UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
OR
For the Quarter Ended September 10, 2004
Commission File No. 1-13881
MARRIOTT INTERNATIONAL, INC.
10400 Fernwood Road
Bethesda, Maryland 20817
(301) 380-3000
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, and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).
Class
Shares outstanding
at October 1, 2004
Class A Common Stock,
$0.01 par value
INDEX
Part I.
Item 1.
Condensed Consolidated Statements of Income - Twelve and Thirty-Six Weeks Ended September 10, 2004 and September 12, 2003
Condensed Consolidated Balance Sheet - as of September 10, 2004 and January 2, 2004
Condensed Consolidated Statement of Cash Flows - Thirty-Six Weeks Ended September 10, 2004 and September 12, 2003
Item 2.
Item 3.
Item 4.
Part II.
Item 5.
Item 6.
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Forward-Looking Statements
We make forward-looking statements in this document based on the beliefs and assumptions of our management, and on information currently available to us. Forward-looking statements include the information about our possible or assumed future results of operations in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other statements throughout this report preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” or similar expressions.
Forward-looking statements involve risks, uncertainties and assumptions, and our actual results may differ materially from those expressed in our forward-looking statements. We therefore caution you not to rely unduly on any forward-looking statements.
Risks and Uncertainties
You should understand that the following important factors, as well as those discussed in Exhibit 99 and elsewhere in this quarterly report, could cause results to differ materially from those expressed in such forward-looking statements. Because there is no way to determine in advance, whether, or to what extent, any present uncertainty will ultimately impact our business, you should give equal weight to each of the following:
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PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
($ in millions, except per share amounts)
(Unaudited)
REVENUES
Base management fees
Franchise fees
Incentive management fees
Owned, leased, corporate housing and other revenue
Timeshare interval sales and services
Cost reimbursements
Synthetic fuel
OPERATING COSTS AND EXPENSES
Owned, leased and corporate housing – direct
Timeshare – direct
Reimbursed costs
General, administrative and other
OPERATING INCOME
Gains and other income
Interest expense
Interest income
Provision for loan losses
Equity in earnings (losses) -Synthetic fuel
-Other
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND MINORITY INTEREST
(Provision) benefit for income taxes
INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTEREST
Minority interest
INCOME FROM CONTINUING OPERATIONS
Discontinued Operations
Income from Senior Living Services, net of tax
Income (loss) from Distribution Services, net of tax
NET INCOME
EARNINGS PER SHARE – Basic
Earnings from continuing operations
Earnings from discontinued operations
Earnings per share
EARNINGS PER SHARE – Diluted
(Loss) earnings from discontinued operations
DIVIDENDS DECLARED PER SHARE
See Notes to Condensed Consolidated Financial Statements
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CONDENSED CONSOLIDATED BALANCE SHEET
($ in millions)
ASSETS
Current assets
Cash and equivalents
Accounts and notes receivable
Prepaid taxes
Other
Assets held for sale
Property and equipment
Goodwill
Other intangible assets
Equity method investments
Notes and other receivables, net
Loans to equity method investees
Loans to timeshare owners
Other notes receivable
Other long-term receivables
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Accounts payable
Current portion of long-term debt
Long-term debt
Casualty self-insurance reserves
Other long-term liabilities
Shareholders’ equity
Class A common stock
Additional paid-in capital
Retained earnings
Deferred compensation
Treasury stock, at cost
Accumulated other comprehensive loss
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CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
OPERATING ACTIVITIES
Income from continuing operations
Adjustments to reconcile to cash provided by operating activities:
Income from discontinued operations
Discontinued operations – gain on sale/exit
Depreciation and amortization
Minority interest in results of synthetic fuel operation
Income taxes
Timeshare activity, net
Working capital changes
Net cash provided by operating activities
INVESTING ACTIVITIES
Capital expenditures
Dispositions
Loan advances
Loan collections and sales
Net cash provided by investing activities
FINANCING ACTIVITIES
Commercial paper, net
Issuance of long-term debt
Repayment of long-term debt
Issuance of Class A common stock
Dividends paid
Purchase of treasury stock
Earn-outs received (paid), net
Net cash used in financing activities
DECREASE IN CASH AND EQUIVALENTS
CASH AND EQUIVALENTS, beginning of period
CASH AND EQUIVALENTS, end of period
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The condensed consolidated financial statements present the results of operations, financial position and cash flows of Marriott International, Inc. (together with its subsidiaries, we, us or the Company).
The accompanying condensed consolidated financial statements have not been audited. We have condensed or omitted certain information and footnote disclosures normally included in financial statements presented in accordance with United States generally accepted accounting principles. We believe the disclosures made are adequate to make the information presented not misleading. You should, however, read the condensed consolidated financial statements in conjunction with the consolidated financial statements and notes to those financial statements in our Annual Report on Form 10-K for the fiscal year ended January 2, 2004. Certain terms not otherwise defined in this quarterly report have the meanings specified in that Annual Report on Form 10-K.
The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, the reported amounts of sales and expenses during the reporting period and the disclosures of contingent liabilities. Accordingly, our ultimate results could differ from those estimates. We have reclassified certain prior year amounts to conform to our 2004 presentation.
In our opinion, the accompanying condensed consolidated financial statements reflect all normal and recurring adjustments necessary to present fairly our financial position as of September 10, 2004 and January 2, 2004, and the results of our operations for the twelve and thirty-six weeks ended September 10, 2004 and September 12, 2003 and cash flows for the thirty-six weeks ended September 10, 2004 and September 12, 2003. Interim results may not be indicative of fiscal year performance because of seasonal and short-term variations. We have eliminated all material intercompany transactions and balances between entities consolidated in these financial statements.
FIN 46, “Consolidation of Variable Interest Entities,” (the “Interpretation”) was effective for all enterprises with variable interests in variable interest entities created after January 31, 2003. FIN 46(R), which was revised in December 2003, was effective for all entities to which the provisions of FIN 46 were not applied as of December 24, 2003. We applied the provisions of FIN 46(R) to all entities subject to the Interpretation as of March 26, 2004. Under FIN 46(R), if an entity is determined to be a variable interest entity, it must be consolidated by the enterprise that absorbs the majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both.
As a result of adopting FIN 46(R), we consolidated our two synthetic fuel joint ventures as of March 26, 2004. The synthetic fuel joint ventures own four coal-based synthetic fuel production facilities (the “Facilities”). The synthetic fuel produced at the Facilities through 2007 qualifies for tax credits based on Section 29 of the Internal Revenue Code.
While the Facilities produce significant losses, these losses are more than offset by the tax benefit associated with the losses and the tax credits generated under Section 29 of the Internal Revenue Code. At September 10, 2004, the ventures had working capital of $1 million and the book value of the Facilities was $32 million. The ventures have no long-term debt.
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We currently consolidate four other entities which are variable interest entities under FIN 46(R). These entities were established with the same partner to lease four Marriott branded hotels. The combined capital in the four variable interest entities is $4 million, which is used primarily to fund hotel working capital. Our equity at risk is $3 million and we hold 55 percent of the common equity shares. In addition, we guarantee a maximum of $1 million of the lease obligations of one of the hotels, and our total exposure to loss is $4 million.
We have one other significant interest in an entity which is a variable interest entity under FIN 46(R). In February 2001, we entered into a shareholders’ agreement with an unrelated third party to form a joint venture to own and lease luxury hotels to be managed by us. In February 2002, the joint venture signed its first lease with a third party landlord. The initial capital structure of the joint venture is $4 million of debt and $4 million of equity. We hold 35 percent of the equity, or $1 million, and 65 percent of the debt, or $3 million, for a total investment of $4 million. In addition, each equity partner entered into various guarantees with the landlord to guarantee lease payments. Our total exposure under these guarantees is $18 million. Our maximum exposure to loss is $22 million. We do not consolidate the joint venture since we do not bear the majority of the expected losses or expected residual returns.
