UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2005
OR
For the transition period from to
Commission file number 001-32319
Sunstone Hotel Investors, Inc.
(Exact Name of Registrant as Specified in Its Charter)
Registrant’s telephone number, including area code: (949) 369-4000
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. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of October 31, 2005, 47,891,722 shares, $0.01 par value per share, of the registrant’s common stock were outstanding.
SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON
For the Quarterly Period Ended September 30, 2005
TABLE OF CONTENTS
Item 1
Financial Statements:
Sunstone Hotel Investors, Inc. and the Sunstone Predecessor Companies:
Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004
Unaudited Consolidated and Combined Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2004
Consolidated Statements of Stockholders’ Equity as of September 30, 2005 (unaudited) and December 31, 2004
Unaudited Consolidated and Combined Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004
Notes to Unaudited Consolidated and Combined Financial Statements
Item 2
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3
Quantitative and Qualitative Disclosures about Market Risk
Item 4
Disclosure Controls and Procedures
Legal Proceedings
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5
Other Information
Item 6
Exhibits
SIGNATURES
i
PART I—FINANCIAL INFORMATION
SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
ASSETS
Current assets:
Cash and cash equivalents
Restricted cash
Accounts receivable, net
Due from affiliates
Inventories
Prepaid expenses
Total current assets
Investment in hotel properties, net
Other real estate, net
Deferred financing costs, net
Goodwill
Other assets, net
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses
Accrued payroll and employee benefits
Due to Management Company
Dividends payable
Distributions payable
Other current liabilities
Current portion of notes payable
Total current liabilities
Notes payable, less current portion
Other liabilities
Total liabilities
Commitments and contingencies (Note 13)
Minority interest
Preferred stock, Series C Cumulative Convertible Redeemable Preferred Stock, $0.01 par value 4,102,564 shares authorized, issued and outstanding, liquidation preference of $24.375 per share
Stockholders’ equity:
Preferred stock, Series A Cumulative Redeemable Preferred Stock, $0.01 par value, 50,000,000 shares authorized; Series A 4,850,000 shares issued and outstanding at September 30, 2005 and none at December 31, 2004, stated at liquidation preference of $25.00 per share
Common stock, $0.01 par value, 100,000,000 shares authorized, 47,870,875 shares issued and outstanding at September 30, 2005 and 34,518,616 issued and outstanding at December 31, 2004
Additional paid in capital
Deferred stock compensation
Accumulated earnings (deficit)
Cumulative dividends
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes to consolidated and combined financial statements.
1
SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES AND
SUNSTONE PREDECESSOR COMPANIES
CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share data)
REVENUES
Room
Food and beverage
Other operating
Management and other fees from affiliates
Total revenues
OPERATING EXPENSES
Advertising and promotion
Repairs and maintenance
Utilities
Franchise costs
Property tax, ground lease, and insurance
Property general and administrative
Corporate general and administrative
Depreciation and amortization
Amortization of deferred stock compensation
Impairment loss
Total operating expenses
Operating income
Interest and other income
Interest expense
Income before minority interest, income taxes and discontinued operations
Income tax benefit
Income from continuing operations before discontinued operations
Income (loss) from discontinued operations
NET INCOME (LOSS)
Preferred stock dividends and accretion
INCOME AVAILABLE TO COMMON STOCKHOLDERS
Basic and diluted per share amounts:
Income from continuing operations available to common stockholders
Income from discontinued operations
Income available to common stockholders per common share
Weighted average common shares outstanding:
Basic
Diluted
Dividends paid per common share
2
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Balance at December 31, 2004 (audited)
Net proceeds from sale of Series A preferred stock
Offering costs from sale of Series C preferred stock
Net proceeds from sale of common stock
Issuance of unvested restricted common stock
Vesting of restricted common stock
Common dividends declared and payable at $0.855 per share
Series A preferred dividends declared and payable at $1.078 per share
Series C preferred dividends declared and payable at $0.393 per share
Accretion of discount on Series C preferred stock
Reallocation of minority interest
Net income
Balance at September 30, 2005 (unaudited)
3
CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Bad debt expense
(Gain) loss on sale of hotel properties
Depreciation
Amortization of deferred franchise fees
Amortization of deferred financing costs
Amortization of loan premiums
Impairment loss—investment in hotel properties and discontinued operations
Loss on interest rate cap agreements
Deferred income taxes
Changes in operating assets and liabilities:
Cash from discontinued operations
Accounts receivable
Prepaid expenses and other assets
Accounts payable and other liabilities
Accrued pension liability
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of hotel properties
Acquisitions of hotel properties
Additions to hotel properties and other real estate
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from preferred securities offerings
Payment of preferred securities offering costs
Proceeds from common stock offerings
Payment of common stock offerings costs
Proceeds from notes payable
Payments on notes payable
Payments of deferred financing costs
Acquisition of interest rate cap agreements
Dividends and distributions paid
Contributions from members
Distributions to members
Contributions from minority interest holders
Distributions to minority interest holders
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest
Income taxes paid
NONCASH FINANCING ACTIVITY
Dividends and distributions payable
4
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS
1. Organization and Description of Business
Sunstone Hotel Investors, Inc. (the “Company”), through its 92.8% controlling interest in Sunstone Hotel Partnership, LLC (the “Operating Partnership”), of which the Company is the sole managing member, and the subsidiaries of the Operating Partnership, including Sunstone Hotel TRS Lessee, Inc. (the “TRS Lessee”) and its subsidiaries, is currently engaged in owning, acquiring, selling, and renovating hotel properties in the United States. The Company operates as a real estate investment trust (“REIT”) for federal income tax purposes.
The Company was formed to succeed the businesses of Sunstone Hotel Investors, L.L.C. (“SHI”), WB Hotel Investors, LLC (“WB”), and Sunstone/WB Hotel Investors IV, LLC (“WB IV”) (collectively, the “Sunstone Predecessor Companies” or the “Predecessor”), which were engaged in owning, acquiring, selling, managing, and renovating hotel properties in the United States. The Company was incorporated in Maryland on June 28, 2004, in anticipation of an initial public offering of common stock (the “IPO”), which was consummated on October 26, 2004, concurrently with the consummation of various formation transactions. These transactions were designed to (i) enable the Company to raise the necessary capital to acquire properties from the Predecessor and repay certain mortgage debt relating thereto, (ii) provide a vehicle for future acquisitions, (iii) enable the Company to comply with certain requirements under the federal income tax laws and regulations relating to real estate investment trusts, (iv) facilitate potential financings and (v) preserve certain tax advantages for the Predecessor. From June 28, 2004 through October 26, 2004, the Company did not have any operations.
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements as of September 30, 2005 and December 31, 2004, and for the three and nine months ended September 30, 2005 include the accounts of the Company, the Operating Partnership and the TRS Lessee and their subsidiaries. Property interests contributed to the Operating Partnership by the Predecessor have been accounted for as a reorganization of entities under common control in a manner similar to a pooling-of-interests. Accordingly, the contributed assets and assumed liabilities were recorded at the Predecessors’ historical cost basis. All significant intercompany balances and transactions have been eliminated.
The accompanying combined financial statements for the three and nine months ended September 30, 2004 include the accounts of SHI, WB, and WB IV. Significant intercompany accounts and transactions have been eliminated for all periods presented.
The accompanying interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States and in conformity with the rules and regulations of the Securities and Exchange Commission. In our opinion, the interim financial statements presented herein reflect all adjustments, consisting solely of normal and recurring adjustments, which are necessary to fairly present the interim financial statements. These financial statements should be read in conjunction with the financial statements included in our Form 10-K, filed with the Securities and Exchange Commission on February 22, 2005.
Use of Estimates
The preparation of consolidated and combined financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.
Reporting Periods
The results we report in our consolidated statement of operations are based on results reported to us by our hotel managers. These hotel managers use different reporting periods. Interstate Hotels & Resorts, Inc., the manager of a majority of our properties, as well as our other managers, Hyatt Corporation and Fairmont Hotels & Resorts, who manage a total of three of our properties, report results on a monthly basis. In contrast, Marriott International, Inc. (“Marriott”), the manager of nine of our properties, uses a fiscal year ending on the Friday closest to December 31, and reports twelve weeks of operations each for the first three quarters of the year and sixteen or seventeen weeks of operations for the fourth quarter of the year. We have elected to adopt quarterly close periods of March 31, June 30 and September 30, and an annual year end of
5
December 31. As a result, our results of operations for the Marriott International, Inc. managed hotels include results from January 1 through March 25 for the first quarter, March 26 through June 17 for the second quarter, June 18 through September 9 for the third quarter, and September 10 through December 31 for the fourth quarter.
