10-Q 1 a07-18750_110q.htm 10-Q

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

(Mark one)

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

For the quarterly period ended June 30, 2007

OR

o                                 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 1-3427

HILTON HOTELS CORPORATION

(Exact name of registrant as specified in its charter)

Delaware

 

36-2058176

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

9336 Civic Center Drive,
Beverly Hills, California

 

90210

(Address of principal executive offices)

 

(Zip code)

(310) 278-4321

(Registrant’s telephone number, including area code)

 

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 twelve 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 o

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 o

Non-accelerated filer o

 

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of July 31, 2007—Common Stock, $2.50 par value—390,396,303 shares.

 




PART I—FINANCIAL INFORMATION

Company or group of companies for which report is filed:

HILTON HOTELS CORPORATION AND SUBSIDIARIES

ITEM 1.   FINANCIAL STATEMENTS

Consolidated Statements of Income
(in millions, except per share amounts)

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

    2006    

 

    2007    

 

   2006   

 

   2007   

 

 

 

(unaudited)

 

(unaudited)

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Owned hotels

 

 

$

678

 

 

 

636

 

 

 

1,185

 

 

 

1,207

 

 

Leased hotels

 

 

476

 

 

 

530

 

 

 

665

 

 

 

985

 

 

Management and franchise fees

 

 

174

 

 

 

201

 

 

 

326

 

 

 

377

 

 

Timeshare and other income

 

 

217

 

 

 

181

 

 

 

428

 

 

 

345

 

 

 

 

 

1,545

 

 

 

1,548

 

 

 

2,604

 

 

 

2,914

 

 

Other revenue from managed and franchised properties

 

 

460

 

 

 

537

 

 

 

842

 

 

 

1,035

 

 

 

 

 

2,005

 

 

 

2,085

 

 

 

3,446

 

 

 

3,949

 

 

Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Owned hotels

 

 

475

 

 

 

435

 

 

 

855

 

 

 

864

 

 

Leased hotels

 

 

415

 

 

 

459

 

 

 

584

 

 

 

872

 

 

Depreciation and amortization

 

 

113

 

 

 

106

 

 

 

198

 

 

 

219

 

 

Impairment loss and related costs

 

 

 

 

 

4

 

 

 

 

 

 

4

 

 

Other operating expenses

 

 

173

 

 

 

168

 

 

 

344

 

 

 

325

 

 

Corporate expense

 

 

43

 

 

 

51

 

 

 

87

 

 

 

97

 

 

 

 

 

1,219

 

 

 

1,223

 

 

 

2,068

 

 

 

2,381

 

 

Other expenses from managed and franchised properties

 

 

457

 

 

 

534

 

 

 

833

 

 

 

1,026

 

 

 

 

 

1,676

 

 

 

1,757

 

 

 

2,901

 

 

 

3,407

 

 

Operating income from unconsolidated affiliates

 

 

18

 

 

 

17

 

 

 

28

 

 

 

31

 

 

Operating Income

 

 

347

 

 

 

345

 

 

 

573

 

 

 

573

 

 

Interest and dividend income

 

 

4

 

 

 

8

 

 

 

15

 

 

 

13

 

 

Interest expense

 

 

(139

)

 

 

(102

)

 

 

(235

)

 

 

(218

)

 

Net interest from unconsolidated affiliates and non-controlled interests

 

 

(13

)

 

 

(13

)

 

 

(22

)

 

 

(25

)

 

Net gain (loss) on foreign currency transactions

 

 

8

 

 

 

(6

)

 

 

26

 

 

 

(14

)

 

Net other gain (loss)

 

 

19

 

 

 

(24

)

 

 

23

 

 

 

6

 

 

Loss from non-operating affiliates

 

 

(4

)

 

 

(4

)

 

 

(8

)

 

 

(8

)

 

Income Before Taxes and Minority and Non-Controlled Interests

 

 

222

 

 

 

204

 

 

 

372

 

 

 

327

 

 

Provision for income taxes

 

 

(90

)

 

 

(71

)

 

 

(140

)

 

 

(114

)

 

Minority and non-controlled interests, net

 

 

 

 

 

(2

)

 

 

(2

)

 

 

(4

)

 

Income From Continuing Operations

 

 

132

 

 

 

131

 

 

 

230

 

 

 

209

 

 

Discontinued operations, net of tax

 

 

12

 

 

 

34

 

 

 

18

 

 

 

51

 

 

Net Income

 

 

$

144

 

 

 

165

 

 

 

248

 

 

 

260

 

 

Basic Earnings Per Share(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Continuing operations

 

 

$

.34

 

 

 

.34

 

 

 

.60

 

 

 

.54

 

 

Discontinued operations

 

 

.03

 

 

 

.09

 

 

 

.05

 

 

 

.13

 

 

 

 

 

$

.37

 

 

 

.42

 

 

 

.65

 

 

 

.67

 

 

Diluted Earnings Per Share(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Continuing operations

 

 

$

.32

 

 

 

.32

 

 

 

.56

 

 

 

.51

 

 

Discontinued operations

 

 

.03

 

 

 

.08

 

 

 

.04

 

 

 

.12

 

 

 

 

 

$

.35

 

 

 

.40

 

 

 

.61

 

 

 

.63

 

 


(1)             Total reported EPS in certain periods differs from the sum of EPS from continuing and discontinued operations due to the required method of computing EPS.

See notes to consolidated financial statements.

1




Hilton Hotels Corporation and Subsidiaries
Consolidated Balance Sheets
(in millions)

 

 

December 31,

 

June 30,

 

 

 

2006

 

2007

 

 

 

 

 

(unaudited)

 

ASSETS

 

 

 

 

 

 

 

 

 

Current Assets

 

 

 

 

 

 

 

 

 

Cash and equivalents

 

 

$

107

 

 

 

170

 

 

Restricted cash

 

 

293

 

 

 

376

 

 

Accounts receivable, net

 

 

618

 

 

 

724

 

 

Inventories

 

 

425

 

 

 

509

 

 

Deferred income taxes

 

 

95

 

 

 

95

 

 

Current portion of notes receivable, net

 

 

55

 

 

 

62

 

 

Other current assets

 

 

207

 

 

 

225

 

 

Discontinued operations

 

 

1,426

 

 

 

 

 

Total current assets

 

 

3,226

 

 

 

2,161

 

 

Investments, Property and Other Assets

 

 

 

 

 

 

 

 

 

Investments and notes receivable, net

 

 

759

 

 

 

834

 

 

Property and equipment, net

 

 

4,818

 

 

 

4,736

 

 

Management and franchise contracts, net

 

 

1,174

 

 

 

1,125

 

 

Leases, net

 

 

310

 

 

 

306

 

 

Brands

 

 

2,486

 

 

 

2,517

 

 

Goodwill

 

 

2,948

 

 

 

3,037

 

 

Deferred income taxes

 

 

76

 

 

 

80

 

 

Other assets

 

 

684

 

 

 

767

 

 

Total investments, property and other assets

 

 

13,255

 

 

 

13,402

 

 

Total Assets

 

 

$

16,481

 

 

 

15,563

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

Current Liabilities

 

 

 

 

 

 

 

 

 

Accounts payable and accrued expenses

 

 

$

1,705

 

 

 

1,804

 

 

Current maturities of long-term debt

 

 

412

 

 

 

994

 

 

Current maturities of non-recourse debt and capital lease obligations of non-controlled entities

 

 

110

 

 

 

114

 

 

Income taxes payable

 

 

40

 

 

 

 

 

Liabilities associated with discontinued operations

 

 

331

 

 

 

 

 

Total current liabilities

 

 

2,598

 

 

 

2,912

 

 

Long-term debt

 

 

6,556

 

 

 

4,684

 

 

Non-recourse debt and capital lease obligations of non-controlled entities

 

 

390

 

 

 

385

 

 

Deferred income taxes and other liabilities

 

 

3,210

 

 

 

3,464

 

 

Stockholders’ equity

 

 

3,727

 

 

 

4,118

 

 

Total Liabilities and Stockholders’ Equity

 

 

$

16,481

 

 

 

15,563

 

 

 

See notes to consolidated financial statements.