FIN 46(R) does not apply to qualifying special purpose entities, such as those periodically used by us to sell notes receivable originated by our timeshare business in connection with the sale of timeshare intervals. We will continue to account for these qualifying special purpose entities in accordance with Statement of Financial Accounting Standards (“FAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”
The following table illustrates the reconciliation of the earnings and number of shares used in the basic and diluted earnings per share calculations.
September 10,
2004
September 12,
2003
Computation of Basic Earnings Per Share
Weighted average shares outstanding
Basic earnings per share from continuing operations
Computation of Diluted Earnings Per Share
After-tax interest expense on convertible debt
Income from continuing operations for diluted earnings per share
Effect of dilutive securities
Employee stock option plan
Deferred stock incentive plan
Restricted stock units
Convertible debt
Shares for diluted earnings per share
Diluted earnings per share from continuing operations
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We compute the effect of dilutive securities using the treasury stock method and average market prices during the period. We determine dilution based on earnings from continuing operations.
In accordance with FAS No. 128 “Earnings per Share,” we do not include the following stock options in our calculation of diluted earnings per share because the option exercise prices are greater than the average market price for our Class A Common Stock for the applicable period:
We have several stock-based employee compensation plans that we account for using the intrinsic value method under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, we do not reflect stock-based employee compensation cost in net income for our Stock Option Program, the Supplemental Executive Stock Option awards or the Employee Stock Purchase Plan.
The following table shows stock-based employee compensation costs we recognized in the twelve and thirty-six weeks ended September 10, 2004 and September 12, 2003 and our deferred compensation balance at September 10, 2004 and January 2, 2004.
Deferred share grants
Restricted share grants
Deferred Compensation
Balance at
January 2,
During the thirty-six weeks ended September 10, 2004, we granted approximately 1.6 million units (each representing one share of our Class A common stock) under the restricted stock unit program which began in the first quarter of 2003.
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The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of FAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation. We have included the impact of measured but unrecognized compensation cost and excess tax benefits credited to additional paid-in-capital in the calculation of the diluted pro forma shares for all periods presented.
Net income, as reported
Add: Stock-based employee compensation expense
included in reported net income, net of related tax effects
Deduct: Total stock-based employee compensation
expense determined under fair value-based method forall awards, net of related tax effects
Pro forma net income
Earnings per share:
Basic – as reported
Basic – pro forma
Diluted – as reported
Diluted – pro forma
We defer revenue received from managed, franchised, and Marriott-owned/leased hotels and program partners equal to the fair value of our future redemption obligation. We determine the fair value of the future redemption obligation based on statistical formulas which project timing of future point redemption based on historical levels, including an estimate of the “breakage” for points that will never be redeemed, and an estimate of the points that will eventually be redeemed. These judgmental factors determine the required liability for outstanding points.
Our management and franchise agreements require that we be reimbursed currently for the costs of operating the program, including marketing, promotion, and communicating with, and performing member services for the Marriott Rewards members. Due to the requirement that hotels reimburse us for program operating costs as incurred, we receive and recognize the balance of the revenue from hotels in connection with the Marriott Rewards program at the time such costs are incurred and expensed. We recognize the component of revenue from program partners that corresponds to program maintenance services over the expected life of the points awarded.
Upon the redemption of points, we recognize as revenue the amounts previously deferred, and recognize the corresponding expense relating to the cost of the awards redeemed.
Our liability for the Marriott Rewards program was $883 million at September 10, 2004 and $784 million at January 2, 2004 of which $601 million and $502 million, respectively, are included in other long-term liabilities in the accompanying condensed consolidated balance sheet.
Our total comprehensive income was $131 million and $63 million, for the twelve weeks ended September 10, 2004 and September 12, 2003, respectively, and $412 million and $337 million, respectively, for the thirty-six weeks ended September 10, 2004 and September 12, 2003. The principal difference between net income and comprehensive income for the twelve weeks ended September 10, 2004 relates to foreign currency translation adjustments, while the principal difference between net income and comprehensive income for the thirty-six weeks then ended relates to a change in accounting estimate partially offset by foreign currency translation adjustments. The principal difference between net income and comprehensive income for both the twelve and thirty-six weeks ended September 12, 2003 relates to foreign currency translation adjustments.
For the thirty-six weeks ended September 10, 2004 approximately 3.7 million shares of Class A Common Stock were issued as a result of exercised options.
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We are a diversified hospitality company with operations in five business segments:
We evaluate the performance of our segments based primarily on the results of the segment without allocating corporate expenses, interest expense, and interest income. With the exception of our synthetic fuel segment, we do not allocate income taxes to our segments. The synthetic fuel operation generated a tax benefit and credits of $28 million and $53 million, respectively, for the twelve weeks ended September 10, 2004 and September 12, 2003, and $105 million and $199 million, respectively, for the thirty-six weeks then ended. As timeshare note sales are an integral part of the timeshare business, we include timeshare note sale gains in our timeshare segment results and we allocate other gains as well as equity in earnings (losses) from our joint ventures to each of our segments.
We have aggregated the brands and businesses presented within each of our segments considering their similar economic characteristics, types of customers, distribution channels, and the regulatory business environment of the brands and operations within each segment.
Revenues
Full-Service
Select-Service
Extended-Stay
Timeshare
Total lodging
Income from Continuing Operations
Synthetic fuel (after-tax)
Unallocated corporate expenses
Interest income, provision for loan losses and interest expense
Income taxes (excluding Synthetic fuel)
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Equity in Earnings (Losses) of Equity Method Investees
Corporate
Guarantees
We issue guarantees to certain lenders and hotel owners primarily to obtain long-term management contracts. The guarantees generally have a stated maximum amount of funding and a term of five years or less. The terms of guarantees to lenders generally require us to fund if cash flows from hotel operations are inadequate to cover annual debt service or to repay the loan at the end of the term. The terms of the guarantees to hotel owners generally require us to fund if the affected hotels do not attain specified levels of operating profit.
Our guarantees include $360 million related to Senior Living Services lease obligations and lifecare bonds. Sunrise Senior Living, Inc. (“Sunrise”) is the primary obligor of the leases and a portion of the lifecare bonds, and CNL Retirement Properties, Inc. (“CNL”) is the primary obligor of the remainder of the lifecare bonds. Prior to the sale of the Senior Living Services business at the end of the first quarter of 2003, these pre-existing guarantees were guarantees by the Company of obligations of consolidated Senior Living Services subsidiaries. Sunrise and CNL have indemnified us for any guarantee fundings we may be called on to make in connection with these lease obligations and lifecare bonds.
We also enter into project completion guarantees with certain lenders in conjunction with hotels and timeshare units that we or our joint venture partners are building.
The maximum potential amount of future fundings and the carrying amount of the liability for expected future fundings at September 10, 2004 are as follows:
Guarantee Type
Maximum PotentialAmount of
Future Fundings
Debt service
Operating profit
Senior Living Services
Project completion
Our guarantees of $1,073 million listed above include $92 million for guarantees that will not be in effect until the underlying hotels open and we begin to manage the properties. The $92 million of guarantees not in effect is comprised of $65 million of operating profit guarantees and $27 million of debt service guarantees. Guarantee fundings to lenders and hotel owners are generally recoverable as loans and are generally repayable to us out of future hotel cash flows and/or proceeds from the sale of hotels.