Accounts Receivable
Accounts receivable primarily represents receivables from hotel guests who occupy hotel rooms and utilize hotel services. Accounts receivable also includes receivables from customers who utilize the Company’s laundry facilities in Salt Lake City, Utah, and Rochester, Minnesota. The Company maintains an allowance for doubtful accounts sufficient to cover potential credit losses. The Company’s accounts receivable at September 30, 2005 and December 31, 2004 includes an allowance for doubtful accounts of $1.4 million and $2.2 million, respectively.
At September 30, 2005 and December 31, 2004, the Company had approximately $5.5 million and $12.3 million in accounts receivable, respectively, with one customer who is operating under a contract with the United States government. The Company has specifically reserved a portion of this particular receivable in the amount of $587,000 and $1.3 million at September 30, 2005 and December 31, 2004, respectively. Additionally, the Company has taken a $2.1 million reserve due to a contract interpretation issue with this customer relating to applicable contract rates during the period from early 2003 through May 2005. The Company is currently involved in ongoing discussions with this customer, and anticipates resolution of this issue prior to December 31, 2005. The ultimate resolution of this matter, however, could result in a reimbursement to this customer in an amount in excess of $2.1 million.
Deferred Financing Costs
Interest expense related to the amortization of deferred financing costs was $0.5 million and $1.3 million for the three months ended September 30, 2005 and 2004, respectively, and $3.0 million and $3.8 million for the nine months ended September 30, 2005 and 2004, respectively.
Minority Interest
Minority interest represents the limited membership interests in the Operating Partnership. The carrying value of the minority interest has been increased by the minority interests’ share of earnings and reduced by cash distributions and the purchase of limited partnership interests. The weighted average number of limited partnership units for the nine months ended September 30, 2005, was 3,699,572. When the Company raises additional equity, it contributes the proceeds to the Operating Partnership for an equivalent number of partnership units. In the event of other changes in common equity, an adjustment to minority interest in the Operating Partnership and stockholders’ equity is recorded to reflect the Company’s increased or decreased ownership in the Operating Partnership. The reconciliation of minority interests for the nine months ended September 30, 2005, is as follows (in thousands, except unit data):
Minority
Interests
Distributions
6
Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per common share (in thousands, except per share data):
Three Months Ended
September 30, 2005
Nine Months Ended
Numerator:
Less preferred dividends and accretion
Numerator for basic and diluted earnings available to common stockholders
Denominator:
Weighted average basic common shares outstanding
Unvested restricted stock awards
Weighted average diluted common shares outstanding
Basic and diluted earnings available to common stockholders per common share
Shares of the Company’s Series C preferred stock have not been included in the above calculation of earnings per share for either the three months or the nine months ended September 30, 2005 as their effect would have been anti-dilutive.
Reclassifications
Certain amounts included in the combined financial statements for prior periods have been reclassified to conform with the most recent financial statement presentation.
3. Investment in Hotel Properties
Investment in hotel properties consisted of the following (in thousands):
September 30,
2005
December 31,
2004
Land
Buildings and improvements
Fixtures, furniture and equipment
Franchise fees
Construction in process
Accumulated depreciation and amortization
On June 23, 2005, the Company purchased interests in six Renaissance hotels as set forth below for approximately $433.7 million. These Renaissance hotels are managed by Marriott. Marriott’s reporting periods include twelve weeks each for the first, second and third quarters of the year, and sixteen or seventeen weeks for the fourth quarter. Marriot’s third quarter included the time period from June 18, 2005 through September 9, 2005. As such, the results of operations for all six hotels from the acquisition date of June 23, 2005 through September 9, 2005 have been included in the Company’s statement of operations for the quarterly period ended September 30, 2005. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on this preliminary allocated purchase price.
Hotel
Location
Number of
Rooms
The acquisition of the Renaissance Orlando Resort at SeaWorld Hotel represents an 85% interest in a partnership that owns that property, as well as the lender’s position in the partnership loan. As a result, all of the economics of the property for the foreseeable future are retained by the Company.
7
On June 27, 2005, the Company purchased the 203-room Sheraton located in Cerritos, California for approximately $25.4 million. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on this preliminary allocated purchase price.
On July 12, 2005, the Company purchased the 444-room Fairmont Hotel located in Newport Beach, California for approximately $72.0 million, and renamed the hotel the Fairmont Newport Beach. This hotel’s results of operations from the acquisition date of July 12, 2005 through the end of the quarterly period ended September 30, 2005 have been included in the Company’s statement of operations. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on this preliminary allocated purchase price.
On July 13, 2005, the Company purchased the remaining 75% interest in the Renaissance Washington, D.C. Hotel for approximately $140 million. The original 25% interest was acquired at a cost of approximately $20 million as part of the six-hotel Renaissance acquisition noted above. The additional 75% interest in this hotel’s results of operations from the acquisition date of July 13, 2005 through the end of Marriott’s third quarter, or September 9, 2005, have been included in the Company’s statement of operations. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on this preliminary allocated purchase price.
4. Discontinued Operations
As part of a strategic plan to dispose of non-core hotel assets, the Company and its Predecessor sold seven hotel properties during 2004 and two hotel properties during the nine months ended September 30, 2005. These nine hotel properties met the “held for sale” and “discontinued operations” criteria in accordance with SFAS 144.
The following sets forth the discontinued operations for the three and nine months ended September 30, 2005 and 2004, related to hotel properties held for sale (in thousands):
Operating revenues
Operating expenses
Gain (loss) on sale of hotels
Provision for income taxes
5. Other Real Estate
Other real estate consists of the following (in thousands):
Laundry facilities:
Accumulated depreciation
Land held for future development or sale
8
6. Other Assets
Other assets at September 30, 2005, include $15.0 million held in escrow for the acquisition of the Century Plaza Hotel in Los Angeles, California, a $2.0 million deposit for capital expenditures for the Fairmont Newport Beach and $10.4 million of other assets.
7. Derivative Financial Instruments
At September 30, 2005 and December 31, 2004, the Company held interest rate cap agreements to manage its exposure to interest rate risks related to its floating rate debt. The fair values of the interest rate cap agreements are included in deferred financing costs, net on the consolidated balance sheets as of September 30, 2005 and December 31, 2004. None of the Company’s interest rate cap agreements held as of September 30, 2005 and December 31, 2004 qualify for effective hedge accounting treatment under SFAS No. 133. Accordingly, changes in the fair value of the Company’s and the Predecessors’ interest rate cap agreements for the three months ended September 30, 2005 and 2004 resulted in a net gain of $2,000 and a net loss of $81,000, respectively, and for the nine months ended September 30, 2005 and 2004 resulted in a net loss of $1,000 and $540,000, respectively. The changes in fair value have been reflected as an increase in interest expense for the three and nine months ended September 30, 2005 and 2004.
The following table summarizes the interest rate cap agreements (dollars in thousands):
Notional amount of variable rate debt
Fair value of interest rate caps
LIBOR rate at which expense is capped
Maturity dates
8. Notes Payable
Notes payable consist of the following (in thousands):
Notes payable requiring payments of interest and principal, with interest at rates ranging from variable of one-month LIBOR plus 2.35% to fixed rates ranging from 4.98% to 9.88%; maturing at dates ranging from September 2007 through August 2024. The notes are collateralized by first deeds of trust on 45 hotel properties and one laundry facility.
Unsecured term loan facility in the amount of $75.0 million requiring monthly payments of interest only subject to an interest rate equal to either, at the Company’s option, a fluctuating rate equal to Citibank, N.A.’s base rate or a periodic fixed rate equal to one-, two-, or six-month LIBOR, plus, in each case, a margin of 1.25% for base rate loans and 2.25% for LIBOR loans. The term loan facility matures in October 2008.
