ITEM 1. BUSINESS
GENERAL
Red Roof Inns is the largest owner/operator of economy chain segment hotels in the United States, with 259 inns (including 5 franchised inns) containing more than 29,600 rooms (including 541 franchised rooms) in 35 states, located primarily throughout the Midwest, East, South and Gulf Coast regions. Red Roof's hotels are designed to attract both the business and leisure traveler seeking room quality and inn locations that are generally comparable to those of mid-price hotels, but at lower average room rates. By not providing full-service, management-intensive facilities and services, such as in-house restaurants or cocktail lounges, banquet centers, conference rooms, room service, recreational facilities or other services and facilities that the Company's targeted customers do not typically value, Red Roof is able to deliver a product that addresses its customers' needs and price expectations. In general, Red Roof's guests are evenly divided between business and leisure travelers.
According to STR, Red Roof has one of the highest occupancy rates in the economy chain segment of the lodging industry. The Company's Comparable Inns had an average occupancy percentage of 71.0% and an average daily room rate ("ADR") of $47.49 for 1997. Comparable Inn revenue per available room ("REVPAR") over the past four years has grown at a compound annual rate of 2.9% to $33.72 for 1997. In 1997, the Company's chainwide occupancy of 69.6% exceeded the economy chain segment average occupancy of 58.1% by 11.5 percentage points and chainwide REVPAR of $33.39 was 32.4% higher than the economy chain segment average of $25.21.
The following table sets forth certain data for the Company's Comparable Inns for the years indicated:
(1) Average occupancy percentage represents total rooms occupied divided by total available rooms. Total available rooms represents the number of rooms available multiplied by the number of days in the reporting period.
(2) ADR represents total room revenues (before allowances) divided by the total number of rooms occupied.
(3) REVPAR represents the average occupancy percentage multiplied by the average daily room rate for the reporting period.
In 1997, the Company's Comparable Inns REVPAR increased by 1.0% over 1996 due to a 5.6% increase in ADR and a 3.2 percentage point decline in the average occupancy percentage. The Company's ADR remained lower than the average for the economy chain segment overall in 1997, which provides the Company with the flexibility to increase rates, as appropriate. In addition, for the four year period from 1993 through 1997, the Company increased operating income at a compound annual growth rate of 7.2% (10.1%, excluding special charges). These increases in operating income were achieved by increasing REVPAR and controlling costs.
Red Roof Inns is a price value leader in the economy chain segment and operates under the philosophy of offering inn locations and room quality comparable to many mid-priced hotels but at substantially lower room rates. Management believes that the customers' perception of value is dependent on three components: price, location and consistent quality. Guests who travel in the economy chain segment do so to save money. Red Roof Inns is able to maintain its low prices as a result of a consistent company-wide emphasis on cost control. Red Roof's inns are generally located near interstate highways, major traffic arteries or major destination areas such as airports, business districts, universities, hospitals or convention centers. All locations are well-constructed and maintained and are attractively landscaped to enhance their appearance. In addition, the Company strives to deliver a consistent guest experience throughout the chain by following a chainwide set of operating, marketing and hospitality standards. The Company's success in providing customer value is demonstrated by its consistently high occupancy levels compared to the average for the economy chain segment.
The Company believes that it has achieved significant brand awareness as a result of its ability to provide high-quality, well-located accommodations and superior value, together with its national advertising campaign featuring actor/comedian Martin Mull. This brand awareness and reputation for price, quality and value have consistently placed Red Roof Inns among the leaders in the economy chain segment in terms of occupancy, rates and REVPAR, according to STR. In addition, the brand name has earned the Company a strong following of loyal guests. In 1997, Red Roof ranked second among economy segment chains for repeat guests based upon survey results from a national travel market research firm. Management believes that the Company's brand identity provides it with a significant advantage over independent hotel operators and other economy segment chains. Together with its operational expertise, this enhances the performance of existing and newly constructed and acquired properties. Management is expanding the chain on a national basis through franchising and hotel development.
The Company promotes and operates its own reservation center and toll-free number (1-800-THE-ROOF) to accept reservations. During 1997, the Company handled approximately 2.7 million calls through the toll-free number, of which approximately 41% were converted to reservations, contributing to the Company's high level of occupancy. Management believes that its leadership in occupancy provides it with increased flexibility to set room pricing under various economic conditions.
The Company has operated its hotels since its first hotel opened in 1973. Red Roof's management has substantial experience in the lodging industry. On average, senior management has approximately 18 years experience in the lodging industry and is supported by operational and administrative vice presidents with an average of 16 years experience and on-site general managers with an average of
seven years experience. Each Red Roof inn is operated as an individual profit center by a general manager who oversees all day-to-day operating activities and implements rate, occupancy and cost containment strategies. Management believes this structure reduces operating costs while creating incentives to maximize REVPAR and enhance operating margins by adapting room rates to prevailing market conditions at individual inns.
STRATEGY
The Company's strategy is to increase cash flow and earnings by (i) increasing REVPAR while controlling costs, (ii) becoming more fee intensive through franchising and partner programs and (iii) increasing the number of inns the Company owns and operates through selective new construction and acquisitions.
INCREASE REVPAR. The Company intends to increase cash flow and earnings through REVPAR increases, primarily by moderate increases in ADR and maintaining or increasing the Company's strong occupancy levels. The Company believes that increases in REVPAR will be achieved as a result of its chainwide inn renewal program ("Project BIG RED"), which was substantially completed in 1997, and through the implementation of an automated revenue management system as described below. The Company also believes that it will be able to increase REVPAR by stimulating room demand through effective advertising and promotion programs.
- PROJECT BIG RED -- In the fourth quarter of 1996, the Company commenced Project BIG RED, a chainwide property renewal program that refurbished and enhanced both the interior decor and exterior appearance of approximately 85% of the Company's inns as well as provided additional room amenities and services for guests. The property renewal program was substantially completed during the fourth quarter of 1997. Project BIG RED gave the rooms a more modern, residential feel with new carpet, wallcovering, furniture, bedspreads and drapes. A brighter paint shade, new signs, improved lighting and additional landscaping enhanced the exterior appeal of the inns and highlighted the properties for approaching travelers. The program also provided additional amenities to all rooms, which management believes will reinforce Red Roof Inns' position as a price value leader in the economy chain segment. The program added features to the Company's business king rooms that better address the needs of the business traveler. Management believes that Project BIG RED will reinforce with the customer the Company's commitment to providing high value and service at reasonable prices, further strengthen the Company's competitive position versus its economy chain segment competitors and enhance revenues by allowing the Company to increase ADR and REVPAR.
The Company recently decided to expand the program to refurbish the remaining 15% of the Company's inns and replace all remaining furniture that does not meet current decor standards. This program commenced in the fourth quarter of 1997 and is expected to be completed in the second quarter of 1998. The total cost for Project BIG RED, including the program expansion, is expected to approximate $68 million. The Company recognized total charges to earnings of $24.5 million related to early asset retirements and other charges associated with Project BIG RED. The Company recognized $10.4 million of these charges ($7.8 million related to early asset retirements) in the fourth quarter of 1996 and $14.1 million ($2.4 million related to early asset retirements) throughout 1997. See "Item 8. Financial Statements and Supplementary Data -- Note 10 to the Consolidated Financial Statements."