2




Hilton Hotels Corporation and Subsidiaries
Consolidated Statements of Cash Flow
(in millions)

 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2006

 

2007

 

 

 

(unaudited)

 

Operating Activities

 

 

 

 

 

Net income

 

$

248

 

260

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

203

 

224

 

Amortization of loan costs

 

8

 

9

 

Net gain on asset dispositions

 

(23

)

(53

)

Loss from non-operating affiliates

 

8

 

8

 

Impairment loss and related costs

 

 

4

 

Change in working capital components:

 

 

 

 

 

Inventories

 

(154

)

(68

)

Accounts receivable

 

(80

)

(114

)

Other current assets

 

(28

)

(22

)

Accounts payable and accrued expenses

 

(166

)

87

 

Income taxes payable

 

(9

)

(43

)

Restricted cash

 

(33

)

(83

)

Change in deferred income taxes

 

49

 

(17

)

Change in other liabilities

 

64

 

34

 

Unconsolidated affiliates’ distributions in excess of earnings

 

1

 

16

 

Change in timeshare notes receivable

 

(51

)

(54

)

Excess tax benefits from share-based payment arrangements

 

(8

)

(16

)

Other

 

13

 

(39

)

Net cash provided by operating activities

 

42

 

133

 

Investing Activities

 

 

 

 

 

Capital expenditures

 

(230

)

(207

)

Additional investments

 

(128

)

(59

)

Proceeds from asset dispositions

 

138

 

1,505

 

Payments received on notes and other

 

113

 

7

 

Acquisitions, net of cash acquired

 

(5,460

)

 

Net cash (used in) provided by investing activities

 

(5,567

)

1,246

 

Financing Activities

 

 

 

 

 

Change in revolving loans, net of issuance costs

 

1,935

 

(246

)

Long-term borrowings, net of issuance costs

 

2,582

 

 

Reduction of long-term debt

 

(75

)

(1,091

)

Issuance of common stock

 

42

 

20

 

Cash dividends

 

(31

)

(31

)

Excess tax benefits from share-based payment arrangements

 

8

 

16

 

Net cash provided by (used in) financing activities

 

4,461

 

(1,332

)

Exchange rate effect on Cash and Equivalents

 

13

 

16

 

(Decrease) Increase in Cash and Equivalents

 

(1,051

)

63

 

Cash and Equivalents at Beginning of Year

 

1,154

 

107

 

Cash and Equivalents at End of Period

 

$

103

 

170

 

 

See notes to consolidated financial statements.

3




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1:   General

The consolidated financial statements presented herein have been prepared by Hilton Hotels Corporation in accordance with the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2006 and should be read in conjunction with the Notes to Consolidated Financial Statements which appear in that report.

On July 3, 2007, we entered into a merger agreement (the “Merger Agreement”) with BH Hotels LLC and BH Hotels Acquisition, Inc., entities controlled by investment funds affiliated with The Blackstone Group L.P. (“Blackstone”) in an all cash transaction valued at approximately $26 billion, including the assumption of debt (the “Blackstone Transaction”). Under the terms of the Merger Agreement, all of our outstanding common stock, with certain limited exceptions, will be cancelled and converted into the right to receive $47.50 per share. The transaction is expected to be completed in the fourth quarter of 2007 and is subject to customary closing conditions, including receipt of stockholder and regulatory approvals.

If the Merger Agreement is adopted by our stockholders and all other closing conditions are met, we will be the surviving corporation of the merger and a wholly owned subsidiary of BH Hotels LLC. Upon completion of the Blackstone Transaction, our stock will be delisted from the New York Stock Exchange and we will no longer be a publicly held corporation. The Merger Agreement contains customary restrictions on our operations prior to the consummation of the transaction, including restrictions related to the incurrence of debt, acquiring and disposing of assets, entering into material contracts and capital expenditures.

We and BH Hotels LLC filed ratification and report forms under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, with the Federal Trade Commission and the Antitrust Division of the Department of Justice, and the applicable waiting period commenced on July 20, 2007. We and BH Hotels LLC received notice of “early termination” of the waiting period on July 31, 2007.

In March 2007, we announced the exchange of contracts to sell our Scandic hotel brand and certain of our owned and leased hotels (“Scandic”). The sale was completed in April 2007. Scandic is presented as discontinued operations in our consolidated financial statements (see “Note 11: Discontinued Operations”). On February 23, 2006, we acquired the lodging assets of Hilton Group plc (“Hilton International” or “HI”) in an all cash transaction (“the HI Acquisition”). Our consolidated financial statements for the six months ended June 30, 2006 include the results of HI from the date of acquisition. See “Note 3: Purchase of Hilton International” to our Annual Report on Form 10-K for the year ended December 31, 2006.

Our consolidated financial statements for the three and six months ended June 30, 2006 and 2007 are unaudited; however, in the opinion of management, all adjustments (which include normal recurring accruals) have been made which are considered necessary to present fairly the operating results and financial position for the unaudited periods.

Our consolidated financial statements reflect certain reclassifications to prior period balances to conform with classifications adopted in 2007. These reclassifications have no effect on net income.

Note 2:   Earnings Per Share (EPS)

Basic EPS is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. The weighted average number of common shares outstanding totaled 385 million and 384 million for the three and six months ended June 30, 2006 and 390 million and 389 million for the three and six months ended June 30, 2007, respectively. Diluted

4




EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted. The dilutive effect of stock-based compensation and convertible securities increased the weighted average number of common shares by 34 million for both the three and six months ended June 30, 2006, and 34 million and 35 million for the three and six months ended June 30, 2007, respectively. In addition, the increase to net income resulting from interest on convertible securities assumed to have not been paid for the purpose of calculating diluted EPS was approximately $3 million for the three month periods ended June 30, 2006 and 2007, and approximately $6 million for the six month periods ended June 30, 2006 and 2007. The sum of basic EPS for the first two quarters of 2006 and 2007 differs from the year to date EPS due to the required method of computing EPS in the respective periods.

Note 3:   Stock-Based Compensation

We maintain the 2004 Omnibus Equity Compensation Plan which provides for the grant of options, stock units, performance units and other stock based awards. In addition, we maintain three stock plans with substantially identical terms that provide for the grant of options. Pre-tax stock compensation expense included in net income was $9 million and $19 million for the three and six months ended June 30, 2006, and $16 million and $31 million for the three and six months ended June 30, 2007, respectively.

Stock Options

We granted 2,530,165 stock options in the six months ended June 30, 2006 and 1,768,763 stock options in the six months ended June 30, 2007 with weighted average exercise prices of $25.35 and $35.23 per share, respectively, and estimated weighted average grant date fair values of approximately $13.44 and $14.01 per share, respectively.

The fair values of options granted in 2007 were estimated on the date of grant using the Black-Scholes option-pricing model. The assumptions used an expected volatility rate of 31%, dividend yield of 0.5%, expected term of 7 years and a weighted average risk-free interest rate of 4.8%. Volatility is based on historical information with terms consistent with the expected life of our non-qualified stock options. The risk-free rate is based on the quoted treasury yield curve at the time of grant, with terms consistent with the expected life of our non-qualified stock options. The dividend yield is based on the current annual dividend payment of $0.16 per share.

During the six months ended June 30, 2006 and 2007, a total of 3,242,280 and 1,403,336 stock options were exercised, with a total intrinsic value of $42 million and $31 million, respectively.

Restricted Stock Units

During the six months ended June 30, 2006 and 2007, we awarded restricted stock in the form of time-based units (“TBU”) and performance-based units (“PBU”). In the six months ended June 30, 2006, we granted 3,098,296 TBUs and 1,620,328 PBUs with weighted average grant date fair values of $23.84 and $24.84 per share, respectively. In the six months ended June 30, 2007, we granted 1,725,403 TBUs and 456,170 PBUs, both with weighted average grant date fair values of $35.23 per share.

During the six months ended June 30, 2006 and 2007, total restricted stock vested was 639,402 units and 1,874,948 units, with fair values of $15 million and $65 million, respectively.

5




Note 4:   Comprehensive Income

Comprehensive income for the three and six months ended June 30, 2006 and 2007 is as follows:

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

   2006   

 

    2007    

 

  2006  

 

   2007   

 

 

 

(in millions)

 

(in millions)

 

Net income

 

 

$

144

 

 

 

165

 

 

 

248

 

 

 

260

 

 

Change in unrealized gains and losses, net of tax

 

 

1

 

 

 

 

 

 

3

 

 

 

(2

)

 

Cash flow hedge adjustment, net of tax

 

 

(1

)

 

 

7

 

 

 

 

 

 

 

 

Cumulative translation adjustment, net of tax

 

 

161

 

 

 

31

 

 

 

197

 

 

 

80

 

 

Comprehensive income

 

 

$

305

 

 

 

203

 

 

 

448

 

 

 

338

 

 

 

Note 5:   Synthetic Fuel Investment

We have a 24 percent minority interest investment in a coal-based synthetic fuel facility which is accounted for using the equity method as we lack a controlling financial interest. The facility produced operating losses, our proportionate share of which totaled approximately $4 million and $8 million for the three and six months ended June 30, 2006 and 2007, respectively. These losses are reflected as loss from non-operating affiliates in our accompanying consolidated statements of income.

The synthetic fuel produced at this facility qualifies for tax credits (based on Section 45K of the Internal Revenue Code) which reduce our provision for income taxes. The tax credits, combined with the tax benefit associated with the operating losses, totaled approximately $4 million and $8 million for the three and six months ended June 30, 2006 and 2007, respectively. As a result, there is no net effect on our net income from the investment for the three and six months ended June 30, 2006 and 2007.