Secured revolving credit facility in the amount of $150.0 million requiring monthly payments of interest only on the principal amount drawn subject to an interest rate equal to either, at the Company’s option, a fluctuating rate equal to Citibank, N.A.’s base rate or a periodic fixed rate equal to one-, two-, three- or six-month LIBOR, plus, in each case, an applicable margin based on the Company’s leverage. The applicable margin is a percentage rate per annum that ranges from 0.5% to 1.0% for base rate loans and 1.5% to 2.0% for LIBOR loans. The revolving credit facility also requires a quarterly fee of 0.5% on the average unused commitment on the facility and a 0.125% fee upon the issuance of each letter of credit. The revolving credit facility is secured by first deeds of trust on eight hotel properties. Total available under the revolving credit facility was $121.3 million at September 30, 2005. The revolving credit facility matures in October 2007 and has a one year extension.
Construction loan requiring monthly payments of interest only at one-month LIBOR plus 3.25% and is collateralized by one hotel. The loan was paid off in March 2005.
Less: current portion
9
In April 2005, the Company closed ten individual non cross-collateralized mortgage loans totaling $276.0 million. The loans are each for a term of ten years and have a fixed rate of 5.34%. The proceeds of these loans were used to repay $244.3 million of existing mortgage loans.
In June 2005, the Company closed $250.0 million in four separate mortgage loans, each secured by one hotel, with terms ranging between seven and eleven years and a weighted average fixed interest rate of 5.14%. The proceeds of these loans were used to fund the acquisition of interests in six Renaissance hotels.
In June 2005, the Company assumed a $9.2 million fixed rate mortgage loan with a maturity date of August 2024 and a fixed interest rate of 8.78% in connection with the acquisition of the Sheraton Cerritos, Cerritos, California.
In July 2005, the Company assumed a $54.0 million fixed rate mortgage loan with a maturity date of April 2023 and a fixed interest rate of 7.50% in connection with the acquisition of the remaining 75% interest in the Renaissance Washington, D.C.
Total interest incurred and expensed on the notes payable is as follows (in thousands):
Continuing operations:
Deferred financing fees
(Gain)/Loss on interest rate cap
Prepayment penalty paid—continuing operations
Discontinued operations:
9. Income Taxes
The income tax benefit (provision) included in the consolidated and combined statements of operations is as follows (in thousands):
Current:
Federal
State
Deferred:
Valuation allowance
10
Benefit from (provision for) income taxes applicable to continuing operations and discontinued operations is as follows (in thousands):
Benefit from (provision for) continuing operations:
Current
Deferred
Provision for continuing operations
Benefit from (provision for) discontinued operations:
Benefit from discontinued operations
Benefit from income taxes
The provision for income taxes differs from the federal statutory rate due to various expenses that are not deductible for tax purposes.
The tax effects of temporary differences giving rise to the deferred tax assets (liabilities) are as follows (in thousands):
Deferred tax assets:
NOL carryover
State taxes, amortization and other
Other reserves
Current deferred tax asset before valuation allowance
Deferred tax liabilities:
Other
Net deferred tax assets
The deferred tax assets at September 30, 2005 were primarily due to net operating loss carryforwards and timing differences in the deductibility of various reserves for tax purposes as compared to book purposes. A valuation allowance is maintained to offset its deferred tax assets due to uncertainties surrounding their realization.
At September 30, 2005 and December 31, 2004, the Company had federal net operating loss carryforwards of $19.7 million and $5.2 million, respectively, which begin to expire in 2025.
At September 30, 2005 and December 31, 2004, the Company had state net operating loss carryforwards of $19.7 million and $5.2 million, respectively, which begin to expire in 2010.
10. Preferred Stock, Series C
In July 2005, the Company sold 4,102,564 shares of 6.45% Series C Cumulative Convertible Redeemable Preferred Stock (“Series C preferred stock”) with a liquidation preference of $24.375 per share to Security Capital Preferred Growth, Incorporated, an investment vehicle advised by Security Capital Research & Management Incorporated, for gross proceeds of $99.0 million, or $24.13 per share, which included a 1% discount to the conversion price/liquidation preference. Other costs of the offering totaled $130,000. Net proceeds of $99.0 million were contributed to the Operating Partnership in exchange for preferred units with economic terms substantially identical to the Series C preferred stock. The net proceeds were used to partially finance the Company’s acquisition of six Renaissance hotels. On or after July 8, 2010, the Series C preferred stock will be redeemable at the Company’s option, in whole or in part, at any time or from time to time, for cash at a redemption price of $24.375 per share, plus accrued and unpaid dividends up to and including the redemption date. The holder has the right to redeem the Series C preferred stock in the event of any of the following: (1) a change in control of the Company; (2) a REIT termination event; or, (3) a termination of the Company’s listing on either the New York Stock Exchange, or NASDAQ. Holders of Series C preferred stock will generally have no voting rights. However, if the Company is in violation
11
of certain financial ratios for four consecutive quarters, the holders have the right to elect one director to serve on the Company’s board of directors. In addition, if the Company is in arrears on dividends on the Series C preferred stock for four or more quarters, the holders have the right to elect two additional directors to serve on the Company’s board of directors. The holders are eligible to receive a participating dividend should the Company’s common dividend increase beyond $1.34 per share from its current level of $1.14 per share. The Series C preferred stock has no maturity date and the Company is not required to redeem the Series C preferred stock at any time.
The initial carrying value of the Series C preferred stock was recorded at its sales price less costs to issue on the date of issuance. This carrying value is periodically adjusted so that the carrying value will equal the redemption value on the redemption date, which is the earliest date available for the Company to redeem the preferred stock. The carrying value will also be periodically adjusted for any accrued and unpaid dividends, if any. At September 30, 2005 and December 31, 2004, the Series C preferred stock carrying value consisted of the following (in thousands):
Initial fair value, sales price of $99.0 million, less costs to issue of $130,000
Redemption value accretion
11. Stockholders’ Equity
Series A Cumulative Redeemable Preferred Stock
In March 2005, the Company sold 4,850,000 shares of 8.0% Series A and B Cumulative Redeemable Preferred Stock with a liquidation preference of $25.00 per share for gross proceeds of $121.3 million. Underwriting and other costs of the offering totaled $3.8 million. Net proceeds of $117.5 million were contributed to the Operating Partnership in exchange for preferred units with economic terms substantially identical to the Series A and B preferred stock. Subsequent to this offering, the Series B shares were exchanged for an equivalent number of shares of Series A preferred stock. The net proceeds were used to reduce borrowings under the Company’s credit facility and for acquisitions. On or after March 17, 2010, the Series A preferred stock will be redeemable at the Company’s option, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus accrued and unpaid dividends up to and including the redemption date. Holders of Series A preferred stock will generally have no voting rights. However, if the Company is in arrears on dividends on the Series A preferred stock for six or more quarterly periods, whether or not consecutive, holders of the Series A preferred stock will be entitled to vote at its next annual meeting and each subsequent annual meeting of stockholders for the election of two additional directors to serve on the Company’s board of directors until all unpaid dividends and the dividend for the then-current period with respect to the Series A preferred stock have been paid or declared and a sum sufficient for the payment thereof set aside for payment. The Series A preferred stock has no maturity date and the Company is not required to redeem the Series A preferred stock at any time.
Common Stock
On October 26, 2004, the Company commenced operations after completing the IPO, which consisted of the sale of 21,294,737 shares of common stock at a price per share of $17.00, generating gross proceeds of $362.0 million. The proceeds to the Company, net of underwriters’ discount and offering costs, were $333.5 million. The proceeds from the IPO were used to acquire limited partnership interests in the Operating Partnership held by the Predecessors’ members as a result of the IPO for $195.9 million, repay secured notes payable of $210.1 million, and purchase a ground lessor’s interest in a ground lease under one of the properties that was purchased for $6.3 million. On November 23, 2004, as a result of the exercise of the underwriters’ over-allotment option, the Company sold an additional 3,165,000 shares of common stock resulting in gross proceeds of $53.8 million which it used to purchase an additional 3,165,000 limited partnership interests in the Operating Partnership from the Predecessor.
On June 10, 2005, the Company and selling stockholders completed a follow-on offering of 12,180,800 shares, including the exercise of the underwriters’ over-allotment option, of common stock at a price per share of $23.40 (before underwriting discounts and offering costs). The public offering consisted of 3,000,000 primary shares, generating gross proceeds of $70.2 million and 9,180,800 secondary shares sold by affiliates of Westbrook Partners, LLC. The proceeds to the Company, net of underwriters’ discount and offering costs, were $65.3 million and were used for acquisitions.
