F-1/A 1 df1a.htm AMENDMENT NO. 2 TO FORM F-1 Amendment No. 2 to Form F-1
Table of Contents

As filed with the Securities and Exchange Commission on October 23, 2006

Registration No. 333-137800

 


SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


AMENDMENT NO. 2

TO

FORM F-1

REGISTRATION STATEMENT

UNDER THE SECURITIES ACT OF 1933

 


HOME INNS & HOTELS MANAGEMENT INC.

(Exact name of Registrant as specified in its charter)

Not Applicable

(Translation of Registrant’s name into English)

 

Cayman Islands   7011   Not Applicable
(State or other jurisdiction of
incorporation or organization)
  (Primary Standard Industrial
Classification Code Number)
  (I.R.S. Employer
Identification Number)

No. 400 Tian Yao Qiao Road

Shanghai 200030, People’s Republic of China

(8621) 6486-1818

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 


CT Corporation System

111 Eighth Avenue

New York, New York 10011

(212) 664-1666

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 


Copies to:

 

David T. Zhang, Esq.

Latham & Watkins LLP

41st Floor, One Exchange Square

8 Connaught Place, Central

Hong Kong

+(852) 2522-7886

  Leiming Chen, Esq.
Simpson Thacher & Bartlett LLP
7th Floor, ICBC Tower
3 Garden Road, Central
Hong Kong
+(852) 2514-7600

 


Approximate date of commencement of proposed sale to the public: as soon as practicable after the effective date of this registration statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨                      

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨                      

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨                      

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. ¨

 


CALCULATION OF REGISTRATION FEE

 

 
Title of each class of
securities to be registered
   Amount to be
registered (1)
   Proposed maximum aggregate
offering price (1)
   Amount of
registration fee (2)

Ordinary shares, par value US$0.005 per share (3)(4)

   18,170,000    US$109,020,000    US$11,666
 
(1) Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(a) under the Securities Act of 1933.
(2) Paid previously.
(3) Includes ordinary shares initially offered and sold outside the United States that may be resold from time to time in the United States either as part of their distribution or within 40 days after the later of the effective date of this registration statement and the date the shares are first bona fide offered to the public, and also includes ordinary shares that may be purchased by the underwriters pursuant to an over-allotment option. These ordinary shares are not being registered for the purpose of sales outside the United States.
(4) American depositary shares issuable upon deposit of the ordinary shares registered hereby have been registered under a separate registration statement on Form F-6 (Registration No.333-137983). Each American depositary share represents two ordinary shares.

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to such Section 8(a), may determine.

 



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The information in this prospectus is not complete and may be changed. Neither we nor the selling shareholders may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion

Preliminary Prospectus Dated                     , 2006

7,900,000 American Depositary Shares

LOGO

Home Inns & Hotels Management Inc.

Representing 15,800,000 Ordinary Shares

 


This is the initial public offering of American depositary shares, or ADSs, of Home Inns & Hotels Management Inc., or Home Inns. Home Inns is offering 4,885,827 ADSs, and the selling shareholders disclosed in this prospectus are offering an additional 3,014,173 ADSs. Each ADS represents two ordinary shares. The ADSs are evidenced by American depositary receipts, or ADRs. Home Inns will not receive any of the proceeds from the sale of ADSs by the selling shareholders.

Prior to this offering, there has been no public market for the ADSs or the shares. We anticipate the initial public offering price will be between US$10.00 and US$12.00 per ADS. The ADSs have been approved for listing on the Nasdaq Global Market under the symbol “HMIN.”

The underwriters have an option to purchase up to an additional 988,410 ADSs from Home Inns and an additional 196,590 ADSs from the selling shareholders at the initial public offering price, less underwriting discounts and commissions, within 30 days from the date of this prospectus.

See “Risk Factors” beginning on page 13 to read about risks you should consider before buying the ADSs.

 

     Initial public
offering price
   Underwriting
discounts and
commissions
   Proceeds,
before expenses,
to Home Inns
   Proceeds, before
expenses, to the selling
shareholders

Per ADS

   US$    US$    US$    US$

Total

   US$    US$    US$    US$

The underwriters expect to deliver the ADSs evidenced by the ADRs against payment in U.S. dollars in New York, New York on             , 2006.

Neither the United States Securities and Exchange Commission nor any state securities commission or other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

Credit Suisse   Merrill Lynch & Co.

 

Deutsche Bank Securities

The date of this prospectus is             , 2006


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LOGO


Table of Contents

TABLE OF CONTENTS

 

     Page

PROSPECTUS SUMMARY

   1

RISK FACTORS

   13

FORWARD-LOOKING STATEMENTS

   29

USE OF PROCEEDS

   30

DIVIDEND POLICY

   31

CAPITALIZATION

   32

DILUTION

   33

EXCHANGE RATE INFORMATION

   35

ENFORCEABILITY OF CIVIL LIABILITIES

   36

SELECTED CONSOLIDATED FINANCIAL DATA

   37

MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   42

INDUSTRY BACKGROUND

   68

BUSINESS

   72

REGULATION

   86

MANAGEMENT

   90

PRINCIPAL AND SELLING SHAREHOLDERS

   97

RELATED PARTY TRANSACTIONS

   100

DESCRIPTION OF SHARE CAPITAL

   103

DESCRIPTION OF AMERICAN DEPOSITARY SHARES

   108

SHARES ELIGIBLE FOR FUTURE SALE

   115

TAXATION

   117

UNDERWRITING

   122

NOTICE TO CANADIAN RESIDENTS

   127

EXPENSES RELATING TO THIS OFFERING

   129

LEGAL MATTERS

   130

EXPERTS

   130

WHERE YOU CAN FIND ADDITIONAL INFORMATION

   130

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

   F-1

 


No dealer, salesperson or other person is authorized to give any information or to represent anything not contained in this prospectus. You must not rely on any unauthorized information or representations. This prospectus is an offer to sell only the ADSs offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information in this prospectus is current only as of the date of this prospectus.

Through and including             , 2006 (the 25th day after the date of this prospectus), all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to unsold allotments or subscriptions.

 

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PROSPECTUS SUMMARY

The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information and financial statements appearing elsewhere in this prospectus. In addition to this summary, we urge you to read the entire prospectus carefully, especially the risks of investing in our ADSs discussed under “Risk Factors,” before deciding whether to buy our ADSs.

Home Inns & Hotels Management Inc.

Our Company

We are a leading economy hotel chain in China based on the number of our hotels and the number of our hotel rooms as well as the geographic coverage of our hotel chain. We develop and operate economy hotels across China under our award-winning “Home Inn” brand. Since we commenced operations in 2002, we have become one of the best-known economy hotel brands in China. We offer a consistent product and high-quality services to primarily serve the fast growing population of value-conscious individual business and leisure travelers who demand clean, comfortable and convenient lodging.

We have achieved our growth by utilizing two business models. We either lease real estate properties on which we develop and operate hotels or we franchise our brand to hotel owners and manage these hotel properties. We refer to the former type of hotels as “leased-and-operated hotels” and to the latter type of hotels as “franchised-and-managed hotels.” As of June 30, 2006, our Home Inns hotel chain consisted of 63 leased-and-operated hotels in operation with an additional 33 leased-and-operated hotels under development, and 19 franchised-and-managed hotels in operation with an additional 24 franchised-and-managed hotels under development, covering 40 cities in China. We have received many awards and accolades for our innovative, consistent and high-quality product and services across our hotel chain, including the “2006 Leading Brand in Economy Hotels in China” from the China Hotel Association and the “Golden Pillow Award” for best brand in economy hotels in China in 2006 from the 21st Century Business Herald, a nationwide economic journal in China.

We have experienced substantial growth while maintaining profitability since 2003. Our Home Inns hotels in operation grew rapidly from 10 hotels in four cities as of the end of 2003 to 68 hotels in 22 cities as of the end of 2005, and our net income grew from RMB1.5 million in 2003 to RMB20.9 million (US$2.6 million) in 2005. In the six months ended June 30, 2006, we generated total revenues of RMB249.1 million (US$31.2 million) and net income of RMB27.2 million (US$3.4 million).

Industry Background

China’s lodging industry has expanded rapidly as a result of the substantial growth of the Chinese economy over the past several years. According to Euromonitor International, or Euromonitor, total sales in China’s lodging industry grew from RMB190 billion in 1999 to RMB264 billion in 2004.

While China’s lodging industry continues to grow, it remains highly fragmented. According to Euromonitor, hotels accounted for only approximately 5% of total lodging outlets in China in 2004, with the remainder being guesthouses and other privately owned lodging outlets. Within the hotel sector of the lodging industry, the top ten brands accounted for an approximate 6% market share in 2004 in terms of sales.

Economy hotel chains have emerged and expanded in China in recent years to primarily target value-conscious individual business and leisure travelers. The growth in demand for economy hotel chains in China is

 

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being driven by both general factors, such as the growth of the Chinese economy and the growth of China’s travel and lodging industry, as well as more specific factors, such as a rapid increase in the number of small-to medium-sized enterprises, or SMEs, the growth of domestic tourism, the expansion of urban business centers and the fragmentation of the lodging industry.

We believe the economy hotel market in China is still at an early stage of development. There are significant growth opportunities for economy hotel operators to develop new properties and convert existing lodging facilities. Competitiveness of an economy hotel chain is determined by the hotel chain’s ability to provide a consistent product, high-quality services, an efficient reservation system and effective sales channels, as well as its brand-name recognition and geographic coverage. We believe economy hotel chains that have established a reputable brand and a nationwide network, such as our Home Inns hotel chain, are well-positioned to capture the opportunities presented by the continuing growth of the economy hotel market in China.

Our Strengths, Strategies and Challenges

We believe that the following competitive strengths contribute to our success and differentiate us from our competitors:

 

    scale and leadership in the economy hotel market in China as measured by the number of our hotels and the number of our hotel rooms as well as the geographic coverage of our hotel chain;

 

    innovative, distinctive and consistent product;

 

    outstanding track record as evidenced by our ability to rapidly expand our hotel chain from ten hotels operating in four cities as of the end of 2003 to 82 hotels operating in 26 cities as of June 30, 2006 while having maintained profitability since 2003;

 

    efficient and integrated operational infrastructure and information systems; and

 

    experienced management team and motivated staff.

Our goal is to become the leading economy hotel chain in China. We intend to achieve our goal by pursuing the following growth strategies:

 

    expand geographical coverage to capitalize on our early-mover advantage;

 

    increase penetration in existing markets;

 

    continue to build brand awareness and customer loyalty;

 

    increase our revenue per available room, or RevPAR, by optimizing customer channel mix and maximizing room rate growth; and

 

    further enhance our information and operational systems and human resources management.

The successful execution of our strategies is subject to certain risks and uncertainties, including:

 

    risks associated with our limited operating history;

 

    uncertainties associated with our ability to continue our growth while maintaining our profitability;

 

    uncertainties associated with our ability to fund working capital needs as we have incurred a working capital deficit resulting primarily from payables relating to the cost of leasehold improvements;

 

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    uncertainties in our ability to expand our operations while maintaining the consistent quality of our product and enhancing profitability;

 

    uncertainties in our ability to respond to competitive pressures; and

 

    uncertainties associated with factors typically affecting the lodging industry, including changes in economic conditions, natural disasters or outbreaks of serious contagious diseases in markets where we have a presence.

Please see “Risk Factors” and other information included in this prospectus for a detailed discussion of these risks and uncertainties.

Corporate Information

We incorporated Home Inns & Hotels Management (Hong Kong) Limited, or Home Inns Hong Kong, in May 2001 and commenced operations in July 2002 through Home Inns & Hotels Management (Beijing) Co, Ltd., or Home Inns Beijing, a company established in China, and its subsidiaries and affiliates. In May 2006, we established a holding company, Home Inns & Hotels Management Inc., under the laws of the Cayman Islands in preparation for this offering.

Our principal executive offices are located at No. 400 Tian Yao Qiao Road, Shanghai 200030, People’s Republic of China. Our telephone number at this address is +(8621) 6486-1818. Our registered office in the Cayman Islands is located at the offices of M&C Corporate Services Limited, P.O Box 309GT, Ugland House, South Church Street, George Town, Grand Cayman, Cayman Islands, British West Indies. In addition, we have two branch offices in China. Our agent for service of process in the United States is CT Corporation System, located at 111 Eighth Avenue, New York, New York 10011.

Investors should contact us for any inquiries through the address and telephone number of our principal executive offices. Our website is http://www.homeinns.com. The information contained on our website is not a part of this prospectus.

 

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Corporate Structure and History

The following diagram illustrates our corporate structure, the place of formation and the ownership interests of our subsidiaries as of September 30, 2006.

LOGO

 


* Home Inns Shanghai owns 75% of one joint venture and 51% of each of the other three joint ventures.

Home Inns Hong Kong was incorporated in Hong Kong in May 2001 by its individual founders and Ctrip.com International, Ltd., or Ctrip, a leading China-based travel consolidator. Through a series of transactions, Ctrip disposed of all of its ownership interest in Home Inns Hong Kong in August 2003 to focus on its core business of travel consolidation and to prepare for its initial public offering, which was completed in December 2003.

In April 2002, Home Inns Hong Kong and Beijing Capital Travel International Hotel Group Co., Ltd., or Beijing Capital Travel, entered into a joint venture agreement to form Home Inns Beijing to operate branded economy hotels in China. Beijing Capital Travel is a subsidiary of Beijing Tourism Group, or BTG. Home Inns Hong Kong and BTG owned 55% and 45%, respectively, of Home Inns Beijing when it commenced operations in July 2002. Subsequently, Home Inns Hong Kong gradually increased its ownership interest in Home Inns Beijing by contributing additional funds to the registered capital of Home Inns Beijing. Home Inns Hong Kong’s ownership interest in Home Inns Beijing was increased to 95.59% as of February 2005.

We have been actively managing Home Inns Beijing since its inception. Home Inns Hong Kong’s ownership in Home Inns Beijing was accounted for under the equity method since Home Inns Beijing’s inception until April 2004, because during this period of time, BTG had substantive participation rights that enabled it to veto significant decisions made by Home Inns Hong Kong. In April 2004, Home Inns Hong Kong and Beijing Capital Travel entered into a revised joint venture agreement, under which Home Inns Hong Kong obtained control of Home Inns Beijing. As a result, Home Inns Beijing has been our consolidated subsidiary since then.

 

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In May 2006, we incorporated Home Inns & Hotels Management Inc. in the Cayman Islands in preparation for this offering. In June 2006, all of the then-existing shareholders of Home Inns Hong Kong exchanged their respective shares of Home Inns Hong Kong for an equivalent number of shares of Home Inns & Hotels Management Inc. of equivalent classes. As a result, Home Inns Hong Kong became our wholly owned subsidiary in June 2006. Our consolidated financial statements reflect the share exchange in June 2006 and have been prepared as if our current corporate structure had been in existence throughout the relevant periods.

 

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Conventions Which Apply to this Prospectus

Unless we indicate otherwise, all information in this prospectus reflects the following:

 

    no exercise by the underwriters of their option to purchase up to 988,410 additional ADSs representing 1,976,820 ordinary shares from us and up to 196,590 additional ADSs representing 393,180 ordinary shares from the selling shareholders; and

 

    conversion of all outstanding preferred shares to ordinary shares immediately prior to the closing of this offering.

Except where the context otherwise requires and for purposes of this prospectus only:

 

    “we,” “us,” “our company,” “our” and “Home Inns” refer to Home Inns & Hotels Management Inc., a Cayman Islands company, and its predecessor entities and subsidiaries, and in the context of discussing our consolidated financial data before April 2004, excluding Home Inns Beijing and its subsidiaries;

 

    “BTG” refers to Beijing Tourism Group, a state-owned enterprise established in the PRC, and its predecessors and subsidiaries, including Beijing Capital Travel International Hotel Group Co., Ltd.;

 

    “China” or “PRC” refers to the People’s Republic of China, excluding Taiwan, Hong Kong and Macau;

 

    “Home Inns Beijing” refers to Home Inns Hotel Management (Beijing) Co., Ltd., and its subsidiaries, which have been our consolidated subsidiaries since April 2004;

 

    “Home Inns Hong Kong” refers to Home Inns & Hotels Management (Hong Kong) Limited;

 

    “Home Inns Shanghai” refers to Home Inns Hotel Management (Shanghai) Co., Ltd.;

 

    “our hotels” refers, collectively, to our leased-and-operated and franchised-and-managed hotels;

 

    “average daily rate” refers to total hotel room revenues divided by the total number of occupied rooms in a given period;

 

    “occupancy rate” refers to the total number of occupied rooms divided by the total number of available rooms in a given period;

 

    “RevPAR” represents revenue per available room, which is calculated by dividing total hotel room revenues by the total number of available rooms in a given period or by multiplying average daily rates and occupancy rates in a given period;

 

    “shares” or “ordinary shares” refers to our ordinary shares; “preferred shares” refers to our Series A convertible preferred shares, Series B convertible preferred shares and Series C convertible preferred shares, collectively;

 

    “ADSs” refers to our American depositary shares, each of which represents two ordinary shares, and “ADRs” refers to the American depositary receipts that evidence our ADSs; and

 

    “RMB” or “Renminbi” refers to the legal currency of China; “$,” “dollars,” “US$” or “U.S. dollars” refers to the legal currency of the United States; and “HK$” refers to the legal currency of Hong Kong.

 

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THE OFFERING

The following information assumes that the underwriters will not exercise their option to purchase additional ADSs in the offering, unless otherwise indicated.

 

Offering price

We currently estimate that the initial public offering price will be between US$10.00 and US$12.00 per ADS.

 

ADSs offered by us

4,885,827 ADSs.

 

ADSs offered by the selling shareholders

3,014,173 ADSs.

 

ADSs outstanding immediately after this offering

7,900,000 ADSs.

 

Ordinary shares outstanding immediately after this offering

64,470,129 ordinary shares.

 

ADS to ordinary share ratio

One ADS represents two ordinary shares.

 

The ADSs

The ADSs will be evidenced by ADRs.

 

    The depositary will hold the shares underlying your ADSs. You will have rights as provided in the deposit agreement.

 

    If, however, we declare dividends on our ordinary shares, the depositary will pay you the cash dividends and other distributions it receives on our ordinary shares, after deducting its fees and expenses.

 

    You may turn in your ADSs to the depositary in exchange for ordinary shares. The depositary will charge you fees for any exchange.

 

    We may amend or terminate the deposit agreement without your consent. If you continue to hold your ADSs, you agree to be bound by the deposit agreement as amended.

 

 

To better understand the terms of the ADSs, you should carefully read the “Description of American Depositary Shares” section of this prospectus. You should also read the deposit agreement, which is filed as an exhibit to the registration statement that includes this prospectus.

 

Over-allotment option

We and the selling shareholders have granted to the underwriters an option, which is exercisable within 30 days from the date of this prospectus, to purchase up to an aggregate of 1,185,000 additional ADSs.

 

Use of proceeds

Our net proceeds from this offering are expected to be approximately US$47.4 million, assuming an initial public offering price of US$11.00 per ADS, which is the midpoint of the estimated public offering price range. We plan to use the net proceeds we receive from this offering to fund capital expenditures, repay our outstanding indebtedness to a related party, and for general corporate purposes. See “Use of Proceeds” for additional information.

 

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We will not receive any of the proceeds from the sale of ADSs by the selling shareholders.

 

Lock-up

We have agreed with the underwriters to a lock-up of shares for a period of 180 days after the date of this prospectus. In addition, our executive officers, directors and our existing shareholders have also agreed with the underwriters to a lock-up of shares for a period of 180 days after the date of this prospectus or, in the case of Poly Victory Investments Limited, or Poly Victory, one of our principal shareholders, three years after the date of this prospectus. See “Underwriting.”

 

Listing

Our ADSs have been approved for listing on the Nasdaq Global Market under the symbol “HMIN.” Our ordinary shares will not be listed on any exchange or traded on any automated quotation system.

 

Risk factors

See “Risk Factors” and other information included in this prospectus for a discussion of risks you should carefully consider before investing in our ADSs.

 

Depositary

The Bank of New York.

The number of ordinary shares that will be outstanding immediately after this offering:

 

    assumes the conversion of all outstanding preferred shares into 22,924,886 ordinary shares immediately prior to the completion of this offering;

 

    excludes 3,042,886 ordinary shares issuable upon the exercise of options outstanding as of the date of this prospectus, at a weighted average exercise price of US$2.41 per share; and

 

    excludes ordinary shares reserved for future issuances under our share incentive plans.

 

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Our Summary Consolidated Financial and Operating Data

You should read the following information in conjunction with our and Home Inns Beijing’s consolidated financial statements and related notes, “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

The following summary consolidated financial information has been derived from our consolidated financial statements included elsewhere in this prospectus. Our summary consolidated statement of operations data for the years ended December 31, 2003, 2004 and 2005 have been derived from our consolidated financial statements for the relevant periods which have been audited by PricewaterhouseCoopers Zhong Tian CPAs Limited Company, an independent registered public accounting firm, and are prepared and presented in accordance with generally accepted accounting principles in the United States, or U.S. GAAP, and reflect our current corporate structure as if it had been in existence throughout the relevant periods. Our summary consolidated statement of operations data for the six months ended June 30, 2005 and 2006 and our consolidated balance sheet data as of June 30, 2006 have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. We have prepared the unaudited consolidated financial statements on the same basis as our audited consolidated financial statements. The unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the periods presented.

 

    For the Year Ended December 31,     For the Six Months Ended
June 30,
 
  2003     2004     2005     2005     2006  
    RMB     RMB     RMB     US$     RMB     RMB     US$  
    (in thousands, except share, per share and per ADS data)  

Consolidated Statement of Operations Data:

             

Total Revenues

  —       96,000     285,861     35,758     109,406     249,059     31,154  

Less: Business tax and related surcharges

  —       (5,101 )   (16,830 )   (2,105 )   (6,669 )   (13,344 )   (1,669 )

Net revenues

  —       90,899     269,031     33,653     102,737     235,715     29,485  

Operating costs and expenses(1)

  (365 )   (82,031 )   (238,435 )   (29,826 )   (91,795 )   (195,837 )   (24,497 )

Income (loss) from operations

  (365 )   8,868     30,596     3,827     10,942     39,878     4,988  

Income (loss) before income tax expense, minority interests and share of income of affiliated companies

  (365 )   9,183     32,255     4,035     12,913     39,150     4,897  

Minority interests

  —       552     (4,797 )   (600 )   (2,016 )   (2,697 )   (337 )

Share of income of affiliated companies

  1,879     1,972     —       —       —       —       —    

Net income

  1,514     5,969     20,933     2,618     8,305     27,249     3,409  

Amount allocated to participating preferred shareholders

  (868 )   (2,960 )   (9,487 )   (1,187 )   (3,757 )   (12,413 )   (1,553 )

Net income available to ordinary shareholders

  646     3,009     11,446     1,431     4,548     14,836     1,856  

Earnings per share

             

Basic

  0.06     0.15     0.42     0.05     0.17     0.54     0.07  

Diluted

  0.06     0.15     0.40     0.05     0.16     0.51     0.06  

Earnings per ADS(2)

             

Basic

  0.12     0.30     0.84     0.10     0.34     1.08     0.14  

Diluted

  0.12     0.30     0.80     0.10     0.32     1.02     0.12  

Weighted average ordinary shares outstanding:

             

Basic

  11,000,000     19,981,424     27,399,140     27,399,140     27,399,140     27,399,140     27,399,140  

Diluted

  11,000,000     20,315,681     28,713,188     28,713,188     28,560,208     29,235,149     29,235,149  

(1)    Include share-based compensation expenses as follows:

      

           
    For the Year Ended December 31,     For the Six Months Ended
June 30,
 
  2003     2004     2005     2005     2006  
    RMB     RMB     RMB     US$     RMB     RMB     US$  
    (in thousands)  

Share-based compensation expenses

  —       149     960     120     486     1,035     129  

 

(2) Each ADS represents two ordinary shares.

