Choice Hotels International, Inc. 2009 Guidance Call Transcript

Choice Hotels International, Inc. (CHH)

2009 Guidance Call

December 17, 2008 10:00 am ET

Executives

Stephen P. Joyce - President & Chief Executive Officer

David L. White - Chief Financial Officer

David A. Pepper - Senior Vice President, Development and Sales

Analysts

Patrick Scholes - Friedman, Billings, Ramsey & Co.

David Katz - Oppenheimer & Co.

William Truelove - UBS

Kevin Milota – JP Morgan

Michael Millman - Soleil-Millman Research

Presentation

Operator

Good morning and welcome to the Choice Hotels International, Inc. 2009 outlook conference call. (Operator Instructions) As a reminder today’s call is being recorded.

During the course of this conference call certain predictive or forward-looking statements will be used to assist you in understanding the company and its results which constitute forward-looking statements under the Safe Harbor provision of the Securities Reform Act of 1995. These forward-looking statements generally can be identified by phrases such as Choice or its management believes, expects, anticipates, foresees, forecasts, estimates, or other words or phrases of similar import. Such statements are subject to risk and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Please consult the company’s Form 10-K for the year ended December 31, 2007, and other SEC filings for information about important risk factors affecting the company that you should consider. Although we believe the expectations reflected in the forward-looking statements are reasonable we cannot guarantee future results, levels of activity, performance, or achievements. We caution you, do not place undue reliance on forward-looking statements which reflect our analyses only and speak only as of today’s date. We undertake no obligation to publicly update our forward-looking statements to reflect subsequent events or circumstances.

You can find a reconciliation of our non-GAAP financial measures referred to in our remarks as part of the presentation filed as a Form 8-K with the Securities and Exchange Commission. A copy of this presentation is posted on our website at www.choicehotels.com under the Investor Information Section.

With that being said, I would now like to introduce Steve Joyce, President and Chief Executive Officer of Choice Hotels International, Inc.

Stephen P. Joyce

Good morning. Thank you for joining us this morning. I apologize on behalf of the company that we cancelled the half-day conference that we had scheduled, but I think given the market volatility that we are currently facing, we felt that the opportunity to deeply explore our brands and to give you the opportunity to see the depth of our management team would be better done and better received at a future date and we will plan to do that.

Joining me this morning are David White, our Chief Financial Officer, and David Pepper, our Senior Vice President for Development and Sales, and they will be participating on the Q&A portion of the program.

During this morning’s call we are going to refer to the 2009 Outlook Presentation which was filed on Form 8-K with the SEC and it is posted on our website, which is www.investor.choicehotels.com. While I am not going to walk you through that presentation slide-by-slide, I encourage you to print it out and keep a copy with you. It is a good reference point for how our company works. It also includes some critical important information for you in evaluating our company and our shares. I will refer to some slides during today’s call.

I know that you all are very interested in our 2009 outlook and guidance and we will be discussing that later in this morning’s call, but on today’s call, first what we wanted to do was provide an overview of the company and our perspective on why we believe Choice is a compelling investment opportunity for not only the current environment, but more importantly, for long-term investors and this company was built for conditions like this, which we will discuss in more detail.

I want to highlight our domestic and our international growth opportunities, which are both significant. I want to summarize the value proposition that our brands and services represent to our hotel owners and the relationship with those owners that will enable our growth in the future; talk a little bit about the strong financial model that we enjoy and the benefits and the opportunities that it creates for us; and then finally, our thoughts on the current environment and what we see in terms of performance for the company, but also how we will manage differently in the downturn and our outlook for 2009.

Choice Hotels is a strong, growing, global hotel franchisor with well-known diversified brands. It is the only significant hotel lodging company in the business that is a pure-play franchise environment. We have ten brands serving economy, mid-scale, up-scale, and extended stay. We have a strong central reservations system and a rapidly growing loyalty program, Choice Privileges, which allows us to leverage the power of our marketing and distribution platform over our 5,700 some hotels to deliver business in significant chunks to our hotels and to drive demand from owners and franchisees for our brands.

As you can see on Slide 4 of the presentation, we are the nation’s second largest hotel company, with a 9.4% share of branded hotels, as measured by the number of hotels open on October 31, 2008. We also have been the leading domestic gainer of market share over the past five years, among the major hotel companies, which you can also see on Slide 4.

We have successfully grown our business in good times and bad. We typically convert hotels into our system in difficult times, and add new construction hotels in good times.

We have brands that meet all the stages of a hotel’s life cycle, which makes us somewhat unique in the business.

We believe our brands position us well for strong future growth. We are very confident that the stable of brands we have can continue to grow our market share with those brands and see significant opportunity for each one.

We provide business and leisure travelers a range of high-quality, high-value lodging options at varying price points. In this environment our value orientation we think is going to serve significantly well.