On June 23, 2005, the Company completed a private offering to GIC Real Estate, an investment arm of the Government of Singapore, of 3,750,000 and 294,000 shares of common stock at a price per share of $20.65 and $21.97,
12
respectively, generating gross proceeds of $83.9 million. The proceeds to the Company, net of offering costs, were $83.8 million and were used for acquisitions.
On June 28, 2005, the Company completed a private offering to Security Capital Preferred Growth Incorporated, an investment vehicle advised by Security Capital Research & Management Incorporated, of 300,000 shares of common stock at a price per share of $22.347, generating net proceeds of $6.7 million which were used for acquisitions.
On September 20, 2005, the Company and selling stockholders completed a follow-on offering of 6,700,000 shares of common stock at a price per share of $24.34 (before underwriting discounts and offering costs). The public offering consisted of 5,993,554 primary shares, generating gross proceeds of $145.9 million and 706,446 secondary shares sold by affiliates of Westbrook Partners, LLC. The proceeds to the Company, net of underwriters’ discount and offering costs, were $142.2 million and were used for acquisitions.
12. Long-Term Incentive Plan
Restricted shares granted pursuant to the Company’s Long-Term Incentive Plan vest over periods from three to five years from the date of grant. The value of shares granted has been calculated based on the share price on the date of grant and is being amortized as compensation expense over the vesting periods. For the three and nine months ended September 30, 2005, the Company’s expense related to these restricted shares was $466,000 and $1.5 million, respectively. At September 30, 2005 and December 31, 2004, the unearned compensation related to restricted share grants was $7.1 million and $7.3 million, respectively, and has been classified as a component of stockholders’ equity in the accompanying balance sheet.
13. Commitments and Contingencies
Franchise Agreements
Total franchise costs incurred by the Company and Predecessor during the three months ended September 30, 2005 and 2004 totaled $7.6 million and $7.4 million, respectively. Of the total franchise costs, franchise royalties totaled $4.2 million for both 2005 and 2004. Franchise costs for the nine months ended September 30, 2005 and 2004, both totaled $20.9 million, of which franchise royalties were $11.4 million in 2005 and $11.5 million in 2004. The remaining franchise costs include advertising, reservation and priority club assessments. Franchise costs included in discontinued operations totaled $0.3 million and $1.5 million, respectively, for the three and nine months ended September 30, 2004.
Renovation and Construction Commitments
At September 30, 2005 and December 31, 2004, the Company had various contracts outstanding with third parties in connection with the renovation of certain of the hotel properties. The remaining commitments under these contracts at September 30, 2005 and December 31, 2004 totaled $33.1 million and $7.8 million, respectively.
Operating Leases
Rent expense incurred pursuant to ground lease agreements for the three months ended September 30, 2005 and 2004 totaled $1.6 million and $1.1 million, respectively, and for the nine months ended September 30, 2005 and 2004 totaled $3.2 million and $3.0 million, respectively, and was included in property tax, ground lease and insurance in the accompanying statements of operations.
Rent expense incurred pursuant to the lease on the corporate facility for the three months ended September 30, 2005 and 2004 totaled $82,000 and $189,000, respectively, and for the nine months ended September 30, 2005 and 2004 totaled $274,000 and $567,000, respectively, and was included in general and administrative expenses in the accompanying statements of operations.
Contract Interpretation Issue
The Company has a contract interpretation issue with a customer who is operating under a contract with the United States government. The ultimate resolution of this issue could result in the Company reimbursing this customer for certain amounts. The Company has reserved $2.1 million at September 30, 2005 related to this matter, and expects to have this matter resolved prior to December 31, 2005. However, the ultimate resolution of this matter could result in a reimbursement to the customer in an amount in excess of $2.1 million.
At September 30, 2005 and December 31, 2004, the Company had $29.5 million and $34.8 million, respectively, of outstanding irrevocable letters of credit to guarantee the Company’s financial obligations related to the Interstate Hotels &
13
Resorts, Inc. (the “Management Company”) workers’ compensation insurance programs and certain notes payable. The beneficiary may draw upon these letters of credit in the event of a contractual default by the Company relating to each respective obligation.
14. Transactions With Affiliates
Management Fees
On March 30, 2004, the Predecessor entered into a management agreement with an affiliate to provide management services for the hotel located in Nashville, Tennessee owned by an affiliate. The agreement was to expire March 30, 2009 and included successive one-year renewal options. Pursuant to the agreement, the Company was to receive from the affiliate a base management fee of 2.5% of gross operating revenues, as defined. In connection with the IPO, this agreement was cancelled and a new agreement was entered into with Management Company.
On January 30, 2004, the Predecessor entered into a management agreement with an affiliate to provide management services for the hotel located in Beverly Hills, California owned by the affiliate. The agreement was to expire January 30, 2009 and included successive one-year renewal options. Pursuant to the agreement, the Company was to receive from the affiliate a base management fee of 2.5% of gross operating revenues, as defined. In connection with the IPO, this agreement was cancelled and a new agreement was entered into with the Management Company.
On May 22, 2002, the Predecessor entered into a management agreement with an affiliate to provide management services for the hotel property located in Nashville, Tennessee owned by Westbrook Real Estate Partners, L.L.C. (“Westbrook”). Two of our board members are managing principals of Westbrook. The agreement was to expire on May 22, 2007 and included successive one-year renewal options. Pursuant to the agreement, the Predecessor was to receive from Westbrook a base management fee of 4.0% of gross operating revenues, as defined. This agreement was terminated in February 2004 following the sale of the hotel.
On May 29, 2002, the Company entered into eight asset management agreements with an affiliate to provide asset management services for the hotel properties owned by Westbrook. The agreements were to expire on May 29, 2007 and included successive one-year renewal options. Pursuant to the agreements, the Company was to receive an asset management fee of 1.0% of gross operating revenues, as defined. At December 31, 2004, none of the agreements were in effect due to the sale of all eight properties to an unaffiliated third party.
For the three and nine months ended September 30, 2004, aggregate management fees and asset management fees earned from affiliates totaled $113,000 and $297,000, respectively. The Company did not earn any management fees for the three and nine months ended September 30, 2005.
Asset Management Fees
Following the Company’s IPO, the Company entered into asset management agreements to supervise outstanding capital expenditure projects for four hotel properties owned by affiliates.
Accounting Fee
Prior to the Company’s IPO, the Company received an accounting fee from certain affiliates equal to $10 per available room per month. Aggregate accounting fees earned from affiliates totaled $16,000 and $36,000 for the three and nine months ended September 30, 2004, respectively.
Acquisition Fees
During the three and nine months ended September 30, 2004, in connection with successful acquisitions of hotel properties by certain affiliated companies, the Predecessor received aggregate acquisition fees in the amount of $0 and $318,000, respectively, in exchange for rendering services in connection with such acquisitions. Such acquisition fees were recognized as revenue and were included in management and other fees from affiliates. The Company did not earn any acquisition fees for the three and nine months ended September 30, 2005.
Other Reimbursements
From time to time, the Company pays for certain expenses such as payroll, insurance and other costs on behalf of certain affiliates. The affiliates generally reimburse such amounts on a monthly basis. At September 30, 2005 and December 31, 2004, amounts owed to the Company by its affiliates amounted to $87,000 and $147,000 and are included in due from affiliates.
14
Transactions With Others
The Company purchases telecommunications equipment from Gemini Telemanagement Systems, or GTS, a telecommunications equipment provider based in Redwood City, California. The Company’s Chief Executive Officer and President, Robert A. Alter, is a 5.2% stockholder in GTS, and his brother, Richard Alter, is the majority stockholder in GTS. The Company paid GTS $35,000 and $344,000, respectively for the three and nine months ended September 30, 2005, and $104,000 and $678,000, respectively for the three and nine months ended September 30, 2004.
15. Subsequent Events
In October 2005, the Company acquired the 728-room Century Plaza Hotel and Spa located in Century City, California for $293.0 million and named Hyatt Corporation as manager. The Company has commenced a renovation program, at an anticipated cost of $22.5 million, which will include the renovation of all guest rooms. Following the acquisition, the hotel was re-named the Hyatt Regency Century Plaza. In conjunction with this acquisition, the Company obtained $175.0 million in debt to finance a portion of the purchase price. The loan will mature in 2014.
