Comparison of 2002 Operating Results and 2001 Operating Results

    The Company recorded net income of $60.8 million for the year ended December 31, 2002, an increase of $46.5 million from net income of $14.3 million for the year ended December 31, 2001. Net income in 2001 included an impairment charge of $22.7 million associated with the Company's determination to write-off its entire investment in Friendly Hotels PLC (currently known as C.H.E. Group PLC) ("Friendly"). Net income for 2001 also reflects $10.3 million of equity losses (net of taxes) in Friendly.

Management analyzes its business based on net franchise revenues, which is total revenues excluding marketing and reservation revenues and hotel operations, and franchise operating expenses that are reflected as selling, general and administrative expenses.

    Franchise Revenues: Net franchise revenues were $172.1 million for the year ended December 31, 2002 compared to $170.0 million for the year ended December 31, 2001. Royalty fees increased $2.7 million to $142.9 million from $140.2 million in 2001, an increase of 1.9%. The increase in royalties is primarily attributable to a 4.4% increase in the number of domestic franchised hotel rooms and an increase in the effective royalty rate of the domestic hotel system to 3.97% from 3.95%, offset by a 3.8% decrease in RevPAR. Domestic initial fee revenue, included in the initial franchise and relicensing fees caption above, generated from executed franchise contracts increased 7.8% to $8.3 million for the year ended December 31, 2002 from $7.7 million for the year ended December 31, 2001. Relicensing fees declined 11.5% to $4.6 million for the year ended December 31, 2002 from $5.2 million for the year ended December 31, 2001. Relicensing fees are charged to the new property owner of a franchised property whenever an ownership change occurs and the property remains in the franchise system. The decrease in relicensing fees in 2002 reflects a lower number of such ownership changes in 2002 compared to 2001. Total domestic franchise agreements executed in 2002 were 304, compared to 300 total agreements executed in 2001. The number of rooms covered by contracts executed were 25,657 in 2002 compared to 25,757 in 2001. Revenues generated from partner services was $11.9 million, compared to $12.0 million in 2001.

    The number of domestic rooms on-line increased to 282,423 from 270,514, an increase of 4.4% for the year ended December 31, 2002. For 2002, the total number of domestic hotels on-line grew 4.7% to 3,482 from 3,327 for 2001. International rooms on-line decreased slightly to 91,299 as of December 31, 2002 from 92,035 as of December 31, 2001, a decrease of 0.8%. The total number of international hotels on-line decreased to 1,182 from 1,218, a decrease of 3.0% for the year ended December 31, 2002. The decrease in international hotels online is primarily due to termination of certain Flag properties which failed to maintain the Company's brand standards or which declined to formalize a franchise relationship following the Company's acquisition of a controlling interest in Flag Choice Hotels during 2002. As of December 31, 2002, the Company had 310 franchised hotels with 23,766 rooms either in design or under construction in its domestic system. The Company has an additional 164 franchised hotels with 17,799 rooms under development in its international system as of December 31, 2002.

    Franchise Expenses: The cost to operate the franchising business is reflected in selling, general and administrative expenses. Selling, general and administrative expenses were $54.9 million for the year ended December 31, 2002, a decrease of $1.2 million from the year ended December 31, 2001 total of $56.1 million. As a percentage of net franchise revenues, selling, general and administrative expenses declined to 31.9% in 2002 from 33.0% in 2001. This decline, which increased franchising margins from 67.0% to 68.1%, was largely due to reductions in selling, general and administrative expenses resulting from the Company's 2001 and 2000 restructurings.

    Marketing and Reservations: The Company's franchise agreements require the payment of franchise fees which include marketing and reservation fees. These fees, which are based on a percentage of the franchisees'gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing and media advertising. 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.

    Total marketing and reservation revenues were $190.1 million and $168.2 million for the years ended December 31, 2002 and 2001, respectively. Depreciation and amortization attributable to marketing and reservation activities was $13.0 million and $11.8 million for the years ended December 31, 2002 and 2001, respectively. Interest expense attributable to reservation activities was $1.4 million and $2.0 million for the years ended December 31, 2002 and 2001, respectively. Marketing and reservation activities provided a positive cash flow of $17.2 million and $20.3 million for the years ended December 31, 2002 and 2001, respectively. As of December 31, 2002 and 2001, the Company's balance sheet includes a receivable of $44.9 million and $49.4 million, respectively, for marketing and reservation fees. The Company has the contractual authority to require that the franchisees in the system at any given point repay the Company for any deficits related to marketing and reservation activities. The Company's current franchisees are legally obliged to pay any assessment the Company imposes on its franchisees to obtain reimbursement of such deficit regardless of whether those constituents continue to generate gross room revenue. The Company has no present intention to accelerate repayment of the deficit from current franchisees.

    Hotel Operations: In September 2000, the Company received title to three MainStay properties from Sunburst Hospitality Corporation ("Sunburst") as consideration for $16.3 million of the then $149 million amount due under a note receivable from Sunburst. Revenues from hotel operations were $3.3 million and $3.2 million for the years ended December 31, 2002 and 2001, respectively. Selling, general and administrative expenses from hotel operations were $2.9 million and $2.5 million for those years, respectively.

    Depreciation and Amortization: Depreciation and amortization decreased to $11.3 million in the year ended December 31, 2002 from $12.5 million in the year ended December 31, 2001. This decrease is primarily attributable to the Company's adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", pursuant to which the Company stopped amortizing goodwill effective January 1, 2002.

    Friendly: The Company's entire investment in Friendly was written off in 2001, accordingly, the Company's 2002 results of operations do not include any equity method losses or other amounts related to Friendly. In addition to the $22.7 million impairment described below, the Company recorded equity method losses associated with its investment in Friendly totaling $10.3 million (net of tax) for the year ended December 31, 2001.

    On February 21, 2002, Friendly announced that it had been unable to find an acceptable buyer for its business and would terminate such efforts at that time. Given the bid period termination and the adverse economic conditions of Friendly, the Company disposed of its entire preferred and common equity interest in Friendly on March 20, 2002, and immediately relinquished its three seats on Friendly's board of directors. Accordingly, the Company reduced its investment in Friendly to zero through a $22.7 million charge to reflect the permanent impairment of this asset as of December 31, 2001.

    Interest and Other: Interest expense of $13.1 million in the year ended December 31, 2002 is down $2.3 million from $15.4 million in the year ended December 31, 2001 due primarily to lower effective interest rates. The Company's weighted average interest rate as of December 31, 2002 was 4.39% compared to 4.52% as of December 31, 2001. Included in the results for 2002 and 2001 is approximately $4.6 million and $4.2 million, respectively, of interest income earned on the note receivable from Sunburst. The note from Sunburst accrued interest up until June 2002, at which point interest became payable semi-annually in arrears. As of December 31, 2002, the Company's balance sheet includes an interest receivable from Sunburst of $2.3 million which is included in other current assets in the accompanying consolidated balance sheets and was paid to the Company by Sunburst in January 2003.