We offer travelers a hotel for many different travel occasions and by the same token we provide hotel developers with a range of new construction and conversion brands suitable for the different types of hotels and development needs that those owners and franchises have and in the environment that they are operating in.

We also have brands that are suitable for every life cycle stage of a hotel asset, which gives us opportunities that other companies do not have.

We want to emphasize that, even given our size, we have what we believe is a significant room to grow our current brands. We are the leading gainer of market share over the past five years, as I’ve mentioned, but we feel very confident that we have room to grow our franchise system further.

We are focusing on growing our core brand units and Choice’s market share over the next several years, and if you look on Slides 6 and 7 on the presentation they will show the competitive landscape for the U.S. market for new construction and conversion brands. As you can see on these slides, the opportunities to continue to expand the size and scale of our existing brands is considerable.

While I continue to believe that our new construction brands are well positioned for long-term growth, in the current weak lodging environment I would highlight the potential to grow our strong conversion hotel brands, as we have done in the past.

The opportunities are coming from independent hotels seeking to affiliate with a strong distribution system or owners moving assets into the Choice family from other hotel brands, either because of a desire to upscale the brand currently on their hotel or because of opportunities created by other brands moving hotels out of their systems.

The domestic hotel pipeline stood at 955 hotels under development, awaiting conversion, or approved for development as of September 30, 2008, as you can see on Slide 8 in the presentation.

The majority of these, or 724 of these hotels, are new construction hotels, of which approximately 161 are under construction. There are an additional 231 conversion hotels in the pipeline at the end of September, and it is important to note that for 2008 and 2009 we expect approximately 70% of our gross domestic unit openings to be conversion hotels.

If liquidity per transactions improves, we could see the number of conversion hotel contracts executed and opened during the year increase. This is the normal cycle for us as we enter into a difficult time for the economy. Typically in the past we have picked up significant conversion opportunities. The one thing that continues to limit this, however, somewhat is the current lack of liquidity in the markets and the lack of hotel transactions.

Our ability to grow our system through both new construction and conversion hotels is a tremendous positive for all of our key stakeholders as we can shift our strategies based on economic circumstance.

The marketing and distribution strength can support more brands. We currently view upscale full-service and upscale extended stay brands as potential long-term opportunities for the company.

Two-thirds of our guests currently are leisure travelers. Our ultimate goal is to also capture a large share of business travelers, larger than we currently do, and we will strengthen our appeal of our brands to the business traveler and to our Choice Privilege members and growing that program rapidly as one of the fastest growing rewards programs in the business.

The Ascend Collection, which we have recently launched, is the most recent example of our ability to add additional brand affiliations to our distribution channel, provide growth opportunities for ourselves, and provide real value and interest to our owners and franchisees.

The Ascend Collection is a collection of historic boutique, or upscale unique properties that maintain their local market identity and name and benefit significantly from tapping into our robust reservations and distribution systems, and Choice Privileges rewards program.

There are hundreds of hotels in the U.S. that are candidates for the Ascend Collection. We think that the current down lodging market will encourage membership in this program and expect to see significant growth in the near term.

On the international side, on Slide 9, you will see our current global distribution. We have 1,100 hotels across five continents in more than 30 countries. We have achieved steady, profitable growth without significant incentive or financing or assets from the company being put behind this growth.

However, we feel that the mid-scale brands will be of tremendous appeal to developers and consumers in a number of countries where Choice does not have a significant presence, or only a handful of hotels.

We believe that we can make significant inroads into markets such as China and India where there is tremendous need for mid-market, three-starred lodging alternatives without significant commitment of assets but with some support from the company.

I have traveled extensively in the United States, meeting our owners and franchisees and visiting our hotels in my first six months. I will be spending a significant amount of time over the next six months traveling to the markets outside of the U.S., evaluating our opportunities as we formalize our international growth strategy.

I will be updating you this coming summer regarding our international plans, providing more color and more information on our long-term international growth opportunities on a basis of where we think it makes sense for us to grow and what opportunities we see there in the near mid-term and long term.

I will remind you, as I have in the past, that the international opportunity, particularly with countries in which we are not currently well represented, is a long-term opportunity, as we first need to put resources on the ground that will then create relationships with the right development partners that will then lead to hotels being done, that will then lead to a strong and robust pipeline.

So in terms of international growth, we think that will be a significant opportunity for us, but we will share more information on that later in the year.

Attracting and retaining additional franchisees to our system requires and unrelenting focus on building great relationships and maintaining the ones with our existing franchisees and providing those hoteliers valuable brands and services that are required to successfully operate hotels in the segments where our brands compete.

We have very strong marketing and distribution programs that leverage our expertise in online, interactive marketing, loyalty programs, and central reservations systems. We believe with the platform that we have today, that that will allow us grow the company significantly and gain additional economy to scale as we add units. Our franchisee services and our mind set are about providing real value and real help to our franchisees in up and down markets.