Note 6:   Derivative Instruments and Hedging Activities

As of June 30, 2007, we have an outstanding swap agreement which qualifies for hedge accounting as a cash flow hedge of a foreign currency denominated liability. The gain or loss on the change in the fair value of the derivative is included in earnings to the extent it offsets the earnings impact of changes in the fair value of the hedged obligation. Any difference is deferred in accumulated other comprehensive income, a component of stockholders’ equity.

During the first six months of 2007, we had short-term foreign currency forward agreements related to 800 million of the Scandic sales proceeds (see “Note 11: Discontinued Operations”). These agreements included a foreign currency forward covering approximately £210 million, which functioned as an economic hedge of our British Pound denominated debt that was repaid with a portion of the sale proceeds upon completion of the sale. The contract did not qualify as a cash flow hedge. As a result, net gains on the contract of approximately $3 million and $10 million for the three and six months ended June 30 2007, respectively, are reflected in net other gain (loss) in our consolidated statements of income. Net losses of approximately $3 million and $10 million for the three and six months ended June 30, 2007, respectively, related to the British Pound denominated debt are reflected in net gain (loss) on foreign currency transactions in our consolidated statements of income.

Our other short-term foreign currency forward agreements related to the Scandic proceeds qualified for hedge accounting as cash flow hedges. In the second quarter of 2007, we recognized approximately $27 million of cumulative translation adjustment losses in connection with the Scandic sale. These losses, which had been included in accumulated other comprehensive income, are reflected in net other gain (loss) in our consolidated statements of income.

6




We have three tranches of long-term debt denominated in foreign currencies which qualify as hedges of the foreign currency exposure of our net investment in foreign operations acquired as part of the HI Acquisition. The gains or losses on the long-term debt are included in accumulated other comprehensive income as part of the cumulative translation adjustment to the extent that the instruments are effective as hedges. The net loss included in accumulated other comprehensive income related to our net investment hedges totaled approximately $125 million and $280 million at June 30, 2006 and 2007, respectively. The gains and losses recorded in accumulated other comprehensive income are relieved when we substantially exit foreign operations in a market covered by our hedging instruments.

We assess on a quarterly basis the effectiveness of our hedges in offsetting the variability in the cash flow or fair values of the hedged items. There were no amounts recognized or reclassified into earnings for the three and six months ended June 30, 2006 and 2007 due to hedge ineffectiveness or due to excluding from the assessment of effectiveness any component of the hedges.

We enter into short-term foreign currency forward and swap agreements in the normal course of business in relation to certain of our cash flows from foreign operations. The gains or losses on the instruments are largely offset by gains or losses on the related assets or liabilities. At June 30, 2007, the notional amount of our foreign currency instruments was approximately $88 million. We do not enter into derivative financial instruments for trading or speculative purposes.

Note 7:   Long-Term Debt

Long-term debt at December 31, 2006 and June 30, 2007 is as follows:

 

 

December 31,

 

June 30,

 

 

 

2006

 

2007

 

 

 

(in millions)

 

Industrial development revenue bonds at adjustable rates, due 2015

 

 

$

82

 

 

 

82

 

 

Senior notes, with an average rate of 7.7%, due 2008 to 2031

 

 

2,045

 

 

 

1,673

 

 

Mortgage notes, 5.8% to 8.6%, due 2008 to 2016

 

 

289

 

 

 

289

 

 

7.95% Collateralized borrowings, due 2010

 

 

454

 

 

 

449

 

 

Chilean inflation-indexed note, effective rate of 7.65%, due 2009(1)

 

 

145

 

 

 

149

 

 

3.375% Contingently convertible senior notes due 2023(2)

 

 

575

 

 

 

575

 

 

Capital lease obligations, 6.34% to 8.75%, due 2007 to 2097

 

 

142

 

 

 

142

 

 

Term loan A, at adjustable rates, due 2011

 

 

1,302

 

 

 

924

 

 

Term loan B, at adjustable rates, due 2013

 

 

283

 

 

 

 

 

Revolving loans, at adjustable rates, due 2011

 

 

1,634

 

 

 

1,395

 

 

Other

 

 

17

 

 

 

 

 

 

 

 

6,968

 

 

 

5,678

 

 

Less current maturities of long-term debt

 

 

(412

)

 

 

(994

)

 

Net long-term debt

 

 

$

6,556

 

 

 

4,684

 

 


(1)          Interest rates include the impact of interest rate swaps.

(2)          Contingently convertible senior notes callable on April 15, 2008 are included in current maturities of long-term debt.

7




In addition to our long-term debt, our consolidated balance sheets include debt and capital lease obligations related to variable interest entities consolidated under FIN 46(R) that are non-recourse to us. Non-recourse debt and capital lease obligations of non-controlled entities at December 31, 2006 and June 30, 2007 are as follows:

 

 

December 31,

 

June 30,

 

 

 

2006

 

2007

 

 

 

(in millions)

 

Mortgage note, 5.97%, due 2007

 

 

$

100

 

 

 

100

 

 

Capital lease obligations, 6.34%, due 2007 to 2025

 

 

370

 

 

 

354

 

 

Other

 

 

30

 

 

 

45

 

 

 

 

 

500

 

 

 

499

 

 

Less current maturities of non-recourse debt and capital lease obligations of non-controlled entities

 

 

(110

)

 

 

(114

)

 

Net non-recourse debt and capital lease obligations of non-controlled entities

 

 

$

390

 

 

 

385

 

 

 

Note 8:   New Accounting Standards

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), to clarify the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standard (“FAS”) 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. We adopted FIN 48 on January 1, 2007 (see “Note 14: Income Taxes”).

In September 2006, the FASB issued FAS 157, “Fair Value Measurements.” FAS 157 defines fair value, provides a framework for measuring fair value, and expands the disclosures required for fair value measurements. FAS 157 applies to other accounting pronouncements that require fair value measurements; it does not require any new fair value measurements. FAS 157 is effective for our financial statements issued for fiscal 2008 and interim periods within that year. We do not expect this statement to have a material impact on our results of operations or financial position.

In February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” FAS 159 permits an entity to measure certain financial instruments and certain other items at fair value and report their unrealized gains and losses in earnings. FAS 159 is effective as of January 1, 2008. We are currently evaluating the impact that FAS 159 will have on our results of operations or financial position.

8




Note 9:   Segment Information

Our operations consist of three reportable segments which are based on similar products or services: Hotel Ownership, Managing and Franchising, and Timeshare. Segment results are presented net of consolidating eliminations for fee-based services, which is the basis used by management to evaluate segment performance. Managing and Franchising revenue includes reimbursements from managed properties and franchisees for certain costs incurred on their behalf, which are included in other revenue from managed and franchised properties in the consolidated statements of income. Segment results are as follows:

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

   2006   

 

   2007   

 

   2006   

 

   2007   

 

 

 

(in millions)

 

(in millions)

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Hotel Ownership

 

 

$

1,198

 

 

 

1,188

 

 

 

1,922

 

 

 

2,232

 

 

Managing and Franchising

 

 

634

 

 

 

738

 

 

 

1,168

 

 

 

1,412

 

 

Timeshare

 

 

173

 

 

 

159

 

 

 

356

 

 

 

305

 

 

 

 

 

$

2,005

 

 

 

2,085

 

 

 

3,446

 

 

 

3,949

 

 

Operating income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Hotel Ownership

 

 

$

225

 

 

 

231

 

 

 

336

 

 

 

360

 

 

Managing and Franchising

 

 

150

 

 

 

180

 

 

 

291

 

 

 

338

 

 

Timeshare

 

 

46

 

 

 

36

 

 

 

93

 

 

 

65

 

 

Corporate and other unallocated expenses

 

 

(74

)

 

 

(102

)

 

 

(147

)

 

 

(190

)

 

Total operating income

 

 

347

 

 

 

345

 

 

 

573

 

 

 

573

 

 

Interest and dividend income

 

 

4

 

 

 

8

 

 

 

15

 

 

 

13

 

 

Interest expense

 

 

(139

)

 

 

(102

)

 

 

(235

)

 

 

(218

)

 

Net interest from unconsolidated affiliates and non-controlled interests

 

 

(13

)

 

 

(13

)

 

 

(22

)

 

 

(25

)

 

Net gain (loss) on foreign currency transactions

 

 

8

 

 

 

(6

)

 

 

26

 

 

 

(14

)

 

Net other gain (loss)

 

 

19

 

 

 

(24

)

 

 

23

 

 

 

6

 

 

Loss from non-operating affiliates

 

 

(4

)

 

 

(4

)

 

 

(8

)

 

 

(8

)

 

Income before taxes and minority and non-controlled interests

 

 

222

 

 

 

204

 

 

 

372

 

 

 

327

 

 

Provision for income taxes

 

 

(90

)

 

 

(71

)

 

 

(140

)

 

 

(114

)

 

Minority and non-controlled interests, net

 

 

 

 

 

(2

)

 

 

(2

)

 

 

(4

)

 

Income from continuing operations

 

 

132

 

 

 

131

 

 

 

230

 

 

 

209

 

 

Discontinued operations, net

 

 

12

 

 

 

34

 

 

 

18

 

 

 

51

 

 

Net Income

 

 

$

144

 

 

 

165

 

 

 

248

 

 

 

260

 

 

 

Note 10:   Acquisitions and Dispositions

We consider properties to be held for sale when management approves and commits to a formal plan to actively market a property for sale, executes a formal sales contract, allows the buyer to complete its due diligence review and receives a non-refundable deposit. Until necessary approvals have been received and substantive conditions to the buyer’s obligation to perform have been satisfied, we do not consider a sale to be probable.

