered to: (i) existing franchisees; (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.

 

The franchise sales organization employs both sales managers as well as franchise sales directors. Through December 31, 2006, the sales managers had geographic oversight over all of our brands to ensure each prospective hotel is placed in the appropriate brand, facilitate teamwork and information sharing amongst the sales directors and provide better service to our top developers. Our franchise sales directors operated in brand specific selling teams to leverage their brand expertise to enhance product consistency and deal flow. Effective January 1, 2007, the Company reorganized the franchise sales efforts into brand specific divisions with both sales managers and franchise sales directors responsible for specific brands. The new brand centric structure consists of the upscale and extended stay market brands (Cambria Suites, MainStay Suites and Suburban Extended Stay Hotels), mid-market brands (Comfort Inn, Comfort Suites and Sleep Inn), full service market brands (Quality and Clarion) and economy market brands (Econo Lodge and Rodeway Inn). These changes support the Company’s efforts to leverage its core strengths in order to take advantage of opportunities for further growth and integrate our brands and strategies to allow our brand teams to focus on understanding, anticipating and meeting the unique needs of key customer segments. Franchise sales efforts emphasize the benefits of affiliating with one of the Choice brands, our commitment to improving hotel profitability, our television, radio and print brand advertising campaigns, the Choice central reservation system, our training and support systems (including our proprietary property management systems) and our history of growth and profitability.

 

During 2006, Choice received 1,137 applications for new franchise agreements (not including relicensings of existing agreements) compared to 962 in 2005. These applications resulted in the execution of 720 new franchise agreements in 2006, compared to 639 in 2005. An application received does not always result in an executed franchise agreement during the year received or at all due to various factors, such as financing and agreement on contractual terms. Our objective is to continue to grow our portfolio by continuing to sell our existing brands, creating extensions of our existing brands and introducing new brands within the various lodging chain segments.

 

Because retention of existing franchisees is important to our growth strategy, we have a formal impact policy. This policy offers existing franchisees protection from the opening of a same-brand property within a specified distance, depending upon the market in which the property is located.

 

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Franchise Agreements

 

Our standard domestic franchise agreement, excluding contracts for Suburban Extended Stay Hotel (“Suburban”), 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. Suburban franchise agreements acquired through the Company’s acquisition of Suburban Franchise Holding, Inc. contain 10-year terms.

 

When the responsibility for development is transferred to an international 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 training, 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 franchised hotels outside the United States.

 

Either party to our standard domestic franchise agreement can terminate the agreement prior to the conclusion of the agreement’s term under certain circumstances, such as upon designated anniversaries of the agreement. Early termination options give us flexibility in eliminating or re-branding properties, if they become weak performers for reasons other than contractual failure by the franchisee. We also have the right to terminate a franchise agreement if a franchisee fails to bring the property into compliance with contractual or quality standards within specified periods of time. The franchise agreements also typically contain liquidated damage provisions resulting from a franchisee’s termination of the franchise agreement outside the designated anniversaries. Master franchise agreements typically contain provisions permitting us to terminate the agreement for failure to meet a specified development schedule.

 

In 2006 and 2005, we increased our efforts to enforce quality and contractual standards as well as eliminate weak performers. However, in 2006 and 2005, we still retained 95% of franchisees, which were in our domestic system in the previous year.

 

Franchise agreements are individually negotiated and vary among the different Choice brands and franchises, 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 the Company’s marketing and reservation activities. Most marketing fees support marketing programs designed to support all of the Choice brands, while some contribute to brand-specific marketing programs.

 

Our standard franchise fees are as follows:

 

QUOTED FEES BY BRAND AS OF DECEMBER 31, 2006

 

        

On-Going Fees as a Percentage of

Franchisee’s Gross Room Revenues


 

Brand


  

Initial Fee Per

Room/Minimum


  Royalty Fees

    Marketing Fees

    Reservation
Fees


    Combined
Marketing and
Reservation Fees


 

Cambria Suites

   $ 500/$60,000   5.00 %   2.10 %   1.75 %   —    

Comfort Inn

   $ 500/$50,000   5.65 %   2.10 %   1.75 %   —    

Comfort Suites

   $ 500/$50,000   5.65 %   2.10 %   1.75 %   —    

Quality Inn

   $ 300/$35,000   4.65 %   2.10 %   1.75 %   —    

Quality Suites

   $ 300/$50,000   4.65 %   2.10 %   1.75 %   —    

Clarion

   $ 300/$40,000   4.25 %   2.00 %   1.25 %   —    

Sleep Inn

   $ 300/$40,000   4.65 %   2.10 %   1.75 %   —    

MainStay Suites

   $ 300/$30,000   5.00 %   —       —       2.50 %

Econo Lodge

   $ 250/$25,000   4.50 %   —       —       3.50 %

Rodeway Inn

     (1)   (2)     (3)     (3)     —    

Suburban

   $ 225/$30,000   5.00 %   —       —       2.50 %

 

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(1)

 

Initial fee of $7,500 for properties with up to 85 rooms. Additional $90 per room fee for each room over 85 rooms.

(2)

 

Royalty rate is $15.00 per room per month with $1.00 escalations on each of the 2nd, 3rd, 4th and 5th anniversaries of the franchise agreement.

(3)

 

Marketing and reservation fees are $8.00 and $5.00 per room per month, respectively.

 

Franchise Operations

 

Our operations are designed to improve RevPAR and lower operating and development costs for our franchisees, as these are the measures of performance that most directly impact 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 (“CRS”). On average, approximately one-third of the gross room revenue booked at franchisees’ properties is reserved through our central reservation system, which consists of our toll-free telephone reservation system, our proprietary internet site, interfaces with global distribution systems, and other internet reservations sites. Our reservation system consists of a computer reservation system, three reservation centers in North America and several international reservation centers operated by our master franchisees or us. Reservation agents trained on the reservation system can match each caller with a Choice-branded hotel meeting the caller’s needs. Our CRS provides a data link to our franchised properties as well as to airline reservation systems such as Amadeus, Galileo, SABRE and Worldspan that facilitate the reservation process for travel agents. We also offer our rooms for sale on our own proprietary internet site (www.choicehotels.com) as well as those of other travel companies.

 

We continue to implement our integrated reservation strategy to improve reservations delivery, reduce franchisee costs and improve licensee satisfaction by enhancing our website, choicehotels.com, and selectively distributing our inventory with third parties that can drive additional business to Choice and its brands. We have established agreements with key third party travel intermediaries to gain additional distribution points. These agreements typically offer Choice brands preferred placement on these third party sites at reduced transaction fees. We also continue to educate our individual franchisees about the unfavorable impact to their business of contracting with sites with which we do not have preferred agreements. We currently have agreements with many but not all major online third party sites.

 

Property Management Systems. Our proprietary property and yield management systems, Profit Manager by Choice Hotels and ChoiceADVANTAGE, are designed to help franchisees maximize profitability and compete more effectively by managing their rooms inventory, rates and reservations. The Profit Manager system is used by substantially all of our domestic non-economy brand franchises. ChoiceADVANTAGE is utilized primarily by our economy brand franchises. These systems synchronize each hotel’s inventory with our system, giving our reservation sales agents last room sell capabilities at every hotel. These systems include a revenue management feature that calculates and suggests optimum rates based on each hotel’s past performance and projected occupancy. These tools are critical to business delivery and yield improvement as they facilitate the franchisee’s ability to effectively manage their hotel operations, determine appropriate rates, drive occupancy and participate in Choice marketing programs.

 

Brand Name Marketing and Advertising. Our marketing and advertising programs are designed to heighten consumer awareness and preference for the Choice brands as offering the greatest value and convenience in the midscale and economy segments. Marketing and advertising efforts include national television, internet and radio advertising, print advertising in consumer and trade media and promotional events, including joint marketing promotions with vendors and corporate partners.

 

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Numerous marketing and sales programs are conducted which target specific groups, including corporate travelers, senior citizens, automobile club members, families, government and military employees, and meeting planners. Other marketing efforts include domestic and international trade show programs, publication of group and tour rate directories, direct-mail programs, electronic direct marketing e-mail programs, centralized commissions for travel agents, fly-drive programs in conjunction with major airlines, and annual publication of a travel and vacation directory.

 

Since 1998, we have operated a loyalty program called Choice Privileges®, which includes all of our mid-scale brands (Comfort, Clarion, Quality, Sleep and MainStay Suites) to attract and retain travelers by rewarding frequent stays with points towards free hotel stays and other rewards. Suburban Extended Stay Hotel is expected to be added to the program during 2007. As of December 31, 2006, the program had approximately 5.2 million members. In 2001, we launched a similar loyalty program called EA$Y CHOICE® for our Econo Lodge and Rodeway Inn brands. The EA$Y CHOICE program is a stamp redemption program and has no membership requirement to participate. Choice Privileges® and EA$Y CHOICE participants can earn points/stamps redeemable for free stays in Choice brand properties. Choice also offers guests the ability to earn airline miles for qualifying stays redeemable for flights with Southwest Airlines, United Air Lines, American Airlines, US Airways, Continental Airlines, America West Airlines, Delta Air Lines, Northwest Airlines, Mexicana Airlines, Air Canada and Alaska Airlines. These programs allow us to conduct lower cost, more targeted marketing campaigns to our consumers.

 

Marketing and advertising programs are directed by our marketing department, which utilizes the services of independent advertising agencies. We also employ home- based sales personnel geographically located across the United States using personal sales calls, telemarketing and other techniques 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. All sales personnel sell business for all of the Choice brands.

 

Our field based brand performance consultants work with franchisees to maximize RevPAR. These coordinators 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 that cover housekeeping, maintenance, brand identification and minimum service offering. 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 periodically at each property. Properties that 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 and awards are used to reward franchisees that 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.

 

Training. We maintain a training department that 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 best use 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 have developed an interactive computer-based training system that will train hotel employees at their own pace.

 

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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.

 

Competition

 

Competition among franchise lodging chains is intense in attracting potential franchisees to the system, retaining existing franchisees and in generating reservations for franchisees. Franchise contracts are typically long-term in nature, but most allow the hotel owner to opt out of the agreement at mutually agreed upon anniversary dates.

 

We believe that hotel operators choose lodging franchisors based primarily on the 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 also 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.

 

Since our franchise system revenues are based on franchisees’ gross room revenues, our prospects for growth are largely dependent upon the ability of our franchisees to compete in the lodging market, our ability to convert competitor franchises and independent hotels to our brands and the ability of our franchisees to obtain financing to construct new hotels.

 

The ability of a hotel to compete may be affected by a number of factors, including the location and quality of the property, the number and quality of competing lodging facilities 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 49 states, the District of Columbia and more than 40 countries and territories outside the United States, as well as our range of products and room rates.

 

We believe that our focus on core business strategies, combined with our financial strength and size, scale and distribution will enable us to remain competitive.

 

Service Marks and Other Intellectual Property

 

The service marks Choice Hotels International, Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, Econo Lodge, Rodeway Inn, MainStay Suites, Cambria Suites, Suburban Extended Stay Hotel, Choice Privileges, Easy Choice and related marks and logos are material to our business. We, directly and through our franchisees, actively use 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. Depending on the jurisdiction, trademarks and other registered marks are valid as long as they are in use and/or their registrations are properly maintained and they have not been found to have become generic.

 

Seasonality

 

The hotel industry is seasonal in nature. For most hotels, demand is lower in December through March than during the remainder of the year. Our principal source of revenues is franchise fees based on the gross room revenues of our franchised properties. The Company’s franchise fee revenues and operating income reflect the industry’s seasonality and historically have been lower in the first quarter than in the second, third or fourth quarters.

 

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Regulation

 

The Federal Trade Commission (the “FTC”), various states and certain other foreign jurisdictions (including Australia, France, Canada, and Mexico) regulate the sale of franchises. The FTC requires franchisors to make extensive disclosure to prospective 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.

 

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.

 

Impact of Inflation and Other External Factors

 

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.

 

We expect to benefit in the form of increased franchise fees from future growth in consumer demand for hotel rooms as well as in the supply of hotel rooms, which do not result in excess lodging industry capacity. However, a prolonged decline in demand for hotel rooms would negatively impact our business.