In October 2005, pursuant to rights granted to Security Capital Preferred Growth Incorporated in the Series C Cumulative Convertible Redeemable Preferred Stock Purchase Agreement among the Company, the Operating Partnership, and Security Capital Preferred Growth Incorporated dated as of April 27, 2005, as amended, the Company agreed to sell to Security Capital Preferred Growth Incorporated 599,355 shares of its common stock at a purchase price of $23.85 per share. The closing of the sale of these shares is scheduled to occur, if all conditions to close in the Stock Purchase Agreement among the Company, the Operating Partnership, and Security Capital Preferred Growth Incorporated have been satisfied or waived, on the first business day prior to the next record date with respect to any dividend on the common stock.
15
Cautionary Statement
This report contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “forecasts,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of such terms and other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those expressed or implied by these forward-looking statements. In evaluating these statements, you should specifically consider the risks outlined in detail in our Form S-11, filed with the Securities and Exchange Commission on August 31, 2005, and our Form S-3, filed with the Securities and Exchange Commission on October 27, 2005, under the caption “Risk Factors” and elsewhere in this Form 10-Q, including but not limited to the following factors:
These factors may cause our actual events to differ materially from the expectations expressed or implied by any forward-looking statement. We do not undertake to update any forward-looking statement.
Overview
We own primarily upper upscale and upscale hotels in the United States operated under leading brand names franchised or licensed from others, such as Marriott, Hilton, InterContinental, Hyatt, Fairmont, Starwood, Carlson and Wyndham.
Operations
Our financial data prior to October 26, 2004 is for our predecessor companies, who owned and operated the hotels during the periods presented. In conjunction with our initial public offering, we made substantial changes to our operations to effect the formation and structuring transactions as further discussed in our Form 10-K and to qualify and elect to be treated as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Code. As a result, our historical results of operations prior to October 26, 2004 are not indicative of our current results of operations.
16
Formation and structuring transactions and our initial public offering. The following items occurred and affect our results of operations as a result of our initial public offering:
REIT structure. For us to qualify as a REIT, our income cannot be derived from our operation of hotels. Therefore, consistent with the provisions of the Code, Sunstone Hotel Partnership and its subsidiaries have leased our hotel properties to our taxable REIT subsidiary lessee, Sunstone Hotel TRS Lessee, Inc., or the TRS Lessee, who has in turn contracted with “eligible independent contractors” to manage our hotels. Under the Code, an “eligible independent contractor” is an independent contractor who is actively engaged in the trade or business of operating “qualified lodging facilities” for any person unrelated to us and the TRS Lessee. Sunstone Hotel Partnership and the TRS Lessee are consolidated into our financial statements for accounting purposes. Since we control both Sunstone Hotel Partnership and our TRS Lessee, our principal source of funds on a consolidated basis are from the performance of our hotels. The earnings of the TRS Lessee are subject to taxation like other C corporations, which reduce our operating results, funds from operations and the cash otherwise available for distribution to our stockholders.
Factors Affecting Our Results of Operations
Revenues. Substantially all of our revenues are derived from the operation of our hotels. Specifically, our revenues consist of the following:
The following performance indicators are commonly used in the hotel industry:
17
Operating costs and expenses. Our operating costs and expenses consist of the following:
Most categories of variable operating expenses, such as utilities and certain labor costs, such as housekeeping, fluctuate with changes in occupancy. Increases in RevPAR attributable to improvements in occupancy are accompanied by increases in most categories of variable operating costs and expenses. Increases in RevPAR attributable to improvements in ADR typically only result in increases in limited categories of operating costs and expenses, primarily credit card commissions, franchise fees and franchise assessments. Thus, improvements in ADR have a more significant impact on improving our operating margins than occupancy.
We continually seek to improve our operating leverage, which generally refers to the ability to generate incremental profit based on limited variable costs. Notwithstanding our efforts to reduce variable costs, there are limits to how much we or the Management Company and our other operators can accomplish in that regard without affecting the competitiveness of our hotels and our guests’ experiences at our hotels. Furthermore, we have significant fixed costs, such as depreciation and amortization, insurance and other expenses associated with owning hotels that do not necessarily decrease when circumstances such as market factors cause a reduction in our hotel revenue. For example, we have experienced increases in wages, employee benefits (especially workers’ compensation in our California hotels and health insurance) and utility costs, which negatively affected our operating margin. Our historical performance may not be indicative of future results, and our future results may be worse than our historical performance.
Acquisition, Sale and Major Redevelopment Activity
Our results during the periods discussed have been, and our future results will be, affected by our acquisition, sale and redevelopment activity during the applicable period.
Acquisition of hotels.The following table sets forth the hotels that we have acquired or developed since the beginning of 2004 and indicates their room count and acquisition date:
Hyatt Century Plaza, Los Angeles, California
Fairmont Hotel, Newport Beach, California
Sheraton Hotel, Cerritos, California
Renaissance Orlando Resort at Sea World, Orlando, Florida(1)
Renaissance Harborplace, Baltimore, Maryland
Renaissance Concourse, Atlanta, Georgia
Renaissance Long Beach, Long Beach, California
Renaissance Westchester, White Plains, New York
Renaissance Washington, D.C., Washington, D.C.
Residence Inn by Marriott, Rochester, Minnesota
JW Marriott, Cherry Creek, Colorado(4)
18
The aggregate cost for the eight hotels acquired during our first three quarters of 2005 totaled approximately $671.3 million, or $169,000 per room.
Sale of hotels. The following table sets forth the hotels that have been sold since the beginning of 2004 and indicates their room count and sale date:
Doubletree, Carson, California
Holiday Inn, Mesa, Arizona
San Marcos Resort, Chandler, Arizona
Holiday Inn, Flagstaff, Arizona
Concord Hotel and Conference Center, Concord, California
Four Points Sheraton, Silverthorne, Colorado
Holiday Inn, Anchorage, Alaska
Holiday Inn, La Mirada, California
Hawthorn Suites, Anaheim, California
The aggregate net sale proceeds for the nine closed hotel dispositions through September 30, 2005 were $85.5 million, or $41,000 per room. The results of operations of all of the hotels identified above and the gains or losses on dispositions through September 30, 2005 are included in discontinued operations for all periods presented through the time of sale. The proceeds from the sales are included in our cash flows from investing activities for the respective periods.
The following table summarizes our portfolio and room data since the beginning of 2004 through September 30, 2005 adjusted for the hotels acquired and sold during the respective periods.
Portfolio Data—Hotels
Number of hotels—beginning of period
Add: Acquisitions
Add: Developments
Less: Sales
Less: Assets not included
Number of hotels—end of period
Portfolio Data—Rooms
Number of rooms—beginning of period
Add: Room expansions
Less: Rooms converted to other usage
Number of rooms—end of period
Average rooms per hotel—end of period
19
Operating Results
Comparison of Three Months Ended September 30, 2005 to Three Months Ended September 30, 2004
The following table presents our unaudited operating results for the three months ended September 30, 2005 and 2004, including the amount and percentage change in the results between the two periods. The operating results for 2004 have been derived by combining the predecessor companies’ results for the period of July 1, 2004 through September 30, 2004.
Hotel operating
Income tax provision
NET INCOME
Preferred stock dividends
Operating Statistics
Occupancy(1)
Average daily rate(1)
RevPAR(1)
Room revenue. Room revenue increased $34.2 million, or 36.4%, to $128.3 million for the three months ended September 30, 2005, from $94.1 million for the three months ended September 30, 2004. This increase was primarily due to $30.3 million generated from the eight hotels we acquired subsequent to September 30, 2004. In addition, organic growth in our existing portfolio base contributed $8.3 million due to an increase in ADR, slightly offset by a small decrease in occupancy. These increases were partially offset by $4.4 million related to properties that were included in our third quarter 2004 results of operations but were not contributed to us by the predecessor companies.
Food and beverage revenue. Food and beverage revenue increased $15.0 million, or 56.0%, to $41.7 million for the three months ended September 30, 2005 from $26.7 million for the three months ended September 30, 2004. This increase
20
was primarily driven by $15.4 million contributed by our eight new hotels, as well as $0.8 million generated from increased restaurant revenue at our existing locations during 2005 as compared with 2004, partially offset by $1.2 million from properties that were included in our third quarter 2004 results of operations but were not contributed to us by the predecessor companies.
