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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
-------------------
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarter ended JUNE 30, 1999
--------------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission file number 0-26304
SUNSTONE HOTEL INVESTORS, INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
--------------------
Maryland 52-1891908
- --------------------------------- -------------------
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
903 Calle Amanecer, San Clemente, CA 92673
- --------------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (949) 369-4000
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. Yes X No
As of August 13, 1999, there were 37,931,726 shares of Common Stock outstanding.
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SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON FORM 10-Q
JUNE 30, 1999
TABLE OF CONTENTS
PART I -- FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page
----
<S> <C>
ITEM 1. FINANCIAL STATEMENTS
SUNSTONE HOTEL INVESTORS, INC.
Consolidated Balance Sheets as of June 30, 1999 and December 31, 1998........................ 3
Consolidated Statements of Operations for the Three and Six Months
Ended June 30, 1999 and 1998............................................................. 4
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 1999 and 1998............................................................. 5
Notes to Consolidated Financial Statements................................................... 6
SUNSTONE HOTEL PROPERTIES, INC. ("LESSEE")
Consolidated Balance Sheets as of June 30, 1999 and December 31, 1998........................ 12
Consolidated Statements of Operations for the Three and Six Months
Ended June 30, 1999 and 1998............................................................. 13
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 1999 and 1998............................................................. 14
Notes to Consolidated Financial Statements................................................... 15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS................................................... 18
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK............................ 26
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS..................................................................... 27
ITEM 5. OTHER INFORMATION..................................................................... 28
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...................................................... 36
SIGNATURES .................................................................................... 37
</TABLE>
2
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PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1999 1998
-------------------------------
(Unaudited)
<S> <C> <C>
ASSETS:
Investments in hotel properties, net $874,801,000 $840,974,000
Other real estate investment properties, net 20,201,000 17,027,000
Cash and cash equivalents 1,930,000 859,000
Restricted cash 1,408,000 2,853,000
Rent receivable - Lessee 12,060,000 7,498,000
Other assets, net 6,499,000 6,425,000
------------ ------------
$916,899,000 $875,636,000
============ =============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Revolving line of credit $305,000,000 $274,500,000
Notes payable 136,909,000 104,969,000
Accounts payable and other accrued expenses 12,980,000 18,921,000
Dividends payable to preferred stockholders 498,000 503,000
------------ ------------
455,387,000 398,893,000
------------ ------------
Commitments and contingencies (Note 8)
Minority interest 23,909,000 25,493,000
Stockholders' equity:
7.9% Class A Cumulative Convertible Preferred Stock, $.01 par value,
10,000,000 authorized; 250,000 issued and outstanding as of June 30,
1999 and December 31, 1998 (liquidation preference $100 per share
aggregating $25,000,000) 3,000 3,000
Common stock, $.01 par value, 150,000,000 authorized; 37,929,477 and
37,572,263 issued and outstanding as of June 30, 1999 and December 31,
1998, respectively 380,000 376,000
Additional paid-in capital 483,242,000 479,848,000
Distributions in excess of earnings (46,022,000) (28,977,000)
------------ ------------
437,603,000 451,250,000
------------ ------------
$916,899,000 $875,636,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
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SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------- -----------------------------
1999 1998 1999 1998
------------ ------------ ------------ -------------
<S> <C> <C> <C> <C>
REVENUES:
Lease revenue - Lessee $ 25,136,000 $ 24,775,000 $ 49,898,000 $ 48,462,000
Interest and other income 228,000 83,000 358,000 140,000
------------ ------------ ------------ ------------
25,364,000 24,858,000 50,256,000 48,602,000
------------ ------------ ------------ ------------
EXPENSES:
Real estate related depreciation and amortization 10,292,000 8,993,000 20,281,000 16,912,000
Interest expense and amortization of financing costs 7,176,000 5,513,000 13,645,000 10,108,000
Real estate and personal property taxes and insurance 2,986,000 2,883,000 6,078,000 5,662,000
General and administrative 1,558,000 871,000 2,906,000 2,374,000
Transaction costs 2,222,000 -- 2,222,000 --
------------ ------------ ------------ ------------
Total expenses 24,234,000 18,260,000 45,132,000 35,056,000
------------ ------------ ------------ ------------
Income before gain on disposition of hotel property
and minority interest 1,130,000 6,598,000 5,124,000 13,546,000
Gain on disposition of hotel property -- -- 490,000 --
Minority interest (31,000) (324,000) (243,000) (675,000)
------------ ------------ ------------ ------------
NET INCOME 1,099,000 6,274,000 5,371,000 12,871,000
Distributions on preferred shares (492,000) (492,000) (979,000) (979,000)
------------ ------------ ------------ ------------
INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 607,000 $ 5,782,000 $ 4,392,000 $ 11,892,000
============ ============ ============ ============
EARNINGS PER SHARE
Basic $ 0.02 $ 0.15 $ 0.12 $ 0.33
============ ============ ============ ============
Diluted $ 0.02 $ 0.15 $ 0.12 $ 0.32
============ ============ ============ ============
DIVIDENDS DECLARED PER SHARE $ 0.285 $ 0.275 $ 0.57 $ 0.55
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
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SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
------------------------------
1999 1998
------------- -------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 5,371,000 $ 12,871,000
Adjustments to reconcile net income
to net cash provided by operating activities:
Minority interest 243,000 675,000
Depreciation and amortization 20,281,000 17,016,000
Amortization of financing costs 1,180,000 1,079,000
Gain on disposition of hotel property (490,000) --
Changes in operating assets and liabilities:
Rent receivable - Lessee (4,562,000) (4,611,000)
Other assets, net 2,944,000 (494,000)
Accounts payable and other accrued expenses 769,000 1,697,000
------------- -------------
Net cash provided by operating activities 25,736,000 28,233,000
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, improvements and additions to
hotel properties (68,272,000) (145,626,000)
Acquisitions, improvements and additions to
other real estate investments (3,488,000) --
Proceeds from sale of hotel property 4,000,000 --
Restricted cash 1,445,000 (184,000)
Payments received on notes receivable 100,000 23,000
------------- -------------
Net cash used in investing activities (66,215,000) (145,787,000)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock 2,725,000 69,713,000
Payment of deferred financing costs -- (1,283,000)
Borrowings on revolving line of credit 34,500,000 137,000,000
Principal payments on revolving line of credit (4,000,000) (53,000,000)
Borrowings on notes payable 42,423,000 --
Principal payments on notes payable (10,483,000) (16,698,000)
Distributions to common stockholders (21,437,000) (19,396,000)
Distributions to minority interests (1,194,000) (1,195,000)
Distributions to preferred stockholders (984,000) (979,000)
------------- -------------
Net cash provided by financing activities 41,550,000 114,162,000
------------- -------------
Net change in cash and cash equivalents 1,071,000 (3,392,000)
Cash and cash equivalents, beginning of period 859,000 3,584,000
------------- -------------
Cash and cash equivalents, end of period $ 1,930,000 $ 192,000
============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION, RELATIONSHIP WITH LESSEE AND BASIS OF PRESENTATION
Organization:
Sunstone Hotel Investors, Inc., a Maryland corporation (the "Company"
or "Sunstone"), was formed in September 1994 and commenced operations as a real
estate investment trust ("REIT") on August 15, 1995. At June 30, 1999, the
Company had a 94.8% interest in Sunstone Hotel Investors, L.P. (the "Operating
Partnership") which also commenced operations in August 1995. The Company
conducts all of its business through and is the sole general partner of the
Operating Partnership.
At June 30, 1999, the Company's portfolio included 58 hotel properties,
primarily located in the western United States, all of which are leased to
Sunstone Hotel Properties, Inc. (the "Lessee") under operating leases (the
"Percentage Leases") that provide for the payment of base and percentage rent.
The Lessee is owned by Robert A. Alter, Chairman, Chief Executive Officer and
President of the Company (80%), and Charles L. Biederman, Vice Chairman and
Executive Vice President of the Company (20%). The Lessee has entered into a
management agreement pursuant to which all of the hotels are managed by Sunstone
Hotel Management, Inc. (the "Management Company"), of which Mr. Alter is the
sole shareholder.
Relationship with Lessee:
The Company must rely solely on the Lessee to generate sufficient cash
flow from the operation of the hotels to enable the Lessee to meet its
substantial rent obligation to the Company under the Percentage Leases. The
Lessee has incurred significant losses from its inception in 1995. At June 30,
1999, the Lessee's stockholder's deficit amounted to $9.6 million. At June 30,
1999, the Lessee's rent payable to the Company amounted to $12.1 million. Also
at June 30, 1999, the Lessee's current liabilities exceeded its current assets
by $9.0 million. The ability of the Lessee to fund its daily operations and
continue to remain current on its substantial rent obligation to the Company is
a result of the original terms under the Percentage Leases, for the payment of
rent to the Company, which allow monthly base rent to be paid in arrears and
monthly percentage rent to be paid within 45 days after the respective month
end. The Company's management will continue to evaluate the financial condition
of the Lessee and continue to evaluate other factors regarding the relationship
between the Company and the Lessee.