 

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 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 other unpredictable external factors, which may negatively impact us, are wars, acts of terrorism, airline strikes, gasoline shortages, severe weather and the risks described below under the Item 1A. Risk Factors.

 

Employees

 

We employed domestically approximately 1,860 people as of February 15, 2007. None of our employees are represented by unions or covered by collective bargaining agreements. We consider our relations with our employees to be good.

 

Item 1A.    Risk Factors.

 

Choice Hotels International, Inc. and subsidiaries is subject to various risks, which could have a negative effect on the Company and its financial condition. These risks could cause actual operating results to differ from those expressed in certain “forward looking statements” contained in this Form 10-K as well as in other Company communications. Before you invest in our securities you should carefully consider these risk factors together with all other information included in our publicly filed documents.

 

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We are subject to the operating risks common in the lodging and franchising industries.

 

A significant portion of our revenue is derived from fees based on room revenues at hotels franchised under our brands. As such, our business is subject, directly or through our franchisees, to the following risks common in the lodging and franchising industry, among others:

 

   

changes in the number of hotels operating under franchised brands;

 

   

changes in the relative mix of franchised hotels in the various lodging industry price categories;

 

   

changes in occupancy and room rates achieved by hotels;

 

   

desirability of hotel geographic location;

 

   

changes in general and local economic and market conditions, which can adversely affect the level of business and leisure travel, and therefore the demand for lodging and related services;

 

   

increases in costs due to inflation may not be able to be totally offset by increases in room rates;

 

   

over-building in one or more sectors of the hotel industry and/or in one or more geographic regions, could lead to excess supply compared to demand, and to decreases in hotel occupancy and/or room rates;

 

   

changes in travel patterns;

 

   

changes in governmental regulations that influence or determine wages, prices or construction costs;

 

   

other unpredictable external factors, such as acts of god, war, terrorist attacks, epidemics, airline strikes, transportation and fuel price increases and severe weather, may reduce business and leisure travel;

 

   

increases in the cost of human capital, energy, healthcare, insurance and other operating expenses resulting in lower operating margins;

 

   

the financial condition of franchisees and travel related companies;

 

   

franchisors’ ability to develop and maintain positive relations with current and potential franchisees; and,

 

   

changes in exchange rates or sustained recessionary periods in the U.S. (affecting domestic travel) and internationally could also unfavorably impact future results.

 

We are subject to risks relating to acts of God, terrorist activity, epidemics and war.

 

Our financial and operating performance may be adversely affected by acts of God, such as natural disasters and/or epidemics in locations where we have a high concentration of franchisees and areas of the world from which our franchisees draw a large number of guests. Some types of losses, such as from terrorism and acts of war may be either uninsurable or too expensive to justify insuring against. Should an uninsured loss or a loss in excess of insured limits occur, our results of operations and financial condition may be adversely affected.

 

We may not grow our franchise system or we may lose business by failing to compete effectively.

 

Our operational and growth prospects depend on the strength and desirability of our brands. We believe that hotel operators choose lodging franchisors based primarily on the value and quality of each franchisor’s brand and services, the extent to which affiliation with that franchisor may increase the hotel operator’s reservations and profits, and the franchise fees charged. Demographic, economic or other changes in markets may adversely affect the desirability of our brands and, correspondingly, the number of hotels franchised under the Choice brands.

 

We compete with other lodging companies for franchisees. As a result, the terms of new franchise agreements may not be as favorable as our current franchise agreements. Our competition may reduce or change fee structures, or make greater use of financial incentives such as loans and guarantees to acquire franchisees. This may potentially cause us to respond by charging lower fees or increasing our use of financial incentives,

 

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which may impact our margins. New competition may emerge using different business models with a lesser reliance on franchise fees. In addition, an excess supply of hotel rooms may discourage potential franchisees from constructing new hotels, thereby limiting a source of growth of the franchise fees received by us.

 

We may not achieve our objectives for growth in the number of franchised hotels.

 

The number of properties and rooms franchised under our brands significantly affects our results. There can be no assurance that we will be successful in achieving our objectives with respect to growing the number of franchised hotels in our system or that we will be able to attract qualified franchisees. The growth in the number of franchised hotels is subject to numerous risks, many of which are beyond the control of our franchisees or us. Among other risks, the following factors affect our ability to achieve growth in the number of franchised hotels.

 

   

the ability of our franchisees to open and operate additional hotels profitably. Factors affecting the opening of new hotels, or the conversion of existing hotels to a Choice brand, include, among others:

 

   

the availability of hotel management, staff and other personnel;

 

   

the cost and availability of suitable hotel locations;

 

   

the availability and price of capital to allow hotel owners and developers to fund investments;

 

   

cost effective and timely construction of hotels (which construction can be delayed due to, among other reasons, labor and materials availability, labor disputes, local zoning and licensing matters, and weather conditions); and

 

   

securing required governmental permits.

 

   

our ability to continue to enhance our reservation, operational and service delivery systems to support additional franchisees in a timely, cost-effective manner;

 

   

our formal impact policy, which offers franchisees protection from the opening of a same-brand property within a specified distance, may adversely impact our growth potential;

 

   

the effectiveness and efficiency of our development organization;

 

   

our failure to introduce new brands that gain market acceptance, may adversely impact our unit growth potential;

 

   

our dependence on our independent franchisees’ skills and access to financial resources necessary to open the desired number of hotels; and,

 

   

our ability to attract and retain qualified domestic and international franchisees.

 

Contract terms for new hotel franchises may be less favorable.

 

The terms of the franchise agreements for new or conversion hotels are influenced by contract terms offered by our competitors at the time these agreements are entered into. Accordingly, we cannot assure you that contracts for new hotel franchises entered into or renewed in the future will be on terms that are as favorable to us as those under our existing agreements.

 

Under certain circumstances our franchisees may terminate our franchise contracts.

 

We franchise hotels to third parties pursuant to franchise contracts. These contracts may be terminated, renegotiated or expire. These franchise contracts typically have an initial term of twenty years with provisions permitting the franchisee to terminate the agreements after five, ten or fifteen years under certain circumstances. While our contracts provide for liquidated damages related to franchisee terminations outside the contract provisions, these damage amounts are typically less than the fees we would have received if a licensee fulfilled its contractual terms. In addition, there can be no assurance that we will be able to replace terminated franchise

 

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contracts, or that the terms of renegotiated or new contracts will be as favorable as the terms that existed before such replacement or renegotiation.

 

Deterioration in the general financial condition of our franchisees may adversely affect our results.

 

Our operating results are impacted by the ability of our franchisees to generate revenues at properties they franchise from us. An extended period of occupancy or room rate declines may adversely affect the operating results and financial condition of our franchisees.

 

The hotel industry is highly competitive. Competition is based primarily on the level of service, quality of accommodations, convenience of locations and room rates. Our franchisees compete for guests with other hotel properties in their geographic markets. Some of their competitors may have substantially greater marketing and financial resources than our franchisees, and they may construct new facilities or improve their existing facilities, reduce their prices or expand and improve their marketing programs in ways that adversely affect our franchisees operating results and financial condition.

 

These factors, among others, could adversely affect the operating results and financial condition of our franchisees and result in declines in the number of franchised properties and/or franchise fees and other revenues derived from our franchising business. In addition, at times, the Company provides financial support to our franchisees via notes and guarantees. Factors that may adversely affect the operating results and financial condition of these franchisees may result in the Company incurring losses related to this financial support.

 

Increasing use of internet reservation channels may decrease loyalty to our brands or otherwise adversely affect us.

 

A growing percentage of our hotel rooms are booked through internet travel intermediaries. If such bookings continue to increase, these intermediaries may be able to obtain higher commissions, reduced room rates or other significant contract concessions from our franchisees or us. Moreover, some of these internet travel intermediaries are attempting to commoditize hotel rooms, by increasing the importance of price and general indicators of quality at the expense of brand identification. These intermediaries hope that consumers will eventually develop brand loyalties to their reservations systems rather than to our lodging brands. If this happens our business and profitability may be significantly harmed. We have established agreements with many key third party websites to limit transaction fees for hotels but we currently do not have agreements with several large internet travel intermediaries.

 

We are dependent upon our employees’ ability to manage our growth.

 

Our future success and our ability to manage future growth depend in large part upon the efforts and skills of our senior management and our ability to attract and retain key officers and other highly qualified personnel. Competition for such personnel is intense. There can be no assurance that we will continue to be successful in attracting and retaining qualified personnel. Accordingly, there can be no assurance that our senior management will be able to successfully execute and implement our growth and operating strategies.

 

We and our franchisees are reliant upon technology.

 

The lodging industry depends upon the use of sophisticated technology and systems including technology utilized for reservation systems, property management, procurement, operation of our customer loyalty programs and administrative systems. The operation of many of these systems is dependent upon third party data communication networks and software upgrades, maintenance and support. These technologies can be expected to require refinements and there is the risk that advanced new technologies will be introduced. There can be no assurance that as various systems and technologies become outdated or new technology is required we will be able to replace or introduce them as quickly as our competitors or within budgeted costs for such technology.

 

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There can be no assurance that we will achieve the benefits that may have been anticipated from any new technology or system. Further, there can be no assurance that disruptions of the operation of these systems will not occur as a result of failures related to third party systems and support.

 

Our international operations are subject to special political and monetary risks.

 

We have franchised properties open and operating in more than 40 countries and territories outside of the United States. We also have investments in two foreign hotel franchisors. International operations generally are subject to political and other risks that are not present in U.S. operations. These risks include the risk of war or civil unrest, expropriation and nationalization. In addition, some international jurisdictions laws do not adequately protect our intellectual property and restrict the repatriation of non-U.S. earnings. Various international jurisdictions also have laws limiting the right and ability of non-U.S. entities to pay dividends and remit earnings to affiliated companies unless specified conditions have been met. In addition, sales in international jurisdictions typically are made in local currencies, which subjects us to risks associated with currency fluctuations. Currency devaluations and unfavorable changes in international monetary and tax policies could have a material adverse effect on our profitability and financing plans, as could other changes in the international regulatory climate and international economic conditions.

 

We are subject to certain risks related to our indebtedness.

 

As a result of our debt obligations, we are subject to the following risks, among others:

 

   

the risk that cash flows from operations or available lines of credit will be insufficient to meet required payments of principal and interest when due;

 

   

the risk that (to the extent we maintain floating rate indebtedness) interest rates increase;

 

   

our leverage may adversely affect our ability to obtain additional financing for acquisitions, working capital, capital expenditures or other purposes, if required;

 

   

our existing debt agreements contain covenants that limit our ability to, among other things, borrow additional money, sell assets or engage in mergers. If we do not comply with these covenants, or do not repay our debt on time, we would be in default under our debt agreements. Unless any such default is waived by our lenders, the debt could become immediately payable and this would have a material adverse impact on us; and,

 

   

the liquidity of the market for our publicly traded senior notes depends upon the number of holders of those securities, our performance, the market for similar securities, the interest of securities dealers in making a market in those securities and other factors.

 

While our senior debt is currently rated investment grade by both of the major rating agencies, there can be no assurance we will be able to maintain this rating. In the event our senior debt is not investment grade, we would likely incur higher borrowing costs.

 

Anti-takeover provisions may prevent a change in control.

 

Our restated certificate of incorporation, the staggered terms of our board of directors and the Delaware General Corporation Law each contain provisions that could have the effect of making it more difficult for a party to acquire, and may discourage a party from attempting to acquire, control of our Company without approval of our board of directors. These provisions could discourage tender offers or other bids for our common stock at a premium over market price.

 

The concentration of share ownership may influence the outcome of certain matters.

 

The concentration of share ownership by our directors and affiliates allows them to substantially influence the outcome of matters requiring shareholder approval. As a result, acting together, they may be able to control

 

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or substantially influence the outcome of matters requiring approval by our shareholders, including the elections of directors and approval of significant corporate transactions, such as equity compensation plans.

 

Forward-looking statements may prove inaccurate.

 

We have made forward-looking statements in our reports on Form 10-Q, Form 10-K and other communications that are subject to risks and uncertainties. You should note that many factors, some of which are discussed in such reports, could affect future financial results and could cause those results to differ materially from those expressed in our forward-looking statements contained in such reports.