Other operating revenue. Other operating revenue increased $0.6 million, or 5.7%, to $11.9 million for the three months ended September 30, 2005 from $11.3 million for the three months ended September 30, 2004. Our eight newly acquired hotels contributed $1.5 million to other operating revenue during our third quarter of 2005. This increase was partially offset by a decrease of $0.6 million, net, in our existing hotels due to the continuing trend of declining telephone revenue, combined with a decrease in transportation revenue, slightly offset by growth in our electronic purchasing platform, Buy Efficient, L.L.C. In addition, other operating revenue decreased $0.3 million from properties that were included in our third quarter 2004 results of operations but were not contributed to us by the predecessor companies.
Management and other fees from affiliates. Management and other fees from affiliates in 2004 relate to the Doubletree, Nashville, Tennessee and Residence Inn by Marriott, Beverly Hills, California, which are properties owned by affiliates. As a result of our initial public offering, we no longer receive any management or other fees from these hotels.
Hotel operating expenses. Hotel operating expenses, which are comprised of room, food and beverage, advertising and promotion, repairs and maintenance, utilities, and other hotel operating expenses increased $32.7 million, or 40.5%, to $113.4 million for the three months ended September 30, 2005 from $80.7 million for the same time period in 2004. Our newly acquired hotels contributed $33.0 million in hotel operating expense during our third quarter of 2005. In addition, hotel operating expenses in our existing hotel portfolio increased $3.6 million during our third quarter of 2005 as compared with the same time period in 2004 primarily as a result of increases in advertising and promotion, franchise costs, and utilities. These increases were partially offset by $3.9 million from properties that were included in our third quarter 2004 results of operations but were not contributed to us by the predecessor companies, as well as ground lease expense incurred in 2004 but which ground lease was purchased as a part of our formation and structuring transactions.
Property general and administrative expense. Property general and administrative expense increased $9.9 million, or 89.5%, to $21.0 million for the three months ended September 30, 2005 from $11.1 million for the three months ended September 30, 2004. Of the increase, our newly acquired hotels contributed $5.0 million during our third quarter of 2005. The remaining increase was due to $2.2 million in management and accounting fees payable to the Management Company that were not payable in 2004 prior to our initial public offering, other hotel specific expenses, such as increased credit card commissions and franchise fees associated with the overall increase in revenue, partially offset by properties that were included in our third quarter 2004 results of operations but were not contributed to us by the predecessor companies.
Corporate general and administrative expense. Corporate general and administrative expense decreased to $3.1 million during our third quarter of 2005 as compared with $6.3 million during the same time period in 2004, primarily as a result of the expected decrease in salaries and wages attributable to the transfer of certain employees to the Management Company, partially offset by the increased costs of being a public company.
Depreciation and amortization expense. Depreciation and amortization increased $6.3 million to $20.8 million for the three months ended September 30, 2005 from $14.5 million for the three months ended September 30, 2004, primarily as a result of the eight hotels acquired since our third quarter of 2004, which contributed $6.1 million, slightly offset by properties that were included in our third quarter 2004 results of operations but were not contributed to us by the predecessor companies.
Interest expense. Interest expense increased $2.3 million to $15.9 million for the three months ended September 30, 2005 from $13.6 million for the three months ended September 30, 2004. This increase was primarily due to greater outstanding loan balances in 2005 as compared with 2004, as we obtained additional loans to finance our acquisitions. As such, we incurred an additional $2.9 million in interest expense during our third quarter 2005 as compared to the same time period in 2004. The higher interest was partially offset by a decrease in deferred financing fees amortization of $0.6 million in 2005 as compared to 2004.
Our total notes payable, including the current portion, was $1,020.3 million at September 30, 2005 and $915.2 million at September 30, 2004, with a weighted average interest rate per annum of approximately 5.8% at September 30, 2005 and 5.5% at September 30, 2004. At September 30, 2005, 91.4% of the amount outstanding under our notes payable was fixed and 8.6% of the amount outstanding under our notes payable was floating.
Provision for income taxes. As limited liability companies, the predecessor companies were pass-through entities and not liable for Federal and certain state income taxes, which were the responsibility of their respective members. However, some of our predecessor companies were corporations that were liable for taxes on their earnings. We maintain a taxable
21
REIT subsidiary which is liable for taxes on its earnings. The change in the tax provision is attributable to the historical tax provision for our predecessor companies being eliminated.
Income (loss) from discontinued operations. Income (loss) from discontinued operations was zero for the three months ended September 30, 2005, as no hotels were sold or held for sale during this time period. Income (loss) from discontinued operations totaled a $1.4 million loss for the three months ended September 30, 2004. At September 30, 2004, four of our hotels were held for sale and included in discontinued operations. As described under “—Acquisition, Sale and Major Redevelopment Activity—Sale of Hotels,” two of these hotels were subsequently sold in November 2004, and the remaining two hotels were sold during our second quarter of 2005. Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have reclassified the results of operations for these four hotels as discontinued operations.
Comparison of Nine Months Ended September 30, 2005 to Nine Months Ended September 30, 2004
The following table presents our unaudited operating results for the nine months ended September 30, 2005 and 2004, including the amount and percentage change in the results between the two periods. The operating results for 2004 have been derived by combining the predecessor companies’ results for the period of January 1, 2004 through September 30, 2004.
22
Room revenue. Room revenue increased $45.2 million, or 17.7%, to $300.5 million for the nine months ended September 30, 2005, from $255.4 million for the nine months ended September 30, 2004. This increase was primarily due to the $31.7 million generated from the eight hotels we have acquired since the beginning of 2005, and the one hotel we acquired in June 2004. In addition, organic growth in our existing portfolio base contributed $22.8 million due to increases in ADR and occupancy. These increases were partially offset by $9.3 million related to properties that were included in our 2004 year to date results of operations but were not contributed to us by the predecessor companies.
Food and beverage revenue. Food and beverage revenue increased $16.3 million, or 20.4%, to $96.4 million for the nine months ended September 30, 2005 from $80.1 million for the nine months ended September 30, 2004. This increase was primarily driven by $15.4 million contributed by the eight hotels we have acquired since the beginning of 2005, and the one hotel we acquired in June 2004, as well as $2.9 million generated from higher occupancy rates during 2005 as compared with 2004, partially offset by $2.0 million from properties that were included in our 2004 year to date results of operations but were not contributed to us by the predecessor companies.
Other operating revenue. Other operating revenue increased $1.1 million, or 3.3%, to $33.7 million for the nine months ended September 30, 2005 from $32.6 million for the nine months ended September 30, 2004. Our eight hotels acquired since the beginning of 2005, combined with the one hotel we acquired in June 2004, contributed $1.7 million to other operating revenue year to date in 2005. This increase was partially offset by $0.6 million from properties that were included in our 2004 year to date results of operations but were not contributed to us by the predecessor companies. Other operating revenue in our existing hotel portfolio remained relatively consistent for the nine months ended September 30, 2005 as compared with the same time period in 2004.
Hotel operating expenses. Hotel operating expenses, which are comprised of room, food and beverage, advertising and promotion, repairs and maintenance, utilities, and other hotel operating expenses increased $36.1 million, or 15.9%, to $263.5 million for the nine months ended September 30, 2005 from $227.3 million for the same time period in 2004. Our newly acquired hotels contributed $33.9 million in hotel operating expense year to date in 2005. In addition, hotel operating expenses in our existing hotel portfolio increased $10.1 million year to date in 2005 as compared with the same time period in 2004 primarily as a result of higher occupancies combined with increases in advertising and promotion. These increases were partially offset by $7.9 million from properties that were included in our year to date 2004 results of operations but were not contributed to us by the predecessor companies, as well as ground lease expense incurred in 2004 but which ground lease was purchased as a part of our formation and structuring transactions.
Property general and administrative expense. Property general and administrative expense increased $18.2 million, or 57.4%, to $50.0 million for the nine months ended September 30, 2005 from $31.8 million for the nine months ended September 30, 2004. Of the increase, our newly acquired hotels contributed $5.0 million for the nine months ended September 30, 2005. The remaining increase was due to a $2.1 million reserve for a contract interpretation issue with a customer, $6.4 million in management and accounting fees payable to the Management Company that were not payable in 2004 prior to our initial public offering, other hotel specific expenses, such as increased credit card commissions and franchise fees associated with the overall increase in revenue, and a mid-year 2004 acquisition, partially offset by properties that were included in our nine months ended September 30, 2004 results of operations but were not contributed to us by the predecessor companies. The ultimate resolution of the contract interpretation issue with a customer could result in a reimbursement to the customer in an amount in excess of $2.1 million.