Basis of Presentation:
The consolidated financial statements include the accounts of the
Company and its subsidiaries, including the Operating Partnership. All
significant intercompany transactions and balances have been eliminated.
The interim consolidated financial statements of the Company have been
prepared without audit in accordance with generally accepted accounting
principles for interim information and with the instructions for Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The Company believes that the disclosures are
adequate to make the information presented not misleading when read in
conjunction with the audited consolidated financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1998 and
Quarterly Reports on Form 10-Q for prior quarters of 1999. The financial
information presented herein reflects all adjustments, consisting only of normal
recurring accruals, which are, in the opinion of management, necessary for a
fair presentation of the results
6
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION, RELATIONSHIP WITH LESSEE AND BASIS OF PRESENTATION (continued)
for the interim periods presented. The results for the three and six months
ended June 30, 1999 are not necessarily indicative of the results to be expected
for the year ended December 31, 1999.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Significant estimates made in preparing
the consolidated financial statements include the collectibility of rent
receivable, the recoverability of long-lived assets and the outcome of claims,
litigation and other contingencies (see Note 8); actual results could differ
materially from those estimates in the near term.
Seasonality:
The hotel industry is seasonal in nature. Seasonal variations in
occupancy at the Company's hotels may cause quarterly fluctuations in the
Company's lease revenues.
Reclassifications:
Certain prior period balances have been reclassified to conform with
the current period presentation.
2. ACQUISITION OF SUNSTONE
On April 5, 1999, the Company received a merger offer from SHP
Acquisition, LLC ("SHP"), certain management personnel of the Lessee and
Westbrook Funds III. The Lessee leases and operates all of the Company's hotels
and is owned by Robert A. Alter, Chairman and Chief Executive Officer of the
Company and Charles L. Biederman, Vice Chairman and Executive Vice President of
the Company. Westbrook Partners LLC is a New York based real estate opportunity
fund, which is a 9.6% stockholder in the Company, whose managing principal, Paul
Kazilionis, is a director of the Company. The original offer to purchase was for
all the common stock of the Company at $9.50 to $10.00 in cash per share.
Upon receiving the SHP merger offer, the Company formed the Special
Committee of the Board of Directors, comprised of all the independent members of
the Board of Directors, to study the proposal and consider the Company's
alternatives. The Special Committee was advised by Goldman, Sachs & Co. and
Altheimer & Gray.
Upon the recommendation of the Special Committee of the Board of
Directors of the Company and the approval of the Board of Directors, Sunstone
entered into a merger agreement (the "Merger Agreement" or the "Merger") as of
July 12, 1999 with SHP, an affiliate of Westbrook Partners LLC and certain
members of Sunstone's senior management. Under the terms of the Merger Agreement
each share of common stock of the Company will be exchanged for $10.35 in cash,
as such amount may be adjusted. Minority interests in the Operating Partnership
can elect to receive the same consideration per Unit or an equity interest in
the acquiring entity.
The Merger Agreement is subject to the vote of the Company's common
stockholders and minority interests, as well as certain other conditions,
including the receipt of consents from certain major franchisors of Sunstone's
hotels and the closing of SHP's financing. SHP has received a commitment for
debt financing for the transaction, which is expected to close during the fourth
quarter of 1999.
7
<PAGE> 8
The Merger Agreement provides for a breakup fee and expenses of up to
$25.0 million to be paid to SHP in the event that the Company wishes to accept a
superior proposal to acquire the Company. Under such circumstances, the Company
has the right to purchase all the shares of the Lessee and the Management
Company, for a total amount of $30.0 million in cash.
As required by the Merger Agreement, the Company will not pay a
distribution to stockholders or minority interests at any time prior to the
closing of the Merger. However, the aggregate purchase price will be increased
by an amount equal to 50% of any increase in the Company's cash balance,
adjusted as specified in the Merger Agreement, between June 30, 1999 and five
business days prior to the closing of the Merger, but not less than $0.06 per
share. The aggregate purchase price also is subject to a possible price
reduction in connection with certain contingent payments.
In conjunction with this transaction, the Company incurred and expensed
$2.2 million primarily for legal and accounting services.
3. INVESTMENTS IN HOTEL PROPERTIES
During the second quarter of 1999, the Company completed the
acquisition of two newly built properties, the 121-room Residence Inn by
Marriott in San Diego and the 154-room Hilton Garden Inn in Sacramento, for a
total of $28.0 million. Both properties were acquired under the terms of
definitive purchase agreements which were entered into during the fourth quarter
of 1997 with third party developers. Additionally, the Company completed, or was
in the process of completing, substantial renovations at seven of the hotel
properties, and in connection with such renovations, the Company incurred costs
of approximately $15.7 million during the second quarter of 1999.
4. REVOLVING LINE OF CREDIT
Borrowings under the Credit Facility accrue interest at LIBOR plus a
margin that is based on the leverage of the Company. At June 30, 1999, the
Company had $305.0 million outstanding under its Credit Facility with an actual
borrowing rate of LIBOR plus 2.0%. Borrowing base and loan-to-value limits, as
well as other financial performance covenants restrict the availability of
borrowings under the Credit Facility. The Company's total liabilities as defined
under the terms of the Credit Facility are restricted by a leverage covenant
("Leverage Covenant") which allows the Company to borrow funds when the lesser
of (i) 50% of the cost basis of the hotels or (ii) 50% of the cost basis of
hotels owned for no more than six full fiscal quarters plus a valuation based on
the net operating income ("NOI") for hotels owned longer than six fiscal
quarters exceeds the Company's total liabilities. Effective July 1, 1999, the
eleven remaining hotels that were acquired in connection with the acquisition of
Kahler Realty Corporation in October of 1997 (the "Kahler Hotels") lost their
cost consideration and are required to be valued based on their respective NOI.
As a result of such change, the Company is not in compliance with the Leverage
Covenant which, if not modified by September 1, 1999, will cause the Company to
be in default under the Credit Facility. In addition, the Company's borrowing
base at June 30, 1999 does not support the current level of outstanding
borrowings under the Credit Facility and the Company cannot currently borrow any
additional amounts under the Credit Facility. As a result, the Company will be
required to re-margin the Credit Facility and repay approximately $4.9 million
during the third quarter of 1999.
The Company has entered into negotiations with the Credit Facility
lenders for relief with respect to the Leverage Covenant. While no agreement has
been executed, the Company has received a proposal from the co-agent banks under
the Credit Facility to modify the terms of the Credit Facility to allow the
Kahler Hotels to be valued at their cost basis for an additional two quarters,
for a total of eight quarters. In exchange for such modification, the lenders
will require a modification fee of approximately $1.0 million, an increase in
the borrowing rate, limitations on expenditures for new acquisitions and
renovations, maintenance of minimum liquidity and possibly other requirements
and restrictions. Additionally, in the event the Merger does not close, the
lenders will require the Company to secure the Credit Facility with the hotel
properties and pay additional fees and further increase the borrowing rate.
The Credit Facility term expires on July 1, 2000. During the first
quarter of 1999, the Company requested a one-year extension of the term to July
1, 2001 which the lenders have denied. As a result, the Company is evaluating
possible means of meeting near-term debt service requirements and improving
liquidity through refinancing existing indebtedness, issuing additional equity
securities and divesting certain hotel assets. The Company has also modified its
capital
8
<PAGE> 9
expenditures and renovation programs. As previously discussed, the Company will
not pay a distribution to stockholders or minority interests at any time prior
to the closing of the Merger. However, the Company anticipates that the
distributions already made during 1999 are sufficient to satisfy the federal
income tax requirements with respect to distributions in order for the Company
to continue to qualify as a REIT.
No assurances can be made regarding the availability or terms of
additional sources of capital for the Company in the future and no assurances
can be given regarding the Company's ability to successfully refinance the
maturity of existing indebtedness, including, without limitation, the Credit
Facility. No assurances can be given regarding the Company's success in securing
an amendment to the Credit Facility whereby an existing breach of the Leverage
Covenant would be remedied. If the Merger does not close and the Company is
unable to secure additional sources of financing in the future, is unable to
successfully refinance existing indebtedness, or is unable to obtain amendments
to the Credit Facility, no assurance can be made that the Company will be able
to meet its financial obligations as they come due without substantial
disposition of assets outside the ordinary course of business, restructuring of
debt or revisions of the Company's operations. Additionally, no assurances can
be given that the lack of future financing sources would not have a material
adverse effect on the Company's financial condition and results of operations.