Upon designation as an asset held for sale, we review the carrying value of the property and, as appropriate, adjust the value to the lower of its carrying value or its estimated fair value less estimated cost to sell and we cease recording depreciation and amortization expense (see “Note 11: Discontinued Operations” and “Note 16: Subsequent Events”).

To the extent we realize a gain from the sale of real estate and maintain significant continuing involvement in the form of a long-term management contract, the gain is deferred and recognized in

9




earnings over the term of the contract. Results include the recognition of pre-tax deferred gains totaling $10 million and $19 million in the three and six months ended June 30, 2006 and $10 million and $20 million in the three and six months ended June 30, 2007, respectively.

First Six Months of 2007

In the first quarter of 2007, we sold our minority interests in eight joint venture properties for cash of approximately $51 million, resulting in pre-tax gains of approximately $20 million.

In the second quarter of 2007, we sold three wholly owned hotels for total cash of approximately $328 million. We have retained long-term management agreements on all three hotels. Due to our continuing involvement in management of the hotels, pre-tax deferred gains totaling approximately $223 million on the sale of the three hotels have been deferred and will be recognized over the lives of the management contracts. The sale of properties in the second quarter resulted in a reduction in our consolidated goodwill balance of approximately $2 million. In addition, we sold our minority interest in a joint venture property for approximately $1 million, resulting in a pre-tax loss of approximately $1 million.

The $6 million net other gain in our consolidated statement of income for the six months ended June 30, 2007 also includes $17 million of net losses on foreign currency contracts related to the Scandic sale proceeds and $4 million of other net gains.

In the second quarter of 2007, we completed the sale of our Scandic hotel brand and certain of our owned and leased hotels for 833 million, equivalent to approximately $1.1 billion on the transaction date, resulting in a net pre-tax gain on sale of approximately $47 million which is included in discontinued operations on our consolidated statements of income (see “Note 11: Discontinued Operations”).

Results in the 2007 second quarter include a loss of approximately $4 million to reduce the value of our minority interest in a joint venture investment to its estimated fair value. This charge is reflected in impairment loss and related costs in our consolidated statements of income.

First Six Months of 2006

In the first quarter of 2006, we completed the HI Acquisition for approximately £3.3 billion, equivalent to approximately $5.7 billion on the transaction date, excluding acquisition costs, in an all cash transaction. In the first quarter of 2007, we increased goodwill by approximately $31 million, reflecting the final allocation of the purchase price to the assets acquired and liabilities assumed.

Also in the first quarter of 2006, we acquired long-term management contracts for four properties, three of which became part of our Waldorf=Astoria collection. In addition, we completed the sale of two wholly owned hotels for cash of approximately $177 million, resulting in a pre-tax loss of approximately $38 million and a reduction in our consolidated goodwill balance of approximately $10 million. We retained long-term management agreements on both of the properties. In addition to the sales of these wholly owned hotels, we sold our minority interest in a joint venture property for cash of approximately $27 million, resulting in a pre-tax gain of approximately $11 million.

In the second quarter of 2006, we sold a wholly owned hotel for net proceeds of approximately $17 million, resulting in a pre-tax gain of approximately $8 million. The hotel continues to operate as a Hilton branded property under the terms of a 20-year franchise agreement. In addition, we sold our interest in a joint venture property for approximately $5 million, resulting in a pre-tax loss of approximately $2 million.

The $23 million net other gain in our consolidated statement of income for the six months ended June 30, 2006 also includes $33 million of gains on settlement recoveries related to mold found in certain areas of the Hilton Hawaiian Village in 2002 and $11 million in other gains.

10




We have engaged Eastdil Secured, LLC to act as our broker for the sale of certain of our owned hotels. Fees earned by Eastdil related to owned hotels sold in each of the six months ended June 30, 2006 and 2007 were approximately $1 million. Benjamin V. Lambert, a director of our company, is Chairman of Eastdil.

Note 11:   Discontinued Operations

In April 2007, we completed the sale of our Scandic hotel brand and certain of our owned and leased hotels for 833 million, equivalent to approximately $1.1 billion on the transaction date. Net proceeds, after transaction costs and taxes, of approximately $1.04 billion were used to pay down borrowings under our senior credit facilities. At the time we exchanged contracts in March 2007, we designated Scandic as held for sale and stopped recording depreciation and amortization expense. Scandic is presented as discontinued operations in our consolidated financial statements.

Total Scandic assets classified as discontinued operations by segment as of December 31, 2006 are as follows:

 

 

December 31,

 

 

 

2006

 

 

 

(in millions)

 

Assets by segment:

 

 

 

 

 

Hotel Ownership

 

 

$

1,380

 

 

Managing and Franchising

 

 

43

 

 

Corporate and other

 

 

3

 

 

Total assets

 

 

$

1,426

 

 

 

The assets and liabilities of Scandic classified as discontinued operations included in our consolidated balance sheet as of December 31, 2006 were as follows:

 

 

December 31,

 

 

 

2006

 

 

 

(in millions)

 

Current Assets

 

 

 

 

 

Cash and equivalents

 

 

$

31

 

 

Accounts receivable, net

 

 

41

 

 

Inventories

 

 

5

 

 

Other current assets

 

 

32

 

 

Total current assets

 

 

109

 

 

Investments, Property and Other Assets

 

 

 

 

 

Property and equipment, net

 

 

165

 

 

Management and franchise contracts, net

 

 

10

 

 

Leases, net

 

 

9

 

 

Brands

 

 

360

 

 

Goodwill

 

 

762

 

 

Deferred income taxes

 

 

9

 

 

Other assets

 

 

2

 

 

Total investments, property and other assets

 

 

1,317

 

 

Total Assets

 

 

$

1,426

 

 

Current Liabilities

 

 

 

 

 

Accounts payable and accrued expenses

 

 

$

196

 

 

Income taxes payable

 

 

4

 

 

Total current liabilities

 

 

200

 

 

Deferred income taxes and other liabilities

 

 

131

 

 

Total Liabilities

 

 

$

331

 

 

 

11




Summary operating results for Scandic discontinued operations are as follows:

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

    2006    

 

    2007    

 

   2006   

 

   2007   

 

 

 

(in millions)

 

(in millions)

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Owned hotels

 

 

$

3

 

 

 

2

 

 

 

4

 

 

 

8

 

 

Leased hotels

 

 

195

 

 

 

54

 

 

 

272

 

 

 

269

 

 

Management and franchise fees

 

 

1

 

 

 

1

 

 

 

1

 

 

 

1

 

 

 

 

 

199

 

 

 

57

 

 

 

277

 

 

 

278

 

 

Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Owned hotels

 

 

2

 

 

 

2

 

 

 

2

 

 

 

6

 

 

Leased hotels

 

 

157

 

 

 

47

 

 

 

218

 

 

 

220

 

 

Depreciation and amortization

 

 

4

 

 

 

 

 

 

5

 

 

 

5

 

 

Other operating expenses

 

 

17

 

 

 

3

 

 

 

24

 

 

 

22

 

 

 

 

 

180

 

 

 

52

 

 

 

249

 

 

 

253

 

 

Operating Income

 

 

19

 

 

 

5

 

 

 

28

 

 

 

25

 

 

Net (loss) gain on foreign currency transactions

 

 

(5

)

 

 

1

 

 

 

(6

)

 

 

2

 

 

Net other gain(1)

 

 

 

 

 

47

 

 

 

 

 

 

47

 

 

Income Before Taxes

 

 

14

 

 

 

53

 

 

 

22

 

 

 

74

 

 

Provision for income taxes

 

 

(2

)

 

 

(19

)

 

 

(4

)

 

 

(23

)

 

Net Income

 

 

$

12

 

 

 

34

 

 

 

18

 

 

 

51

 

 


(1)          Net other gain represents the net gain on the sale of Scandic. The net gain includes the recognition of $63 million of cumulative translation adjustment gains due to the substantial exit of operations from several foreign markets, partially offset by $16 million of other losses on the Scandic sale. The cumulative translation adjustment gains had previously been deferred in accumulated other comprehensive income, a component of stockholders’ equity.