 

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     As of June 30, 2006
     Actual    As adjusted (1)
     RMB    US$    RMB    US$
     (in thousands)

Consolidated Balance Sheet Data:

           

Cash and cash equivalents

   80,981    10,130    459,583    57,489

Total assets

   502,780    62,892    881,382    110,251

Total current liabilities

   190,903    23,880    190,903    23,880

Total shareholders’ equity

   207,367    25,939    585,969    73,298

(1) Our consolidated balance sheet data as of June 30, 2006 are adjusted to give effect to (i) the automatic conversion of all of our outstanding preferred shares into 22,924,886 ordinary shares immediately prior to the closing of this offering and (ii) the issuance and sale of 4,885,827 ADSs by us in this offering, assuming an initial public offering price of US$11.00 per ADS, the midpoint of the estimated range of the initial public offering price, after deducting estimated underwriting discounts, commissions and estimated offering expenses payable by us and assuming no exercise of the underwriters’ over-allotment option. A US$1.00 increase (decrease) in the assumed initial public offering price of US$11.00 per ADS would increase (decrease) the amounts representing cash and cash equivalents, total assets and total shareholders’ equity by US$4.5 million.

The following table presents certain unaudited financial data and selected operating data as of and for the dates and periods indicated. We present operating data for 2003 and 2004 as if we had consolidated Home Inns Beijing throughout the relevant periods.

 

     As of and for the Year Ended
December 31,
   As of and for the
Six Months Ended
June 30,
     2003    2004    2005    2005    2006

Non-GAAP Financial Data:

              

EBITDA(1) (in thousands of RMB)

   1,513    17,684    51,790    19,924    59,008

Operating Data(2):

              

Total hotels in operation:

              

Leased-and-operated hotels(3)

   10    18    54    34    63

Franchised-and-managed hotels

   0    8    14    10    19

Total rooms

   1,131    2,991    8,197    5,372    9,707

Geographic coverage:

              

Number of cities

   4    8    22    11    26

Occupancy rate (as a percentage)

   72.4    86.8    89.8    86.6    93.8

Average daily rate (in RMB)

   175    191    182    184    181

RevPAR (in RMB)

   127    166    163    159    170

(1) We believe that earnings before interest, income tax expense, depreciation and amortization, or EBITDA, is a useful financial metric to assess our operating and financial performance before the impact of investing and financing transactions and income taxes. In addition, we believe that EBITDA is widely used by other companies in the lodging industry and may be used by investors as a measure of our financial performance. Given the significant investments that we have made in the past in property, plant and equipment, depreciation and amortization expense comprises a meaningful portion of our cost structure. We believe that EBITDA will provide investors with a useful tool for comparability between periods because it eliminates depreciation and amortization expense attributable to capital expenditures. The presentation of EBITDA should not be construed as an indication that our future results will be unaffected by other charges and gains we consider to be outside the ordinary course of our business.

 

    

The use of EBITDA has certain limitations. Depreciation and amortization expense for various long-term assets, income tax expense, interest expense and interest income have been and will be incurred and are not reflected in the presentation of EBITDA. Each of these items should also be considered in the overall evaluation of our results. Additionally, EBITDA does not consider capital expenditures and other investing activities and should not be considered as a measure of our liquidity. We compensate for these limitations by providing the relevant disclosure of our depreciation and amortization, interest expense and interest income, income tax expense, capital expenditures and other relevant items both in our reconciliations to the U.S. GAAP financial measures and in our consolidated financial statements, all of which should be considered when evaluating our performance. The term EBITDA is not defined under U.S. GAAP, and EBITDA is not a measure of net income, operating income, operating performance or liquidity presented in accordance with U.S.

 

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GAAP. When assessing our operating and financial performance, you should not consider this data in isolation or as a substitute for our net income, operating income or any other operating performance measure that is calculated in accordance with U.S. GAAP. In addition, our EBITDA may not be comparable to EBITDA or similarly titled measures utilized by other companies since such other companies may not calculate EBITDA in the same manner as we do.

 

     A reconciliation of EBITDA to net income, which is the most directly comparable U.S. GAAP measure, is provided below:

 

     For the Year Ended December 31,      For the Six Months Ended
June 30,
 
     2003      2004      2005      2005      2006  
     RMB      RMB      RMB      US$      RMB      RMB      US$  
     (in thousands)  

Net income

   1,514      5,969      20,933      2,618      8,305      27,249      3,409  

Interest income

   (1 )    (88 )    (223 )    (28 )    (96 )    (291 )    (36 )

Interest expense

   —        98      709      89      —        2,719      340  

Income tax expense

   —        5,738      6,526      817      2,593      9,204      1,151  

Depreciation and amortization

   —        5,967      23,845      2,983      9,122      20,127      2,518  
                                                

EBITDA

   1,513      17,684      51,790      6,479      19,924      59,008      7,382  
                                                

 

(2) We have presented the operating data in 2003 and 2004 to include those of Home Inns Beijing as Home Inns Beijing was managed by us throughout these two years.

 

(3) Includes four hotels operated through separate joint ventures with third parties. We own 75% of one joint venture and 51% of each of the other three joint ventures.

 

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Home Inns Beijing’s Summary Consolidated Financial Data

You should read the following information in conjunction with Home Inns Beijing’s consolidated financial statements and related notes, “Home Inns Beijing’s Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

The following summary consolidated financial information has been derived from Home Inns Beijing’s consolidated financial statements included elsewhere in this prospectus. Home Inns Beijing’s consolidated statement of operations data for the years ended December 31, 2003 and 2004 has been derived from its consolidated financial statements for the relevant periods which have been audited by PricewaterhouseCoopers Zhong Tian CPAs Limited Company, an independent registered public accounting firm, and is prepared and presented in accordance with U.S. GAAP.

In April 2002, Home Inns Hong Kong and BTG entered into a joint venture agreement to form Home Inns Beijing to operate branded economy hotels in China. Home Inns Hong Kong and BTG owned 55% and 45%, respectively, of Home Inns Beijing when it commenced operations in July 2002. Subsequently, Home Inns Hong Kong gradually increased its ownership interest in Home Inns Beijing by contributing additional funds to the registered capital of Home Inns Beijing. Home Inns Hong Kong’s ownership interest in Home Inns Beijing was increased to 95.59% as of February 2005.

We have been actively managing Home Inns Beijing since its inception. Home Inns Hong Kong’s ownership in Home Inns Beijing was accounted for under the equity method since Home Inns Beijing’s inception until April 2004, because during this period of time, BTG had substantive participation rights that enabled it to veto significant decisions made by Home Inns Hong Kong. In April 2004, Home Inns Hong Kong and Beijing Capital Travel entered into a revised joint venture agreement, under which Home Inns Hong Kong obtained effective control of Home Inns Beijing. As a result, Home Inns Beijing has been our consolidated subsidiary since then.

 

     For the Year Ended
December 31,
 
   2003     2004  
     (in RMB thousands)  

Revenues

   43,842     115,278  

Less: Business tax and related surcharges

   (1,662 )   (6,150 )

Net revenues

   42,180     109,128  

Operating costs and expenses

   (39,490 )   (96,139 )

Income from operations

   2,690     12,989  

Net income

   2,488     7,735  

 

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RISK FACTORS

You should consider carefully all of the information in this prospectus, including the risks and uncertainties described below, before making an investment in our ADSs. Any of the following risks could have a material adverse effect on our business, financial condition and results of operations. In any such case, the market price of our ADSs could decline, and you may lose all or part of your investment.

Risks Related to Our Business

Our operating results are subject to conditions typically affecting the lodging industry.

Our operating results are subject to conditions typically affecting the lodging industry, including the following:

 

    changes in the national, regional or local economic conditions;

 

    natural disasters or travelers’ fears of exposure to serious contagious diseases;

 

    the attractiveness of our hotels to customers and competition from other hotels;

 

    local market conditions such as an oversupply of, or a reduction in demand for, hotel rooms;

 

    the performance of managerial and other employees of our hotels; and

 

    increases in operating costs and expenses due to inflation and other factors.

Changes in any of these conditions could adversely affect our occupancy rates, average daily rates and RevPAR or otherwise adversely affect our results of operations and financial condition.

We may not be able to manage our expected growth, which could adversely affect our operating results.

Since our inception, we have experienced substantial growth. We have increased the number of our hotels in operation in China from five in 2002 to 82 as of June 30, 2006, and we intend to continue to develop and operate additional hotels in different geographic locations in China. This expansion has placed, and will continue to place, substantial demands on our managerial, operational, technological and other resources. Our planned expansion will also require us to maintain the consistency of our product and the quality of our services to ensure that our brand does not suffer as a result of any deviations, whether actual or perceived, in the consistency of our product and the quality of our services. In order to manage and support our growth, we must continue to improve our existing operational, administrative and technological systems and our financial and management controls, and recruit, train and retain qualified hotel management personnel as well as other administrative and sales and marketing personnel, particularly as we expand into new markets. We cannot assure you that we will be able to effectively and efficiently manage the growth of our operations, recruit and retain qualified personnel and integrate new hotels into our operations. Any failure to effectively and efficiently manage our expansion may materially and adversely affect our ability to capitalize on new business opportunities, which in turn may have a material adverse effect on our results of operation.

Expansion into new markets may present operating and marketing challenges that are different from those that we currently encounter in our existing markets. In addition, our expansion within existing markets may adversely affect the financial performance of our existing hotels in those markets and, as a result, negatively affect our overall results of operations. Our inability to anticipate the changing demands that expanding operations will impose on our management and information and operational systems, or our failure to quickly adapt our systems and procedures to the new markets could result in lost revenue and increased expenses and otherwise harm our results of operations and financial condition.

 

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If the value of our brand or image diminishes, it could have a material and adverse effect on our business and results of operations.

Our “Home Inn” brand is associated with a leading economy hotel chain offering cleanness, convenience and comfort with consistent, high-quality service among value-conscious individual business and leisure travelers in China. Our continued success in maintaining and enhancing our brand and image depends, to a large extent, on our ability to satisfy customer needs by further developing and maintaining our innovative and distinctive product and maintaining consistent quality of services across our hotel chain, as well as our ability to respond to competitive pressures. If we are unable to do so, our occupancy rates may decline, which could in turn adversely affect our results of operations. Our business may also be adversely affected if our public image or reputation were to be diminished by the operations of any of our hotels, whether due to unsatisfactory service, accidents or otherwise. Our brand is integral to our sales and marketing efforts. If the value of our brand or image is diminished or if our brand does not continue to be attractive to customers, our business and results of operations may be materially and adversely affected.

If we are not able to hire, train and retain qualified managerial and other employees, our brand and our business may be materially and adversely affected.

Our managerial and other employees manage our hotels and interact with our customers on a daily basis. They are critical to maintaining the quality and consistency of our services as well as our established brand and reputation. It is important for us to attract qualified managerial and other employees who have experience in lodging or other consumer-service industries and are committed to our “customer-first” approach. There may be a limited supply of such qualified individuals in some of the cities in China where we have operations and other cities into which we intend to expand. In addition, criteria such as dedication are difficult to ascertain during the recruitment process. We must hire and train qualified managerial and other employees on a timely basis to keep pace with our rapid growth while maintaining consistent quality of services across our hotels in various geographic locations. We must also provide continuous training to our managerial and other employees so that they are equipped with up-to-date knowledge of various aspects of our hotel operations and can meet our demand for high-quality services. If we fail to do so, the quality of our services may decrease in one or more of the markets where we operate, which in turn, may have a material and adverse effect on our brand and our business.

We may not be able to successfully identify or secure additional hotel properties.

We plan to open more hotels in targeted markets to further grow our business. We may not be successful in identifying and leasing or franchising additional hotel properties at desirable locations and on commercially reasonable terms or at all. Some cities in China have undergone economic development and expansion for several decades while others are still at an early stage of development. In more developed cities, it may be difficult to increase the number of hotels because we or our competitors already have operations in such cities. In less developed cities, demand for our hotels may not increase as rapidly as we expect. Even if we are able to successfully identify and acquire new hotel properties via lease or franchise arrangements, new hotels may not generate the returns we expect. We also may incur costs in connection with evaluating hotel properties and negotiating with property owners, including ones that we are subsequently unable to lease or franchise. If we fail to successfully identify or compete for additional hotel properties, our ability to execute our growth strategy could be impaired and our business and prospects may be materially and adversely affected.

Our financial and operating performance may be adversely affected by epidemics, natural disasters and other catastrophes.

Our financial and operating performance may be adversely affected by epidemics, natural disasters and other catastrophes, particularly in locations where we operate a large number of hotels. In early 2003, several economies in Asia, including China, were affected by the outbreak of severe acute respiratory syndrome, or SARS. During May and June of 2003, many businesses in China were closed by the PRC government to prevent

 

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transmission of SARS. Our business and results of operations were materially and adversely affected by the outbreak of SARS. In addition, some Asian countries, including China, have recently encountered incidents of the H5N1 strain of bird flu, or avian flu. This disease, which originally spread through poultry populations, is capable in some circumstances of being transmitted to humans and is often fatal. Losses caused by epidemics, natural disasters and other catastrophes, including SARS, avian flu, earthquakes or typhoons, are either uninsurable or too expensive to justify insuring against in China. In the event an uninsured loss or a loss in excess of insured limits occurs, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any financial obligations related to the hotel. Similarly, war (including the potential for war) and terrorist activity (including threats of terrorist activity), travel-related accidents, as well as geopolitical uncertainty and international conflict, will affect travel and may in turn have a material adverse effect on our business and results of operation. In addition, we may not be adequately prepared in contingency planning or recovery capability in relation to a major incident or crisis, and as a result, our operational continuity may be adversely affected and our reputation may be harmed.

Our legal right to lease certain properties could be challenged by property owners or other third parties, which could prevent us from continuing to operate the affected hotels or increase the costs associated with operating these hotels.

We do not hold any land-use rights with respect to the land on which our hotels are located nor do we own any of the hotel properties we operate. Instead, our business model relies on leases with third parties who either own the properties or lease the properties from the ultimate property owner. As of June 30, 2006, four of our lessors had not obtained title certificates for the properties operated by us. We cannot assure you that title to properties we currently lease or franchise will not be challenged. There may be challenges to the title of the properties which, if successful, could impair the development or operations of our hotels on such properties. In addition, we are subject to the risk of potential disputes with property owners. Such disputes, whether resolved in our favor or not, may divert management attention, harm our reputation or otherwise disrupt our business.

Where our immediate lessors are not the ultimate owners of hotel properties, in several instances, no consent was obtained from the owners to sublease the hotel properties to us. A lessor’s failure to duly obtain the title to the property or to receive any necessary approvals from the ultimate owner or the primary lease holder, as applicable, could potentially invalidate our lease or result in the renegotiation of such lease leading to less favorable terms. Moreover, we cannot assure you that the building ownership or leasehold in connection with our franchised-and-managed hotels will not be subject to similar third-party challenges. Some of the properties we or our franchisees lease from third parties were subject to mortgages at the time the leases were signed. In such circumstances and where consent to the lease was not obtained from the mortgage holder, the lease may not be binding on the transferee of the property if the mortgage holders foreclose on the mortgage and transfer the property, which could in turn materially and adversely affect our ability to operate the hotel facility.

If we are unable to compete successfully, our financial condition and results of operations may be harmed.

The lodging industry in China is highly competitive. Competition in the industry is primarily based on room rates, quality of accommodations, brand name recognition, convenience of location, geographic coverage, service quality, range of services, and guest amenities. We compete primarily with other economy hotel chains as well as various regional and local economy hotels. We also compete with two- and three-star hotels, as we offer rooms with standards comparable to many of those hotels while maintaining competitive pricing. In addition, we may also face competition from new entrants in the economy hotel segment in China. As compared to developing four- or five-star hotels, developing economy hotels does not require significant capital commitments or human resources. This relatively low barrier to entry potentially allows new competitors to enter our markets quickly to compete with our business. Furthermore, we compete with all other hotels for guests in each market in which we operate, as our typical business and leisure traveler customers may change their travel, spending and consumption patterns and choose to stay in hotels in different segments. New and existing competitors may offer

 

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competitive rates, greater convenience, services or amenities or superior facilities, which could attract customers away from our hotels, resulting in a decrease in occupancy and average daily rates for our hotels. Any of these factors may have an adverse effect on our competitive position, results of operations and financial condition.

Our limited operating history makes it difficult to evaluate our future prospects and results of operations.

We believe that our future success depends on our ability to significantly increase revenue and profitability from our operations. We have a limited operating history. We commenced operations in 2002. Accordingly, you should consider our future prospects in light of the risks and challenges encountered by a company with a limited operating history. These risks and challenges include:

 

    the uncertainties associated with our ability to continue our growth while maintaining our profitability;

 

    preserving our competitive position in the economy hotel segment of the lodging industry in China;

 

    offering an innovative product to attract recurring and new customers;

 

    implementing our strategy and modifying it from time to time to respond effectively to competition and changes in customer preferences and needs;

 

    increasing awareness of our “Home Inn” brand and continuing to develop customer loyalty; and

 

    attracting, training, retaining and motivating qualified personnel.

If we are unsuccessful in addressing any of these risks or challenges, our business may be materially and adversely affected.

Failure to retain our senior management could harm our business.

We place substantial reliance on the lodging and other consumer-service industry experience and the institutional knowledge of members of our senior management team. Mr. David Jian Sun, our chief executive officer, Ms. May Wu, our chief financial officer, and Ms. Rixin Liang, our chief operating officer, are particularly important to our future success due to their substantial experience in the lodging and other consumer-service industries. We do not carry key person insurance on any of our senior management team. The loss of the services of one or more of these members of our senior management team due to their departure or otherwise could hinder our ability to effectively manage our business and implement our growth strategies. Finding suitable replacements for Mr. Sun, Ms. Wu and Ms. Liang could be difficult, and competition for such personnel of similar experience is intense. If we lose the services of any of them, our business may be adversely affected.

Interruption or failure of our information and operational systems could impair our ability to effectively provide our services, which could damage our reputation.

Our ability to provide consistent and high-quality services throughout our hotel chain depends on the continued operation of our proprietary information and operational systems, including our property management, central reservation, customer relationship management and management reporting systems. Any damage to or failure of our systems could interrupt our service. Our systems are vulnerable to damage or interruption as a result of power loss, telecommunications failures, computer viruses, fires, floods, earthquakes, interruptions in access to our toll-free numbers, hacking or other attempts to harm our systems, and similar events. Our servers, which are maintained in Shanghai, may also be vulnerable to break-ins, sabotage and vandalism. Some of our systems are not fully redundant, and our disaster recovery planning does not account for all possible scenarios. In addition, our systems and technologies may become outdated and we may not be able to replace or introduce upgraded systems as quickly as our competitors or within budgeted costs for such upgrades. If we experience frequent or persistent system failures, our quality of services and our reputation could be harmed. The steps we need to take to increase the reliability and redundancy of our systems may be costly, which could reduce our operating margin, and may not be successful in reducing the frequency or duration of system failures and service interruptions.

 

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Any failure to protect our trademarks and other intellectual property rights could have a negative impact on our business.

We believe our brand, trade name, trademarks and other intellectual property are critical to our success. “Home Inn” is a highly recognized brand in the economy hotel segment of China’s lodging industry. The success of our business depends in part upon our continued ability to use our brand, trade names and trademarks to increase brand awareness and to further develop our brand. The unauthorized reproduction of our trademarks could diminish the value of our brand and its market acceptance, competitive advantages or goodwill. In addition, our proprietary information and operational systems, which have not been patented or otherwise registered as our property, are a key component of our competitive advantage and our growth strategy.

Monitoring and preventing the unauthorized use of our intellectual property is difficult. The measures we take to protect our brand, trade names, trademarks and other intellectual property rights may not be adequate to prevent their unauthorized use by third parties. Furthermore, the application of laws governing intellectual property rights in China and abroad is uncertain and evolving, and could involve substantial risks to us. If we are unable to adequately protect our brand, trade names, trademarks and other intellectual property rights, we may lose these rights and our business may suffer materially.

Accidents or injuries in our hotels may adversely affect our reputation and subject us to liability.

There are inherent risks of accidents or injuries in hotels. One or more accidents or injuries at any of our hotels could adversely affect our safety reputation among customers and potential customers, decrease our overall occupancy rates and increase our costs by requiring us to take additional measures to make our safety precautions even more visible and effective. If accidents or injuries occur at any of our hotels, we may be held liable for costs related to the injuries. Our current property and liability insurance policies may not provide adequate coverage and we may be unable to renew our insurance policies or obtain new insurance policies without increases in cost or decreases in coverage levels.

We may not be able to develop hotel properties on a timely or cost-efficient basis, which may adversely affect our growth strategy and business.

We develop all of our leased-and-operated hotels directly. Our involvement in the development of properties presents a number of risks, including construction delays or cost overruns, which may result in increased project costs or forgone revenue. We may be unable to recover development costs we incur for projects that are not pursued to completion. Properties that we develop could become less attractive due to market saturation or oversupply, with the result that we may not be able to recover development costs at the expected rate, or at all. In addition, we may not have available cash to complete projects that have commenced, or we may be unable to obtain financings for development of future properties on favorable terms, if at all. If we are unable to successfully manage our hotel development to minimize these risks, our growth strategy and business prospects may be adversely affected.

Our costs and expenses may remain constant or increase even if our revenues decline.

A significant portion of our operating costs, including rent, is fixed. Accordingly, a decrease in our revenues could result in a disproportionately higher decrease in our earnings because our operating costs and expenses are unlikely to decrease proportionately. For example, the period during which China’s Spring Festival holiday falls generally account for a lower portion of our annual revenues than the other periods, but our expenses do not vary as significantly with changes in occupancy and revenues as we need to continue to pay rent and salary, make regular repairs, maintenance and renovations and invest in other capital improvements throughout the year to maintain the attractiveness of our hotels. Our property development and renovation costs may increase as a result of increasing costs of materials. However, we have a limited ability to pass increased costs to customers through room rate increases. Therefore, our costs and expenses may remain constant or increase even if our revenues decline.