The range of our services to franchisees to drive more guests to hotels, and to help them operate more profitably, was important last year but it is more important this year and you will see us doing additional support and programs and training and consulting opportunities to help them do well and to optimize their performance even in the down market.

We do this collaboratively with our owners and as a result, they have told us that they like doing business with us and are interested in doing more. In a recent survey we saw a strong uptick in the franchisees’ intent to recommend our brands to their friends and to do more themselves. This comes by listening and working closely with them. If they aren’t successful, we will not be successful.

To achieve the vision of providing the highest ROI of any hotel franchising company via our centralized franchise services, we are providing a strong list of programs, including inventory and rate management, guest service consulting, onsite regional training and Web-based training. We utilize our system scale and distribution to deliver innovative, one-of-a-kind programs.

For example, we were the first to provide hospitality care, which is a low-cost, limited benefit health plan designed specifically for part-time and hourly employees in the hospitality industry, which we provide to our franchisees on a low-cost basis, which then allows them to be preferred employers in their market places.

On the marketing and e-commerce side, we continue and will accelerate our ability to drive guests to our hotels. We utilize the $300.0+ million annual marketing and reservations systems fees under a range of activities designed to drive guests through our central channels. These programs are extremely attractive to franchisees and help drive them to affiliate with us in the future for their next hotel deals.

The program enable many of our brands to benefit from the tremendous name recognition that we have and our efforts help us to centrally deliver roughly one-third of our U.S. owners’ gross room revenues, a figure that is approaching $1.7 billion annually.

Www.choicehotels.com is one of the highest converted websites among our competitive set. According to a leading online competitive intelligence service hit-wise, in the month of September more reservations were booked on www.choicehotels.com than any of our top competitors websites.

By driving guests to these central channels, we are able to help our franchisees maximize their profitability, as these central channels provide higher rated business than the opportunities on-property.

If you go to Slide 13, we highlight Choice Privileges, which is our rapidly growing loyalty program, with 7.5 million members worldwide. We added 1.0 million to this program in the last 12 months and we are creating new programs and incentives that we believe will enable us to grow this program significantly in 2009, taking advantage of looking for customers that travel in good times and bad and making them loyal members of our program.

The program incorporates all ten brands and contributes over 20% of our owners’ domestic gross revenues, which is up 12% from five years ago.

We continue to globalize this program as we have introduced it earlier in 2008 in Europe and we are looking to accelerate membership growth in the program over the next few years, both domestically and internationally.

Our brands and exceptional services for our franchisees have and we believe will continue to position us for continued growth of our global franchise business across all of the brands and across the globe.

We continue to focus on growth coupled with highly attractive fee-for-service business model which positions us well to continue to deliver strong financial performance with relatively less volatility to RevPAR swings than the other lodging models that you have experiences, as you can see on Slide 21 of the presentation.

Our model does not require substantial amounts of maintenance capital to grow and it contributes to a generation of strong free cash flows with relatively low volatility and incredible returns on invested capital, unmatched in the business.

While not losing sight of the need to ensure adequate liquidity to operate this business, it is consistent with our past practices that our number one priority is to return excess capital to shareholders over the long term. That has served this company incredibly well in the past and it will be our hallmark in the future.

The company has generated and returned to shareholders more than $1.0 billion of free cash flow since 1997 through share repurchases and dividends and we expect, again, liquidity permitting, over time to continue to be opportunistic buyers of the stock, as you can see on Slide 25 our buying activity, and have done so at what we believe to be very attractive valuation discounts.

We also have a very strong dividend policy, which we have steadily increased over the past five years, and will continue to do so unless tax environments changes.

Under the current environment, we are turning to a very challenging year in 2009 with a very challenging end of 2008. There is obviously a tremendous amount of uncertainty related to the economy and how that will impact lodging demand.

From a consumer standpoint we are currently seeing a confluence of many negative indicators that make the next year very challenging for consumers, which in turn will make it challenging for our franchisees and for us. according to the blue chip economic advisors the consensus to predict the U.S. economy is now mired in what will most likely be perhaps the deepest recession in post-World War II history.

This recession began for us in the spring. The real GDP forecast, while there are significant ranges, we are working from a forecast that has a decline of 1.1% in 2009. This is the first annual decline in the real GDP since 1991 and our forecast is the largest annual decline since 1982. Other prognosticators have indicated the potential for even more pronounced declines in 2009.

In the third quarter, personal consumption fell 3.7%, the largest decline since the fourth quarter of 1974 according to data from the Bureau of Economic Analysis. According to the BEA data, these declines are sharper than the 1990/19991 recession and personal consumption did not decline in the last recession.

