Service Properties Trust - Quarter Report: 2012 March (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2012

 

OR

 

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 1-11527

 

HOSPITALITY PROPERTIES TRUST

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

617-964-8389

(Registrant’s Telephone Number, Including Area Code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer, accelerated filer” and “smaller reporting company” in Rule 12b—2 of the Exchange Act.

 

 

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

 

Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of May 7, 2012: 123,554,667

 

 

 

HOSPITALITY PROPERTIES TRUST

 

FORM 10-Q

 

March 31, 2012

 

INDEX

 

		Page
PART I	Financial Information (unaudited)
	Item 1. Financial Statements
	Condensed Consolidated Balance Sheets — March 31, 2012 and December 31, 2011	1
	Condensed Consolidated Statements of Income and Comprehensive Income — Three Months Ended March 31, 2012 and 2011	2
	Condensed Consolidated Statements of Cash Flows — Three Months Ended March 31, 2012 and 2011	3
	Notes to Condensed Consolidated Financial Statements	4
	Item 2.
	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
	Item 3.
	Quantitative and Qualitative Disclosures About Market Risk	33
	Item 4.
	Controls and Procedures	34
	Warning Concerning Forward Looking Statements	35
	Statement Concerning Limited Liability	38
PART II	Other Information
	Item 1A.
	Risk Factors	39
	Item 2.
	Unregistered Sales of Equity Securities and Use of Proceeds	40
	Item 6.
	Exhibits	41
	Signatures	44

 

References in this Form 10-Q to “HPT”, “we”, “us” or “our” include Hospitality Properties Trust and its consolidated subsidiaries unless otherwise noted or the context indicates otherwise.

 

 

Part 1     Financial Information

 

Item 1.  Financial Statements

 

HOSPITALITY PROPERTIES TRUST

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(dollars in thousands, except share data)

 

 

		March 31,			December 31,
		2012			2011
ASSETS
Real estate properties, at cost:
Land		$	1,415,880		$	1,360,773
Buildings, improvements and equipment		4,998,896			4,879,908
		6,414,776			6,240,681
Accumulated depreciation		(1,392,603		)	(1,367,868		)
		5,022,173			4,872,813
Property held for sale		18,440			18,440
Cash and cash equivalents		148,211			8,303
Restricted cash (FF&E reserve escrow)		59,644			50,196
Other assets, net		229,556			183,821
		$	5,478,024		$	5,133,573
LIABILITIES AND SHAREHOLDERS’ EQUITY
Unsecured revolving credit facility		$	—		$	149,000
Unsecured term loan		400,000			—
Senior notes, net of discounts		1,888,275			1,887,891
Convertible senior notes, net of discount		8,478			78,823
Security deposits		90,168			106,422
Accounts payable and other liabilities		104,629			103,668
Due to related persons		3,121			3,713
Dividends payable		7,833			4,754
Total liabilities		2,502,504			2,334,271
Commitments and contingencies
Shareholders’ equity:
Preferred shares of beneficial interest, no par value, 100,000,000 shares authorized:
Series B preferred shares; 8 7/8% cumulative redeemable; zero and 3,450,000 shares issued and outstanding, respectively, aggregate liquidation preference $86,250		—			83,306
Series C preferred shares; 7% cumulative redeemable; 12,700,000 shares issued and outstanding, aggregate liquidation preference $317,500		306,833			306,833
Series D preferred shares; 7 1/8% cumulative redeemable; 11,600,000 and zero shares issued and outstanding, respectively, aggregate liquidation preference $290,000		280,108			—
Common shares of beneficial interest, $.01 par value; 200,000,000 shares authorized; 123,554,667 and 123,521,535 shares issued and outstanding, respectively		1,236			1,235
Additional paid in capital		3,464,411			3,463,534
Cumulative net income		2,272,957			2,232,953
Cumulative other comprehensive income		6,912			1,605
Cumulative preferred distributions		(224,469		)	(213,281		)
Cumulative common distributions		(3,132,468		)	(3,076,883		)
Total shareholders’ equity		2,975,520			2,799,302
		$	5,478,024		$	5,133,573

 

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

 

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HOSPITALITY PROPERTIES TRUST

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(Unaudited)

(in thousands, except per share data)

 

		Three Months Ended March 31,
		2012			2011
Revenues:
Hotel operating revenues		$	224,985		$	197,537
Rental income		73,260			79,533
FF&E reserve income		3,175			4,914
Total revenues		301,420			281,984
Expenses:
Hotel operating expenses		150,021			129,753
Depreciation and amortization		61,363			56,314
General and administrative		10,522			9,264
Acquisition related costs		1,060			—
Loss on asset impairment		889			—
Total expenses		223,855			195,331
Operating income		77,565			86,653
Interest income		66			29
Interest expense (including amortization of deferred financing costs and debt discounts of $1,578 and $1,501, respectively)		(34,092		)	(33,339		)
Equity in earnings of an investee		45			37
Income before income taxes		43,584			53,380
Income tax expense		(636		)	(332		)
Net income		42,948			53,048
Excess of liquidation preference over carrying value of preferred shares redeemed		(2,944		)	—
Preferred distributions		(11,188		)	(7,470		)
Net income available for common shareholders		$	28,816		$	45,578
Net income		$	42,948		$	53,048
Other comprehensive income:
Unrealized gain on TA common shares		5,308			5,852
Equity interest in investee’s unrealized gains (losses)		(1		)	4
Other comprehensive income		5,307			5,856
Comprehensive income		$	48,255		$	58,904
Weighted average common shares outstanding		123,523			123,444
Basic and diluted earnings per common share:
Net income available for common shareholders		$	0.23		$	0.37

 

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

 

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HOSPITALITY PROPERTIES TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

 