 

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Our lessors’ failure to comply with lease registration and other compliance requirements under PRC law may subject these lessors or us to fines or other penalties that may negatively affect our ability to operate our hotels.

As an operator and manager of hotel properties, we, our franchisees and those from whom we lease properties, are subject to a number of land- and property-related legal requirements. For instance, under PRC law, all lease agreements are required to be registered with the local housing bureau. Our standard lease agreement generally requires the lessor to make such registrations. However, as of June 30, 2006, 35 lessors of the hotels we operate and manage had not obtained registrations of their leases from the relevant authorities as required and we continue to remind these lessors to obtain registrations under our lease agreements with them. In addition, based on the specific land use right certificates and property ownership certificates currently held by some of our lessors, certain hotel properties we lease are restricted to industrial and other uses, rather than for commercial service use. The failure of our lessors to register lease agreements as required by law or to ensure that the hotel properties are operated in compliance with their designated use may subject these lessors or us to fines or other penalties which may negatively affect our ability to operate the hotels covered under those leases.

We have limited insurance coverage.

We carry property insurance that covers the assets that we own at our hotels, but not the buildings or any other assets owned by our lessors. Although we require our lessors to purchase customary insurance policies, we cannot guarantee that they will adhere to such requirements. If we were held liable for amounts and claims exceeding the limits of our insurance coverage or outside the scope of our insurance coverage, our business, results of operations and financial condition may be materially and adversely affected. In addition, we do not have any business disruption insurance coverage for our operations to cover losses that may be caused by natural disasters or catastrophic events, such as SARS or avian flu. Any business disruption or natural disaster may result in our incurring substantial costs and diversion of our resources.

If we are unable to maintain our hotels’ good condition and attractive appearance, our hotel occupancy rates may decline.

In order to maintain our hotels’ good condition and attractive appearance, our hotels require ongoing renovations and other leasehold improvements, including periodic replacement of furniture, fixtures and equipment. If we and our franchisees do not make needed leasehold investments and improvements, we could lose our market share to our competitors and our hotel occupancy rates may decline.

The growth of on-line and other hotel reservation intermediaries and travel consolidators may adversely affect our margins and profitability.

Some of our hotel rooms are booked through travel intermediaries and consolidators to whom we pay commissions for such services. If these intermediaries and consolidators become the primary channel through which our customers make their bookings, they may be able to negotiate higher commissions, reduced room rates, or other significant concessions from us. We believe that the aim of such intermediaries and consolidators is to have consumers develop loyalties to their reservation systems rather than to our brand. The operations of these travel intermediaries and consolidators may adversely affect our ability to control the supply and price of our room inventory, which would in turn adversely affect our margins and profitability.

If we fail to maintain an effective system of internal controls over financial reporting, we may not be able to accurately report our financial results or prevent fraud.

We will be subject to reporting obligations under the U.S. securities laws. The Securities and Exchange Commission, or the SEC, as required by Section 404 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, adopted rules requiring every public company to include a management report on such company’s internal

 

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controls over financial reporting in its annual report, which contains management’s assessment of the effectiveness of the company’s internal controls over financial reporting. In addition, an independent registered public accounting firm must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. These requirements will first apply to our annual report on Form 20-F for the fiscal year ending on December 31, 2007. Our management may conclude that our internal controls over our financial reporting are not effective. Moreover, even if our management concludes that our internal controls over financial reporting is effective, our independent registered public accounting firm may still decline to attest to our management’s assessment or may issue a report that is qualified if it is not satisfied with our internal controls or the level at which our controls are documented, designed, operated or reviewed, or if it interprets the relevant requirements differently from us. Our reporting obligations as a public company will place a significant strain on our management, operational and financial resources and systems for the foreseeable future. Prior to this offering, we have been a young, private company with limited accounting and other resources with which to adequately address our internal controls and procedures. As a result, when our independent registered public accounting firm audited our consolidated financial statements for the three years ended December 31, 2003, 2004 and 2005 in connection with this offering, they identified certain control deficiencies including two material weaknesses in our internal control over financial reporting, as defined in Audit Standard No. 2 of the Public Company Accounting Standards Board. Specifically, the two material weaknesses identified by our independent registered public accounting firm consisted of (i) our lack of adequate review and monitoring over financial reporting and disclosure process, as well as our lack of sufficient control over the financial closing and reporting procedures; and (ii) the lack of sufficient U.S. GAAP knowledge of our accounting staff. We plan to remediate these material weaknesses and other control deficiencies in time to meet the deadline for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act. If, however, we fail to timely achieve and maintain the adequacy of our internal controls, we may not be able to conclude that we have effective internal controls over financial reporting. Moreover, effective internal controls over financial reporting are necessary for us to produce reliable financial reports and are important to help prevent fraud. As a result, our failure to achieve and maintain effective internal controls over financial reporting could result in the loss of investor confidence in the reliability of our financial statements, which in turn could harm our business and negatively impact the trading price of our ADSs. Furthermore, we anticipate that we will incur considerable costs and devote significant management time and efforts and other resources to comply with Section 404 of the Sarbanes-Oxley Act.

We will incur increased costs as a result of being a public company.

As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and Nasdaq, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to increase our legal, accounting and financial compliance costs and to make certain corporate activities more time-consuming and costly. In addition, we will incur additional costs associated with our public company reporting requirements. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

Changes in our accounting treatment for employee share options to the fair value method beginning from 2006, could significantly reduce our net income.

Beginning in 2006, we are required to account for share-based compensation in accordance with FASB Statement No. 123(R), Share-Based Payment, which requires a public company to recognize, as an expense, the fair value of share options and other share-based compensation to employees based on the vesting schedule of the share-based awards. Historically, we recorded share-based compensation to the extent that the fair value of the shares on the date of grant exceeded the exercise price of the option. Beginning in 2006, we could have ongoing accounting charges significantly greater than those we would have recorded under our past method of accounting for share options, which could significantly reduce our net income.

 

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The approval of the China Securities Regulatory Commission, or the CSRC, may be required in connection with this offering under a recently adopted PRC regulation; any requirement to obtain prior CSRC approval could delay this offering and a failure to obtain this approval, if required, could have a material adverse effect on our business, operating results, reputation and trading price of our ADSs, and may also create uncertainties for this offering; the regulation also establishes more complex procedures for acquisitions conducted by foreign investors which could make it more difficult to pursue growth through acquisitions.

On August 8, 2006, six PRC regulatory agencies, namely, the PRC Ministry of Commerce, the State Assets Supervision and Administration Commission, or SASAC, the State Administration for Taxation, the State Administration for Industry and Commerce, the CSRC, and the PRC State Administration of Foreign Exchange, or SAFE, jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the New M&A Rule, which became effective on September 8, 2006. This New M&A Rule purports, among other things, to require offshore special purpose vehicles, or SPVs, formed for overseas listing purposes through acquisitions of PRC domestic companies and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange. On September 21, 2006, the CSRC published a notice on its official website specifying documents and materials required to be submitted to it by SPVs seeking CSRC approval of their overseas listings. While the application of the New M&A Rule remains unclear, we believe, based on the advice of our PRC counsel, Commerce & Finance Law Offices, that CSRC approval is not required in the context of this offering because we established our PRC subsidiaries by means of direct investment other than by merger or acquisition of PRC domestic companies. However, we cannot assure you that the relevant PRC government agency, including the CSRC, would reach the same conclusion as our PRC counsel. If the CSRC or other PRC regulatory body subsequently determines that we need to obtain the CSRC’s approval for this offering, we may face sanctions by the CSRC or other PRC regulatory agencies. In such event, these regulatory agencies may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds from this offering into the PRC, or take other actions that could have a material adverse effect on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our ADSs. The CSRC or other PRC regulatory agencies may also take actions requiring us, or making it advisable for us, to halt this offering before settlement and delivery of the ADSs offered by this prospectus.

The New M&A Rule also established additional procedures and requirements that could make merger and acquisition activities by foreign investors more time-consuming and complex, including requirements in some instances that the Ministry of Commerce be notified in advance of any change-of-control transaction in which a foreign investor takes control of a PRC domestic enterprise. In the future, we may grow our business in part by acquiring complementary businesses, although we do not have any plans to do so at this time. Complying with the requirements of the New M&A Rule to complete such transactions could be time-consuming, and any required approval processes, including obtaining approval from the Ministry of Commerce, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.

If the relevant PRC authorities take the position that this offering is subject to their approval because a shareholder of ours is controlled by a state-owned entity, we may be subject to administrative sanctions or penalties.

A notice issued by the State Council of China in June 1997, or the State Council notice, required certain PRC companies to receive approval from relevant PRC authorities prior to transferring assets out of China for purposes of effecting a public offering and listing. Specifically, the State Council notice provides that, if a non-public offshore company with “PRC funds,” or a PRC funded company, plans to issue and list shares outside the PRC, approval from the relevant government authorities at the provincial level or higher or the approval of the CSRC may be required. The ultimate owner of Poly Victory, one of our shareholders, is BTG, a PRC state-owned enterprise. Although Poly Victory currently holds 24.4% of our outstanding voting securities, it does not

 

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control or have significant influence on us as we have a controlling group that in the aggregate owns 32.5% of our outstanding voting securities. This group consists of seven individuals who are unrelated to Poly Victory or BTG and who have entered into an acting-in-concert agreement. Under the terms of the State Council notice, it is not clear whether Poly Victory’s investment in our company would cause us to be treated as a PRC funded company for purposes of the notice. Our PRC counsel, Commerce & Finance Law Offices, has advised us that the State Council notice does not apply to Poly Victory in the context of this offering because Poly Victory has no control over us, and no application for approval from any PRC government authority in connection with this offering has been made. However, if any relevant government authority subsequently determines that the State Council notice applies to this offering, we may be subject to administrative sanctions or penalties.

Risks Related to Doing Business in China

Adverse changes in economic and political policies of the PRC government could have a material adverse effect on the overall economic growth of China, which could adversely affect our business.

We conduct substantially all of our business operations in China. As the travel industry is highly sensitive to business and personal discretionary spending levels, it tends to decline during general economic downturns. Accordingly, our results of operations, financial condition and prospects are subject to a significant degree to economic developments in China. China’s economy differs from the economies of most developed countries in many respects, including with respect to the amount of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. While the PRC economy has experienced significant growth in the past 20 years, growth has been uneven across different regions and among various economic sectors of China. The PRC government has implemented various measures to encourage economic development and guide the allocation of resources. While some of these measures benefit the overall PRC economy, they may also have a negative effect on us. For example, our results of operations and financial condition may be adversely affected by government control over capital investments or changes in environmental, health, labor or tax regulations that are applicable to us.

The PRC government also exercises significant control over China’s economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Since late 2003, the PRC government implemented a number of measures, such as increasing the People’s Bank of China’s statutory deposit reserve ratio and imposing commercial bank lending guidelines that had the effect of restricting loans to certain industries. These actions, as well as future actions and policies of the PRC government, could materially affect our liquidity and access to capital and our ability to operate our business.

Uncertainties with respect to the Chinese legal system could adversely affect us.

We conduct our business primarily through our subsidiaries in China. Our operations in China are governed by PRC laws and regulations. Our subsidiaries are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to foreign-invested enterprises. The PRC legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. Since 1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, China has not developed a fully integrated legal system and recently-enacted laws and regulations may not sufficiently cover all aspects of economic activities in China. In particular, because these laws and regulations are relatively new, and because of the limited volume of published court decisions and their nonbinding nature, the interpretation and enforcement of these laws and regulations involve uncertainties. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.

 

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Governmental control of currency conversion may affect the value of your investment.

The PRC government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of China. We receive substantially all of our revenues in RMB. Under our current structure, our income will be primarily derived from dividend payments from our PRC subsidiaries. Shortages in the availability of foreign currency may restrict the ability of our PRC subsidiaries and our affiliated entity to remit sufficient foreign currency to pay dividends or other payments to us, or otherwise satisfy their foreign currency dominated obligations. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from trade-related transactions, can be made in foreign currencies without prior approval from SAFE, by complying with certain procedural requirements. However, for most capital account items, approval from appropriate government authorities is required where RMB is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of bank loans denominated in foreign currencies. The PRC government may also at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay dividends in foreign currencies to our shareholders, including holders of our ADSs.

Fluctuation in the value of the RMB may have a material adverse effect on your investment.

The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a managed band based on market supply and demand and by reference to a basket of certain foreign currencies. This change in policy has resulted in an approximately 3.4% appreciation of the RMB against the U.S. dollar between July 21, 2005 and June 30, 2006. While the international reaction to the RMB revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which may result in a further and more significant appreciation of the RMB against the U.S. dollar. Our revenues and costs are mostly denominated in the RMB, and a significant portion of our financial assets are also denominated in the RMB. We rely entirely on dividends paid to us by our subsidiaries in China. Any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues, earnings and financial position, and the value of, and any dividends payable on, our ADSs in U.S. dollars. For example, an appreciation of the RMB against the U.S. dollar would make any new RMB-denominated investments or expenditures more costly to us, to the extent that we need to convert U.S. dollars into the RMB for such purposes. An appreciation of the RMB against the U.S. dollar would also result in foreign currency translation losses for financial reporting purposes when we translate our U.S. dollar denominated financial assets into the RMB, as the RMB is our reporting currency. As of June 30, 2006, our U.S. dollar denominated financial assets consisted solely of a cash balance of approximately US$0.7 million. We expect to have additional U.S. dollar denominated assets from the net proceeds we will receive from this offering pending our application of such proceeds to the uses described in “Use of Proceeds.”

Recent PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident shareholders to personal liability and limit our ability to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us, or otherwise adversely affect us.

SAFE issued a public notice in October 2005 requiring PRC residents to register with the local SAFE branch before establishing or controlling any company outside of China for the purpose of capital financing with assets or equity of PRC companies, referred to in the notice as an “offshore special purpose company.” Under this public notice, PRC residents who are shareholders and/or beneficial owners of such offshore special purpose companies were required to register with the local SAFE branch before March 31, 2006. We have requested our shareholders and/or beneficial owners who are subject to the registration requirements under the SAFE notice to register with the local SAFE branch. Failure of these shareholders and/or beneficial owners to register with the

 

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local SAFE branch as required by the SAFE notice or failure of future shareholders of our company who are PRC residents to comply with the registration procedures set forth in the SAFE notice may subject such shareholders and/or beneficial owners to fines and other government actions and may also limit our ability to fund our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute dividends to our company or otherwise adversely affect our business.

We rely principally on dividends and other distributions on equity paid by our subsidiaries to fund any cash and financing requirements we may have, and any limitation on the ability of our subsidiaries entities to make payments to us could have a material adverse effect on our ability to conduct our business.

We are a holding company, and we rely principally on dividends from our subsidiaries in China for our cash requirements, including any debt we may incur. Current PRC regulations permit our subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations. In addition, each of our subsidiaries in China are required to set aside a certain amount of its after-tax profits each year, if any, to fund certain statutory reserves. These reserves are not distributable as cash dividends. As of December 31, 2005, a total of RMB125.8 million (US$15.7 million) were not distributable in the form of dividends to us due to these PRC regulations. Furthermore, if our subsidiaries in China incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other payments to us. In addition, the PRC tax authorities may require us to adjust our taxable income under the contractual arrangements we currently have in place in a manner that would materially and adversely affect our subsidiaries’ ability to pay dividends and other distributions to us. Any limitation on the ability of our subsidiaries to distribute dividends or other payments to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our businesses, pay dividends, or otherwise fund and conduct our business.

PRC regulation of loans and direct investment by offshore holding companies to PRC entities may delay or prevent us from using the proceeds of this offering to make loans or additional capital contributions to our PRC operating subsidiaries.

In utilizing the proceeds of this offering in the manner described in “Use of Proceeds,” as an offshore holding company of our PRC operating subsidiaries, we may make loans to our PRC subsidiaries, or we may make additional capital contributions to our PRC subsidiaries. Any loans to our PRC subsidiaries are subject to PRC regulations. For example, loans by us to our subsidiaries in China, which are foreign-invested enterprises, to finance their activities cannot exceed statutory limits and must be registered with the SAFE.

We may also decide to finance our subsidiaries by means of capital contributions. These capital contributions must be approved by the PRC Ministry of Commerce or its local counterpart. We cannot assure you that we will be able to obtain these government approvals on a timely basis, if at all, with respect to future capital contributions by us to our subsidiaries. If we fail to receive such approvals, our ability to use the proceeds of this offering and to capitalize our PRC operations may be negatively affected, which could adversely affect our liquidity and our ability to fund and expand our business.

We have benefited from certain financial subsidies and preferential tax treatments in China. Reduction or elimination of these subsidies or preferential tax treatments may have an adverse effect on our results of operations.

Various local tax authorities in China have provided financial subsidies in the form of certain tax refunds to us. However, these tax authorities may reduce or eliminate any or all of these financial subsidies at any time in the future. There is no assurance that we will continue to receive any financial subsidies in the form of tax refunds or otherwise as the grant of such subsidies is within the discretion of relevant local government authorities. In addition, some of our subsidiaries are subject to lower enterprise income tax rates or tax exemptions due to the preferential tax treatments granted by the local tax authorities. For example, our wholly

 

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owned subsidiary, Hemei Hotel Management Company, enjoys a 15% enterprise income tax rate due to its place of incorporation and operation in the Pudong New District of Shanghai. If such preferential tax treatments granted by local tax authorities are deemed to be in violation of national laws and regulations or are abolished or altered, our subsidiaries will be subject to the standard enterprise income tax rate, which currently is 33%. Under current PRC regulations, if it is determined that a taxpayer has underpaid tax due to prior advice from relevant tax authorities, the taxpayer may still be required to pay the full amount of unpaid tax within three years after such determination but the taxpayer will not be subject to any penalty or late payment fee. Reduction or elimination of the financial subsidies or preferential tax treatments we currently enjoy may have an adverse effect on our results of operations.

Risks Related to Our ADSs and This Offering

There has been no public market for our ordinary shares or ADSs prior to this offering, and you may not be able to resell our ADSs at or above the price you paid, or at all.

Prior to this initial public offering, there has been no public market for our ordinary shares or ADSs. We have applied to have our ADSs listed on the Nasdaq Global Market. Our ordinary shares will not be listed or quoted for trading on any exchange. If an active trading market for our ADSs does not develop after this offering, the market price and liquidity of our ADSs will be materially and adversely affected.

The initial public offering price for our ADSs will be determined by negotiations between us and the representatives of the underwriters and may bear no relationship to the market price for our ADSs after the initial public offering. We cannot assure you that an active trading market for our ADSs will develop or that the market price of our ADSs will not decline below the initial public offering price.

The market price for our ADSs may be volatile.

The market price for our ADSs may be volatile and subject to wide fluctuations in response to factors including the following:

 

    actual or anticipated fluctuations in our quarterly operating results;

 

    changes in financial estimates by securities research analysts;

 

    conditions in the travel and lodging industries;

 

    changes in the economic performance or market valuations of other lodging companies;

 

    announcements by us or our competitors of new products, acquisitions, strategic partnerships, joint ventures or capital commitments;

 

    addition or departure of key personnel;

 

    fluctuations of exchange rates between the RMB and U.S. dollar or other foreign currencies;

 

    potential litigation or administrative investigations;

 

    release of lock-up or other transfer restrictions on our outstanding ADSs or ordinary shares or sales of additional ADSs; and

 

    general economic or political conditions in China.

In addition, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also materially and adversely affect the market price of our ADSs.

 

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You will experience immediate and substantial dilution in the net tangible book value of ADSs purchased.

The initial public offering price per ADSs will be substantially higher than the net tangible book value per ADS prior to the offering. Consequently, when you purchase ADSs in the offering at an assumed initial public offering price of US$11.00 per ADS, which is the midpoint of the estimated public offering price range, you will incur immediate dilution of US$8.70 per ADS. See “Dilution.” In addition, you may experience further dilution to the extent that additional ordinary shares are issued upon exercise of outstanding options and options we may grant from time to time.

We may need additional capital, and the sale of additional ADSs or other equity securities could result in additional dilution to our shareholders.

We believe that our current cash and cash equivalents, anticipated cash flow from operations and the proceeds from this offering will be sufficient to meet our anticipated cash needs for the foreseeable future. We may, however, require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If these resources are insufficient to satisfy our cash requirements, we may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity securities could result in additional dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations. We cannot assure you that financing will be available in amounts or on terms acceptable to us, if at all.

Substantial future sales of our ADSs in the public market, or the perception that these sales could occur, could cause the price of our ADSs to decline.

Additional sales of our ordinary shares in the public market after this offering, or the perception that these sales could occur, could cause the market price of our ADSs to decline. Upon completion of this offering, we will have 64,470,129 ordinary shares outstanding. All shares sold in this offering will be freely transferable without restriction or additional registration under the Securities Act of 1933. The remaining ordinary shares outstanding after this offering will be available for sale, upon the expiration of the 180-day lock-up period beginning from the closing of this offering, subject to volume and other restrictions as applicable under Rule 144 under the Securities Act. Any or all of these shares may be released prior to expiration of the lock-up period at the discretion of the lead underwriters for this offering. To the extent shares are released before the expiration of the lock-up period and these shares are sold into the market, the market price of our ADSs could decline.

In addition, certain holders of our ordinary shares after the completion of this offering will have the right to cause us to register the sale of a total of 22,924,886 shares under the Securities Act. Registration of these shares under the Securities Act would result in these shares becoming freely tradable without restriction under the Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the public market could cause the price of our ADSs to decline.

Our corporate actions are substantially controlled by our officers, directors and principal shareholders.

After this offering, our executive officers, directors and principal shareholders will beneficially own approximately 66.5% of our outstanding shares. Seven individual shareholders of our company, namely, Neil Nanpeng Shen, Qi Ji, Chung Lau, Min Fan, Rixin Liang, David Jian Sun and May Wu, have entered into an acting-in-concert agreement, under which they have agreed to act together on all matters requiring shareholder approval and to appoint one representative to vote on behalf of all of them at our shareholder meetings until July 2007. These seven shareholders, who currently hold a total of 17,769,037 ordinary shares, or 32.5% of our outstanding voting securities, could exert substantial influence over matters requiring approval by our shareholders, including electing directors and approving mergers or other business combination transactions. In addition, BTG, through its affiliate, Poly Victory, owns 24.5% of our outstanding voting securities and has the right to appoint, and has appointed, two directors of our company. Under the financing transaction agreement we

 

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entered into with BTG in June 2005, BTG agreed to provide financing in the form of loans to us and, in the event of our default, has the right to enforce its rights by, among other things, converting the total principal amount of the indebtedness into an equity interest in our company at a pre-determined price. The concentration of our share ownership may discourage, delay or prevent a change in control of our company, which could deprive our shareholders of an opportunity to receive a premium for their shares as part of a sale of our company and might reduce the price of our ADSs. These actions may be taken even if they are opposed by our other shareholders, including those who purchase ADSs in this offering.