Personal consumption is forecast to be down 1% in 2009, the largest decline since 1942. Personal wealth declined due to significant stock market losses, as well as other investments. The housing market, typically a bellwether for the economy, has historic levels of foreclosures and enormous losses in home equity. Millions of Americans today have negative equity in their homes. Unemployment, which is a very important statistic for us and a statistic strongly correlated with our performance from a RevPAR and revenue standpoint, is at an historic level of job losses.

2008 job losses are projected to total 1.9 million jobs through November 30, 2008, according to the Bureau of Labor Statistics. With the unemployment claims in the first week of December, they are now forecasting the job loss to exceed 2.1 million jobs. This is the largest decline since 1945.

The fire sale of Wall Street firms has fueled erosion of consumer confidence, which hit an all-time low in October, according to the Conference Board.

So what is the impact of that on the hotel business? Well, hotel construction is obviously very dependent on capital and access to credit, and unlike the last few downturns, this credit cycle has become increasingly difficult for hoteliers, even for us, where our typical deal has been shielded more from changes in liquidity in the market.

As mentioned on our third quarter earnings call, the lending environment has had a meaningful and curtailing impact on our supply growth, as well as the rest of the industry’s, and also has affected potential conversion opportunities in the industry.

Our opinion is that the impact on new construction brands is likely to be even more pronounced in 2010, including our new construction brand projects that have not yet started or have been delayed.

Many of the financial institutions are out of the hotel lending business or significantly reducing the capital allocated to hotel lending for indeterminate periods and are unable to tell us when they will re-enter the markets. Others are reducing their loan to cost, loan to value ratios in a serious manner and it is impacting developer returns as required mortgage rates now are reaching the double-digit levels. Financial institutions are increasing credit spreads and are tightening all the covenants when they are lending.

In the new construction environment, similar to the last downtown, the franchisee development of new construction will be impacted much more than conversions. From our personal experience, applications for new construction hotels were down 15% year-to-date through the end of November 2008, with conversion applications down roughly 7% for the same period.

Credit market environments for conversions is very different than the last downturn. As you look at financings, conversions are heavily dependent on transactions in the hotel business. Those of you following the business have seen that the overall decline in transactions in 2008 peaked in the high-70%s and closed in on 80% in terms of reductions of deals year-over-year.

We were relatively sheltered from that decline, which occurred early in the year, but even our business, which is typically more in the $3.0 million to $5.0 million transaction range, began to be effected towards the latter part of the year.

While the near-term conversion activity has been down, we are optimistic based on historical patterns and a return of liquidity that it will pick up quicker than new construction, as it was the case in 2001 to 2003, which was a time when we significantly ramped up our growth in these areas.

On the relicensing side, a similar impact can be felt. As we saw in the last downturn, the number of transactions in revenues are declining, you can see this on Slide 19 of the presentation, and developers are facing this very difficult financing credit environment. Relicensings are obviously heavily reliant on transactions and as I discussed earlier, that dramatic downturn in those transactions is affecting our relicensing revenues.

That turn turned down more sharply in the last few months and we are forecasting a full year decline in relicensing of a 28% decline and relicensing fees down by about one-third as the lack of transactions impacts this line.

It is not all negative for hoteliers. Unlike the last downturn, we are not facing an intermediary environment that we faced at that point. Those third-party sites that resulted in deep discounting and loss of room control to websites from the hotel lodging companies are not in a position today to do that. They are not in a position to help dictate pricing, as they did in the last downturn, so we believe pricing will hold up better as we enter into this negative environment.

The precipitous fall-off in gas prices will help and steady hotels could get more people off the roads, and our brands, which are very much highway-oriented and very much positioned as value brands, stand to benefit significantly, not only from more people on the road, but from more people on the road and trading down.

The leisure market, which is two-thirds of our guests, traditionally has held up much better in downturns than the business traveler and we are hoping for the same results this time around.

Now turning to what we’re doing for both the company and our franchisees in this difficult environment, obviously even with the strength of our balance sheet and the strength of our brands and model, we are going to alter the way we are managing the company to manage it appropriately given the environment.

We think it’s appropriate that we be increasingly cautious about how we manage our resources and you will see declines in our company’s expenditures, given the current environment. This will represent a departure from our recent cost growth trajectory over the last several years.

As a company, we maintain our commitment to all of the items on our strategic agenda, which will facilitate long-term growth of the business and returns to our shareholders. We still believe strongly in Cambria Suites and our extended-stay brands, Main Stay and Suburban, and we know that they will be successful long term for our stakeholders.

As mentioned in the last few calls, we will likely deploy some capital to accelerate these brand growths, however, in this environment where first mortgages are not available, sliver capital is not going to spur growth and as a result, while we are working on a number of deals, we have put out no capital to date under these programs.

We have communicated to our franchisees our commitment to their success, are communicating with them regularly, and working on their behalf in providing resources to them to help them optimize and survive this difficult environment.