 

Government regulation could impact our business.

 

The Federal Trade Commission (the “FTC”), various states and certain foreign jurisdictions where we market franchises regulate the sale of franchises. The FTC requires franchisors to make extensive disclosure to prospective franchisees but does not require registration. A number of states in which our franchisees operate require registration or disclosure in connection with franchise offers and sales. In addition, several states in which our franchisees operate 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 business has not been materially affected by such regulation, there can be no assurance that this will continue or that future regulation or legislation will not have such an effect.

 

Failure to comply with the Sarbanes-Oxley Act could impact our business.

 

There can be no assurance that the periodic evaluation of our internal controls required by the Sarbanes-Oxley Act will not result in the identification of significant control deficiencies or that our auditors will be able to attest to the effectiveness of our internal control over financial reporting. Failure to comply may have consequences on our business including, but not limited to, increased risks of financial statement misstatements, SEC sanctions and negative capital market reactions.

 

We are subject to certain risks related to litigation filed by or against us.

 

We cannot predict with certainty the cost of defense, the cost of prosecution or the ultimate outcome of litigation filed by or against us, including, remedies or damage awards. This litigation may include, but is not limited to, actions or negligence by franchisees outside of our control. We are not liable for the actions of our franchisees; however, there is no guarantee that we would be insulated from liability in all cases.

 

Disruption or malfunction in our information systems could adversely affect our business.

 

Our information technology system is vulnerable to damage or interruption from:

 

   

earthquakes, fires, floods and other natural disasters;

 

   

power losses, computer systems failures, internet and telecommunications or data network failures, operator negligence, improper operation by or supervision of employees, physical and electronic losses of data and similar events; and

 

   

computer viruses, penetration by individuals seeking to disrupt operations or misappropriate information and other breaches of security.

 

We rely on this system to perform functions critical to our ability to operate, including our central reservation systems. Accordingly, an extended interruption in the systems’ function could significantly curtail, directly and indirectly, our ability to conduct our business and generate revenue.

 

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The weakening of our intellectual property could impact our business.

 

Our intellectual property is fundamental to our brands and our franchising business. We generate, maintain, license and enforce a substantial portfolio of trademarks and other intellectual property rights. We use our intellectual property rights to protect development activities, to protect our good name, to promote our brand name recognition, to enhance our competitiveness and to otherwise support our business goals and objectives. Our intellectual property rights, however, may be challenged, cancelled, invalidated or circumvented, or may fail to provide us with significant competitive advantages.

 

Item 1B.    Unresolved Staff Comments.

 

None.

 

Item 2.    Properties.

 

Our principal executive offices are located at 10750 Columbia Pike, Silver Spring, MD 20901. The offices are leased from a third party. We own our reservation and property system’s information technology office in Phoenix, AZ, and reservation centers in Minot, ND and Grand Junction, CO. We also lease office space in Phoenix, AZ, Bethesda, MD, Atlanta, GA, Australia, London, Canada, Germany, France and Mexico. Management believes that the Company’s existing properties 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.

 

We own three MainStay Suites ® hotels located in Brentwood, TN, Pittsburgh, PA and Greenville, SC.

 

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 position, liquidity 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 year ended December 31, 2006.

 

 

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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 as of December 31, 2006 are set forth below. The business address of each executive officer is 10750 Columbia Pike, Silver Spring, Maryland 20901.

 

Name


   Age

    

Position


Stewart Bainum, Jr.

   60      Chairman of the Board of Directors

Charles A. Ledsinger, Jr.

   57      Vice Chairman and Chief Executive Officer

David L. White

   38      Chief Financial Officer

William Carlson

   48      Senior Vice President, Consumer Revenue Growth

David E. Goldberg

   39      Senior Vice President, Brand Value

Bruce N. Haase

   46      Senior Vice President, International

Daniel Head

   43      Senior Vice President, Business Intelligence and Strategy

Mary Beth Knight

   46      Senior Vice President, E-Commerce

Thomas Mirgon

   50      Senior Vice President, Human Resources and Administration

Janna Morrison

   45      Senior Vice President, Customer Care and Technology Services

David Pepper

   39      Senior Vice President, Franchise Growth and Performance

Gary Thomson

   52      Senior Vice President, Chief Information Officer

Scott E. Oaksmith

   35      Controller

Paul Mamalian

   37      General Counsel

Executive Officers Separating From the Company

    Subsequent to December 31, 2006

Joseph M. Squeri

   41      President and Chief Operating Officer

Wayne W. Wielgus

   52      Executive Vice President and Chief Marketing Officer

Michael J. DeSantis

   48      Senior Vice President, Senior Strategic Advisor and Secretary

 

Background of Continuing Executive Officers:

 

Stewart Bainum, Jr. Director from 1977 to 1996 and since 1997. Chairman of the Board of Choice Hotels from March 1987 to November 1996 and since October 1997; Chairman of the Board of Realty Investment Company, Inc. since December 2005; Chairman of the Board of Sunburst Hospitality Corporation since November 1996. He was a director of Manor Care, Inc. from September 1998 to September 2002, serving as Chairman from September 1998 until September 2001. From March 1987 to September 1998, he was Chairman and Chief Executive Officer of Manor Care, Inc. He served as President of Manor Care of America, Inc. and Chief Executive Officer of ManorCare Health Services, Inc. from March 1987 to September 1998, and as Vice Chairman of Manor Care of America, Inc. from June 1982 to March 1987.

 

Charles A. Ledsinger, Jr. Vice Chairman, Chief Executive Officer and Director of the Company since September 2006. He was President, Chief Executive Officer and Director of the Company from August 1998 to September 2006. He was 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; and Senior Vice President and Chief Financial Officer of Promus Companies Incorporated from August 1990 to June 1995. He serves as a director of Darden Restaurants and FelCor Lodging Trust, Inc.

 

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David L. White. Chief Financial Officer since September 2006. He was Vice President, Finance & Controller of Choice from December 2002 to September 2006; Vice President, Financial/SEC Reporting from September 2002 to December 2002. He was Senior Manager, Ernst & Young, LLP from May 2002 to September 2002. He was employed by Arthur Andersen LLP as Senior Manager from May 1999 to May 2002, and manager from October 1998 to May 1999. He served as Assistant Controller for the energy marketing division of Statoil Energy, Inc. from May 1997 to September 1998.

 

William Carlson. Senior Vice President, Consumer Revenue Growth of Choice since May 2006. He was Vice President, Consumer Marketing of the Company from October 1998 to May 2006.

 

David E. Goldberg. Senior Vice President, Brand Value of Choice since December 2005. He was Senior Vice President, Corporate Strategy from January 2005 until December 2005. He was Vice President, Corporate and Brand Strategy and Treasurer from February 2004 until January 2005. He was Vice President, Strategy and Business Development from February 2002 to February 2004; Senior Director, Strategy and Business Development from January 2001 to February 2002; Director of Corporate Development from July 1999 to January 2001. He was Managing Associate with McManis Associates from January 1998 through July 1999 and a Consultant with Andersen Consulting from September 1994 through January 1998.

 

Bruce N. Haase. Senior Vice President, International of the Company since October 2000. He was Vice President – Finance and Treasurer from April 2000 until October 2000. He was Vice President, Finance and Treasurer of The Ryland Group, Inc., in Columbia, Maryland, from August 1999 until March 2000 and Vice President and Treasurer from October 1995 until August 1999.

 

Dan Head. Senior Vice President, Business Intelligence and Strategy of Choice since December 2005. He was Vice President, Corporate Strategy from September 2005 until December 2005. He served as a Managing Director for Bearing Point from July 2002 until September 2005; and was employed by Arthur Andersen Business Consulting as a partner in the technology, media and communications practice areas from September 1998 until July 2002.

 

Mary Beth Knight. Senior Vice President, E-Commerce of the Company since May 2006. She was Vice President, E-Commerce of Choice from April 2002 until May 2006. Prior to April 2002, she was Vice President, E-Commerce for Best Western International.

 

Thomas Mirgon. Senior Vice President, Human Resources and Administration since April 1998. He was Senior Vice President, Human Resources of the Company from March 1997 to April 1998 and of Choice’s predecessor company from March 1997 to October 1997; Vice President, Administration of Interim Services from August 1993 to February 1997; and 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.

 

Janna Morrison. Senior Vice President, Customer Care and Technology Services of Choice since December 2005. She was Senior Vice President, Franchise Services from November 2001 until December 2005. She was Vice President, Property Systems from 1998 to November 2001; Vice President, Revenue Management from 1995 to 1998.

 

David Pepper. Senior Vice President, Franchise Growth and Performance of Choice since December 2005. He was Senior Vice President, Development of Choice from January 2005 until December 2005. He was Vice President, Franchise Sales from June 2002 until January 2005. He was Vice President, Franchise Sales with USFS in Atlanta, Georgia from 1996 through June 2002.

 

Gary Thomson. Senior Vice President, Chief Information Officer of Choice since August 2000. He was Vice President – Information Systems Technologies from November 1993 until August 2000.

 

Scott E. Oaksmith. Controller of the Company since September 2006. He was Assistant Controller of Choice from February 2004 to September 2006. He was Director, Marketing and Reservations, Finance from October

 

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2002 until February 2004. Prior to joining the Company, he was employed by American Express Tax & Business Services, Inc. from January 1994 to October 2002, last serving as Senior Manager from October 2000 to October 2002.

 

Paul Mamalian. General Counsel of Choice since September 2006. He was Assistant General Counsel from August 2004 to September 2006 and Senior Attorney from July 2003 to August 2004. Prior to joining Choice, he was a Senior Associate with Pillsbury Winthrop from April 2000 to November 2002.

 

Background of Executive Officers Separating from the Company Subsequent to December 31, 2006

 

Joseph M. Squeri. President and Chief Operating Officer since September 2006. He was Executive Vice President, Operations and Chief Financial Officer from May 2005 to September 2006. He was Executive Vice President and Chief Financial Officer from May 2004 to May 2005. He was Senior Vice President, Development and Chief Financial Officer of the Company from March 2002 until May 2004; Treasurer of the Company from April 1998 to February 2004 and since December 2004; Vice President, Finance and Controller of the Company from March 1997 to June 1999 and of Former Choice from March 1997 to October 1997.

 

Wayne W. Wielgus. Executive Vice President and Chief Marketing Officer since September 2004. He was Senior Vice President, Marketing of Choice From September 2000 until September 2004. He was Vice President, Marketing of Best Western International, Inc., in Phoenix, Arizona, from 1996 until September 2000 and Senior Vice President, Marketing-Americas from 1993 until 1996 for Forte Hotels PLC.

 

Michael J. DeSantis. Senior Vice President, Senior Strategic Advisor and Secretary of the Company since September 2006. He was Senior Vice President, General Counsel and Secretary of the Company from June 1997 to September 2006 and of Former Choice from June 1997 to October 1997. He was Senior Attorney for Choice’s predecessor company 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; and Assistant General Counsel of Caterair International from May 1990 to March 1994.

 

PART II

 

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

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 and cash dividends declared per share for each quarterly period for the two most recently completed years.

 

QUARTERLY MARKET PRICE RANGE OF COMMON STOCK AND CASH DIVIDENDS DECLARED

 

     Market Price Per Share*

  

Cash Dividends

Declared Per Share*


Quarters Ended


       High    

       Low    

  

2005

                    

March 31,

   $ 31.66    $ 27.94    $ 0.1125

June 30,

     33.95      29.31      0.1125

September 30,

     33.70      29.65      0.13

December 31,

     42.56      31.47      0.13

2006

                    

March 31,

   $ 49.15    $ 40.77    $ 0.13

June 30,

     61.38      44.90      0.13

September 30,

     61.75      35.26      0.15

December 31,

     47.57      39.50      0.15

 *   Per share amounts have been retroactively adjusted for a two-for-one stock split effected in the form of a stock dividend distributed on October 21, 2005 to shareholders of record on October 7, 2005.

 

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The Company currently maintains the payment of a quarterly dividend on its common shares outstanding, however, the declaration of future dividends are subject to the discretion of the board of directors. We expect that cash dividends will continue to be paid at a comparable or increased rate in the future, subject to future business performance.

