Choice Hotels International Q3 2007 Earnings Call Transcript

Choice Hotels International, Inc (CHH)

Q3 2007 Earnings Call

October 25, 2007 9:30 am ET

Executives

Charles Ledsinger - Vice Chairman and Chief Executive Officer

Dave White - Chief Financial Officer

Analysts

William Truelove - UBS

David Katz - CIBC World Markets

Felicia Hendricks - Lehman Brothers

Joseph Greff - Bear Stearns

Jeff Donnelly - Wachovia Securities

Michael Millman - Soleil-Millman Research

Presentation

Operator

Good morning and welcome to the Choice Hotels International third quarter 2007 earnings conference call. (Operator Instructions).

Now during the course of this conference call certain predictive or forward-looking statements will be use to assist you in understanding the company and its results.

Such statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements.

The company’s Form 10-K for the year ended December 31^st, 2006 details some of the important risk factors that you should review. Although, we believe that the expectations reflected in the forward looking statements are reasonable. We cannot guarantee future results, levels of activity, performance or achievements.

We caution you not to place undo reliance on forward-looking statements, which reflect our analysis only, and speak only as of today’s date. We undertake no obligation to publicly update the forward-looking statements to reflect subsequent events or circumstances.

Now with that being said, I’d now like to introduce Charles Ledsinger, Vice Chairman and Chief Executive Officer of Choice Hotels.

Charles Ledsinger

Thank you. Good morning everyone. And welcome to our third quarter 2007 earnings conference call. And with me this morning is Dave White, our Chief Financial Officer.

Yesterday after the market close, we reported the third quarter 2007 results. And after I discuss some of the highlights for the quarter, I’ll open up the call for your questions.

We continue to execute our strategy for profitable growth and we’re pleased with our strong third quarter results. For the quarter domestic unit and rooms growth were 5.7% and 4.4% respectively.

RevPAR increased 5.6% for the quarter compared to the same period of last year. RevPAR for our mid-scale without food and beverage brands Comfort Inn, Comfort Suites and Sleep Inn increased 6.1% driven by improvement in occupancy and a 5.4% increase in average daily rate. These brands represent approximately half of our domestic room supply.

Coming off back-to-back record years franchise development in 2006 and 2005, we’re pleased that our 2007 franchise development results continue to be strong. During the third quarter we executed a 182 new domestic hotel franchise contracts compared to 178 for the third quarter in 2006, which was a record year. And year-to-date we’ve executed 469 new franchise contracts, an increase from 453 during the same period of 2006. Our strong unit growth RevPAR and franchise sales results for key contributors to strong financial results for the quarter.

Operating income for the third quarter increased 14%, $62.4 million compared to $54.6 million for the third quarter in 2006. Adjusted diluted EPS, which excludes certain income tax contingency reversals and in 2006 a loss on extinguishment of debt increased 16% to $0.58 compared to adjusted diluted EPS of $0.50 for the third quarter in ’06. Diluted earnings per share for the third quarter in 2007 were $0.59.

As we indicated in yesterday’s press release, we’re increasing our full year 2007 diluted EPS guidance from $1.62 to $1.67 and our EBITDA guidance for the full year 2007 from $187.5 million to approximately $189 million. Our fourth quarter diluted earnings per shares expected to be $0.41.

These figures assume a 4% increase in RevPAR for the fourth quarter 2007 and full year 2007. These figures also assume for full year '07 a net domestic unit growth of approximately 5%, a 4 basis point increase in the effective royalty rate and an effective tax rate is 36.1%. And finally these figures include $3.7 million severance charge, which was recorded in the first quarter of this year.

During the third quarter, we also continued to execute against our long-term strategy of returning excess capital to shareholders. Since the beginning of the year through the end of third quarter, we’ve repurchased 4.1 million shares of our stock for approximately $155 million. During this same period we paid cash dividends on our common stock $29.5 million.

In closing, we continue to demonstrate strong performances; we add more hotels to our distribution system; grow our operating income, and return excess capital to our shareholders. We remain confident in our ability to continue to grow our market share in the segments in which we operate.

And now I’d like to open up the call to any question you might have.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question this morning comes from the line of William,Truelove with UBS.

William Truelove - UBS

Maybe David can take a shot at this question. On leverage ratios, where do you want to target eventually or what do you feel you are happy in terms of your leverage ratios? Where do you see the company being in the next few years? What's the good range, so we can try to model potentially what you might be buying in stock and additions going forward? Thanks.

Dave White

We don’t have any specific target of leverage levels that we feel we have to maintain on the balance sheet if you will. If you look back over the past five or six years that the share repurchase program has been into place, we've certainly been comfortable with leverage level up to three, three and a quarter.

