IHR Interstate Hotels & Resorts,

 

 

 

 

 

www.ihrco.com
This Form 10-Q can be accessed at no charge through above website.

 

 

(703) 387-3100

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   þ   Yes      o  No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o      Accelerated filer  þ      Non-accelerated filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o      No  þ

 

The number of shares of Common Stock, par value $0.01 per share, outstanding at November 1, 2007 was 31,718,817.

 

 

INTERSTATE HOTELS & RESORTS, INC.

 

INDEX

 

 

 

PART I. FINANCIAL INFORMATION

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

The accompanying notes are an integral part of the consolidated financial statements.

 

INTERSTATE HOTELS & RESORTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

We are a premier hotel real estate investor and one of the largest independent U.S. hotel management companies not affiliated with a hotel brand, measured by number of rooms under management. We derive our earnings from the ownership of strategic hotel properties and a diversified portfolio of hotel management agreements. While we continue to focus on our core business as a leading provider of hospitality management services, we continue to expand our portfolio of owned hotels in an effort to diversify and enhance our earnings. In 2007, a significant portion of our operating income has been related to owned hotels. We have two reportable operating segments: hotel ownership (through whole-ownership and joint ventures) and hotel management. A third reportable segment, corporate housing, was disposed of on January 26, 2007, with the sale of BridgeStreet, our corporate housing division.

 

Our management portfolio is diversified by brand, franchise and ownership group to which we provide related services in the hotel, resort and conference center markets. These services include insurance and risk management, purchasing and capital project management, information technology and telecommunications, and centralized accounting services. As of September 30, 2007, we owned six hotel properties, with 1,755 rooms, and held non-controlling minority interests in 15 joint ventures, which own or hold ownership interests in 20 of our managed properties. We and our affiliates also managed 184 hotel properties and five ancillary service centers (which consist of two laundry centers, two convention centers, and a spa facility), with 42,435 rooms in 36 states, the District of Columbia, Canada, Russia, Belgium, Ireland and Mexico.

 

Our corporate housing division was disposed of on January 26, 2007, with the sale of BridgeStreet. It provided apartment rentals for both individuals and corporations with a need for temporary housing as an alternative to long-term apartment rentals or prolonged hotel stays. The assets and liabilities of our corporate housing division were presented as held for sale in our consolidated balance sheet as of December 31, 2006 and as discontinued operations in our consolidated statement of operations and cash flows for all periods presented in this report.

 

Our subsidiary operating partnership, Interstate Operating Company, L.P., indirectly holds substantially all of our assets. We are the sole general partner of that operating partnership. Certain independent third parties and we are limited partners of the partnership. The interests of those third parties are reflected as minority interest on our consolidated balance sheet. The partnership agreement gives the general partner full control over the business and affairs of the partnership. We own more than 99% of the subsidiary operating partnership.

 

 

General

 

We have prepared these unaudited consolidated interim financial statements according to the rules and regulations of the Securities and Exchange Commission. Accordingly, we have omitted certain information and footnote disclosures that are normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). These interim financial statements should be read in conjunction with the financial statements, accompanying notes and other information included in our Annual Report on Form 10-K, for the year ended December 31, 2006.

 

In our opinion, the accompanying unaudited consolidated interim financial statements reflect all normal and recurring adjustments necessary for a fair presentation of the financial condition and results of operations and cash flows for the periods presented. The preparation of financial statements in accordance with GAAP requires us to make estimates and assumptions. Such estimates and assumptions affect the reported amounts of assets and liabilities, as well as the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Our actual results could differ from those estimates. The results of operations for the interim periods are not necessarily indicative of our results for the entire year.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

These consolidated financial statements include our accounts and the accounts for all of our majority owned subsidiaries. We eliminate all significant intercompany balances and transactions. Certain reclassifications have been made to our prior year financial statements to conform to our current presentation.

 

Revenue Recognition Related to Termination Fees

 

As we have existing management agreements with Blackstone, the previous owner of multiple hotels which we have purchased, we evaluate the impact of EITF Issue No. 04-1, “Accounting for Preexisting Relationships between the Parties to a Business Combination” (“EITF 04-1”) on the purchase accounting for these acquisitions. Our agreements with Blackstone have provisions which require the payment of termination fees if Blackstone elects to terminate the management contract or sells the hotel to any buyer, including us. We determine the amount by which the pricing of these contracts is favorable when compared to the pricing we have negotiated with owners for recently executed management contracts for comparable hotel properties and compare this amount to the amount of the required termination fee due from Blackstone. EITF 04-1 requires that we recognize the lesser of the amounts as a gain on the settlement of the executory contract and as part of the acquisition cost of the hotel. For the Hilton Houston Westchase and Westin Atlanta Airport acquisitions, the amount by which the pricing of the Blackstone contracts are favorable to us exceeded the stated termination fees due to us from Blackstone. Accordingly, we recorded in revenue, the stated termination fees for the Hilton Houston Westchase and the Westin Atlanta Airport of $1.0 million and $1.4 million, respectively, at the time of acquisition.

 

Related Parties

 

In January 2007, we were retained as manager for two properties owned by Capstar Hotel Company, LLC (“New Capstar”), a newly formed real estate investment company founded by Paul Whetsell, our current Chairman of the Board. As of September 30, 2007, balances related to New Capstar have been included within “due from related parties” on our consolidated balance sheet and “management fees — related parties” on our consolidated statement of operations.