- REVENUE MANAGEMENT SYSTEM -- In 1996, the Company contracted with Aeronomics, Inc., a leader in automated yield management systems for the hotel and airline industries, to develop and implement a fully automated revenue management system. The system is linked to both the central reservation system and the individual property management system, providing real-time information. The system is essentially an inventory control system that will enable the Company to better manage both occupancy and rate by analyzing historical data, trends and current reservation activity to forecast future trends. Inn managers will use the system to foresee peak occupancy days and predict cancellations, no-shows, stay-overs and walk-in traffic which will enable them to adjust room rates and better manage both lengths of stay and discount business. Management expects the revenue management system to be fully implemented in the second quarter of 1998. Based upon an analysis completed by Aeronomics, Inc., management believes that implementation of the automated yield management system has the potential to increase revenues one to four percent.
FEE BASED INCOME. The Company intends to increase cash flow and earnings through the development of fee based income. By becoming more fee intensive, the Company expects to increase the stability of its revenue and income streams, become less vulnerable to changing conditions in the lodging industry or changes in factors which directly influence the operation of its inns and utilize less of its capital. The Company believes that it will generate fee based income from both its franchising programs and its partner marketing programs.
- FRANCHISING -- In the fall of 1996, the Company began a program to offer Red Roof franchises to qualified franchisees. The franchising program is focused on developing relationships with experienced, high quality hotel owners who will develop new Red Roof inns and/or convert existing hotels to the Red Roof name. The Company believes that this strategy will allow it to continue to expand the Red Roof brand nationally without requiring significant investment and increase revenues and cash flow while maintaining consistent quality across the entire chain. Franchise applicants are evaluated on hotel operating expertise and financial stability. Franchise conversion properties and developed hotel construction plans are reviewed for adherence to Company standards. In addition, the Company reviews the competitive market environment of each proposed franchised hotel. Approved applicants are granted the right to use the Red Roof Inn name, obtain reservations through the Company's central reservation system and use the Company's inn designs, operating systems and procedures. In return for this right, the franchisees pay an initial fee and ongoing royalty, marketing and reservation fees to the Company. These ongoing fees are based on a percentage of gross room revenues at the franchised properties. The total amount of fees collected by the Company will vary depending on the total revenues generated by all of its franchisees. The Company's franchise fee structure contains a unique provision that allows a franchisee to earn a discount to the royalty fee by achieving high levels of customer satisfaction, as measured by an independent survey conducted by a market research firm. The Company believes that this provision provides it with a competitive advantage in attracting high quality franchisees. The Company also believes that its franchises are attractive because of its superior occupancy, attractive operating margins, newly designed buildings with interior corridors and high percentage of rentable space, significant open territories in the Red Roof Inns system, consistency of the Company's product and service, and the development, operational, reservations and marketing support provided by the Company's experience as an owner/operator.
The Company believes its franchise strategy will enable it to penetrate major and secondary markets nationwide without requiring a significant capital investment. The franchise program should enable the Company to increase its revenues, cash flow and earnings while maintaining its consistent quality across the entire chain.
As of January 3, 1998, the Company had five franchised inns open, six franchised inns under construction or conversion and projected to open in 1998 and 11 additional executed franchise agreements.
- PARTNERSHIP MARKETING -- In 1997, the Company initiated a partnership marketing program through which the Company formed alliances with other well-known consumer product and service companies in order to offer its guests additional value-added services. The Company actively promotes its partners' products or services either at the inns or through the central reservation center in exchange for fees from the partner companies. The Company believes that its strong following of loyal guests and reputation for value, quality and service make it an attractive partner and allow it to create alliances with high quality companies that will further enhance the attractiveness of Red Roof Inns to its guests. Management believes that this strategy generates increased revenue and cash flow while providing additional value-added services to the Company's guests.
HOTEL DEVELOPMENT. The Company continues to expand through both the construction of new inns and the acquisition of existing inns in key markets. The Company evaluates expansion opportunities within existing markets, as well as selected regions of the country where the Company has not historically had a substantial presence. The Company's current development and acquisition strategy is focused on locating a select number of high visibility properties in key strategic locations, such as in central business districts of major cities or near major airports. In addition to the foregoing, the Company may consider, under appropriate circumstances, the acquisition of local or regional chains. The Company believes that it has a strong corporate infrastructure to accommodate significant inn expansion, including an experienced development, acquisition and finance team, an effective central reservation system, a well-developed property management system and an extensive management training program.
In 1996, the Company introduced a new building design featuring all interior corridors, regionally based decor packages and new bathroom designs. This new building design offers approximately 77% rentable space.
Since the Merger, the Company has purchased 29 development sites (three under long term lease agreements) located in Arizona, Florida, Georgia, New York, North Carolina, Ohio, Tennessee and Texas. The Company estimates that ultimately it will construct a total of approximately 3,933 rooms on these development sites. A total of 17 developed inns consisting of 2,253 rooms were open as of January 3, 1998.
As the Company pursues its development strategy, acquisitions of existing inns will be targeted in those markets where there are no suitable development sites that meet the Company's stringent standards for location, visibility, accessibility, performance and cost. Since the Merger, the Company has acquired 28 inns (one under a long term lease agreement) consisting of 3,800 rooms (after conversion and room additions) located in Alabama, Arizona, California, Colorado, Connecticut, Florida, Maryland, Massachusetts, Mississippi, New Jersey, North Carolina, South Carolina, Texas, Virginia and Washington, D.C. A total of 27 acquired inns with 3,498 rooms were open as of January 3, 1998.
Certain of the acquired inns differ from the Company's existing inns in terms of construction, number of rooms, room size, building configuration, signage and decor and in other respects. See "Item 2.
ITEM 2. PROPERTIES
The Company believes that it has frequently benefited from identification and development of attractive locations in local markets prior to many of its competitors. In addition, since Red Roof was one of the first economy segment chains, the Company is firmly established in many of its markets.
Red Roof adheres to rigorous standards in building and maintaining each inn. Management believes that its high-quality construction standards are superior to that of many of its competitors.
A Red Roof inn contains on average approximately 115 rooms. In addition to standard rooms, each inn has rooms equipped for the handicapped and has "business king" rooms containing a king-sized bed, a recliner, a desk and computer tie-in services. Each inn features a choice of rooms for non-smokers and smokers, free unlimited local telephone calls, remote-control television with CNN, ESPN and Showtime, pay-per-view movies and video games, free coffee and USA Today newspapers in the lobby, 24-hour front desk and message service, direct corporate billing and free parking. Many of the Company's inns are adjacent to free-standing restaurants affiliated with restaurant chains such as Bob Evans, Shoney's and Cracker Barrel that provide food service to Red Roof's guests.