So, we’re not uncomfortable with those levels. I think the credit rating agencies are comfortable with us in that range as well, maintaining our investment and great credit rating.

So, the share repurchase program I think that nothing has changed there in terms of our philosophy that, if we have excess capital, excess cash, we will return that over a long period of time to our shareholders through the dividend or the share repurchase programs.

Our first preference would be to continue to use it to grow the business, but we’ll do the right thing from the shareholder perspective with their cash over time.

Operator

And our next question then comes from the line of David Katz with CIBC World Markets.

David Katz - CIBC World Markets

Nice job on the quarter. I know we keep asking this question and I think we know what the answer is, but I’m just going to keep asking it anyway. Just in case the answer changes, but are you perceiving or seeing anything that’s showing up in your business in terms of weakness on the consumer, weakness from gas prices. The perception out there seems to be, that companies like Choice and the categories that you are in are susceptible to consumer trends that are out there. So like I said I'll just keep asking it just in case something does show up in your business.

Charles Ledsinger

It’s a good question Dave. And to be honest with you, not really. The main thing is we're not only just RevPAR growth we're unit growth. So it seems like, if look back historically kind of what happens is is that we play the cycles and we're a very good defensive play, but we also do well in the up cycles too.

So, if things from a development standpoint, what happens is is that often the new hotels and new brands or small brands or new hotels have been created sometimes--it may be independence too--when the cycles turn and things get little bit tougher they start look for the larger brand organizations to affiliate with, larger platforms. And so we benefit in that scenario.

We also benefit frankly, in under-supply growth because we have both new build and conversion. So, I'd say from the development side which is for us--we are unit growth market share company--the most important thing.

Secondly, RevPAR is important, but probably not quite as important on a margin. And we're not seeing it; we had a very strong summer and I'm not saying we're showing the fourth quarter we don’t have a lot of visibility, we don’t put lots of rooms out very far. So it’s hard for us to really I think with a lot of clear sightedness say, ‘this is what we can see on the books, and this is going to happen.’ We tend to follow the industry; we are a little stronger in the summer months when there is a little more leisure travel.

And also I think, I'd just say they're popular price brands, and so, they're value-oriented brands. So, sometimes you do see switching from some of the higher price brand if there is squeeze on the consumer.

So, gas really hadn't had an impact on us, we haven't seen it really in the RevPAR. A recession in the economy is going to have an impact on everybody. But probably frankly a little less us than some others.

David Katz - CIBC world markets

Now, if we can just go back to something that I think was an answer to Will's original question. I want to make sure I heard you right. You talked about being comfortable, at the 3 to 3.25 times leverage range?

Charles Ledsinger

Mm-hm.

David Katz - CIBC world markets

And you’re obviously quite a bit below that, at this point.

Charles Ledsinger

Uh-huh.

David Katz - CIBC world markets

So, when I look at your guidance and I think one of the assumptions in your guidance is that the share count basically remains the same for the forth quarter. Right? We don’t only want to think about this in terms of the fourth quarter, but taking a little longer-term view, the assumption that your share count remains anything close to the same is given that comment is probably not really all that relevant. Is it?

Charles Ledsinger

Well, I think what you should look at is just what the historical practice has been. As we sit here today we don’t see the future much different than we've seen the past. Meaning that, we’re going to return capital to shareholders.

David Katz - CIBC world markets

Got it.

Charles Ledsinger

We’re also, as Dave said we'd like to find ways to grow our business profitably and so hopefully we're going to get some opportunities going forward to do that. It’s a balancing act between opportunistic ability to purchase valuations and what alternatives might be.

David Katz - CIBC world markets

Right. And if you could forgive me for not knowing this, were you not permitted to buy back any stock since September 30th or did you choose not do so for one reason or another?

Charles Ledsinger

We weren’t prohibited.

David Katz - CIBC world markets

So for the last three weeks or so you elected not to for one reason or another.

Charles Ledsinger

We haven’t really disclosed anything for post-quarter end but between the announcement date of our increased authorization from the Board and the end of the quarter we didn’t buy anything else.

I think if you look back, we’ve announced Board authorization increases over the past ten years that that program has been in place and as Chuck mentioned over time, a pretty good track record of actually executing on them over time.

David Katz - CIBC world markets

Okay. One last one and then I will get out of the way here, but on the international side I just wanted to check back on that. I know we should be measuring this more in terms of years more than months, but how long before we start to see some real evidence of that business becoming meaningful for you all.

Dave White

I think it’s obviously in terms of rooms share and unit share, probably close 20% of our room supply and unit supply. The model's a little bit different internationally than it is in the domestic market; we’ve got great scale here in the U.S., 4300 properties so it obviously makes the business profitability a lot better than it is internationally, but we feel pretty good about the partners we have internationally where we do master franchising and spots where we’re doing it direct, in Canada, Australia, Asia. It will take time to have a more meaningful financial impact but we feel like we’re doing well there.