5. NOTES PAYABLE
On May 11, 1999, the Company repaid a $6.1 million promissory note with
proceeds from a $16.1 million promissory note dated May 7, 1999 that requires
monthly interest only payments at LIBOR plus 2.25%, matures October 30, 1999 and
is secured by hotel properties with a net book value of $24.3 million at June
30, 1999.
On May 28, 1999, the Company acquired the newly built 121-room
Residence Inn by Marriott in San Diego and the 154-room Hilton Garden Inn in
Sacramento. These acquisitions were financed with proceeds from a $20.8 million
promissory note dated May 27, 1999 that requires monthly interest only payments
at either the Prime Rate plus .50% or LIBOR plus 2.0%, matures May 27, 2001 and
is secured by the two hotel properties with a net book value of $27.9 million at
June 30, 1999.
6. EQUITY
On May 17, 1999, the Company issued 277,513 shares of its common stock
under the Company's Dividend Reinvestment and Stock Purchase Plan (the "Plan").
The Plan provides for the issuance of common stock at a price based on the
twelve day trading period subsequent to acceptance and subject to certain
thresholds and discounts as set by the Company. The issuance price of the shares
sold was $9.08 per share, resulting in proceeds of approximately $2.5 million.
9
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------- ----------------------------
1999 1998 1999 1998
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Numerator:
Net income $ 1,099,000 $ 6,274,000 $ 5,371,000 $ 12,871,000
Distributions on preferred shares (492,000) (492,000) (979,000) (979,000)
------------ ------------ ------------ ------------
Numerator for basic and diluted earnings per share:
Income available to common stockholders after
effect of dilutive securities $ 607,000 $ 5,782,000 $ 4,392,000 $ 11,892,000
============ ============ ============ ============
Denominator:
Denominator for basic earnings per share - weighted
average shares outstanding 37,782,576 37,530,453 37,689,914 36,491,409
Effect of dilutive securities:
Stock options 15,000 137,545 7,500 153,956
------------ ------------ ------------ ------------
Denominator for diluted earnings
per share - adjusted weighted average shares
and assumed conversions 37,797,576 37,667,998 37,697,414 36,645,365
============ ============ ============ ============
Basic earnings per share $ 0.02 $ 0.15 $ 0.12 $ 0.33
============ ============ ============ ============
Diluted earnings per share $ 0.02 $ 0.15 $ 0.12 $ 0.32
============ ============ ============ ============
</TABLE>
The computation of diluted earnings per share does not assume the
conversion of the 7.9% Class A Convertible Preferred Stock because their
inclusion would have been anti-dilutive. Additionally, the computation of
diluted earnings per share does not assume the conversion of the Operating
Partnership units because such conversion would not have any impact on diluted
earnings per share.
10
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
8. COMMITMENTS AND CONTINGENCIES
In connection with the Merger, eight lawsuits have been filed naming
the Company, certain directors and officers of the Company and other parties as
defendants. The factual basis alleged to underlie all eight lawsuits are
essentially identical. Substantively, they assert that Robert A. Alter, Charles
L. Biederman and Paul Kazilionis, in conjunction with Westbrook Partners LLC
(and other purported Westbrook affiliated entities), SHP and the Lessee, have
offered an unfair buyout price for the outstanding shares of the Company.
Plaintiffs in each of these lawsuits purport to seek both injunctive relief and
damages on behalf of the purported class based upon these allegations.
Management is unable to determine whether these lawsuits will have a material
adverse effect on the Company's financial position or results of operations. The
Company intends to defend the actions vigorously. No amounts related to these
lawsuits or the proposed acquisition have been accrued in the accompanying
financial statements.
9. SUBSEQUENT EVENTS
On July 15, 1999, the Company opened the newly built Courtyard by
Marriott in Lynnwood, Washington, located approximately 15 miles north of
downtown Seattle. The 164-room hotel includes a limited number of suites, as
well as, a restaurant, lobby lounge, pool, fitness room, business center and
approximately 1,500 square feet of meeting space. The hotel was developed by the
Company for a cost of $10.0 million and was financed in part with proceeds from
a $7.7 million promissory note and Building Loan Agreement, both dated June 28,
1999. This financing is secured by a first deed of trust and requires monthly
interest only payments at either the Prime Rate plus .25% or LIBOR plus 2.5% per
year, but not less than 7% per year and matures June 28, 2000. The Company has
the option to extend the maturity date for up to one year. Subsequent to June
30, 1999, $4.2 million was disbursed to the Company under such Building Loan
Agreement.
11
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SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1999 1998
------------ -------------
(Unaudited)
<S> <C> <C>
ASSETS:
Current assets
Cash and cash equivalents $ 6,412,000 $ 3,639,000
Receivables, net of allowance for doubtful accounts
of $196,000 and $388,000, respectively 11,221,000 10,771,000
Due from affiliates, net 751,000 164,000
Inventories 1,817,000 1,824,000
Prepaid expenses and other current assets 1,104,000 640,000
------------ ------------
21,305,000 17,038,000
Management agreements, net 304,000 366,000
Property and equipment, net 137,000 154,000
Other assets 503,000 420,000
------------ ------------
$ 22,249,000 $ 17,978,000
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT:
Current liabilities
Rent payable - Sunstone Hotel Investors, Inc. $ 12,060,000 $ 7,498,000
Accounts payable 7,079,000 8,811,000
Accrued payroll and employee benefits 6,467,000 6,697,000
Sales taxes payable 2,406,000 1,915,000
Due to affiliates, net 168,000 --
Stockholder line of credit 650,000 650,000
Other liabilities 1,435,000 1,295,000
------------ ------------
30,265,000 26,866,000
Long-term liability
Accrued pension liability 1,568,000 1,603,000
------------ ------------
31,833,000 28,469,000
------------ ------------
Commitments and contingencies (Note 5)
Stockholders' deficit
Common stock, no par value, 100,000 shares authorized;
125 shares issued and outstanding 498,000 498,000
Accumulated deficit (Note 2) (9,515,000) (10,422,000)
Accumulated other comprehensive loss (567,000) (567,000)
------------ ------------
(9,584,000) (10,491,000)
------------ ------------
$ 22,249,000 $ 17,978,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
12
<PAGE> 13
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- -------------------------------
1999 1998 1999 1998
----------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
REVENUES:
Room $53,209,000 $51,840,000 $105,860,000 $ 99,750,000
Food and beverage 8,519,000 11,239,000 17,491,000 21,232,000
Other 6,514,000 8,166,000 13,208,000 15,358,000
----------- ----------- ------------ ------------
Total revenues 68,242,000 71,245,000 136,559,000 136,340,000
----------- ----------- ------------ ------------
EXPENSES:
Room 11,833,000 12,994,000 23,575,000 24,372,000
Food and beverage 6,714,000 9,386,000 13,650,000 17,926,000
Other 3,931,000 4,496,000 7,789,000 8,890,000
Advertising and promotion 5,677,000 5,160,000 11,068,000 9,898,000
Repairs and maintenance 2,706,000 3,006,000 5,106,000 5,581,000
Utilities 2,161,000 2,785,000 4,751,000 5,214,000
Franchise costs 2,181,000 1,839,000 4,225,000 3,257,000
Management and accounting fees to related party 1,415,000 311,000 2,813,000 1,545,000
Rent expense - Sunstone Hotel Investors, Inc. 25,136,000 24,775,000 49,898,000 48,462,000
General and administrative 6,357,000 6,423,000 12,777,000 13,117,000
----------- ----------- ------------ ------------
Total expenses 68,111,000 71,175,000 135,652,000 138,262,000
----------- ----------- ------------ ------------
NET INCOME (LOSS) $ 131,000 $ 70,000 $ 907,000 $(1,922,000)
=========== =========== ============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
13
<PAGE> 14
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
---------------------------
1999 1998
----------- ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 907,000 $(1,922,000)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Bad debt expense -- 86,000
Depreciation 41,000 94,000
Amortization 127,000 169,000
Changes in operating assets and liabilities:
Receivables, net (450,000) (847,000)
Due from affiliates, net (587,000) 557,000
Inventories 7,000 (32,000)
Prepaid expenses and other current assets (529,000) (431,000)
Other assets (83,000) --
Rent payable - Sunstone Hotel Investors, Inc. 4,562,000 4,811,000
Accounts payable (1,732,000) 652,000
Accrued payroll and employee benefits (230,000) 780,000
Sales taxes payable 491,000 896,000
Due to affiliates, net 168,000 --
Accrued pension liability (35,000) 13,000
Other liabilities 140,000 (336,000)
----------- -----------
Net cash provided by operating activities 2,797,000 4,490,000
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (24,000) (83,000)
Proceeds from Lessor upon execution of certain leases -- 708,000
----------- -----------
Net cash provided by (used in) investing activities (24,000) 625,000
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from stockholder line of credit 1,450,000 --
Payments on stockholder line of credit (1,450,000) --
Payments on capital lease obligation -- (27,000)
----------- -----------
Net cash used in financing activities -- (27,000)
----------- -----------
Net change in cash and cash equivalents 2,773,000 5,088,000
Cash and cash equivalents, beginning of period 3,639,000 4,352,000
----------- -----------
Cash and cash equivalents, end of period $ 6,412,000 $ 9,440,000
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
14
<PAGE> 15
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF PRESENTATION
Sunstone Hotel Properties, Inc. (the "Lessee") was incorporated in
Colorado in October 1994 and commenced operations effective with the completion
of an initial public stock offering by Sunstone Hotel Investors, Inc. (the
"Lessor") on August 15, 1995. The Lessee leases hotel properties, which are
primarily located in the western United States, from the Lessor pursuant to
long-term leases (the "Percentage Leases"). The Lessee operates 100% of the
hotel properties owned by the Lessor. The Lessee is owned by Robert A. Alter,
Chairman and President of the Lessor (80%), and Charles L. Biederman, Director
and Executive Vice President of the Lessor (20%). At June 30, 1999, the Lessee
leased 58 hotel properties from the Lessor.