 

In May 2006, The Blackstone Group (“Blackstone”), acquired MeriStar Hospitality Corporation (“MeriStar”). MeriStar had previously been considered a related party as Mr. Whetsell was also the CEO of MeriStar. Mr. Whetsell did not become part of the Blackstone management team and accordingly, we no longer consider Blackstone to be a related party. As such, the line items “due from related parties” on our consolidated balance sheet and “management fees — related parties” on our consolidated statement of operations do not include any amounts associated with Blackstone at December 31, 2006 and for the period from May 2, 2006, through December 31, 2006, although fees received from MeriStar prior to May 2, 2006, continue to be included in “management fees — related parties.”

 

Our managed properties for which we also hold a joint venture ownership interest continue to be included in “management fees — related parties.” See Note 4, “Investments in Affiliates” for further information on these related party amounts.

 

Stock-Based Compensation

 

On January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share Based Payment” (“SFAS 123R”) using the modified prospective method. Beginning January 1, 2003, we have used the Black-Scholes pricing model to estimate the value of stock options granted to employees. The adoption of SFAS 123R did not have a material impact on our results of operations or financial position as all of our unvested stock-based awards as of December 31, 2005 had previously been accounted for under the fair value method of accounting. See Note 13, “Stock-Based Compensation,” for additional information.

 

Accounting for Uncertainty in Income Taxes

 

On January 1, 2007, we adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes— an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109. FIN 48 also

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. See Note 14, “FIN 48 — Recognition and Measurement of Tax Positions and Benefits,” for additional information.

 

Recently Issued Accounting Pronouncements

 

In June 2006, EITF Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement, That Is, Gross versus Net Presentation” (“EITF 06-3”) was ratified. EITF 06-3, which is effective for periods beginning after December 15, 2006, requires the disclosure of the accounting policy for any tax assessed by a governmental authority that is directly imposed on a revenue producing transaction on a gross (included in revenues and costs) or net (excluded from revenues) basis. We have reported revenues from our owned-hotels, which are subject to various taxes assessed by government authorities, including sales and use taxes, on a net basis.

 

In September 2006, FASB Statement No. 157, “Fair Value Measurements” (“SFAS 157”) was issued. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of the adoption of this statement.

 

In February 2007, FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities (as amended)” (“SFAS 159”) was issued. The fair value option established by this Statement permits all entities to choose to measure eligible items at fair value at specified election dates. It provides entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of the adoption of this statement.

 

 

We calculate our basic earnings per common share by dividing net income by the weighted average number of shares of common stock outstanding. Our diluted earnings per common share assumes the issuance of common stock for all potentially dilutive stock equivalents outstanding. Potentially dilutive shares include restricted stock and stock options granted under our various stock compensation plans and operating partnership units held by minority partners. In periods in which there is a loss, diluted shares outstanding will equal basic shares outstanding to prevent anti-dilution. Basic and diluted earnings per common share are as follows (in thousands, except per share amounts):

 

 

 

 

 

 

 

In March 2007, we invested $0.5 million to acquire a 15% interest in the Radisson Cross Keys hotel in Baltimore, Maryland. We plan to invest an additional $0.3 million for future capital improvements.

 

In April 2007, the joint venture which owns the Doral Tesoro Hotel and Golf Club refinanced its existing debt and made a distribution to us of $1.8 million, which included the return of our initial investment of $1.5 million and a return on investment. As the distribution received was greater than our investment balance at the time of the

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

distribution, the investment balance was reduced to zero with the remainder recorded as a deferred gain. The distribution in excess of our investment will be deferred until such time as the assets in the venture are sold or another such event has occurred, resulting in the culmination of an earnings process. The distribution did not impact our percentage investment ownership interest in the joint venture.

 

In July 2007, we invested in one entity and formed a new entity in two separate transactions with the Steadfast Companies (“Steadfast”) to own and manage hotels in Mexico. We invested $0.5 million for a 50% interest in a new joint venture to manage hotels. We have determined that we are not the primary beneficiary or otherwise do not control this joint venture, and therefore account for our interest using the equity method.

 

Simultaneous with formation of the management joint venture, we advanced $5.7 million, in the form of a convertible debt instrument, to an existing Steadfast entity that owns a three-property portfolio of Tesoro ^® resorts. The debt is convertible into a 15% equity interest in this Steadfast entity upon the consent of the senior lender. We expect to receive the consent in the fourth quarter of 2007. The Steadfast entity then plans to invest $10.0 million for comprehensive renovations and improvements at all three resort properties in the near future. The new management joint venture described above took over management of the three-property portfolio of Tesoro ^® resorts upon its formation and will serve as a platform for future growth in Mexico.

 

During 2007, we also invested an additional $1.2 million in the IHR Greenbuck Hotel Venture, LLC, a joint venture established to develop, construct and operate as many as five to ten aloft ^® hotels over the next several years. Currently, the joint venture has begun the construction of two hotels located in Rancho Cucamonga, CA and Cool Springs, TN.

 

We had related party accounts receivable for management fees and reimbursable costs from the hotels currently owned by the joint ventures of $1.0 million and $1.4 million as of September 30, 2007 and December 31, 2006, respectively. We earned related party management fees from our joint ventures of $1.0 million and $2.7 million for the three and nine months ended September 30, 2007, respectively, and $1.3 million and $3.5 million for the three and nine months ended September 30, 2006, respectively.