Operator

Thanks and the next question comes from the line of Felicia Hendricks with Lehman Brothers.

Felicia Hendricks - Lehman Brothers

Just a few questions, one is you’ve been asked this before and the answer’s been it’s been too early but I’m just wondering where we are now.

In terms of having any kind of insight to your franchisees and their ability to access the debt markets, has that gotten more costly for them and is that going to become an issue in terms of growing units and then I have some follow-up questions.

Charles Ledsinger

Felicia we really haven’t seen that. Most of our franchisees are using local and smaller lenders and so they really just haven’t been affected the same way that some of the larger institutions have. It’s really a little bit different animal and it may be costing them little more, but probably more likely is they are required to put in a little bit more equity in.

But that really hasn’t been a constraint, we are still selling a lot of new franchises and we are opening a lot of hotels and I haven’t heard that getting the financing has been the issue; construction time, because of some of the permitting and all the things that have to come together has stretched out a little bit longer

We had a quarter, good year this year in terms of new hotels opening and also very good on new sales on contracts. So we just haven’t seen; I’ve talked to a lot of people, they haven’t said that that’s really been the constraint.

Felicia Hendricks - Lehman Brothers

That’s good.

Charles Ledsinger

Yeah, hope it continues

Felicia Hendricks - Lehman Brothers

Yeah. Since your business is based on unit growth I do too. So, just getting to your guidance, I think there’s a little bit of a difference when you re-look at the RevPAR percentage changes between what we’re looking at and the guidance that you’re giving just because we don't have the same store numbers including the Suburban acquisition last year. I was wondering if you could just give us those numbers for the fourth quarter and full year last year?

Dave White

Full year RevPAR including suburban in ’06 was $40.13. And fourth quarter including Suburban was $39.70

Felicia Hendricks - Lehman Brothers

And then just finally, what was the share count at the end of your quarter?

Dave White

I don't have that right here in front of me. Let me track that down and before we end the call I’ll give you that.

Operator

And our next question then comes form the line of Joseph Greff with Bear Stearns.

Joseph Greff - Bear Stearns

How sustainable is 5% net domestic unit growth. I mean, given the pipeline, and the progress you’re making with some of the brands, is that something that you think is sustainable for next couple of years?

Or what it is a two-year sustainable unit growth rate and I guess how different is it one a property basis versus a rooms basis?

Charles Ledsinger

We usually targeted sort of four to five unit growth. And, I think that that probably translates into somewhere between 3.5 to 4.5 on rooms growth. For us unit growth is important, I mean units are important because you get paid fees when you sell a new franchise, you get paid fees when a franchise sells that’s a re-licensing fee, that’s not by rooms, that’s by units.

So there is fair amount of income that gets generated by unit growth. We get fees whether the hotel opens or not. So, now we don’t like to do that, because, obviously it takes up space and it takes up time. But if you look at our revenue generation, there is a fair amount of fees that are generated through those sales of new units.

Rooms of course are what pay the royalties so over time that’s an obviously important part too. But they’re both important. I’d say that, probably four to five and then on rooms probably a little bit less, just because the mix of properties going forward is a little different than the historical mix has been.

But we have Cambria coming on, which is our bigger units. And so that will have a kind of a mitigating impact. That’s still small in the whole scheme of things.

Joseph Greff - Bear Stearns

Got you. And then, one final question, David, with respect to next year, I know you don’t provide a guidance, do you think the level of, what we would characterize as capital investments or CapEx for next year is consistent with what you’re doing this year or should that go up or should that go down and what are the drivers there?

Dave White

We haven’t really gone through all of our planning at this point, included that with our Board, so I’m a little hesitant to provide any kind of guidance like that at this point. But we are middle of December this year hosting an investor day where we’re presently planning to talk about ’08 expectations.

Charles Ledsinger

And just to answer that question on the quarter-end share count we were at 62.8 million shares outstanding and that’s before any type of dilution factor for options.

Operator

 (Operator Instructions). We now go a question from the line of Jeff Donnelly, with Wachovia Securities.

Jeff Donnelly - Wachovia Securities

Good morning guys. Marriott told us on its earning call that re-licensing fees could be significantly lower than previously expected as pure transactions in the marketplace were dropping the ability to capture those fees, what’s your take on that, is that something you expect to see in your portfolio?

Dave White

We had a strong third quarter from a re-licensing prospective and we will put those details as we always do in our 10-Q here in a week or so. Q3 was strong and I think that also ties into Chuck’s earlier comments about credit availability; I mean, there’s liquidity there to get these transactions closed and I’m not seen anything else that would cause me at this point to have any concern in that area.