		For the Three Months Ended March 31,
		2012			2011
Cash flows from operating activities:
Net income		$	42,948		$	53,048
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization		61,363			56,314
Amortization of deferred financing costs and debt discounts as interest		1,578			1,501
Straight line rental income		(354		)	(1,216		)
Security deposits applied to payment shortfalls		(16,250		)	(16,704		)
FF&E reserve income and deposits		(7,865		)	(14,767		)
Loss on asset impairment		889			—
Equity in earnings of an investee		(45		)	(37		)
Other non-cash (income) expense, net		170			(628		)
Changes in assets and liabilities:
Increase in other assets		(7,841		)	(1,898		)
Decrease in accounts payable and other liabilities		(13,010		)	(19,179		)
Increase (decrease) in due to related persons		(545		)	59
Cash provided by operating activities		61,038			56,493
Cash flows from investing activities:
Real estate acquisitions		(150,500		)	—
Real estate improvements		(50,205		)	—
FF&E reserve fundings		(25,502		)	(5,854		)
Cash used in investing activities		(226,207		)	(5,854		)
Cash flows from financing activities:
Proceeds from issuance of preferred shares, net		280,108			—
Proceeds from unsecured term loan		400,000			—
Redemption of preferred shares		(86,250		)	—
Repurchase of convertible senior notes		(70,576		)	—
Repayment of mortgage note		—			(3,383		)
Borrowings under revolving credit facility		378,000			60,000
Repayments of revolving credit facility		(527,000		)	(33,000		)
Deferred financing costs		(2,432		)	—
Distributions to preferred shareholders		(11,188		)	(7,470		)
Distributions to common shareholders		(55,585		)	(55,550		)
Cash provided by (used in) financing activities		305,077			(39,403		)
Increase in cash and cash equivalents		139,908			11,236
Cash and cash equivalents at beginning of period		8,303			4,882
Cash and cash equivalents at end of period		$	148,211		$	16,118
Supplemental cash flow information:
Cash paid for interest		$	54,938		$	54,419
Cash paid for income taxes		140			104
Non-cash investing activities:
Property managers’ deposits in FF&E reserve		$	7,133		$	12,309
Property managers’ purchases with FF&E reserve		(28,187		)	(38,865		)
Non-cash financing activities:
Issuance of common shares		$	878		$	—

 

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

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 1.  Basis of Presentation

 

The accompanying condensed consolidated financial statements of Hospitality Properties Trust and its subsidiaries, or HPT, or we, our or us, are unaudited. Certain information and disclosures required by U.S. generally accepted accounting principles, or GAAP, for complete financial statements have been condensed or omitted. We believe the disclosures made are adequate to make the information presented not misleading. However, the accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2011, as amended, or our 2011 Annual Report.  In the opinion of our management, all adjustments, which include only normal recurring adjustments considered necessary for a fair presentation, have been included in these condensed consolidated financial statements.  These condensed consolidated financial statements include the accounts of HPT and its subsidiaries, all of which are 100% owned directly or indirectly by HPT.  All material intercompany transactions and balances have been eliminated. Our operating results for interim periods and those of our managers and tenants are not necessarily indicative of the results that may be expected for the full year. Reclassifications have been made to the prior year’s condensed consolidated financial statements to conform to the current year’s presentation.

 

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts. Actual results could differ from those estimates.  Significant estimates in the condensed consolidated financial statements include the allowance for doubtful accounts, purchase price allocations, useful lives of fixed assets and impairment of real estate and intangible assets.

 

We have determined that each of our taxable REIT subsidiaries, or TRSs, is a variable interest entity, or VIE, as defined under the Consolidation Topic of the Financial Accounting Standards Board, or FASB, Accounting Standards CodificationTM.   We have concluded that we must consolidate each of our TRSs because we are the entity with the power to direct the activities that most significantly impact such VIEs’ performance and we have the obligation to absorb the majority of the potential variability in gains and losses of each VIE, with the primary focus on losses, and are, therefore, the primary beneficiary of each VIE.

 

Note 2.  New Accounting Pronouncements

 

In January 2012, we adopted FASB Accounting Standards Update No. 2011-04, Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRS.  This update clarified the application of existing fair value measurement requirements.  This update also required reporting entities to disclose additional information regarding fair value measurements categorized within Level 3 of the fair value hierarchy.  This update was effective for interim and annual reporting periods beginning after December 15, 2011.  The implementation of this update did not cause any material changes to the disclosures in, or presentation of, our condensed consolidated financial statements.

 

In January 2012, we adopted FASB Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income.  This update eliminates the prior option to report other comprehensive income and its components in the statement of shareholders’ equity.  This update is intended to enhance comparability between entities that report under GAAP and to provide a more consistent method of presenting non-owner transactions that affect an entity’s equity.  The update was effective for interim and annual reporting periods beginning after December 15, 2011.  The implementation of this update did not cause any material changes to our condensed consolidated financial statements.

 

Note 3.  Revenue Recognition

 

We report hotel operating revenues for managed hotels in our Condensed Consolidated Statements of Income. We generally recognize hotel operating revenues, consisting primarily of room and food and beverage sales, when services are provided. Our share of the net operating results of our managed hotels in excess of the minimum returns due to us, or additional returns, are generally determined annually. We recognize additional returns due to us under our

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

management agreements at year end when all contingencies are met and the income is earned. We had no deferred additional returns for the three months ended March 31, 2012 and 2011.

 

We recognize rental income from operating leases on a straight line basis over the term of the lease agreements.  Rental income includes $354 and $1,216 for the three months ended March 31, 2012 and 2011, respectively, of adjustments necessary to record rent on the straight line basis.

 

We determine percentage rent due to us under our leases annually and recognize it at year end when all contingencies have been met and the rent is earned. We had deferred percentage rent of $1,309 and $541 for the three months ended March 31, 2012 and 2011, respectively.

 

We own all the capital expenditure reserves, or FF&E reserves, for our hotels. We do not report the amounts which are escrowed as FF&E reserves for our managed hotels as FF&E reserve income. We report deposits by our third party hotel tenants into the escrow accounts as FF&E reserve income.

 

Note 4.  Per Common Share Amounts

 

We calculate per common share amounts using the weighted average number of common shares outstanding during the period. We had no dilutive common share equivalents at March 31, 2012 or 2011.

 

Note 5.  Shareholders’ Equity

 

Preferred Shares

 

In January 2012, we sold 11,600,000 Series D cumulative redeemable preferred shares at a price of $25.00 per share in a public offering for net proceeds of $280,108 (after underwriting and other offering expenses).  Each of our Series D preferred shares has a distribution rate of $1.78125 per annum, payable in equal quarterly amounts, and a liquidation preference of $25.00 per share ($290,000 in aggregate). The Series D preferred shares are redeemable for $25.00 per share each plus accrued and unpaid distributions at our option at any time on or after January 15, 2017, or at the option of the holders of the Series D preferred shares if a change of control occurs which results in our common shares (or the common securities of an acquiring or surviving entity) not being listed or quoted on the New York Stock Exchange or certain other exchanges or quotation systems.  Also, upon the occurrence of such a change of control, holders of Series D preferred shares that we do not elect to redeem may at their option convert those Series D preferred shares into our common shares (or certain alternative consideration) at a conversion rate generally based on their $25.00 liquidation preference and the market price of our common shares at the time of conversion, subject to a cap.

 

On February 13, 2012, we redeemed our 3,450,000 outstanding 8.875% Series B cumulative redeemable preferred shares at the stated liquidation preference price of $25.00 per share plus accrued and unpaid distributions to the date of redemption. We reduced net income available for common shareholders for the three months ended March 31, 2012, by $2,944, which represented the amount by which the liquidation preference for our Series B cumulative redeemable preferred shares that we redeemed exceeded our carrying amount for those preferred shares as of the date of redemption.

 

Distributions

 

On January 17, 2012, we paid a $0.5546875 per share distribution to our Series B preferred shareholders with respect to the period ended January 14, 2012.