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In addition to the guarantees noted above, in conjunction with financing obtained for specific projects or properties owned by joint ventures in which we are a party, we may provide industry standard indemnifications to the lender for loss, liability, or damage occurring as a result of the actions of the other joint venture owner or our own actions, in each case limited to the lessor of (i) our ownership interest in the entity; or (ii) the actual loss, liability or damage occurring as a result of our actions.
Also in addition to the guarantees noted above, we have guaranteed lease obligations with minimum annual payments of approximately $56 million and total remaining payments through the initial term plus available extensions of approximately $1.46 billion. We also guarantee payment of real estate taxes and other charges associated with the leases. Third parties have severally indemnified us for all payments we may be required to make. Since we assumed these guarantees seven years ago we have not funded any amounts, and we do not expect to fund any amounts under these guarantees in the future.
Loan Commitments and Letters of Credit
As of September 10, 2004, we had extended approximately $80 million of loan commitments to owners of lodging properties under which we expect to fund approximately $34 million by December 31, 2004, and $18 million over the following two years. We do not expect to fund the remaining $28 million of commitments, which expire as follows: $14 million in one to three years; and $14 million after five years.
At September 10, 2004, we also had $123 million of letters of credit outstanding on our behalf, the majority of which are related to our self-insurance programs. Surety bonds issued on our behalf as of September 10, 2004, totaled $420 million, the majority of which were requested by federal, state, or local governments related to our timeshare and lodging operations and self-insurance programs.
Litigation and Arbitration
CTF/HPI arbitration and litigation. On April 8, 2002, we initiated an arbitration proceeding against CTF Hotel Holdings, Inc. (CTF) and its affiliate, Hotel Property Investments (B.V.I.) Ltd. (HPI), in connection with a dispute over procurement and other issues for certain Renaissance hotels and resorts that we manage for CTF and HPI. On April 12, 2002, CTF filed a lawsuit in U.S. District Court in Delaware against us and Avendra LLC, alleging that, in connection with procurement at 20 of those hotels, we engaged in improper acts of self-dealing, and claiming breach of fiduciary, contractual and other duties; fraud; misrepresentation; and violations of the RICO and the Robinson-Patman Acts. CTF seeks various remedies, including a stay of the arbitration proceedings against CTF and unspecified actual, treble and punitive damages. The district court enjoined the arbitration with respect to CTF, but granted our request to stay the court proceedings pending the resolution of the arbitration with respect to HPI. Both parties have appealed that ruling. The arbitration panel hearing on the matter began April 6, 2004 and concluded on June 11, 2004. Briefing is concluded and the matter is now before the panel for decision.
In a decision dated August 23, 2004, a panel of the Third Circuit affirmed the district court’s stay of the arbitration as to CTF but reversed the district court’s stay of the trial. On September 7, 2004, we filed with the Third Circuit a petition for rehearing and for rehearing en banc in which we asked the court to reconsider its decision vacating the stay of the trial. The petition was denied on September 24, 2004.
We believe that CTF’s and HPI’s claims against us are without merit, and we intend to vigorously defend against them. However, we cannot assure you as to the outcome of the arbitration or the related litigation; nor can we currently estimate the range of any potential losses to the Company.
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Our long-term debt at September 10, 2004 and January 2, 2004, consisted of the following:
Senior Notes:
Series B, interest rate of 6.875%, maturing November 15, 2005
Series C, interest rate of 7.875%, maturing September 15, 2009
Series D, interest rate of 8.125%, maturing April 1, 2005
Series E, interest rate of 7.0%, maturing January 15, 2008
Other senior note, interest rate of 3.114% at January 2, 2004, matured April 1, 2004
Commercial paper, average interest rate of 1.2% at September 10, 2004
Mortgage debt, average interest rate of 7.9%, maturing May 1, 2025
LYONs
Less current portion
As of September 10, 2004 all debt, other than mortgage debt and $10 million of other debt, is unsecured.
On April 7, 2004, we sent notice to the holders of our Liquid Yield Option Notes due 2021 (the “Notes”), that, subject to the terms of the indenture governing the Notes, we would purchase for cash, at the option of each holder, any Notes tendered by the holder and not withdrawn on May 10, 2004, at a purchase price of $880.50 per $1,000 principal amount at maturity. The Notes, issued on May 8, 2001, carried a yield to maturity of 0.75 percent, and were convertible into approximately 0.9 million shares of our Class A Common Stock.
Holders of all outstanding Notes, approximately $70 million aggregate principal amount at maturity, tendered their Notes for repurchase. Accordingly, on May 11, 2004, we repurchased all of the outstanding Notes for aggregate cash consideration of approximately $62 million. No Notes remain outstanding following the purchase.
On April 1, 2004, Cendant exercised its option to redeem our interest in the Two Flags joint venture, which at that time owned the trademarks and licenses for the Ramada and Days Inn lodging brands in the United States. In the third quarter of 2004, we recorded a pre-tax gain of approximately $13 million in connection with this transaction when we collected our $200 million note receivable and the sale was complete.
For our entire 2003 fiscal year, we earned $24 million from our interest in the Two Flags joint venture, which was reflected as equity in earnings in the income statement. In the third quarter of 2003, our equity earnings included $5 million attributable to our interest in the Two Flags joint venture, while our third quarter 2004 equity earnings reflect no impact associated with the Two Flags joint venture due to the redemption of our interest. We recognized equity in earnings from the Two Flags joint venture of $6 million and $17 million for the thirty-six weeks ended September 10, 2004 and September 12, 2003, respectively. For the twelve and thirty-six weeks ended September 10, 2004 we recognized $4 million and $8 million, respectively, of interest income in connection with the $200 million note, collected in the third quarter of 2004, related to the purchase of our interest in the Two Flags joint venture.
We continue to own the trademarks and licenses for Ramada International outside of the United States, operate and franchise hotels outside of the United States and Canada under the Ramada International brand name, and license the Ramada name in Canada to Cendant. However, subsequent to the third quarter 2004, the Company and Cendant signed a non-binding letter of intent for Cendant to purchase Ramada
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International, primarily a franchised brand from the Company. The transaction, which we expect to complete during the fourth quarter of 2004, is still pending approval by regulatory authorities and final negotiation of terms. We do not expect that the transaction will have a material impact to the Company.
In the second quarter of 2004, we sold $150 million of notes receivable generated by our timeshare business in connection with the sale of timeshare intervals. In conjunction with the sale, we received net proceeds of $141 million, retained residual interests of $33 million, and recorded a gain of $27 million. We used the following key assumptions to measure the fair value of the residual interests: discount rate of 7.9 percent; expected annual prepayments, including defaults, of 18.5 percent; expected weighted average life of prepayable notes receivable, excluding prepayments and defaults, of 81 months; and expected weighted average life of prepayable notes receivable, including prepayments and defaults, of 41 months. Our key assumptions are based on experience.
In October 2001, we acquired four coal-based synthetic fuel production facilities (the “Facilities”) for $46 million in cash from PacifiCorp Financial Services (“PacifiCorp”). Three of the four plants are held in one entity and one of the plants is held in a separate entity. The synthetic fuel produced at the Facilities through 2007 qualifies for tax credits based on Section 29 of the Internal Revenue Code (credits are not available for fuel produced after 2007). We began operating these Facilities in the first quarter of 2002. Although the Facilities produce significant losses, these losses are more than offset by the tax credits generated under Section 29, which reduce our income tax expense.
On June 21, 2003, we sold an approximately 50 percent ownership interest in the synthetic fuel entities. We received cash and promissory notes totaling $25 million at closing, and we are receiving additional profits that we expect will continue over the life of the ventures based on the actual amount of tax credits allocated to the purchaser.