 

As of February 15, 2007, there were 2,296 holders of record of the Company’s common stock.

 

EQUITY COMPENSATION PLAN INFORMATION

 

The following table sets forth information regarding the number of shares of the Company’s common stock that were subject to outstanding stock options at December 31, 2006.

 

    

Number of shares to be

issued upon exercise of

outstanding options,

warrants and rights*


  

Weighted average

exercise price of

outstanding options,

warrants and rights*


  

Number of shares

remaining available for

future issuance under

equity compensation

plans (excluding shares

reflected in column (a))*


Plan Category


   (a)

   (b)

   (c)

Equity compensation plans approved by shareholders

   2,622,833    $ 15.03    3,166,764

Equity compensation plans not approved by shareholders

   237,326    $ 6.27    Not applicable

 *   On May 1, 2006, the Company’s shareholders approved a new long-term incentive plan (“LTIP”) authorizing the issuance of 3.2 million share-based awards.

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

The following table sets forth purchases of Choice Hotels International, Inc. common stock made by the Company during the twelve months ended December 31, 2006.

 

Month Ending


  

Total Number of

Shares Purchased


  

Average Price

Paid per Share


  

Total Number of Shares

Purchased as Part of

Publicly Announced

Plans or Programs(1)


   Maximum Number of
Shares that may yet be
Purchased Under the Plans
or Programs, End of Period


January 31, 2006

   813    $ 42.16    —      5,102,701

February 28, 2006

   25,981      47.81    —      5,102,701

March 31, 2006

   —        —      —      5,102,701

April 30, 2006

   —        —      —      5,102,701

May 31, 2006

   —        —      —      5,102,701

June 30, 2006

   —        —      —      5,102,701

July 31, 2006

   —        —      —      5,102,701

August 31, 2006

   —        —      —      5,102,701

September 30, 2006

   1,172      42.78    —      5,102,701

October 31, 2006

   —        —      —      5,102,701

November 30, 2006

   —        —      —      5,102,701

December 31, 2006

   827      45.36    —      5,102,701
    
  

  
  

Total

   28,793    $ 47.38    —      5,102,701
    
  

  
  

(1)

 

The Company’s share repurchase program was initially approved by the board of directors on June 25, 1998.

 

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During the year ended December 31, 2006, the Company purchased 28,793 shares of common stock from employees to satisfy minimum tax-withholding requirements from the vesting of restricted stock grants. These purchases were not part of the board repurchase authorization.

 

Item 6.    Selected Financial Data.

 

Company results (in millions, except per share data)

 

     As of and for the year ended December 31,

     2002

   2003

   2004

   2005

   2006

Total Revenues

   $ 365.6    $ 385.9    $ 428.2    $ 477.4    $ 544.7

Net Income

     60.8      71.9      74.3      87.6      112.8

Basic Earnings per Share(1)

     0.78      1.01      1.12      1.36      1.72

Diluted Earnings per Share(1)

     0.76      0.98      1.08      1.32      1.68

Total Assets

     316.8      267.3      263.4      265.3      303.3

Long-Term Debt

     307.8      246.7      328.7      274.1      172.5

Cash Dividends Declared Per Common Share(1)

     —        0.10      0.425      0.485      0.56

(1)

 

Per share amounts have been retroactively adjusted for a two-for-one stock split effected in the form of a stock dividend distributed on October 21, 2005 to shareholders of record on October 7, 2005.

 

Matters that affect the comparability of our annual results are as follows:

 

   

Net income in 2003 included a $3.4 million ($0.05 per share) gain on the prepayment of a note receivable from Sunburst. As a result of this prepayment, interest income earned on this note receivable totaling approximately $4.5 million per annum will not be received in future years.

 

   

Net income in 2004 included a $0.7 million loss on extinguishment of debt related to the refinancing of the Company’s senior credit facility. In addition, results reflect a reduction of income tax expense related to the resolution of certain tax contingencies of approximately $1.2 million. Those items represent diluted EPS of $0.01, net.

 

   

Net income in 2005 included additional income tax expense of approximately $1.2 million related to the Company’s repatriation of foreign earnings pursuant to the American Jobs Creation Act and a reduction of income tax expense related to the resolution of certain tax contingencies of approximately $4.9 million. Those items represent diluted EPS of $0.06, net.

 

   

Net income in 2006 included a $0.3 million loss on extinguishment of debt related to the refinancing of the Company’s senior credit facility and a reduction of income tax expense related to the resolution of certain tax contingencies of approximately $12.8 million. In addition, the Company’s adoption of SFAS No. 123R reduced net income by approximately $0.3 million. Those items represent diluted EPS of $0.20, net.

 

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operation.

 

The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand Choice Hotels International, Inc. and subsidiaries. MD&A is provided as a supplement to – and should be read in conjunction with – our consolidated financial statements and the accompanying notes.

 

Overview

 

We are a hotel franchisor with franchise agreements representing 5,376 hotels open and 930 hotels under development as of December 31, 2006, with 437,385 rooms and 72,555 rooms, respectively, in 49 states, the

 

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District of Columbia and more than 40 countries and territories outside the United States. Our brand names include Comfort Inn®, Comfort Suites®, Quality®, Clarion®, Sleep Inn®, Econo Lodge®, Rodeway Inn®, MainStay Suites®, Suburban Extended Stay Hotel®, Cambria Suites™ and Flag Hotels®.

 

The Company conducts its international franchise operations through a combination of direct franchising and master franchising which allow the use of our brands by third parties in foreign countries. The Company has made equity investments in certain non-domestic lodging franchise companies that conduct franchise operations for the Company’s brands under master franchising relationships. As a result of our use of master franchising relationships and international market conditions, total revenues from international franchising operations comprised only 6% and 5% of our total revenues in 2006 and 2005, respectively while representing approximately 22% of our franchise system hotels open at December 31, 2006 and 2005, respectively.

 

On October 30, 2006, the Company acquired 100% of the stock of Choice Hotels Franchise GmbH (“CHG”). CHG was a wholly owned subsidiary of one of the Company’s master franchisees, CHE Hotel Group PLC (“CHE”). Under the master franchise agreement with CHE, CHG franchised hotels under the Company’s brands in Austria, Germany, Italy, Czech Republic and potions of Switzerland. As a result of this acquisition, the master franchise agreement between the Company and CHE covering these countries terminated. The results of CHG have been consolidated with the Company since October 30, 2006.

 

On November 30, 2006, the Company acquired CHE’s assets, including franchise contracts, related to its franchising of hotels under the Company’s brands in France, Belgium, Portugal, Spain and portions of Switzerland. As a result of acquisition, the master franchise agreement between the Company and CHE covering these countries terminated and the Company commenced direct franchising operations in these countries on November 30, 2006.

 

These transactions enable Choice to continue its strategy of more closely directing the growth of our franchise operations throughout continental Europe.

 

During 2005, the Company acquired 100% of the stock of Suburban Franchise Holding Company, Inc. (“Suburban”) and its wholly owned subsidiary, Suburban Franchise Systems, Inc. for $12.8 million. Suburban is the franchisor of Suburban Extended Stay Hotels and at acquisition had 67 units (8,942 rooms) operating in the economy extended stay segment primarily in the southeastern United States. The acquisition allowed the Company to enter, on an accelerated basis, the economy extended stay segment, a market in which it did not previously compete. The results of Suburban have been consolidated with the Company since September 28, 2005.

 

On September 14, 2005, the Company’s board of directors declared a two-for one stock split effected in the form of a stock dividend. The stock dividend was distributed on October 21, 2005 to shareholders of record on October 7, 2005. Share data and earnings per share data included in MD&A reflect the stock split, applied retroactively, to all periods presented.

 

Our Company generates revenues, income and cash flows primarily from initial and continuing royalty fees attributable to our franchise agreements. Revenues are also generated from brand solutions (formerly known as partner services) endorsed vendor arrangements, hotel operations and other sources. The hotel industry is seasonal in nature. For most hotels, demand is lower in December through March than during the remainder of the year. Our principal source of revenues is franchise fees based on the gross room revenues of our franchised properties. The Company’s franchise fee revenues and operating income reflect the industry’s seasonality and historically have been lower in the first quarter than in the second, third or fourth quarters.

 

With a focus on hotel franchising instead of ownership, we benefit from the economies of scale inherent in the franchising business. The fee and cost structure of our business provides opportunities to improve operating results by increasing the number of franchised properties and effective royalty rates of our franchise contracts

 

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resulting in increased initial fee revenue; ongoing royalty fees and brand solutions revenues. In addition, our operating results can also be improved through our company wide efforts related to improving property level performance. In addition to these revenues, we also collect marketing and reservation fees to support centralized marketing and reservation activities for the franchise system. As a lodging franchisor, Choice has relatively low capital expenditure requirements.

 

The principal factors that affect the Company’s results are: the number and relative mix of franchised hotels; growth in the number of hotels under franchise; occupancy and room rates achieved by the hotels under franchise; the effective royalty rate achieved; and our ability to manage costs. The number of rooms at franchised properties and occupancy and room rates at those properties significantly affect the Company’s results because our 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. Our variable overhead costs associated with franchise system growth have historically been less than incremental royalty fees generated from new franchises. Accordingly, continued growth of our franchise business should enable us to realize benefits from the operating leverage in place and improve operating results.

 

We are contractually required by our franchise agreements to use the marketing and reservation fees we collect for system-wide marketing and reservation activities. These expenditures, which include advertising costs and costs to maintain our central reservations system, help to enhance awareness and increase consumer preference for our brands. Greater awareness and preference promotes long-term growth in business delivery to our franchisees, which ultimately increases franchise fees earned by the Company.

 

Our Company articulates its mission as a commitment to our customers’ profitability by providing our customers with hotel franchises that generate the highest return on investment of any hotel franchise. We have developed an operating system dedicated to our franchisees’ success that focuses on delivering guests to our franchised hotels and reducing costs for our hotel owners. We strive every day to continuously improve our franchise offerings to enhance our customers’ profitability and create the highest return on investment of any hotel franchise.

 

We believe that executing our strategic priorities creates value. Our Company focuses on two key value drivers:

 

Profitable Growth. Our success is dependent on improving the performance of our hotels, increasing our system size by selling additional hotel franchises and effective royalty rate improvement. We attempt to improve our franchisees’ revenues and overall profitability by providing a variety of products and services designed to increase business delivery to and/or reduce operating and development costs for our franchisees. These products and services include national marketing campaigns, a central reservation system, property and yield management systems, quality assurance standards and endorsed vendor relationships. We believe that healthy brands, which deliver a compelling return on investment for franchisees, will enable us to sell additional hotel franchises and raise royalty rates. We have established multiple brands that meet the needs of many types of guests, and can be developed at various price points and applied to both new and existing hotels. This ensures that we have brands suitable for creating growth in a variety of market conditions. Improving the performance of the hotels under franchise, growing the system through additional franchise sales and improving franchise agreement pricing while maintaining a disciplined cost structure are the keys to profitable growth.

 

Maximizing Financial Returns and Creating Value for Shareholders. Our capital allocation decisions, including capital structure and uses of capital, are intended to maximize our return on invested capital and create value for our shareholders. We believe our strong and predictable cash flows create a strong financial position that provides us a competitive advantage. Our business does not require significant capital to operate and grow, therefore, we can maintain a capital structure that generates high financial returns and use our excess cash flow to increase returns to our shareholders. We have returned value to our shareholders in two primary ways: share

 

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repurchases and dividends. In 1998, we instituted a share repurchase program which has generated substantial value for our shareholders. Through December 31, 2006, we have repurchased 33.6 million shares (including 33.0 million prior to the two-for-one stock split effected in October 2005) of common stock at a total cost of $711.9 million since the program’s inception. Considering the effect of the two-for-one stock split, the Company has repurchased 66.6 million shares at an average price of $10.69 per share through December 31, 2006. Our cash flows from operations support our ability to complete the repurchase of approximately 5.1 million shares presently remaining under our current board of directors’ authorization at December 31, 2006. The Company expects to continue to return value to its shareholders through a combination of dividends and share repurchases, subject to market and other conditions and upon completion of the current authorization we will evaluate the propriety of additional share repurchases with our board of directors. In 2006, we paid cash dividends totaling approximately $35.4 million and we presently expect to continue to pay dividends in the future. Based on our present dividend rate and outstanding share count, aggregate annual dividends would be approximately $39.6 million.