 

On February 15, 2012, we paid a $0.4375 per share distribution to our Series C preferred shareholders with respect to the period ended February 14, 2012.  On April 2, 2012, we declared a $0.4375 per share distribution to our Series C preferred shareholders of record on April 30, 2012, with respect to the period ending May 14, 2012. We expect to pay this amount on or about May 15, 2012.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

On March 1, 2012, we declared a $0.43046875 per share distribution to our Series D preferred shareholders of record on March 30, 2012, with respect to the period ended April 14, 2012. We paid this amount on April 16, 2012.

 

On February 23, 2012, we paid a $0.45 per share distribution to our common shareholders.  On April 9, 2012, we declared a $0.45 per share distribution to our common shareholders of record on April 26, 2012.  We expect to pay this amount on or about May 24, 2012.

 

Common Share Issuances

 

As further described in Note 11, under the terms of our business management agreement with Reit Management & Research LLC, or RMR, on March 29, 2012, we issued 33,132 of our common shares to RMR in payment of an incentive fee for services rendered to us by RMR during 2011.  These shares had a market value of $877 based on the per common share price of $26.47, which was the closing price of our common shares on the New York Stock Exchange on that day.

 

Comprehensive Income

 

Cumulative other comprehensive income represents the unrealized gain (loss) on the TravelCenters of America LLC, or TA, shares we own and our share of the comprehensive income (loss) of Affiliates Insurance Company, or AIC.  See Note 11 for a description of these investments.

 

Note 6.  Indebtedness

 

We have a $750,000 interest only, unsecured revolving credit facility.  Our credit facility matures on September 7, 2015, and subject to our payment of an extension fee and meeting certain other conditions, we have the option to extend the facility for one year to September 7, 2016.  Our revolving credit facility bears interest at LIBOR plus 130 basis points, subject to adjustments based on our senior unsecured debt ratings.  The weighted average interest rate for borrowings under our revolving credit facility was 1.59% for the three months ended March 31, 2012.  As of March 31, 2012, we had no amounts outstanding under our revolving credit facility and $750,000 available for borrowings.

 

On March 12, 2012, we entered into a five year $400,000 unsecured term loan.  The loan matures on March 13, 2017, and is prepayable, without penalty, at any time.  Our term loan bears interest at LIBOR plus 145 basis points, subject to adjustment based on our senior unsecured debt ratings.  The weighted average annual interest rate for amounts outstanding on our term loan was 1.70% for the period March 12, 2012 to March 31, 2012.

 

On March 20, 2012, we repurchased at par plus accrued and unpaid interest $70,576 of our 3.8% convertible senior notes due 2027 which were tendered by the holders thereof for repurchase by us.

 

We separately account for the liability (debt) and equity (conversion option) components of our 3.8% convertible senior notes due 2027 to reflect the fair value of the liability component based on our non-convertible borrowing cost at the issuance date. We measured the fair value of the debt components of the notes at issuance based on an estimated effective interest rate of 6.06% and amortized the resulting discount as an increase to interest expense over the expected life of the debt (assuming holders of the notes exercised in full their options to require us to repay the notes on March 20, 2012).

 

·                  The net carrying amount of our 3.8% convertible senior notes due 2027 was $8,478 and $78,823 as of March 31, 2012 and December 31, 2011, respectively.

·                  The unamortized discount on such notes was $0 and $231 as of March 31, 2012 and December 31, 2011, respectively. We amortized the discount through March 20, 2012, the first date on which the holders of our 3.8% convertible senior notes could require that we redeem them.

·                  Interest expense with respect to our 3.8% convertible senior notes for the three months ended March 31, 2012 and 2011 includes non-cash amortization of $270 and $392, respectively.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

·                  The amount allocated as the equity component of the 3.8% convertible senior notes was $37,710 as of March 31, 2012 and is included in additional paid in capital in our Condensed Consolidated Balance Sheets.

 

On April 11, 2012, we redeemed at par all of our outstanding 6.85% senior notes due 2012 for $100,829 plus accrued and unpaid interest.

 

Note 7.  Real Estate Properties

 

At March 31, 2012, we owned 474 properties consisting of 289 hotels and 185 travel centers that were operated under nine management agreements or leases and leased one hotel.

 

At March 31, 2012, one of our hotels was held for sale.  See Note 13 for further information relating to our hotel held for sale.

 

During the three months ended March 31, 2012, we funded $75,668 of improvements to certain of our properties, which resulted in a $6,232 increase in our annual minimum returns and rents.

 

On January 31, 2012, we completed an acquisition of the entities which own the Royal Sonesta Hotel Boston in Cambridge, MA, or the Cambridge Hotel, (400 rooms) and lease the Royal Sonesta Hotel New Orleans in New Orleans, LA, or the New Orleans Hotel, (483 rooms) for a total cost of $153,515 ($150,500 cash consideration and $3,015 of assumed net liabilities), excluding related acquisition costs.  We have included the results of these hotels in our condensed consolidated financial statements from the date of acquisition. The pro forma impact of including the results of operations of the hotels from the beginning of the period is not material to our condensed consolidated financial statements.  The following table summarizes our preliminary allocation of the acquisition costs to estimated fair value of the assets we acquired and the liabilities we assumed:

 

 

Land		$	31,510
Building		77,664
Furniture, fixtures and equipment		18,979
Intangible assets (including the leasehold value of the New Orleans hotel)		34,647
Other, net		2,990
Deferred tax liability		(12,275		)
Total		$	153,515

 

Simultaneous with this acquisition, we entered into management agreements with Sonesta International Hotels Corporation (formerly known as Sonesta Acquisition Corp.), or Sonesta.  See Notes 11 and 12 for further information about these transactions.

 

Note 8. Income Taxes

 

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, and, accordingly are generally not subject to federal and most state income taxation on our operating income provided we distribute our taxable income to our shareholders and meet certain organization and operating requirements.  We are subject to income tax in Canada, Puerto Rico and certain states despite our REIT status.  Further, we lease our managed hotels to our wholly owned TRSs that, unlike most of our other subsidiaries, file a separate consolidated tax return and are subject to federal, state and foreign income taxes.  Our consolidated income tax provision (or benefit) includes the income tax provision (or benefit) related to the operations of our TRSs and certain state and foreign income taxes incurred by us despite our REIT status.