As a result of a put option, we consolidated the two synthetic fuel joint ventures through November 6, 2003. Effective November 7, 2003, because the put option was voided, we began accounting for the synthetic fuel joint ventures, using the equity method of accounting. Beginning March 26, 2004, as a result of adopting FIN 46(R), we have again consolidated the synthetic fuel joint ventures and we reflect our partner’s share of the operating losses as minority interest.
In July 2004 Internal Revenue Service (“IRS”) field auditors issued a notice of proposed adjustment and later a Summary Report to PacifiCorp that included a challenge to the placed-in-service dates of three of the four synthetic fuel facilities owned by one of our synthetic fuel joint ventures. One of the conditions to qualify for tax credits under Section 29 of the Internal Revenue Code is that the production facility must have been placed-in-service before July 1, 1998.
We strongly believe that all the facilities meet the placed-in-service requirement. Although we are engaged in discussions with the IRS and are confident this issue will be resolved in our favor and not result in a material charge to us, we cannot assure you as to the ultimate outcome of this matter.
On October 6, 2004, subsequent to the end of the third quarter, we entered into amendment agreements with our synthetic fuel partner that result in a shift in the allocation of tax credits between us. On the synthetic fuel facility that is not being reviewed by the IRS, our partner will increase its allocation of tax credits from approximately 50 percent to 90 percent for the next six months and pay a higher price per tax credit to us for that additional share of tax credits. With respect to the three synthetic fuel facilities under IRS review, our partner will reduce its allocation of tax credits from approximately 50 percent to an average of roughly 5 percent during the next six months. If the IRS’ placed-in-service challenge regarding the three facilities is not successfully resolved by March 31, 2005, our partner will have the right to return
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its ownership interest in those three facilities to Marriott at that time. We will have the flexibility to continue to operate at current levels, reduce production, and/or sell an interest to another party. If there is a successful resolution by March 31, 2005 our partner’s share of the tax credits from all four facilities will return to approximately 50 percent. In any event, on March 31, 2005, our share of the tax credits from the one facility not under review will return to approximately 50 percent.
Since acquiring the plants, we have recognized approximately $384 million of tax credits from all four plants through September 10, 2004. The tax credits recognized through September 10, 2004 associated with the three facilities in question totaled approximately $283 million.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
CONSOLIDATED RESULTS
Continuing Operations
The following discussion presents an analysis of results of our operations for the twelve and thirty-six weeks ended September 10, 2004 and September 12, 2003.
Twelve Weeks Ended September 10, 2004 Compared to Twelve Weeks Ended September 12, 2003
Revenues increased 9 percent to $2,304 million in 2004, primarily reflecting higher fees resulting from strong demand for hotel rooms and unit expansion, as well as strong timeshare demand.
Operating Income
Operating income increased $9 million to $99 million in 2004. The increase is primarily due to higher fees which are related both to stronger REVPAR driven principally by increased occupancy and average daily rate and to the growth in the number of rooms, and stronger timeshare results reflecting strong demand and improved margins, partially offset by higher general and administrative expenses and a higher synthetic fuel operating loss associated with both higher production and the inclusion of net synthetic earn-out payments received as a component of gains and other income in 2004.
Total lodging financial results
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Income from continuing operations increased 42 percent to $132 million in 2004, and diluted earnings per share from continuing operations increased 45 percent to $0.55. The favorable results were primarily driven by strong hotel demand, new unit growth, strong timeshare results, increased gains, higher net interest and strong synthetic fuel results which include both the tax benefit associated with the losses and the tax credits, and a favorable minority interest variance, partially offset by higher income taxes excluding the synthetic fuel impact and higher general and administrative expenses.
Marriott Lodging
We consider lodging revenues and lodging financial results to be meaningful indicators of our performance because they measure our growth in profitability as a lodging company and enable investors to compare the sales and results of our lodging operations to those of other lodging companies.
Lodging, which includes our Full-Service, Select-Service, Extended-Stay, and Timeshare segments, reported financial results of $175 million in the third quarter of 2004, compared to $140 million in the third quarter of 2003 and revenues of $2,217 million in the third quarter of 2004, a 10 percent increase from revenues of $2,016 million in the third quarter of 2003. The results reflect a 16 percent increase in base, franchise and incentive fees, from $165 million in the third quarter of 2003 to $192 million in the third quarter of 2004, favorable timeshare results and increased gains of $9 million. The increase in base and franchise fees was driven by higher REVPAR for comparable rooms, primarily resulting from both domestic and international occupancy and rate increases and new unit growth. We have added 177 properties (28,376 rooms) and deflagged 48 properties (7,675 rooms) since the third quarter of 2003. Systemwide REVPAR for comparable North American properties increased 7.7 percent, and REVPAR for our comparable North American company-operated properties increased 8.3 percent. Systemwide REVPAR for comparable international properties, including Ritz-Carlton, increased 15.6 percent, and REVPAR for comparable international company-operated properties including Ritz-Carlton increased 17.6 percent. The increase in incentive management fees during the quarter reflects the impact of increased international travel, particularly in Asia, and increased business at properties in North America. Worldwide REVPAR for comparable company-operated properties increased 10.6 percent while worldwide REVPAR for comparable systemwide properties increased 9.3 percent.
Our properties in the southeast region of the United States experienced cancellations and a few properties closed due to mandatory evacuations and power outages resulting from hurricanes Frances and Charley in the 2004 third quarter. However, the post hurricane business from area residents, Federal Emergency Management Agency (“FEMA”), and insurance company representatives offset most of the impact.
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Summary of Properties by Brand. We opened 36 lodging properties (6,045 rooms) during the third quarter of 2004, while 21 hotels (2,962 rooms) exited the system, increasing our total properties to 2,806 (505,658 rooms). The following table shows properties by brand as of September 10, 2004 (excluding 2,547 rental units relating to Marriott ExecuStay):
Brand
Full-Service Lodging
Marriott Hotels & Resorts
Marriott Conference Centers
JW Marriott Hotels & Resorts
The Ritz-Carlton
Renaissance Hotels & Resorts
Ramada International
Bulgari Hotel & Resort
Select-Service Lodging
Courtyard
Fairfield Inn
SpringHill Suites
Extended-Stay Lodging
Residence Inn
TownePlace Suites
Marriott Executive Apartments
Marriott Vacation Club International
The Ritz-Carlton Club
Marriott Grand Residence Club
Horizons by Marriott Vacation Club International
Total
REVPAR. We consider Revenue per Available Room (REVPAR) to be a meaningful indicator of our performance because it measures the period over period change in room revenues for comparable properties. We calculate REVPAR by dividing room sales for comparable properties by room nights available to guests for the period. REVPAR may not be comparable to similarly titled measures such as revenues.
The following table shows occupancy, average daily rate and REVPAR for each of our comparable principal established brands. We have not presented statistics for company-operated North American Fairfield Inn and SpringHill Suites properties here because we operate only a limited number of properties as both these brands are predominantly franchised and such information would not be meaningful for those brands (identified as “nm” in the table below). Systemwide statistics include data from our franchised properties, in addition to our owned, leased and managed properties. For North American properties (except for The Ritz-Carlton which includes June through August), the occupancy, average daily rate and REVPAR statistics used throughout this report for the twelve weeks ended September 10, 2004, include the period from June 19, 2004 through September 10, 2004, while the twelve weeks ended September 12, 2003, include the period from June 21, 2003 through September 12, 2003.
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Marriott Hotels & Resorts (1)
Occupancy
Average Daily Rate
REVPAR
The Ritz-Carlton (2)
Composite – Full-Service (3)
Composite – Select-Service & Extended-Stay (4)
Composite – All (5)
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Systemwide international statistics by region are based on comparable worldwide units, excluding North America. The following table shows occupancy, average daily rate and REVPAR for international properties by region/brand.