 

The recoverability of the carrying values of our investments in and advances to affiliates is dependent upon the operating results of the underlying real estate investments. Future adverse changes in the hospitality and lodging industry, market conditions or poor operating results of the underlying investments could result in future impairment losses or the inability to recover the carrying value of these interests. The debt of all investees is non-recourse to us and we do not guarantee any of our investees’ obligations. We are not the primary beneficiary or controlling investor in any of these joint ventures, however we exert significant influence as the manager of the underlying assets, and therefore account for our interests under the equity method.

 

 

 

We amortize the value of our intangible assets as they all have definite useful lives, over their estimated useful lives, which generally correspond with the expected terms of the associated management, franchise, or financing agreements. For the nine months ended September 30, 2007, we recognized management contract impairment charges of $1.2 million, including $0.7 million for the Westin Atlanta Airport, which we purchased from Blackstone in May 2007, $0.4 million associated with seven properties sold by Sunstone Hotels Investors, Inc. (“Sunstone REIT”) and $0.1 million related to other terminated or lost management contracts. For the nine months ended September 30, 2006, the management contract impairment losses of $10.7 million primarily consisted of $9.7 million for the termination of management contracts related to 21 MeriStar/Blackstone properties and $0.7 million for 14 Sunstone REIT properties sold during the nine month period ended September 30, 2006.

 

We incurred scheduled amortization expense on our remaining management contracts and franchise fees of $1.3 million and $4.0 million for the three and nine months ended September 30, 2007, respectively, and $0.5 million and $2.0 million for the three and nine months ended September 30, 2006, respectively. We also incurred amortization expense related to deferred financing fees of $0.3 million and $1.4 million for the three and nine months ended September 30, 2007, respectively, and $0.2 million and $0.6 million for the three and nine months ended September 30, 2006, respectively. During the first quarter of 2007, $0.5 million of deferred financing fees related to our old senior credit facility was amortized in connection with our entrance into a new $125.0 million senior secured credit facility (“Credit Facility”) and the related payoff of our old senior credit facility and subordinated term loan. Amortization of deferred financing fees are included in interest expense.

 

In connection with the new Credit Facility, we recorded $2.2 million of financing fees, which will be amortized over the term of the new Credit Facility. During the second quarter of 2007, we recorded an additional $0.8 million of financing fees in connection with the amendment of our new Credit Facility. See Note 8, “Long-Term Debt,” for additional information related to the Credit Facility.

 

We evaluate our capitalized management contracts for impairment when circumstances warrant. When we receive notification that a management contract will be terminated early, we evaluate when or if amortization should be accelerated or if any remaining management contract costs should be impaired. We have revised the estimated economic lives of the underlying management contracts for the remaining Blackstone properties to approximately four years as Blackstone has initiated plans to sell most of the portfolio of hotels within four years and had taken over management or executed sales of seven hotels as of December 31, 2006. The change in estimate occurred in December 2006 and was applied as of January 1, 2007. As of September 30, 2007, we do not believe the carrying value of $24.8 million associated with the remaining management contracts is impaired. We will continue to assess the recorded value of our management contracts and their related amortization periods as circumstances warrant.

 

Our goodwill is related to our hotel management segment. We evaluate goodwill annually for impairment during the fourth quarter; however, when circumstances warrant, we will assess the valuation of our goodwill more frequently. During the nine months ended September 30, 2007, no significant management contract losses or other transactions or events occurred which were not already considered in our analysis during the fourth quarter of 2006.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Based on this, we did not re-evaluate of our goodwill for impairment in the third quarter of 2007. Our impairment analysis performed in the fourth quarter of 2006 assumed the net loss of 45 management contracts in 2007. We are in the process of budgeting hotel operations and the resulting management fees for 2008 and future periods, assessing industry conditions and trends, and evaluating the stability of our existing management contract portfolio and pipeline. This information and other information will serve as the basis for our annual goodwill impairment analysis to be performed in the fourth quarter.

 

 

Deferred revenue is comprised of incentive fees for certain of our managed properties that will be recognized as revenue at the end of the contract year (the fourth quarter of 2007) in accordance with EITF D-96 “Accounting for Management Fees Based on a Formula”. Certain owners pay us estimated incentive fees prior to the end of the contract year. Other hotel owners pay us the incentive fees following the close of the contract year. Other consists of legal expenses, sales and use tax accruals, property tax accruals, owners insurance for our managed hotels, general and administrative costs of managing our business and various other items. No individual amounts in Other represent more than 5% of current liabilities.

 

 

Senior Credit Facility

 

In March 2007, we entered into a new senior secured Credit Facility with various lenders. The Credit Facility consisted of a $65.0 million term loan and a $60.0 million revolving loan. Upon entering into the Credit Facility, we borrowed $65.0 million under the term loan, using a portion of it to pay off the remaining obligations under our previous credit facility. In May 2007, we amended the Credit Facility to increase the borrowings under our term loan by $50.0 million, resulting in a total of $115.0 million outstanding under the term loan, and increased the availability under our revolving loan to $85.0 million. In addition, we have the ability to increase the revolving credit facility and/or term loan by up to $75.0 million, in the aggregate, by seeking additional commitments from lenders. Simultaneously with the amendment, we used the additional $50.0 million under the term loan, along with cash on hand, to purchase the 495-room Westin Atlanta Airport. See Note 12, “Acquisitions and Dispositions,” for additional information relating to the purchase.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The actual interest rates on both the revolving loan and term loan depend on the results of certain financial tests. As of September 30, 2007, based on those financial tests, borrowings under the term and revolving loan bore interest at the 30-day LIBOR rate plus 275 basis points (a rate of 7.88% per annum). We incurred interest expense of $2.5 million and $5.2 million on the senior credit facilities for the three and nine months ended September 30, 2007, respectively, and $1.6 million and $4.5 million for the three and nine months ended September 30, 2006, respectively.