Basis of Presentation:
The consolidated financial statements include the accounts of the
Lessee and its subsidiaries. All significant intercompany transactions and
balances have been eliminated.
The interim consolidated financial statements of the Lessee have been
prepared without audit in accordance with generally accepted accounting
principles for interim information and with the instructions for Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The Lessee believes that the disclosures are
adequate to make the information presented not misleading when read in
conjunction with the Lessee's audited consolidated financial statements included
in the Lessor's Annual Report on Form 10-K for the year ended December 31, 1998
and Quarterly Reports on Form 10-Q for prior quarters of 1999. The financial
information presented herein reflects all adjustments, consisting only of normal
recurring accruals, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods presented. The results
for the three and six months ended June 30, 1999 are not necessarily indicative
of the results to be expected for the year ended December 31, 1999.
Seasonality:
The hotel industry is seasonal in nature. Seasonal variations in hotel
occupancy may cause quarterly fluctuations in the Lessee's revenues.
Use of Estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Significant estimates include estimates
related to claims, legal actions and other similar contingencies (see Note 5)
and actual results could differ materially from those estimates in the near
term.
Reclassifications:
Certain prior period balances have been reclassified to conform with
the current period presentation.
15
<PAGE> 16
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. STOCKHOLDERS' DEFICIT
During the three and six months ended June 30, 1999, the Lessee had net
income of $131,000 and $907,000, respectively; however, the Lessee has incurred
significant losses from its inception in 1995. At June 30, 1999, the Lessee's
stockholders' deficit amounted to $9.6 million. At June 30, 1999, the Lessee's
rent payable to the Lessor amounted to $12.1 million. Also at June 30, 1999, the
Lessee's current liabilities exceeded its current assets by $9.0 million. The
ability of the Lessee to fund its daily operations and continue to remain
current on its substantial rent obligation to the Lessor is a result of the
original terms under the Percentage Leases, for the payment of rent to the
Lessor, which allow monthly base rent to be paid in arrears and monthly
percentage rent to be paid within 45 days after the respective month end.
3. PERCENTAGE LEASE AGREEMENTS
At June 30, 1999, all rent payments due the Lessor are current. Under
the terms of the Percentage Leases, base rent is payable to the Lessor in
arrears and percentage rent is payable 45 days after the end of each respective
month. As such and as of June 30, 1999, the $12.1 million due the Lessor
consists of percentage rent for the months of May and June 1999 and base rent
for the month of June 1999.
Certain Percentage Leases, as amended, allow for the abatement of base
rent related to rooms taken out of service during major renovations. The Lessor
abated $110,000 and $391,000 of base rent during the three months and six months
ended June 30, 1999, respectively. No rent was abated during the three and six
month periods ended June 30, 1998.
4. CERTAIN TRANSACTIONS WITH RELATED PARTIES
Sunstone Hotel Management, Inc. (the "Management Company"), a company
wholly owned by Robert A. Alter, Chairman of the Lessee, provides management and
accounting services to the Lessee pursuant to the terms of a management
agreement. The agreement has a one year term and is automatically renewed.
Management fees are computed on an individual hotel basis and range from 1% to
2% of gross revenues. Accounting fees are computed as a fixed amount per room on
an individual hotel basis and range from $8.50 to $11.50 per room per month.
During the three and six months ended June 30, 1999, $1.1 million and $2.2
million, in management fees were incurred, respectively, and during the three
and six months ended June 30, 1998, $0 and $937,000 in management fees were
incurred, respectively. During the three and six months ended June 30, 1999,
$307,000 and $622,000, in accounting fees were incurred, respectively, and
during the three and six months ended June 30, 1998, $311,000 and $608,000 in
accounting fees were incurred, respectively. Amounts due to affiliates
represents management and accounting fees payable to the Management Company
reduced by reimbursements due from the Management Company for certain expenses
paid by the Lessee on behalf of the Management Company and certain salaries and
other expenses incurred by the Lessee and allocated to the Management Company.
Reimbursements from the Management Company, which are recorded as a reduction of
the related general and administrative expenses, totaled $240,000 and $288,000,
respectively, during the three and six months ended June 30, 1999.
Upon the execution of each Percentage Lease, the Lessor assigns certain
hotel operating assets and liabilities to the Lessee at the Lessor's net book
value. The Lessee records all such hotel operating assets and liabilities at the
Lessor's costs with a corresponding net amount payable to or receivable from the
Lessor, depending on whether net assets or liabilities were assigned. The Lessor
also reimburses the Lessee for costs it incurs related to the Lessor's
renovation of hotels. Amounts due from affiliates primarily includes
reimbursements due from the Lessor reduced by the amount due to the Lessor for
net hotel operating assets assigned by the Lessor to the Lessee upon the
execution of each Percentage Lease.
16
<PAGE> 17
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. CERTAIN TRANSACTIONS WITH RELATED PARTIES (continued)
The Lessee has a $1.5 million line of credit with its primary
stockholder. The line of credit bears interest at the prime rate plus 0.25%, is
unsecured and has a maturity date of December 29, 1999. The line is to be used
exclusively for general short-term working capital needs. In January 1999, an
additional $800,000 was drawn on the stockholder line of credit by the Lessee
for working capital needs. In February 1999, the Lessee paid down the line of
credit by $650,000, plus related unpaid accrued interest. In June 1999, an
additional $650,000 was drawn and $800,000 was paid down on the stockholder line
of credit. Interest incurred on the line of credit during the three months and
six months ended March 31, 1999 totaled $14,000 and $31,000 respectively.
On February 15, 1999, the Lessee began leasing office space from the
Lessor when it moved its corporate facilities into a building owned by the
Lessor.
5. COMMITMENTS AND CONTINGENCIES
On April 5, 1999, the Lessor received an acquisition offer from SHP
Acquisition, LLC ("SHP"), formed by Robert A. Alter, certain management
personnel of the Lessee and Westbrook Funds III. Westbrook Partners LLC is a New
York based real estate opportunity fund, an affiliate of which is a 9.6%
stockholder in the Lessor, whose managing principal, Paul Kazilionis, is a
director of the Lessor.
Upon receiving the SHP merger offer, the Lessor formed the Special
Committee of the Board of Directors, comprised of all the independent members of
the Board of Directors, to study the proposal and consider the Lessor's
alternatives. The Special Committee was advised by Goldman, Sachs & Co. and
Altheimer & Gray.
Upon the recommendation of the Special Committee of the Board of
Directors of the Lessor and the approval of the Board of Directors, the Lessor
entered into a merger agreement (the "Merger Agreement" or the "Merger") as of
July 12, 1999 with SHP, an affiliate of Westbrook Partners LLC and certain
members of the Lessor's senior management. Under the terms of the Merger
Agreement each share of common stock of the Lessor will be exchanged for $10.35
in cash, as such amount may be adjusted.
The Merger Agreement is subject to the vote of the Lessor's common
stockholders and minority interests, as well as certain other conditions,
including the receipt of consents from certain major franchisors of the Lessor's
hotels and the closing of SHP's financing. SHP has received a commitment for
debt financing for the transaction, which is expected to close during the fourth
quarter of 1999.
The Merger Agreement provides for a breakup fee and expenses of up to
$25.0 million to be paid to SHP in the event that the Lessor wishes to accept a
superior proposal to acquire the Lessor. Under such circumstances, the Lessor
has the right to purchase all the shares of the Lessee and the Management
Company, for a total amount of $30.0 million in cash.