To maintain the overall quality of the Company's existing inns, each inn undergoes periodic renovations and capital improvements as required. These renovations are completed in accordance with established maintenance programs that list specific tasks to be completed, including such items as seasonal landscaping and inspection of the condition of sidewalks, parking areas and signage. In 1995, 1996 and 1997, the Company spent approximately $14.5 million, $17.1 million and $6.9 million (exclusive of BIG RED expenditures), respectively, on capital improvements to existing inns. Capital improvements to existing inns in 1997 were low in relation to historical spending because of the chainwide property renewal program (Project BIG RED) conducted throughout 1997.
In the fourth quarter of 1996, the Company commenced Project BIG RED, a chainwide property renewal program that refurbished and enhanced both the interior decor and exterior appearance of approximately 85% of the Company's inns as well as provided additional room amenities and services for guests. The property renewal program was substantially completed in the fourth quarter of 1997. Project BIG RED gave the rooms a more modern, residential feel with new carpet, wallcovering, furniture, bedspreads and drapes. A brighter paint shade, new signs, improved lighting and additional landscaping enhanced the exterior appeal of the inns and highlighted the properties for approaching travelers. The program also provided additional amenities to all rooms, which management believes will reinforce Red Roof Inns' position as a price value leader in the economy chain segment. The program added features to the Company's business king rooms that better address the needs of the business traveler. Management believes that Project BIG RED will reinforce with the customer the Company's commitment to providing high value and service at reasonable prices, further strengthen the Company's competitive position versus its economy chain segment competitors and enhance revenues by allowing the Company to increase ADR and REVPAR.
The Company recently decided to expand the program to refurbish the remaining 15% of the Company's inns and replace all remaining furniture that does not meet current decor standards. This program commenced in the fourth quarter of 1997 and is expected to be
completed in the second quarter of 1998. The total cost for Project BIG RED, including the program expansion, is expected to approximate $68 million. The Company recognized total charges to earnings of $24.5 million related to early asset retirements and other charges associated with Project BIG RED. The Company recognized $10.4 million of the charges ($7.8 million related to early asset retirements) during the fourth quarter of 1996 and $14.1 million ($2.4 million related to early asset retirements) throughout 1997. See "Item 8. Financial Statements and Supplementary Data -- Note 10 to the Consolidated Financial Statements."
In 1996, the Company introduced a new building design featuring all interior corridors, regionally based decor packages and new bathroom designs. This new building design offers approximately 77% rentable space.
Since the Merger, the Company has purchased 29 development sites (three under long term lease agreements) in the following locations: Texas -- San Antonio (3), Houston (3), El Paso (2), Laredo, Austin, Plano and DeSoto; Arizona -- Phoenix (3), Tempe and Tucson; Florida -- West Palm Beach, Gainesville and Jacksonville; Georgia -- Atlanta and Macon; Ohio -- Columbus and Youngstown; North Carolina -- Rocky Mount and Raleigh; Tennessee -- Jackson and Nashville; and New York -- Long Island. These inns will have a total of approximately 3,933 rooms when fully developed. A total of 17 developed inns consisting of 2,253 rooms were open as of January 3, 1998.
As part of its expansion strategy, the Company has acquired, and will continue to acquire, existing inn properties which may differ from inns built by the Company in terms of construction, number of rooms, room size, building configuration, signage, decor and other respects. After acquisition and conversion by the Company, acquired inns are consistent with the Company's enhanced quality and other standards. See "Item 1 -- Business -- Hotel Development."
Since the Merger, the Company acquired 28 hotels (one under a long term lease agreement) in the following locations: Alabama -- Gadsden; Arizona -- Tucson; California -- Anaheim, Ontario, Santa Ana, San Dimas, San Francisco and Victorville; Colorado -- Colorado Springs; Connecticut -- Hartford; Florida -- Naples, Ft. Lauderdale and Miami; Maryland -- Rockville; Massachusetts -- Woburn; Mississippi -- Tupelo; New Jersey -- Tinton Falls; North Carolina -- Greenville and Cary; South Carolina -- Charleston and Myrtle Beach; Texas -- Austin, Corpus Christie, Dallas and Houston (2); Virginia -- Charlottesville and Washington, D.C. These inns will have a total of 3,800 rooms after conversion and room additions. A total of 27 inns with 3,498 rooms were open at January 3, 1998.
For information with respect to planned expenditures in connection with newly developed and acquired properties, see "Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition -- Capital Resources and Liquidity -- Capital Expenditures."
At January 3, 1998, the Company had a total of 259 inns open and operating (including 5 franchised inns) in 35 states primarily throughout the Midwest, East, South and Gulf Coast regions of the United States, with concentrations in Ohio (29), Michigan (20), Texas (21), Pennsylvania (15), North Carolina (15), Florida (14) and Illinois (13).
At five company owned Red Roof properties, the Company leases both the land and the buildings. At two of these four properties (the Harrisburg-North, Pennsylvania and Parkersburg, West Virginia inns), the landlord in each case is a partnership in which the Company owns or controls a substantial majority of the partnership interests. At the Parkersburg, West Virginia property, the lease expires in 2001 and the Company does not have an option to extend the lease or purchase the property. At the Harrisburg, Pennsylvania property, the Company subleases the property from the partnership which leases the property from the Dauphin County Industrial Development Authority. The Harrisburg lease expires in 2004 and the partnership has the option to purchase the property at any time during or within 90 days of the expiration of the term of the lease, for an amount equal to $100,000 above the balance then due on the industrial revenue bonds issued to finance the development of the property. The Company does not have an option to extend the lease or purchase the Harrisburg property. At the third property, located in Charleston, West Virginia, the lease expires in 2016 (including the exercise of all renewals) and the Company does not have an option to extend the lease or purchase the property. At the fourth property, located in Colorado Springs, Colorado, the lease expires in 2015 (including the exercise of all renewals) and the Company has an option to purchase the property at fair market value. At the fifth property located in Columbus, Ohio, the lease expires in 2027 (including the exercise of all renewals) and the Company does not have an option to purchase the property.
Ten company owned Red Roof properties are subject to ground leases. All ground leases have remaining terms including renewal options aggregating longer than 24 years.
The remainder of the Company's inns are 100% owned in fee by the Company. As of January 3, 1998, 94 inns were encumbered by mortgage loans or industrial revenue bonds maturing in various years from 1998 to 2009. In addition, the Company has a $250 million bank credit facility (the "Bank Credit Facility") which is secured by 80 inns. See "Item 8. Financial Statements and Supplementary Data -- Note 4 to the Consolidated Financial Statements."
The Company owns its corporate office building located in suburban Columbus, Ohio. It is encumbered by a mortgage loan maturing in 2009.