Caribbean & Latin America
Average daily rate
Continental Europe
United Kingdom
Middle East & Africa
Asia Pacific (3)
Sub-total Composite International (4), (5)
The Ritz-Carlton International
Total Composite International (4)
Total Worldwide (6)
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Segment results
Full-Service Lodging includes our Marriott Hotels & Resorts, The Ritz-Carlton, Renaissance Hotels & Resorts, Ramada International and Bulgari Hotels & Resorts brands. Our third quarter 2004 segment results reflect a $13 million increase in base management, incentive management and franchise fees, partially offset by higher general and administrative costs. The increase in fees is largely due to higher REVPAR, reflecting occupancy and rate increases, and the growth in the number of rooms. Since the third quarter of 2003, across our Full-Service Lodging segment, we have added 70 hotels (14,337 rooms) and deflagged 19 hotels (3,995 rooms).
Gains were flat with last year, while equity results were slightly lower than last year. On April 1, 2004, Cendant exercised its option to redeem our interest in the Two Flags joint venture, which owns the trademarks and licenses for the Ramada and Days Inn lodging brands in the United States. In the third quarter of 2003, our equity earnings included $5 million attributable to our interest in the Two Flags joint venture, while our third quarter 2004 equity earnings do not reflect any amounts associated with the Two Flags joint venture due to the redemption of our interest. We recorded a pre-tax gain of approximately $13 million in the third quarter of 2004 when we received the proceeds from the Two Flags sale. In the prior year quarter we recognized a $9 million gain associated with our sale of an international joint venture.
REVPAR for Full-Service Lodging comparable company-operated North American hotels increased 8.2 percent to $104.45. Occupancy for these hotels increased to 73.7 percent, while average daily rates increased 4.1 percent to $141.64.
Financial results for our international operations were strong across most regions, generating a 17.6 percent REVPAR increase for comparable company-operated hotels including Ritz-Carlton. Occupancy increased 6.7 percentage points, while average daily rates increased to $121.56. International operations were unfavorably impacted by SARS in 2003. As noted above, in the year ago quarter we recognized a $9 million gain associated with our sale of an international joint venture. Versus the prior year quarter, we experienced stronger demand particularly in China, Hong Kong, Australia, Egypt and Brazil.
Select-Service Lodging includes our Courtyard, Fairfield Inn and SpringHill Suites brands. The $14 million increase in segment results reflects a $9 million increase in base management, incentive management and franchise fees, a favorable variance of $4 million on gains, essentially flat equity results, and flat general and administrative costs. The increase in fees is largely due to higher REVPAR, driven primarily by occupancy and rate increases, and the growth in the number of rooms. Across our Select-Service Lodging segment, we have added 84 hotels (10,425 rooms) and deflagged 26 hotels (3,539 rooms) since the third quarter of 2003.
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Extended-Stay Lodging includes our Residence Inn, TownePlace Suites, Marriott Executive Apartments, and Marriott ExecuStay brands. The decline in revenue is primarily attributable to the shift in the ExecuStay business towards franchising. Our base and incentive management fees were roughly flat compared to last year while our franchise fees, principally associated with our Residence Inn brand, increased $2 million. The increase in franchise fees is largely due to higher REVPAR and the growth in the number of rooms. Since the third quarter of 2003, across our Extended-Stay Lodging segment, we have added 21 hotels (2,303 rooms) and deflagged one hotel (80 rooms). In addition, we recorded $4 million of gains in 2004 versus no gains in 2003. ExecuStay experienced improved results compared to the prior year quarter, resulting from increased occupancy and rate, primarily in the New York market, along with reduced operating costs associated with the shift towards franchising.
REVPAR for Select-Service and Extended-Stay Lodging comparable company-operated North American hotels increased 8.4 percent to $71.32. Occupancy for these hotels increased to 76.5 percent, while average daily rates increased 4.4 percent to $93.25.
Timeshareincludes our Marriott Vacation Club International, The Ritz-Carlton Club, Marriott Grand Residence Club and Horizons by Marriott Vacation Club International brands. Timeshare revenues of $348 million in 2004 and $328 million in 2003, include interval sales, base management fees and cost reimbursements. Including our three joint ventures, contract sales, which represent sales of timeshare intervals before adjustment for percentage of completion accounting, increased 25 percent primarily due to strong demand in South Carolina, California, and Nevada. The favorable segment results reflect a 1 percent increase in timeshare interval sales and services, higher margins primarily resulting from the use of lower cost marketing channels, the mix of units sold and lower financing costs, partially offset by higher general and administrative expenses. Additionally, the third quarter 2003 results were impacted by a $2 million loss associated with an interest rate swap agreement. Reported revenue growth trailed contract sales growth because of a higher proportion of sales in joint venture projects and projects with lower average construction completion levels.
Synthetic Fuel
For the twelve weeks ended September 10, 2004, the synthetic fuel operation generated revenue of $87 million and income from continuing operations of $31 million comprised of: operating losses of $31 million and a $1 million tax provision, offset by net earn-out payments received of $19 million, tax credits of $29 million, and minority interest of $15 million reflecting our partner’s share of the operating losses.
For the twelve weeks ended September 12, 2003, the synthetic fuel operation generated revenue of $93 million and income from continuing operations of $21 million comprised of: operating losses of $3 million, which includes net earn-out payments made of $5 million; and minority interest expense of
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$29 million, reflecting our partner’s share of the tax credits, tax benefits and operating losses; a $1 million tax benefit; and tax credits of $52 million. The $10 million increase in synthetic fuel results to $31 million from $21 million is primarily due to our sale of a 50 percent interest in the synthetic fuel joint ventures in the third quarter of 2003 and to slightly higher production in 2004. In connection with the sale, a higher percentage (90 percent) of the tax credits was allocated to our joint venture partner in the 2003 third quarter compared to roughly 50 percent in the 2004 third quarter. See Note 12, “Synthetic Fuel” in Part I, Item 1, Notes to Condensed Consolidated Financial Statements, for further information related to our synthetic fuel operations.
General, Administrative and Other Expenses
General, administrative and other expenses increased $9 million in the third quarter of 2004 to $126 million, reflecting higher administrative expenses in both our lodging and timeshare businesses, primarily associated with increased overhead costs related to the Company’s unit growth and increased development costs associated with our timeshare joint ventures. Lower litigation expenses of $9 million in 2004 were offset by $10 million of insurance proceeds received in 2003.
Gains and Other Income
The following table shows our gains and other income for the twelve weeks ended September 10, 2004 and September 12, 2003:
Net synthetic fuel earn-out payments received
Gains on sale of real estate
Gains on sale of joint ventures
Interest Expense
Interest expense decreased $3 million to $23 million primarily due to the repayment of $234 million of senior debt in the fourth quarter of 2003 and other debt reductions, partially offset by lower capitalized interest resulting from fewer projects under construction.
Interest Income and Income Tax
Interest income, before the provision for loan losses increased $2 million (6 percent) to $33 million, reflecting higher loan balances and higher rates. For the twelve weeks ended September 10, 2004 we recognized $4 million of interest income in connection with the $200 million note, collected in the third quarter of 2004, related to the purchase of our interest in the Two Flags joint venture.
Income from continuing operations before income taxes generated a tax provision of $28 million in the third quarter of 2004, compared to a tax benefit of $16 million in 2003. The difference is primarily attributable to the impact of our synthetic fuel joint ventures, which generated a tax benefit and tax credits of $28 million in 2004, compared to $53 million in 2003, and to higher pre-tax income. In the 2003 third quarter, we sold a 50 percent interest in our synthetic fuel joint ventures and we currently consolidate the joint ventures.