We have told our owners we still need to deliver services and programs to them that make sense at their hotel and to continue to deliver ROIs to them. We are working diligently to utilize our resources in a way that maximizes guest deliveries to their hotels, to maximize the heads and the beds that they need to help stay healthy.

These actions we are taking to drive our business for our franchisees, which we are communicating regularly to them, includes rolling out ads in February that focus on our brands’ value and orientation, focusing more on consumer advertising dollars, on transactional ads at the expense of brand imaging, and adding rate packages to www.choicehotels.com that offer value-oriented vacations and tours.

You will also see us put significant effort, as I mentioned earlier, to the growth of Choice Privileges and we are helping franchisees weather this environment by offering online and in-person training courses focused on managing and succeeding in a downturn.

We are monitoring our franchisees’ financial situation very closely. We have seen a slight uptick in days sales outstanding but it is still less than 30 days so there is no indication that franchisees are unable to pay their franchise fees and we have also seen no material increase in franchisee bankruptcies.

Now to turn to the 2008 outlook. Our current financial outlook for full year 2008 and the related assumptions are highlighted on Slide 29 of your presentation. Let me touch on a few of the highlights.

Our current expectations are net domestic unit growth of 5.5%, a full year RevPAR decline of 1.8%, a 6 basis point increase in the effective royalty rate, and an effective tax of 37%.

We expect adjusted EBITDA and adjusted diluted EPS for 2008 to be $196.5 million and $1.71 respectively. Our 2008 adjusted EBITDA and adjusted diluted EPS excludes a %6.1 million pre-tax charge, which is approximately $0.06 per diluted earnings per share resulting from the previously announced acceleration of the company’s management succession plan. This charge was recorded in the second quarter of 2008.

In addition to that, our current expectations for adjusted diluted EBITDA has been reduced by an incremental $2.1 million based on termination benefits compared to our previous guidance, as a result of unanticipated work force reductions given the operating environment.

Adjusted diluted earnings per share includes the previously mentioned termination benefit charge of $0.02 per share as well as incremental investment losses of approximately $0.03 related to assets held in the company’s non-qualified retirement plans compared to our previous expectations.

To turn to the 2009 outlook, and given the uncertainty in this global economy and the tightening of credit marks, we do not know with any certainty when we will emerge from the current down cycle and in this environment it is difficult to provide definitive RevPAR guidance and as RevPAR trends are very volatile at this point and are not easily predictable, as you have seen in the forecast given in previous third quarter companies began to decline.

We are still attempting to give you some guidance into the future. Given this backdrop, with the warning of the volatility and the difficulty in visibility of us seeing into the future, as our window into our bookings is relatively short term compared to other companies, we are going to forecast full year 2009 RevPAR declines of 6%. This fits relatively in the middle of forecasts given by industry consultants. It is also, though, short of the declines forecasted by many of you on this phone call and many of the folks on Wall Street.

Many are forecasting deeper declines than we have had and a result we have provided an outlook showing what our expectations would be if RevPAR was down 8% in 2009.

We are fully prepared with appropriate contingency plans in terms of discretionary spend in the event that RevPAR declines more than we currently expect and our current financial outlook for the full year 2008 and 2009 are based on the assumptions highlighted on Slide 29.

For 2009 we expect net domestic unit growth of at least 3.5%. For the full year 2009 we expect royalty rate improvement of 3 basis points and an effective tax rate of 36.5%.

In addition, our 2009 forecast assumes no share repurchases subsequent to December 17, 2008. You can expect from us a similar pattern that we have done in the past, and that is, when we see opportunity at a discount to what we think the intrinsic value of the stock is, that we will buy opportunistically.

At our targeted RevPAR decline of 6%, we expect earnings before interest, taxes, depreciation, and amortization expense, and diluted EPS to be approximately $184.2 million and $1.74 respectively.

Assuming RevPAR declines of 8%, which we are not forecasting but this is for comparative purposes, we expect EBITDA and diluted EPS of $179.8 million and $1.69 respectively.

So in conclusion, despite the current recession and its impact on our industry, Choice is uniquely positioned to take advantage of this opportunity to grow significantly, to use supply to offset declines in RevPAR, and to look positively in 2009 and hopefully an improving economic condition and liquidity condition towards the end of the year, which will give us not only a better 2009 but a very positive 2010.

Our long-term growth prospects remain extremely promising. We feel very confident in our ability to return value to the shareholders, as we have done in the past an done in this quarter, on account of our ten strong brands, our domestic and international growth opportunities, an enviable business model, and the overall financial strength that we have as a company.

With that, I will now open this call up for questions from you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Patrick Scholes - Friedman, Billings, Ramsey & Co.

Patrick Scholes - Friedman, Billings, Ramsey & Co.

A question on your negative 6% RevPAR expectations for next year. What is you stance on that playing out quarterly? Is it correct to assume that you think that the back half of next year that easy comps will be beginning to help you out?