Corporate general and administrative expense. Corporate general and administrative expense decreased to $8.8 million for the nine months ended September 30, 2005, as compared with $17.7 million during the same time period in 2004, primarily as a result of the expected decrease in salaries and wages attributable to the transfer of certain employees to the Management Company, partially offset by the increased costs of being a public company.
Depreciation and amortization expense. Depreciation and amortization increased $7.6 million to $49.8 million for the nine months ended September 30, 2005 from $42.2 million for the nine months ended September 30, 2004, primarily as a result of the eight hotels we have acquired since the beginning of 2005, which contributed $6.5 million, and the one hotel we acquired in June 2004, slightly offset by properties that were included in our year to date 2004 results of operations but were not contributed to us by the predecessor companies.
Interest expense. Interest expense increased $3.6 million to $43.3 million for the nine months ended September 30, 2005 from $39.7 million for the nine months ended September 30, 2004. This increase was caused by several factors. First,
23
interest expense increased due to a $2.8 million loan prepayment penalty incurred in 2005. An additional expense of $1.0 million was incurred due to higher loan balances in 2005 as compared with 2004, and $0.7 million was incurred due to a write-off of deferred financing fees. These increases were partially offset by a decrease in deferred financing fees amortization of $0.9 million year to date in 2005 as compared with 2004.
Impairment loss. Impairment loss in 2004 consists of hotel impairment losses of $7.4 million at six hotels and does not include any goodwill impairment loss. The hotel impairment loss in 2004 related to our determination that the current carrying values of the hotels were no longer recoverable based on estimated future cash flows to be generated by the hotels. This determination resulted from certain depressed hotel markets. The fair values of the hotels were determined using factors such as net operating cash flows, terminal capitalization rates and replacement costs as described under “—Critical Accounting Policies—Impairment of long-lived assets.”
Provision for income taxes. As limited liability companies, the predecessor companies were pass-through entities and not liable for Federal and certain state income taxes, which were the responsibility of their respective members. However, some of our predecessor companies were corporations that were liable for taxes on their earnings. We maintain a taxable REIT subsidiary which is liable for taxes on its earnings. The change in the tax provision is attributable to the historical tax provision for our predecessor companies being eliminated.
Income (loss) from discontinued operations. Income (loss) from discontinued operations totaled income of $2.9 million for the nine months ended September 30, 2005, as compared with a loss of $20.0 million for the same time period in 2004. As described under “—Acquisition, Sale and Major Redevelopment Activity—Sale of Hotels,” we sold seven hotels in 2004 and two hotels in 2005. Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have reclassified the results of operations for these hotels as discontinued operations.
24
UNAUDITED PRO FORMA FINANCIAL DATA
As of September 30, 2005 and For the Three and Nine Months Ended September 30, 2005
The following unaudited pro forma financial data as of September 30, 2005 and for the three and nine months ended September 30, 2005, gives effect to (1) the acquisition of the Century Plaza Hotel, Los Angeles, California, and the related placement of debt, (2) the acquisition of the remaining 75% interest in the Renaissance Hotel, Washington D.C., (3) the acquisition of Sheraton, Cerritos, California, (4) the sale by us of 4,102,564 shares of series C convertible redeemable preferred stock, (5) the acquisition of five Renaissance Hotels and a 25% interest in one Renaissance Hotel (the “CTF Acquired Properties”), (6) the acquisition of the Fairmont Hotel, (7) the sale of 3,750,000 shares of common stock at $20.65 per share and the sale of 294,000 shares of common stock at $21.97 per share to GIC Real Estate, (8) the sale of 300,000 shares of common stock at $22.347 per share to Security Capital Preferred Growth Incorporated and the sale of 3,000,000 shares of common stock at $23.40 (before underwriters’ discount and offering costs) per share to the public, (9) the placement of $250.0 million of fixed rate debt, (10) the replacement of existing debt with $276.0 million in fixed rate debt and (11) the sale by us of 4,850,000 shares of 8.0% series A cumulative redeemable preferred stock.
The following unaudited pro forma financial statements as of September 30, 2005 and for the three and nine months ended September 30, 2005 give effect to the above transactions if they had not already occurred as if they had occurred on September 30, 2005 for purposes of the unaudited pro forma balance sheet as of September 30, 2005. For purposes of the unaudited pro forma statement of operations for the three and nine months ended September 30, 2005, these transactions are presented as if they had occurred on July 1, 2005 and on January 1, 2005, respectively.
The unaudited pro forma financial data and related notes are presented for informational purposes only and do not purport to represent what our results of operations would actually have been if the transactions had in fact occurred on the dates discussed above. They also do not project or forecast our results of operations for any future date or period.
We believe that the pro forma information is useful to better understand the ongoing operations and financial performance during the periods presented.
The unaudited pro forma financial data should be read together with our historical consolidated and combined financial statements and related notes included elsewhere in this Form 10-Q and with the information set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The pro forma adjustments are based on available information and upon assumptions that we believe are reasonable; however, we cannot assure you that actual results will not differ from the pro forma information and perhaps in material and adverse ways.
25
PRO FORMA BALANCE SHEET
(Unaudited)
Prepaid expenses and other current assets
LIABILITIES AND MEMBERS’ EQUITY
Accounts payable and other accrued expenses
Current portion of secured notes payable
Minority interests
Series C convertible redeemable preferred stock
Stockholders’ equity
Preferred stock
Common stock
Unearned and accrued stock compensation
Total liabilities and equity
26
Notes to Unaudited Pro Forma Balance Sheet as of September 30, 2005
Cash paid
Debt placed in conjunction with the acquisition
Purchase price
Closing costs
Total costs
27
PRO FORMA CONDENSED INCOME STATEMENT
For the Three Months Ended September 30, 2005
Other hotel
General and administrative
General and administrative—corporate
General and administrative—property operations
Operating income (loss)
Income (loss) from continuing operations before minority interest and income taxes
Income (loss) from continuing operations
Income (loss) available to common stockholders
Income per share to common stockholders:
Basic and diluted
Common shares outstanding (7):
28
Notes to Unaudited Pro Forma Income Statement for the Three Months Ended September 30, 2005
6a. Reflects the net change in interest resulting from the fixed rate mortgage loan refinance and the new debt incurred in connection with the purchase of the CTF Acquired Properties, the Renaissance Washington, Washington, D.C., the Sheraton Cerritos, and the Century Plaza Hotel, Los Angeles, California
Actual interest expense
Net increase in interest expense
Pro forma interest expense
6b. Record minority interest for the pro forma period:
Pro forma income available to minority interest holders and common stockholders
Minority ownership percentage
Basic shares outstanding as of September 30, 2005
Unvested restricted stock grants made to employees
Diluted shares outstanding
29
For the Nine Months Ended September 30, 2005
Income available to common stockholders
Income (loss) per share to common stockholders:
Common shares outstanding (8):
30
PRO FORMA INCOME STATEMENT
Notes to Unaudited Pro Forma Income Statement for the Nine Months Ended September 30, 2005
7a. Reflects the net change in interest resulting from the fixed rate mortgage loan refinance and the new debt to be incurred in connection with the purchase of the CTF Acquired Properties, the Renaissance Washington, Washington, D.C., the Sheraton Cerritos, and the Century Plaza, Los Angeles, California
7b. Reflects a full period of preferred stock dividends on the 4,850,000 shares of 8.0% series A preferred stock
Actual preferred stock dividends
Increase in preferred stock dividends for full period
Pro forma preferred stock dividends
7c. Reflects a full period of preferred stock dividends on the 4,102,564 shares of series C convertible redeemable preferred stock
7d. Record minority interest for the pro forma period:
31
Liquidity and Capital Resources
Historical. During the periods presented, our historical sources of cash included our operating activities, working capital, long-term notes payable, bank credit facilities, contributions by the Sunstone Predecessor Companies and proceeds of our public and private offerings of common and preferred stock. Our primary uses for cash were for acquisitions of hotels, capital expenditures for hotels, operating expenses, distributions to the Sunstone Predecessor Companies, repayment of notes payable and dividends.
Operating activities. Net cash provided by operating activities was $59.7 million for the nine months ended September 30, 2005 compared to $41.0 million for the nine months ended September 30, 2004. This increase was primarily due to improved profitability during the nine months ended September 30, 2005 combined with additional cash generated from our newly acquired properties, partially offset by an increase in restricted cash made in connection with acquisitions that closed in 2005.