Note 12:   Guarantees

We have established franchise financing programs with third party lenders to support the growth of our brands. As of June 30, 2007, we have provided guarantees of $16 million on loans outstanding under the programs. In addition, we have guaranteed $24 million of debt and other obligations of unconsolidated affiliates and third parties, bringing our total guarantees to $40 million. Approximately $14 million have indefinite terms, with the balance having remaining terms of one to 13 years. We also have commitments under letters of credit totaling $109 million as of June 30, 2007. We believe it is unlikely that material payments will be required under our outstanding guarantees or letters of credit.

In addition, we remain a guarantor on 12 operating leases sold as part of the sale of the Red Lion hotel chain in 2001. We have entered into an indemnification and reimbursement agreement with Red Lion Hotels Corporation (“RLH”) which requires RLH to reimburse us for any costs and expenses incurred in connection with the guarantee. The minimum lease commitment under these 12 operating leases totals approximately $5 million annually through 2020.

We also remain a guarantor on 15 operating leases sold as part of the Scandic transaction. We have entered into indemnification and reimbursement agreements with the new owners of Scandic which require the owners to reimburse us for any costs and expenses incurred in connection with the guarantees. The minimum lease commitment under these 15 operating leases totals approximately $16 million annually through 2012, $13 million annually through 2015 and $8 million annually through 2022.

12




We have also provided performance guarantees to certain owners of hotels that we operate under management contracts. Most of these guarantees allow us to terminate the contract rather than fund shortfalls if specified performance levels are not achieved. In limited cases, we are obligated to fund performance shortfalls. As of June 30, 2007, we have nine contracts containing performance guarantees with possible cash outlays totaling approximately $572 million through 2020. Funding under these performance guarantees is expected to total approximately $13 million in 2007. Funding under these guarantees in future periods is dependent on the operating performance levels of these hotels over the remaining term of the performance guarantees. Although we anticipate that the future operating performance levels of these hotels will be largely achieved, there can be no assurance that this will be the case. In addition, we do not anticipate losing a significant number of management contracts during the remainder of 2007 pursuant to these guarantees.

Our consolidated financial statements as of June 30, 2006 and 2007 include liabilities of approximately $4 million and $21 million, respectively, for potential obligations under our outstanding guarantees. Under certain circumstances, we may be obligated to provide additional guarantees or letters of credit totaling approximately $74 million at June 30, 2007.

Note 13:   Employee Benefit Plans

We sponsor multiple domestic and international employee benefit plans. We have a noncontributory retirement plan in the United States (the “Domestic Plan”) which covers certain non-union employees. Benefits are based upon years of service and compensation. Since December 31, 1996, employees have not accrued additional benefits under the Domestic Plan. We also have multiple employee benefit plans that cover many of our international employees. These plans include a plan that covers workers in the United Kingdom (the “U.K. Plan”) and a number of smaller plans that cover workers in various countries across the world (the “International Plans”). For the three and six months ended June 30, 2007, we paid $3 million and $5 million, respectively, in employer contributions to the U.K. Plan and $6 million and $13 million, respectively, in employer contributions to the International Plans. We expect to contribute approximately $9 million to the U.K. Plan and $25 million to the International Plans in 2007. We do not expect to make any contributions to the Domestic Plan in 2007.

Our net periodic benefit cost for the three and six months ended June, 2006 and 2007 consisted of the following (in millions):

 

 

Domestic Plan

 

U.K. Plan

 

International Plans

 

 

 

Three Months Ended

 

Three Months Ended

 

Three Months Ended

 

 

 

June 30,

 

June 30,

 

June 30,

 

 

 

    2006    

 

    2007    

 

    2006    

 

    2007    

 

    2006    

 

    2007    

 

Expected return on plan assets

 

 

$

5

 

 

 

5

 

 

 

7

 

 

 

6

 

 

 

1

 

 

 

2

 

 

Service cost

 

 

 

 

 

 

 

 

(2

)

 

 

(2

)

 

 

(6

)

 

 

(6

)

 

Interest cost

 

 

(4

)

 

 

(4

)

 

 

(5

)

 

 

(5

)

 

 

(2

)

 

 

(2

)

 

Net annual benefit income (cost)

 

 

$

1

 

 

 

1

 

 

 

 

 

 

(1

)

 

 

(7

)

 

 

(6

)

 

 

 

 

Domestic Plan

 

U.K. Plan

 

International Plans

 

 

 

Six Months Ended

 

Six Months Ended

 

International Plans

 

 

 

June 30,

 

June 30,

 

June 30,

 

 

 

    2006   

 

    2007   

 

    2006   

 

    2007   

 

    2006   

 

    2007   

 

Expected return on plan assets

 

 

$

10

 

 

 

10

 

 

 

9

 

 

 

13

 

 

 

2

 

 

 

5

 

 

Service cost

 

 

 

 

 

 

 

 

(3

)

 

 

(5

)

 

 

(8

)

 

 

(13

)

 

Interest cost

 

 

(8

)

 

 

(9

)

 

 

(6

)

 

 

(10

)

 

 

(3

)

 

 

(5

)

 

Amortization of prior service cost

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net annual benefit income (cost)

 

 

$

1

 

 

 

1

 

 

 

 

 

 

(2

)

 

 

(9

)

 

 

(13

)

 

 

13




The International Plans service cost for the three and six months ended June 30, 2006 includes $2 million and $3 million, respectively, of contributions under defined contribution plans. Service cost for the International Plans for the three and six months ended June 30, 2007 includes $3 million and $7 million, respectively, of contributions under defined contribution plans.

Note 14:   Income Taxes

On January 1, 2007, we adopted the provisions of FIN 48 “Accounting for Uncertainty in Income Taxes.” As a result of adoption, we provided for a $14 million increase in the net liability for our unrecognized income tax positions. Of this, $6 million was recorded as an adjustment to our opening balance of retained earnings and $8 million was recorded as an increase to goodwill in connection with the HI Acquisition.

The total amounts of our unrecognized tax positions as of January 1, 2007 and June 30, 2007, were $132 million and $141 million, respectively, of which $35 million and $40 million would impact our effective tax rate if recognized. Included in these totals are gross accrued interest and penalties of $19 million and $23 million as of January 1 and June 30, 2007, respectively, of which $2 million and $4 million was recognized as a component of our income tax expense during the three and six months ended June 30, 2007, respectively. We reasonably estimate that the amount of our unrecognized tax positions will not change significantly within the next twelve months.

The gross increase in our unrecognized tax positions resulting from tax positions taken during the three and six months ended June 30, 2007, was $5 million and $9 million, respectively. There were no increases or decreases in unrecognized tax benefits during the three or six months ended June 30, 2007, as a result of tax positions taken during prior periods.

As of January 1, 2007, any interest and penalties incurred in connection with settlement of income tax liabilities and interest income received in connection with settlement of income tax liabilities will be accounted for as a component of our income tax expense. Prior to January 1, 2007, interest and penalties incurred in connection with settlement of income tax liabilities were accounted for as a component of our provision for income taxes, while interest income received in connection with the settlement of income tax liabilities were accounted for as interest and dividend income.

We file income tax returns with federal, state, local and foreign jurisdictions. As of June 30, 2007, we remain subject to federal and state examinations of our income tax returns for the years 2002 through 2006.

Note 15:   Insurance Recoveries

On August 29, 2005, Hurricane Katrina hit the Gulf Coast, affecting two of our consolidated hotels: the majority owned Hilton New Orleans Riverside and the wholly owned Hilton New Orleans Airport. Both properties suffered some physical damage, and both properties were closed to paying guests for a period following the hurricane. We have insurance policies that provide coverage for physical damage and business interruption, including lost profits. These policies also reimburse us for other costs and expenses incurred relating to the damages and losses suffered.

We recognized approximately $7 million of business interruption insurance proceeds during the three and six months ended June 30, 2006 and approximately $5 million and $8 million for the three and six months ended June 30, 2007, respectively. These proceeds are recorded as owned hotel revenue in our consolidated statements of income. Additionally, we recognized approximately $3 million and $6 million of insurance recoveries related to building and property losses for both of the three and six months ended June 30, 2006 and 2007, respectively, which are recorded as net other gain in our consolidated statements of income.

14




Note 16:   Subsequent Events

In April 2007, we entered into an agreement to sell up to ten hotels in continental Europe for 566 million, equivalent to approximately $770 million on the agreement date. In July 2007, we completed the sale of eight of the ten hotels. We expect to complete the sale of the remaining two properties by the end of the third quarter 2007 and will retain management agreements on nine of the ten hotels. The ten hotels are classified as held for sale within property and equipment, net, in our June 30, 2007 consolidated balance sheet.