Jeff Donnelly - Wachovia Securities

And just a follow up on some of your earlier questions on your pipeline; Chuck, you touched on this in one of your comments, that there’s a chance that maybe your completion or deliveries will perhaps slow a little bit in your pipeline simply because construction periods are taking a little longer.

Do you have an estimate how much longer that is taking so we can have a sense of maybe how your room completions change over the next 24 months?

Dave White

That’s not unique to Choice, that’s applicable to really the entire industry. Six months is tacked on a new construction project over the past year or two just with all the things you have to go through to get a hotel open.

So, for us, a hotel can open as quickly as 12-13 months and can take much longer than that too. It’s hard to generalize but as Chuck talked about, our expectations still remain strong for these brands over time.

Jeff Donnelly - Wachovia Securities

Do you have international royalty fees for the quarter?

Dave White

I don’t have those right here in front me but we would put those in our Q, which we are going to file here in the next week or so.

Operator

We have a question then from the line of Michael Millman with Soleil-Millman Research.

Michael Millman - Soleil-Millman Research

Several questions, can you talk about why, fourth quarter RevPAR seems to be well below the third quarter gain and whether that has to do with last year’s acquisitions or is there something else involved?

Charles Ledsinger

Well, I think seasonality has something to do with it. But we had a very strong third quarter. And we’ve said all along, I think for the year, we’re sort of in-line with where we said we’re going to be for the year and our expectations that that’s about where we’re going to end up.

It’s a little bit more based on what the industry prognosticators are saying and as opposed to clear visibility that we have in our business per se. So we try to look at what our historic performance is, vis-à-vis the industry and then look and see if there is any thing else unusual in the business, which there is not, or any trends that we’re seeing.

So, we’re saying we’re going to hit the year number and David if you have any further insight.

Dave White

Yeah, just looking at the PwC and STR publication recently, as well as lot of the others in the industry, I mean, it doesn’t seem inconsistent with what some of the other hotel companies have put out there and certainly not inconsistent with what PwC and STR are expecting in terms of Q4, a slight deceleration industry-wide in RevPAR.

Michael Millman - Soleil-Millman Research

I asked because, it just seems that your third quarter RevPAR was much higher than you had guided and your fourth quarter now looks like it’s much lower than you had guided back a couple of months ago.

Dave White

But Michael, on Q4, I mean, I think in our second quarter call, we had guided a Q3 RevPAR of 4.5 and on the call we talked about Q4 being in the mid-fours to get us to four for the full year.

We’ve been pretty consistently saying 4% RevPAR I think since the beginning of the year; you’d have to go back to the first quarter release. But I think we’ve been at 4% for 2007 all year and in the most recent call, we guided to mid-fours in the fourth quarter.

So we’re not really that different where we thought we were last time we had this last call.

Michael Millman - Soleil-Millman Research

Okay, on the mid-scale, the occupancy was up 50 basis points. How long do you think you can continue to get ADRs of five plus with under 1% occupancy increases? What’s the sustainability there?

Dave White

Well, I think that trend is pretty much what everybody’s seen is that occupancy has been modestly increasing to flat. The forecast for next year actually occupancies to be down a little bit.

So I think to the extent that we exhibit the same trends as the industry does and I would expect that would be sustainable the same way. I mean, I don’t think we’re going to see big differentiation from what the rest of the industry in our segments is seeing.

Michael Millman - Soleil-Millman Research

No I recognize that’s industry, I was just wondering if you were concerned about sustainability of industry getting rate without …?

Dave White

I see what you’re saying. Well yes; I mean, ideally you’d love to have occupancy increasing as well as rate. But I think that the rate differential tends to be more supply driven. So supply on RevPARs, supply stays in levels where we’ve seen it.

You’ll probably still be able to drive it through rate; those won’t last forever probably. So, hopefully the economy cooperates, and we’re able to continue to push that rate but I think it’s a cyclical business that I think right now is still seeing lots of pricing power and then hopefully that’ll continue.

What you’re seeing now, is probably, we’ve still got a little bit more demand than we have supply coming into the markets. So we’re seeing that positive RevPAR and positive pricing power.

Michael Millman - Soleil-Millman Research

And the West Coast fires, is this looking like a mini-Katrina, in terms of the hotel business?

Charles Ledsinger

I don’t know the answer to that, that’s a good question. I’m sure there is many people displaced and there is going to have to be homes rebuilt. Whether it is to the extent that there was in New Orleans, I just don’t know the answer to that. I certainly think that it will have an impact on the business.

Operator

I’m showing no further questions in queue.

Charles Ledsinger

Okay. Well, thank you very much.

Operator

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