Management’s Discussion and Analysis of Financial Condition and Results of Operations

    Choice Hotels International, Inc. and subsidiaries (together "the Company") is one of the largest hotel franchisors in the world with 4,664 hotels open and 474 hotels under development as of December 31, 2002, representing 373,722 rooms open and 41,565 rooms under development in 48 countries and territories. The Company franchises hotels under the Comfort, Comfort Suites, Quality, Clarion, Sleep Inn, Econo Lodge, Rodeway Inn, MainStay Suites and Flag Choice Hotels brand names. The Company's franchises operate in all 50 states, Puerto Rico and 38 additional countries and territories. Approximately 96% of the Company's franchising revenue is derived from hotels franchised in the United States.

    The principal factors that affect the Company's results are: growth in the number of hotels under franchise; operating performance, including occupancy and room rates, achieved by the hotels under franchise; the number and relative mix of franchised hotels; the effective royalty rate achieved; and the Company's ability to manage costs. The number of rooms at franchised properties and occupancies and room rates at those properties significantly affect the Company's results because franchise royalty fees are based upon room revenues at franchised hotels. The key industry standard for measuring hotel operating performance is revenue per available room ("RevPAR"), which is calculated by multiplying the percentage of occupied rooms by the average daily room rate realized. Our variable overhead costs associated with franchise system growth have historically been less than incremental royalty fees generated from new franchisees; therefore, the Company is able to capture a significant portion of those royalty fees as operating income.

Critical Accounting Policies

  Revenue Recognition

    The Company accounts for initial franchise fees in accordance with Statement of Financial Accounting Standards ("SFAS") No. 45, "Accounting for Franchise Fee Revenue." The Company enters into franchise agreements committing to provide franchisees with various marketing services, a centralized reservation system and limited rights to utilize the Company's registered tradenames and trademarks. These agreements typically have an initial term of twenty years with provisions permitting franchisees to terminate after five, ten, or fifteen years under certain circumstances. In most instances, initial franchise fees are recognized upon execution of the franchise agreement because the initial franchise fee is non-refundable and the Company has no continuing obligations related to the franchisee. The initial franchise fee related to executed franchise agreements which include incentives, such as future potential rebates, are deferred and recognized when the incentive criteria are met or the agreement is terminated, whichever occurs first.

    Royalty fees, which are typically based on a percentage of gross room revenues of each franchisee, are recorded when earned. Reserves for uncollectible royalty fees are charged to bad debt expense and are included in selling, general and administrative expenses in the accompanying consolidated statements of income.

    The Company's franchise agreements require the payment of franchise fees, including marketing and reservation fees, which are used exclusively by the Company for expenses associated with providing franchise services such as national marketing, media advertising, central reservation systems and technology services. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated.

    The Company revised its presentation of marketing and reservation revenues during the fourth quarter of 2001 to comply with Emerging Issues Task Force ("EITF") Issue No. 99-19 "Reporting Revenue Gross as a Principal versus Net as an Agent." The Company had previously presented these revenues net of related expenses on its consolidated statements of income. EITF 99-19 requires that these revenues be recorded gross and accordingly, the Company has revised its financial statement presentation for all periods presented. In addition, net advances to and repayments from the franchise system for marketing and reservation activities have been reclassified to present these activities as cash flows from operating activities for all periods presented. These revisions had no effect on the net income or cash flows reported during the periods revised.

    Reservation fees and marketing fees not expended in the current year are carried over to the next fiscal year and expended in accordance with the franchise agreements. Shortfall amounts are similarly recovered in subsequent years. Cumulative excess or shortfall amounts from the operation of these programs are recorded as a marketing or reservation fee payable or receivable. Under the terms of the franchise agreements, the Company may advance capital as necessary for marketing and reservation activities and recover such advances through future fees (see Note 6 to the Consolidated Financial Statements).

    The Company generates partner services revenues from hotel industry vendors. Partner services revenues are generally earned based on the level of goods or services purchased from endorsed vendors by hotel owners and hotel guests who stay in the Company's franchised hotels. The Company accounts for these revenues in accordance with Staff Accounting Bulletin No. 101, ("SAB 101") "Revenue Recognition." SAB 101 provides guidance on the recognition, presentation and disclosure of revenue in financial statements. The Company recognizes partner services revenues when the services are performed or the product delivered, evidence of an arrangement exists, the fee is fixed and determinable and collectibility is probable. SAB 101 requires the Company to defer the recognition of partner services revenues related to upfront fees. Such upfront fees are generally recognized over a period corresponding to the Company's estimate of the life of the arrangement.

  Impairment Policy

    The Company evaluates the impairment of property and equipment and other long-lived assets, including franchise rights and other definite-lived intangibles, in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 states that an impairment of long-lived assets has occurred whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured based on net, undiscounted expected cash flows. Assets are considered to be impaired if the net, undiscounted expected cash flows are less than the carrying amount of the assets. Impairment charges are recorded based upon the difference between the carrying value of the asset and the fair value. The Company did not record any impairment on long-lived assets during the years ended December 31, 2002, 2001 or 2000.

    The Company evaluates the impairment of goodwill in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," which requires goodwill to be assessed on at least an annual basis for impairment using a fair value basis. Because the Company operates in one reporting segment in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" and related interpretations, the fair value of the Company's total assets are used to determine if goodwill may be impaired. According to SFAS No. 142, quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement if available. The Company did not record any impairment of goodwill in 2002, 2001 or 2000 based on assessments performed by the Company.

    The Company evaluates the collectibility of notes receivable in accordance with SFAS No. 114, "Accounting by Creditors For Impairment of a Loan." SFAS No. 114 states that a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. The Company reviews outstanding notes receivable on a periodic basis to ensure that each is fully collectible by reviewing the financial condition of its debtors. If the Company concludes that it will be unable to collect all amounts due, the Company will record an impairment charge based on the present value of expected future cash flows, discounted at the loan's effective interest rate. The Company did not record any impairment charges related to notes receivable during the years ended December 31, 2002 or 2001. During the year ended December 31, 2000, the Company recorded $7.6 million of impairment losses related to its subordinated term note to Sunburst Hospitality Corporation (see Note 7).

  Stock Compensation

    The Company accounts for its stock-based employee compensation plans in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense related to fixed employee stock options is recorded only if on the date of grant the fair value of the underlying stock exceeds the exercise price. The Company adopted the disclosure only requirements of SFAS No. 123, "Accounting for Stock-Based Compensation," which allows entities to continue to apply the provisions of APB Opinion No. 25 for transactions with employees and to provide pro forma net income disclosures as if the fair value based method of accounting, described in SFAS No. 123 had been applied to employee stock option grants.

    Effective January 1, 2003, the Company adopted, in accordance with SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure," the fair value based method of accounting for stock option awards granted on or after January 1, 2003.