Stephen P. Joyce

The general view is it starts out tougher and then improves over the year, both with easier comps, but also we are hoping that the overall environment picks up somewhat.

The general view is there is a certain amount of hysteria in the performance today, that as people begin to get accustomed to the environment, they will take a deep breath and begin traveling more. And so it’s both a combination of we’re hoping some improved actual performance, but then also obviously the easier comps come into play.

Patrick Scholes - Friedman, Billings, Ramsey & Co.

Drilling down a little more on your RevPAR expectations, with that 6% being sort of a weighted average of your brands, how would you break that out between mid-scale versus economy?

David L. White

What I would look at is, we spent a lot of time looking at the Price Waterhouse forecast for 2009, so if you look at what they are forecasting for mid-scale, with F&B, they’re down 6.3%. The economy brands segment is down about 5.9% and then the mid-scale without food and beverage is down just a little bit less, down 4%.

So, we skew a little bit more towards kind of economy and the mid-scale with F&B numbers. What I would recommend is you go back and look at how our RevPAR indexes against Smith Travel on a blended basis and you can kind of back into our thinking there.

Stephen P. Joyce

I think the other thing to keep in mind is when you look at some of the other companies’ projected declines for 2009 you will see a number of them higher. Most of those companies have significant exposure to the upper upscale and luxury segment, which are clearly bearing the brunt of the downturn.

Patrick Scholes - Friedman, Billings, Ramsey & Co.

When I look at your expectations for unit growth, in 2008 it was 5.5%, next year 3.5%. It seems a little bit more of a steeper drop off than I would have expected considering most industry expectations are for actually supply growing at a slight greater level in 2009 than 2008. Is that because you have greater expectations for last minute conversions in there? What are your thoughts on that?

David A. Pepper

We still expect a good unit growth, it’s just we expect our new construction pipeline to slow down a bit. We are looking this year at about 156 projects to open, next year about 129 new constructions. So you can see that’s where our biggest drop is.

But yet, we are still seeing an uptick in our conversion units. We’re actually going to go from 332 units of conversion units open to 334 units, it’s what we are predicting for next year.

So, it is certainly a product of the new construction environment dropping off a bit. But, again, because of our brands and where we are positioned, our conversions are still doing well and we’re actually starting to see an uptick in application volume with our conversion brands.

And again, this is off of a bigger base, with our growth that we have seen in the last six years, and we are probably see a slight uptick in our terminations.

Stephen P. Joyce

The thing that obviously is a big swing factor in this forecast is what happens with liquidity. And we are not at all comfortable that there is going to be a significant change in that any time early in 2009. And obviously the longer it takes for liquidity to come back to the market, the longer it will be for us to see that normal upswing in conversions and also relicensing, both of which help drive our top line.

Operator

Your next question comes from David Katz - Oppenheimer & Co.

David Katz - Oppenheimer & Co.

I think most would probably feel comfortable that you will continue to generate free cash. I think we spend more time not only figuring how much but what your uses for that will be. What is your target leverage? Can you envision yourself being debt free at some point? How are you thinking about your stock and other uses at this point?

Stephen P. Joyce

We are very comfortable levering up into the 3 range. We are low now. Historically that is low for us, being at 1, 1-2, and so we are very comfortable levering up for the right opportunity. So whether it be return of wealth to the shareholders, which obviously, the kind of incredible thing about this company is that if you look over the earnings and the cash flow, basically this company has earned about $1.0 billion over its existence and it’s paid out about $1.0 billion to its shareholders, which is an incredible statistic, I think.

And so what you will see us do over the next year is look for opportunities that come up as a result of the downturn. We would love to look at additional brands and if we can find one with the right pricing, because of the opportunity you will see us move on that. We are looking at opportunities all the time. We have not seen anything of interest yet.

And we also will be able to look at, if the market environment and equities continue to trade down or stay low, that will continue to provide opportunity for us.

In the near term, on that opportunity, you’ve got issues with liquidity around the cost. If you are looking at comparable lodging companies, a lot of what we’re seeing is 1,000 over. That’s pretty expensive debt to take on and so as a result we are proceeding very cautiously.

Also, given the environment, we are staying fairly liquid to make sure, regardless of what happens, that we are in terrific shape. And so I think what you will see is over the year you will see us poised to take advantage of whatever opportunities come up, hopefully somewhat aided by a better debt environment.

David Katz - Oppenheimer & Co.

I think one of the issue from your last call was the decision to allocate a few million dollars to pursue Cambria franchisees and I think it was from an institutional base that you’re familiar with. Do you have any updates on where that is and if that’s bearing any fruit yet?

Stephen P. Joyce

The resulting financing environment has pretty much shut down that window, so we are evaluating lots of deals, but to date we have done no deals, either under the mezzanine program that we discussed or the equity program that we have in place. So the reality is, particularly on the equity side, when you can buy first paper and yield 14% or 15%, your appetite for taking development risk to grow hotels is not high.