Minority Interest
The principal difference between minority interest for the third quarter of 2004 versus the third quarter of 2003 is related to the change in the ownership structure of the synthetic fuel joint ventures as a result of the sale of 50 percent of our interest in the joint ventures. Due to the purchaser’s put option which expired on November 6, 2003, minority interest for the third quarter of 2003 reflected our partner’s share of the synthetic fuel operating losses and their share of the associated tax benefit along with their share of the tax credits. For the third quarter of 2004, minority interest reflects our partner’s share of the synthetic fuel losses only.
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Thirty-Six Weeks Ended September 10, 2004 Compared to Thirty-Six Weeks Ended September 12, 2003
Revenues increased 13 percent to $6,958 million in 2004, reflecting higher fees related to increased demand for hotel rooms and unit expansion, as well as strong sales in our timeshare segment.
Operating income increased $152 million to $368 million in 2004. The increase is primarily due to higher fees which are related both to stronger REVPAR driven principally by increased occupancy and average daily rate and to the growth in the number of rooms, and stronger timeshare results which are mainly attributable to strong demand and improved margins, partially offset by higher general and administrative expenses and a higher synthetic fuel operating loss associated with both higher production, the change in the ownership structure of the joint ventures as a result of the sale of 50 percent of our interest in the joint ventures and the inclusion of net synthetic fuel earn-out payments received as a component of gains and other income in 2004.
For the thirty-six weeks ended September 10, 2004, the synthetic fuel operation generated $61 million of operating losses compared to operating losses of $104 million for the thirty-six weeks ended September 12, 2003. For the thirty-six weeks ended September 12, 2003, 100 percent of the operating losses of the synthetic fuel joint ventures were recorded by us. While we sold a 50 percent ownership interest in the synthetic fuel joint ventures in the 2003 third quarter, we continued to consolidate the joint ventures in the 2003 third quarter because the purchaser had a put option, which expired November 6, 2003, wherein the purchaser had the ability to return its ownership interest to us. Effective November 7, 2003, as a result of the put option’s expiration, we began accounting for the synthetic fuel joint ventures using the equity method of accounting, and therefore our share of the losses of the synthetic fuel joint ventures were recorded below operating income in the first quarter of 2004. As a result of adopting FIN 46(R) on March 26, 2004, we again consolidated the synthetic fuel joint ventures and recorded 100 percent of the operating losses during the second and third quarters as a component of operating income.
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Income from continuing operations increased 33 percent to $406 million, and diluted earnings per share from continuing operations increased 35 percent to $1.69. The favorable results were primarily driven by strong hotel demand, new unit growth, strong timeshare results, higher interest income as a result of higher balances and rates, lower interest expense due to debt reductions, lower loan loss provisions, stronger synthetic fuel results and increased gains of $41 million, partially offset by higher income taxes excluding the synthetic fuel impact, and higher general and administrative expenses. In addition, international operations were unfavorably impacted by the war in Iraq and SARS in 2003.
Lodging, which includes our Full-Service, Select-Service, Extended-Stay, and Timeshare segments, reported financial results of $579 million in the first three quarters of 2004, compared to $462 million in the first three quarters of 2003 and revenues of $6,760 million in the first three quarters of 2004, a 14 percent increase from revenues of $5,924 million in the first three quarters of 2003. The results reflect a 17 percent increase in base, franchise and incentive fees, from $510 million in the first three quarters of 2003 to $599 million in the first three quarters of 2004, favorable timeshare results and increased gains of $13 million. The increase in base and franchise fees was driven by higher REVPAR for comparable rooms primarily resulting from both domestic and international occupancy and average daily rate increases and new unit growth. Systemwide REVPAR for comparable North American properties increased 7.5 percent, and REVPAR for our comparable North American company-operated properties increased 7.8 percent. Systemwide REVPAR for comparable international properties, including Ritz-Carlton, increased 17.4 percent, and REVPAR for comparable international company-operated properties including Ritz-Carlton increased 20.0 percent. The increase in incentive management fees during the first three quarters of the year reflects the impact of increased international travel, particularly in Asia, and increased business at properties in North America. We have added 177 properties (28,376 rooms) and deflagged 48 properties (7,675 rooms) since the third quarter of 2003. Worldwide REVPAR for comparable company-operated properties increased 10.6 percent while worldwide REVPAR for comparable systemwide properties increased 9.4 percent.
The following table shows occupancy, average daily rate and REVPAR for each of our comparable principal established brands. We have not presented statistics for company-operated North American Fairfield Inn and SpringHill Suites properties because we operate only a limited number of properties as both these brands are
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predominantly franchised and such information would not be meaningful for those brands (identified as “nm” in the table below). Systemwide statistics include data from our franchised properties, in addition to our owned, leased and managed properties. For North American properties (except for The Ritz-Carlton which includes January through August), the occupancy, average daily rate and REVPAR statistics used throughout this report for the thirty-six weeks ended September 10, 2004, include the period from January 3, 2004 through September 10, 2004, while the thirty-six weeks ended September 12, 2003, include the period from January 4, 2003 through September 12, 2003.
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Comparable Systemwide
North American Properties
Thirty-Six Weeks
Ended September 10, 2004
29
30
Change
2004/2003
Full-Service Lodging includes our Marriott Hotels & Resorts, The Ritz-Carlton, Renaissance Hotels & Resorts, Ramada International and Bulgari Hotels & Resorts brands. The 2004 segment results reflect a $57 million increase in base management, incentive management and franchise fees, partially offset by increased administrative costs. The increase in fees is largely due to stronger REVPAR, driven primarily by occupancy and rate increases, and the growth in the number of rooms. Since the third quarter of 2003, across our Full-Service Lodging segment, we have added 70 hotels (14,337 rooms) and deflagged 19 hotels (3,995 rooms).
Gains were up $4 million and joint venture results were down $4 million compared to the prior year. On April 1, 2004, Cendant exercised its option to redeem our interest in the Two Flags joint venture, which owns the trademarks and licenses for the Ramada and Days Inn lodging brands in the United States. In the first three quarters of 2003, our equity earnings included $17 million attributable to our interest in the Two Flags joint venture, while our equity in earnings for the first three quarters of 2004 reflect only a $6 million impact due to the redemption of our interest. We recorded a pre-tax gain of $13 million in the third quarter of 2004 when we received the proceeds from the Two Flags sale. In the prior year third quarter we recognized a $9 million gain associated with our sale of an international joint venture.
REVPAR for Full-Service Lodging comparable company-operated North American hotels increased 7.8 percent to $110.12. Occupancy for these hotels increased to 72.8 percent, while average daily rates increased 2.6 percent to $151.35.
Financial results for our international operations were strong across most regions, generating a 20.0 percent REVPAR increase for comparable company-operated hotels including Ritz-Carlton. Occupancy increased 8.9 percentage points, while average daily rates increased to $127.66. International operations were unfavorably impacted by SARS in 2003. As noted above, in the year ago third quarter we recognized a $9 million gain associated with our sale of an international joint venture. Versus the prior year, we experienced stronger demand particularly in China, Hong Kong, Australia, Brazil, Egypt, Mexico, and the United Kingdom.
Select-Service Lodging includes our Courtyard, Fairfield Inn and SpringHill Suites brands. The increase in revenues over the prior year, reflects stronger REVPAR, driven primarily by occupancy and rate increases, and the growth in the number of rooms across our select-service brands. Base management, incentive management and franchise fees increased $21 million, and gains were $10 million higher than the prior year period. These increases were partially offset by reserves recorded for performance guarantees we expect to fund and an increase in administrative costs, resulting in an increase in segment results from $81 million in 2003 to $104 million in 2004. Across our Select-Service Lodging segment, we have added 84 hotels (10,425 rooms) and deflagged 26 hotels (3,539 rooms) since the third quarter of 2003.