You may not have the same voting rights as the holders of our ordinary shares and may not receive voting materials in time to be able to exercise your right to vote.

Except as described in this prospectus and in the deposit agreement, holders of our ADSs will not be able to exercise voting rights attaching to the shares evidenced by our ADSs on an individual basis. Holders of our ADSs will appoint the depositary or its nominee as their representative to exercise the voting rights attaching to the shares represented by the ADSs. You may not receive voting materials in time to instruct the depositary to vote, and it is possible that you, or persons who hold their ADSs through brokers, dealers or other third parties, will not have the opportunity to exercise a right to vote.

You may not be able to participate in rights offerings and may experience dilution of your holdings as a result.

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. Under the deposit agreement for the ADSs, the depositary will not offer those rights to ADS holders unless both the rights and the underlying securities to be distributed to ADS holders are either registered under the Securities Act of 1933, as amended, or exempt from registration under the Securities Act with respect to all holders of ADSs. We are under no obligation to file a registration statement with respect to any such rights or underlying securities or to endeavor to cause such a registration statement to be declared effective. In addition, we may not be able to take advantage of any exemptions from registration under the Securities Act. Accordingly, holders of our ADSs may be unable to participate in our rights offerings and may experience dilution in their holdings as a result.

You may be subject to limitations on transfer of your ADSs.

Your ADSs represented by the ADRs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary deem it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited, because we are incorporated under Cayman Islands law, conduct substantially all of our operations in China and the majority of our officers reside outside the United States.

We are incorporated in the Cayman Islands, and conduct substantially all of our operations in China through our wholly owned subsidiaries in China. Most of our officers reside outside the United States and some or all of the assets of those persons are located outside of the United States. As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in the Cayman Islands or in China in the event that you believe that your rights have been infringed under the securities laws or otherwise. Even if you are successful in bringing an action of this kind, the laws of the Cayman Islands and of China may render you unable to enforce a judgment against our assets or the assets of our directors and officers. There is no statutory

 

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recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will generally recognize and enforce a non-penal judgment of a foreign court of competent jurisdiction without retrial on the merits. For more information regarding the relevant laws of the Cayman Islands and China, see “Enforceability of Civil Liabilities.”

Our corporate affairs are governed by our memorandum and articles of association and by the Companies Law (2004 Revision) and common law of the Cayman Islands. The rights of shareholders to take legal action against our directors and us, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedents in the United States. In particular, the Cayman Islands has a less developed body of securities laws as compared to the United States, and provides significantly less protection to investors. In addition, Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States.

As a result of all of the above, our public shareholders may have more difficulty in protecting their interests through actions against our management, directors or major shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States.

Our articles of association contain anti-takeover provisions that could have a material adverse effect on the rights of holders of our ordinary shares and ADSs.

We have adopted our amended and restated articles of association that will become effective upon the completion of this offering. Our new articles of association contain provisions limiting the ability of others to acquire control of our company or cause us to enter into change-of-control transactions. These provisions could have the effect of depriving our shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of our company in a tender offer or similar transaction. For example, our board of directors has the authority, without further action by our shareholders, to issue preferred shares in one or more series and to fix their designations, powers, preferences, privileges, and relative participating, optional or special rights and the qualifications, limitations or restrictions, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights associated with our ordinary shares, in the form of ADS or otherwise. Preferred shares could be issued quickly with terms calculated to delay or prevent a change in control of our company or make removal of management more difficult. If our board of directors decides to issue preferred shares, the price of our ADSs may fall and the voting and other rights of the holders of our common shares and ADSs may be materially and adversely affected.

Our management will have considerable discretion as to the use of the net proceeds from this offering.

We have not allocated the majority of the net proceeds of this offering to any particular purpose. Rather, our management will have considerable discretion in the application of the net proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase our share price. The net proceeds from this offering may be placed in investments that do not produce income or that lose value.

 

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We may be classified as a passive foreign investment company, which could result in adverse United States federal income tax consequences for U.S. Holders.

Based on the price of the ADSs in this offering and the expected price of our ADSs and ordinary shares following this offering, and the composition of our income and assets, we do not expect to be considered a “passive foreign investment company,” or PFIC, for United States federal income tax purposes for our current taxable year ending December 31, 2006. However, we must make a separate determination each year as to whether we are a PFIC (after the close of each taxable year). Accordingly, we cannot assure you that we will not be a PFIC for our current taxable year ending December 31, 2006 or any future taxable year. A non-U.S. corporation will be considered a PFIC for any taxable year if either (i) at least 75% of its gross income is passive income or (ii) at least 50% of the value of its assets (based on an average of the quarterly values of the assets during a taxable year) is attributable to assets that produce or are held for the production of passive income. The value of our assets generally will be determined by reference to the market price of our ADSs and ordinary shares, which may fluctuate considerably. In addition, the composition of our income and assets will be affected by how, and how quickly, we spend the cash we raise in any offering. If we were treated as a PFIC for any taxable year during which a U.S. Holder held an ADS or an ordinary share, certain adverse United States federal income tax consequences could apply to the U.S. Holder. For the definition of “U.S. Holder” and a more detailed discussion of United States federal income tax consequencies to U.S. Holders, see “Taxation—United States Federal Income Taxation—Passive Foreign Investment Company.”

 

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FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts are forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those expressed or implied by the forward-looking statements.

You can identify these forward-looking statements by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “likely to” or other similar expressions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements include:

 

    our anticipated growth strategies;

 

    our future business development, results of operations and financial condition;

 

    expected changes in our revenues and certain cost or expense items;

 

    our ability to attract customers and leverage our brand;

 

    trends and competition in the lodging industry; and

 

    our ability to develop new hotels at desirable locations in a timely and cost-effective manner.

You should read thoroughly this prospectus and the documents that we refer to in this prospectus with the understanding that our actual future results may be materially different from and worse than what we expect. We qualify all of our forward-looking statements by these cautionary statements. Other sections of this prospectus include additional factors which could adversely impact our business and financial performance. Moreover, we operate in an evolving environment. New risk factors and uncertainties emerge from time to time and it is not possible for our management to predict all risk factors and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

You should not rely upon forward-looking statements as predictions of future events. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds from this offering of approximately US$47.4 million, or approximately US$57.5 million if the underwriters exercise their option to purchase additional ADSs in full, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us. These estimates are based upon an assumed initial offering price of US$11.00 per ADS, which is the midpoint of the estimated public offering price range. We will not receive any of the proceeds from the sale of ADSs by the selling shareholders. A US$1.00 increase (decrease) in the assumed initial public offering price of US$11.00 per ADS would increase (decrease) the net proceeds of this offering by US$4.5 million, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us.

We intend to use the net proceeds from this offering as follows:

 

    approximately US$35.0 million to fund the expansion of our hotel chain and the improvement of existing hotel properties;

 

    approximately US$7.5 million to repay all of our outstanding indebtedness to BTG; and

 

 

    the balance to fund working capital and for other general corporate purposes, which may include strategic acquisitions of complementary businesses, although we are not currently negotiating any such transaction.

The following table sets forth a summary of our outstanding indebtedness to BTG as of September 30, 2006, which we intend to repay using part of the proceeds we will receive from this offering:

 

Lender

   Date of
Borrowing
   Due Date   

Principal

(in RMB)

   Principal
(in US$)
   Interest
Rate
 

BTG

   07/15/2005    07/14/2008    20,000,000    2,501,783    6.1747 %

BTG

   09/07/2005    09/06/2008    10,000,000    1,250,891    6.1747 %

BTG

   10/18/2005    10/17/2007    10,000,000    1,250,891    6.1747 %

BTG

   01/11/2006    01/10/2008    20,000,000    2,501,783    6.1747 %

In utilizing the proceeds of this offering, as an offshore holding company, we are permitted, under PRC regulations, to provide funding to our PRC subsidiaries only through loans or capital contributions. Subject to satisfaction of applicable government registrations and approval requirements, we may extend inter-company loans or make additional capital contributions to our PRC subsidiaries to fund their capital expenditures or working capital. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all. See “Risk Factors—Risks Related to Doing Business in China—PRC regulation of loans and direct investment by offshore holding companies to PRC entities may delay or prevent us from using the proceeds of this offering to make loans or additional capital contributions to our PRC operating subsidiaries.”

The foregoing represents our current intentions to use and allocate the net proceeds of this offering based upon our present plans and business conditions. Our management, however, will have significant flexibility and discretion to apply the net proceeds of this offering. If an unforeseen event occurs or business conditions change, we may use the proceeds of this offering differently than as described in this prospectus.

Pending use of the net proceeds, we intend to hold our net proceeds in demand deposits or invest them in interest-bearing government securities.

 

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DIVIDEND POLICY

We have no present plan to declare and pay any dividends on our shares or ADSs in the near future. We currently intend to retain most, if not all, of our available funds and any future earnings to operate and expand our business.

We are a holding company incorporated in the Cayman Islands. We rely on dividends from our subsidiaries in China. Current PRC regulations permit our subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, each of our subsidiaries in China is required to set aside a certain amount of its accumulated after-tax profits each year, if any, to fund certain statutory reserves. These reserves may not be distributed as cash dividends. Further, if our subsidiaries in China incur debt on their own behalf, the instruments governing the debt may restrict their ability to pay dividends or make other payments to us.

Our board of directors has complete discretion as to whether to distribute dividends, subject to the approval of our shareholders. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that the board of directors may deem relevant. If we pay any dividends, we will pay our ADS holders to the same extent as holders of our ordinary shares, subject to the terms of the deposit agreement, including the fees and expenses payable thereunder. See “Description of American Depositary Shares.” Cash dividends on our ordinary shares, if any, will be paid in U.S. dollars.

 

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CAPITALIZATION

The following table sets forth our capitalization as of June 30, 2006:

 

    on an actual basis;

 

    on an as adjusted basis to reflect the automatic conversion of all of our outstanding preferred shares into 22,924,886 ordinary shares upon the closing of this offering, and the sale of 9,771,654 ordinary shares in the form of ADSs by us in this offering at an assumed initial public offering price of US$5.50 per share, which is the midpoint of the estimated public offering price range, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

You should read this table together with our consolidated financial statements and the related notes included elsewhere in this prospectus and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

     As of June 30, 2006
     Actual    As adjusted (1)
     RMB    US$    RMB    US$
     (in thousands)

Loans

   126,000    15,761    126,000    15,761

Shareholders’ equity:

           

Ordinary shares,

US$0.005 par value, 177,075,114 shares authorized, 27,399,140 shares issued and outstanding

   1,134    142    2,474    310

Series A preferred shares,

US$0.005 par value, 17,241,400 shares authorized, issued and outstanding on an actual basis

   714    89    —      —  

Series B preferred shares,

US$0.005 par value, 2,417,645 shares authorized, issued and outstanding on an actual basis

   100    13    —      —  

Series C preferred shares,

US$0.005 par value, 3,265,841 shares authorized, issued and outstanding on an actual basis

   135    17    —      —  

Additional paid-in capital

   151,104    18,901    529,315    66,211

Statutory reserve

   11,360    1,421    11,360    1,421

Retained earnings

   42,820    5,356    42,820    5,356

Total shareholders’ equity(2)

   207,367    25,939    585,969    73,298
                   

Total capitalization(2)

   333,367    41,700    711,969    89,059
                   

(1) The “as adjusted” information discussed above is for illustrative purpose only. Our ordinary shares, additional paid-in capital, total shareholders’ equity and total capitalization following the completion of this offering are subject to adjustment based on the actual initial public offering price and other terms of this offering determined at pricing.

 

(2) Assuming the number of ADSs offered by us as set forth on the cover page of this prospectus remains the same, and after deduction of underwriting discounts and commissions and the estimated offering expenses payable by us, a US$1.00 increase (decrease) in the assumed initial public offering price of US$11.00 per ADS would increase (decrease) each of total shareholders’ equity and total capitalization by US$4.5 million.

 

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DILUTION

Our net tangible book value as of June 30, 2006 was approximately US$0.43 per share, and US$0.86 per ADS. Net tangible book value per share represents the amount of total tangible assets, minus the amount of total liabilities, divided by the total number of ordinary shares outstanding. Dilution is determined by subtracting net tangible book value per ordinary share from the assumed public offering price per ordinary share.

Without taking into account any other changes in such net tangible book value after June 30, 2006, other than to give effect to (i) the conversion of all of our preferred shares into ordinary shares, which will occur automatically upon the closing of this offering, and (ii) our sale of the 4,885,827 ADSs offered in this offering, at an assumed initial public offering price of US$11.00 per ADS, the midpoint of the estimated public offering price range, and after deduction of underwriting discounts and commissions and estimated offering expenses (assuming the over-allotment option is not exercised), our pro forma net tangible book value at June 30, 2006 would have been US$1.15 per outstanding ordinary share, including ordinary shares underlying our outstanding ADSs, or US$2.30 per ADS. This represents an immediate increase in net tangible book value of US$0.72 per ordinary share, or US$1.44 per ADS, to existing shareholders and an immediate dilution in net tangible book value of US$4.35 per ordinary share, or US$8.70 per ADS, to purchasers of ADSs in this offering.

The following table illustrates the dilution on a per ordinary share basis assuming that the initial public offering price per ordinary share is US$5.50 and all ADSs are exchanged for ordinary shares:

 

Assumed initial public offering price per ordinary share

   US$ 5.50

Net tangible book value per ordinary share

   US$ 1.15
      

Amount of dilution in net tangible book value per ordinary share to new investors in the offering

   US$ 4.35
      

Amount of dilution in net tangible book value per ADS to new investors in the offering

   US$ 8.70
      

A $1.00 increase (decrease) in the assumed public offering price of US$11.00 per ADS would increase (decrease) our pro forma net tangible book value after giving effect to the offering by US$4.5 million, the pro forma net tangible book value per ordinary share and per ADS after giving effect to this offering by US$0.08 per ordinary share and US$0.16 per ADS and the dilution in pro forma net tangible book value per ordinary share and per ADS to new investors in this offering by US$0.42 per ordinary share and US$0.84 per ADS, assuming no change to the number of ADSs offered by us as set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and other offering expenses.

 

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The following table summarizes, on a pro forma basis as of October 3, 2006, the differences between the shareholders as of October 3, 2006 and the new investors with respect to the number of ordinary shares purchased from us, the total consideration paid and the average price per ordinary share paid at an assumed initial public offering price of US$11.00 per ADS before deducting estimated underwriting discounts and commissions and estimated offering expenses. The total number of ordinary shares does not include 988,410 ADSs issuable pursuant to the exercise of the over-allotment option granted to the underwriters. The pro forma information discussed above is illustrative only. Our net tangible book value following the completion of this offering is subject to adjustment based on the actual initial public offering price of our ADSs and other terms of this offering determined at pricing.

 

     Ordinary Shares
Purchased
    Total Consideration     Average Price
Per Ordinary
Share
   Average Price
Per ADS
     Number    Percent     Amount    Percent           

Existing shareholders

   54,698,475    85 %   US$ 27,839,896    34 %   US$ 0.51    US$ 1.02

New investors

   9,771,654    15 %     53,744,097    66 %     5.50      11.00
                             

Total

   64,470,129    100 %   US$ 81,583,993    100 %     
                             

The discussion and tables above also assume no exercise of any outstanding stock options. As of the date of this prospectus, there are 3,042,886 ordinary shares issuable upon exercise of outstanding stock options at a weighted average exercise price of US$2.41 per share, and there are 200,927 ordinary shares plus 6% of our total outstanding shares from time to time (excluding shares issuable upon exercise of options or otherwise pursuant to any of our share incentive plans) available for future issuance upon the exercise of future grants under our share incentive plans. To the extent that any of these options are exercised, there will be further dilution to new investors.

 

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EXCHANGE RATE INFORMATION

Our business is conducted in China and substantially all of our revenues are denominated in RMB. However, periodic reports made to shareholders will be expressed in U.S. dollars using the then current exchange rates. This prospectus contains translations of RMB amounts into U.S. dollars at specific rates solely for the convenience of the reader. The conversion of RMB into U.S. dollars in this prospectus is based on the noon buying rate in The City of New York for cable transfers of RMB as certified for customs purposes by the Federal Reserve Bank of New York. Unless otherwise noted, all translations of financial data from RMB to U.S. dollars in this prospectus were made at a rate of RMB7.9943 to US$1.00, the noon buying rate in effect as of June 30, 2006. We make no representation that any RMB or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or RMB, as the case may be, at any particular rate, the rates stated below, or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of RMB into foreign exchange and through restrictions on foreign trade. On October 20, 2006, the noon buying rate was RMB7.9028 to US$1.00.

The following table sets forth information concerning exchange rates between the RMB and the U.S. dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this prospectus or will use in the preparation of our periodic reports or any other information to be provided to you. The source of these rates is the Federal Reserve Bank of New York.

 

Period

   Noon Buying Rate
   Period
End
   Average (1)    Low    High
     (RMB Per US$1.00)

2001

   8.2766    8.2770    8.2786    8.2676

2002

   8.2800    8.2770    8.2800    8.2669

2003

   8.2767    8.2772    8.2800    8.2765

2004

   8.2765    8.2768    8.2774    8.2764

2005

   8.0702    8.1940    8.2765    8.0702

2006

           

April

   8.0165    8.0143    8.0248    8.0040

May

   8.0215    8.0131    8.0300    8.0005

June

   7.9943    8.0042    8.0225    7.9943

July

   7.9690    7.9897    8.0018    7.9690

August

   7.9538    7.9722    8.0000    7.9538

September

   7.9040    7.9334    7.9545    7.8965

October (through October 20)

   7.9028    7.9072    7.9168    7.9000

(1) Annual averages are calculated from month-end rates. Monthly averages are calculated using the average of the daily rates during the relevant period.

 

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ENFORCEABILITY OF CIVIL LIABILITIES

We were incorporated in the Cayman Islands in order to enjoy the following benefits:

 

    political and economic stability;

 

    an effective judicial system;

 

    a favorable tax system;

 

    the absence of exchange control or currency restrictions; and

 

    the availability of professional and support services.

However, certain disadvantages accompany incorporation in the Cayman Islands. These disadvantages include:

 

    the Cayman Islands has a less developed body of securities laws as compared to the United States and these securities laws provide significantly less protection to investors; and

 

    Cayman Islands companies may not have standing to sue before the federal courts of the United States.

Our constituent documents do not contain provisions requiring that disputes, including those arising under the securities laws of the United States, between us, our officers, directors and shareholders, be arbitrated.

All of our operations are conducted in China, and substantially all of our assets are located in China. A majority of our officers are nationals or residents of jurisdictions other than the United States and a substantial portion of their assets are located outside the United States. As a result, it may be difficult for a shareholder to effect service of process within the United States upon these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

We have appointed CT Corporation System, 111 Eighth Avenue, New York, New York 10011, as our agent upon whom process may be served in any action brought against us under the securities laws of the United States.

Maples and Calder, our counsel as to Cayman Islands law, and Commerce & Finance Law Offices, our counsel as to PRC law, have advised us, respectively, that there is uncertainty as to whether the courts of the Cayman Islands and China, respectively, would:

 

    recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States; or

 

    entertain original actions brought in each respective jurisdiction against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.

Maples and Calder has further advised us that a final and conclusive judgment in the federal or state courts of the United States under which a sum of money is payable, other than a sum payable in respect of taxes, fines, penalties or similar charges, may be subject to enforcement proceedings as a debt in the courts of the Cayman Islands under the common law doctrine of obligation.

Commerce & Finance Law Offices has further advised us that the recognition and enforcement of foreign judgments are provided for under PRC Civil Procedures Law. PRC courts may recognize and enforce foreign judgments in accordance with the requirements of PRC Civil Procedures Law based either on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

Our Selected Consolidated Financial Data

You should read the following information in conjunction with our and Home Inns Beijing’s consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

The following selected consolidated financial information has been derived from our consolidated financial statements included elsewhere in this prospectus. Our consolidated statement of operations data for the years ended December 31, 2003, 2004 and 2005 and our consolidated balance sheet data as of December 31, 2004 and 2005 have been derived from our consolidated financial statements for the relevant periods which have been audited by PricewaterhouseCoopers Zhong Tian CPAs Limited Company, an independent registered public accounting firm, and are prepared and presented in accordance with U.S. GAAP, and reflect our current corporate structure as if it had been in existence throughout the relevant periods. Our selected consolidated statement of operations data for the six months ended June 30, 2005 and 2006 and our consolidated balance sheet data as of June 30, 2006 have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. Our selected consolidated statement of operations data for the year ended December 31, 2002 and our consolidated balance sheet data as of December 31, 2002 and 2003 have been derived from our unaudited consolidated financial statements which are not included in this prospectus. We have prepared the unaudited consolidated financial information on the same basis as our audited consolidated financial statements. The unaudited consolidated financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the periods presented. Our historical results do not necessarily indicate results expected for any future periods. As Home Inns Beijing, our primary operating entity, was not established until April 2002, we do not believe our financial data for the year ended December 31, 2001 provide any meaningful information by which to evaluate our business, and thus have not included our selected financial data for 2001 in this section or elsewhere in this prospectus.

We have been actively managing Home Inns Beijing since its inception. Home Inns Hong Kong’s ownership in Home Inns Beijing was accounted for under the equity method since Home Inns Beijing’s inception until April 2004, because during this period of time, BTG had substantive participation rights that enabled it to veto significant decisions made by Home Inns Hong Kong. In April 2004, Home Inns Hong Kong and Beijing Capital Travel, a subsidiary of BTG, entered into a revised joint venture agreement, under which Home Inns Hong Kong obtained control of Home Inns Beijing. As a result, Home Inns Beijing has been our consolidated subsidiary since then.