15




ITEM 2.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Company

We are engaged in the ownership, management and development of hotels, resorts and timeshare properties and the franchising of lodging properties. At June 30, 2007, our system contained 2,896 properties totaling approximately 490,000 rooms in 76 countries and territories. Our brands include Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Homewood Suites, Hampton, Conrad and the Waldorf=Astoria Collection. In addition, we develop and operate timeshare resorts through Hilton Grand Vacations Company and its related entities. We are also engaged in various other activities related or incidental to the operation of hotels.

The number of properties and rooms at June 30, 2007 by brand and by type are as follows:

Brand

 

 

 

Properties

 

Rooms

 

Type

 

Properties

 

Rooms

 

Hilton

 

 

509

 

 

176,016

 

Owned(1)

 

 

54

 

 

27,640

 

Hilton Garden Inn

 

 

327

 

 

45,083

 

Leased

 

 

84

 

 

25,350

 

Doubletree

 

 

179

 

 

46,380

 

Joint Venture

 

 

44

 

 

14,267

 

Embassy Suites

 

 

185

 

 

45,144

 

 

 

 

182

 

 

67,257

 

Homewood Suites

 

 

201

 

 

22,095

 

Managed

 

 

333

 

 

99,021

 

Hampton

 

 

1,433

 

 

141,799

 

Franchised

 

 

2,348

 

 

320,386

 

Conrad

 

 

14

 

 

4,991

 

 

 

 

2,681

 

 

419,407

 

Other

 

 

15

 

 

5,156

 

 

 

 

 

 

 

 

 

Timeshare

 

 

33

 

 

3,774

 

Timeshare

 

 

33

 

 

3,774

 

Total

 

 

2,896

 

 

490,438

 

Total

 

 

2,896

 

 

490,438

 


(1)          Includes majority owned and controlled hotels.

Our operations consist of three reportable segments which are based on similar products or services: Hotel Ownership, Managing and Franchising, and Timeshare. The Hotel Ownership segment derives earnings from owned, majority owned and leased hotel properties and equity earnings from unconsolidated affiliates (primarily hotel and other real estate joint ventures). The Managing and Franchising segment provides services including hotel management and licensing of our family of brands to franchisees. This segment generates its revenue from fees charged to hotel owners. As a manager of hotels, we are typically responsible for supervising or operating the hotel in exchange for fees based on a percentage of the hotel’s gross revenue, operating profits, cash flow, or a combination thereof. We charge franchise fees, depending on the brand, of up to five percent of rooms revenue in exchange for the use of one of our brand names. The Timeshare segment consists of multi-unit timeshare resorts. This segment sells and finances timeshare intervals and operates timeshare resorts.

Our results are significantly affected by occupancy and room rates achieved by our hotels, our ability to manage costs, foreign currency exchange rate movements related to our international operations, our relative mix of owned, leased, managed and franchised hotels, the quantity and pricing of timeshare interval sales and changes in the number of available hotel rooms and timeshare intervals through acquisition, development and disposition. Results are also impacted by economic conditions and capacity. Unfavorable changes in these factors could negatively impact hotel room demand and pricing which, in turn, could limit our ability to pass through operating cost increases in the form of higher room rates. Additionally, our ability to manage costs could be adversely impacted by significant increases in operating expenses, resulting in lower operating margins. See “Other Matters—Forward-Looking Statements” below, our preliminary proxy statement on Schedule 14A, Item 1A “Risk Factors” under Part II of this Form 10-Q and Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006 for a description of these and other conditions that could adversely affect our results of operations.

16




The hospitality industry is seasonal in nature. However, the periods during which our properties experience higher or lower levels of demand vary from property to property and depend principally upon location. Based on historical results, we generally expect our revenue to be lower in the first fiscal quarter of each year than in each of the three subsequent quarters.

We anticipate that a favorable economic environment will continue to benefit the lodging industry and us during the remainder of 2007. A continuation of strong hotel demand among business, group and leisure travelers, combined with limited full-service hotel supply growth, should enable us to charge higher room rates. We also anticipate growth in our management and franchise fee business as the number of hotels in our system continues to increase. Increases in construction costs could result in downward pressure on the margins achieved by our timeshare business. Reported revenue and expenses from our timeshare business are also expected to be negatively impacted by deferrals required under percentage-of-completion accounting as we continue construction of new timeshare projects. We will continue to focus on managing our costs, achieving revenue per available room (“RevPAR”) premiums in the markets where we operate, increasing occupancy, adding new units to our family of brands, leveraging technology and delivering outstanding customer service. We believe that our focus on these objectives, combined with our financial strength, diverse market presence, strong brands, strategically located properties and ability to grow our brands internationally will enable us to remain competitive.

Definitive Merger Agreement

On July 3, 2007, we entered into a merger agreement (the “Merger Agreement”) with BH Hotels LLC and BH Hotels Acquisition, Inc., entities controlled by investment funds affiliated with The Blackstone Group L.P. (“Blackstone”) in an all cash transaction valued at approximately $26 billion, including the assumption of debt (the “Blackstone Transaction”). Under the terms of the Merger Agreement, all of our outstanding common stock, with certain limited exceptions, will be cancelled and converted into the right to receive $47.50 per share. The transaction is expected to be completed in the fourth quarter of 2007 and is subject to customary closing conditions, including receipt of stockholder and regulatory approvals.

If the Merger Agreement is adopted by our stockholders and all other closing conditions are met, we will be the surviving corporation of the merger and a wholly owned subsidiary of BH Hotels LLC. Upon completion of the Blackstone Transaction, our stock will be delisted from the New York Stock Exchange and we will no longer be a publicly held corporation. The Merger Agreement contains customary restrictions on our operations prior to the consummation of the transaction, including restrictions related to the incurrence of debt, acquiring and disposing of assets, entering into material contracts and capital expenditures.

On July 27, 2007, we filed a preliminary proxy statement with the Securities and Exchange Commission (“SEC”) in connection with the Blackstone Transaction. See our preliminary proxy statement on Schedule 14A and Item 1A “Risk Factors” under Part II of this Form 10-Q for a description of conditions related to the Blackstone Transaction that could adversely affect our results of operations.

We and BH Hotels LLC filed ratification and report forms under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, with the Federal Trade Commission and the Antitrust Division of the Department of Justice, and the applicable waiting period commenced on July 20, 2007. We and BH Hotels LLC received notice of “early termination” of the waiting period on July 31, 2007.

17




Critical Accounting Policies and Estimates

In our Annual Report on Form 10-K for the year ended December 31, 2006, we identified the critical accounting policies which affect our more significant estimates and assumptions used in preparing our consolidated financial statements. Those policies include accounting for notes receivable, property and investments, sales of real estate, intangible assets, self-insurance, commitments and contingencies, currency translation, Hilton HHonors (our guest loyalty program), purchase accounting, revenue recognition and income taxes. We have not changed these policies from those previously disclosed in our Annual Report.

Development and Capital Spending

Overview

We intend to grow our hotel system primarily through franchising and the addition of management contracts. We will also continue to invest in capital improvements and select projects at our owned hotels and the development of timeshare properties. In addition, we may seek to acquire ownership interests in hotel properties on a strategic and selective basis, either directly or through investments in joint ventures.

We added a total of 115 properties, primarily franchises, with approximately 16,300 rooms to our system during the six months ended June 30, 2007. Excluding the Scandic sale, a total of 27 properties, primarily franchises, with approximately 5,000 rooms were removed from our system during the same period.

In July 2007, we received three highest-ranking awards in the J.D. Power and Associates 2007 North American Hotel Guest Satisfaction Index Study, outperforming all other hospitality companies within their respective segments. Hilton Garden Inn received the highest ranking (for the sixth consecutive year) in the mid-scale full service segment. Embassy Suites received the highest ranking (for the sixth time) in the upscale segment. Homewood Suites received the highest ranking (for the fifth time) in the extended-stay segment.

We believe the continued strong performance of our brands has enabled us to significantly enhance our development pipeline compared to our industry competitors. We have nearly 900 hotels, primarily franchises, with approximately 120,000 rooms in our development pipeline at June 30, 2007. The majority of the hotels in our current development pipeline are in the Americas (U.S., Canada, Latin America and the Caribbean), though international development is expected to comprise an increasingly larger percentage of our development pipeline over the next few years. The actual opening of hotels in our development pipeline is subject to various conditions and uncertainties.

Our ability to grow the number of hotels in our system is affected by the factors referenced under “Other Matters—Forward-Looking Statements” below, our preliminary proxy statement on Schedule 14A, Item 1A “Risk Factors” under Part II of this Form 10-Q and Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006, such as international, national and regional economic conditions; the effects of actual and threatened terrorist attacks and international conflicts; acts of God, such as natural disasters; credit availability; relationships with franchisees and property owners; and competition from other hotel brands.