The Company believes that it maintains adequate aggregate insurance coverage on its properties, subject to appropriate deductibles. The Company uses a retrospective self-insurance plan for general liability and workers compensation insurance. See "Item 8. Financial Statements and Supplementary Data -- Note 1 to the Consolidated Financial Statements."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in various lawsuits arising in the normal course of business. The Company believes that the ultimate outcome of these lawsuits will not have a material adverse effect on the Company's business, assets, financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year ended January 3, 1998, no matter was submitted to a vote of the Company's security holders through the solicitation of proxies or otherwise.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
On January 31, 1996, the Company issued 10,000,000 shares of common stock, $.01 par value, in an initial public offering (the "Offering") at a price of $16 per share. See "Item 8. Financial Statements and Supplementary Data -- Note 6 to the Consolidated Financial Statements." The Company's common stock began trading on the New York Stock Exchange (the "NYSE") on February 1, 1996. As of February 27, 1998, there was approximately 206 holders of record of the Company's common stock and the closing sales price per share as reported by the NYSE was $17-15/16. The following table presents the quarterly high and low sales prices of the Company's common stock during 1997 and 1996 as reported by the NYSE.
Subsequent to the Merger, the Company has not paid any dividends on its common stock. It is the general policy of the Company to retain its earnings to support the growth of its business. Any dividends declared will be at the discretion of the Board of Directors and will depend upon the Company's financial condition, earnings and other factors. The Merger was consummated concurrently with the initial offering of the Company's 9-5/8% Senior Unsecured Notes due 2003 (the "Notes") in a private placement. The Indenture pursuant to which the Notes were issued, the Company's Bank Credit Facility and an agreement relating to certain of the Company's mortgage indebtedness contain restrictions or limitations upon the payment of dividends by the Company. See "Item 8. Financial Statements and Supplementary Data -- Notes 4 and 5 to the Consolidated Financial Statements."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data (excluding Comparable Inn statistics) relating to the Company have been taken or derived from the historical financial statements of the Company and are qualified in their entirety by reference to such financial statements and notes. See "Item 8. Financial Statements and Supplementary Data." The financial data as of December 17, 1993 and for the 50 weeks of 1993 have been derived from audited financial statements of the Predecessor Company which are not included in this report. The financial data as of January 1, 1994, December 31, 1994, December 30, 1995, for the two weeks of 1993 and for the fiscal year 1994 have been derived from audited financial statements of the Company which are not included in this report.
(1) The Company operates on a 52-53 week fiscal year which ends on the Saturday nearest to December 31. The 1993 (combined), 1994, 1995 and 1996 fiscal years each consisted of 52 weeks while the 1997 fiscal year consisted of 53 weeks. The actual year end for each fiscal year was as follows: December 17, 1993 (50 weeks pre-Merger), January 1, 1994 (2 weeks post-Merger), December 31, 1994, December 30, 1995, December 28, 1996 and January 3, 1998.
(2) In 1995, the Company recognized $3,142 of severance expense relating to a change in management. In 1996, the Company recognized expenses of $10,398 and $450 relating to the inn renewal program and an adjustment to recognize impairments of certain long-lived assets, respectively. In 1997, the Company recognized expenses of $14,066 and $1,421 relating to the inn renewal program and severance expenses associated with the re-engineering program, respectively. See "Item 8. Financial Statements and Supplementary Data -- Notes 1 and 10 to the Consolidated Financial Statements."
(3) Operating income, income before income taxes, net income, cash flow from operations and EBITDA for the 50 weeks ended December 17, 1993 were reduced by a special charge of $3,814 related to payment to participants in a stock appreciation rights plan as a result of the change of control.
(4) Operating income, income before income taxes and EBITDA for 1995 were reduced by a special charge of $3,142 relating to a change in management. Had such charge not been incurred, operating income, income before income taxes and EBITDA would have been $84,709, $33,980 and $112,132, respectively, with EBITDA as a percentage of revenues being 38.5%. Net income and cash flow from operations for 1995 were reduced by $1,873 ($.10 per share -- basic and diluted) due to such charge. Excluding this charge, net income and cash flow from operations would have been $20,195 ($1.10 per share -- basic and $1.09 per share -- diluted) and $49,658, respectively. See Item 8. Financial Statements and Supplementary Data -- Note 10 to the Consolidated Financial Statements."
(5) Operating income and income before income taxes for 1996 were reduced by special charges of $10,398 relating to the inn renewal program (including $7,847 related to early asset retirements) and $450 relating to an adjustment to recognize impairments of certain long-lived assets. Had such charges not been incurred, operating income and income before income taxes would have been $91,436 and $50,524, respectively. EBITDA was reduced by $2,551 relating to these charges. EBITDA would have been $120,531 with EBITDA as a percentage of revenues being 38.0%. Net income and cash flow from operations for 1996 were reduced by $6,481 ($.24 per share -- basic and diluted) and $1,524, respectively. Excluding these charges, net income and cash flow from operations would have been $30,545 ($1.12 per share -- basic and $1.11 per share -- diluted) and $62,072, respectively. See "Item 8. Financial Statements and Supplementary Data -- Notes 1 and 10 to the Consolidated Financial Statements."
(6) Operating income and income before income taxes and extraordinary item for 1997 were reduced by special charges of $1,421 for severance compensation relating to the re-engineering and $14,066 relating to the inn renewal program (including $2,387 related to early asset retirements). Had such charges not been incurred, operating income and income before income taxes and extraordinary item would have been $103,462 and $58,210 respectively. EBITDA was reduced by $13,100 relating to these charges. EBITDA would have been $138,750 with EBITDA as a percentage of revenues being 39.5%. Income before extraordinary item and cash flow from operations for 1997 were reduced by $9,462 ($.34 per share -- basic and $.33 per share -- diluted) and $8,004, respectively. Excluding these charges, income before extraordinary item and cash flow from operations would have been $35,566 ($1.27 per share -- basic and $1.26 -- diluted) and $87,180, respectively. Net income was reduced by an extraordinary charge of $746, net of tax ($.02 per share -- basic and $.03 per share -- diluted) related to the write-off of unamortized loan costs of $1,228 related to the Company's refinancing of its bank credit facility. See "Item 8. Financial Statements and Supplementary Data -- Notes 1 and 10 to the Consolidated Financial Statements."
(7) Prior to the merger, the Company was a Qualified Subchapter S Corporation and did not pay federal taxes at the corporate level. Following the Merger, the Company became subject to federal income taxes and additional state income taxes.
(8) Adjusted to give effect solely to the issuance of an additional 10,000 shares in the Offering, 1994 and 1995 net income per share would have been $.59 -- basic and diluted in 1994 and $.65 -- basic and $.64 -- diluted in 1995.
(9) Subsequent to the Merger, the Company has not paid any dividends on its common stock.
(10) EBITDA is operating income plus the sum of interest income, other income, depreciation, amortization and loss on fixed asset retirements. EBITDA is not intended to represent cash flow from operations as defined by generally accepted accounting principles, and such information should not be considered as an alternative to net income, cash flow from operations or any other measure of performance prescribed by generally accepted accounting principles. EBITDA is included herein because management believes that certain investors find it to be a useful tool for measuring the ability to service debt.
(11) For purposes of calculating the ratio of earnings to fixed charges, earnings include income before income taxes plus fixed charges, excluding capitalized interest. Fixed charges consist of interest expense, including capitalized interest, and the portion of rental expense representative of an interest factor.