 

    For the Year Ended December 31,     For the Six Months Ended June 30,  
  2002    2003    2004     2005     2005     2006  
    RMB    RMB    RMB     RMB     US$     RMB     RMB     US$  
    (in thousands, except share, per share and per ADS data)  

Consolidated Statement of Operations Data

                 

Revenues:

                 

Leased-and-operated hotels

  —      —      93,687     279,948     35,018     106,978     243,492     30,458  

Franchised-and-managed hotels

  —      —      2,313     5,913     740     2,428     5,567     696  
                                             

Total revenues

  —      —      96,000     285,861     35,758     109,406     249,059     31,154  
                                             

Less: Business tax and related surcharges

  —      —      (5,101 )   (16,830 )   (2,105 )   (6,669 )   (13,344 )   (1,669 )
                                             

Net revenues

  —      —      90,899     269,031     33,653     102,737     235,715     29,485  
                                             

 

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    For the Year Ended December 31,     For the Six Months Ended June 30,  
  2002     2003     2004     2005     2005     2006  
    RMB     RMB     RMB     RMB     US$     RMB     RMB     US$  
    (in thousands, except share, per share and per ADS data)  

Consolidated Statement of Operations Data (continued)

               

Operating costs and expenses(1):

               

Leased-and-operated hotel costs:

               

Rents and utilities

  —       —       (30,703 )   (94,784 )   (11,856 )   (36,701 )   (73,976 )   (9,254 )

Personnel costs

  —       —       (12,949 )   (41,225 )   (5,157 )   (15,782 )   (36,502 )   (4,566 )

Depreciation and amortization

  —       —       (5,681 )   (23,335 )   (2,919 )   (8,828 )   (19,730 )   (2,468 )

Consumables, food and beverage

  —       —       (6,441 )   (20,765 )   (2,598 )   (7,609 )   (17,811 )   (2,228 )

Others

  —       —       (8,162 )   (26,100 )   (3,265 )   (9,783 )   (23,022 )   (2,880 )
                                               

Total leased-and-operated hotel costs

  —       —       (63,936 )   (206,209 )   (25,795 )   (78,703 )   (171,041 )   (21,396 )
                                               

Sales and marketing expenses

  —       —       (2,113 )   (7,691 )   (962 )   (2,754 )   (3,898 )   (488 )

General and administrative expenses

  (40 )   (365 )   (15,983 )   (24,535 )   (3,069 )   (10,338 )   (20,898 )   (2,613 )
                                               

Total operating costs and expenses

  (40 )   (365 )   (82,032 )   (238,435 )   (29,826 )   (91,795 )   (195,837 )   (24,497 )
                                               

Income (loss) from operations

  (40 )   (365 )   8,867     30,596     3,827     10,942     39,878     4,988  
                                               

Interest income

  2     1     89     222     28     96     291     36  

Interest expense

  —       —       (98 )   (709 )   (89 )   —       (2,719 )   (340 )

Other non-operating income

  —       —       325     2,146     269     1,875     1,700     213  
                                               

Income (loss) before income tax expense, minority interests and share of income of affiliated companies

  (38 )   (364 )   9,183     32,255     4,035     12,913     39,150     4,897  
                                               

Income tax expense

  —       —       (5,738 )   (6,525 )   (817 )   (2,592 )   (9,204 )   (1,151 )

Minority interests

  —       —       552     (4,797 )   (600 )   (2,016 )   (2,697 )   (337 )

Share of income (loss) of affiliated companies

  (535 )   1,878     1,972     —       —       —       —       —    
                                               

Net income (loss)

  (573 )   1,514     5,969     20,933     2,618     8,305     27,249     3,409  
                                               

Amount allocated to participating preferred shareholders

  —       (868 )   (2,960 )   (9,487 )   (1,187 )   (3,757 )   (12,413 )   (1,553 )
                                               

Net income (loss) available to ordinary shareholders

  (573 )   646     3,009     11,446     1,431     4,548     14,836     1,856  
                                               

Earnings (loss) per share:

               

Basic

  (0.05 )   0.06     0.15     0.42     0.05     0.17     0.54     0.07  

Diluted

  (0.05 )   0.06     0.15     0.40     0.05     0.16     0.51     0.06  

Earnings (loss) per ADS(2):

               

Basic

  (0.10 )   0.12     0.30     0.84     0.10     0.34     1.08     0.14  

Diluted

  (0.10 )   0.12     0.30     0.80     0.10     0.32     1.02     0.12  

Weighted average ordinary shares outstanding:

               

Basic

  11,000,000     11,000,000     19,981,424     27,399,140     27,399,140     27,399,140     27,399,140     27,399,140  

Diluted

  11,000,000     11,000,000     20,315,681     28,713,188     28,713,188     28,560,208     29,235,149     29,235,149  

 

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(1) Share-based compensation expenses are included in the consolidated statement of operations data as follows:

 

     For the Year Ended December 31,    For the Six Months Ended June 30,
   2002    2003    2004    2005    2005    2006
     RMB    RMB    RMB    RMB    US$    RMB    RMB    US$
     (in thousands)

Leased-and-operated hotel costs—personnel costs

   —      —      8    8    1    6    6    1

General and administrative expenses

   —      —      141    952    119    480    1,029    128

 

(2) Each ADS represents two ordinary shares.

The following table presents a summary of our consolidated balance sheet data as of December 31, 2002, 2003, 2004 and 2005 and as of June 30, 2006:

 

      As of December 31,    As of June 30,
      2002    2003    2004    2005    2006
     RMB    RMB    RMB    RMB    US$    RMB    US$
     (in thousands)

Consolidated Balance Sheet Data:

                    

Cash and cash equivalents

   1,797    11,342    26,292    37,727    4,719    80,981    10,130

Total assets

   6,983    47,466    174,304    375,002    46,909    502,780    62,892

Total current liabilities

   2,054    2,193    39,768    119,187    14,909    190,903    23,880

Deferred rental

   —      —      11,890    26,534    3,319    33,103    4,141

Long-term loan from a related party

   —      —      —      40,000    5,004    60,000    7,505

Convertible preferred shares

   —      813    813    949    119    949    119

Ordinary shares

   455    455    1,134    1,134    142    1,134    142

Additional paid-in capital

   5,046    43,062    110,687    152,878    19,123    151,104    18,901

Total shareholders’ equity

   4,929    45,273    116,861    179,083    22,401    207,367    25,939

 

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Home Inns Beijing’s Selected Consolidated Financial Data

You should read the following information in conjunction with Home Inns Beijing’s consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

The following selected consolidated financial information has been derived from Home Inns Beijing’s consolidated financial statements included elsewhere in this prospectus. Home Inns Beijing’s consolidated statement of operations data and consolidated balance sheet data for the years ended December 31, 2003 and 2004 have been derived from its consolidated financial statements for the relevant periods which have been audited by PricewaterhouseCoopers Zhong Tian CPAs Limited Company, an independent registered public accounting firm, and are prepared and presented in accordance with U.S. GAAP.

We have been actively managing Home Inns Beijing since its inception. Home Inns Hong Kong’s ownership in Home Inns Beijing was accounted for under the equity method since Home Inns Beijing’s inception until April 2004, because during this period of time, BTG had substantive participation rights that enabled it to veto significant decisions made by Home Inns Hong Kong. In April 2004, Home Inns Hong Kong and Beijing Capital Travel, a subsidiary of BTG, entered into a revised joint venture agreement, under which Home Inns Hong Kong obtained control of Home Inns Beijing. As a result, Home Inns Beijing has been our consolidated subsidiary since then.

 

     For the Year Ended December 31,  
   2003      2004  
     RMB      RMB  
     (in thousands)  

Consolidated Statement of Operations Data:

     

Revenues:

     

Leased-and-operated hotels

   43,842      112,914  

Franchised-and-managed hotels

   —        2,364  
             

Total revenues

   43,842      115,278  
             

Less: Business tax and related surcharges

   (1,662 )    (6,150 )
             

Net revenues

   42,180      109,128  
             

Operating costs and expenses(1):

     

Leased-and-operated hotel costs:

     

Rents and utilities

   (13,901 )    (36,463 )

Personnel costs

   (6,677 )    (15,653 )

Consumables, food and beverage

   (3,268 )    (8,149 )

Depreciation and amortization

   (2,179 )    (6,685 )

Others

   (5,720 )    (10,019 )
             

Total leased-and-operated hotel costs

   (31,745 )    (76,969 )
             

Sales and marketing expenses

   (2,141 )    (2,563 )

General and administrative expenses

   (5,604 )    (16,607 )
             

Total operating costs and expenses

   (39,490 )    (96,139 )
             

Income from operations

   2,690      12,989  
             

Interest income

   86      110  

Interest expense

   —        (125 )

Other non-operating income

   30      328  
             

Income before income tax expense and minority interests

   2,806      13,302  
             

Income tax expense

   (318 )    (6,861 )

Minority interests

   —        1,294  

Share of income of affiliated companies

   —        —    
             

Net income

   2,488      7,735  
             

 

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(1)    Share-based compensation expenses are included in the statement of operations data as follows:

    
     For the Year Ended December 31,
   2003      2004
     RMB      RMB
     (in thousands)

Leased-and-operated hotel costs—personnel costs

   —        8

General and administrative expenses

   —        141

The following table presents a summary of Home Inns Beijing’s consolidated balance sheet data as of December 31, 2003 and 2004:

 

     As of December 31,
     2003    2004
     RMB    RMB
     (in thousands)

Consolidated Balance Sheet Data:

     

Cash and cash equivalents

   16,283    16,710

Total assets

   56,985    130,562

Total current liabilities

   13,843    39,900

Deferred rental

   2,681    11,890

Paid-in capital

   38,945    68,945

Additional paid-in capital

   —      150

Total shareholders’ equity

   40,461    78,346

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the section entitled “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are a leading economy hotel chain in China based on the number of our hotels and the number of our hotel rooms as well as the geographic coverage of our hotel chain. We develop and operate economy hotels across China under our award-winning Home Inn brand. We have experienced substantial growth while maintaining profitability since 2003. Our Home Inns hotels in operation grew rapidly from 10 hotels in four cities as of the end of 2003 to 68 hotels in 22 cities as of the end of 2005, and our net income grew from RMB1.5 million in 2003 to RMB20.9 million (US$2.6 million) in 2005. In the six months ended June 30, 2006, we generated total revenues of RMB249.1 million (US$31.2 million) and net income of RMB27.2 million (US$3.4 million). As of June 30, 2006, our Home Inns hotel chain consisted of 63 leased-and-operated hotels in operation with an additional 33 leased-and-operated hotels under development and 19 franchised-and-managed hotels in operation with an additional 24 franchised-and-managed hotels under development, covering 40 cities in China.

We have achieved our growth by utilizing two business models. We either lease properties on which we develop and operate hotels or we franchise our brand to hotel owners and manage these hotels. We refer to the former type of hotels as “leased-and-operated hotels” and to the latter type of hotels as “franchised-and-managed hotels.” Our recent growth has been primarily organic, through developing and operating additional hotels in existing markets and expanding the geographic reach of our hotel chain. We intend to develop and operate additional hotels under both business models to maintain or achieve a dominant position in every market covered by our Home Inns hotel chain.

Our operating results are subject to conditions typically affecting the lodging industry, including changes in the national, regional or local economic conditions in China; natural disasters or travelers’ fears of exposure to serious contagious diseases; the attractiveness of our hotels to customers and competition from other hotels; local market conditions such as an oversupply of, or a reduction in demand for, hotel rooms; and increases in operating costs and expenses due to inflation and other factors. Unfavorable changes in any of these conditions could negatively impact our occupancy rates, average daily rates and, as a result, RevPAR or otherwise adversely affect our results of operations. While our operating results are influenced by conditions typically affecting the lodging industry and also by conditions in each of the geographic markets we operate, they are more directly affected by company-specific key performance indicators as discussed below.

Key Performance Indicators

We utilize a set of non-financial and financial key performance indicators which our senior management reviews frequently. The review of these indicators facilitates timely evaluation of the performance of our business and effective communication of results and key decisions, allowing our business to react promptly to changing customer demands and market conditions.

Our non-financial key performance indicators consist of the increase in the total number of hotels and hotel rooms in our Home Inns hotel chain as well as RevPAR achieved by our hotels. The increase in the number of hotels in our hotel chain is largely affected by the demand for our hotels in various cities and our ability to successfully identify and secure new properties and develop new hotels at desirable locations. RevPAR is a

 

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commonly used operating measure in the hospitality industry and is defined as the product of average occupancy rates and average daily rates achieved. Occupancy rates of our hotels mainly depend on the locations of our hotels, the effectiveness of our sales and brand promotion efforts, our ability to maintain the consistency and quality of our facilities and service, the performance of managerial and other employees of our hotels, as well as our ability to respond to competitive pressure. We set room rates of our hotels primarily based on the location of a hotel and room rates charged by our competitors within the same locality. Changes in RevPAR primarily due to changes in average occupancy rates achieved have different implications on our total revenues and profitability than changes in RevPAR primarily due to changes in average daily rates achieved. For example, increases in occupancy at our hotels would generally lead to increases in room revenues as well as additional incremental costs, such as housekeeping services, utilities and room amenity costs. However, RevPAR increases due to higher room rates generally would not result in these additional room-related costs. As a result, RevPAR increases due to higher room rates would have a greater positive effect on our profitability.

Our financial key performance indicators consist of our revenue and cost structure, which are discussed in greater details in the following paragraphs. In addition, we use EBITDA, a non-GAAP financial measure, as a key financial performance indicator to assess our operating results before the impact of interest, income taxes, depreciation and amortization. Given the significant investments that we have made in leasehold improvements, depreciation and amortization expense comprises a significant portion of our cost structure. We believe that EBITDA is widely used by other companies in the lodging industry and may be used by investors as a measure of our financial performance.

Revenues. In 2005, we generated total revenues of RMB285.9 million (US$35.8 million). Our revenues are significantly affected by the following operating measures which are widely used in the hospitality industry and appear throughout this prospectus:

 

    the total number of hotels in our hotel chain;

 

    the total number of hotel rooms in our hotel chain;

 

    occupancy rates achieved by our hotels;

 

    average daily rates achieved by our hotels; and

 

    RevPAR achieved by our hotels, which represents the product of average daily rates and occupancy rates.

Our future revenue growth will depend significantly upon our ability to expand our hotel chain into new markets in China and maintain and further increase occupancy rates, average daily rates and RevPAR at existing hotels. As of June 30, 2006, we had entered into binding contracts with lessors of 33 properties for our leased-and-operated hotels which are currently under development. We expect to incur an additional RMB140.0 million (US$17.5 million) in capital expenditures in connection with the completion of the leasehold improvements of these hotels. To support this planned expansion, we currently expect to hire approximately 900 to 1,200 new employees for hotel operations and approximately 15 to 20 new employees for our corporate office. We intend to fund this planned expansion with our operating cash flow, existing cash balance and the remaining funds available under our credit facilities which amounted to approximately RMB20.0 million (US$2.5 million) as of June 30, 2006.

 

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The following table sets forth the revenues generated by our leased-and-operated hotels and franchised-and-managed hotels, both in absolute amount and as a percentage of total revenues for the periods indicated.

 

     For the Year Ended December 31,     For the Six Months Ended June 30,  
   2004     2005     2005     2006  
     RMB     %     RMB     US$     %     RMB     %     RMB     US$     %  
     (in thousands except percentages)  

Revenues:

                    

Leased-and-operated hotels

   93,687     97.6     279,948     35,018     97.9     106,978     97.8     243,492     30,458     97.8  

Franchised-and-managed hotels

   2,313     2.4     5,913     740     2.1     2,428     2.2     5,567     696     2.2  
                                                            

Total revenues

   96,000     100.0     285,861     35,758     100.0     109,406     100.0     249,059     31,154     100.0  
                                                            

Less: Business tax and related surcharges

   (5,101 )   (5.3 )   (16,830 )   (2,105 )   (5.9 )   (6,669 )   (6.1 )   (13,344 )   (1,669 )   (5.4 )
                                                            

Net revenues

   90,899     94.7     269,031     33,653     94.1     102,737     93.9     235,715     29,485     94.6  
                                                            

Leased-and-operated Hotels. In 2005, we generated revenues of RMB279.9 million (US$35.0 million) from our leased-and-operated hotels, which accounted for 97.9% of our total revenues for the year. For the first half of 2006, we generated revenues of RMB243.5 million (US$30.5 million) from our leased-and-operated hotels, which accounted for 97.8% of our total revenues for the period. We expect that revenues from our leased-and-operated hotels will continue to constitute a substantial majority of our total revenues in the foreseeable future.

For our leased-and-operated hotels, we lease properties from real estate owners or lessors and we are responsible for hotel development and customization to conform to the standards of Home Inns, as well as for repairs and maintenance and operating costs and expenses of properties over the term of the lease. We are also responsible for all aspects of hotel operations and management, including hiring, training and supervising the managers and employees required to operate our hotels and purchasing supplies. We typically pay fixed rent on a quarterly basis for the first three or five years of the lease term, after which we are generally subject to a 3% to 5% increase every three to five years.

Revenues from our leased-and-operated hotels primarily consist of revenues from sales of room stays and, to a much lesser extent, revenues from sales of food and beverage at our hotels and other services. We recognize revenues from sales of room stays, food and beverage when our services are rendered.

Franchised-and-managed Hotels. In 2005, we generated revenues of RMB5.9 million (US$0.7 million) from our franchised-and-managed hotels, which accounted for 2.1% of our total revenues for the year. For the first half of 2006, we generated revenues of RMB5.6 million (US$0.7 million) from our franchised-and-managed hotels, which accounted for 2.2% of our total revenues for the period. We expect that revenues from our franchised-and-managed hotels will increase in the foreseeable future as we add more franchised-and-managed hotels in our hotel chain.

For our franchised-and-managed hotels, we franchise our “Home Inn” brand to franchisees who are property owners, lessors or existing hotel operators, and we are generally responsible for managing these hotels. Under a typical franchise agreement between us and a franchisee, the franchisee is generally required to pay us an initial franchise fee of RMB200,000 to RMB300,000, annual franchise fees of 3% of the revenues of the hotel, as well as an annual management fee of 3% of the revenues of the hotel. The franchisee is responsible for the costs of hotel development and customization to conform to the standards of Home Inns, as well as for repairs and maintenance and operating expenses of the hotel. We assist the franchisee in property design, construction, systems installation, and hotel personnel recruiting and training before the franchised-and-managed hotel commences operations. We allow our franchisees to utilize our integrated hotel information and operational systems, such as central reservation system, and charge them an annual or variable fee for such use.

 

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We recognize the initial franchise fee as revenue when the franchised-and-managed hotel opens for business, the fee becomes non-refundable, and we have fulfilled all our commitments and obligations. We recognize ongoing franchise and management fees as revenues when the franchised-and-managed hotel recognizes revenues from which we derive the fees. We recognize fees received from franchisees for system usage, maintenance and support as revenues when our services are rendered.

Operating Costs and Expenses. Our operating costs and expenses consist of costs for our leased-and-operated hotels, sales and marketing expenses, general and administrative expenses and other operating expenses. The following table sets forth the components of our operating costs and expenses, both in absolute amount and as a percentage of total revenues for the periods indicated.

 

     For the Year Ended December 31,     For the Six Months Ended June 30,  
   2004     2005     2005     2006  
     RMB     %     RMB     US$     %     RMB     %     RMB     US$     %  
     (in thousands except percentages)  

Total revenues

   96,000     100.0     285,861     35,758     100.0     109,406     100.0     249,059     31,154     100.0  

Less: Business tax and related surcharges

   (5,101 )   (5.3 )   (16,830 )   (2,105 )   (5.9 )   (6,669 )   (6.1 )   (13,344 )   (1,669 )   (5.4 )
                                                            

Net revenues

   90,899     94.7     269,031     33,653     94.1     102,737     93.9     235,715     29,485     94.6  
                                                            

Leased-and-operated hotel costs:

                    

Rents and utilities

   (30,703 )   (32.0 )   (94,784 )   (11,856 )   (33.1 )   (36,701 )   (33.5 )   (73,976 )   (9,254 )   (29.7 )

Personnel costs

   (12,949 )   (13.5 )   (41,225 )   (5,157 )   (14.4 )   (15,782 )   (14.4 )   (36,502 )   (4,566 )   (14.7 )

Depreciation and amortization

   (5,681 )   (5.9 )   (23,335 )   (2,919 )   (8.2 )   (8,828 )   (8.1 )   (19,730 )   (2,468 )   (7.9 )

Consumables, food and beverage

   (6,441 )   (6.7 )   (20,765 )   (2,598 )   (7.3 )   (7,609 )   (7.0 )   (17,811 )   (2,228 )   (7.2 )

Others

   (8,162 )   (8.5 )   (26,100 )   (3,265 )   (9.1 )   (9,783 )   (8.9 )   (23,022 )   (2,880 )   (9.2 )
                                                            

Total leased-and-operated hotel costs

   (63,936 )   (66.6 )   (206,209 )   (25,795 )   (72.1 )   (78,703 )   (71.9 )   (171,041 )   (21,396 )   (68.7 )
                                                            

Sales and marketing expenses

   (2,113 )   (2.2 )   (7,691 )   (962 )   (2.7 )   (2,754 )   (2.5 )   (3,898 )   (488 )   (1.6 )

General and administrative expenses

   (15,983 )   (16.7 )   (24,535 )   (3,069 )   (8.6 )   (10,338 )   (9.4 )   (20,898 )   (2,613 )   (8.4 )
                                                            

Total operating costs and expenses

   (82,032 )   (85.5 )   (238,435 )   (29,826 )   (83.4 )   (91,795 )   (83.9 )   (195,837 )   (24,497 )   (78.6 )
                                                            

Leased-and-operated Hotel Costs. Our leased-and-operated hotel costs consist of costs and expenses directly attributable to our operation of leased-and-operated hotels, primarily including rental payments and utility costs for hotel properties, compensation and benefits for our hotel-based employees, costs of hotel room consumable products, depreciation and amortization of leasehold improvements, and commissions to travel intermediaries and consolidators. We anticipate that our leased-and-operated hotel costs will increase as we continue to open new leased-and-operated hotels and hire additional hotel-based employees.

Sales and Marketing Expenses. Our sales and marketing expenses primarily consist of advertising expenses, production costs of marketing materials, expenses associated with our membership reward program, and compensation and benefits for our sales and marketing personnel, including personnel at our centralized reservation center. We expect that our sales and marketing expenses will increase as we further expand into new geographic locations and promote our brand.

General and Administrative Expenses. Our general and administrative expenses primarily consist of compensation and benefits for our corporate office employees and other employees who are not sales and marketing or hotel-based employees, costs of third-party professional services, and rental payments relating to office and administrative functions. We expect that our general and administrative expenses will increase in the near term as we hire additional personnel and incur additional costs in connection with the expansion of our business and with being a publicly traded company, including costs of enhancing our internal controls.

 

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Our leased-and-operated hotel costs and general and administrative expenses include share-based compensation expenses. The following table sets forth the allocation of our share-based compensation expenses both in absolute amount and as a percentage of total share-based compensation expenses, among the cost and expense items set forth below. Share-based compensation expenses are allocated among these items based on the nature of the work our employees were assigned to perform.

 

    For the Year Ended
December 31,
  For the Six Months Ended
June 30,
  2004   2005   2005   2006
    RMB   %   RMB   US$   %   RMB   %   RMB   US$   %
    (in thousands except percentages)

Leased-and-operated hotel costs—personnel costs

  8   5.4   8   1   0.8   6   1.2   6   1   0.6

General and administrative expenses

  141   94.6   952   119   99.2   480   98.8   1,029   128   99.4
                                       

Total share-based compensation expenses

  149   100.0   960   120   100.0   486   100.0   1,035   129   100.0
                                       

We adopted an Employee’s Stock Option Plan, or the Option Plan, in 2003 and have granted options and stock purchase rights under the Option Plan since 2003. Prior to January 1, 2006, we accounted for share-based compensation expenses in accordance with Accounting Principles Board Opinion No. 25, or APB No. 25, “Accounting for Stock Issued to Employees. In general, share-based compensation expenses under APB No. 25 are recognized based on the difference, if any, between the estimated fair value of our ordinary shares and the exercise price of the options or other equity incentives on the date of grant. Share-based compensation expenses on each date of grant, if any, are recorded in our shareholders’ equity as additional paid-in capital with an offsetting entry recorded as deferred share-based compensation. Deferred share-based compensation is amortized on a straight-line basis and charged to expense over the vesting period of the underlying options.