In total, we anticipate spending approximately $975 million on capital expenditures in 2007, which includes approximately $260 million for routine improvements and technology, approximately $390 million for timeshare projects and approximately $325 million for hotel renovation, hotel investment and special projects. Routine improvements include expenditures for equipment, hotel fixtures and wall and floor coverings. Expenditures required to complete our capital spending programs are expected to be financed through available cash flow from operations and general corporate borrowings. To the extent we complete additional asset sales in 2007, capital expenditures can be expected to decrease. Anticipated capital expenditures are subject to change due to, among other things, changes in business operations and economic conditions.

18




To the extent allowed under the Merger Agreement, we will continue to review our owned hotel portfolio for potential repositioning or re-branding opportunities (see “Liquidity and Capital Resources—Acquisitions and Dispositions”). In April 2007, we signed an agreement to sell up to ten hotels in continental Europe to Morgan Stanley Real Estate for approximately 566 million, equivalent to approximately $770 million on the announcement date. In July 2007, we completed the sale of eight of the ten hotels (see “Note 16: Subsequent Events” to the consolidated financial statements under Item 1). Net proceeds from the sale of these ten hotels are expected to be used to repay borrowings under our senior credit facilities.

As discussed in “Note 10: Acquisitions and Dispositions” to the consolidated financial statements under Item 1, until the necessary approvals have been received and substantive conditions to the buyer’s obligation to perform have been satisfied, we do not consider a sale to be probable. When we sell a hotel property, it is generally our preference to retain a management or franchise agreement; however, we may sell hotels without retaining our brand.

Hotel Ownership

Capital expenditures during the six months ended June 30, 2007, excluding timeshare projects, totaled $207 million, consisting primarily of routine improvements and special projects at our owned and leased hotels. The expenditures include approximately $49 million for renovations at the Hilton New York, Waldorf=Astoria and Hilton Hawaiian Village. Renovation projects are expected to continue at The Hilton Hawaiian Village and the Waldorf=Astoria during the remainder of 2007. We continue to place a priority on making appropriate capital expenditures to maintain and upgrade our owned assets.

Managing and Franchising

Total property additions in the six months ended June 30, 2007 included 105 franchise properties and ten managed properties owned by third parties. These additions included 18 properties which, due in part to the market share leadership of our brands, were converted to our family of brands in the period. The 18 conversions included nine Doubletrees, four Hiltons, three Hamptons and two Hilton Garden Inns.

During the six month period, we added new Hilton hotels across the U.S. and in China, Ireland, Poland, Spain and the U.A.E. Additionally, we added new Doubletree hotels in Chicago, Augusta, Milwaukee, Columbus, Boston and Richmond. In Chicago, we opened our 1,400th Hampton Inn, representing the brands 140,000th room. Also during the period, we entered into management agreements for a Conrad in Abu Dhabi, Hiltons in Costa Rica and Jordan, and a Doubletree in Costa Rica. We announced the ground breaking of the 498-room Waldorf=Astoria at Bonnet Creek and the 1,000-room Hilton Bonnet Creek, part of a resort development adjacent to the Walt Disney World® Resort in Florida. We also announced the ground breaking on the 1,400-room Hilton Orlando at the Orange County Convention Center. We will manage all three hotels upon completion, which is scheduled for late 2009.

During the second quarter of 2007, we announced four new development agreements as follows:

·       A letter of understanding with the Caribbean Property Development Group to develop approximately 15 franchised hotels in Central America and the Caribbean under our Hilton Garden Inn, Hampton by Hilton and Homewood Suites by Hilton brands over the next five years.

·       A letter of understanding for a development alliance with London and Regional Properties to develop approximately 25 managed hotels in Russia under our Conrad, Hilton, Doubletree by Hilton, Hilton Garden Inn and Hampton by Hilton brands over the next five years.

·       A letter of understanding for a development alliance with Shiva Hotels Limited to develop approximately 15 managed hotels in the U.K. and Ireland under our Hilton, Hilton Garden Inn and Hampton by Hilton brands over the next five years.

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·       A letter of understanding for a development alliance with Somerston Hotels U.K. Limited to develop approximately 25 franchised hotels in the U.K. under our Hilton Garden Inn and Hampton by Hilton brands over the next five years.

Timeshare

We are currently developing new timeshare projects in Las Vegas, Nevada; Orlando, Florida; New York, New York; Honolulu and Waikoloa, Hawaii. At our Tuscany Village property in Orlando, the first six phases totaling 376 units are open and construction has begun on the final 64 units, which are scheduled to open in spring 2008. Our property on the Las Vegas Strip, which when completed will consist of 1,582 units in four towers, is approximately 45% complete.

In 2007, we began construction of our new timeshare project at Ruby Lake in Orlando. Phase I of the Ruby Lake project is expected to contain 141 units and is scheduled for completion in 2009 and Phase II is expected to contain 171 units and is scheduled for completion in 2010. Construction continues at our Waikikian Tower project in Honolulu at the Hilton Hawaiian Village. Upon completion scheduled for late 2008, the Waikikian Tower is expected to contain 331 units. We also continue to develop our Kings Land project in Waikoloa. Phase I of our Kings Land development is expected to contain 198 units and is scheduled for completion in late 2008. We began construction of our new timeshare development in New York City on West 57th Street in the second quarter of 2007. Upon completion in early 2009, the 57th Street Tower is expected to contain 161 units.

As we are currently constructing several new timeshare projects, our timeshare business is expected to be negatively impacted, from a reporting standpoint, by percentage-of-completion accounting associated with new projects in 2007. Percentage-of-completion accounting requires the deferral of revenue and expenses associated with new projects under construction. We expect the impact of percentage-of-completion accounting on our 2007 results to substantially reverse in 2008.

Capital expenditures associated with our timeshare projects during the six months ended June 30, 2007 totaled approximately $153 million. Timeshare capital expenditures are expected to total approximately $390 million in 2007 as we continue to invest in the development of new product in Las Vegas, Orlando, New York and Hawaii. The capital expenditures associated with our non-lease timeshare products are reflected as inventory until the timeshare intervals are sold. We also provide financing to the buyers of our timeshare intervals. During the six months ended June 30, 2007, we issued approximately $186 million of loans related to timeshare financings. Principal collections on timeshare notes during the same period were approximately $132 million.

Liquidity and Capital Resources

Overview

Net cash provided by operating activities was $42 million and $133 million for the six months ended June 30, 2006 and 2007, respectively. The increase relates primarily to changes in working capital components. Net cash used in investing activities was $5.567 billion for the six months ended June 30, 2006 and net cash provided by investing activities was $1.246 billion for the six months ended June 30, 2007. Cash used in the 2006 period reflects the acquisition of the lodging assets of Hilton Group plc, including its operating subsidiary, Hilton International Co. (“Hilton International” or “HI”) in an all cash transaction (“the HI Acquisition”). Cash provided by investing activities in the 2007 period reflects increased proceeds from asset sales, including the Scandic sale. Net cash provided by financing activities was $4.461 billion for the six months ended June 30, 2006 and net cash used in financing activities was $1.332 billion for the six months ended June 30, 2007. The variance is primarily due to borrowings under our senior credit facilities to partially fund the HI Acquisition in the first six months of 2006, while the 2007 period reflects increased debt repayments due to asset sales.

20




Cash and equivalents increased $63 million from December 31, 2006 to $170 million at June 30, 2007. Restricted cash totaled $376 million at June 30, 2007, an increase of $83 million from December 31, 2006. The increase in restricted cash balances is primarily due to an increase in refundable deposits on the sale of timeshare intervals combined with an increase in cash reserves related to our collateralized borrowings. Restricted cash includes cash related to certain consolidated hotels, the use of which is restricted for hotel purposes (including under the terms of collateralized borrowings); refundable deposits on the sale of timeshare intervals; and cash balances held by consolidated non-controlled entities. We believe that our operating cash flow, available borrowings under our revolving credit facilities and our ability to obtain additional financing through various financial markets are sufficient to meet our liquidity needs (see “Liquidity and Capital Resources—Financing”). However, any projections of future financial needs and sources of working capital are subject to uncertainty. If the proposed Blackstone Transaction is consummated, we will incur substantial debt, which will significantly change our financial position. See “Results of Operations,” “Other Matters—Forward-Looking Statements,” our preliminary proxy statement on Schedule 14A and Item 1A “Risk Factors” under Part II of this form 10-Q for further discussion of conditions that could adversely affect our estimates of future financial needs and sources of working capital.

Financing

As outlined in the Merger Agreement, if instructed by BH Hotels LLC, we will use commercially reasonable efforts to commence tender offers to purchase all of our outstanding senior notes (excluding convertible debt) contingent upon the consummation of the Blackstone Transaction. Additionally, we expect that our senior credit facilities and other forms of debt will be substantially repaid and extinguished upon completion of the Blackstone Transaction.