And on top of that, as you look at the ability to obtain project financing, it is the most difficult environment I have ever seen.

So those programs, while we will continue to work them, because at some point there will be an opening and an opportunity, we are not going to put out any capital in 2008 and right now if we were going to put capital of any substance out in 2009, things have got to change significantly in the debt markets.

David Katz - Oppenheimer & Co.

You mentioned the notion of adding brands to the portfolio. Can you share any color about what segments or areas you would see as additive?

Stephen P. Joyce

We mentioned our desire to kind of build our business base, as well. The two segments we like the most are sort of the upscale conversion full-service brand opportunity. And then an upscale extended-stay opportunity to blend and support and match with our Main Stay and Suburban extended-stay brands.

Operator

Your next question comes from William Truelove – UBS.

William Truelove - UBS

Slide 13, the percentage from rewards. That’s a great number, 21%. How does that stack up against some of your major competitors?

Stephen P. Joyce

If you are looking at Hilton and Marriott, for example, which I am more familiar with, it is gaining on but somewhat below their numbers. I will tell you, though, that those programs have been in place roughly twice as long as Choice Privileges has been in place and I think our growth rates are higher, but I think you would see that while we’ve done very well so far, there is still some gap between the performance of the Hilton and the Marriott rewards program and ours, which is what we see as the opportunity.

William Truelove - UBS

On Slide 27 you talk about the revolver being due in 2011, no maturities due until 2011. Is the revolver the only thing due in 2011 or is there something else?

David L. White

Really the only facilities that we have at our disposal are the $350.0 million revolver, which is scheduled to expire in June of 2011, and as you can see we have $76.0 million available currently. And then we have a $5.0 million, I will call it a guidance line, that did not have any balance on it as of the end of the day yesterday, that is essentially due on demand, but there was no balance on it as of the end of yesterday.

So total credit facility on revolvers for us is $355.0 million. We don’t have any other debt on our balance sheet of a long-term nature.

William Truelove - UBS

When you talk about wanting to expand markets where you have few hotels, on Slide 9, you show four hotels in China. I assume China is a market, long term, you want to be in. How are you going to try to expand into China given that the market is suffering from probably an extensive amount of supply, especially on the economy segment? What’s sort of the strategic plan there?

Stephen P. Joyce

China is one of our most significant targets. The reality is the over-supply has occurred really in the upper upscale segment, the number of five- and six-star hotels. We believe over the next five years that infrastructure is going to then generate 300.0 million to 330.0 million middle-class folks traveling up and down those highways that are being built, that are not going to be looking for the hard budget that’s in place currently, but will be looking for more of a moderate tier brand. And as a result, we think our brands play in very well with that.

We are not planning on going with budget brands to international. We are planning on going sort of the moderate tier and up. And we think that China, while it has an over-supply of five- and six-star hotels, what they don’t have in any significant numbers is hotels that operate in that moderate tier, because in that tier what there are is old five- or six-star hotels that didn’t get renovated, and then you drop significantly down to very hard budget-type properties, the [Xe Zangs] and the [Ho Minhs] and so as a result, over time, we see that market growing for that moderate tier traveler and that’s where our brands would play.

Operator

Your next question comes from Kevin Milota – JP Morgan.

Kevin Milota – JP Morgan

I have a question on the effective royalty rate, improvement declines from 6 basis points to 3 basis points. I was wondering if that’s more a mix shift away from new construction to conversions?

David L. White

There’s a whole host of factors that end up impacting that. I guess what I would tell you is that over the past several years you have seen our effective royalty rate tweak up anywhere from 4% to 6% so we have seen a range of outcomes. For next year what we did was we went through essentially all of the contracts that we have presently and kind of modeled out what the effective royalty rate would be contractually, plus made some estimates around the mix, and when you roll that all up you get to about 3 basis points.

Obviously if the new construction online numbers were to be more favorable than what we currently forecast, that could give us a little bit of a lift. It depends on what happens with properties that leave the system. As David Pepper alluded to, we have some termination levels next year that could also impact that to a slight degree.

Kevin Milota – JP Morgan

And is that tougher to increase in a king of a up-market environment? Kind of assuming 2010 is that year.

David L. White

I think the way to think about increasing the effective royalty rate is a kind of a long-term strategy, because the way that happens is through a combination of things. First of all, as we add more new construction hotels, those are typically going to be higher royalty-rated properties and as older properties leave our system, on the termination side, they are going to leave with rates that were much lower effective royalty rates, because we reset the royalty rates for the brands over long periods of time.

And then the other piece of it that impacts it is relicensing. So to the extend relicensing volumes are better than we think, that’s another good window for us to reset the pricing on the contracts.

There are a whole bunch of factors that kind of play into it. I don’t know that it is, on balance, a big disadvantage in the down cycle relative to the up cycle on that. Although, there may be a slight edge to the up cycle because you get more relicensing transactions.