 

During the three months ended March 31, 2012, we recognized current tax expense of $972, which includes $495 of federal taxes, $35 of foreign taxes and $442 of certain state taxes that are payable without regard to our REIT status and TRS tax loss carry forwards. In addition, during the three months ended March 31, 2012, we recognized a deferred tax benefit of $336, related to a basis difference at our Puerto Rico and New Orleans hotels and Canadian tax losses available to offset future income.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 9.  Segment Information

 

		For the Three Months Ended March 31, 2012
		Hotels			Travel  Centers			Corporate			Consolidated
Hotel operating revenues		$	224,985		$	—		$	—		$	224,985
Rental income		21,942			51,318			—			73,260
FF&E reserve income		3,175			—			—			3,175
Total revenues		250,102			51,318			—			301,420
Hotel operating expenses		150,021			—			—			150,021
Depreciation and amortization		39,958			21,405			—			61,363
General and administrative		—			—			10,522			10,522
Acquisition related costs		1,060			—			—			1,060
Loss on asset impairment		889			—			—			889
Total expenses		191,928			21,405			10,522			223,855
Operating income (loss)		58,174			29,913			(10,522		)	77,565
Interest income		—			—			66			66
Interest expense		—			—			(34,092		)	(34,092		)
Equity in earnings of an investee		—			—			45			45
Income (loss) before income taxes		58,174			29,913			(44,503		)	43,584
Income tax expense		—			—			(636		)	(636		)
Net income (loss)		$	58,174		$	29,913		$	(45,139	)	$	42,948
		As of March 31, 2012
		Hotels			Travel  Centers			Corporate			Consolidated
Total assets		$	3,109,296		$	2,200,682		$	168,046		$	5,478,024
		For the Three Months Ended March 31, 2011
		Hotels			Travel  Centers			Corporate			Consolidated
Hotel operating revenues		$	197,537		$	—		$	—		$	197,537
Rental income		29,701			49,832			—			79,533
FF&E reserve income		4,914			—			—			4,914
Total revenues		232,152			49,832			—			281,984
Hotel operating expenses		129,753			—			—			129,753
Depreciation and amortization		36,463			19,851			—			56,314
General and administrative		—			—			9,264			9,264
Total expenses		166,216			19,851			9,264			195,331
Operating income (loss)		65,936			29,981			(9,264		)	86,653
Interest income		—			—			29			29
Interest expense		—			—			(33,339		)	(33,339		)
Equity in earnings of an investee		—			—			37			37
Income (loss) before income taxes		65,936			29,981			(42,537		)	53,380
Income tax expense		—			—			(332		)	(332		)
Net income (loss)		$	65,936		$	29,981		$	(42,869	)	$	53,048
		As of December 31, 2011
		Hotels			Travel  Centers			Corporate			Consolidated
Total assets		$	2,905,065		$	2,202,199		$	26,309		$	5,133,573

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 10. Significant Tenant

 

TA is the lessee of 39% of our real estate properties, at cost, as of March 31, 2012.  The following table presents summary financial information for TA for the three months ended March 31, 2012, as reported in its Quarterly Report on Form 10-Q, or TA’s Quarterly Report:

 

		For the Three Months Ended
		March 31,
		2012			2011
Operations
Total revenues		$	1,994,869		$	1,782,114
Total cost of goods sold		1,751,517			1,552,631
Net loss		(14,185		)	(16,572		)
Cash Flows
Net cash provided by (used in) operating activities		4,471			(49,407		)
Net cash used in investing activities		(27,231		)	(22,219		)
Net cash used in financing activities		(571		)	(586		)
Net decrease in cash		(23,318		)	(72,191		)
Cash and cash equivalents at the beginning of the period		118,255			125,396
Cash and cash equivalents at the end of the period		94,937			53,205

 

		As of March 31,
		2012			2011
Financial Position
Current assets		$	492,615		$	412,047
Noncurrent assets		540,008			501,036
Current liabilities		319,648			275,919
Noncurrent liabilities		407,903			401,877
Total shareholders’ equity		305,072			235,287

 

The summary financial information of TA is presented to comply with applicable accounting regulations of the Securities and Exchange Commission, or the SEC.  References in these financial statements to TA’s Quarterly Report are included as textual references only, and the information in TA’s Quarterly Report is not incorporated by reference into these financial statements.  See Note 11 for further information relating to our TA leases.

 

Note 11. Related Person Transactions

 

We have no employees.  Personnel and various services we require to operate our business are provided to us by RMR.  We have two agreements with RMR to provide management and administrative services to us: (1) a business management agreement and (2) a property management agreement.  Under our business management agreement with RMR, we acknowledge that RMR also provides management services to other companies, including TA.  One of our Managing Trustees, Mr. Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Our other Managing Trustee, Mr. Adam Portnoy, is the son of Mr. Barry Portnoy, and an owner, President, Chief Executive Officer and a director of RMR.  Each of our executive officers is also an officer of RMR.  Certain of TA’s executive officers are officers of RMR.  Our Independent Trustees also serve as independent directors or independent trustees of other public companies to which RMR provides management services.  Mr. Barry Portnoy serves as a managing director or managing trustee of those companies and Mr. Adam Portnoy serves as a managing trustee of a majority of those companies.

 

Pursuant to our business management and property management agreements with RMR, we incurred expenses of $8,648 and $8,285 for the three months ended March 31, 2012 and 2011, respectively.  In March 2012, we issued 33,132 shares to RMR in satisfaction of the incentive fee RMR earned for services provided to us during 2011, in accordance with the terms of the business management agreement.   These amounts are included in general and administrative expenses in our condensed consolidated financial statements.

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

TA is our former 100% owned subsidiary.  TA became a public company in a spin off transaction in 2007. We are TA’s largest shareholder and, as of the date of this report, we owned 2,540,000 common shares of TA, or approximately 8.8% of TA’s outstanding common shares.  One of our Managing Trustees, Mr. Barry Portnoy, is also a managing director of TA.

 

TA is our largest tenant and has two leases with us, the TA No. 1 lease and the TA No. 2 lease, pursuant to which TA currently leases 185 travel centers from us.  The TA No. 1 lease is for 145 travel centers that TA operates under the “TravelCenters of America” or “TA” brand names.   The TA No. 2 lease is for 40 travel centers that TA operates under the “Petro” brand name.  The TA No. 1 lease expires on December 31, 2022.  The TA No. 2 lease expires on June 30, 2024, and may be extended by TA for up to two additional periods of 15 years each.  Both of these leases require TA to: (1) make payments to us of minimum rents; (2) pay us percentage rent equal to 3% of non-fuel revenue and 0.3% of fuel revenues over threshold amounts established in 2011 and to be established in 2012 (with the first $2,500 of percentage rents under the TA No. 2 lease previously waived by us), respectively; and (3) maintain the leased travel centers, including structural and non-structural components.  In addition to minimum and percentage rent, TA is obligated to pay us ground rent of approximately $5,126 per year under the TA No. 1 lease.  Previously deferred rent due from TA of $107,085 and $42,915 is due in December 2022 and June 2024, respectively.  We have not recognized any of the deferred rent as rental income or as rents receivable due to uncertainties regarding future collection.