(12) Earnings were inadequate to cover fixed charges by $785 in the two weeks ended January 1, 1994 due to the seasonality of the Company's business. See "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
OVERVIEW
The following tables sets forth certain operating data for the periods indicated:
(1) The Company operates on a 52-53 week fiscal year which ends on the Saturday nearest to December 31. The 1995 and 1996 fiscal years each consisted of 52 weeks and the 1997 fiscal year consisted of 53 weeks. The actual year end for each fiscal year was as follows: December 30, 1995, December 28, 1996 and January 3, 1998.
(2) Operating income for 1995 was reduced by a special charge of $3,142 relating to a change in management. Had such charge not been incurred, operating income for 1995 would have been $84,709 and operating income as a percentage of revenues would have been 29.1%. See "Item 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of Red Roof Inns, Inc.
We have audited the accompanying consolidated balance sheets of Red Roof Inns, Inc. and its subsidiaries as of December 28, 1996 and January 3, 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended January 3, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Red Roof Inns, Inc. and its subsidiaries at December 28, 1996 and January 3, 1998, and the results of their operations and their cash flows for each of the three years in the period ended January 3, 1998 in conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP Columbus, Ohio February 16, 1998
RED ROOF INNS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 28, 1996 and January 3, 1998 (in thousands)
See notes to consolidated financial statements.
RED ROOF INNS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) December 28, 1996 and January 3, 1998 (in thousands, except par values)
See notes to consolidated financial statements.
RED ROOF INNS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 30, 1995, December 28, 1996 and January 3, 1998 (in thousands, except per share amounts)
See notes to consolidated financial statements.
RED ROOF INNS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the Years Ended December 30, 1995, December 28, 1996 and January 3, 1998 (in thousands)
See notes to consolidated financial statements.
RED ROOF INNS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 30, 1995, December 28, 1996 and January 3, 1998 (in thousands)
See notes to consolidated financial statements.
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 30, 1995, December 28, 1996 and January 3, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL - The Company was formed in November 1993 and is a subsidiary of The Morgan Stanley Real Estate Fund, L.P. (MSREF). The Company operates on a 52-53 week fiscal year which ends on the Saturday nearest to December 31. At December 30, 1995 (1995), December 28, 1996 (1996) and January 3, 1998 (1997), the Company operated 231, 248 and 254 inns, respectively. The 1995 and 1996 years consist of 52 weeks each and the 1997 year consists of 53 weeks.
PRINCIPLES OF CONSOLIDATION - The accompanying consolidated financial statements include the accounts of Red Roof Inns, Inc. and its wholly owned subsidiaries, RRI Investment Co. and RRI Financial Inc. All material intercompany transactions and balances have been eliminated in consolidation.
NATURE OF OPERATIONS - The Company, whose revenues are primarily derived from room rentals, is an owner/operator and franchiser of economy inns. The Company's properties are primarily located throughout the Midwest, East, South and Gulf Coast regions of the United States. The Company began franchising economy inns in 1997 and at January 3, 1998 five franchised inns were in operation.
FRANCHISE REVENUE - Franchise revenue consists of royalty fees, which are based on a percentage of franchised inns gross room sales, and initial franchise fees which are recorded as revenue when an inn opens as a franchised unit. Total franchise revenue for 1997 was approximately $225,000. Reservation fees and marketing fees charged by the Company to its franchised inns (total of approximately $12,000 and $15,000, respectively for 1997) are recorded as a reduction of corporate and marketing expenses.
USE OF ESTIMATES - The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates, but it is management's opinion that any changes in estimates would not have a material effect on the consolidated financial statements.
SUPPLIES - Supplies inventory is stated at cost, which represents the cost to supply the inns with their respective initial operating inventories. Replacements needed to maintain or increase the original operating inventory are charged to expense in the period such replacement or increase occurs.
PROPERTY AND EQUIPMENT - Property and equipment are stated at cost. Depreciation and amortization of property and equipment is based on the straight-line method over estimated composite useful lives that range from 3 to 15 years for furniture, fixtures and equipment and 12 to 40 years for buildings and improvements.
CAPITALIZATION OF DEVELOPMENT EXPENSES - Costs incurred by the Company related to site development and acquisitions are capitalized and allocated to the properties developed or acquired. Costs capitalized during 1995, 1996 and 1997 totaled $1,138,000, $2,162,000 and $2,385,000, respectively.
GOODWILL - The excess of the purchase price over the fair values of net assets acquired (goodwill) is being amortized on a straight-line basis over 35 years. Goodwill at December 28, 1996 and January 3, 1998 is net of accumulated amortization of $6,922,000 and $9,187,000, respectively.
DEFERRED LOAN FEES AND COSTS - Deferred loan fees and costs are amortized using the straight-line method over the terms of the loans ranging from 5 to 15 years. Deferred loan fees and costs at December 28, 1996 and January 3, 1998 are net of accumulated amortization of $2,958,000 and $3,571,000, respectively.
In May 1997, the Company refinanced its $150 million bank credit facility with a $250 million bank credit facility. In connection with the refinancing, the Company recognized an extraordinary charge against income of $746,000, net of tax, ($.02 per share -- basic and $.03 per share -- diluted) related to the write off of unamortized loan costs of $1,228,000.
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
OTHER ASSETS - Other assets principally include software costs, net of accumulated amortization using the straight-line method over a useful life of five years, preliminary site acquisition costs, escrow deposits for furniture replacements and investments in affiliates.
ASSET IMPAIRMENTS - Annually, or more frequently if events or circumstances change, a determination is made by management, in accordance with Statement of Financial Accounting Standards (SFAS) No. 121, to ascertain whether property and equipment, goodwill, and other intangible assets have been impaired based on the sum of estimated future undiscounted cash flows from operating activities. If the estimated net cash flows are less than the carrying amount of such assets, the Company recognizes an impairment loss in an amount necessary to write down such assets to a fair value as determined from expected discounted cash flows. During 1996, the Company recorded an impairment charge of $450,000 related to land held for sale and a charge of $7,847,000 related to assets being disposed in connection with its inn renewal program. During 1997, the Company recorded a charge of $3,009,000 substantially related to assets being disposed in connection with its inn renewal program. These amounts have been included in special charges. (See Note 10).
Based upon its most recent analysis, the Company believes that property, goodwill and other intangibles at January 3, 1998 are realizable and the depreciation and amortization periods are appropriate.
INCOME TAXES - The Company is subject to federal, state and local income taxes. Income taxes are provided for all taxable items included in the statements of income in accordance with SFAS No. 109.
SELF-INSURANCE PROGRAMS - The Company uses a retrospective self-insurance plan for general liability and workers' compensation. A liability has been recorded in the financial statements based on information currently available as to the estimated ultimate cost for incidents incurred prior to the balance sheet dates. Losses in excess of certain limits are insured with third-party insurance companies. Estimated payments against the insurance liability for each of the next five years are: 1998 -- $4,157,000; 1999 -- $2,492,000; 2000 -- $1,881,000; 2001 -- $1,549,000 and 2002 -- $473,000.