 

The debt under the Credit Facility is guaranteed by certain of our wholly-owned subsidiaries and collateralized by pledges of ownership interests, owned hospitality properties, and other collateral that was not previously prohibited from being pledged by any of our existing contracts or agreements. The Credit Facility contains covenants that include maintenance of certain financial ratios at the end of each quarter, compliance reporting requirements and other customary restrictions. At September 30, 2007, we were in compliance with the loan covenants of the Credit Facility.

 

 

 

 

Based on the terms of these mortgage loans, a prepayment cannot be made during the first year after it has been entered. After one year, a penalty of 1% is assessed on any prepayments. The penalty is reduced ratably over the course of the second year. There is no penalty for prepayments made in the third year.

 

In April 2007, we repaid in full, $19.0 million of mortgage debt relating to the Hilton Concord. We incurred no prepayment penalties in connection with the early repayment. We incurred interest expense related to our mortgage loans of $1.0 million and $3.1 million for the three and nine months ended September 30, 2007, respectively, and $0.4 million and $1.0 million for the three and nine months ended September 30, 2006, respectively.

 

 

At September 30, 2007, the total fair value of these interest rate cap agreements was approximately $15,000. The change in fair value for these interest rate cap agreements was immaterial and is recognized in the consolidated statement of operations.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

We are organized into two reportable segments: hotel ownership (through whole-ownership and joint ventures) and hotel management. A third reportable segment, corporate housing, was disposed of on January 26, 2007 with the sale of BridgeStreet and its affiliated subsidiaries. Each segment is managed separately because of its distinctive economic characteristics. Reimbursable expenses, classified as “other revenue and expenses from managed properties” on the statement of operations, are not included as part of this segment analysis. These reimbursable expenses are all part of the hotel management segment.

 

Hotel ownership includes our wholly-owned hotels and joint venture investments. For the hotel ownership segment presentation, we have allocated internal management fee expense of $0.7 million and $1.5 million for the three and nine months ended September 30, 2007, respectively, and $0.2 million and $0.5 million for the three and nine months ended September 30, 2006, respectively. These fees are eliminated in consolidation but are presented as part of the segment to present their operations on a stand-alone basis. Interest expense related to hotel mortgages and other debt drawn specifically to finance the hotels is included in the hotel ownership segment. As of January 1, 2007, our entire debt balance relates to our hotel ownership segment.

 

Hotel management includes the operations related to our managed properties, our purchasing, construction and design subsidiary and our insurance subsidiary. Revenue for this segment consists of “management fees” (which includes $3.2 million of business interruption proceeds received during the first quarter of 2006), “termination fees” and “other” from our consolidated statement of operations. Our insurance subsidiary, as part of the hotel management segment, provides a layer of reinsurance for property, casualty, auto and employment practices liability coverage to our hotel owners.

 

Corporate is not actually a reportable segment but rather includes costs that do not specifically relate to any other single segment of our business. Corporate includes expenses related to our public company structure, certain restructuring charges, Board of Directors costs, audit fees, unallocated corporate interest expense and an allocation for rent and legal expenses. Corporate assets include the Company’s cash accounts, deferred tax assets, deferred financing fees and various other corporate assets.

 

Due to the sale of our third reportable segment, corporate housing, in January 2007, the operations of this segment are included as part of discontinued operations on the consolidated statement of operations for all periods presented. The assets related to this segment have been presented as assets held for sale on the consolidated balance sheet as of December 31, 2006. The assets of our corporate housing segment of $40.4 million as of September 30, 2006, are separately included within the corporate assets in the segment presentation below. As the corporate housing segment was sold, we have not presented it within the following segment presentation. See Note 12, “Acquisitions and Dispositions” for more information on the disposition of the segment.

 

Capital expenditures include the “acquisition of hotels” and “purchases of property and equipment” line items from our cash flow statement. All amounts presented are in thousands.

 

 

 

 

 

Revenues from continuing foreign operations, excluding reimbursable expenses, were as follows (in thousands) ^{(1) (2)} :

 

 

 

 

A significant portion of our management fees for the three and nine month periods ended September 30, 2007 were derived from Blackstone and Sunstone REIT. As of September 30, 2007, we managed 17 hotels for Blackstone and 30 hotels and two ancillary service centers for Sunstone REIT. The total management fees for all Blackstone

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

properties which we managed at September 30, 2007, accounted for $1.5 million, or 16%, of management fees for the three months ended September 30, 2007, and $4.9 million, or 15%, of management fees for the nine month period ended September 30, 2007. The Sunstone REIT properties accounted for $2.3 million, or 24%, of management fees for the three months ended September 30, 2007, and $6.6 million, or 20%, of management fees for the nine month period ended September 30, 2007.

 

 

We managed eight properties that were damaged or closed due to hurricanes in 2004. In March 2006, we settled our claim for lost management fees and received approximately $3.2 million in business interruption proceeds. This recovery is recorded in management fees on the income statement.