 

We recognized rental income from our leases with TA of $51,318 and $49,832 for the three months ended March 31, 2012 and 2011, respectively.  Rental income for the three months ended March 31, 2012 and 2011 includes $357 and $1,204, respectively, of adjustments necessary to record rent on our TA No. 1 lease on a straight line basis.  We had deferred percentage rent of $729 under our TA No. 1 lease for the three months ended March 31, 2012.  We determine percentage rent due under our TA No. 1 lease annually and recognize it at year end when all contingencies are met.

 

Under both of our leases with TA, TA may request that we fund additional amounts for capital improvements to the leased facilities in return for minimum rent increases; however TA is not required to request that we fund those capital improvements it makes to our properties and we are not required to fund any such request.  We funded $13,060 for capital improvements to TA under this lease provision during the three months ended March 31, 2012.  See Note 10 above for more information about TA.

 

The stockholders of Sonesta are Mr. Barry Portnoy and Mr. Adam Portnoy, who are our Managing Trustees, and they also serve as directors of Sonesta.  As noted above, Messrs. Barry and Adam Portnoy have relationships with RMR and RMR provides management services to us.

 

On November 2, 2011, we entered into a purchase agreement, or the Purchase Agreement, with Sonesta and its wholly owned subsidiary, PAC Merger Corp., or Merger Sub, and together with Sonesta, the Sellers, to purchase from Sonesta the entities, or the Hotel Entities, that own the Cambridge Hotel and lease the New Orleans Hotel.  At that time, the Cambridge Hotel and the New Orleans Hotel were owned or leased and operated by subsidiaries of what was then known as Sonesta International Hotels Corporation, or SNSTA.  The Purchase Agreement was a component part of a transaction that involved the acquisition by merger, or the Merger, of all of SNSTA’s shares by Sonesta pursuant to an agreement and plan of merger, or the Merger Agreement, which was entered into between Sonesta, Merger Sub and SNSTA on November 2, 2011.

 

Subject to the terms and conditions of the Merger Agreement, on January 31, 2012, Merger Sub merged with and into SNSTA.  Pursuant to the Purchase Agreement, we advanced the approximately $150,500 aggregate purchase price for the Hotel Entities to the Sellers for the purpose of the Sellers consummating the Merger under the Merger Agreement. The purchase price was reduced by the outstanding principal and accrued interest owed under a variable rate mortgage loan due in 2015 secured by the Cambridge Hotel, or the Cambridge Loan. We prepaid this mortgage loan, which had an outstanding principal balance of approximately $31,035, and unwound a related interest rate hedge agreement for $2,525 on January 31, 2012.

 

Pursuant to the Purchase Agreement, following the consummation of the Merger, Sonesta initiated a restructuring of SNSTA, which resulted in SNSTA owning equity interests of the Hotel Entities and certain related assets and the Hotel Entities owning only the real estate comprising the Cambridge Hotel and the leasehold for the New Orleans Hotel and

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

related furniture, fixtures and equipment and certain other assets, and in Sonesta or its subsidiaries (other than SNSTA and its subsidiary Hotel Entities) owning the other assets of SNSTA, including its management businesses and brands and assuming all liabilities of SNSTA, other than the liabilities associated with the Cambridge Loan, income taxes, taxes related to retained assets and certain payables and other liabilities. Pursuant to the Purchase Agreement, after giving effect to that restructuring, Sonesta then transferred to us all of the then issued and outstanding capital stock of SNSTA (which then owned the Hotel Entities, which in turn own or lease the Cambridge Hotel and the New Orleans Hotel), free and clear of any liens, encumbrances or other restrictions (other than the Cambridge Loan and certain other matters). We currently expect that Sonesta will retain the management business of SNSTA and that Sonesta and its Sonesta management team will be available to operate other of our hotels, including certain hotels we now own and we are considering rebranding and hotels we may selectively acquire in the future.

 

Simultaneously with consummation of the Purchase Agreement on January 31, 2012, Sonesta entered hotel management agreements, or the Management Agreements, with subsidiaries of ours which provide for Sonesta to manage for us each of the Cambridge Hotel and the New Orleans Hotel.  Routine property maintenance, which is expensed, is an operating expense of the hotels and repairs and periodic renovations, which are capitalized, are funded by us, except in the case of the New Orleans Hotel where capital expenditures are borne in large part by the lessor.  Under the Management Agreements, capitalized improvements over threshold amounts are added to our invested capital.  Pursuant to the Management Agreements, we incurred expenses of $460 for the three months ended March 31, 2012.  These amounts are included in hotel operating expenses in our condensed consolidated financial statements.  See Note 12 for further information regarding these agreements.

 

On April 23, 2012, Sonesta entered into a hotel management agreement with our subsidiary for the Hilton Head Resort, a hotel historically owned by us and managed by a subsidiary of InterContinental Hotels Group, plc, or InterContinental, under its Crowne Plaza brand.  In addition, on April 23, 2012, our subsidiary and Sonesta entered into a pooling agreement, under which, we and Sonesta agreed that the management agreement for the Cambridge Hotel and the Hilton Head Resort, along with other hotels which in the future may be managed for us by Sonesta and which we and Sonesta may agree will be pooled with those two hotels, are to be combined for purposes of calculating gross revenues, payment of hotel operating expenses, payment of fees and distributions and the calculation of minimum returns due to us.  For more information about the Sonesta management agreements please see Note 12 below.

 

We, RMR, TA and four other companies to which RMR provides management services each currently own approximately 14.3% of AIC, an Indiana insurance company.  All of our Trustees, all of the trustees and directors of the other publicly held AIC shareholders and nearly all of the directors of RMR currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC because all of our Trustees are also directors of AIC.  We may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we are not obligated to do so.  Our investment in AIC had a carrying value of $5,335 and $5,291 as of March 31, 2012 and December 31, 2011, respectively.  During the three months ended March 31, 2012 and 2011, we recognized income of $45 and $37, respectively, related to this investment.  In June 2010, we and the other shareholders of AIC purchased property insurance providing $500,000 of coverage pursuant to an insurance program arranged by AIC and with respect to which AIC is a reinsurer of certain coverage amounts.  This program was modified and extended in June 2011 for a one year term and we paid a premium of $5,773 in connection with that renewal, which amount may be adjusted from time to time in response to our acquisition and disposition of properties that are included in that program.  We currently expect that we will renew this program, as it may be modified, in June 2012.  We are also currently investigating the possibilities to expand our insurance relationships with AIC to include other types of insurance.  By participating in this insurance business with RMR and the other companies to which RMR provides management services, we expect that we may benefit financially by possibly reducing our insurance expenses or by realizing our pro-rata share of any profits of this insurance business.