ADVERTISING - The Company expenses the costs of advertising (including production costs) the first time advertising takes place. Advertising expenses consist of local advertising which is included in direct room expenses and billboard and national media advertising which is included in marketing and inn renewal program expenses. Advertising expense was $17,728,000, $17,907,000 and $25,224,000 for 1995, 1996 and 1997, respectively.
EARNINGS PER SHARE - In 1997, the Company adopted SFAS No. 128, "Earnings Per Share" which required retroactive adoption. The new standard simplifies the computation of earnings per share and requires the presentation of basic and diluted earnings per share. Basic income per share amounts are based on the weighted average number of shares of common stock outstanding during the years presented. Diluted income per share amounts are based on the weighted average number of shares of common stock and stock options outstanding during the years presented.
CASH EQUIVALENTS - Cash in excess of daily requirements is invested in money market and government securities with maturities of three months or less. Such investments are considered to be cash equivalents. The majority of such funds are held by the Company's administrative agent bank. The Company has not experienced any losses on these investments.
RECLASSIFICATIONS - Certain amounts in the prior years' financial statements have been reclassed to conform with the 1997 presentation.
2. TRANSACTIONS WITH AFFILIATES
The Company operates two hotels under long-term capital lease agreements with affiliated partnerships which own the hotels. Such affiliation exists because the Company is a partner in the partnerships. The Company's ownership interests in the operating profits and losses of such partnerships are 3% and 29%, respectively, and ownership in the residual values of such partnerships is 73% and 80%, respectively. The partnerships are consolidated as capital leases and are immaterial to the consolidated financial statements.
The Company was provided certain underwriting services through an affiliate of MSREF in connection with the Company's 1996 initial public stock offering and obtains certain shared administrative services with unrelated parties through master contracts available through MSREF.
3. LEASES
The Company leases certain assets used in its operations under long-term capital leases, principally three hotels (including one with an unrelated party) and land. These leases typically contain renewal and purchase options and expire at various dates through 2006. The leases generally require payment of property taxes, insurance and maintenance costs. The Company leases land, hotels, a warehouse and billboard advertising space under noncancelable operating leases. Land leases expire at various dates through 2034 and other leases expire at various dates through 2019. Total operating rent expense for 1995, 1996 and 1997 was $11,269,000, $12,622,000 and $12,248,000, respectively.
Future minimum lease payments under non-cancelable leases January 3, 1998 are as follows (in thousands):
The following is a summary of property and equipment under capital leases (in thousands):
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. MORTGAGE NOTES AND BANK FACILITY
Principal payments due for each of the next five years are: 1998 -- $10,472,000; 1999 -- $23,381,000; 2000 -- $20,437,000; 2001 -- $27,477,000; and 2002 -- $199,652,000.
In May 1997, the Company refinanced its $150 million bank credit facility with a $250 million bank credit facility. The available borrowing commitment declines to $245 million in March 2000 and periodically declines thereafter to $150 million at the May 2002 maturity date. Borrowings under the bank credit facility bear interest at either LIBOR plus tiered spreads based upon the Company's leverage ratios or the administrative agent's prime rate. The bank credit facility also contains various covenants that include restrictions on the incurrence of additional debt, stock repurchase and the payment of dividends which are similar to the covenants related to the senior unsecured notes. The bank credit facility contains events of default. Both the covenants and events of default are customary for financing of similar size and nature, including a change in control of the Company.
Notes payable and the bank credit facility are collateralized by certain property and equipment with a net book value totaling $380,000,000 and $470,000,000 at December 28, 1996 and January 3, 1998, respectively.
As of January 3, 1998, the Company has $4,323,000 in standby letters of credit from banks, expiring at various dates through December 2005.
5. SENIOR UNSECURED NOTES
In December 1993, the Company issued $200,000,000 of senior unsecured notes (the "Notes") due 2003. The Notes bear interest at 9-5/8% payable semi-annually. The Notes contain covenants that include restrictions on the incurrence of additional debt, stock repurchase and the payment of dividends. At January 3, 1998, $186,170,000 is available for restricted payments under the terms of the Notes of which $49,566,000 is available from retained earnings.
The Notes are not redeemable by the Company until December 15, 1998 when they become redeemable at 104.813% of their principal amount, declining ratably to par on and after December 15, 2000, plus accrued interest.
6. STOCKHOLDERS' EQUITY
During 1995, the Company's stockholders made a capital contribution of $18,000,000 to provide funds for inn acquisitions. On January 31, 1996, the Company issued 10,000,000 shares of common stock in an initial public offering (the "Offering") at a price of $16.00 per share. Net proceeds of the Offering were approximately $149 million which were used to repay approximately $128 million of mortgage
indebtedness. Approximately $21 million was retained for inn acquisitions, conversions, new development and for general corporate purposes.
In connection with the Offering, $9.6 million in underwriting discounts and commissions were paid to certain underwriters, including an affiliate of MSREF.
In August 1996, the Company repurchased 500,000 shares of its common stock in the open market for an aggregate purchase price of $6,476,000, or $12.95 per share. During the fourth quarter of 1997, the Company purchased 500,000 shares of its common stock in the open market for an aggregate purchase price of $7,976,000, or $15.95 per share. The shares were placed in treasury and will be used to fulfill the Company's requirements for its stock option and stock purchase plans.
7. EMPLOYEE AND DIRECTOR STOCK PLANS
In March 1995, the Company adopted a non-qualified Management Stock Option Plan for certain officers and employees effective as of December 29, 1994. In December 1995, the Company's Board of Directors adopted the Amended and Restated 1994 Management Equity Incentive Plan (the "Plan"). The Plan is overseen by the Compensation Committee appointed by the Board of Directors, which is comprised of not less than two directors who are not officers or employees of the Company.
Under the terms of the Plan, awards may be granted in the form of: (i) incentive stock options, which are intended to qualify under Sec. 422 of the Internal Revenue Code of 1986, as amended; (ii) stock options which are not intended to so qualify; (iii) shares of the Company's common stock which will be subject to certain conditions and restrictions ("restricted shares"); or (iv) performance units ("performance units"), which represent the right to receive an amount equal to the value related to the performance units awarded, such as the fair market value of a share of common stock. Awards may be granted by the committee at its discretion to key employees (including officers and directors who are employees) of the Company. The Plan generally provides that the number of shares of common stock with respect to which options, restricted shares and performance units may be granted to any individual employee may not exceed 400,000 during any single fiscal year. The aggregate number of shares of common stock which may be issued under the Plan is 2,400,000 provided that in no event shall more than 10% of the shares of common stock authorized for issuance under the Plan be granted in the form of awards other than options.