 

 

Insurance Matters

 

As part of our management services to hotel owners, we generally obtain casualty (workers’ compensation and general liability) insurance coverage for our managed hotels. In December 2002, one of the carriers we used to obtain casualty insurance coverage was downgraded significantly by rating agencies. In January 2003, we negotiated a transfer of that carrier’s current policies to a new carrier. We have been working with the prior carrier to facilitate a timely and efficient settlement of the original 1,213 claims outstanding under the prior carrier’s casualty policies. The prior carrier has primary responsibility for settling these claims from its assets. As of September 30, 2007, 46 claims remained outstanding. If the prior carrier’s assets are not sufficient to settle these outstanding claims, and the claims exceed amounts available under state guaranty funds, we may be required to settle those claims. We are indemnified under our management agreements for such amounts, except for periods prior to January 2001, when we leased certain hotels from owners. Based on currently available information, we believe the ultimate resolution of these claims will not have a material adverse effect on our consolidated financial position, results of operations or liquidity.

 

During 2005, the prior carrier presented invoices to us and other policy holders related to dividends previously granted to us and other policy holders with respect to the prior policies. Based on this information we have determined that the amount is probable and estimable and have therefore recorded the liability. In September 2005, we invoiced the prior carrier for premium refunds due to us on previous policies. The initial premiums on these policies were calculated based on estimated employee payroll expenses and gross hotel revenues. Due to the September 11th terrorist attacks and the resulting substantial decline in business and leisure travel in the months that followed, we reduced hotel level headcount and payroll. The estimated premiums billed were significantly overstated and as a result, we are owed refunds on the premiums paid. The amount of our receivable exceeds the dividend amounts claimed by the prior carrier. We have reserved the amount of the excess, given the financial condition of the carrier. We hold the legal right of offset in regard to this receivable and payable with the prior insurance carrier. We will continue to pursue collection of our receivable and do not expect to pay any amounts to the prior carrier prior to reaching an agreement with it regarding the contractual amounts due to us. To the extent we do not collect sufficiently on our receivable and pay amounts that we have been invoiced, we will vigorously attempt to recover any additional amounts from our owners.

 

 

The operating lease obligations shown in the table above have not been reduced by a non-cancelable sublease related to our former corporate office space. We remain secondarily liable under this lease in the event that the sub-lessee defaults under the sublease terms. Given the size and financial stability of the sub-lessee, we do not believe that any payments will be required as a result of the secondary liability provisions of the primary lease agreements. We expect to receive minimum payments under this sublease as follows (in thousands):

 

 

Commitments Related to Management Agreements and Hotel Ownership

 

Under the provisions of management agreements with certain hotel owners, we are obligated to provide an aggregate of $2.0 million to these hotel owners in the form of investments or loans. The timing of future investments or working capital loans to hotel owners is not currently known as these advances are at the hotel owner’s discretion.

 

In connection with our owned hotels, we have committed to provide certain funds for property improvements as required by the respective brand franchise agreements. As of September 30, 2007, we had ongoing renovation and property improvement projects with remaining expected costs to complete of approximately $20.2 million, of which $18.0 million is directly attributable to comprehensive renovations for the Westin Atlanta Airport.

 

Letters of Credit

 

As of September 30, 2007, we had a $1.5 million letter of credit outstanding from Northridge Insurance Company in favor of our property insurance carrier. The letter of credit expires on April 4, 2008. We are required by the property insurance carrier to deliver the letter of credit to cover its losses in the event we default on payments to the carrier. Accordingly, the lender has required us to restrict a portion of our cash equal to the amount of the letter of credit, which we present as restricted cash on the consolidated balance sheet. We also have a $0.8 million letter of credit outstanding from Bank of America in favor of the insurance carrier that issues surety bonds on behalf of the properties we manage. The letter of credit expires on March 31, 2008. We are required by the insurance carrier to deliver the letter of credit to cover its risk in the event the properties default on their required payments related to the surety bonds.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Contingent Liabilities Related to Partnership Interests

 

We own interests in several partnerships and other joint ventures. To the extent that any of these partnerships or joint ventures become unable to pay its obligations, those obligations would become obligations of the general partners. We are not the sole general partner of any of our joint ventures. While we believe we are protected from any risk of liability because our investments in these partnerships as a general partner were conducted through the use of single-purpose entities, to the extent any debtors pursue payment from us, it is possible that we could be held liable for those liabilities, and those amounts could be material.

 

 

Acquisitions

 

In May 2007, we acquired the 495-room Westin Atlanta Airport in Georgia, from an affiliate of Blackstone, for a total acquisition cost of $76.1 million, including normal and customary closing costs. We funded the acquisition through a combination of borrowings on our Credit Facility and cash on hand. From May 24, 2007 to September 30, 2007, hotel revenues and operating income of $8.2 million and $1.7 million, respectively, have been included in our consolidated statement of operations. The acquisition cost of the hotel was allocated as follows (in thousands):

 

 

As the purchase of the Westin Atlanta Airport was a material acquisition, we are providing the pro forma financial information set forth below (in thousands), which represents the combined results as if the acquisition had occurred on January 1, 2006. This pro forma information is not necessarily indicative of the results that actually would have occurred nor does it intend to indicate future operating results.