We have adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS No. 123 (R), beginning on January 1, 2006, under which share-based compensation expenses will be recognized generally over the vesting period of the award based on the fair value of the award on the grant date. As a result, we expect that our share-based compensation expenses will increase significantly compared to what we would have recorded under APB No. 25.

Taxation

We are incorporated in the Cayman Islands. Under the current law of the Cayman Islands, we are not subject to income or capital gains tax. In addition, dividend payments are not subject to withholding tax in the Cayman Islands.

Home Inns Hong Kong is subject to a profit tax at the rate of 17.5% on assessable profit determined under relevant Hong Kong tax regulations. To date, Home Inns Hong Kong has not been required to pay profit tax as it had no assessable profit.

Our subsidiaries and affiliated entities in China are subject to a business tax at a rate of approximately 5.5% on revenues generated from providing services and related surcharges by various local tax authorities. In addition, our subsidiaries and affiliated entities in China are generally subject to the standard enterprise income tax rate, which currently is 33%. However, some of our subsidiaries are subject to lower enterprise income tax rates due to the preferential tax treatments granted by the local tax authorities. For example, our wholly owned subsidiary, Hemei Hotel Management Company, enjoys a reduced 15% enterprise income tax rate due to its place of incorporation and operation in the Pudong New District of Shanghai.

Various local tax authorities in China have provided financial subsidies in the form of certain tax refunds to us. However, these tax authorities could reduce or eliminate any or all of these financial subsidies at any time in the future. Reduction or elimination of the financial subsidies we currently enjoy may have an adverse effect on our results of operations.

 

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Critical Accounting Policies

We prepare financial statements in accordance with U.S. GAAP, which requires us to make judgments, estimates and assumptions that affect the reported amounts of our assets and liabilities and the disclosure of our contingent assets and liabilities at the end of each fiscal period and the reported amounts of revenues and expenses during each fiscal period. We continually evaluate these judgments and estimates based on our own historical experience, knowledge and assessment of current business and other conditions, our expectations regarding the future based on available information and assumptions that we believe to be reasonable, which together form our basis for making judgments about matters that are not readily apparent from other sources. Since the use of estimates is an integral component of the financial reporting process, our actual results could differ from those estimates. Some of our accounting policies require a higher degree of judgment than others in their application.

The selection of critical accounting policies, the judgments and other uncertainties affecting application of those policies and the sensitivity of reported results to changes in conditions and assumptions are factors that should be considered when reviewing our financial statements. We believe the following accounting policies involve the most significant judgments and estimates used in the preparation of our financial statements.

Basis of Consolidation

Our consolidated financial statements included elsewhere in this prospectus include the financial statements of Home Inns & Hotels Management Inc., its subsidiaries and variable interest entity, or VIE, subsidiaries.

We applied the provisions of Financial Accounting Standards Board, or FASB, Interpretation No. 46 (Revised 2003), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” or FIN46(R), to account for certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support.

Under FIN46(R), a company is required to consolidate a VIE if that company has a variable interest that will absorb a majority of the expected losses, receives a majority of the entity’s expected residual returns, or both. The company that absorbs a majority of the VIE’s expected losses and receives a majority of the VIE’s expected residual returns is a primary beneficiary.

We are the primary beneficiary of four variable interest entities, Home Inns & Hotels Management (Xiamen) Co., Ltd, or Home Inns Xiamen, Home Inns & Hotels Management (Fuzhou) Co., Ltd, or Home Inns Fuzhou, Home Inns & Hotels Management (Caoxi) Co., Ltd, or Home Inns Caoxi, and Home Inns & Hotels Management (Caobao) Co., Ltd, or Home Inns Caobao, of which the principal activity generally relates to hotel management. The total registered capital of the four VIEs was RMB4.0 million (US$0.5 million) as of December 31, 2005. The entities were considered variable interest entities because the equity at risk of each entity was not sufficient to finance its intended activities without additional financial support. We have a 51% ownership interest in Home Inns Xiamen, Home Inns Fuzhou and Home Inns Caoxi and 75% ownership interest in Home Inns Caobao, and we are considered the primary beneficiary of these entities because we absorb a majority of the entities’ expected losses and receive a majority of the entities’ expected residual returns. As a result, the operations of the VIEs are included in our consolidated financial statements since their incorporation in 2004.

The entities that operate the franchised-and-managed hotels are considered variable interest entities as the franchisees do not have the ability to make decisions that have a significant impact on the success of the franchise arrangement. However, as the franchisees provide all necessary capital to finance the operation of the franchised properties and absorb a majority of the expected losses, we are not considered the primary beneficiary of those entities.

 

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Property and Equipment

We state property and equipment at cost less accumulated depreciation and accumulated impairment losses, if any. We depreciate property and equipment to write off their cost less expected residual value, on a straight line basis over their expected useful lives.

At each balance sheet date, we consider both internal and external sources of information to assess whether there is any indication that assets included in property and equipment are impaired. If any such indication exists, we estimate the recoverable amount of assets and, if less than carrying value, an impairment loss is recognized to reduce the carrying value of the assets to their recoverable amount. We recognize such impairment losses in the consolidated profit and loss account. The gain or loss on disposal of property and equipment is the difference between the net sales proceeds and the carrying amount of the underlying asset, and is recognized in the consolidated profit and loss account.

Goodwill

Goodwill represents the excess of the cost of an acquired entity over the appropriate share of the fair value of the identifiable assets, including separately identifiable intangible assets, and liabilities acquired. The provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” or SFAS 142, require that a two-step impairment test be performed annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. The first step of the test for impairment compares the book value of our reporting unit under which goodwill is recorded to its estimated fair value. The second step of the goodwill impairment test, which is only required when the net book value of the reporting unit exceeds the fair value, measures impairment as the difference between the implied fair value of goodwill and its book value. Goodwill is not amortized. We recognized no impairment for the periods presented in this prospectus.

Intangible Assets

Intangible assets consist primarily of intangible assets acquired in business combinations. We apply the criteria specified in SFAS No. 141 “Business Combinations,” or SFAS 141, to determine whether an intangible asset should be recognized separately from goodwill. We recognize intangible assets acquired through business acquisitions as assets separate from goodwill if they satisfy either the “contractual-legal” or “separability” criterion. We recognize and measure intangible assets, including favorable lease agreements and certain franchise agreements existing as of the date of acquisition, at fair value upon acquisition. Intangible assets from such business combination transactions are amortized over the remaining operating lease term or the franchise agreement term, as appropriate. We state purchased software at cost, which comprises purchase price less accumulated amortization and impairment, if any.

Impairment of Long-lived Assets and Definite-lived Intangible Assets

We review long-lived assets and definite-lived intangible assets for impairment whenever events or changes in circumstances indicate that carrying amount of an asset may not be recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” or SFAS 144. We assess the recoverability of the long-lived assets and definite-lived intangible assets (other than goodwill) by comparing the carrying amount to the estimated future undiscounted cash flow associated with the related assets. If the estimated future undiscounted cash flows are less than the carrying value, an indication of impairment is present and we recognize a loss for the difference between fair value, using the expected discounted cash flows, and the carrying value of the assets. We use estimates and judgments in these impairment tests, and if different estimates or judgments had been utilized, the timing or the amount of the impairment charges could be different. We recognised no impairment for the periods presented.

 

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Provisions for Customer Reward Program

We invite our customers to participate in a customer reward program. Prior to November 14, 2004, membership was free of charge. We commenced charging a one-time membership fee after that date for new members. Members enjoy discounts on room rates, priority in hotel reservation, and accumulate membership points for their paid stays, which can be redeemed for membership upgrades, room night awards and other gifts. The estimated incremental costs to provide membership upgrades, room night awards and other gifts are accrued and recorded as a provision for customer reward program as members accumulate points and recognized as sales and marketing expense in the accompanying statement of operations. As members redeem awards or their entitlements expire, the provision is reduced correspondingly. As of December 31, 2004 and 2005 and June 30, 2006, we made provisions of RMB68,275, RMB776,645 (US$97,150) and RMB1,667,335 (US$208,565), respectively, based on the estimated liabilities under the customer reward program.

Revenue Recognition

Revenue from leased-and-operated hotels represents primarily room rentals and food and beverage sales from the leased-and-operated hotels. We recognize such revenues when goods and services are delivered.

Revenues from franchised-and-managed hotels are derived from franchise agreements where the franchisees are required to pay (i) an initial one-time franchise fee and (ii) on-going management and service fees based on a percentage of revenue, which approximate 5% to 6% of the room revenues of the franchised hotels. The one-time franchise fee is recognized when the franchise hotel opens for business, the fee becomes non-refundable, and we have fulfilled all of our commitments and obligations, including assisting the franchisees in property design, leasehold improvement construction project management, systems installation, personnel recruiting and training. On-going management and service fees are recognized when the underlying service revenue is recognized by the franchisees’ operations. Other revenues generated from franchise agreements, including system maintenance and support fee and central reservation system usage fee, are recognized when services are provided.

Given the limited history in operating Home Inn’s customer reward program, we recognize all one-time membership fees as deferred revenue when received. We will recognize revenues from the one-time membership fees when the customers are no longer entitled to the benefits of the membership card, or over the estimate average customer relationship period upon having sufficient history to reliably estimate the customer relationship period.

Share-based Compensation

Prior to December 31, 2005, we accounted for share-based compensation arrangements in accordance with Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees”, or APB No. 25, and complied with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, or SFAS No. 123. Under APB No. 25, compensation cost is recognized based on the difference, if any, between the estimated fair value of the ordinary shares and the amount an employee is required to pay to acquire the ordinary shares, as determined on the date the option is granted. Total compensation cost is recorded in shareholders’ equity as additional paid-in capital and deferred share-based compensation. Deferred share-based compensation is amortized on a straight-line basis and charged to expense over the vesting period of the underlying options.

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment”, or SFAS No. 123(R), which revises SFAS No. 123, and supersedes APB No. 25. Under the fair value recognition provisions of SFAS No. 123(R), we applied the prospective transition method and measured share-based compensation at fair value on the awards’ grant date based on the estimated number of awards that are expected to vest. Under the prospective transition method, we continued to account for non-vested awards outstanding under the provisions of APB No. 25. Only awards granted (or modified,

 

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repurchased, or cancelled) after the adoption of SFAS No. 123(R) were accounted for under the provisions of SFAS No. 123(R).

We adopted an employee’s stock option plan in 2003 and granted options to our directors, officers and other employees under the option plan. The following table sets forth a summary of our option grants since the beginning of 2004.

 

Date of Grant

   Number of Ordinary
Shares Underlying
Options Granted
   Option Exercise
Price (in US$)
  

Fair Value of
Ordinary Shares

(in US$)

   Type of
Valuation
 

03/01/2004

   604,182    0.3309    0.1239    (1 )

09/01/2004

   542,428    0.3309    0.7589    (1 )

01/01/2005

   461,589    0.3309    0.9324    (1 )

07/01/2005

   180,000    1.5310    1.3327    (1 )

12/01/2005

   586,483    2.2500    1.9730    (1 )

03/01/2006

   300,000    1.5310    2.7170    (2 )

03/17/2006

   510,000    2.7170    2.7170    (2 )

07/04/2006

   302,000    3.2020    3.2020    (2 )

10/02/2006

   659,000    5.5000    5.5000    (3 )

(1) Retrospective valuation by the independent appraiser.
(2) Contemporaneous valuation by the independent appraiser.
(3) Good faith determination by our board of directors based on the midpoint of the estimated price range for this offering.

Determination of the amount of share-based compensation expense to be recognized requires significant judgment, including, most importantly, the estimated fair value of our ordinary shares underlying the options as of each date of grant. We have engaged an independent appraiser, American Appraisal China Limited, or AA, to assist in the determination of the fair value of our ordinary shares underlying options as of each date of grant since January 1, 2004. Determining the fair value of ordinary shares requires making complex and subjective judgments regarding projected financial and operating results, our unique business risks, the liquidity of our shares and our operating history and prospects at the time of grant.

In assessing the fair value of our ordinary shares, AA considered the following principal factors:

 

    the nature of our company since our inception;

 

    the global economic outlook in general and the specific economic and competitive elements affecting our business and market;

 

    the nature and prospects of the lodging industry in China;

 

    the market-derived investment returns of entities engaged in the hotel operation business;

 

    the growth of our operations; and

 

    our business risks.

AA believes the income approach, also known as the discounted cash flow, or DCF, approach, to be most relevant and reliable only if it is a contemporaneous valuation in which the key assumptions exist at the valuation date and are not biased by hindsight. As we were a young, start-up company prior to 2006 and did not prepare cash flow projections during the period, AA adopted the market approach to determine the fair values of our ordinary shares as of various dates in 2004 and 2005. Under this approach, financial ratios and market price data of comparable companies are analyzed. Ten comparable companies were selected primarily based on the nature of the business, the geographical location and the consideration of other market participants. The ten companies selected are primarily engaged in the hotel operation business. AA determined market multiples of the comparable companies based on the latest available financial information. The market multiples were then adjusted to take into account our growth and business risk. The market multiples so derived were applied to our performance indicators and discounted to reflect the lack of liquidity.

 

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AA used a combination of the income approach and the market approach to assess the fair value of our ordinary shares in 2006. The income approach involves applying appropriate discount rates to estimated cash flows that are based on earnings forecasts. The major assumptions used in deriving the fair values are consistent with our business plan, including:

 

    opening schedule of new hotels;

 

    average occupancy rate;

 

    average daily room rate; and

 

    operating margins.

Other major assumptions used by AA in calculating the fair values of our ordinary share in 2006 include the following:

 

    Weight of DCF and market multiples: The independent appraiser assigned 60% weight to the DCF approach and 40% weight to the market multiples approach because we had achieved better visibility of future earnings at the time, which made the DCF approach more meaningful.

 

    Weighted average costs of capital, or WACC: WACC of between 15% and 16.5% were used. This was the combined result of the changes in risk-free rate, industry average beta, and the decrease in our company-specific risk as we continued to grow and meet important milestones.

 

    Capital market valuation multiples: The independent appraiser obtained and assessed updated capital market valuation data of ten comparable companies.

 

    Lack of marketability discount, or LOMD: The independent appraiser quantified the LOMD by the Black-Scholes option-pricing model. This method treats the right to sell our ordinary shares freely before a liquidity event as a put option. The farther the valuation date is from a liquidation event, the higher the option value and thus the higher the implied LOMD. The LOMD was determined to be 6.9%.

The above assumptions used by AA in deriving the fair values were consistent with our business plan and major milestones achieved by us. AA also used other general assumptions, including the following:

 

    no material changes in the existing political, legal, fiscal and economic conditions and travel industry in China;

 

    no major changes in tax law in China or the tax rates applicable to our subsidiaries and consolidated affiliated entities in China;

 

    exchange rates between the Renminbi and U.S. dollars will not differ materially from current rates;

 

    our future growth will not be constrained by the lack of funding;

 

    our ability to retain competent management and key personnel to support our ongoing operations; and

 

    industry trends and market conditions for hotel and related industries will not deviate significantly from economic forecasts.

These assumptions are inherently uncertain. The increase in the fair value of our ordinary shares from January 2004 to July 2006 was primarily attributable to the growth of our revenues and net income as well as the number of hotels in operation as indicated in the table below. In addition, the rapid and substantial expansion of Home Inns hotels during the period has proved the viability of our business strategy and execution capability and

 

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enhanced our credibility, as demonstrated by our successful financings through issuance of preferred shares to unrelated third-party investors and obtaining credit facilities from commercial banks.

 

As of and for the Quarter Ended

   Revenues
(in RMB thousands)
  

Net Income

(in RMB thousands)

   No. of Hotels
in Operation
  

Other Major Milestones

03/31/2004

   —      1,922    14   

06/30/2004

   25,580    1,648    17    Obtaining control of Home Inns Beijing

09/30/2004

   32,769    1,864    24   

12/31/2004

   37,651    534    26   

03/31/2005

   45,275    3,126    36    Obtaining RMB40 million financing through issuance of Series C preferred shares to unrelated third-party investors

06/30/2005

   64,131    5,179    44    Obtaining financing from BTG in the form of an RMB80 million credit facility provided by a commercial bank entrusted by BTG

09/30/2005

   77,733    5,199    54   

12/31/2005

   98,722    7,431    68    Obtaining RMB20 million unsecured loans from a commercial bank in China

03/31/2006

   110,672    7,885    75   

06/30/2006

   138,387    19,364    82    Obtaining RMB46 million unsecured loans from a commercial bank in China

Share-based compensation expense recognized for the years ended December 31, 2003, 2004 and 2005 amounted to nil, RMB149,705 and RMB959,826 (US$120,064), respectively, and for the six months ended June 30, 2006, amounted to RMB1,035,145 (US$129,485).

Although it is reasonable to expect that the completion of this offering may increase the value of our ordinary shares underlying outstanding options as a result of the increased liquidity and marketability of our shares, the amount of such additional value could not be measured with precision or certainty at the time of the appraisals. With respect to the options granted on October 2, 2006, our board of directors determined that the midpoint of the estimated price range for this offering would be a reasonable measure of the fair value of our ordinary shares as of that date as we had made significant progress in connection with this offering.

Taxation

Income tax expenses are recorded using the liability method. Deferred tax assets or liabilities are recognized for the estimated future tax effects attributable to temporary differences and tax loss carryforwards. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in statements of operations in the period that includes the enactment date. A valuation allowance is recorded to reduce the amount of deferred tax assets if it is considered more likely than not that such assets will not be realized. In doing so, management must make judgments and estimates as to whether we have future taxable income available to utilize the deferred tax assets. As of December 31, 2004 and 2005 and June 30, 2006, we had deferred tax assets of RMB5,166,186 and RMB15,295,113 (US$1,913,252) and RMB18,248,764 (US$2,282,722), respectively. No valuation allowance was made against the deferred tax assets as of December 31, 2004 and 2005 and as of June 30, 2006.

 

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Selected Operating Data

The following table presents certain selected operating data of our company as of and for the dates and periods indicated. We present operating data for 2003 and 2004 to include those of Home Inns Beijing since Home Inns Beijing was managed by us throughout these two years. Our revenues have been and will continue to be significantly affected by these operating measures which are widely used in the hospitality industry.

 

     As of and for the Year Ended
December 31,
   As of and for the
Six Months Ended
June 30,
     2003      2004      2005    2005      2006

Operating Data:

                    

Total hotels in operation:

                    

Leased-and-operated hotels(1)

   10      18      54    34      63

Franchised-and-managed hotels

   0      8      14    10      19

Total rooms

   1,131      2,991      8,197    5,372      9,707

Geographic coverage:

                    

Number of cities

   4      8      22    11      26

Occupancy rate (as a percentage)

   72.4      86.8      89.8    86.6      93.8

Average daily rate (in RMB)

   175      191      182    184      181

RevPAR (in RMB)

   127      166      163    159      170

(1) Include four hotels operated through separate joint ventures with third parties. We own 75% of one joint venture and 51% of each of the other three joint ventures.

Results of Operations

In April 2002, we and BTG formed Home Inns Beijing to operate economy hotels in China. We and BTG owned 55% and 45%, respectively, of Home Inns Beijing upon its formation. We have been actively managing Home Inns Beijing since it commenced operations in 2002. Subsequently, Home Inns Hong Kong gradually increased its ownership interest in Home Inns Beijing by contributing additional funds to the registered capital of Home Inns Beijing. Home Inns Hong Kong increased its ownership interest in Home Inns Beijing to 95.59% as of February 2005. In April 2004, we and Beijing Capital Travel, a subsidiary of BTG, entered into a revised joint venture agreement under which we gained control of Home Inns Beijing, which has been our consolidated subsidiary since then. For periods prior to April 2004, we accounted for our interest in Home Inns Beijing using the equity method as BTG had the participation rights in certain decisions in the ordinary course of business of Home Inns Beijing.

The following table sets forth certain unaudited financial data relating to our consolidated results of operations in 2003 and 2004 assuming we had held a 93.47% interest in Home Inns Beijing and consolidated Home Inns Beijing throughout 2003 and 2004. This information has been derived from Note 7 to our consolidated financial statements included elsewhere in this prospectus and is presented below for you to have a better understanding of the financial results of the Home Inns hotel chain in these two periods.

 

     For the Year Ended December 31,
     2003    2004
     RMB    RMB
     (in thousands)

Net revenues

   42,180    109,128

Income from operations

   2,180    12,550

Net income

   1,842    6,820

 

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Our Selected Quarterly Results of Operations

The following table presents our selected unaudited quarterly results of operations for the eight quarters in the period ended June 30, 2006. This information should be read together with our consolidated financial statements and related notes included elsewhere in this prospectus. Our business has grown rapidly and substantially since we commenced operations in April 2002. Our limited operating history makes it difficult to predict future operating results. We believe that the quarter-to-quarter comparison of operating results should not be relied upon as being indicative of results for any future quarters or for a full year.