Generally, each option will have a term ending 10 years from the date of grant. Each option will vest and become exercisable on such date or dates and on the basis of other criteria, including without limitation the performance of the Company, as the committee may determine at its discretion and as shall be specified in the option agreement evidencing the grant of such options. The option price is determined by the committee at the time of the grant and may not be less than the fair market value of the shares of common stock on the date of grant (exclusive of the options granted in 1994, which were issued at less than fair market value at the time of the grant.) Options granted in 1995, 1996 and 1997 vest at the rate of 25% per year.
In October 1995, the Company adopted the 1995 Director Stock Option Plan for directors who are not officers or employees of the Company. The plan is administered by a committee of not less than two directors appointed by the Board of Directors. Any eligible director is automatically granted an initial option to purchase 10,000 shares. Subsequently, following each annual meeting of the stockholders of the Company, each eligible director shall be granted an option to purchase 1,000 shares. The initial option to purchase 10,000 shares vests in equal amounts over a five-year period and future grants vest immediately. The exercise price of the options is based on the fair market value of the common stock on the last trading day prior to the date on which the option is granted. All options expire 10 years after the date of grant. The Company has reserved 60,000 shares under the Plan and in 1996 and 1997, granted options to purchase 10,000 and 22,000 shares, respectively.
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following table summarizes option activity for the years presented:
At December 30, 1995, December 28, 1996 and January 3, 1998, options exercisable under the Company's stock option plans totaled 210,550; 518,149 and 734,640 shares, respectively, and had a weighted average option price per share of $7.66, $11.51 and $13.01, respectively. For options outstanding at January 3, 1998, 124,750, 430,555, and 179,335 shares are exercisable at a weighted average exercise price of $5.43, $13.91, and $16.11, respectively. The weighted average remaining contractual life of these options is 6.0, 8.3, and 8.3 years, respectively.
At January 3, 1998, 844,850 shares are available for future grants of stock options.
During 1995, 1996 and 1997, the Company recognized compensation expense in corporate expenses of $488,000, $339,000 and $281,000 respectively, related to the granting of options in 1994 at less than fair market value at the date of grant. Grants in 1995, 1996 and 1997 were issued at fair market value.
SFAS No. 123, "Accounting for Stock-Based Compensation," defines a fair value method of accounting for stock options and similar equity instruments. Under the fair value method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period, which is usually the vesting period. Companies are encouraged, but not required, to adopt the fair value method of accounting for employee stock-based transactions. Companies are also permitted to continue to account for such transactions under Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees," but are required to disclose in a note to the financial statements pro forma net income and earnings per share as if the company had applied the new method of accounting. The Company applies APB No. 25 in accounting for its stock-based compensation plans. Had compensation cost been
determined on the basis of fair value pursuant to SFAS No. 123, for options granted in 1995, 1996 and 1997, net income and earnings per share would have been as follows (in thousands, except per share amounts):
The following weighted average assumptions were used in the option pricing model: a risk free interest rate of 7.7%, 6.7% and 6.8% for 1995, 1996 and 1997, respectively; an expected life of the options of 7.5 years; no expected dividend yield and a volatility factor of .25 for 1995 and 1996 and volatility factor of .26 for 1997. The weighted average per share fair value of the options granted in 1995, 1996 and 1997 was $6.91, $6.59 and $7.40, respectively.
Due to the inclusion of only 1995, 1996 and 1997 option grants, the effects of applying SFAS No. 123 in 1995, 1996 and 1997 may not be representative of the pro forma impact in future years.
8. EMPLOYEE STOCK PURCHASE PLAN
In February 1998, the Company's Board of Directors adopted the Company's Amended and Restated 1996 Employee Stock Purchase Plan (the "Stock Purchase Plan") which is intended to qualify under Sec. 423 of the Internal Revenue Code. The purpose of the Stock Purchase Plan is to provide employees of the Company with an opportunity to acquire or increase a proprietary interest in the Company by applying payroll deductions or contributions to the purchase of shares of the Company's common stock. All employees of the Company are eligible to participate in the Stock Purchase Plan. The purchase price is 85% of the fair market value of the Company's common stock at the beginning of the contribution period, which begins on the last Sunday of January and ends on the last Saturday of the following January of each year or, if less, 85% of such fair market value on the last day of the contribution period. The Stock Purchase Plan allows employees to purchase shares through contribution or payroll deductions of up to 10% of base pay, and provides that no employee may purchase in any calendar year shares having a value (determined at the time the right to purchase is granted) in excess of $25,000. The aggregate number of shares of common stock reserved for purchase under the stock purchase plan is 300,000. Such shares may be either authorized by unissued shares or issued shares reacquired by the Company and held as treasury shares.
In January 1997, the Company sold 48,647 shares of common stock out of treasury to employees at $12.64 per share for the 1996 plan year and in January 1998, sold 34,916 shares of common stock out of treasury to employees at $15.19 per share for the 1997 plan year. The weighted average per share fair value of the shares issued in 1997 and 1998 was $3.26 and $3.87, respectively.
9. RETIREMENT PLANS
The Company has a defined benefit pension plan (the "Pension Plan") covering all employees except seasonal employees. The benefits are based on years of service, final average compensation and final average compensation in excess of average social security covered compensation at retirement. The Company's funding policy was to contribute annually at least the minimum amount required under the funding standards of ERISA. Pension Plan assets are held by a bank trust company and are invested primarily in cash equivalents and fixed income investments. On December 28, 1996, the Company froze the Pension Plan which decreased the Company's projected benefit obligations by $2,500,000 and resulted in a curtailment gain of $286,000. During 1997, the Company terminated the Pension Plan, subject
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
to receipt of appropriate regulatory approvals. Earned benefits through the date the Pension Plan was frozen are expected to be paid to employees during 1998, at which time a final settlement cost of approximately $1,600,000 will be paid by the Company.
The weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.25% and 6.11% at December 28, 1996 and January 3, 1998, respectively. The decrease in the discount rate for 1997 reflects the interest rate that will be used to determine lump sum payments for the Pension Plan termination. The rate of increase in future compensation was 5% and the expected long-term rate of return on assets was 9% for 1996.
The following table sets forth the Pension Plan's funded status as of December 28, 1996, and January 3, 1998 and amounts recognized in the financial statements (in thousands):
In addition to the Pension Plan described above, the Board of Directors agreed to establish a supplementary pension plan for its President and Chief Executive Officer. Accordingly, the Company has an additional accrued liability of $85,000 and $131,000 as of December 28, 1996 and January 3, 1998, respectively, related to such supplementary plan.
In July 1997, the Board of Directors adopted the Company's 401(k) Savings Plan (the "Savings Plan") which qualifies under Section 401(a) of the Internal Revenue Code. The purpose of the Savings Plan is to encourage current employees to save funds for retirement, attract new employees and retain current employees. All Company employees with one year of service who meet certain other minimum age and hours of service requirements are eligible to participate in the Savings Plan. The Savings Plan allows employees to deduct up to 15% of their base and bonus pay, subject to various limitations required by the I.R.S. The Company matched 25% of employee contributions up to 6% of base and bonus pay in 1997 and may or may not, at its sole discretion match this or other amounts in the future. The 1997 expense related to this plan was approximately $171,000.