 

For further information about these and other such relationships and related person transactions, please see elsewhere in this Quarterly Report on Form 10-Q, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related Person Transactions” in Part I, Item 2 and “Warning Concerning Forward Looking Statements,” and our 2011 Annual Report, our Proxy Statement for our 2012 Annual Meeting of Shareholders dated February 29, 2012, or our Proxy Statement, and our other filings with the SEC, including Note 8 to our Consolidated

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Financial Statements included in our 2011 Annual Report, the sections captioned  “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related Person Transactions” and “Warning Concerning Forward Looking Statements” of our 2011 Annual Report and the section captioned “Related Person Transactions and Company Review of Such Transactions” and the information regarding our Trustees and executive officers in our Proxy Statement.  In addition, please see the section captioned “Risk Factors” of our 2011 Annual Report for a description of risks that may arise from these transactions and relationships.  Our filings with the SEC, including our 2011 Annual Report and our Proxy Statement, are available at the SEC’s website at www.sec.gov.  In addition, copies of certain of our agreements with these parties, including our business management agreement and property management agreement with RMR, various agreements we have with TA and Sonesta and our shareholder agreement with AIC and its shareholders, are also publicly available as exhibits to our public filings with the SEC and accessible at the SEC’s website.

 

Note 12. Hotel Management Agreements and Leases

 

Marriott No. 234 agreement.  We and Marriott International, Inc., or Marriott, previously identified 21 hotels included in our management contract with Marriott covering 71 hotels, or the Marriott No. 234 agreement, for potential sale.  In February 2012, we entered an agreement to sell our Marriott branded hotel in St. Louis, Missouri with a net book value of $18,440 at March 31, 2012 for $35,000 excluding closing costs.  We will retain the net proceeds from the sale and the amount of minimum returns due from Marriott under the agreement will be reduced by 9% per annum of the net sale proceeds.  We currently expect to complete this sale in the second quarter of 2012.  This pending sale is subject to customary closing conditions; accordingly we cannot provide any assurance that we will sell this hotel.  In March 2012, we withdrew the remaining 20 hotels from sale consideration.  We are in discussions with Marriott about retaining these hotels in the Marriott No. 234 agreement and us funding certain improvements to these hotels.  We expect that the amount of minimum returns due to us from Marriott under the Marriott No. 234 agreement will be increased by 9% per annum of the amounts funded.  Discussions with Marriott are ongoing, and we cannot provide any assurance an agreement will be reached or on what the final amount we will invest in improvements to these hotels will be.

 

During the three months ended March 31, 2012, the net cash flows of the 71 hotels were $9,224 less than the minimum return payments due to us. Marriott provided $6,923 of guaranty payments to us.  Also, during the period from March 31, 2012 to May 7, 2012, the minimum return payments we received for these hotels were $774 less than the contractual minimum returns due to us.  Marriott was not required to make any guaranty payments to us because the minimum return payments received were in excess of the guaranty threshold.  The balance of this guaranty was $23,950 as of May 7, 2012.

 

InterContinental agreement.  We and InterContinental previously identified 42 hotels included in our management contract with InterContinental covering 130 hotels, or the InterContinental agreement, which we may remove from the contract and rebrand or offer for sale.  In February and April 2012, we provided notice to InterContinental that we plan to remove four of these hotels, with a net book value of $112,804 as of March 31, 2012, from our InterContinental agreement.  As described in Note 11, on April 23, 2012, we entered into a management agreement with Sonesta for one of these hotels, which was converted to the Sonesta brand and management on April 27, 2012. We currently expect to convert the other three hotels to the Sonesta brand and management during the second quarter of 2012.  Our annual minimum returns under the InterContinental agreement will decrease by a total of $9,923 when these four hotels are removed.  In April 2012, we and InterContinental agreed to retain three of the remaining 38 hotels, with a net book value of $4,205 as of March 31, 2012, in the InterContinental agreement.  We continue to evaluate plans to rebrand the remaining 35 hotels, including the conversion of certain hotels to the Sonesta brand and management.  If these hotels are rebranded, the amount of the minimum returns due from InterContinental will be reduced by agreed amounts per hotel; and, if we determine to retain these hotels under InterContinental management, we will invest certain amounts to improve these hotels and the amount of minimum returns due from InterContinental under the agreement will be increased by 8% per annum of the amounts funded.  We are in discussions about rebranding certain of these hotels; however, we cannot provide any assurance that we will rebrand any of these 35 hotels.

 

During the three months ended March 31, 2012, the payments we received under our agreements with InterContinental were $16,250 less than the minimum amounts contractually required.  We applied the available security deposit to cover

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

these shortfalls.  Also, during the period from March 31, 2012 to May 7, 2012, the minimum return payments we received under our InterContinental agreement were $408 more than the minimum amounts due to us.  We increased the available security deposit by the additional amounts received.  The remaining balance of the security deposit was $39,978 as of May 7, 2012.

 

When we reduce the amounts of the security deposits we hold for these agreements or any other operating agreements for payment deficiencies, we record income equal to the amounts by which these deposits are reduced up to the minimum return or minimum rent due to us. However, reducing the security deposits does not result in additional cash flow to us of the deficiency amounts, but reducing amounts of security deposits may reduce the refunds due to the respective lessees or managers who have provided us with these deposits upon expiration of the respective lease or management agreement.  The security deposits are non-interest bearing and are not held in escrow.  Under all of our hotel contracts that include a security deposit, any amount of the security deposits which are applied to payment deficits may be replenished from future cash flows from the applicable hotel operations pursuant to the terms of the respective contracts.

 

Sonesta agreements.  As described in Note 11, on January 31, 2012, we entered into two management agreements with Sonesta to manage our Cambridge Hotel and New Orleans Hotel.  The management agreement for our Cambridge Hotel, which we refer to as our Sonesta No. 1 agreement, provides that we are paid a fixed minimum return equal to 8% of our invested capital, as defined, if gross revenues of the hotels, after payment of hotel operating expenses and base fees payable to Sonesta, are sufficient to do so.  Under the terms of this agreement, we may earn additional returns of 80% of cash flow after payment of our minimum returns and reimbursement of operating losses or working capital advances, if any.  We are required to fund operating losses or working capital shortfalls, but may recover these amounts from future cash flows, if any.  As described in this Note 12, we rebranded one hotel we own as a Sonesta hotel in April 2012 and we currently expect to rebrand an additional three hotels we own as Sonesta hotels in the second quarter of 2012.   The management agreement for the hotel rebranded in April 2012 as a Sonesta hotel is on similar terms to our Sonesta No. 1 agreement and it provides that we shall receive a minimum annual return equal to 8% of our invested capital, as defined, after payment of hotel operating expenses and base management fees to Sonesta; and this agreement has been pooled with our existing management agreement for our Cambridge Hotel and we currently expect that, if those additional three hotels are rebranded as Sonesta hotels, we and Sonesta will agree to combine the management agreements for those hotels with the existing pooled management agreements.