 

    For the Three Months Ended  
    September 30,
2004
    December 31,
2004
    March 31,
2005
    June 30,
2005
    September 30,
2005
    December 31,
2005
    March 31,
2006
    June 30,
2006
 
    (in RMB thousands)  

Consolidated Statement of Operations Data:

               

Revenues:

               

Leased-and-operated hotels

  31,451     36,757     44,203     62,775     75,939     97,031     108,681     134,811  

Franchised-and-Managed hotels

  1,318     894     1,072     1,356     1,794     1,691     1,991     3,576  
                                               

Total revenues

  32,769     37,651     45,275     64,131     77,733     98,722     110,672     138,387  
                                               

Less: Business tax and related surcharges

  (1,702 )   (2,030 )   (2,848 )   (3,821 )   (4,370 )   (5,792 )   (5,908 )   (7,436 )
                                               

Net revenues

  31,067     35,621     42,427     60,310     73,363     92,930     104,764     130,951  
                                               

Operating costs and expenses(1):

               

Leased-and-operated hotel costs:

               

Rents and utilities

  (10,356 )   (13,094 )   (15,797 )   (20,904 )   (26,825 )   (31,257 )   (36,512 )   (37,464 )

Personnel costs

  (4,347 )   (4,939 )   (6,435 )   (9,347 )   (10,542 )   (14,901 )   (17,711 )   (18,791 )

Consumables, food and beverage

  (2,113 )   (2,640 )   (2,857 )   (4,752 )   (5,839 )   (7,317 )   (8,166 )   (9,645 )

Depreciation and amortization

  (1,861 )   (2,104 )   (3,843 )   (4,985 )   (5,903 )   (8,603 )   (9,078 )   (10,652 )

Others

  (3,016 )   (2,432 )   (3,913 )   (5,870 )   (7,713 )   (8,603 )   (11,642 )   (11,380 )
                                               

Total leased-and-operated hotel costs

  (21,693 )   (25,209 )   (32,845 )   (45,858 )   (56,822 )   (70,681 )   (83,109 )   (87,932 )
                                               

Sales and marketing expenses

  (606 )   (919 )   (971 )   (1,783 )   (2,046 )   (2,891 )   (1,683 )   (2,215 )

General and administrative expenses

  (4,277 )   (7,957 )   (5,775 )   (4,563 )   (6,184 )   (8,014 )   (7,271 )   (13,627 )
                                               

Total operating costs and expenses

  (26,576 )   (34,085 )   (39,591 )   (52,204 )   (65,052 )   (81,586 )   (92,063 )   (103,774 )
                                               

Income from operations

  4,491     1,536     2,836     8,106     8,311     11,344     12,701     27,177  
                                               

Interest income

  12     57     28     68     47     80     68     223  

Interest expense

  (49 )   (8 )   —       —       (215 )   (494 )   (1,149 )   (1,570 )

Other non-operating income

  —       67     1,813     62     117     154     50     1,650  
                                               

Income before income tax expense, minority interests and share of income (loss) of affiliated companies

  4,454     1,652     4,677     8,236     8,260     11,084     11,670     27,480  
                                               

Income tax expense

  (2,773 )   (1,015 )   (935 )   (1,657 )   (1,661 )   (2,272 )   (2,739 )   (6,465 )

Minority interests

  183     (103 )   (616 )   (1,400 )   (1,400 )   (1,381 )   (1,046 )   (1,651 )
                                               

Net Income

  1,864     534     3,126     5,179     5,199     7,431     7,885     19,364  
                                               

(1) Share-based compensation expenses are included in our operating costs and expenses as follows:

 

 

Leased-and-operated hotel cost - personnel costs

  2     2     2     2     2     2     3     3  

General and administrative expenses

  28     113     233     249     230     240     344     685  

 

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Our quarterly revenues, operating income and net income have experienced continued growth for the eight quarters in the period ended June 30, 2006, except that we experienced a sequential decrease in our operating income and net income in the quarter ended December 31, 2004. This decrease was primarily due to an increase in pre-operating expenses of the hotels under development. Our net income for the quarter ended June 30, 2006 increased substantially compared to the preceding quarter. This increase was mainly because the number of leased-and-operated hotels that had commenced operations for over six months increased significantly from 41 in the quarter ended March 31, 2006 to 54 in the quarter ended June 30, 2006.

The following table presents certain selected operating data of our company as of and for the eight quarters in the period ended June 30, 2006. We present operating data for 2003 and 2004 as if we had consolidated Home Inns Beijing throughout the relevant periods.

 

    For the Three Months Ended
    September 30,
2004
  December 31,
2004
  March 31,
2005
  June 30,
2005
  September 30,
2005
  December 31,
2005
  March 31,
2006
  June 30,
2006

Operating Data:

               

Total hotels in operation:

               

Leased-and-operated hotels

  17   18   26   34   41   54   60   63

Franchised-and-managed hotels

  7   8   10   10   13   14   15   19

Total rooms

  2,743   2,991   4,269   5,372   6,512   8,197   8,972   9,707

Geographic coverage:

               

Number of cities

  7   8   10   11   13   22   23   26

Occupancy rate (as a percentage)

  92.2   86.4   81.6   90.4   93.1   90.9   89.5   97.7

Average daily rate (in RMB)

  192   193   183   184   181   181   175   186

RevPAR (in RMB)

  177   167   149   166   169   165   157   182

 

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Our Results of Operations

The following table sets forth a summary of our consolidated results of operations, both in absolute amount and as a percentage of total revenues for the periods indicated. This information should be read together with our consolidated financial statements and related notes included elsewhere in this prospectus. Our business has grown rapidly and substantially since we commenced operations in April 2002. Our limited operating history makes it difficult to predict future operating results. We believe that the period-to-period comparison of operating results should not be relied upon as being indicative of future performance.

 

    For the Year Ended December 31,     For the Six Months Ended June 30,  
  2003   2004     2005     2005     2006  
    RMB     %   RMB     %     RMB     US$     %     RMB     %     RMB     US$     %  
                                            (unaudited)           (unaudited)     (unaudited)        
    (in thousands except percentages)  

Consolidated Statement of Operations Data:

                       

Revenues:

                       

Leased-and-operated hotels

  —       —     93,687     97.6     279,948     35,018     97.9     106,978     97.8     243,492     30,458     97.8  

Franchised-and-managed hotels

  —       —     2,313     2.4     5,913     740     2.1     2,428     2.2     5,567     696     2.2  
                                                                     

Total revenues

  —       —     96,000     100.0     285,861     35,758     100.0     109,406     100.0     249,059     31,154     100.0  
                                                                     

Less: Business tax and related surcharges

  —       —     (5,101 )   (5.3 )   (16,830 )   (2,105 )   (5.9 )   (6,669 )   (6.1 )   (13,344 )   (1,669 )   (5.4 )
                                                                     

Net revenues

  —       —     90,899     94.7     269,031     33,653     94.1     102,737     93.9     235,715     29,485     94.6  
                                                                     

Operating costs and expenses:

                       

Leased-and-operated hotel costs:

                       

Rents and utilities

  —       —     (30,703 )   (32.0 )   (94,784 )   (11,856 )   (33.2 )   (36,701 )   (33.5 )   (73,976 )   (9,254 )   (29.7 )

Personnel costs

  —       —     (12,949 )   (13.5 )   (41,225 )   (5,157 )   (14.4 )   (15,782 )   (14.4 )   (36,502 )   (4,566 )   (14.7 )

Depreciation and amortization

  —       —     (5,681 )   (5.9 )   (23,335 )   (2,919 )   (8.2 )   (8,828 )   (8.1 )   (19,730 )   (2,468 )   (7.9 )

Consumables, food and beverage

  —       —     (6,441 )   (6.7 )   (20,765 )   (2,598 )   (7.3 )   (7,609 )   (7.0 )   (17,811 )   (2,228 )   (7.2 )

Others

  —       —     (8,162 )   (8.5 )   (26,100 )   (3,265 )   (9.1 )   (9,783 )   (8.9 )   (23,022 )   (2,880 )   (9.2 )

Total leased-and-operated hotel costs

  —       —     (63,936 )   (66.6 )   (206,209 )   (25,795 )   (72.2 )   (78,703 )   (71.9 )   (171,041 )   (21,396 )   (68.7 )
                                                                     

Sales and marketing expenses

  —       —     (2,112 )   (2.2 )   (7,691 )   (962 )   (2.7 )   (2,754 )   (2.5 )   (3,898 )   (488 )   (1.6 )

General and administrative expenses

  (365 )   —     (15,983 )   (16.6 )   (24,535 )   (3,069 )   (8.5 )   (10,338 )   (9.4 )   (20,898 )   (2,613 )   (8.4 )
                                                                     

Total operating costs and expenses

  (365 )   —     (82,031 )   (85.4 )   (238,435 )   (29,826 )   (83.4 )   (91,795 )   (83.9 )   (195,837 )   (24,497 )   (78.6 )
                                                                     

Income (loss) from operations

  (365 )   —     8,868     9.3     30,596     3,827     10.7     10,942     10.0     39,878     4,988     16.0  
                                                                     

Interest income (expense), net

  1     —     (9 )   (0.0 )   (486 )   (61 )   (0.2 )   96     0.1     (2,428 )   (304 )   (1.0 )
                                                                     

Other non-operating income

  —       —     324     0.3     2,146     269     0.8     1,875     1.7     1,700     213     0.7  

Income tax expense

  —       —     (5,738 )   (6.0 )   (6,526 )   (817 )   (2.3 )   (2,592 )   (2.4 )   (9,204 )   (1,151 )   (3.7 )

Minority interests

  —       —     552     0.6     (4,797 )   (600 )   (1.7 )   (2,016 )   (1.8 )   (2,697 )   (337 )   (1.1 )

Share of income of affiliated companies

  1,878     —     1,972     2.1     —       —       —       —       —       —       —       —    
                                                                     

Net income

  1,514     —     5,969     6.3     20,933     2,618     7.3     8,305     7.6     27,249     3,409     10.9  
                                                                     

 

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Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Revenues. Our total revenues increased by 127.7% from RMB109.4 million for the first half of 2005 to RMB249.1 million (US$31.2 million) for the first half of 2006.

 

    Leased-and-operated Hotels. Revenues from our leased-and-operated hotels increased by 127.6% from RMB107.0 million for the first half of 2005 to RMB243.5 million (US$30.5 million) for the first half of 2006. This increase was primarily due to our expansion of leased-and-operated hotels from 34 hotels and 4,124 rooms as of June 30, 2005 to 63 hotels and 7,579 rooms as of June 30, 2006.

 

    Franchised-and-managed Hotels. Revenues from our franchised-and-managed hotels increased by 133.3% from RMB2.4 million for the first half of 2005 to RMB5.6 million (US$0.7 million) for the first half of 2006. This growth was primarily due to an increase in the number of franchised-and-managed hotels from ten hotels with 1,248 rooms as of June 30, 2005 to 19 hotels with 2,128 rooms as of June 30, 2006.

Operating Costs and Expenses. Our total operating costs and expenses increased substantially from RMB91.8 million for the first half of 2005 to RMB195.8 million (US$24.5 million) for the first half of 2006. This increase resulted from increases in all of our cost and expense line items as our hotel operations substantially expanded in the first half of 2006.

 

    Leased-and-operated Hotel Costs. Our leased-and-operated hotel costs increased substantially from RMB78.7 million for the first half of 2005 to RMB171.0 million (US$21.4 million) for the first half of 2006. This increase was primarily because all items comprising our leased-and-operated hotel costs increased substantially as we expanded our leased-and-operated hotels from 34 hotels and 4,124 rooms as of June 30, 2005 to 63 hotels and 7,579 rooms as of June 30, 2006.

 

    Sales and Marketing Expenses. Our sales and marketing expenses increased from RMB2.8 million for the first half of 2005 to RMB3.9 million (US$0.5 million) for the first half of 2006. This increase was primarily due to increased marketing and promotional expenses in connection with 14 new hotels that opened during the first half of 2006.

 

    General and Administrative Expenses. Our general and administrative expenses increased by 102.9% from RMB10.3 million for the first half of 2005 to RMB20.9 million (US$2.6 million) for the first half of 2006, primarily due to an increase in the total compensation and benefits for our administrative staff as a result of our hiring of over 80 new employees in the areas of finance and accounting, technology infrastructure, human resources and general administration to support our expanded operations and the third-party professional fees we incurred during the first half of 2006.

Income from Operations. Our income from operations increased by 266.1% from RMB10.9 million for the first half of 2005 to RMB39.9 million (US$5.0 million) for the first half of 2006 as a cumulative result of the above factors.

Interest Income (Expense), Net. Our net interest expense was RMB2.4 million (US$0.3 million) for the first half of 2006, primarily due to the interest accrued on our loans during the first half of 2006. We had net interest income of RMB0.1 million in the first half of 2005 primarily due to the interest accrued on our proceeds from the issuance of our Series C preferred shares in January 2005.

Income Tax Expenses. Our income tax expenses increased by 253.8% from RMB2.6 million for the first half of 2005 to RMB9.2 million (US$1.2 million) for the first half of 2006, primarily because of the increased income of our operating subsidiaries in China.

Minority Interest. Minority interest represents BTG’s share of our net income based on its equity interest in Home Inns Beijing and our joint venture partners’ share of the net income of the four leased-and-operated hotels owned by the joint ventures. Minority interest increased from RMB2.0 million for the first half of 2005 to RMB2.7 million (US$0.3 million) for the first half of 2006, due to our increased net income for the first half of 2006.

 

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Net Income. As a result of the foregoing, we had net income of RMB27.2 million (US$3.4 million) for the first half of 2006, an increase of 227.7% from net income of RMB8.3 million for the first half of 2005.

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

Revenues. Our total revenues increased by 197.8% from RMB96.0 million in 2004 to RMB285.9 million (US$35.8 million) in 2005. In addition to the reasons discussed below, the revenue increase was also due to the effect of our consolidation of Home Inns Beijing since April 2004.

 

    Leased-and-operated Hotels. Revenues from our leased-and-operated hotels increased by 198.7% from RMB93.7 million in 2004 to RMB279.9 million (US$35.0 million) in 2005. This increase was primarily due to our substantial expansion of leased-and-operated hotels from 18 hotels and 2,060 rooms as of December 31, 2004 to 54 hotels and 6,555 rooms as of December 31, 2005.

 

    Franchised-and-managed Hotels. Revenues from our franchised-and-managed hotels increased substantially from RMB2.3 million in 2004 to RMB5.9 million (US$0.7 million) in 2005. This growth was primarily due to an increase in the number of franchised-and-managed hotels from eight hotels with 931 rooms as of December 31, 2004 to 14 hotels with 1,642 rooms as of December 31, 2005.

Operating Costs and Expenses. Our total operating costs and expenses increased substantially from RMB82.0 million in 2004 to RMB238.4 million (US$29.8 million) in 2005. This increase resulted from increases in all of our cost and expense line items as we substantially expanded our operations in 2005 and consolidated Home Inns Beijing in April 2004.

 

    Leased-and-operated Hotel Costs. Our leased-and-operated hotel costs increased substantially from RMB63.9 million in 2004 to RMB206.2 million (US$25.8 million) in 2005. This increase was primarily because all items comprising our leased-and-operated hotel costs increased substantially as we expanded our leased-and-operated hotels from 18 hotels and 2,060 rooms as of December 31, 2004 to 54 hotels and 6,555 rooms as of December 31, 2005.

 

    Sales and Marketing Expenses. Our sales and marketing expenses increased substantially from RMB2.1 million in 2004 to RMB7.7 million (US$1.0 million) in 2005. This increase was primarily due to increased marketing and promotional expenses in connection with 42 new hotels that opened in 2005.

 

    General and Administrative Expenses. Our general and administrative expenses increased by 53.1% from RMB16.0 million in 2004 to RMB24.5 million (US$3.1 million) in 2005, primarily due to an increase in the total compensation and benefits for our administrative staff as a result of our hiring of over 60 new employees in the areas of finance and accounting, technology infrastructure, human resources and general administration to support our expanded operations in 2005.

Income from Operations. Our income from operations increased by 243.8% from RMB8.9 million in 2004 to RMB30.6 million (US$3.8 million) in 2005 as a cumulative result of the above factors.

Interest Income (Expense), Net. Our net interest expense increased substantially from RMB9.0 thousand in 2004 to RMB0.5 million (US$0.1 million) in 2005, primarily due to the interest accrued on our loans from BTG in 2005.

Share of Income of Affiliated Companies. Our share of income of affiliated companies decreased from RMB2.0 million in 2004 to nil in 2005 because we consolidated Home Inns Beijing in April 2004.

Income Tax Expenses. Our income tax expenses increased by 14.0% from RMB5.7 million in 2004 to RMB6.5 million (US$0.8 million) in 2005, primarily because of the increased income of our operating subsidiaries in China.

Minority Interest. Minority interest represents BTG’s share of our net income based on its equity interest in Home Inns Beijing and our joint venture partners’ share of the net income of the four leased-and-operated hotels owned by the joint ventures. Minority Interest increased substantially from RMB0.6 million in 2004 to RMB4.8

 

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million (US$0.6 million) in 2005, due to our consolidation of Home Inns Beijing since April 2004 as well as our increased net income in 2005.

Net Income. As a result of the foregoing, we had net income of RMB20.9 million (US$2.6 million) in 2005, an increase of 248.3% from net income of RMB6.0 million in 2004.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

Prior to April 2004, we accounted for our interest in Home Inns Beijing using the equity method. Home Inns Beijing was our material operating entity that recognized all of the revenues and incurred related operating costs and expenses for our hotels prior to April 2004. Consequently, we had no revenues, but only immaterial operating costs and expenses in 2003. Accordingly, we do not believe our consolidated results of operations for 2003 and 2004 provide a meaningful basis for comparison and discussion. However, the following discussion of the results of operations of Home Inns Beijing in 2003 and 2004 provides an indication of the financial performance of the Home Inns hotel chain, which was not consolidated into our results of operations prior to April 2004.

Home Inns Beijing’s Results of Operations in 2003 and 2004

The following table sets forth a summary of Home Inns Beijing’s consolidated results of operations both in absolute amount and as a percentage of total revenues for the periods indicated. This information should be read together with Home Inns Beijing’s consolidated financial statements and related notes included elsewhere in this prospectus.

 

     For the Year Ended December 31,  
   2003     %     2004     %  
     (in RMB thousands except percentages)  

Consolidated Statement of Operations Data:

        

Revenues:

        

Leased-and-operated hotels

   43,842     100.0     112,914     97.9  

Franchised-and-managed hotels

   —       —       2,364     2.1  
                        

Total revenues

   43,842     100.0     115,278     100.0  
                        

Less: Business tax and related surcharges

   (1,662 )   (3.8 )   (6,150 )   (5.3 )
                        

Net revenues

   42,180     96.2     109,128     94.7  
                        

Operating costs and expenses:

        

Leased-and-operated hotel costs:

        

Rents and utilities

   (13,900 )   (31.7 )   (36,462 )   (31.6 )

Personnel costs

   (6,677 )   (15.2 )   (15,653 )   (13.6 )

Consumables, food and beverage

   (3,268 )   (7.5 )   (8,149 )   (7.1 )

Depreciation and amortization

   (2,179 )   (5.0 )   (6,685 )   (5.8 )

Others

   (5,720 )   (13.0 )   (10,019 )   (8.7 )
                        

Total leased-and-operated hotel costs

   (31,744 )   (72.4 )   (76,968 )   (66.8 )
                        

Sales and marketing expenses

   (2,142 )   (4.9 )   (2,564 )   (2.2 )

General and administrative expenses

   (5,604 )   (12.8 )   (16,607 )   (14.4 )
                        

Total operating costs and expenses

   (39,490 )   (90.1 )   (96,139 )   (83.4 )
                        

Income from operations

   2,690     6.1     12,989     11.3  
                        

Interest income (expense), net

   86     0.2     (15 )   0.0  
                        

Other non-operating income

   30     0.1     328     0.3  

Income tax expense

   (318 )   (0.7 )   (6,861 )   (6.0 )

Minority interests

   —       0.0     1,294     1.1  
                        

Net income

   2,488     5.7     7,735     6.7  
                        

 

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Year Ended December 31, 2004 Compared to Year Ended December 31, 2003.

Revenues. Home Inns Beijing’s total revenues increased by 163.2% from RMB43.8 million in 2003 to RMB115.3 million in 2004.

 

    Leased-and-operated Hotels. Revenues from leased-and-operated hotels increased by 157.8% from RMB43.8 million in 2003 to RMB112.9 million in 2004. This increase was primarily due to Home Inns Beijing’s substantial expansion of leased-and-operated hotels from 10 hotels with 1,131 rooms as of December 31, 2003 to 18 hotels with 2,060 rooms as of December 31, 2004.

 

    Franchised-and-managed Hotels. Revenues from franchised-and-managed hotels increased from nil in 2003 to RMB2.4 million in 2004. This change was primarily because Home Inns Beijing had eight franchised-and-managed hotels in operation with 931 rooms as of December 31, 2004, compared to no such hotel in operation as of December 31, 2003.

Operating Costs and Expenses. Home Inns Beijing’s total operating costs and expenses increased by 143.3% from RMB39.5 million in 2003 to RMB96.1 million in 2004. This increase resulted from increases in all cost and expense line items due to the substantial expansion of the Home Inn hotel chain.

 

    Leased-and-operated Hotel Costs. Leased-and-operated hotel costs increased substantially from RMB31.7 million in 2003 to RMB77.0 million in 2004. This increase was primarily because all items comprising Home Inns Beijing’s leased-and-operated hotel costs increased substantially as it expanded its leased-and-operated hotels from 10 hotels with 1,131 rooms as of December 31, 2003 to 18 hotels with 2,060 rooms as of December 31, 2004.

 

    Sales and Marketing Expenses. Home Inns Beijing’s sales and marketing expenses increased substantially from RMB2.1 million in 2003 to RMB2.6 million in 2004. This increase was primarily due to increased marketing and promotional expenses in connection with 16 new hotels that opened in 2004.

 

    General and Administrative Expenses. Home Inns Beijing’s general and administrative expenses increased by 196.4% from RMB5.6 million in 2003 to RMB16.6 million in 2004, primarily due to an increase in the total compensation and benefits for its administrative staff as a result of Home Inns Beijing’s hiring of over 45 new employees in the areas of finance and accounting, technology infrastructure, human resources and general administration to support the expanded operations in 2004.

Income From Operations. Home Inns Beijing’s income from operations increased substantially from RMB2.7 million in 2003 to RMB13.0 million in 2004 as a cumulative result of the above factors.

Interest Income (Expense), Net. Home Inns Beijing had net interest income of RMB0.1 million in 2003 and had net interest expense of RMB0.02 million in 2004, primarily due to the interest earned on its bank deposits in 2003 and the interest accrued on the short-term borrowing in 2004.

Income Tax Expense. Home Inns Beijing’s income tax expenses increased substantially from RMB0.3 million in 2003 to RMB6.9 million in 2004, primarily due to the substantial increase in its income from operations.

Minority Interest. Minority interest represents our joint venture partners’ share of the net income of the four leased-and-operated hotels owned by the joint ventures. Home Inns Beijing did not have minority interest in 2003 because the joint ventures owning the four hotels were established in 2004.

Net Income. As a result of the foregoing, Home Inns Beijing had net income of RMB7.7 million in 2004, compared to net income of RMB2.5 million in 2003.

 

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Our Liquidity and Capital Resources

Our principal sources of liquidity have been cash generated from operating activities, our sale of ordinary shares and preferred shares through private placements, as well as borrowings from BTG and third-party lenders. Our cash and cash equivalents consist of cash on hand and liquid investments which are unrestricted as to withdrawal or use, and which have maturities of three months or less that are placed with banks and other financial institutions. As of June 30, 2006, we had entered into binding contracts with lessors of 33 properties for our leased-and-operated hotels under development. We expect to incur an additional RMB140.0 million (US$17.5 million) in capital expenditures in connection with the completion of the leasehold improvements of these hotels. To support this planned expansion, we currently expect to hire approximately 900 to 1,200 new employees for hotel operations and approximately 15 to 20 new employees for our corporate office and expect to incur additional personnel costs ranging from RMB80.0 million (US$10.0 million) to RMB110.0 million (US$13.8 million) per year in connection with this anticipated headcount increase. We intend to fund this planned expansion with our operating cash flow, existing cash balance and the remaining funds available under our credit facilities, the latter of which amounted to approximately RMB24.0 million (US$3.0 million) as of September 30, 2006.