As required by the Merger Agreement, the Lessor will not pay a
distribution to stockholders or minority interests at any time prior to the
closing of the Merger. However, the aggregate purchase price will be increased
by an amount equal to 50% of any increase in the Lessor's cash balance, adjusted
as specified in the Merger Agreement, between June 30, 1999 and five business
days prior to the closing of the Merger, but not less than $0.06 per share. The
aggregate purchase price also is subject to a possible price reduction in
connection with certain contingent payments.
In connection with the Merger, eight lawsuits have been filed naming
the Lessor, certain directors and officers of the Lessor and other parties
including the Lessee and its shareholders as defendants. The factual basis
alleged to underlie all eight lawsuits are essentially identical. Substantively,
they assert that Robert A. Alter, Charles L. Biederman and Paul Kazilionis, in
conjunction with Westbrook Partners, LLC (and other purported Westbrook
affiliated entities), SHP Acquisition and the Lessee, have offered an unfair
buyout price for the outstanding shares of the Lessor. Plaintiffs in each of
these lawsuits purport to seek both injunctive relief and damages on behalf of
the purported class based upon these allegations. Management is unable to
determine whether these lawsuits will have a material adverse effect on the
Lessee's financial position or results of operations. The Lessee intends to
defend the actions vigorously. No amounts related to these lawsuits or the
proposed acquisition have been accrued in the accompanying financial statements.
The Lessee is involved from time to time in various claims and legal
actions in the ordinary course of business. Management does not believe that the
resolution of such matters will have a material adverse effect on the Lessee's
financial position or results of operations when resolved.
17
<PAGE> 18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements
When used throughout this report, the words "believes", "anticipates"
and "expects" and similar expressions are intended to identify forward-looking
statements. Such statements are subject to the many risks and uncertainties
which affect the Company's business, and actual results could differ materially
from those projected and forecasted. These uncertainties, which include
competition within the lodging industry, the balance between supply and demand
for hotel rooms, the Company's continued ability to execute acquisitions and
renovations, the effect of economic conditions, the availability of capital to
finance planned growth, the Year 2000 Issue, and the liquidity of the Lessee,
are described but are not limited to those disclosed in this report. These and
other factors which could cause actual results to differ materially from those
in the forward-looking statements are discussed under the heading "Risk
Factors". Given these uncertainties, readers are cautioned not to place undue
reliance on such statements. The Company also undertakes no obligation to
publicly release the result of any revisions to these forward-looking statements
that may be made to reflect any future events or circumstances. The following
discussion should be read in conjunction with the financial statements included
elsewhere in this report, as well as the information presented in the Company's
Annual Report on Form 10-K for the year ended December 31, 1998 and Quarterly
Reports on Form 10-Q for prior quarters of 1999.
GENERAL
Sunstone Hotel Investors, Inc. (the "Company" or "Sunstone") is a
self-administered, equity real estate investment trust ("REIT") that through its
94.8% ownership interest in Sunstone Hotel Investors, LP (the "Operating
Partnership"), owns and leases luxury, upscale and mid-price hotels located
primarily in the Pacific and Mountain regions of the western United States. The
hotels operate primarily under national franchises that are among the most
respected and widely recognized in the lodging industry, including brands
affiliated with Marriott International, Inc., Bass Hotels and Resorts, Hilton
Hotels Corporation and Promus Hotel Corporation. As of August 13, 1999, the
Company's portfolio consisted of 59 hotels with a total of 10,525 rooms. The
majority of the Company's hotel portfolio consists of luxury, upscale and
mid-price full-service hotels and upscale extended-stay properties
(approximately 78.0%) with the remainder of the Company's portfolio consisting
of mid-price limited service properties.
ACQUISITION OF SUNSTONE
On April 5, 1999, the Company received a merger offer from SHP
Acquisition, LLC ("SHP"), certain management personnel of the Lessee and
Westbrook Funds III. The Lessee leases and operates all of the Company's hotels
and is owned by Robert A. Alter, Chairman and Chief Executive Officer of the
Company and Charles L. Biederman, Vice Chairman and Executive Vice President of
the Company. Westbrook Partners LLC is a New York based real estate opportunity
fund, which is a 9.6% stockholder in the Company, whose managing principal, Paul
Kazilionis, is a director of the Company. The original offer to purchase was for
all the common stock of the Company at $9.50 to $10.00 in cash per share.
Upon receiving the SHP merger offer, the Company formed the Special
Committee of the Board of Directors, comprised of all the independent members of
the Board of Directors, to study the proposal and consider the Company's
alternatives. The Special Committee was advised by Goldman, Sachs & Co. and
Altheimer & Gray.
Upon the recommendation of the Special Committee of the Board of
Directors of the Company and the approval of the Board of Directors, Sunstone
entered into a merger agreement (the "Merger Agreement" or the "Merger") as of
July 12, 1999 with SHP, an affiliate of Westbrook Partners LLC and certain
members of Sunstone's senior management. Under the terms of the Merger Agreement
each share of common stock of the Company will be exchanged for $10.35 in cash,
as such amount may be adjusted. Minority interests in the Operating Partnership
can elect to receive the same consideration per Unit or an equity interest in
the acquiring entity.
18
<PAGE> 19
The Merger Agreement is subject to the vote of the Company's common
stockholders and minority interests, as well as certain other conditions,
including the receipt of consents from certain major franchisors of Sunstone's
hotels and the closing of SHP's financing. SHP has received a commitment for
debt financing for the transaction, which is expected to close during the fourth
quarter of 1999.
The Merger Agreement provides for a breakup fee and expenses of up to
$25.0 million to be paid to SHP in the event that the Company wishes to accept a
superior proposal to acquire the Company. Under such circumstances, the Company
has the right to purchase all the shares of the Lessee and Sunstone Hotel
Management, Inc., the management company, for a total amount of $30.0 million in
cash.
As required by the Merger Agreement, the Company will not pay a
distribution to stockholders or minority interests at any time prior to the
closing of the Merger. However, the aggregate purchase price will be increased
by an amount equal to 50% of any increase in the Company's cash balance,
adjusted as specified in the Merger Agreement, between June 30, 1999 and five
business days prior to the closing of the Merger, but not less than $0.06 per
share. The aggregate purchase price also is subject to a possible price
reduction in connection with certain contingent payments.
RESULTS OF OPERATIONS
Comparison of the Three Months Ended June 30, 1999 to 1998 and Six Months Ended
June 30, 1999 to 1998
Revenues increased to $25.4 million for the three months ended June 30,
1999 from $24.9 million for the second quarter of 1998. For the six months ended
June 30, 1999, revenues increased to $50.3 million from $48.6 million for the
corresponding period of 1998. The increase in revenues is primarily attributable
to an increased inventory of renovated rooms available for occupancy during the
three and six months ended June 30, 1999 in comparison to the corresponding
periods of 1998. The revenue increases achieved due to the completion of
renovation activities were partially offset by the disposition of certain
non-core hotels during 1998 and the first quarter of 1999. The Company owned
fewer hotels during the three and six months ended June 30, 1999 in comparison
to the corresponding periods of 1998. Revenue per available room ("REVPAR")
increases for continuously owned hotels also contributed to the revenue
increases.
On a same-unit-sales basis for the entire hotel portfolio, REVPAR
increased 4.7% to $57.34 for the second quarter of 1999 from $54.78 for the
second quarter of 1998. The 4.7% growth in REVPAR was driven by an increase in
the average daily rate ("ADR") to $84.77 from $82.09 and an increase in
occupancy to 67.6% from 66.7%.
REVPAR for the non-renovation hotels increased by 1.4%. Non-renovation
hotels include 44 of the Company's 58 hotels owned as of June 30, 1999 which
were not under renovation in either the second quarter of 1998 or 1999. The 1.4%
growth in REVPAR was driven by an increase in the ADR to $84.58 from $82.76 and
a decrease in occupancy to 70.1% from 70.6%.
During the second quarter of 1999, certain of the Company's hotel
markets were negatively impacted by new supply or decreased demand.
Specifically, the Seattle and Pueblo hotel markets, as well as Arizona had
significant new supply come on-line. Also, the Seattle hotel market experienced
less than anticipated demand during the second quarter. On-going supply/demand
imbalances in these markets may continue to negatively impact certain of the
Company's hotels in the near-term.
19
<PAGE> 20
The following table summarizes average occupancy rate, ADR and REVPAR,
on a same-unit-sales basis, for the Company's hotels owned during the three and
six months ended June 30, 1999.