 

We believe these value drivers, when properly implemented, will enhance our profitability, maximize our financial returns and continue to generate value for our shareholders. The ultimate measure of our success will be reflected in the items below.

 

Results of Operation: Royalty fees, operating income, net income and diluted earnings per share (“EPS”) represent key measurements of these value drivers. In 2006, royalty fees revenue totaled approximately $211.6 million, a 13% increase compared to 2005. Operating income totaled $166.6 million for the year ended December 31, 2006, a 16% increase from 2005. Net income for the year ended December 31, 2006 increased $25.2 million to $112.8 million, a 29% increase from 2005. Diluted earnings per share were $1.68, a 27% improvement over 2005. Net income and diluted earnings per share for 2006 include a reduction of income tax expense related to the resolution of provisions for certain income tax contingencies of approximately $12.8 million and a loss on extinguishment of debt of approximately $0.3 million ($0.2 million, net of the related tax effect) related to the refinancing of the Company’s senior credit facility. Those items represent diluted EPS of $0.19, net for the year ended December 31, 2006. Net income and diluted earnings per share for 2005 include additional tax expense of approximately $1.2 million related to the Company’s repatriation of foreign earnings pursuant to the American Jobs Creation Act and a reduction of income tax expense related to the resolution of certain tax contingencies of approximately $4.9 million. Those items represent diluted EPS of $0.06, net for the year ended December 31, 2005. These measurements will continue to be a key management focus in 2007 and beyond.

 

Refer to MD&A heading “Operations Review” for additional analysis of our results.

 

Liquidity and Capital Resources: The Company generates significant cash flows from operations. In 2006 and 2005, net cash provided by operating activities was $153.9 million and $133.6 million, respectively. Since our business does not require significant reinvestment of capital, we utilize cash in ways that management believes provide the greatest returns to our shareholders which include share repurchases and dividends. We believe the Company’s cash flow from operations and available financing capacity are sufficient to meet the expected future operating, investing and financing needs of the business.

 

Refer to MD&A heading “Liquidity and Capital Resources” for additional analysis.

 

Operations Review

 

Comparison of 2006 Operating Results and 2005 Operating Results

 

The Company recorded net income of $112.8 million for the year ended December 31, 2006, an increase of $25.2 million, or 29% from $87.6 million for the year ended December 31, 2005. The increase in net income for the year is primarily attributable to a $22.9 million improvement in operating income and a decline in the

 

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effective income tax rate from 33.0% to 27.4%. The effective income tax rate declined primarily due to the resolution of tax contingencies of approximately $12.8 million in 2006 compared to $4.9 million in 2005 as well as an additional $1.2 million of income tax expense in 2005 related to the Company’s repatriation of foreign earnings. Operating income increased as a result of a $32.1 million, or 14% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) primarily offset by an $8.9 million or 11% increase in selling, general and administrative expense.

 

Summarized financial results for the years ended December 31, 2006 and 2005 are as follows:

 

     2006

    2005

 
     (In thousands)  

REVENUES:

                

Royalty fees

   $ 211,645     $ 187,340  

Initial franchise and relicensing fees

     29,629       25,388  

Brand solutions

     13,945       13,382  

Marketing and reservation

     278,026       243,123  

Hotel operations

     4,505       4,293  

Other

     6,912       3,873  
    


 


Total revenues

     544,662       477,399  
    


 


OPERATING EXPENSES:

                

Selling, general and administrative

     87,112       78,250  

Depreciation and amortization

     9,705       9,051  

Marketing and reservation

     278,026       243,123  

Hotel operations

     3,194       3,225  
    


 


Total operating expenses

     378,037       333,649  
    


 


Operating income

     166,625       143,750  
    


 


Interest expense

     14,098       15,325  

Interest and other investment income

     (2,041 )     (1,094 )

Equity in net income of affiliates

     (1,052 )     (803 )

Loss on extinguishment of debt

     342       —    

Other

     —         (420 )
    


 


Other income and expenses, net

     11,347       13,008  
    


 


Income before income taxes

     155,278       130,742  

Income taxes

     42,491       43,177  
    


 


Net income

   $ 112,787     $ 87,565  
    


 


Weighted average shares outstanding-diluted

     67,050       66,336  
    


 


Diluted earnings per share

   $ 1.68     $ 1.32  
    


 


 

Management analyzes its business based on franchising revenues, which is total revenues excluding marketing and reservation revenues and hotel operations, and franchise operating expenses that are reflected as selling, general and administrative expenses.

 

Franchising Revenues: Franchising revenues were $262.1 million for the year ended December 31, 2006 compared to $230.0 million for the year ended December 31, 2005. The growth in franchising revenues is primarily due to increases in royalty revenues and initial and relicensing fees and other revenues of approximately 13%, 17% and 78%, respectively.

 

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Domestic royalty fees increased $19.1 million to $195.5 million from $176.4 million in 2005, an increase of 10.8%. Excluding the franchises obtained in the September 28, 2005 acquisition of Suburban, the increase in royalties is attributable to a combination of factors including a 3.3% increase in the number of domestic franchised hotel rooms, a 6.1% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system to 4.10% from 4.08%. System-wide RevPAR increases resulted primarily from an average daily rate (“ADR”) increase of 5.2% from the prior year. The acquisition of Suburban contributed approximately $3.0 million of royalty fees for the twelve months ending December 31, 2006 compared to $0.7 million for the year ended December 31, 2005.

 

A summary of the Company’s domestic franchised hotels operating information is as follows:

 

    2006

  2005

  Change

 
    Average
Daily Rate


  Occupancy

    RevPAR

  Average
Daily Rate


  Occupancy

    RevPAR

  Average
Daily Rate


    Occupancy

  RevPAR

 

Comfort Inn

  $ 73.08   63.0 %   $ 46.06   $ 68.84   61.7 %   $ 42.45   6.2 %   130 bps   8.5 %

Comfort Suites

    82.93   67.0 %     55.59     77.51   66.3 %     51.36   7.0 %   70 bps   8.2 %

Sleep

    66.44   62.4 %     41.43     62.52   61.0 %     38.16   6.3 %   140 bps   8.6 %
   

 

 

 

 

 

 

 
 

Midscale without Food & Beverage

    74.18   63.7 %     47.26     69.68   62.4 %     43.51   6.5 %   130 bps   8.6 %
   

 

 

 

 

 

 

 
 

Quality

    66.89   55.3 %     37.01     64.86   54.6 %     35.41   3.1 %   70 bps   4.5 %

Clarion

    78.98   51.2 %     40.41     74.62   52.5 %     39.15   5.8 %   -130 bps   3.2 %
   

 

 

 

 

 

 

 
 

Midscale with Food & Beverage

    69.76   54.3 %     37.87     67.41   54.0 %     36.41   3.5 %   30 bps   4.0 %
   

 

 

 

 

 

 

 
 

Econo Lodge

    53.09   47.7 %     25.31     50.95   48.2 %     24.56   4.2 %   -50 bps   3.1 %

Rodeway

    51.66   45.8 %     23.66     49.91   46.7 %     23.31   3.5 %   -90 bps   1.5 %
   

 

 

 

 

 

 

 
 

Economy

    52.83   47.3 %     24.99     50.78   48.0 %     24.35   4.0 %   -70 bps   2.6 %
   

 

 

 

 

 

 

 
 

MainStay

    67.26   69.4 %     46.66     64.76   65.7 %     42.54   3.9 %   370 bps   9.7 %
   

 

 

 

 

 

 

 
 

Total Domestic System*

  $ 69.71   58.0 %   $ 40.46   $ 66.24   57.6 %   $ 38.15   5.2 %   40 bps   6.1 %
   

 

 

 

 

 

 

 
 


*   Amounts exclude Suburban activity from 2006 because full year comparable pre-acquisition data for 2005 is not available.

 

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Including franchises acquired from Suburban, the number of domestic rooms on-line increased to 339,441 as of December 31, 2006 from 329,353 as of December 31, 2005, an increase of 3.1%. The total number of domestic hotels on-line grew 4.0% to 4,211 as of December 31, 2006 from 4,048 as of December 31, 2005. A summary of the domestic hotels and rooms on-line at December 31, 2006 and December 31, 2005 by brand is as follows:

 

    

December 31,

2006


  

December 31,

2005


   Variance

 
     Hotels

   Rooms

   Hotels

   Rooms

   Hotels

    %

    Rooms

    %

 

Comfort Inn

   1,415    110,877    1,428    111,598    (13 )   (0.9 )%   (721 )   (0.6 )%

Comfort Suites

   433    33,976    411    32,251    22     5.4 %   1,725     5.3 %

Sleep

   327    24,575    319    24,205    8     2.5 %   370     1.5 %
    
  
  
  
  

 

 

 

Midscale without Food & Beverage

   2,175    169,428    2,158    168,054    17     0.8 %   1,374     0.8 %
    
  
  
  
  

 

 

 

Quality

   736    72,054    660    66,316    76     11.5 %   5,738     8.7 %

Clarion

   162    23,945    153    23,554    9     5.9 %   391     1.7 %
    
  
  
  
  

 

 

 

Midscale with Food & Beverage

   898    95,999    813    89,870    85     10.5 %   6,129     6.8 %
    
  
  
  
  

 

 

 

Econo Lodge

   816    49,679    805    49,763    11     1.4 %   (84 )   (0.2 )%

Rodeway

   233    14,168    180    11,051    53     29.4 %   3,117     28.2 %
    
  
  
  
  

 

 

 

Economy

   1,049    63,847    985    60,814    64     6.5 %   3,033     5.0 %
    
  
  
  
  

 

 

 

MainStay

   29    2,183    27    2,047    2     7.4 %   136     6.6 %

Suburban

   60    7,984    65    8,568    (5 )   (7.7 )%   (584 )   (6.8 )%
    
  
  
  
  

 

 

 

Extended Stay

   89    10,167    92    10,615    (3 )   (3.3 )%   (448 )   (4.2 )%
    
  
  
  
  

 

 

 

Total Domestic Franchises

   4,211    339,441    4,048    329,353    163     4.0 %   10,088     3.1 %
    
  
  
  
  

 

 

 

 

International rooms on-line increased to 97,944 as of December 31, 2006 from 97,703 as of December 31, 2005, a 0.2% increase. The total number of international hotels on-line increased from 1,162 as of December 31, 2005 to 1,165 as of December 31, 2006.