In February 2006, we established senior credit facilities in an initial aggregate principal U.S. dollar equivalent of approximately $5.75 billion with the option to increase the size of the facilities by an additional $500 million. Our senior credit facilities consist of the following:

·       U.S. Dollar Denominated Revolver—5 year, $3.25 billion available in U.S. dollars, British Pounds, Euros and Swedish Kronor or other currencies acceptable to the administrative agent. Interest is at a variable rate depending upon our leverage ratio and senior debt ratings, with borrowings at applicable London Interbank Offered Rate (“LIBOR”) plus 87.5 basis points (which includes a 22.5 basis point annual facility fee) at June 30, 2007. The capacity under our revolver was also used to support certain outstanding letters of credit. Total revolving debt capacity of approximately $1.66 billion was available to us at June 30, 2007.

·       Foreign Currency Denominated Term Loan A—5 year, approximate equivalent of $2.38 billion at June 30, 2007, denominated in £675 million, 675 million and Australian $140 million. Interest is at a variable rate depending upon our leverage ratio and senior debt ratings, with borrowings at applicable LIBOR plus 87.5 basis points at June 30, 2007.

·       U.S. Dollar Denominated Term Loan B—7 year, $500 million term loan available only in U.S. dollars. Interest is at LIBOR plus 137.5 basis points.

At June 30, 2007, we have an aggregate principal U.S. dollar equivalent of approximately $2.319 billion outstanding under these facilities.

21




Under the terms of the senior credit facilities, proceeds, if any, from the sale of certain owned properties acquired as part of the HI Acquisition in 2006 are required to be used for the repayment of our senior credit facilities. In addition, we expect that excess cash flow, if any, will be used to repay outstanding debt balances. During the three months ended June 30, 2007, we repaid the British Pound balance of Term Loan A and U.S. Dollar Denominated Term Loan B in full. Additionally, we repaid in full the $375 million of 7.95% Senior Notes which matured in the second quarter of 2007.

In the first quarter of 2007, Standard & Poor’s Ratings Group upgraded our senior debt rating from BB to BB+ and Moody’s Investor Services upgraded our senior debt rating from Ba2 to Ba1. These upgrades, combined with our leverage ratio, are reflected in the interest rates and facility fee of our senior credit facilities at June 30, 2007. Subsequent to the announcement of the Blackstone Transaction, Standard & Poor’s Ratings Group downgraded our senior debt rating from BB+ to BB-. Moody’s Investor Services has not changed their rating.

In October 1997, we filed a shelf registration statement with the Securities and Exchange Commission registering up to $2.5 billion in debt or equity securities. At June 30, 2007, available financing under the shelf totaled $825 million. The terms of any additional securities offered under the shelf will be determined by market conditions at the time of issuance.

Provisions under various loan agreements require us to comply with certain covenants which include limiting the amount of our outstanding indebtedness. Our revolving credit facilities contain two significant financial covenants: a leverage ratio and a debt service ratio. We were in compliance with our financial covenants as of June 30, 2007.

Our debt balance includes approximately $575 million of 3.375% Convertible Senior Notes due in 2023. The notes are convertible into approximately 25.6 million shares of our common stock at a conversion price of $22.50 per share of common stock, upon our stock trading at 120% of the conversion price for 20 consecutive days during the last 30 day period of a financial quarter. As of December 31, 2006, the conversion trigger was met and the notes became convertible at the option of the bond holders. As of June 30, 2007, a total of 9,452 shares have been issued from conversions of debt.

Provisions of the financing agreement related to our 7.95% collateralized borrowings due 2010 require that certain cash reserves be maintained and also restrict the transfer of excess cash generated by the related properties to Hilton if net cash flow falls below a specified level (the cash trap). The cash trap became effective in 2003 due to reduced cash flow from the collateralized properties, primarily the Hilton San Francisco. As of June 30, 2007, cash restricted under the terms of the collateralized borrowings, including required reserves and the cash trap, totaled $239 million. The impact of the cash trap, which is expected to remain in effect throughout 2007, is not expected to have a material impact on our liquidity.

As of June 30, 2007, approximately 42% of our long-term debt, including the impact of interest rate swaps and excluding non-recourse debt and capital lease obligations of non-controlled entities, was floating rate debt. Our total debt, excluding non-recourse debt and capital lease obligations of non-controlled entities, has a weighted average life of approximately 4.7 years and a weighted average interest rate of approximately 6.5%.

22




The following table summarizes our significant contractual obligations as of June 30, 2007, including long-term debt and operating lease commitments:

 

 

 

 

Payments Due by Period

 

 

 

 

 

Less than 1

 

1 - 3

 

4 - 5

 

After 5

 

Contractual Obligations

 

 

 

Total

 

year

 

years

 

years

 

years

 

 

 

(in millions)

 

Total debt

 

$

6,177

 

 

1,108

 

 

 

472

 

 

3,211

 

 

1,386

 

 

Operating leases

 

3,767

 

 

241

 

 

 

447

 

 

426

 

 

2,653

 

 

Less: Non-recourse debt and capital lease obligations of non-controlled entities

 

(499

)

 

(114

)

 

 

(29

)

 

(38

)

 

(318

)

 

Total contractual obligations

 

$

9,445

 

 

1,235

 

 

 

890

 

 

3,599

 

 

3,721

 

 

 

Total debt decreased from December 31, 2006 due to the use of proceeds from the Scandic sale and other property sales to pay down our outstanding debt balances. Operating lease obligations decreased from December 31, 2006 due to the Scandic sale in April 2007 (see “Note 11: Discontinued Operations” to our consolidated financial statements under Item 1). Our total debt includes debt and capital lease obligations related to variable interest entities consolidated under FIN 46(R) that are non-recourse to us. These balances, totaling $499 million, have been deducted in arriving at the total contractual obligations as of June 30, 2007. These amounts are reflected on our consolidated balance sheets as non-recourse debt and capital lease obligations of non-controlled entities.

We have certain tax liabilities under FIN 48 totaling approximately $90 million. These amounts are excluded from the table above as we cannot reasonably estimate the period of cash settlement with respect to the various taxing authorities at June 30, 2007.

Development Financing and Other Commercial Commitments

We have issued guarantees in connection with development financing programs in order to support the growth of our brands. The following table summarizes our development financing and other commercial commitments as of June 30, 2007:

 

 

 

 

Amount of Commitment

 

 

 

 

 

Expiration per Period

 

 

 

 

 

Less than 1

 

1 - 3

 

4 - 5

 

After 5

 

Commercial Commitments

 

 

 

Total

 

year

 

years

 

years

 

years

 

 

 

(in millions)

 

Letters of credit

 

$

109

 

 

109

 

 

 

 

 

 

 

 

 

 

 

Guarantees

 

40

 

 

2

 

 

 

18

 

 

 

6

 

 

 

14

 

 

Total commercial commitments

 

$

149

 

 

111

 

 

 

18

 

 

 

6

 

 

 

14

 

 

 

See “Note 12: Guarantees” to our consolidated financial statements under Item 1 for further discussion of our development financing and other commercial commitments.

Acquisitions and Dispositions

In the six months ended June 30, 2007, we sold three wholly owned hotels, our minority interests in nine joint venture properties (see “Note 10:  Acquisitions and Dispositions” to our consolidated financial statements under Item 1) and our Scandic hotel chain (see “Note 11: Discontinued Operations” to our consolidated financial statements under Item 1). Also, in April 2007 we announced our agreement to sell up to ten hotels in continental Europe. The sale of eight of the hotels closed in July 2007, with the remaining two expected to close in the third quarter of 2007 (see “Note 16: Subsequent Events” to our consolidated financial statements under Item 1).

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Stockholders’ Equity

Dividends paid on common shares were $.04 per share for the three-month periods ended June 30, 2006 and 2007 and $.08 per share for the six-month periods ended June 30, 2006 and 2007.

Results of Operations

Comparison of three months ended June 30, 2006 and 2007

A summary of our consolidated results for the three months ended June 30, 2006 and 2007 is as follows:

 

 

2006

 

2007

 

% Change

 

 

 

(dollars in millions, 
expect per share amounts)

 

Revenue

 

$

2,005

 

2,085

 

 

4

%

 

Operating income

 

347

 

345

 

 

(1

)

 

Discontinued operations, net

 

12

 

34

 

 

 

 

Net income

 

144

 

165

 

 

15

 

 

Basic EPS(1)

 

 

 

 

 

 

 

 

 

Continuing operations

 

.34

 

.34

 

 

 

 

Discontinued operations

 

.03

 

.09

 

 

 

 

Net income

 

.37

 

.42

 

 

14

 

 

Diluted EPS

 

 

 

 

 

 

 

 

 

Continuing operations

 

.32

 

.32

 

 

 

 

Discontinued operations

 

.03

 

.08