SUMMARY OPERATING DATA
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -------------------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
SAME-UNIT-SALES ANALYSIS
ALL HOTELS(1):
Occupancy 67.6% 66.7% 66.6% 65.4%
ADR $84.77 $82.09 $85.82 $83.00
REVPAR $57.34 $54.78 $57.16 $54.30
REVPAR growth 4.7% 5.3%
NON-RENOVATION HOTELS(1):
Occupancy 70.1% 70.6% 68.7% 67.8%
ADR $84.58 $82.76 $82.86 $81.06
REVPAR $59.27 $58.46 $56.92 $54.96
REVPAR growth 1.4% 3.6%
RENOVATION HOTELS(2):
Occupancy 62.4% 58.2% 62.6% 60.8%
ADR $85.21 $80.33 $92.00 $87.15
REVPAR $53.21 $46.79 $57.63 $53.03
REVPAR growth 13.7% 8.7%
</TABLE>
- --------------------
(1) Excludes the Hampton Inn located in Arcadia, California which was sold
during the first quarter of 1999.
(2) Includes seven hotels undergoing renovation in the second quarter of 1999
and seven hotels undergoing renovation in the second quarter of 1998.
Real estate related depreciation and amortization increased $1.3
million and $3.4 million for the three and six months ended June 30, 1999,
respectively, over the corresponding periods of 1998. These increases are
consistent with the net increase in investments in hotel and other real estate
properties. Also contributing to the increases is depreciation of renovations
completed at the hotel properties during 1998 and the first quarter of 1999.
Interest expense and amortization of financing cost increased $1.7
million to $7.2 million for the three months ended June 30, 1999 from $5.5
million for the corresponding quarter of 1998. For the six months ended June 30,
1999, interest expense and amortization of financing costs increased $3.5
million, to $13.6 million from $10.1 million for the corresponding period of
1998. These increases are attributable to higher average borrowings outstanding
and reduced interest capitalized related to hotels undergoing major renovations
for the three and six months ended June 30, 1999 in comparison to the
corresponding periods of 1998.
During the three and six month periods ended June 30, 1999, the Company
incurred increased general and administrative expenses. For the three months
ended June 30, 1999, general and administrative expenses increased to $1.6
million from $871,000 for the corresponding quarter of 1998. For the six months
ended June 30, 1999, general and administrative expenses increased to $2.9
million from $2.4 million for the corresponding period of 1998. These increases
are primarily attributable to costs incurred and expensed by the Company for
pre-opening activities related to three newly built hotels: the Residence Inn by
Marriott in San Diego, California, the Hilton Garden Inn in Sacramento,
California and the Courtyard by Marriott in Lynnwood, Washington.
20
<PAGE> 21
As previously discussed, the Company has entered into a Merger
Agreement to be acquired by SHP. In conjunction with this transaction, the
Company has incurred and expensed $2.2 million primarily for legal and
accounting services.
During the first quarter of 1999, the Company disposed of the 129-room
Hampton Inn located in Arcadia, California, for $8.5 million and recognized a
$490,000 gain.
As a result of the above factors and despite the modest increases in
revenues and REVPAR, income available to common stockholders decreased 89.5% to
$607,000 for the three months ended June 30, 1999 from $5.8 million for the
second quarter of 1998, while diluted earnings per share decreased to $0.02 from
$0.15 per share, an 86.7% decrease. For the six months ended June 30, 1999,
income available to common stockholders decreased 63.0% to $4.4 million from
$11.9 million for the second quarter of 1998, while diluted earnings per share
decreased to $0.12 from $0.32 per share, a 62.5% decrease. (See discussion of
Funds from Operations in "Liquidity and Capital Resources.")
Seasonality and Regional Focus
The Company currently focuses its acquisition efforts principally on
the Pacific and Mountain regions which collectively comprise the western United
States. The geographic distribution of the hotels, which are located in eight
states as of August 13, 1999, reflects the Company's belief that a certain
amount of geographic distribution helps to insulate the Company's hotel
portfolio from local market fluctuations and off-peak seasonal operations that
are typical for the hotel industry. The Company has also sought to increase its
geographic distribution by focusing on major metropolitan areas.
LIQUIDITY AND CAPITAL RESOURCES
Distributions. As previously discussed, the Company has entered into a
Merger Agreement to be acquired by SHP. As required by the Merger Agreement, the
Company will not pay a distribution to stockholders or minority interests at any
time prior to the closing of the Merger. Accordingly, the Company did not
declare a dividend for the second quarter of 1999.
Cash Flow Provided by Operating Activities. The Company's principal
source of cash to fund operating expenses and distributions is cash flow
provided by rent paid by the Lessee. For the six months ended June 30, 1999, the
Lessee failed to achieve the hotel revenues contemplated in the budget and
subsequent forecasts provided to the Company. As a result, rent paid by the
Lessee was less than anticipated. The Lessee's obligations under the Percentage
Leases are largely unsecured and the Lessee's ability to make rent payments to
the Company under the terms of the Percentage Leases are substantially dependent
on the Lessee's ability to generate sufficient cash flow from the operations of
the hotels. (See discussion of the Lessee's stockholders' deficit in the
following section, "The Lessee").
The Company is required under the Percentage Leases to make available
to the Lessee for repair, replacement and refurbishment of furniture, fixtures
and equipment an amount equal to 4% of room revenue per quarter on a cumulative
basis. These funds are intended to maintain the hotels in a competitive
condition. In the event the Merger does not close, the Company anticipates that
cash flow from operations for the second half of 1999 will be insufficient to
fund capital expenditures required under the Percentage Leases, operating
expenses and distributions at the level prior to entering into the Merger
Agreement. Accordingly, it may be necessary for the Company to defer or reduce
the scope of capital expenditures, sell hotel properties or reduce distributions
in the event the Merger does not close.
Cash and cash equivalents as of June 30, 1999 were $1.9 million, as
compared to $859,000 at December 31, 1998. Net cash provided by operating
activities for the six months ended June 30, 1999 was $25.7 million.
21
<PAGE> 22
Cash Flows from Investing and Financing Activities. During the six
months ended June 30, 1999, the Company invested $68.3 million in hotel
properties and $3.5 in other real estate investments. These investments were
primarily funded with borrowings from the Company's $350.0 million unsecured
revolving line of credit facility (the "Credit Facility") from its lenders (led
by Bank One of Arizona, N.A., as the agent bank) and promissory notes secured by
certain hotel properties.
Borrowings under the Credit Facility accrue interest at LIBOR plus a
margin that is based on the leverage of the Company. At June 30, 1999, the
Company had $305.0 million outstanding under its Credit Facility with an actual
borrowing rate of LIBOR plus 2.0%. Borrowing base and loan-to-value limits, as
well as other financial performance covenants restrict the availability of
borrowings under the Credit Facility. The Company's total liabilities as defined
under the terms of the Credit Facility are restricted by a leverage covenant
("Leverage Covenant") which allows the Company to borrow funds when the lesser
of (i) 50% of the cost basis of the hotels or (ii) 50% of the cost basis of
hotels owned for no more than six full fiscal quarters plus a valuation based on
the net operating income ("NOI") for hotels owned longer than six fiscal
quarters exceeds the Company's total liabilities. Effective July 1, 1999, the
eleven remaining hotels that were acquired in connection with the acquisition of
Kahler Realty Corporation in October of 1997 (the "Kahler Hotels") lost their
cost consideration and are required to be valued based on their respective NOI.
As a result of such change, the Company is not in compliance with the Leverage
Covenant which, if not modified by September 1, 1999, will cause the Company to
be in default under the Credit Facility. In addition, the Company's borrowing
base at June 30, 1999 does not support the current level of outstanding
borrowings under the Credit Facility and the Company cannot currently borrow any
additional amounts under the Credit Facility. As a result, the Company will be
required to re-margin the Credit Facility and repay approximately $4.9 million
during the third quarter of 1999.
The Company has entered into negotiations with the Credit Facility
lenders for relief with respect to the Leverage Covenant. While no agreement has
been executed, the Company has received a proposal from the co-agent banks under
the Credit Facility to modify the terms of the Credit Facility to allow the
Kahler Hotels to be valued at their cost basis for an additional two quarters,
for a total of eight quarters. In exchange for such modification, the lenders
will require a modification fee of approximately $1.0 million, an increase in
the borrowing rate, limitations on expenditures for new acquisitions and
renovations, maintenance of minimum liquidity and possibly other requirements
and restrictions. Additionally, in the event the Merger does not close, the
lenders will require the Company to secure the Credit Facility with the hotel
properties and pay additional fees and further increase the borrowing rate.
The Credit Facility term expires on July 1, 2000. During the first
quarter of 1999, the Company requested a one-year extension of the term to July
1, 2001 which the lenders have denied. As a result, the Company is evaluating
possible means of meeting near-term debt service requirements and improving
liquidity through refinancing existing indebtedness, issuing additional equity
securities and divesting certain hotel assets. The Company has also modified its
capital expenditures and renovation programs. As previously discussed, the
Company will not pay a distribution to stockholders or minority interests at any
time prior to the closing of the Merger. However, the Company anticipates that
the distributions already made during 1999 are sufficient to satisfy the federal
income tax requirements with respect to distributions in order for the Company
to continue to qualify as a REIT.