 

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As of December 31, 2006, the Company had 860 franchised hotels with 66,238 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 603 hotels and 46,464 rooms at December 31, 2005. The number of new construction franchised hotels in the Company’s domestic pipeline increased 46% to 602 at December 31, 2006 from 413 at December 31, 2005. The Company had an additional 70 franchised hotels with 6,317 rooms under development in its international system as of December 31, 2006 compared to 84 hotels and 7,611 rooms at December 31, 2005. While the Company’s hotel pipeline provides a strong platform for growth, a hotel in the pipeline does not always result in an open and operating hotel due to various factors. A summary of the domestic franchised hotels under construction, awaiting conversion or approved for development at December 31, 2006 and December 31, 2005 by brand is as follows:

 

 

    December 31, 2006

  December 31, 2005

  Variance

 
    Conversion

 

New

Construction


  Total

  Conversion

  New
Construction


  Total

  Conversion

    New
Construction


    Total

 
                Units

    %

    Units

    %

    Units

    %

 

Comfort Inn

  56   124   180   41   85   126   15     37 %   39     46 %   54     43 %

Comfort Suites

  3   233   236   2   165   167   1     50 %   68     41 %   69     41 %

Sleep

  —     123   123   1   88   89   (1 )   -100 %   35     40 %   34     38 %
   
 
 
 
 
 
 

 

 

 

 

 

Midscale without Food & Beverage

  59   480   539   44   338   382   15     34 %   142     42 %   157     41 %
   
 
 
 
 
 
 

 

 

 

 

 

Quality

  76   10   86   54   12   66   22     41 %   (2 )   -17 %   20     30 %

Clarion

  11   4   15   13   4   17   (2 )   -15 %   —       0 %   (2 )   -12 %
   
 
 
 
 
 
 

 

 

 

 

 

Midscale with Food & Beverage

  87   14   101   67   16   83   20     30 %   (2 )   -13 %   18     22 %
   
 
 
 
 
 
 

 

 

 

 

 

Econo Lodge

  41   5   46   41   9   50   —       0 %   (4 )   -44 %   (4 )   -8 %

Rodeway

  66   3   69   35   —     35   31     89 %   3     NM     34     97 %
   
 
 
 
 
 
 

 

 

 

 

 

Economy

  107   8   115   76   9   85   31     41 %   (1 )   -11 %   30     35 %
   
 
 
 
 
 
 

 

 

 

 

 

MainStay

  —     33   33   1   29   30   (1 )   -100 %   4     14 %   3     10 %

Suburban

  5   24   29   2   9   11   3     150 %   15     167 %   18     164 %
   
 
 
 
 
 
 

 

 

 

 

 

Extended Stay

  5   57   62   3   38   41   2     67 %   19     50 %   21     51 %
   
 
 
 
 
 
 

 

 

 

 

 

Cambria Suites

  —     43   43   —     12   12   —       NM     31     258 %   31     258 %
   
 
 
 
 
 
 

 

 

 

 

 

    258   602   860   190   413   603   68     36 %   189     46 %   257     43 %
   
 
 
 
 
 
 

 

 

 

 

 

 

Excluding the acquisition of Suburban on September 28, 2005, net domestic franchise additions during 2006 increased 14 units to 163 compared to 149 for the same period a year ago. Gross domestic franchise additions increased from 339 for 2005 to 381 for 2006. Net franchise terminations increased to 218 for 2006 from 190 in 2005. During 2006, the Company has continued to execute its strategy to replace franchised hotels that do not meet our brand standards or are underperforming in their market. As the competition gets stronger and more focused on limited service franchising, the Company will continue to focus on improving its system hotels and utilizing the domestic hotels under development as a strong platform for continued system growth.

 

International royalties increased $5.2 million or 47% from $11.0 million in 2005 to $16.2 million in 2006 primarily due to the commencement of royalty payments by over 300 properties in continental Europe under our master franchise agreement with CHE. Prior to January 1, 2006, only reservation fees were assessed to the properties in CHE’s portfolio. Beginning in January 2006, the Company began to assess royalty and marketing fees in addition to the reservation fees.

 

Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed domestic franchise agreements increased 18.5% to $17.9 million for 2006 from $15.1 million for 2005. The increased revenues primarily reflect increased sales of our new construction brands, most notably our Cambria Suites and Comfort Suites offerings, which carry a higher average initial fee than our other brands. New

 

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domestic franchise agreements executed in 2006 totaled 720 representing 57,365 rooms compared to 639 agreements representing 52,862 rooms executed in 2005. During 2006, 288 of the executed agreements were for new construction hotel franchises, representing 22,035 rooms, compared to 237 contracts, representing 18,096 rooms for the same period a year ago, both increases of approximately 22%. The growth in conversion hotel franchise executed contracts increased 7% from 402 for 2005 to 432 for 2006. During 2006, the Company executed 30 new franchise agreements for its Cambria Suites brand bringing the total contracts executed since its launch in January 2005 to 43.

 

A summary of executed domestic franchise agreements by brand for 2006 and 2005 is as follows:

 

    2006

  2005

  % Change

 
    New
Construction


  Conversion

  Total

  New
Construction


  Conversion

  Total

  New
Construction


    Conversion

    Total

 

Comfort Inn

  67   65   132   53   56   109   26 %   16 %   21 %

Comfort Suites

  98   3   101   89   5   94   10 %   (40 )%   7 %

Sleep

  58   1   59   55   2   57   5 %   (50 )%   4 %
   
 
 
 
 
 
 

 

 

Midscale without Food & Beverage

  223   69   292   197   63   260   13 %   10 %   12 %
   
 
 
 
 
 
 

 

 

Quality

  6   143   149   5   148   153   20 %   (3 )%   (3 )%

Clarion

  2   26   28   4   31   35   (50 )%   (16 )%   (20 )%
   
 
 
 
 
 
 

 

 

Midscale with Food & Beverage

  8   169   177   9   179   188   (11 )%   (6 )%   (6 )%
   
 
 
 
 
 
 

 

 

Econo Lodge

  1   80   81   4   85   89   (75 )%   (6 )%   (9 )%

Rodeway

  3   105   108   —     75   75   NM     40 %   44 %
   
 
 
 
 
 
 

 

 

Economy

  4   185   189   4   160   164   0 %   16 %   15 %
   
 
 
 
 
 
 

 

 

MainStay

  9   1   10   14   —     14   (36 )%   NM     (29 )%

Suburban

  14   8   22   —     —     —     NM     NM     NM  
   
 
 
 
 
 
 

 

 

Extended Stay

  23   9   32   14   —     14   64 %   NM     129 %
   
 
 
 
 
 
 

 

 

Cambria Suites

  30   —     30   13   —     13   131 %   NM     131 %
   
 
 
 
 
 
 

 

 

Total Domestic System

  288   432   720   237   402   639   22 %   7 %   13 %
   
 
 
 
 
 
 

 

 

 

Relicensing fees increased 14% to $11.7 million for the year ended December 31, 2006 from $10.3 million for the year ended December 31, 2005. Relicensing fees are charged to the new property owner of a franchised property whenever an ownership change occurs and the property remains in the franchise system. During 2006, relicensings increased 14% from 332 in 2005 to 378 for 2006.

 

Other income increased $3.0 million to $6.9 million for the year ended December 31, 2006 primarily due to an increase in liquidated damage collections related to the early termination of franchise agreements.

 

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were $87.1 million for 2006, an increase of $8.9 million from the 2005 total of $78.2 million. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 33.2% for 2006 compared to 34.0% for 2005. Expenses increased primarily due to higher compensation costs related to stock compensation, variable franchise sales compensation, the launch of the Company’s Cambria Suites brand and the acquisition of Suburban. Despite the increase in expenses, SG&A as a percentage of franchise revenues declined since our variable overhead costs associated with franchise system growth have historically been less than incremental royalty fees generated from new franchises.

 

Depreciation and Amortization: Expenses increased $0.6 million to $9.7 million for 2006 primarily due to the acceleration of depreciation resulting from the renovation and replacement of furniture, fixtures and equipment at two of the Company-owned Mainstay Suites during the second quarter.

 

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Marketing and Reservations: The Company’s franchise agreements require the payment of franchise fees, which include marketing and reservation fees. The fees, which are based on a percentage of the franchisees’ gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing and media advertising. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated.

 

Total marketing and reservations revenues were $278.0 million and $243.1 million for 2006 and 2005, respectively. Depreciation and amortization attributable to marketing and reservation activities was $7.9 million and $7.6 million for the years ended December 31, 2006 and 2005, respectively. Interest expense attributable to reservation activities was $0.9 million and $1.1 million for 2006 and 2005, respectively. Marketing and reservation activities provided positive cash flow of $19.0 million and $19.4 million for the years ended December 31, 2006 and 2005, respectively. As of December 31, 2006 and 2005, the Company’s balance sheet includes a receivable of $6.7 million and $13.2 million, respectively resulting from cumulative marketing expenses incurred in excess of cumulative marketing fee revenues earned. These receivables are recorded as an asset in the financial statements as the Company has the contractual authority to require that the franchisees in the system at any given point repay the Company for any deficits related to marketing and reservations activities. The Company’s current franchisees are legally obligated to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue. The Company has no present intention to accelerate repayment of the deficit from current franchisees. A payable has been recorded in the Company’s balance sheet within other long-term liabilities related to cumulative reservation fee revenues received in excess of reservation fee expenses incurred totaling $8.4 million and $3.6 million at December 31, 2006 and 2005, respectively. Cumulative reservation and marketing fees not expended are recorded as a payable in the financial statements and are carried over to the next fiscal year and expended in accordance with the franchise agreements.

 

Other Income and Expenses, Net: Other income and expenses, net, declined $1.7 million to an expense of $11.3 million for 2006 from $13.0 million for 2005. This decline resulted primarily from a reduction in interest expense from $15.3 million to $14.1 million and a $0.9 million increase in interest income and the appreciation of investments held in the non-qualified employee benefit plans. Interest expense declined due to lower outstanding borrowings on the Company’s variable rate debt offset by higher average interest rates. The Company’s weighted average interest rate as of December 31, 2006 was 6.59% compared to 5.96% as of December 31, 2005. The increase in investment income and decline in interest expense was offset by a loss on extinguishment of debt of $0.3 million attributable to the refinancing of our senior credit facility during the second quarter of 2006 and a $0.4 million gain on sale of investments in the third quarter of 2005.

 

Income Taxes: The Company’s effective income tax provision rate was 27.4% for 2006, compared to the effective income tax provision rate of 33.0% for 2005. The effective income tax rate declined 560 bps primarily due to the resolution of provisions for income tax contingencies totaling approximately $12.8 million as well as an increase in the proportion of foreign income earned over the prior year period, which is taxed at lower rates than statutory federal income tax rates. The effective income tax rate for 2005 also includes additional tax expense of approximately $1.2 million related to the Company’s repatriation of foreign earnings and a reduction of income tax expense related to the resolution of certain tax contingencies of approximately $4.9 million. Depending upon the outcome of certain income tax contingencies during 2007 up to $2.0 million of additional income tax benefits may be reflected in our 2007 results of operations from the resolution of tax contingency reserves.

 

Net income for 2006 increased by 28.8% to $112.8 million, and diluted earnings per share increased 27% to $1.68 for 2006 from $1.32 reported for 2005.

 

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Table of Contents

Comparison of 2005 Operating Results and 2004 Operating Results

 

The Company recorded net income of $87.6 million for the year ended December 31, 2005, an increase of $13.3 million, or 18% from $74.3 million for the year ended December 31, 2004. The increase in net income for the year is primarily attributable to an $18.8 million improvement in operating income and a decline in the effective income tax rate from 35.1% to 33.0% partially offset by a $2.5 million expense increase in other income and expenses. The effective income tax rate declined primarily due to the resolution of tax contingencies of approximately $4.9 million in 2005 compared to $1.2 million in 2004 offset by additional income tax expense of $1.2 million in 2005 related to the Company’s repatriation of foreign earnings. The increase in net other income and expenses related to a $3.7 million increase in interest expense offset by the loss on extinguishment of debt of $0.7 million incurred during 2004. Operating income increased as a result of a $26.2 million, or 12.9% increase in franchising revenues (total revenues excluding marketing and reservation revenues and hotel operations) and decrease in depreciation and amortization expense partially offset by an $8.7 million or 12.5% increase in selling, general and administrative expense.

 

Summarized financial results for the years ended December 31, 2005 and 2004 are as follows:

 

     2005

    2004

 
     (In thousands)  

REVENUES:

                

Royalty fees

   $ 187,340     $ 167,135  

Initial franchise and relicensing fees

     25,388       20,112  

Brand solutions

     13,382       12,524  

Marketing and reservation

     243,123       220,732  

Hotel operations

     4,293       3,729  

Other

     3,873       3,976  
    


 


Total revenues

     477,399       428,208  
    


 


OPERATING EXPENSES:

                

Selling, general and administrative

     78,250       69,542  

Depreciation and amortization

     9,051       9,947  

Marketing and reservation

     243,123       220,732  

Hotel operations

     3,225       3,004  
    


 


Total operating expenses

     333,649       303,225  
    


 


Operating income

     143,750       124,983  
    


 


Interest expense

     15,325       11,605  

Interest and other investment income

     (1,094 )     (1,110 )

Equity in net income of affiliates

     (803 )     (722 )

Loss on extinguishment of debt

     —         696  

Other

     (420 )     (10 )
    


 


Other income and expenses, net

     13,008       10,459  
    


 


Income before income taxes

     130,742       114,524  

Income taxes

     43,177       40,179  
    


 


Net income

   $ 87,565     $ 74,345  
    


 


Weighted average shares outstanding-diluted

     66,336       69,000  
    


 


Diluted earnings per share

   $ 1.32     $ 1.08  
    


 


 

Franchising Revenues: Franchising revenues were $230.0 million for the year ended December 31, 2005 compared to $203.7 million for the year ended December 31, 2004. The growth in franchising revenues is primarily due to increases in royalty revenues and initial and relicensing fees of approximately 12% and 26%, respectively.