 

The New Orleans Hotel is subject to a lease with a third party.  The annual rent payable by us under the lease is calculated as 75% of the sum of the net profit of the hotel (hotel operating revenues less hotel operating expenses, including a 3% management fee to Sonesta), less capital expenditures made during the lease year.  The management agreement for our New Orleans hotel, which we refer to as our Sonesta No. 2 agreement, provides that we  are paid all cash flow of the hotel after the payment of operating expenses, including a management fee to Sonesta and rent expense.

 

We do not have any security deposits or guarantees for our hotels managed by Sonesta.  Sonesta’s incentive management fees, but not its base fees, are only earned after we receive our minimum returns, and we may cancel these management agreements if approximately 75% of our minimum returns are not paid for certain periods.  Accordingly, the returns we receive from hotels managed by Sonesta will depend exclusively upon the performance of those hotels.

 

Other management agreement and lease matters. As of May 7, 2012, all payments due to us from our managers and tenants under our other operating agreements were current.

 

Minimum return and minimum rent payments due to us under some of our other hotel management agreements and leases are supported by guarantees. The guaranty provided by Hyatt Hotels Corporation, or Hyatt, with respect to the 22 hotels managed by Hyatt is limited to $50,000 ($19,277 remaining at March 31, 2012). The guaranty provided by Carlson Hotels Worldwide, or Carlson, with respect to the 11 hotels managed by Carlson is limited to $40,000 ($24,727 remaining at March 31, 2012).  The guaranty provided by Marriott with respect to the one hotel leased by Marriott (our Marriott Contract No. 5) is unlimited and continues throughout the lease term.

 

Certain of our managed hotel portfolios had net operating results that were, in the aggregate, $28,655 and $25,057 less than the minimum returns due to us in the three months ended March 31, 2012 and 2011, respectively.  When the shortfalls are funded by the managers of these hotels under the terms of our operating agreements, we reflect such fundings (including security deposit applications) in our Condensed Consolidated Statements of Income as a reduction of hotel operating expenses. The reduction to operating expenses was $24,594 and $25,057 in the three months ended March 31, 2012 and

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

2011, respectively.  The $4,061 of shortfalls not funded by managers during the three months ended March 31, 2012 represents the unguaranteed portion of our minimum returns from Marriott and from Sonesta.

 

In November 2010, Host Hotels & Resorts, Inc., or Host, notified us that it will not exercise its renewal option at the end of the current lease term for 53 hotels which we have historically referred to as our Marriott Contract No. 1.  In the absence of any default by Host, upon expiration of the agreement on December 31, 2012, we expect to return the $50,540 security deposit to Host, to lease these hotels to one of our TRSs and to continue the existing hotel brand and management agreements with Marriott with respect to these hotels.  In June 2011, Marriott provided notice to us that it intends to exercise its option to renew these management agreements for an additional 12 years to 2024.

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 13.  Fair Value of Assets and Liabilities

 

The table below presents certain of our assets carried at fair value at March 31, 2012, categorized by the level of inputs, as defined in the fair value hierarchy under GAAP, used in the valuation of each asset.

 

					Fair Value at Reporting Date Using
					Quoted Prices in Active Markets for Identical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
Description		Total			(Level 1)			(Level 2)			(Level 3)
Property held for sale (1)		$	18,440		$	—		$	18,440		$	—
Investment securities (2)		$	16,104		$	16,104		$	—		$	—

 

(1)          Our property held for sale consists of one Marriott hotel we had agreed to sell at March 31, 2012.  We estimated the fair value less costs to sell this hotel using the selling price agreed to with a third party (Level 2 inputs).  Because the expected selling price is higher than our net book value for this hotel, the hotel is carried at its net book value.  We removed 20 Marriott branded hotels with a carrying value of $104,585 from held for sale status in March 2012.  As described in Note 12, we are no longer marketing these hotels for sale and expect to retain these hotels. We recorded an $889 loss on asset impairment in the first quarter of 2012 in connection with our decision to remove these hotels from held for sale status.

 

(2)          Our investment securities, including our 2,540,000 shares of TA, which are included in other assets, are reported at fair value which is based on quoted market prices (Level 1 inputs).  Our historical cost basis for these securities was $9,267. The unrealized gain for these securities is included in cumulative other comprehensive income in our condensed consolidated balance sheets.

 

In addition to the investment securities included in the table above, our financial instruments include our cash and cash equivalents, restricted cash, revolving credit facility, unsecured term loan, senior notes and security deposits. At March 31, 2012 and December 31, 2011, the fair values of these additional financial instruments were not materially different from their carrying values, except as follows:

 

		March 31, 2012						December 31, 2011
		Carrying			Fair			Carrying			Fair
		Amount			Value			Amount			Value
Senior Notes, due 2012 at 6.85%(1)		$	100,829		$	102,380		$	100,829		$	105,407
Senior Notes, due 2013 at 6.75%		287,000			297,636			287,000			301,871
Senior Notes, due 2014 at 7.875%		300,000			331,758			300,000			333,887
Senior Notes, due 2015 at 5.125%		280,000			292,493			280,000			290,052
Senior Notes, due 2016 at 6.3%		275,000			303,839			275,000			291,572
Senior Notes, due 2017 at 5.625%		300,000			319,169			300,000			313,106
Senior Notes, due 2018 at 6.7%		350,000			394,256			350,000			386,942
Convertible Senior Notes, due 2027 at 3.8%(2)		8,478			8,717			79,054			80,087
Unamortized discounts		(4,554		)	—			(5,169		)	—
Total financial liabilities		$	1,896,753		$	2,050,248		$	1,966,714		$	2,102,924

 

(1)	We redeemed these notes at par plus accrued interest on April 11, 2012.
(2)	On March 20, 2012, we repurchased $70,576 of our 3.8% convertible senior notes due 2027 which were tendered by the holders thereof for repurchase.

 

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

We estimate the fair value of our indebtedness using discounted cash flow analysis and currently prevailing market interest rates (Level 3 inputs).

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with our condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q and with our 2011 Annual Report.

 

Overview (dollar amounts in thousands, except per share amounts)

 

Our hotel tenants and managers.  Many of our hotel operating agreements contain security features, such as guarantees and security deposits, which are intended to protect minimum returns and rents due to us in accordance with our operating agreements regardless of hotel performance.  However, the effectiveness of various security features to provide uninterrupted receipt by us of minimum returns and rents is not assured, particularly if the U.S. economy and the lodging industry take an extended period to recover from the severe declines experienced during the recent recession.  Further, certain of the guarantees that have been granted to us are limited in amount and duration and do not provide for payment of the entire amount of the applicable minimum return shortfalls.  If our tenants, managers or guarantors do not earn or pay the minimum rents and returns due to us, our cash flows will decline and we may be unable to pay distributions to our shareholders.

 

Marriott No. 234 agreement.  Additional details of this agreement are set forth in Note 12 to our condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q, which disclosure is incorporated herein by reference.