 

 

In February 2007, we acquired the 297-room Hilton Houston Westchase in Texas, from an affiliate of Blackstone, for a total acquisition cost of $51.9 million, including normal and customary closing costs. We financed the acquisition through a non-recourse mortgage loan of $32.8 million and the remainder with a combination of cash on hand and borrowings on our previous credit facility. From February 8, 2007 to September 30, 2007, hotel revenues and operating income of $11.8 million and $2.6 million, respectively, have been included in our consolidated statement of operations. The acquisition cost of the hotel was allocated as follows (in thousands):

 

 

 

Dispositions

 

On January 26, 2007, we sold our BridgeStreet corporate housing subsidiary for total proceeds of approximately $40.5 million in cash, resulting in income from discontinued operations, net of tax, of approximately $20.5 million. This gain has been recorded as part of discontinued operations for the nine months ended September 30, 2007. Our corporate housing business had been classified as its own reportable segment. We classified the assets and liabilities relating to this subsidiary as held for sale in our consolidated balance sheet at December 31, 2006 as detailed in the following table (in thousands):

 

 

The operations of the corporate housing subsidiary have been classified as discontinued operations in our consolidated statement of operations for all periods presented. The following table summarizes operating results, the gain on the sale, and our segment reporting of our corporate housing subsidiary (in thousands):

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The disposition of our corporate housing subsidiary triggered the recognition of significant differences in the carrying values between tax basis and GAAP basis. As the tax basis was significantly higher, there was a loss realized for tax purposes compared to the $20.5 million gain realized in our statement of operations, resulting in a tax benefit on this disposition for the nine month period ended September 30, 2007.

 

In September 2005, we sold the Pittsburgh Airport Residence Inn by Marriott for $11.0 million and recognized a gain on sale of $2.5 million. We received an additional distribution of $0.2 million during the second quarter of 2007 that had been held in escrow for any contingent liabilities. The resulting adjustment to our gain on sale of $0.1 million (net of tax) has been recorded as part of discontinued operations.

 

 

On January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share Based Payment” (“SFAS No. 123R”) using the modified prospective method. Since January 1, 2003, we have used the Black-Scholes pricing model to estimate the value of stock options granted to employees. The adoption of SFAS No. 123R did not have a material impact on our results of operations or financial position as all of our unvested stock-based awards as of December 31, 2005 had previously been accounted for under the fair value method of accounting.

 

A summary of option activity under the equity-based compensation plans as of September 30, 2007, and changes during the nine months then ended is as follows:

 

 

A summary of the restricted stock activity under the equity-based compensation plans as of September 30, 2007, and changes during the nine months then ended is as follows:

 

 

The total intrinsic value of restricted stock which vested during the nine months ended September 30, 2007 was approximately $0.9 million.

 

The restricted stock awards granted in 2007 vest ratably over four years, except for one employee whose awards vest over three years based on his employment agreement. All restricted stock awards granted in prior years vest ratably over three years.

 

The compensation expense related to stock options and restricted stock awards was $0.3 million and $0.9 million for the three and nine month periods ended September 30, 2007, and $0.2 million and $0.8 million for the three and nine month periods ended September 30, 2006, respectively. As of September 30, 2007, there was

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

$2.2 million and $0.1 million of total unrecognized compensation cost related to unvested restricted stock and unvested stock options, respectively.

 

 

The Internal Revenue Service recently changed the tax law related to the utilization of certain employee tax credits to now allow these credits to be utilized to offset alternative minimum tax. Effective in 2007, certain tax credits are now allowed to be utilized during the current year and carried back to 2006 to offset alternative minimum tax paid. We had previously been carrying a valuation allowance for the anticipated amount which would not have been utilized prior to the change in the tax law. This valuation was removed in the third quarter causing the reduction in our effective tax rate. This change resulted in a reduction in the annualized effective tax rate from 42% to 34% as of September 30, 2007. The tax rate for the quarter reflects the additional tax benefit resulting from the true-up of the annual effective rate.

 

We adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we made a comprehensive review of our tax positions in accordance with the more-likely-than-not standard established by FIN 48. The result of the implementation of FIN 48 did not have a material effect on our consolidated financial position or results of operations.

 

The Company does not believe there will be any material changes in our unrecognized tax positions over the next 12 months.

 

We will recognize interest and penalties accrued related to any unrecognized tax benefits in income tax expense. For the nine months ended September 30, 2007, we did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense or penalties recognized during the quarter.

 

We file income tax returns in the U.S. federal jurisdiction, various state and local jurisdictions, and several foreign jurisdictions in which we operate. As of January 1 and September 30, 2007, our open tax years for federal, state and local jurisdictions that remain subject to examination range from 2001 through 2006.

 

 

In October 2007, Equity Inns completed the previously announced merger with an affiliate of Whitehall Street Global Real Estate Partnership 2007. As of September 30, 2007, we managed 38 properties for Equity Inns, consisting of 4,847 rooms. We continue to manage the 38 properties and notice has not been provided, nor any indication given, of the termination of the underlying management agreements for the 38 properties. We will continue to communicate with the new ownership as to its future plans concerning the management of the properties.

 

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), is intended to help the reader understand Interstate Hotels & Resorts Inc., our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated interim financial statements and the accompanying notes.

 

Forward-Looking Statements

 

The SEC encourages companies to disclose forward-looking information so that investors can better understand a company’s future prospects and make informed investment decisions. In this Quarterly Report on Form 10-Q and the information incorporated by reference herein, we make some “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often, but not always, made through the use of words or phrases such as “will likely result,” “expect,” “will continue,” “anticipate,” “estimate,” “intend,” “plan,” “projection,” “would”, “outlook” and other similar terms and phrases. Any statements in this document about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. Forward-looking statements are based on management’s current expectations and assumptions and are not guarantees of future performance that involve known and unknown risks, uncertainties and other factors which may cause our actual results to differ materially from those anticipated at the time the forward-looking statements are made. These risks and uncertainties include those risk factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2006.