 

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Table of Contents

Domestic royalty fees increased $19.3 million to $176.4 million from $157.1 million in 2004, an increase of 12.3%. Excluding the franchises obtained in the acquisition of Suburban, the increase in royalties is attributable to a combination of factors including a 3.6% increase in the number of domestic franchised hotel rooms, a 6.1% increase in RevPAR and an increase in the effective royalty rate of the domestic hotel system to 4.08% from 4.04%. System-wide RevPAR increases resulted primarily from a 4.2% increase in the average daily rate achieved compared to the prior year. The acquisition of Suburban contributed approximately $0.7 million of royalty fees in 2005.

 

A summary of the Company’s domestic franchised hotels operating information is as follows:

 

    2005

  2004

  Change

 
    Average
Daily Rate


  Occupancy

    RevPAR

 

Average

Daily Rate


  Occupancy

    RevPAR

  Average
Daily Rate


    Occupancy

  RevPAR

 

Comfort Inn

  $ 68.84   61.7 %   $ 42.45   $ 65.53   60.1 %   $ 39.37   5.1 %   160 bps   7.8 %

Comfort Suites

    77.51   66.3 %     51.36     73.68   64.1 %     47.26   5.2 %   220 bps   8.7 %

Sleep

    62.52   61.0 %     38.16     59.50   59.5 %     35.42   5.1 %   150 bps   7.7 %
   

 

 

 

 

 

 

 
 

Midscale without Food & Beverage

    69.68   62.4 %     43.51     66.24   60.7 %     40.23   5.2 %   170 bps   8.2 %
   

 

 

 

 

 

 

 
 

Quality

    64.86   54.6 %     35.41     63.62   54.1 %     34.41   1.9 %   50 bps   2.9 %

Clarion

    74.62   52.5 %     39.15     72.37   51.1 %     36.97   3.1 %   140 bps   5.9 %
   

 

 

 

 

 

 

 
 

Midscale with Food & Beverage

    67.41   54.0 %     36.41     66.05   53.2 %     35.15   2.1 %   80 bps   3.6 %
   

 

 

 

 

 

 

 
 

Econo Lodge

    50.95   48.2 %     24.56     48.92   48.2 %     23.57   4.1 %   0 bps   4.2 %

Rodeway

    49.91   46.7 %     23.31     52.33   48.7 %     25.49   (4.6 )%   -200 bps   (8.6 )%
   

 

 

 

 

 

 

 
 

Economy

    50.78   48.0 %     24.35     49.54   48.3 %     23.91   2.5 %   -30 bps   1.8 %
   

 

 

 

 

 

 

 
 

MainStay

    64.76   65.7 %     42.54     61.09   62.2 %     37.97   6.0 %   350 bps   12.0 %
   

 

 

 

 

 

 

 
 

Total Domestic System*

  $ 66.24   57.6 %   $ 38.15   $ 63.56   56.6 %   $ 35.95   4.2 %   100 bps   6.1 %
   

 

 

 

 

 

 

 
 


*   Amounts exclude Suburban activity from 2005 because comparable pre-acquisition data for 2004 is not available.

 

Including franchises acquired from Suburban, the number of domestic rooms on-line increased to 329,353 as of December 31, 2005 from 309,586 as of December 31, 2004, an increase of 6.4%. The total number of domestic hotels on-line grew 5.6% to 4,048 as of December 31, 2005 from 3,834 as of December 31, 2004. A summary of the domestic hotels and rooms on-line at December 31, 2005 and December 31, 2004 by brand is as follows:

 

     December 31,
2005


   December 31,
2004


   Variance

 
     Hotels

   Rooms

   Hotels

   Rooms

   Hotels

    %

    Rooms

    %

 

Comfort Inn

   1,428    111,598    1,432    112,325    (4 )   (0.3 )%   (727 )   (0.6 )%

Comfort Suites

   411    32,251    389    30,682    22     5.7 %   1,569     5.1 %

Sleep

   319    24,205    311    23,766    8     2.6 %   439     1.8 %
    
  
  
  
  

 

 

 

Midscale without Food & Beverage

   2,158    168,054    2,132    166,773    26     1.2 %   1,281     0.8 %
    
  
  
  
  

 

 

 

Quality

   660    66,316    576    58,785    84     14.6 %   7,531     12.8 %

Clarion

   153    23,554    158    23,652    (5 )   (3.2 )%   (98 )   (0.4 )%
    
  
  
  
  

 

 

 

Midscale with Food & Beverage

   813    89,870    734    82,437    79     10.8 %   7,433     9.0 %
    
  
  
  
  

 

 

 

Econo Lodge

   805    49,763    781    48,301    24     3.1 %   1,462     3.0 %

Rodeway

   180    11,051    160    9,925    20     12.5 %   1,126     11.3 %
    
  
  
  
  

 

 

 

Economy

   985    60,814    941    58,226    44     4.7 %   2,588     4.4 %
    
  
  
  
  

 

 

 

MainStay

   27    2,047    27    2,150    —       0.0 %   (103 )   (4.8 )%

Suburban

   65    8,568    —      —      65     NM     8,568     NM  
    
  
  
  
  

 

 

 

Extended Stay

   92    10,615    27    2,150    65     241 %   8,465     394 %
    
  
  
  
  

 

 

 

Total Domestic Franchises

   4,048    329,353    3,834    309,586    214     5.6 %   19,767     6.4 %
    
  
  
  
  

 

 

 

 

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Table of Contents

International rooms on-line increased to 97,703 as of December 31, 2005 from 94,220 as of December 31, 2004, a 3.7% increase. The total number of international hotels on-line increased from 1,143 as of December 31, 2004 to 1,162 as of December 31, 2005.

 

As of December 31, 2005, the Company had 603 franchised hotels with 46,464 rooms under construction, awaiting conversion or approved for development in its domestic system as compared to 460 hotels and 35,652 rooms at December 31, 2004. The number of new construction franchised hotels in the Company’s domestic pipeline increased 45% to 413 at December 31, 2005 from 284 at December 31, 2004. The Company had an additional 84 franchised hotels with 7,611 rooms under development in its international system as of December 31, 2005 compared to 109 hotels and 9,515 rooms at December 31, 2004. While the Company’s hotel pipeline provides a strong platform for growth, a hotel in the pipeline does not always result in an open and operating hotel due to various factors. A summary of the domestic franchised hotels under construction, awaiting conversion or approved for development at December 31, 2005 and December 31, 2004 by brand is as follows:

 

    December 31, 2005

  December 31, 2004

  Variance

 
    Conversion

  New
Construction


  Total

  Conversion

  New
Construction


  Total

  Conversion

    New
Construction


    Total

 
                Units

    %

    Units

    %

    Units

    %

 

Comfort Inn

  41   85   126   44   51   95   (3 )   (7 )%   34     67 %   31     33 %

Comfort Suites

  2   165   167   —     128   128   2     NM     37     29 %   39     30 %

Sleep

  1   88   89   —     51   51   1     NM     37     73 %   38     75 %
   
 
 
 
 
 
 

 

 

 

 

 

Midscale without Food & Beverage

  44   338   382   44   230   274   —       0 %   108     47 %   108     39 %
   
 
 
 
 
 
 

 

 

 

 

 

Quality

  54   12   66   55   16   71   (1 )   (2 )%   (4 )   (25 )%   (5 )   (7 )%

Clarion

  13   4   17   7   3   10   6     86 %   1     33 %   7     70 %
   
 
 
 
 
 
 

 

 

 

 

 

Midscale with Food & Beverage

  67   16   83   62   19   81   5     8 %   (3 )   (16 )%   2     2 %
   
 
 
 
 
 
 

 

 

 

 

 

Econo Lodge

  41   9   50   50   10   60   (9 )   (18 )%   (1 )   (10 )%   (10 )   (17 )%

Rodeway

  35   —     35   19   2   21   16     84 %   (2 )   (100 )%   14     67 %
   
 
 
 
 
 
 

 

 

 

 

 

Economy

  76   9   85   69   12   81   7     10 %   (3 )   (25 )%   4     5 %
   
 
 
 
 
 
 

 

 

 

 

 

MainStay

  1   29   30   1   23   24   —       0 %   6     26 %   6     25 %

Suburban

  2   9   11   —     —     —     2     NM     9     NM     11     NM  
   
 
 
 
 
 
 

 

 

 

 

 

Extended Stay

  3   38   41   1   23   24   2     200 %   15     65 %   17     71 %
   
 
 
 
 
 
 

 

 

 

 

 

Cambria Suites

  —     12   12   —     —     —     —       —       12     NM     12     NM  
   
 
 
 
 
 
 

 

 

 

 

 

    190   413   603   176   284   460   14     8 %   129     45 %   143     31 %
   
 
 
 
 
 
 

 

 

 

 

 

 

Net domestic franchise additions during 2005 were 214 compared to 198 for the same period a year ago. Excluding the acquisition of Suburban, net franchise additions totaled 149. Net domestic franchise additions, excluding Suburban, declined as a result of franchise terminations increasing from 144 in 2004 to 190 in 2005. During 2005, the Company executed a strategy to replace franchised hotels that did not meet our brand standards or were underperforming in their market.

 

Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise agreements increased 13.5% to $15.1 million for the year ended December 31, 2005 from $13.3 million for the year ended December 31, 2004. The increase reflects domestic franchise agreements executed in 2005 of 639 new contracts representing 52,862 rooms compared to 552 agreements representing 47,227 rooms executed in 2004, increases of 16% and 12%, respectively. During 2005, 237 of the executed agreements were for new construction hotel franchises, representing 18,096 rooms, compared to 182 contracts, representing 12,799 rooms for the same period a year ago, increases of approximately 30% and 41%, respectively.

 

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A summary of executed domestic franchise agreements by brand for 2005 and 2004 is as follows:

 

    2005

  2004

  % Change

 
    New
Construction


  Conversion

  Total

  New
Construction


  Conversion

  Total

 

New

Construction


    Conversion

    Total

 

Comfort Inn

  53   56   109   38   71   109   39 %   (21 )%   0 %

Comfort Suites

  89   5   94   79   5   84   13 %   0 %   12 %

Sleep

  55   2   57   33   —     33   67 %   NM     73 %
   
 
 
 
 
 
 

 

 

Midscale without Food & Beverage

  197   63   260   150   76   226   31 %   (17 )%   15 %
   
 
 
 
 
 
 

 

 

Quality

  5   148   153   8   133   141   (38 )%   11 %   9 %

Clarion

  4   31   35   2   28   30   100 %   11 %   17 %
   
 
 
 
 
 
 

 

 

Midscale with Food & Beverage

  9   179   188   10   161   171   (10 )%   11 %   10 %
   
 
 
 
 
 
 

 

 

Econo Lodge

  4   85   89   4   97   101   0 %   (12 )%   (12 )%

Rodeway

  —     75   75   2   35   37   (100 )%   114 %   103 %
   
 
 
 
 
 
 

 

 

Economy

  4   160   164   6   132   138   (33 )%   21 %   19 %
   
 
 
 
 
 
 

 

 

MainStay

  14   —     14   16   1   17   (13 )%   (100 )%   (18 )%

Suburban

  —     —     —     —     —     —     —       —       —    
   
 
 
 
 
 
 

 

 

Extended Stay

  14   —     14   16   1   17   (13 )%   (100 )%   (18 )%
   
 
 
 
 
 
 

 

 

Cambria Suites

  13   —     13   —     —     —     NM     NM     NM  
   
 
 
 
 
 
 

 

 

Total Domestic System

  237   402   639   182   370   552   30 %   9 %   16 %
   
 
 
 
 
 
 

 

 

 

Relicensing fees increased 51.5% to $10.3 million for the year ended December 31, 2005 from $6.8 million for 2004. Relicensing fees are charged to the new property owner of a franchised property whenever an ownership change occurs and the property remains in the franchise system. During 2005, relicensings increased 31% from 254 in 2004 to 332 in 2005.