 

During the three months ended March 31, 2012, the net cash flows of the 71 hotels under our Marriott No. 234 agreement were $9,224 less than the minimum return payments due to us.  Marriott provided $6,923 of guaranty payments to us.  Also, during the period from March 31, 2012 to May 7, 2012, the minimum return payments we received for these hotels were $774 less than the contractual minimum returns due to us.  Marriott was not required to make any guaranty payments to us because the minimum return payments received were in excess of the guaranty threshold.  The balance of this guaranty was $23,950 as of May 7, 2012.

 

InterContinental agreement.  Additional details of this agreement are set forth in Note 12 to our condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q, which disclosure is incorporated herein by reference.

 

During the three months ended March 31, 2012, the payments we received under our agreements with InterContinental were $16,250 less than the minimum amounts contractually required.  We applied the available security deposit to cover these shortfalls.  Also, during the period from March 31, 2012 to May 7, 2012, the minimum return payments we received under our InterContinental agreement were $408 more than the minimum amounts due to us.  We increased the available security deposit by the additional amounts received.  The remaining balance of the security deposit was $39,978 as of May 7, 2012.

 

Sonesta acquisition and agreements.  We do not have any security deposits or guarantees for our hotels managed by Sonesta.  Sonesta’s incentive management fees, but not its base fees, are only earned after we receive our minimum returns, and we may cancel these management agreements if approximately 75% of our minimum returns are not paid for certain periods.  Accordingly, the returns we receive from hotels managed by Sonesta will depend exclusively upon the performance of those hotels.  Additional details of these agreements are set forth in Notes 7, 11 and 12 to our condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q, which disclosure is incorporated herein by reference.

 

Other management agreement and lease matters. As of May 7, 2012, all payments due to us from our managers and tenants under our other operating agreements were current.  For additional details of our guarantees from Hyatt and Carlson, or our lease agreements with TA, please see Notes 11 and 12 to our condensed consolidated financial statements in Part I, Item I of this Quarterly Report on Form 10-Q, which disclosure is incorporated herein by reference.

 

When we reduce the amounts of the security deposits we hold under our operating agreements for payment deficiencies, we record income equal to the amounts by which these deposits are reduced up to the minimum return or minimum rent due to us. However, reducing the security deposits does not result in additional cash flow to us of the deficiency

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

amounts, but reducing amounts of security deposits may reduce the refunds due to the respective lessees or managers who have provided us with these deposits upon expiration of the respective lease or management agreement.  Security deposits are non-interest bearing and are not required to be held in escrow.  Under all of our hotel contracts that include a security deposit, any amount of the security deposits which are applied to payment deficits may be replenished from future cash flows from the applicable hotel operations pursuant to the terms of the respective contracts.  When we receive payments under guarantees under our leases or operating agreements, we receive cash.  When we receive guaranty payments under our hotel operating agreements, generally the hotel operator is allowed to recapture payments it makes to us out of some or all of the hotels’ future cash flows after our minimum returns are paid.

 

In November 2010, Host notified us that it will not exercise its renewal option at the end of the current lease term for 53 hotels which we have historically referred to as our Marriott Contract No. 1.  In the absence of any default by Host, upon expiration of the agreement on December 31, 2012, we expect to return the $50,540 security deposit to Host, to lease these hotels to one of our TRSs and to continue the existing hotel brand and management agreements with Marriott with respect to these hotels.  In June 2011, Marriott provided notice to us that it intends to exercise its option to renew these management agreements for an additional 12 years to 2024.

 

Management Agreements and Leases

 

At March 31, 2012, we owned or leased our 290 hotels operated under eight operating agreements; 234 of these hotels are leased by us to our wholly owned TRSs and managed by hotel operating companies, one hotel is leased by one of our TRSs from a third party and managed by a hotel operating company and 55 are leased to third parties.  At March 31, 2012, we also owned 185 travel centers that are leased to TA under two agreements. Our Condensed Consolidated Statements of Income include operating revenues and expenses of our managed hotels and rental income for leased hotels and travel centers.  Additional information regarding the terms of our management agreements and leases is included in the table on pages 27 and 28 below.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Results of Operations (amounts in thousands, except per share amounts)

 

Three Months Ended March 31, 2012 versus 2011

 

		For the Three Months Ended March 31,
								Increase			% Increase
		2012			2011			(Decrease)			(Decrease)
Revenues:
Hotel operating revenues		$	224,985		$	197,537		$	27,448		13.9%
Rental income:
Minimum rents - hotels		21,942			29,701			(7,759		)	(26.1)%
Minimum rents - travel centers		51,318			49,832			1,486			3.0%
Total rental income		73,260			79,533			(6,273		)	(7.9)%
FF&E reserve income		3,175			4,914			(1,739		)	(35.4)%
Expenses:
Hotel operating expenses		150,021			129,753			20,268			15.6%
Depreciation and amortization - hotels		39,958			36,463			3,495			9.6%
Depreciation and amortization - travel centers		21,405			19,851			1,554			7.8%
Total depreciation and amortization		61,363			56,314			5,049			9.0%
General and administrative		10,522			9,264			1,258			13.6%
Acquisition related costs		1,060			—			1,060			—
Loss on asset impairment		889			—			889			—
Operating income		77,565			86,653			(9,088		)	(10.5)%
Interest income		66			29			37			127.6%
Interest expense		(34,092		)	(33,339		)	753			2.3%
Equity in earnings of an investee		45			37			8			21.6%
Income before income taxes		43,584			53,380			(9,796		)	(18.4)%
Income tax expense		(636		)	(332		)	304			91.6%
Net income		42,948			53,048			(10,100		)	(19.0)%
Excess of liquidation preference over carrying value of preferred shares redeemed		(2,944		)	—			(2,944		)	—
Preferred distributions		(11,188		)	(7,470		)	(3,718		)	49.8%
Net income available for common shareholders		28,816			45,578			(16,762		)	(36.8)%
Weighted average shares outstanding		123,523			123,444			79			0.1%
Net income available for common shareholders per common share		$	0.23		$	0.37		$	(0.14	)	(37.8)%

 

The increase in hotel operating revenues in the first quarter of 2012 compared to the first quarter of 2011 was caused primarily by the conversion of 19 hotels from leased to managed properties in June 2011 and our acquisition of the entities that own or lease two Royal Sonesta Hotels in January 2012.  These increases were partially offset by decreases in hotel operating revenues due primarily to lower occupancy at certain hotels undergoing renovations during all or part of the 2012 period.  Additional operating statistics of our hotels are included in the table on page 29.

 

The decrease in rental income - hotels is a result of the conversion of 19 hotels from leased to managed in June 2011, partially offset by increases in the minimum rents due to us as we funded improvements at certain of our leased hotels in 2011 and 2012.

 

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