We have incurred a working capital deficit resulting primarily from payables relating to the cost of leasehold improvements. Our current assets are insufficient to cover our current liabilities. As of December 31, 2004 and 2005 and June 30, 2006, our net current liabilities amounted to RMB5.5 million, RMB62.8 million and RMB83.6 million (US$10.5 million), respectively. We have been able to meet our working capital needs, and we believe that we will be able to meet our working capital needs in the foreseeable future, with our operating cash flow, existing cash balance and the remaining funds available under our credit facilities.

The following table sets forth a summary of our cash flows for the periods indicated:

 

    For the Year Ended December 31,     For the Six Months Ended June 30,  
  2003     2004     2005     2005     2006  
    RMB     RMB     RMB     US$     RMB     RMB     US$  
                            (unaudited)     (unaudited)     (unaudited)  
    (in thousands)  

Net cash (used in) provided by operating activities

  (340 )   28,664     70,604     8,832     20,789     64,815     8,108  

Net cash used in investing activities

  (28,945 )   (42,319 )   (159,339 )   (19,932 )   (60,564 )   (88,024 )   (11,011 )

Net cash provided by financing activities

  38,830     28,605     100,170     12,530     40,329     66,463     8,314  
                                         

Net increase in cash and cash equivalents

  9,545     14,950     11,435     1,430     554     43,254     5,411  

Cash and cash equivalents at beginning of period

  1,797     11,342     26,292     3,289     26,292     37,727     4,719  
                                         

Cash and cash equivalents at end of the period

  11,342     26,292     37,727     4,719     26,846     80,981     10,130  
                                         

Operating Activities

We have financed our operating activities primarily through cash generated from operations. We currently anticipate that we will be able to meet our needs to fund operations beyond the next twelve months with operating cash flow, existing cash balances and the portion of the net proceeds from this offering remaining after repayment of part of our indebtedness.

Net cash provided by operating activities increased substantially to RMB64.8 million (US$8.1 million) for the first half of 2006. The increase resulted from our expanded operations in the first half of 2006 and was mainly attributable to several factors, including (i) our net income of RMB27.2 million (US$3.4 million) for the first half of 2006, (ii) an add-back of non-cash depreciation and amortization expenses of RMB20.1 million (US$2.5 million), (iii) an increase in deferred revenues of RMB7.3 million (US$0.9 million), and (iv) an increase in deferred rental of RMB6.6 million (US$0.8 million), offset in part by the increases in prepayments and other

 

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current assets. These changes were primarily attributable to the expansion of the Home Inns hotel chain from 44 hotels with 5,372 hotel rooms as of June 30, 2005 to 82 hotels with 9,707 hotel rooms as of June 30, 2006. Net cash provided by operating activities amounted to RMB70.6 million (US$8.8 million) in 2005. The increase was mainly attributable to several factors, including (i) our net income of RMB20.9 million (US$2.6 million), (ii) an add-back of non-cash depreciation and amortization expenses of RMB23.8 million (US$3.0 million), (iii) a substantial increase in deferred rental of RMB14.6 million (US$1.8 million), (iv) an increase in income tax payable of RMB7.6 million (US$1.0 million), and (v) an increase in deferred revenues of RMB5.9 million (US$0.7 million). These changes were primarily attributable to the expansion of the Home Inns hotel chain from 26 hotels with 2,991 hotel rooms as of December 31, 2004 to 68 hotels with 8,197 hotel rooms as of December 31, 2005. Net cash provided by operating activities amounted to RMB28.7 million in 2004. This was primarily due to a net income of RMB6.0 million, an add-back of non-cash expenses including depreciation and amortization, and an increase in other payables and accruals. These changes were primarily attributable to the expansion of the Home Inns hotel chain from 10 hotels with 1,131 hotel rooms as of December 31, 2003 to 26 hotels with 2,991 hotel rooms as of December 31, 2004, as well as our consolidation of Home Inns Beijing since April 2004.

Investing Activities

Our cash used in investing activities is primarily related to our leasehold improvements and purchase of equipment and fixtures used in leased-and-operated hotels. Net cash used in investing activities increased from RMB60.6 million during the first half of 2005 to RMB88.0 million (US$11.0 million) during the first half of 2006, primarily due to an increase in our leasehold improvements and purchase of furniture, fixture and equipment used in an increased number of leased-and-operated hotels in the first half of 2006. Net cash used in investing activities increased from RMB42.3 million in 2004 to RMB159.3 million (US$19.9 million) in 2005, primarily due to a substantial increase in our leasehold improvements and purchase of equipment and fixtures used in an increased number of leased-and-operated hotels in 2005. Net cash used in investing activities increased from RMB28.9 million in 2003 to RMB42.3 million in 2004, primarily due to our purchase of equipment and fixtures used in an increased number of leased-and-operated hotels in 2004, partially offset by net cash acquired in connection with our consolidation of Home Inns Beijing in 2004.

Financing Activities

Our financing activities consist of issuance and sale of our shares to investors and related parties and borrowings from a related party and other third-party lenders. The following table sets forth a summary of our outstanding indebtedness as of September 30, 2006:

 

Lender

   Date of
Loan
Initiation
   Due Date   

Principal

(in RMB)

  

Principal

(in US$)

   Interest
Rate
 

BTG

   07/15/2005    07/14/2008    20,000,000    2,501,783    6.1747 %

BTG

   09/07/2005    09/06/2008    10,000,000    1,250,891    6.1747 %

BTG

   10/18/2005    10/17/2007    10,000,000    1,250,891    6.1747 %

BTG

   01/11/2006    01/10/2008    20,000,000    2,501,783    6.1747 %

China Merchants Bank

   04/29/2006    10/28/2006    40,000,000    5,003,565    5.40 %

China Merchants Bank

   05/30/2006    11/29/2006    6,000,000    750,535    5.40 %

China Merchants Bank

   08/21/2006    02/20/2007    20,000,000    2,501,783    5.58 %

China Merchants Bank

   09/11/2006    03/10/2007    20,000,000    2,501,783    5.022 %

We are required under each loan or financing transaction agreement to notify the lender in advance before we enter into a material merger and acquisition, spin-off, corporate reorganization, new joint venture or sale of material assets transaction. None of our lenders have the right to prevent us from entering into any of these transactions. In addition, under the financing transaction agreement between us and BTG, in the event of default by us under the agreement, BTG has the right to enforce its rights by choosing one of the following options: (i) requesting liquidation of Home Inns Hong Kong or Home Inns Beijing and seeking repayment through legal

 

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proceeding; (ii) converting the total principal amount of the loans into 11.15% of the equity interest in Home Inns Hong Kong if the net assets of Home Inns Hong Kong on the date of default exceeds its net assets as of June 2005; or (iii) converting the total principal amount of the loans into equity interest in Home Inns Beijing at a price determined based on the valuation of Home Inns Beijing at RMB663.5 million (US$83.0 million), if the value of the net assets of Home Inns Beijing exceeds RMB663.5 million (US$83.0 million) on the date of default.

As of September 30, 2006, the remaining funds available under our credit facilities in the aggregate amounted to approximately RMB24.0 million (US$3.0 million). Our loans from China Merchants Bank were drawn under a revolving credit facility which allows us to renew each loan for additional six-month terms at the same interest rate upon expiration of the initial term.

Net cash provided by financing activities increased from RMB40.3 million for the first half of 2005 to RMB66.5 million (US$8.3 million) for the first half of 2006. In the first half of 2006, we borrowed a total of RMB86.0 million (US$10.8 million) from a third-party lender and BTG to fund the rapid expansion of our hotel chain throughout China. Net cash provided by financing activities in the first half of 2005 consisted solely of the proceeds we received from issuance and sale of our Series C preferred shares to a group of third-party investors in January 2005. Net cash provided by financing activities increased substantially from RMB28.6 million in 2004 to RMB100.2 million (US$12.5 million) in 2005, and net cash provided by financing activities decreased from RMB38.8 million in 2003 to RMB28.6 million in 2004. Cash provided by financing activities in 2005 consisted of a total of RMB60.0 million (US$7.5 million) borrowings from a related party and third-party lenders and the RMB40.3 million (US$5.0 million) proceeds from our issuance and sale of preferred shares in the year. Net cash provided by financing activities in 2004 consisted of the RMB30.4 million proceeds from our issuance and sale of our ordinary shares, partially offset by the repayment of our RMB3.0 million short-term borrowings in the year. Cash provided by financing activities in 2003 consisted solely of the RMB38.8 million proceeds from our issuance and sale of preferred shares in 2003.

Home Inns Beijing’s Liquidity and Capital Resources

Home Inns Beijing’s principal sources of liquidity have been cash generated from operating activities and capital contributions from its shareholders. Home Inns Beijing’s cash and cash equivalents consist of cash on hand and liquid investments which are unrestricted as to withdrawal or use, and which have maturities of three months or less that are placed with banks and other financial institutions.

The following table sets forth a summary of Home Inns Beijing’s cash flows for the periods indicated:

 

    For the Year Ended December 31,  
  2003     2004  
    (in RMB thousands)  

Net cash provided by operating activities

  10,193     36,330  

Net cash used in investing activities

  (26,640 )   (67,623 )

Net cash provided by financing activities

  28,945     31,720  
           

Net increase in cash and cash equivalents

  12,498     427  

Cash and cash equivalents at beginning of period

  3,785     16,283  
           

Cash and cash equivalents at end of the period

  16,283     16,710  
           

 

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Operating Activities

Home Inns Beijing has financed its operating activities primarily through cash generated from operations. Net cash provided by operating activities amounted to RMB36.3 million in 2004, as compared to RMB10.2 million in 2003. The increase was mainly attributable to several factors, including (i) a substantial increase in net income from RMB2.5 million in 2003 to RMB7.7 million in 2004, (ii) an increase in non-cash depreciation and amortization of property and equipment expenses from RMB2.3 million in 2003 to RMB7.0 million in 2004, and (iii) an increase in other payables and accruals, including long-term payable for rental expenses in 2004. The increase was partially offset by an increase in accounts receivable and consumables, prepayments and other current assets in 2004. These changes were primarily attributable to the expansion of our Home Inns hotel chain from 10 hotels with 1,131 hotel rooms as of December 31, 2003 to 26 hotels with 2,991 hotel rooms as of December 31, 2004.

Investing Activities

Home Inns Beijing’s cash used in investing activities was primarily related to leasehold improvements and purchase of furniture, fixture and equipment used in leased-and-operated hotels. Net cash used in investing activities increased from RMB26.6 million in 2003 to RMB67.6 million in 2004, primarily due to a substantial increase in the leasehold improvements and purchase of equipment and fixtures used in an increased number of leased-and-operated hotels in 2004.

Financing Activities

Home Inns Beijing’s cash provided by financing activities was related to capital contributions from its shareholders. Net cash provided by financing activities increased from RMB28.9 million in 2003 to RMB31.7 million in 2004, due to an increase in capital contributions from Home Inns Beijing’s shareholders in 2004.

Capital Expenditures

Our and Home Inn Beijing’s capital expenditures were incurred primarily in connection with leasehold improvements, investments in furniture, fixtures and equipment and technology, information and operational software. Our capital expenditures totaled nil, RMB61.7 million and RMB193.2 million (US$24.2 million) in 2003, 2004 and 2005, respectively. Home Inns Beijing’s capital expenditures totaled RMB32.0 million and RMB70.5 million in 2003 and 2004, respectively. We will continue to make capital expenditures to meet the expected growth of our operations and expect cash generated from our operating activities and financing activities will meet our capital expenditure needs in the foreseeable future.

Contractual Obligations

The following table sets forth our contractual obligations as of December 31, 2005:

 

     Payment Due by Period
   Total    Less than
1 year
   1-3
years
   3-5
years
   More than
5 years
     (in RMB millions)

Long-term debt obligations

   40    —      40    —      —  

Operating lease obligations

   1,276    94    194    198    790

Purchase obligations

   103    103    —      —      —  

Investment obligations

   2    2    —      —      —  
                        

Total

   1,421    199    234    198    790
                        

 

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As of December 31, 2005, our long-term debt obligations consisted of the loans due to BTG in an aggregate principal amount of RMB40.0 million (US$5.0 million) with an interest rate of 6.1747% per annum. Each of the loans from BTG would be due in two or three years from the date on which the loan was extended. Our operating lease obligations related to our obligations under lease agreements with lessors of our leased-and-operated hotels. Our purchase obligations primarily consisted of our contractual commitments relating to leasehold improvements and installation of equipment for our leased-and-operated hotels. Our investment obligations consisted of our contractual commitments relating to our investments in two PRC entities which were expected to become our wholly owned subsidiaries upon our payment of the registered capital for these entities.

Off-Balance Sheet Commitments and Arrangements

Other than operating lease obligations set forth in the table above, we have not entered into any financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity, or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

Inflation

Inflation in China has not materially impacted our results of operations in recent years. According to the National Bureau of Statistics of China, the change of consumer price index in China was 1.2%, 3.9% and 1.8% in 2003, 2004 and 2005, respectively.

Holding Company Structure

We are a holding company with no material operations of our own. We conduct our operations primarily through our subsidiaries in China. As a result, our ability to pay dividends and to finance any debt we may incur depends upon dividends paid by our subsidiaries. If our subsidiaries or any newly formed subsidiaries incur debt on their own behalf in the future, the instruments governing their debt may restrict their ability to pay dividends to us. In addition, our subsidiaries are permitted to pay dividends to us only out of their retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Under PRC law, each of Home Inns Beijing, a Sino-foreign enterprise, and Hemei, a wholly foreign owned enterprise, is required to set aside a portion of its after-tax profits each year to fund a statutory reserve and to further set aside a portion of its after-tax profits to fund the employee welfare fund at the discretion of the board or the enterprise itself. Although the statutory reserves can be used, among other ways, to increase the registered capital and eliminate future losses in excess of retained earnings of the respective companies, the reserve funds are not distributable as cash dividends except in the event of liquidation of these subsidiaries.

Quantitative and Qualitative Disclosure about Market Risk

Interest Rate Risk

Our exposure to interest rate risk primarily relates to the interest rates for our outstanding debt and the interest income generated by excess cash invested in liquid investments with original maturities of three months or less. As of June 30, 2006, our total outstanding loans amounted to RMB126.0 million (US$15.8 million) with interest rates varying from 5.31% to 6.1747%. Assuming the principal amount of the outstanding loans remains the same as of December 31, 2006, a 1% increase in each applicable interest rate would add RMB1.3 million (US$0.2 million) to our interest expense in 2006. We intend to use a portion of the net proceeds from this offering to repay the outstanding loans. See “Use of Proceeds.” We have not used any derivative financial instruments to manage our interest risk exposure. Interest-earning instruments carry a degree of interest rate risk.

 

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We have not been exposed to material risks due to changes in interest rates. However, our future interest income may be lower than expected due to changes in market interest rates.

Foreign Exchange Risk

Substantially all of our revenues and most of our expenses are denominated in RMB. Our exposure to foreign exchange risk primarily relates to cash and cash equivalent denominated in U.S. dollars as a result of our past issuances of preferred shares through a private placement and proceeds from this offering. We do not believe that we currently have any significant direct foreign exchange risk and have not hedged exposures denominated in foreign currencies or any other derivative financial instruments. Although in general, our exposure to foreign exchange risks should be limited, the value of your investment in our ADSs will be affected by the foreign exchange rate between U.S. dollars and RMB because the value of our business is effectively denominated in RMB, while the ADSs will be traded in U.S. dollars.

The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of RMB into foreign currencies, including U.S. dollars, has been based on rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 3.4% appreciation of the RMB against the U.S. dollar by June 30, 2006. There remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the RMB against the U.S. dollar. To the extent that we need to convert U.S. dollars we receive from this offering into RMB for our operations, appreciation of the RMB against the U.S. dollar would have an adverse effect on the RMB amount we receive from the conversion. Conversely, if we decide to convert our RMB denominated cash amounts into U.S. dollars amounts for the purpose of making payments for dividends on our ordinary shares or ADSs or for other business purposes, appreciation of the U.S. dollar against the RMB would have a negative effect on the U.S. dollar amount available to us. We have not used any forward contracts or currency borrowings to hedge our exposure to foreign currency exchange risk.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R), which replaces SFAS No. 123 and APB No. 25. Under SFAS No. 123(R), share-based compensation is measured at fair value on the awards’ grant date, based on the estimated number of awards that are expected to vest. Pro forma disclosure is no longer an alternative. SFAS No. 123R is effective for nonpublic companies for fiscal years that begin after December 15, 2005 and we have implemented SFAS No. 123(R) effective January 1, 2006.

For any awards granted subsequent to the adoption of SFAS No. 123(R), compensation expense will be recognized generally over the vesting period of the award based on the fair value of the award on grant date.

On October 6, 2005, FASB Staff Position FAS 13-1 “Accounting for Rental Costs Incurred During a Construction Period,” or FSP FAS 13-1, addresses the accounting for rental costs associated with operating leases that are incurred during a construction period. The FSP reached a consensus that as there is no distinction between the right to use a leased asset during the construction period and the right to use that asset after the construction period, and that the rental costs associated with ground or building operating leases that are incurred during a construction period should be recognized as rental expenses. This guidance is to be applied to the first reporting period beginning after December 15, 2005. Our current accounting policy is consistent with guidance provided by FSP FAS 13-1.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” or SFAS No. 154, which replaces APB Opinion No. 20, “Accounting Changes,” or APB No. 20, and FASB Statement

 

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No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and changes the requirements for the accounting for and reporting of a change in accounting principle. APB No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement will be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

In June 2005, the FASB ratified the Emerging Issues Task Forces Issue No. 05-06, “Determining the Amortization Period for Leasehold Improvements,” or EITF No. 05-06. EITF No. 05-06 provides that the amortization period used for leasehold improvements acquired in a business combination or purchased after the inception of a lease be the shorter of (a) the useful life of the assets or (b) a term that includes required lease periods and renewals that are reasonably assured upon the acquisition or the purchase. The provisions of EITF No. 05-06 should be applied to leasehold improvements (within the scope of this issue) that are purchased or acquired in reporting periods beginning after June 29, 2005. The adoption of EITF No. 05-06 will not have a significant impact on our consolidated financial statements.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109”, or FIN 48, which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective for us on January 1, 2007, with the cumulative effect of the changes in accounting principle, if any, recorded as an adjustment to opening retained earnings. We do not believe the adoption of FIN 48 will have a material effect on our consolidated financial position, cash flows and results of operations.

 

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INDUSTRY BACKGROUND

Emergence and Expansion of Economy Hotel Chains in China

China’s lodging industry has expanded rapidly as a result of the substantial growth of the Chinese economy and travel industry over the past several years. According to Euromonitor, the total number of room-nights in China grew from 811 million in 1999 to 1.2 billion in 2004 and total sales grew from RMB190 billion in 1999 to RMB264 billion in 2004.

The lodging industry in China consists of hotels as well as other forms of accommodation such as guesthouses and privately-owned lodging outlets. Although hotels accounted for only approximately 2.5% and 5.0% of total lodging outlets in China in 1999 and 2004, respectively, the hotel sector represents an increasingly significant portion of the lodging market, accounting for approximately 44.5% and 60.2% of total sales in the lodging market in 1999 and 2004, respectively, according to Euromonitor.

Historically, hotel development projects in China generally focused on star-rated hotels that were primarily targeted at international tourists and corporate travelers. In recent years, economy hotel chains have emerged and expanded in China, gaining a growing customer base consisting primarily of individual domestic business and leisure travelers. According to the 2006 China Economy Hotel Survey published by China’s Ministry of Commerce and the China Hotel Association, or the 2006 Economy Hotel Report, since the concept of a branded economy hotel chain was first introduced in China in 1997, several branded economy hotel chains, including Jinjiang Star, Home Inns and Motel 168, have emerged primarily in China’s economically prosperous eastern coastal region. Since 2004, the growth of branded economy hotel chains in China has accelerated, as evidenced by the existing chains’ rapid expansion into new urban business centers in other regions of China.

Economy hotel chains in China mainly target value-conscious domestic business and leisure travelers who demand convenient lodging, a consistent product and high-quality services. According to the 2006 Economy Hotel Report, in 2005, 37% of economy hotel guests were individual business travelers, 23% were contract corporate customers and 20% were individual leisure travelers. Economy hotel chains aim to satisfy customers’ basic accommodation needs with affordable pricing, a comfortable lodging experience and a standardized product.

The following table sets forth a summary of certain data concerning economy hotel chains in China.

 

     Total Number
of Hotels(2)
   Total Number
of Rooms(2)
   Number of Rooms
Per Hotel(2)
   Average Daily Rate
(in RMB) (3)
   Average Occupancy
Rate (%)(2)(3)

2004(1)

   173    21,716    —      —      —  

2005(1)

   273    36,144    58 to 244    134 to 202    85 to 96

(1) Source: 2006 Economy Hotel Report.
(2) Calculated based only on the data of selected economy hotel chains in China as of the end of each year.
(3) The range represents differences across regional market, including the northern, eastern, southeastern, central, southwestern, northwestern, southern, Beijing and Shanghai markets.

According to the 2006 Economy Hotel Report, the top three economy hotel chains in China, namely, Jinjiang Star, Home Inns and Motel 168, had market shares of 20%, 18% and 10%, respectively, of the Chinese economy hotel market in 2005. Competition among economy hotel chains in China is primarily based on a hotel chain’s ability to provide a consistent product, high-quality services, an efficient reservation system and effective sales channels, as well as specific product features including the design, decoration and guest amenities of the hotels within the chain.

The economy hotel chain segment of China’s lodging industry is still at an early stage of development. However, it is expanding rapidly as a result of a number of factors. There are general factors such as the growth

 

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of the Chinese economy and the growth of the travel and lodging industries in China. In addition, there are more specific factors driving the growth of economy hotel chains in China, such as fast-growing small- to medium-sized enterprises, or SMEs, the growth of domestic tourism, the expansion of urban business centers and the fragmentation of the hotel industry.

General Factors Driving the Growth of Economy Hotel Chains in China

Growth of the Economy in China. China’s economy has grown and is expected to continue to grow rapidly. According to the Economist Intelligence Unit, the gross domestic product in real terms, or real GDP, of China grew from RMB5.4 trillion (US$677.9 billion) in 2001 to RMB7.9 trillion (US$984.3 billion) in 2005, representing a compound annual growth rate, or CAGR, of 9.8%, and is expected to reach RMB11.6 trillion (US$1.4 trillion) in 2010, representing a CAGR of 7.6% from 2006 to 2010.

The following table sets forth a summary of certain data regarding China’s economic growth for the years from 2001 to 2005.

 

     2001    2002    2003    2004    2005    CAGR (2001-2005)  

Real GDP (in billions of RMB) (1)

   5,419    5,911    6,504    7,160    7,869    9.8 %

Real GDP per capita (in RMB) (1) 

   4,246    4,602    5,033    5,508    6,018    9.1 %

Disposable income per capita (in US$)(1)

   490    546    603    682    759    11.5 %

(1) Source: Economist Intelligence Unit.

The following table sets forth a summary of certain projections regarding China’s economic growth for the periods from 2006 to 2010.

 

     2006    2007