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Extended-Stay Lodging includes our Residence Inn, TownePlace Suites, Marriott Executive Apartments, and Marriott ExecuStay brands. The decline in revenue is primarily attributable to the shift in the ExecuStay business towards franchising. Our base and incentive management fees were essentially flat with last year while our franchise fees, principally associated with our Residence Inn brand, increased $7 million. The increase in franchise fees is largely due to the growth in the number of rooms and an increase in REVPAR. Since the third quarter of 2003 we have added 21 hotels (2,303 rooms) and deflagged one hotel (80 rooms). In addition, gains of $8 million in 2004 were favorable to the prior year by $3 million. ExecuStay experienced improved results compared to the first three quarters of last year, resulting from increased occupancy, primarily in the New York market, coupled with lower operating costs associated with the shift in business towards franchising.
REVPAR for Select-Service and Extended-Stay Lodging comparable company-operated North American hotels increased 7.9 percent to $69.38. Occupancy for these hotels increased to 73.9 percent, while average daily rates increased 3.3 percent to $93.85.
Timeshareincludes our Marriott Vacation Club International, The Ritz-Carlton Club, Marriott Grand Residence Club and Horizons by Marriott Vacation Club International brands. Timeshare revenues of $1,083 million and $856 million, in 2004 and 2003, respectively, include interval sales, base management fees and cost reimbursements. Including our three joint ventures, contract sales, which represent sales of timeshare intervals before adjustment for percentage of completion accounting, increased 36 percent primarily due to strong demand in South Carolina, Florida, Hawaii, California, St. Thomas and Aruba. The favorable segment results reflect a 17 percent increase in timeshare interval sales and services, higher margins primarily resulting from the use of lower cost marketing channels, and the mix of units sold, partially offset by a lower note sale gain and higher administrative expenses. Our note sale in the second quarter of 2004 resulted in a $27 million gain versus a $32 million gain in the second quarter of 2003. In addition to a lower note sale gain, we adjusted the discount rate used in determining the fair value of our residual interests due to current trends in interest rates, and recorded a $7 million charge in the second quarter of 2004. Additionally, the 2003 results reflected a $2 million loss associated with an interest rate swap agreement. Reported revenue growth trailed contract sales growth because of a higher proportion of sales in joint venture projects and projects with lower average construction completion.
For the thirty-six weeks ended September 10, 2004, the synthetic fuel operation generated revenue of $198 million and income from continuing operations of $73 million comprised of second and third quarter items: operating losses of $61 million, offset by net earn-out payments received of $28 million, a $2 million tax benefit, tax credits which amounted to $64 million, and minority interest of $29 million reflecting our partner’s share of the operating losses, and first quarter items: equity losses of $28 million, which include net earn-out payments made of $6 million, a tax benefit of $10 million and tax credits which amounted to $29 million.
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For the thirty-six weeks ended September 12, 2003, the synthetic fuel operation generated revenue of $224 million and income from continuing operations of $66 million comprised of: operating losses of $104 million, which includes net earn-out payments made of $37 million; minority interest expense of $29 million reflecting our partner’s share of the tax credits, tax benefits, and operating losses; a $37 million tax benefit; and tax credits which amounted to $162 million. The $7 million increase in synthetic fuel results to $73 million from $66 million is primarily due to our sale of a 50 percent interest in the synthetic fuel joint ventures in the third quarter of 2003 and to slightly higher production in 2004. In connection with the sale, a higher percentage (90 percent) of the tax credits was allocated to our joint venture partner in the 2003 third quarter compared to roughly 50 percent in the 2004 third quarter. See Note 12, “Synthetic Fuel” in Part I, Item 1, Notes to Condensed Consolidated Financial Statements, for further information related to our synthetic fuel operations.
General, administrative and other expenses increased $49 million in the first three quarters of 2004 to $385 million, reflecting higher administrative expenses in both our lodging and timeshare businesses, primarily associated with increased overhead costs related to the Company’s unit growth and increased development costs associated with our timeshare joint ventures, as well as $3 million of higher litigation expenses, a $6 million reduction in foreign exchange gains, and $10 million of insurance proceeds received in 2003, partially offset by lower deferred compensation expenses.
The following table shows our gains and other income for the thirty-six weeks ended September 10, 2004 and September 12, 2003:
Timeshare note sale gains
Interest expense decreased $8 million to $69 million primarily due to the repayment of $234 million of senior debt in the fourth quarter of 2003 and other debt reductions, partially offset by lower capitalized interest resulting from fewer projects under construction.
Interest income, before the provision for loan losses increased $20 million (26 percent) to $98 million, reflecting higher loan balances, including the $200 million note, collected in the third quarter of 2004, related to the purchase of our interest in the Two Flags joint venture, and higher interest rates. For the thirty-six weeks ended September 10, 2004, we recognized $8 million of interest income in connection with the $200 million note.
Income from continuing operations before income taxes generated a tax provision of $79 million in the first three quarters of 2004, compared to a tax benefit of $72 million in 2003. The difference is primarily attributable to the impact of our synthetic fuel joint venture, which generated a tax benefit and tax credits of $105 million in 2004, compared to $199 million in 2003, and to higher pre-tax income. In the third quarter of 2003 we sold a 50 percent interest in our synthetic fuel joint ventures and we currently consolidate the joint ventures.
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The principal difference between minority interest for the thirty-six weeks ended September 10, 2004 versus the thirty-six weeks ended September 12, 2003 is related to the change in the ownership structure of the synthetic fuel joint ventures as a result of the sale of 50 percent of our interest in the joint ventures. Due to the purchaser’s put option which expired on November 6, 2003, minority interest for the thirty-six weeks ended September 12, 2003 reflected our partner’s share of the synthetic fuel operating losses and their share of the associated tax benefit along with their share of the tax credits. For the thirty-six weeks ended September 10, 2004, minority interest reflects our partner’s share of the synthetic fuel losses only.
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LIQUIDITY AND CAPITAL RESOURCES
Cash Requirements and our Credit Facilities
We are party to two multicurrency revolving credit agreements that provide for aggregate borrowings of $2 billion expiring in 2006 ($1.5 billion expiring in July and $500 million expiring in August), which support our commercial paper program and letters of credit. At September 10, 2004, we had no loans outstanding under the facilities. At September 10, 2004, our cash balances combined with our available borrowing capacity under the credit facilities amounted to approximately $2 billion. We consider these resources, together with cash we expect to generate from operations, adequate to meet our short-term and long-term liquidity requirements, finance our long-term growth plans, meet debt service and fulfill other cash requirements.
Cash and equivalents totaled $202 million at September 10, 2004, a decrease of $27 million from year-end 2003, primarily reflecting purchases of treasury stock, debt repayments, loan advances and capital expenditures, partially offset by loan collections and sales, cash from dispositions, commercial paper borrowings, and cash provided by operating activities.
Timeshare Operating Cash Flows
While our timeshare business generates strong operating cash flow, the timing of both cash outlays for the acquisition and development of new resorts and cash received from purchaser financing affects quarterly amounts. We include timeshare interval sales we finance in cash from operations when we collect cash payments or the notes are sold for cash.