No assurances can be made regarding the availability or terms of
additional sources of capital for the Company in the future and no assurances
can be given regarding the Company's ability to successfully refinance the
maturity of existing indebtedness, including, without limitation, the Credit
Facility. No assurances can be given regarding the Company's success in securing
an amendment to the Credit Facility whereby an existing breach of the Leverage
Covenant would be remedied. If the Merger does not close and the Company is
unable to secure additional sources of financing in the future, is unable to
successfully refinance existing indebtedness, or is unable to obtain amendments
to the Credit Facility, no assurance can be made that the Company will be able
to meet its financial obligations as they come due without substantial
disposition of assets outside the ordinary course of business, restructuring of
debt or revisions of the Company's operations. Additionally, no assurances can
be given that the lack of future financing sources would not have a material
adverse effect on the Company's financial condition and results of operations.
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<PAGE> 23
During the six months ended June 30, 1999, the Company invested
approximately $31.9 million renovating hotels. During this period there were ten
hotels that were undergoing significant renovation activities. As previously
discussed and in an effort to improve the Company's near-term liquidity, the
Company has modified its capital expenditure and renovation programs such that
future investments in hotels will be made to prevent or address guest
satisfaction issues and to maintain the hotels in a competitive condition. The
Company estimates it will invest an additional $19.1 million through the balance
of 1999 to complete the renovation of those hotels currently under renovation
and to maintain the competitive condition of the hotel portfolio.
The Company has selectively developed luxury and upscale hotels in
markets where management believes room demand and other competitive factors
justify new construction. During the second quarter of 1999, the Company
completed the acquisition of two newly built hotel properties, the 121-room
Residence Inn by Marriott in San Diego and the 154-room Hilton Garden Inn in
Sacramento, for a total of $28.0 million. Both hotels were acquired under the
terms of definitive purchase agreements which were entered into during the
fourth quarter of 1997 with third party developers. The acquisition of the two
hotels was financed, in part, with proceeds from a $20.8 million promissory note
dated May 27, 1999 that requires monthly interest only payments at either the
Prime Rate plus .50% or LIBOR plus 2.0%, matures May 27, 2001 and is secured by
the two hotel properties.
On July 15, 1999, the Company opened the newly built Courtyard by
Marriott in Lynwood, Washington, located approximately 15 miles north of
downtown Seattle. The 164-room hotel includes a limited number of suites, as
well as a restaurant, lobby lounge, pool, fitness room, business center and
approximately 1,500 square feet of meeting space. The hotel was developed by the
Company for a cost of $10.0 million and was financed in part with proceeds from
a $7.7 million promissory note and Building Loan Agreement, both dated June 28,
1999. This financing is secured by a first deed of trust and requires monthly
interest only payments at either the Prime Rate plus .25% or LIBOR plus 2.5% per
year, but not less than 7% per year and matures June 28, 2000. The Company has
the option to extend the maturity date for up to one year. During July 1999,
approximately $4.2 million was disbursed to the Company under such building Loan
Agreement.
On May 11, 1999, the Company repaid a $6.1 million promissory note with
proceeds from a $16.1 million promissory note dated May 7, 1999 that requires
monthly interest only payments at LIBOR plus 2.25%, matures October 30, 1999 and
is secured by certain hotel properties. Additionally, on May 17, 1999, the
Company issued 277,513 shares of its common stock under the Company's Dividend
Reinvestment and Stock Purchase Plan (the "Plan"). The Plan provides for the
issuance of common stock at a price based on the twelve day trading period
subsequent to acceptance and subject to certain thresholds and discounts as set
by the Company. The issuance price of the shares sold was $9.08 per share,
resulting in proceeds of approximately $2.5 million.
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<PAGE> 24
Funds From Operations ("FFO")
Management believes that funds from operations ("FFO") is a useful
measure of financial performance of an equity REIT, such as the Company. FFO (as
defined in the footnote below) for the three and six months ended June 30, 1999
decreased by 12.5% and 9.3%, respectively, over the corresponding periods of
1998.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------- ----------------------------
1999 1998 1999 1998
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Net Income $ 1,099,000 $ 6,274,000 $ 5,371,000 $ 12,871,000
Add (subtract):
Real estate related depreciation
and amortization 10,292,000 8,993,000 20,281,000 16,912,000
Gain on disposition of hotel property -- -- (490,000) --
Minority interest 31,000 324,000 243,000 675,000
Transaction Costs 2,222,000 -- 2,222,000 --
------------ ------------ ------------ ------------
Funds from operations $ 13,644,000 $ 15,591,000 $ 27,627,000 $ 30,458,000
============ ============ ============ ============
</TABLE>
Management and industry analysts generally consider Funds From Operations to be
an appropriate measure of the performance of an equity REIT. The White Paper on
Funds From Operations approved by the Board of Governors of the National
Association of Real Estate Investment Trusts ("NAREIT") defines Funds From
Operations as net income or loss (computed in accordance with GAAP), excluding
gains or losses from debt restructuring and sales of property, plus real estate
related depreciation and amortization, and after adjustments for unconsolidated
partnerships and joint ventures. The Company computes Funds From Operations in
accordance with standards established by NAREIT, adjusted for minority interest
and nonrecurring transaction costs, which may not be comparable to Funds From
Operations reported by other REITs that do not define the term in accordance
with the current NAREIT definition or that interpret the current NAREIT
definition differently than the Company.
Funds From Operations should be considered in conjunction with net income and
cash flows from operating, investing and financing activities as presented in
the Company's consolidated financial statements and notes thereto. Funds From
Operations should not be considered as an alternative to net income (determined
in accordance with GAAP) as an indication of the Company's financial performance
or to cash flow from operating, investing or financing activities (determined in
accordance with GAAP) as a measure of the Company's liquidity, nor is it
indicative of funds available to fund the Company's cash needs, including its
ability to make cash distributions. Funds From Operations may include funds that
may not be available for management's discretionary use due to the requirements
to conserve funds for capital expenditures and property acquisitions and other
commitments.
The Lessee
For a discussion of the Lessee's revenue operations and a comparison of
the three and six months ended June 30, 1999 to 1998, see "Results of
Operations" of the Company. Additionally, the Lessee has incurred significant
losses from its inception in 1995. At June 30, 1999, the Lessee's stockholders'
deficit amounted to $9.6 million. At June 30, 1999, the Lessee's rent payable to
the Company amounted to $12.1 million. Also at June 30, 1999, the Lessee's
current liabilities exceeded its current assets by $9.0 million. The ability of
the Lessee to fund its daily operations and continue to remain current on its
substantial rent obligation to the Company is a result of the original terms
under the Percentage Leases, for the payment of rent to the Company, which allow
monthly base rent to be paid in arrears and monthly percentage rent to be paid
within 45 days after the respective month end.
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<PAGE> 25
YEAR 2000 ISSUE
The term "Year 2000 Issue" is a general term used to describe the
complications that may be caused by existing computer hardware and software that
were designed by the respective manufacturers without consideration of the
upcoming change in the century. Many computer systems recognize calendar years
by the last two digits in the date code field. Beginning in the year 2000, these
date code fields will need to accept four digit entries to distinguish
twenty-first century dates from twentieth century dates. If not corrected,
computer systems may fail or create erroneous results causing disruptions of
operations.
The Company's in-house computer systems environment is limited to
software and hardware developed by third parties. All of the Company's computer
systems, consisting of financial reporting and accounting systems only, were
installed in the last two years and management believes such systems are Year
2000 compliant. However, the Company's business is heavily dependent upon the
efforts of the Lessee and third parties with whom the Lessee conducts
significant business.
The Lessee relies on information technology ("IT") systems and other
systems and facilities such as PBX switches, elevators, heating, ventilation and
air conditioning, security, fire and life safety and other environmental systems
("embedded systems") to conduct its business. Both the IT and the embedded
systems are subject to the Year 2000 Issue which, if not remedied in time, could
have an impact on the operations of the Lessee. The Lessee also may be exposed
to risk from third parties with whom the Lessee interacts who fail to adequately
address their own Year 2000 issues. Such third parties include franchisors,
vendors, suppliers and significant customers.
To mitigate and minimize the number and seriousness of any disruptions
caused by the Year 2000 Issue, the Company and the Lessee have developed and
adopted a Year 2000 Compliance Program (the "Compliance Program") which involves
the following four phases: assessment, which includes development of an action
plan and inventorying of hotel systems, remediation, testing and implementation.