Investing activities. Our cash used in investment activities fluctuates primarily based on acquisitions, sales and renovations of hotels. Net cash used in investing activities was $701.5 million in the nine months ended September 30, 2005 compared to $48.1 million in the nine months ended September 30, 2004. During the nine months ended September 30, 2005, we acquired eight hotels for $671.3 million, paid a deposit of $15.0 million on an additional hotel which we acquired in October 2005, and paid $0.7 million in other deposits, for a total of $687.0. In addition, we have invested $42.4 million of capital expenditures in our hotels, and we have received net proceeds of $27.9 million from the sale of two hotels and a vacant land parcel. During the same time period in 2004, we developed and acquired two hotels for $49.6 million and invested $36.1 million of capital expenditures in our hotels. Additionally, we received net proceeds of $37.6 million from the sale of five hotels and a vacant land parcel.
Financing activities. Net cash provided by financing activities was $781.4 million for the nine months ended September 30, 2005 compared to $13.5 million for the nine months ended September 30, 2004. Net cash provided by financing activities for the nine months ended September 30, 2005 consisted primarily of net proceeds from our preferred securities and primary common stock offerings of $216.3 million and $298.0 million, respectively, and proceeds from notes payable of $589.4 million, partially offset by $38.0 million of dividends and distributions to our shareholders and holders of membership units in the Operating Partnership, $281.5 million of principal payments on notes payable and $2.8 million in deferred financing costs. Net cash provided by financing activities for the nine months ended September 30, 2004 consisted primarily of proceeds from notes payable of $42.8 million and contributions from the Sunstone Predecessor Companies of $25.3 million partially offset by $9.4 million of distributions to the Sunstone Predecessor Companies and $45.2 million of principal payments on notes payable.
Future. We expect our primary uses for cash to be for acquisitions of hotels, capital expenditures for hotels, operating expenses, debt service and distributions to holders of our common and preferred stock and membership units in our Operating Partnership. We also expect our primary sources of cash will continue to come from the operations of our hotels and our working capital. In addition, we have a $150.0 million senior secured revolving credit facility.
We believe that our capital structure, including our $150.0 million revolving credit facility and cash flow from operations, will provide us with sufficient liquidity to meet our current operating expenses and other expenses directly associated with our business and properties. We have interest rate protection agreements covering all of our variable rate debt, which accounted for 8.6% of our total outstanding indebtedness at September 30, 2005. In April 2005, we closed ten individual non cross-collateralized fixed rate mortgage loans totaling $276.0 million. The loans are each for a term of ten years with a fixed rate of 5.34%. In June 2005, we closed $250.0 million in mortgage loans with terms ranging between seven and eleven years and a weighted average fixed interest rate of 5.14%. Also in June 2005, we assumed a $9.2 million fixed rate mortgage loan with a maturity date of August 2024 and a fixed interest rate of 8.78%. In July, 2005, we assumed a $54.0 million fixed rate mortgage loan with a maturity date of April 2023 and a fixed interest rate of 7.50%. As of September 30, 2005, 91.4% of the Company’s outstanding debt is fixed rate. We believe this debt capital structure is appropriate for the operating characteristics of our business and provides for significant prepayment and refinancing flexibility.
In the future, we may also explore other financing alternatives, including our sale of equity and debt securities. Our ability to incur additional debt depends on a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions imposed by existing lenders under our existing notes payable, including our revolving credit facility. Our ability to raise funds through the issuance of equity securities depends on, among other things, general market conditions for hotel companies and REITs and market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time. However, the capital markets may not be available to us when needed on favorable terms or at all.
32
Contractual Obligations
The following table summarizes our payment obligations and commitments as of September 30, 2005 (in thousands):
Contractual obligations
Notes payable
Operating lease obligations
Construction commitments
Employment obligations
Total
Capital Expenditures and Reserve Funds
We believe we maintain each of our hotels in good repair and condition and in conformity with applicable franchise agreements, ground leases, laws and regulations. Our capital expenditures primarily relate to the ongoing maintenance of our hotels and are budgeted in the reserve accounts described in the following paragraph. We also incur capital expenditures following the acquisition of hotels for renovation and development. Our capital expenditures for 2005 are expected to be approximately $65.0 million to $75.0 million. This renovation budget includes our $33.1 million of contractual construction commitments. All of these amounts are expected to be funded out of our cash and reserve accounts. Our capital expenditures could increase if we determine to acquire, renovate or develop additional hotels in the future. Our capital expenditures also fluctuate from year to year, since we are not required to spend the entire amount in the reserve accounts each year.
With respect to our hotels that are operated under franchise agreements with major national hotel brands and for all of our hotels subject to a first mortgage lien, we are obligated to maintain a furniture, fixture and equipment, or FF&E, reserve account for future planned and emergency-related capital expenditures at these hotels. The amount funded into each of these reserve accounts is determined pursuant to the management, franchise and loan agreements for each of the respective hotels, ranging between 4.0% and 5.0% of the respective hotel’s total annual revenue. As of September 30, 2005, $26.2 million was available in restricted cash reserves for future capital expenditures at our hotels. According to the respective loan agreements, the reserve funds are to be held by the respective lenders in a restricted cash account.
Derivative Financial Instruments
We use derivative financial instruments, primarily interest rate caps, to manage our exposure to the interest rate risks related to the following variable rate debt. Following the repayment of some of our floating rate debt with the proceeds from our initial public offering, we own interest rate caps having aggregate notional amounts well in excess of our floating rate debt. At September 30, 2005, our interest rate caps consisted of the following:
The net settlements, if any, paid or received under these interest rate cap agreements are accrued consistent with the terms of the agreements and are recognized in interest expense over the term of the related debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. We generally use outside consultants to determine the fair values of our derivative instruments. Such methods generally incorporate market conventions and techniques such as discounted cash flow analysis and option pricing models to determine fair value. We believe these methods of estimating fair value result in general approximation of value,
33
and such value may or may not actually be realized. For the nine months ended September 30, 2005, our mark to market adjustments of these contracts resulted in a net loss of $1,000.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements during the periods presented and did not have any upon the completion of our offering.
Seasonality
The lodging business is seasonal in nature, and we experience some seasonality in our business as indicated in the table below. Revenue for hotels in tourist areas generally are substantially greater during tourist season than other times of the year. Quarterly revenue also may be adversely affected by events beyond our control, such as extreme weather conditions, terrorist attacks or alerts, SARS, airline strikes, economic factors and other considerations affecting travel.
Our revenues by quarter during 2004 and 2005 were as follows (dollars in thousands):
Revenues
Inflation
Inflation may affect our expenses, including, without limitation, by increasing such costs as taxes, property and casualty insurance and utilities.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated and combined financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.
We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our combined financial statements.
34
New Accounting Standards and Accounting Changes
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment. SFAS 123(R) requires all share-based payments to employees, including grants of common stock, to be recognized in the financial statements based on their fair values. The adoption of the provisions of SFAS 123(R) had no material impact to us.
Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Some of our outstanding debt has a variable interest rate. As described in “—Derivative Financial Instruments” above, we use some derivative financial instruments, primarily interest rate caps, to manage our exposure to interest rate risks related to our floating rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. As of September 30, 2005, our total outstanding debt was approximately $1,020.3 million, of which approximately $88.1 million, or 8.6%, was variable rate debt. If market rates of interest on our variable rate debt decrease by 1.0% or approximately 100 basis points, the decrease in interest expense on our variable rate debt would increase future earnings and cash flows by approximately $881,000 annually. On the other hand, if market rates of interest on our variable debt increase by 1.0% or approximately 100 basis points, the increase in interest expense on our variable debt would decrease future earnings and cash flows by approximately $881,000 annually.
Interest risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments. These analyses do not consider the effect of a reduced level of overall economic activity. If overall economic activity is significantly reduced, we may take actions to further mitigate our exposure. However, because we cannot determine the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.
35
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this quarterly report on Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of such date, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in applicable SEC’s rules and forms. No system of controls, no matter how well designed and operated, can provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
There have been no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
36
PART II—OTHER INFORMATION
We are involved from time to time in various claims, disputes and other legal actions in the ordinary course of business. We do not believe that the resolution of such additional matters will have a material adverse effect on our financial position or results of operations when resolved.
None.
37
The following Exhibits are filed as a part of this report:
Description
38
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.
Date: November 8, 2005
By:
39