 

Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this Quarterly Report on Form 10-Q, our most recent Annual Report on Form 10-K, and the documents incorporated by reference herein. You should not place undue reliance on any of these forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made and we do not undertake to update any forward-looking statement or statements to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible to predict which will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

Overview and Outlook

 

Our Business  — We are a premier hotel real estate investor and one of the largest independent U.S. hotel management companies not affiliated with a hotel brand, measured by number of rooms under management. We derive our earnings from the ownership of a group of strategic hotel properties and a diversified portfolio of hotel management agreements. While we continue to focus on our core business as a premier provider of hospitality management services, we are also expanding our portfolio of owned hotels in an effort to diversify and enhance our earnings. As such, in 2007, a significant portion of our operating income has been related to owned hotels. We have two reportable operating segments: hotel ownership (through whole-ownership and joint ventures) and hotel management. A third reportable segment, corporate housing, was disposed of on January 26, 2007, with the sale of BridgeStreet, our corporate housing subsidiary. The results of this segment are reported as discontinued operations in our consolidated financial statements for all periods presented.

 

As of September 30, 2007, we owned six hotels with 1,755 rooms and held non-controlling minority interests in 15 joint ventures, which hold ownership interests in 20 of our managed properties. We and our affiliates also managed 184 properties, with 42,435 rooms in 36 states, the District of Columbia, Canada, Russia, Belgium, Ireland and Mexico. Our portfolio of managed properties is diversified by brand, franchise and ownership group. We manage hotels representing more than 30 franchise and brand affiliations and also operate 15 independent hotels. Our managed hotels are owned by more than 65 different ownership groups.

Industry Overview — The lodging industry, of which we are a part, is subject to international and national events. We have been impacted by several events over the previous several years, including the ongoing threat of terrorism and other hostilities, the potential outbreak of infectious disease and natural disasters. As we conduct our business on a national and international level, our activities are also affected by changes in the performance of regional and global economies.

 

During the first nine months of 2007, the U.S. economy experienced trended growth of real GDP by 3% which is expected to continue through the fourth quarter of 2007. In the second half of 2006 and throughout 2007, the significant growth that the lodging industry experienced in 2004 and 2005 began to decelerate. This trend is expected to continue into the fourth quarter of 2007 and through 2008. This deceleration may be compounded by the tightening credit markets, decline in the housing market, increases in oil and energy prices, lower productivity growth, and a broad uncertainty in the general U.S. economy.

 

During the first six months of 2007, RevPAR increased 5.5%, down from 9.5% during the same period in 2006, driven mostly by ADR growth in the current year. Looking forward, RevPAR is forecast to finish the year with an annual RevPAR growth rate of 5.7%, followed in 2008 and 2009 by growth rates of 5.3% and 4.5%, respectively. Supply additions continue to accelerate slightly, which has restrained occupancy growth, and is expected to continue through the remainder of 2007, and into 2009.

 

Our outlook remains optimistic in the near term, as our RevPAR for the nine month period ended September 30, 2007, has grown 8.9% compared to the same period in 2006. This growth has been driven primarily by ADR growth of 7.5%. Occupancy growth also contributed 1.2% to the overall growth.

 

Financial Highlights — During the first nine months of 2007, we continued to highlight our ability to successfully expand and stabilize our income generating activities through our acquisitions of strategic hospitality properties. In January 2007, we sold BridgeStreet for $40.5 million, resulting in a gain on sale of $20.5 million. This transaction provided the ability to recycle capital into our core business, the lodging and hospitality industry, allowing us to leverage our experience and forge stronger returns on our investments and serve as a catalyst for continued future growth. In February 2007, we purchased our fifth wholly-owned property, the Hilton Houston Westchase, and in May 2007, we purchased the Westin Atlanta Airport, our largest wholly-owned acquisition to date. For the nine months ended September 30, 2007, revenues from our owned-hotels were $52.3 million, an increase of $33.7 million compared to the same period in 2006. In addition, operating income from owned-hotels increased by $10.7 million while gross margins increased 330 basis points during the nine month period ended September 30, 2007 compared to the same period in the prior year.

 

While our overall operations have benefited from the acquisitions of wholly-owned real estate, we continue to experience the effects of the significant number of management contracts lost during 2006 and the first nine months of 2007. Total management fees were $32.7 million for the first nine months of 2007, a decrease of $10.5 million from the same period in 2006 (net of the $3.2 million of business interruption proceeds received in the first quarter of 2006). Although our management contract losses have been significant over the past eight quarters, we believe our overall portfolio of third party management agreements is beginning to stabilize as evidenced during the third quarter of 2007, where we realized a net decrease of only three properties.

 

In another effort to diversify our earnings sources, we have continued to expand internationally. In February 2007, we opened our first international office in Moscow in February to capitalize on the potential growth in the international markets. In addition, we commenced the management of four additional international hotels, including our first in Ireland and Belgium. We have also begun managing three resort properties in Mexico through one of our joint venture affiliates. During 2007, we and our affiliates have increased the number of international properties under management to 11 and will continue to diversify our earnings streams through whole and partnership acquisitions of strategic hospitality properties, as well as continue to source new management opportunities both domestically and internationally.

 

Investments in and Acquisitions of Real Estate — In February 2007, we acquired the 297-room Hilton Houston Westchase from affiliates of Blackstone, for a total acquisition price of $51.9 million. We financed part of the acquisition through a non-recourse mortgage loan of $32.8 million and the remainder with a combination of cash on

hand and borrowings on our old credit facility. The hotel is currently undergoing the final phase of an $11 million comprehensive renovation program, of which $8.5 million was completed by the previous owner.