Operator

Your next question comes from Michael Millman - Soleil-Millman Research.

Michael Millman - Soleil-Millman Research

Can you give us some break down of your fixed costs and your variable costs and how you expect those to differ 2009 versus 2008?

Also, you talk about relicensing fees being down one-third, is that synonymous with the franchise fees? Maybe you can give us some guidance on what that total category is.

In terms of the conversions, I think you said the conversions typically cost $3.0 million to $5.0 million. I was curious as to whether your potential conversions are coming from owners who either have this cash or have these lines already established.

On adjusted EPS, why is the $0.06 charges from earlier in the year taken out of adjusted but these new charges are included in adjusted?

David L. White

On the question about why we take out the charge related to management acceleration charge of $0.06 but we don’t take out this $2.1 million severance cost, really internally we think about that, I guess I would say our policy is for severance costs that relate to executives that have contractual arrangements with the company, which is typically going to be the senior-most executives in the company, those are the ones where we will add it back, but the other severance is more broader-based severance that we believe appropriate not to add back. We do have severance from time to time in operating the business.

On the relicensing side of things, what we were trying to explain is if you look at last year’s revenues, for 2007, total relicensing revenues were close to $13.0 million. For 2008, in our guidance, we are assuming that those revenues fall off about 30% for 2008 and we have at this point modeled some further deterioration into 2009, which I think if you look at that slide we have in the deck on relicensings you can kind of see how the pattern plays out in previous licensing cycles, and I current thinking is that will play out here, as well.

In terms of fixed costs versus the variable costs, if you look at the corporate SG&A for this business, it is predominantly payroll. More like about 20% of the cost is tied to essentially variable compensation programs, management incentive plan bonuses, commission programs, so there is some variability there. But the balance of our costs, if you were to break it down, the biggest piece of it by far is payroll and the related costs of people, travel, and the real estate with housing them and insurance. So there is some flexibility in the cost structure.

I think, as Steve pointed out, we do expect to see our cost structure decline for 2009 and we will keep you apprised of that as we move forward.

Stephen P. Joyce

So the $3.0 million to $5.0 million was not about what it takes to do a conversion, the $3.0 million to $5.0 million referenced what the average size of one of our hotels trades for, so what we were attempting to suggest was that the financing market has gotten so difficult that it has affected even our transactions, which on an average sale for a Comfort Inn or a Quality, may be in the $3.0 million to $5.0 million range. That was the size of the transaction, not of the renovation.

Michael Millman - Soleil-Millman Research

What would the cost typically be for an owner converting to one of your brands?

Stephen P. Joyce

It depends totally on the condition of the hotel. It can run from paying for nothing other than the signs of the systems to a total gut job of a property. It depends on the condition of the property and when it was last renovated and how current and transitional and appropriate it is for the brand.

Michael Millman - Soleil-Millman Research

In this environment are you seeing conversions more from the former, where there was just no costs?

Stephen P. Joyce

No. They come to us for a number of different reasons: one, they were independent; two, they didn’t like the brand they were under; or three, they were in a brand that is moving a different direction. And so it really depends on the life cycle of the hotel and how old they are and when their last renovation was. And we haven’t seen any significant shift in that.

Michael Millman - Soleil-Millman Research

Just getting back to the question on the relicensing. So the relicensing is only part of the franchise fees and so the franchise fees, would we expect to see that decline because construction is probably a bigger piece of it than conversions?

David L. White

The relicensing fees, revenue, we include in the line item on our income statement called Initial and Relicensing Fees, so when we collect that fee is when a hotel that is already in our system is sold by an existing franchisee to a new owner, which essentially creates a new relicensing fee for us. So that’s included within that line item.

If you look at the royalty fees, really the key metrics you want to model when you think about our domestic royalties, are the units, the size of the system, plus your assumptions around unit growth, which we’re thinking around 3.5% next year, and then model in the impact of RevPAR and the effective royalty rate, is how we model our domestic royalties.

Michael Millman - Soleil-Millman Research

I was trying to get to the franchise fees piece, excluding the relicensing fees piece.

David L. White

The way to think about is for 2007 it was about $12.7 million, of relicensing fees. For 2008, and that’ s included within that line item in our annual report, for 2008, for the full year, we are expecting that relicensing fees, which will be included in that line item, to be down about one-third.

Operator

At this time there are no additional questions in queue.

Stephen P. Joyce

Thank you for joining us on this call. Hopefully the outlook we provided is helpful in your analysis of our company and the industry. Obviously I would reiterate our remarks around the volatility and the uncertainty we have going forward, but I think of the companies out there we are extremely well positioned to weather any storm and take advantage of the opportunities that present themselves.

So with that, I thank you for joining us and wish everyone a happy holiday.

Operator

This concludes today’s conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!