The following table shows the net operating activity from our timeshare business (which excludes the portion of net income from our timeshare business, as that number is a component of income from continuing operations):
Timeshare development, less cost of sales
New timeshare mortgages, net of collections
Note sale gains
Note sale proceeds
Financially reportable sales less than closed sales
Collection on retained interests in notes sold
Other cash inflows (outflows)
Net cash inflows (outflows) from timeshare activity
Asset Securitizations and Other
In June 2004, we sold $150 million of notes receivable generated by our timeshare business in connection with the sale of timeshare intervals. In conjunction with the sale, we received net proceeds of $141 million, retained residual interests of $33 million, and recorded a gain of $27 million. We used the following key assumptions to measure the fair value of the residual interests: discount rate of 7.9 percent; expected annual prepayments, including defaults, of 18.5 percent; expected weighted average life of prepayable notes receivable, excluding prepayments and defaults, of 81 months; and expected weighted average life of prepayable notes receivable, including prepayments and defaults, of 41 months. Our key assumptions are based on experience.
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In March 2004 we also sold one lodging note associated with an equity method investee, for cash proceeds of $57 million.
Debt
In the first three quarters of 2004, debt decreased by $80 million from $1,455 million to $1,375 million, due to the second quarter 2004 repurchase of all of our Liquid Yield Option Notes due 2021 (the “Notes”) totaling $62 million, the maturity in the second quarter of 2004 of $46 million of senior notes and other debt reductions of $22 million, partially offset by a $50 million increase in commercial paper borrowings used to finance capital expenditures, share repurchases, and our Notes repurchase.
On April 7, 2004, we sent notice to the holders of our Notes that, subject to the terms of the indenture governing the Notes, we would purchase for cash, at the option of each holder, any Notes tendered by the holder and not withdrawn on May 10, 2004, at a purchase price of $880.50 per $1,000 principal amount at maturity. The Notes, issued on May 8, 2001, carried a yield to maturity of 0.75 percent, and were convertible into approximately 0.9 million shares of our Class A Common Stock.
Cendant Joint Venture
On April 1, 2004, Cendant exercised its option to redeem our interest in the Two Flags joint venture, which owns the trademarks and licenses for the Ramada and Days Inn lodging brands in the United States. We recorded a pre-tax gain of approximately $13 million in connection with this transaction in the third quarter of 2004 when we collected our $200 million note receivable and the sale was complete.
For our entire 2003 fiscal year, we earned $24 million from our interest in the Two Flags joint venture, which was reflected as equity in earnings in the income statement. Our equity in earnings attributable to the Two Flags joint venture was $5 million and $17 million for the twelve and thirty-six weeks ended September 12, 2003, respectively, versus $6 million for the thirty-six weeks ended September 10, 2004. For the thirty-six weeks ended September 10, 2004, we recognized $8 million of interest income in connection with the $200 million note, collected in the third quarter of 2004, related to the purchase of our interest in the Two Flags joint venture.
We continue to own the trademarks and licenses for Ramada International outside of the United States, operate and franchise hotels outside of the United States and Canada under the Ramada International brand name, and license the Ramada name in Canada to Cendant. However, subsequent to the third quarter 2004, the Company and Cendant signed a non-binding letter of intent for Cendant to purchase Ramada International, primarily a franchised brand from the Company. Pending approval by regulatory authorities and final negotiation of terms, the transaction is expected to be completed in the fourth quarter of 2004. We do not expect the transaction to have a material impact to the Company.
CONTRACTUAL OBLIGATIONS AND OFF BALANCE SHEET ARRANGEMENTS
Except for the increase in commercial paper borrowings and the repurchase of our Liquid Yield Option Notes due 2021, both discussed in “Debt” above, our contractual obligations and off balance sheet arrangements, which we discussed on pages 34 and 35 of our Annual Report on Form 10-K for fiscal year 2003, have not materially changed since January 2, 2004.
SHARE REPURCHASES
We purchased 12.9 million shares of our Class A Common Stock during the thirty-six weeks ended September 10, 2004 at an average price of $45.71 per share.
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CRITICAL ACCOUNTING POLICIES
Certain of our critical accounting policies require the use of judgment in their application or require estimates of inherently uncertain matters. Our accounting policies comply with United States generally accepted accounting principles, although a change in the facts and circumstances of the underlying transactions could significantly change the resulting financial statement impact. We have discussed those policies that we believe are critical and require the use of complex judgment in their application in our Annual Report on Form 10-K for fiscal year 2003. Since the date of that Form 10-K, there have been no material changes to our critical accounting policies or the methodologies or assumptions we apply under them.
OTHER MATTERS
Our independent auditor, Ernst & Young LLP (E&Y) recently notified the Securities and Exchange Commission (“SEC”), the Public Company Accounting Oversight Board and the Audit Committee of our Board of Directors that certain non-audit services E&Y performed in China for a large number of public companies, including Marriott, have raised questions regarding E&Y’s independence in its performance of audit services.
With respect to Marriott, from 2001 through May of 2004, E&Y performed tax calculation and preparation services for Marriott employees located in Beijing (4 to 8 employees during the applicable period), and affiliates of E&Y made payment of the relevant taxes on behalf of Marriott. The payment of those taxes involved handling of Company related funds, which is not permitted under SEC auditor independence rules. These actions by affiliates of E&Y have been discontinued, and both the amount of the taxes and the fees paid to E&Y in connection with these services are de minimis.
The Audit Committee and E&Y discussed E&Y’s independence with respect to the Company in light of the foregoing facts. E&Y informed the Audit Committee that it does not believe that the holding and paying of those funds impaired E&Y’s independence with respect to the Company. The Company, based on its own review, also is not aware of any additional non-audit services that may compromise E&Y’s independence in performing audit services for the Company.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risk has not materially changed since January 2, 2004.
Item 4. Controls and Procedures
As of the end of the period covered by this quarterly report, we carried out an evaluation, under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures which, by their nature, can provide only reasonable assurance regarding management’s control objectives. You should note that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. There have been no changes in the internal control over financial reporting that occurred during the third quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based upon the foregoing evaluation, our Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures are effective to timely alert them to any material information relating to the Company (including its consolidated subsidiaries) that must be included in our periodic SEC filings.
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PART II – OTHER INFORMATION
Item 1. Legal Proceedings
The legal proceedings and claims described under the heading captioned “Contingencies” in Note 8 of the Notes to Condensed Consolidated Financial Statements set forth in Part I, Item 1 of this Quarterly Report are hereby incorporated by reference. From time to time, we are also subject to certain legal proceedings and claims in the ordinary course of business. We currently are not aware of any such legal proceedings or claims that we believe will have, individually or in aggregate, a material adverse effect on our business, financial condition, or operating results.
Legal Proceeding Terminated During the Third Quarter
Strategic Hotel litigation. On August 20, 2002, several direct or indirect subsidiaries of Strategic Hotel Capital, L.L.C. (Strategic) filed suit against us in the Superior Court of Los Angeles County, California in a dispute related to the management, procurement and rebates related to three California hotels that we manage for Strategic. On June 4, 2004 we signed an agreement to resolve the litigation filed by Strategic Hotel Capital, L.L.C. on terms that are not material to the Company. The court formally dismissed the suit on July 12, 2004, after certain necessary third party consents were obtained.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
(in millions, except per share amounts)
Period
Maximum
Number of Sharesthat May Yet BePurchased Underthe Plans orPrograms (1)
June 19, 2004 – July 16, 2004
July 17, 2004 – August 13, 2004
August 14, 2004 – September 10, 2004
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
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Item 5. Other Information
Item 6. Exhibits
Description
39
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
18th day of October, 2004
/s/ Arne M. Sorenson
Arne M. Sorenson
Executive Vice President and
Chief Financial Officer
/s/ Carl T. Berquist
Carl T. Berquist
Executive Vice President, Financial
Information and Risk Management
(Principal Accounting Officer)
40