 

In May 2007, we acquired the 495-room Westin Atlanta Airport for a total purchase price of $76.1 million, representing our largest hotel acquisition to date. Simultaneous to amending the Credit Facility, we borrowed an additional $50.0 million of term loans to finance the acquisition, with the remainder paid from cash on hand. The hotel has commenced on a comprehensive $18.0 million renovation program designed to provide all of the full-service features and amenities that travelers have come to expect at a Westin property.

 

We have also been actively seeking joint venture investment opportunities during the first nine months of 2007. In March 2007, we continued to grow our portfolio of joint ventures by investing $0.5 million to acquire a 15% interest in the Radisson Hotel Cross Keys in Baltimore, Maryland. We also contributed an additional $1.2 million to an existing joint venture which will build five to ten aloft ^® hotels over the next several years. Intended to be similar to the W Hotel ^® brand, aloft ^® is the new premium select-service hotel brand being introduced by Starwood Hotels & Resorts Worldwide, Inc. Our joint venture partner is responsible for site selection, construction and development management, while we will operate the hotels. The joint venture has signed long-term franchise agreements for the first two properties. Construction commenced on the first property located in Rancho Cucamonga, CA in January 2007, while the second location in Cool Springs, TN broke ground in August 2007.

 

In July 2007, we formed a strategic partnership with Steadfast Companies (“Steadfast”) to own and operate hotels in Mexico. We advanced $5.7 million to an entity owned by Steadfast in the form of a convertible debt instrument. The debt is convertible upon the approval of the senior lender. Upon conversion, the debt will convert to a 15% ownership interest in the Steadfast entity which currently owns a three-property portfolio of Tesoro ^® resorts. We have received verbal approval for the conversion and are awaiting the completion of the documentation process of the approval from the senior lender, which we expect to receive in the fourth quarter of 2007. The joint venture plans to invest $10.0 million for comprehensive renovations and improvements at all three resort properties in the near future, of which our share will be approximately $1.5 million. We also invested $0.5 million for a 50% interest in a separate joint venture with Steadfast to manage hotels. The new management joint venture took over management of the three-property portfolio of Tesoro ^® resorts upon its formation. This joint venture, which is a platform for further growth in Mexico, took over management of the three-property portfolio immediately upon its formation.

 

In August 2007, we entered a partnership with Premier Properties USA to build three hotels. We will operate all three properties upon the completion of construction and own a 15% equity interest in the partnership. Construction on the first hotel is expected to begin during the fourth quarter of 2007.

 

In September 2007, we, along with affiliates of Investcorp International, Inc., signed a definitive agreement to acquire the 321-room Hilton Seelbach Louisville in Kentucky, the 226-room Crowne Plaza Madison in Wisconsin and the 288-room Sheraton Columbia in Maryland from an affiliate of The Blackstone Group. The Hilton Seelbach and the Crowne Plaza Madison will be owned by a joint venture in which the Company will invest $4.7 million and hold a 15% equity interest.

 

As part of the overall transaction, we will acquire 100% of the third hotel, the Sheraton Columbia, for $46.5 million. We plan to invest $12 million in a comprehensive renovation of the property, including upgrades to all guest rooms and public spaces. We will finance the transaction with a combination of debt financing and cash on hand. The transaction is expected to close during the fourth quarter.

 

Increase in our Borrowing Capacity — In March 2007, we closed on our Credit Facility. The Credit Facility consisted of a $65.0 million term loan and a $60.0 million revolving loan. Upon entering into the Credit Facility, we borrowed $65.0 million under the term loan using a portion of it to pay off the remaining obligation under the old credit facility. In May 2007, we amended the Credit Facility to increase the available limit under our term loan and borrow an additional $50.0 million, increasing the total outstanding balance under our term loan to $115.0 million. The amendment also increased the availability under our revolving loan to $85.0 million. The proceeds from the additional $50.0 million of borrowings under our term loan were used to purchase the Westin Atlanta Airport. The Credit Facility provides for a total borrowing capacity of $200.0 million under the term loan and revolver, compared

to $108.0 million under the previous credit facility. In addition, we have the ability to increase the revolving credit facility and/or term loan by up to $75.0 million, in the aggregate, by seeking additional commitments from lenders.

 

Turnover of Management Contracts — We continued to realize the effects of the significant number of hotel purchase and sale transactions in the real estate market, which reduced the number of properties we manage. We ceased managing 59 hotels during the first nine months of 2007 (two of which we purchased), including the loss of 22 properties owned by CNL Hotels & Resorts, Inc., which were sold as two portfolios. As a result, we were terminated as the manager of 17 of those properties and continue to manage five of these properties for the new owner as of September 30, 2007. In addition, Sunstone REIT sold seven hotels, which resulted in the termination of our management contracts for those properties.

 

During the first nine months of 2007, Blackstone sold 20 hotels, including the Hilton Houston Westchase and Westin Atlanta Airport, which we purchased in February 2007 and May 2007, respectively, and two hotels which we continued to manage as of September 30, 2007, for the new owners. We continued to manage 17 Blackstone properties at September 30, 2007, which accounted for $4.9 million in management fees for the nine months ended September 30, 2007. Termination fees due to us as of September 30, 2007 for hotels previously sold by Blackstone are $17.3 million (assuming Blackstone does not replace the lost management contracts).

 

In summary, the management fees earned for the 59 management contracts terminated in the first nine months of 2007 is as follows (in thousands):