The Company adopted a Deferred Compensation Plan and Executive Deferred Compensation Plan (the "Compensation Plans") effective February 1, 1998 to provide a tax deferred accumulation opportunity to a select group of management employees through deferrals of cash compensation and company related contributions. Participants in the Compensation Plans may contribute 1% to 15% of their base
annual salary which, when added to their Savings Plan deferral, does not exceed the dollar limitation in effect under Internal Revenue Service Code Section 402(g). Participants in the Executive Deferred Compensation portion of the Compensation Plans may contribute up to 50% and 100% of their base salary and bonus, respectively.
10. SPECIAL CHARGES
The following special charges were incurred by the Company during the years presented (in thousands):
On June 30, 1995, the Company appointed Francis W. Cash to the position of President, Chief Executive Officer and Director succeeding Jack Van Fossen who had retired. In addition, on June 30, 1995, the Executive Vice President and Chief Financial Officer; Vice President, General Counsel and Secretary; and Vice President and Corporate Counsel terminated their employment with the Company and received severance benefits provided under their respective employment agreements. Accordingly, the Company recorded an expense of $3,142,000 for such severance benefits and certain expenses associated with the employment of new executive officers.
During 1996, the Company recorded an impairment charge of $450,000, in accordance with SFAS No. 121, related to land held for sale.
In 1996, the Company commenced Project BIG RED, a chainwide property renewal program that refurbished and enhanced both the interior decor and exterior of approximately 85% of the Company's inns and provided additional room amenities and services for guests. Included in the program are expenditures to update guest rooms with new carpet, wallcovering, furniture, bedspreads and drapes. Improvements to the exterior of the properties include painting, new signs, improved lighting and additional landscaping. The expanded program is expected to be completed in the second quarter of 1998 at a total cost of approximately $68 million. In 1997 and 1996, the Company incurred expenditures of $50,031,000 and $10,745,000, respectively, related to this program of which $38,134,000 and $8,095,000 was capitalized and $11,679,000 and $2,551,000 was expensed, respectively. In addition, the Company recognized charges of $2,387,000 and $7,847,000 in 1997 and 1996, respectively, related to early asset retirements in connection with the program.
In the second half of 1977, the Company commissioned a task force to perform a thorough examination of its corporate structure and processes to increase productivity and reduce costs in relation to its strategic growth plans ("re-engineering program"). Among the task force recommendations implemented were (i) the elimination of repetitive processes and increased utilization of its corporate resources through the consolidation of selected corporate departments, (ii) redirected corporate resources toward the franchise program and corporate sales group, and (iii) measures undertaken to increase hotel operating efficiencies. The Company took a fourth quarter charge to income of $1,421,000 related to severance expenses associated with the re-engineering program.
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. INCOME TAXES
The components of the provision for income taxes consist of the following (in thousands):
The effective tax rate differs from the statutory rate as follows:
The tax effects of significant items comprising the Company's net deferred tax balances are as follows (in thousands):
12. COMMITMENTS AND CONTINGENCIES
The Company is involved in various claims and legal proceedings arising from the normal course of business. While the ultimate liability, if any, from these proceedings is presently indeterminable, in the opinion of management, these matters should not have a material adverse effect on the consolidated financial statements of the Company.
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of financial instruments disclosed below as of December 28, 1996 and January 3, 1998 were determined using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented may not be indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts.
The following methods and assumptions were used to estimate the fair value of financial instruments; (i) mortgage notes -- the estimated fair value is based on current rates and payment terms offered to the Company and (ii) senior unsecured notes -- the estimated fair value is based upon a quoted published market price (in thousands):
14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
(1) Operating income was reduced and net income (loss) was affected by a special charge related to a SFAS No. 121 adjustment to recognize impairment of fixed assets of $450 and $269 ($.01 per share -- basic and diluted), respectively.
(2) Operating income and net income was reduced by a special charge related to the inn renewal program of $10,398 and $6,212 ($.23 per share -- basic and diluted), respectively.
RED ROOF INNS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) Operating income, income before extraordinary item and net income were reduced by special charges related to the inn renewal program as follows: first quarter -- $4,771 and $2,899 ($.10 per share -- basic and diluted); second quarter -- $4,770 and $2,897 ($.10 per share -- basic and diluted); third quarter -- $2,333 and $1,417 ($.05 per share -- basic and diluted); fourth quarter -- $2,192 and $1,381 ($.05 per share -- basic and diluted), and full year -- $14,066 and $8,594 ($.31 per share -- basic and $.30 per share -- basic and diluted), respectively.
(4) Net income was reduced by and extraordinary charge of $746, net of tax, ($.02 per share basic and $.03 per share -- diluted) related to the write-off of unamortized loan costs on the refinancing of the Company's bank credit facility.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The information in the proxy statement for the Company's 1998 annual meeting of stockholders under the headings "Election of Directors", "Compensation of Directors", "Executive Officers" and "Compliance With Section 16 (a) of The Exchange Act" is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information in the proxy statement for the Company's 1998 annual meeting of stockholders under the heading "Executive Compensation" is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information in the proxy statement for the Company's 1998 annual meeting of stockholders under the heading "Voting Securities and Principal Holders Thereof" is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information in the proxy statement for the Company's 1998 annual meeting of stockholders under the headings "Election of Directors," "Compensation Committee Interlocks and Insider Participation" and "Certain Relationships and Related Transactions" is incorporated herein by reference.
ITEM 14.
ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
* Executive plans and arrangements required to be filed pursuant to Item 601 (b) (10) of Regulation S-K.
(b) Reports on Form 8-K:
No reports on Form 8-K were filed for the last quarter of the reporting period.
(c) Exhibits:
The exhibits are submitted following the signatures.
(d) Financial Statement Schedules:
The financial statement schedules and the independent auditor's report thereon are submitted following the signatures.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, Red Roof Inns, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 24th day of March 1998.
RED ROOF INNS, INC.
By /s/ FRANCIS W. CASH
-------------------------------------- Name: Francis W. Cash Title: Chairman of the Board, President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of Red Roof Inns, Inc. and in the capacities and on the dates indicated.
SCHEDULE II RED ROOF INNS, INC. AND SUBSIDIARIES CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS (in thousands)
(1) Uncollectible accounts written off, net of amounts recovered.
INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES
The Board of Directors and Stockholders of Red Roof Inns, Inc.
We have audited the consolidated financial statements of Red Roof Inns, Inc. and its subsidiaries as of December 28, 1996 and January 3, 1998, and for each of the three years in the period ended January 3, 1998, and have issued our report thereon dated February 16, 1998; such report is included elsewhere in this Form 10-K. Our audits also included the consolidated financial statement schedules of Red Roof Inns, Inc. and its subsidiaries, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP Columbus, Ohio February 16, 1998
EXHIBIT INDEX
Exhibit No. Description --- -----------
11.01 Statement re computation of per share earnings 12.01 Statement re computation of ratios. 23.00 Consent of Deloitte & Touche LLP 24.00-24.06 Directors and Officers Powers of Attorney