 

Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative expenses were $78.3 million for the year ended December 31, 2005, an increase of $8.8 million from the year ended December 31, 2004 total of $69.5 million. As a percentage of revenues, excluding marketing and reservation fees and hotel operations, total SG&A expenses were 34.0% for the year ended December 31, 2005 compared to 34.1% for 2004. Expenses increased primarily due to higher compensation costs including variable franchise sales and key management incentive compensation and increased travel and entertainment expenses related to the expansion of the franchise sales force.

 

Marketing and Reservations: The Company’s franchise agreements require the payment of franchise fees, which include marketing and reservation fees. The fees, which are based on a percentage of the franchisees’ gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing and media advertising. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated.

 

Total marketing and reservations revenues were $243.1 million and $220.7 million for the years ended December 31, 2005 and 2004, respectively. Depreciation and amortization attributable to marketing and reservation activities was $7.6 million and $9.1 million for the years ended December 31, 2005 and 2004, respectively. Interest expense attributable to reservation activities was $1.1 million and $1.5 million for the years ended December 31, 2005 and 2004, respectively. Marketing and reservations activities provided positive cash flow of $19.4 million and $19.7 million for the years ended December 31, 2005 and 2004, respectively. As of December 31, 2005, the Company’s balance sheet includes a receivable of $13.2 million for marketing fees and a

 

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payable of $3.6 million for reservation fees. At December 31, 2004, the Company’s balance sheet contained a receivable for marketing and reservation fees of $21.7 million.

 

Other Income and Expenses, Net: Other income and expense, net increased $2.5 million to an expense of $13.0 million for the year ended December 31, 2005 from $10.5 million for the same period in 2004. This increase resulted from a $3.7 million increase in interest expense to $15.3 million for the twelve months ended December 31, 2005 resulting from higher average interest rates and outstanding borrowings on the Company’s variable rate debt. The Company’s weighted average interest rate as of December 31, 2005 was 5.96% compared to 4.58% as of December 31, 2004. The increase in interest expense was partially offset by a loss on extinguishment of debt of approximately $0.7 million attributable to the refinancing of the Company’s senior credit facility during the third quarter of 2004.

 

Income Taxes: The Company’s effective income tax provision rate was 33.0% for the year ended December 31, 2005, a decrease of 210 basis points from the effective income tax provision rate of 35.1% for the year ended December 31, 2004. The effective income tax rate for 2005 declined due to the resolution of certain tax contingencies of approximately $4.9 million offset by additional income tax expense of $1.2 million related to the Company’s repatriation of foreign earnings. The 2004 effective income tax rate reflects the resolution of certain tax contingencies totaling approximately $1.2 million.

 

Net income for 2005 increased by 17.8% to $87.6 million, and diluted earnings per share increased 22.2% to $1.32 in 2005 from $1.08 reported for 2004. A portion of the increase in diluted earnings per share is attributable to stock repurchases made by the Company in 2005 and 2004.

 

Liquidity and Capital Resources

 

Net cash provided by operating activities increased $20.3 million to $153.9 million from $133.6 million for the years ended December 31, 2006 and 2005, respectively. Cash flows from operating activities increased primarily due to improvements in operating income. Operating cash flows for 2005 included $9.9 million of excess tax benefits from stock based compensation. Due to the adoption of SFAS No. 123R on January 1, 2006, these benefits have been reclassified from operating to financing activities during 2006. Were these amounts excluded from operating cash flows for 2005, net cash flow provided by operating activities would have increased by $30.2 million from 2005.

 

The Company revised its presentation of cash flows for all periods presented related to dividends received from equity method investees during the fourth quarter of 2006. The Company had previously presented these cash flows as investing activities on its consolidated statement of cash flows. SFAS No. 95 “Statement of Cash Flows” requires the classification of these dividends, which represent a return on investments, as operating cash flows. There was no effect on any other previously reported income statement or balance sheet amounts.

 

Net cash repayments related to marketing and reservation activities totaled $19.0 million during 2006 compared to repayments of $19.4 million during the year ended December 31, 2005. The Company expects marketing and reservation activities to generate positive cash flows of between $3.5 million and $5.0 million in 2007.

 

Cash used in investing activities for the years ended December 31, 2006, 2005 and 2004 was $17.3 million, $24.5 million and $14.5 million, respectively. During 2005, investing cash flows for 2005 included the payment of $7.3 million related to the Company’s acquisition of Suburban. As a lodging franchisor, the Company has relatively low capital expenditure requirements. During the years ended December 31, 2006, 2005 and 2004, capital expenditures totaled $7.7 million, $11.5 million, and $6.9 million, respectively. Capital expenditures include the renovations of the Company’s three owned Mainstay Suites, installation and upgrades of system-wide

 

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property and yield management systems and upgrades to disaster recovery hardware and financial and reservation systems.

 

Financing cash flows relate primarily to the Company’s borrowings under its credit lines, treasury stock purchases and dividends. On June 16, 2006, the Company entered into a $350 million senior unsecured revolving credit agreement (the “Revolver”), with a syndicate of lenders. The proceeds from the Revolver were used to refinance and terminate a previous senior credit facility (the “Old Credit Facility”). The Revolver allows the Company to borrow, repay and reborrow revolving loans up to $350 million (which includes swingline loans for up to $20 million and standby letters of credit up to $30 million) until the scheduled maturity date of June 16, 2011. The Company has the ability to request an increase in available borrowings under the Revolver by an additional amount of up to $150 million by obtaining the agreement of the existing lenders to increase their lending commitments or by adding additional lenders. The rate of interest generally applicable for revolving loans under the Revolver are, at the Company’s option, equal to either (i) the greater of the prime rate or the federal funds effective rate plus 50 basis points, or (ii) an adjusted LIBOR rate plus a margin between 22 and 70 basis points based on the Company’s credit rating. The Revolver requires the company to pay a quarterly facility fee, based upon the credit rating of the Company, at a rate between 8 and 17 1/2 basis points, on the full amount of the commitment (regardless of usage). The Revolver also requires the payment of a quarterly usage fee, based upon the credit rating of the Company, at a rate between 10 and 12 1/2 basis points, on the amount outstanding under the commitment, at all times when the amount borrowed under the Revolver exceeds 50% of the total commitment. The Revolver includes customary financial and other covenants that require the maintenance of certain ratios including maximum leverage and interest coverage. At December 31, 2006, the Company was in compliance with all covenants under the Revolver. The Revolver also restricts the Company’s ability to make certain investments, incur certain debt, and dispose of assets, among other restrictions. As of December 31, 2006, the Company had $72.2 million of revolving loans outstanding pursuant to the Revolver.

 

The proceeds from the Revolver are used for general corporate purposes, including working capital, debt repayment, stock repurchases, dividends and investments.

 

In 1998, the Company completed a $100 million senior unsecured note offering (“the Senior Notes”), bearing a coupon rate of 7.13% with an effective rate of 7.22%. The Senior Notes will mature on May 1, 2008, with interest 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 previous credit facility. The Senior Notes contain a call provision that would require the Company to pay a premium if the Senior Notes were redeemed prior to their maturity. At December 31, 2006, the call provision would have resulted in a premium of $2.5 million.

 

Effective July 14, 2006, the Company’s Senior Notes are guaranteed jointly, severally, fully and unconditionally by 7 wholly-owned domestic subsidiaries. There are no legal or regulatory restrictions on the payment of dividends to Choice Hotels International, Inc. from subsidiaries that do not guarantee the Senior Notes.

 

The Company has a line of credit with a bank providing up to an aggregate of $10 million of borrowings which is due upon demand. The line of credit ranks pari-pasu (or equally) with the Revolver. Borrowings under the line of credit bear interest at rates established at the time of the borrowings based on prime minus 175 basis points.

 

As of December 31, 2006, no amounts were outstanding pursuant to this line of credit.

 

The Company also has a note with an outstanding balance at December 31, 2006 of $0.4 million and bears interest based on seventy percent of prime. The loan requires monthly principal and interest payments and has a maturity date of January 1, 2009.

 

As of December 31, 2006, the total debt outstanding for the Company was $172.5 million, of which $0.1 million was scheduled to mature in the twelve months ending December 31, 2007.

 

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Through December 31, 2006, the Company had purchased 33.6 million shares (including 33.0 million prior to the two-for-one stock split) of its common stock under its share repurchase program at a total cost of $711.9 million. Considering the effect of the two-for-one stock split in October 2005, the Company has repurchased 66.6 million shares at an average price of $10.69 per share. The Company did not purchase any shares under its repurchase program during 2006. At December 31, 2006, the Company had approximately 66.4 million shares of common stock outstanding and had remaining authorization to purchase up to 5.1 million shares. Subsequent to December 31, 2006 through February 28, 2007, the Company had repurchased an additional 0.2 million shares of its common stock at a total cost of $7.1 million.

 

In September 2004, the Company’s board of directors increased the quarterly dividend rate to $0.1125, a 12.5% increase from the previous quarterly rate of $0.10. Dividends paid in 2004 were approximately $27.7 million. In September 2005, the Company’s board of directors increased the quarterly dividend rate to $0.13, or a 15.6% increase from the previously quarterly rate of $0.1125. This increase raised the annual dividend rate on the Company’s common stock from $0.45 to $0.52 per share. Dividends paid in 2005 were approximately $30.2 million. In 2006, the Company’s board of directors again increased the quarterly dividend rate to $0.15, a 15.4% increase from the previous quarterly rate of $0.13. This increase raises the annual dividend rate on the Company’s common stock from $0.52 to $0.60 per share. Dividends paid in 2006 were approximately $35.4 million. Based on our present dividend rate and outstanding share count, aggregate annual dividends for 2007 would be approximately $39.6 million.

 

The Company expects to continue to return value to its shareholders through a combination of dividends and share repurchases, subject to market and other conditions.

 

In the first quarter of 2007, certain executive officers separated from the Company. As a result of these separations, the Company will recognize approximately $4.5 million in termination benefits in the consolidated statement of income during 2007. In addition, deferred compensation and retirement obligations totaling approximately $1.7 million included as non-current liabilities in the Company’s consolidated balance sheets will be remitted during 2007.

 

The following table summarizes our contractual obligations as of December 31, 2006

 

     Payment due by period

Contractual Obligations


   Total

  

Less than

1 year


   1-3 years

   3-5 years

  

More than

5 years


     (in millions)

Long-term debt(1)

   $ 182.1    $ 7.3    $ 102.6    $ 72.2    $ —  

Operating lease obligations

     34.8      5.2      10.0      9.5      10.1

Purchase obligations

     1.3      1.3      —        —        —  

Other long-term liabilities(2)

     53.5      —        18.1      4.5      30.9
    

  

  

  

  

Total contractual cash obligations

   $ 271.7    $ 13.8    $ 130.7    $ 86.2    $ 41.0
    

  

  

  

  


(1)

 

Long-term debt amounts include interest on fixed rate debt obligations.

(2)

 

Subsequent to year end, certain executive officers were terminated from the Company. Other long-term liabilities at December 31, 2006 included deferred compensation and retirement plan obligations owed to these employees totaling approximately $5.4 million that was expected to be remitted to the employees more than 5 years after December 31, 2006. As a result of the terminations, the Company will remit $1.7 million of these obligations in 2007 and $1.7 million, $1.0 million and $1.0 million in the 1-3 years, 3-5 years and more than 5 years after December 31, 2006, respectively.

 

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Contingent cash payments related to the acquisition of Suburban during 2005 have been excluded from the table above since no liabilities have been recorded. However, contingent cash payments, of up to $5 million, may be required upon the satisfaction of the following conditions:

 

 

 

$2.5 million payable if at any time prior to the 3rd anniversary of closing at least 84 Suburban franchises are open or under construction and at least 79 are open on that date;

 

 

 

An additional $2.5 million payable if at any time prior to the 3rd anniversary of closing, but in no event prior to the 2nd anniversary of closing, at least 100 Suburban franchises are open or under construction and at least 90 are open on that date;

 

   

Both contingent payments are subject