With the assistance of outside consultants, site surveys have been performed and
all hotel systems have been identified and inventoried and include information
such as the manufacturer or vendor who performed the installation or currently
services or maintains each system. The Lessee has completed contacting these
vendors to obtain certification relating to their Year 2000 compliance testing.
In addition, all parties for building systems that service leased premises, or a
facility within leased premises are located and are operated and controlled by
or interact with a software program will be identified and contacted. It should
be noted that due to the complexity of some of the systems, in many cases, the
only way to determine the potential impact of the systems would be to verify the
Year 2000 effect with the particular vendor. The assessment phase was completed
in February 1999.
Status of Progress in Becoming Year 2000 Compliant, Including Timetable for
Completion of Each Remaining Phase - Hotel and Lessee Systems:
Based on the results of the site assessments, the identified IT and
embedded systems will be replaced or upgraded. The system upgrades will be
prioritized according to their critical importance. Life safety systems and
emergency services will take priority in accordance with the steps laid out in
the Compliance Program. The various vendors associated with any system
replacements or upgrades have been contacted to determine their readiness to
deal with these system enhancements. Performance of certain testing by the
vendors may be required in several cases to ensure Year 2000 compliance. Certain
vendors, manufacturers, service personnel, consultants, contractors, lessees and
lessors will be requested to prepare a letter certifying and warranting that all
systems, utilities and services containing time and date-related coding and
internal programs, shall continue without interruption beyond December 31, 1999.
The implementation will be monitored and managed on a real-time basis to ensure
a smooth upgrade of the systems. Completion of the implementation and testing
phases for all significant systems was achieved in July 1999, with all
remediated systems to be fully tested and implemented by September 30, 1999,
with 100% completion targeted for October 31, 1999.
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<PAGE> 26
Nature and Level of Importance of Third Party Systems and Their Exposure to the
Year 2000:
The Lessee is in the process of surveying its vendors and service
providers that are critical to the Lessee's business to determine whether they
are Year 2000 compliant. The Lessee expects that these surveys will be completed
by the end of the third quarter of 1999, but cannot guarantee that all vendors
or service providers will respond to the survey, and therefore the Lessee may
not be able to determine Year 2000 compliance of those vendors or service
providers. By the end of the third quarter of 1999, the Lessee will determine
the extent to which the Lessee will be able to replace those vendors not in
compliance. There may be instances in which the Lessee will have no alternative
but to remain with non-compliant vendors or service providers. The inability of
vendors to complete their Year 2000 resolution process in a timely fashion could
materially impact the Company and the Lessee. The effect of compliance by
vendors is not determinable.
Cost of Addressing Year 2000 Issues:
The Company estimates that total cost for the Year 2000 compliance
review, evaluation, assessment and remediation efforts should not exceed $1.0
million and will be funded by the Company through its operating cash flows. To
date, the costs incurred to address the Year 2000 issue consist primarily of
services provided by outside consultants for onsite system surveys and the
replacement and upgrade of hardware and software and total $250,000. Of these
costs, $163,000 related to consulting services was expensed by the Company in
the first quarter of 1999, with the balance related to hardware and software
purchases capitalized as of June 30, 1999.
Risks Presented by Year 2000 Issues:
Management of the Company and the Lessee believe they have an effective
plan in place to resolve the Year 2000 Issue in a timely manner. As noted above,
the Lessee has not yet completed all necessary phases of the Year 2000 program.
In the event that the Lessee does not complete any additional phases, the Lessee
may encounter system failures associated with third-party vendors such as
disruptions in passenger transportation or transportation systems generally,
loss of utility and telecommunications services, the loss or disruption of hotel
reservations made on centralized reservation systems and errors or failures in
financial transactions or payment processing systems such as credit cards. These
disruptions could adversely affect the Company and the Lessee, their businesses
and their financial conditions. The Company and the Lessee cannot predict the
actual effects of the Year 2000 Issue on their businesses, such effects depend
on numerous uncertainties such as whether significant third parties have
properly and timely addressed the Year 2000 Issue, and whether broad-based or
systemic economic failures may occur. Due to the general uncertainty inherent in
the Year 2000 Issue and the Company's and Lessee's dependence on third parties,
Management is unable to determine at this time whether the consequences of Year
2000 failures will have a material impact.
Contingency Plan:
The Lessee is in the process of developing its contingency plan for the
systems operated an maintained by the Lessee and the hotels. This is necessary
in order to provide for the most likely worst case scenarios regarding Year 2000
compliance. The contingency plan is expected to be completed in 1999.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Refer to the Company's Annual Report on Form 10-K for the year ended
December 31, 1998 for detailed disclosure about quantitative and qualitative
disclosures about market risk which have not materially changed since December
31, 1998.
26
<PAGE> 27
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
During the quarter ended June 30, 1999 and in connection with the
acquisition of Sunstone, eight lawsuits were filed (five in Maryland and three
in California). (See discussion of proposed acquisition in Part I, Item 2,
"Liquidity and Capital Resources.") The causes of action alleged, parties sued,
courts in which the lawsuits were filed and dates when the actions were
instituted are as follows:
o Augusto Belloco v. Sunstone Hotel Investors, Inc., Sunstone Hotel
Investors, Inc., Robert A. Alter, Charles L. Biederman, H. Raymond
Bingham, C. Robert Enever, Laurence S. Geller, Fredric H. Gould, David
Lambert, Paul D. Kazilionis, Edward Sondker and Westbrook Partners,
Baltimore City Circuit Court, Maryland, Case No. 24-C-99-001601
(breach of fiduciary duty); Complaint filed on April 7, 1999.
o Lee Brenin v. Sunstone Hotel Investors, Inc., Robert A. Alter, Charles
L. Biederman, Paul Kazilionis, Fredric H. Gould, H. Raymond, Bingham,
Laurence S. Geller, C. Robert Enever, David Lambert and Edward H.
Sondker, Montgomery County Circuit Court, Maryland, Case No. 198629-V
(breach of fiduciary duty); Complaint filed April 7, 1999.
o Rongelap Resettlement Trust Fund v. Sunstone Hotel Investors, Inc.,
Robert A. Alter, Carles L. Biederman, R. Terrence Crowley, Sam
Marshall, Edward H. Sondker, Laurence S. Geller, H. Raymond Bingham,
Fredric H. Gould, David E. Lambert, C. Robert Enever, Paul D.
Kazilionis, Westbrook Partners and Sunstone Hotel Properties, Inc.,
Montgomery County Circuit Court, Maryland, Case No. 198654-V (breach
of fiduciary duty; misrepresentation); Complaint filed April 7, 1999.
o Charles Branch v. Robert A. Alter, Fredric H. Gould, Paul D.
Kazilionis, David Lambert, C. Robert Enever, Edward H. Sondker,
Charles L. Biederman, H. Raymond Bingham, Laurence S. Geller and
Sunstone Hotel Investors, Inc., Baltimore County Circuit Court,
Maryland, Case No. 03-C-99-003422 (breach of fiduciary duty);
Complaint filed on April 8, 1999.
o Judith Muti v. Sunstone Hotel Investors, Inc., Robert A. Alter,
Charles L. Biederman, H. Raymond Bingham, C. Robert Enever, Laurence
S. Geller, Fredric H. Gould, David Lambert, Paul D. Kazilionis, Edward
Sondker and Westbrook Partners, Baltimore City Circuit Court,
Maryland, Case No. 24-C-99-001810 (breach of fiduciary duty);
Complaint filed on April 21, 1999.
o Tom Yuan v. Robert A. Alter, Fredric H. Gould, Paul Kazilionis, C.
Robert Enever, Edward H. Sondker, David Lambert, Charles L. Biederman,
H. Raymond Bingham, Laurence S. Geller, Westbrook Real Estate Fund I,
LP, Westbrook Real Estate Co-Investment Partnership I, LP, SHP
Acquisition, LLC, Sunstone Hotel Properties, Inc. and Sunstone Hotel
Investors, Inc., Orange County Superior Court, California, Case No. CV
807886 (breach of fiduciary duty; misrepresentation); Complaint filed
on April 8, 1999.
o Edward Mittleman v. Sunstone Hotel Investors, Inc., Robert A. Alter,
Charles L. Biederman, R. Terrence Crowley, Sam Marshall, Edward H.
Sondker, Laurence S. Geller, H. Raymond Bingham, Fredric H. Gould,
David E. Lambert, C. Robert Enever, Paul D. Kazilionis, Westbrook
Partners, LLC, Sunston Hotel Properties, Inc., Orange County Superior
Court, California, Case No. CV 808099 (breach of fiduciary duty;
misrepresentation); Complaint filed on April 14, 1999.
o William Buie and Anita Smith v. Sunstone Hotel Investors, Inc., SHP
Acquisition, LLC, Robert A. Alter, Charles L. Biederman, H. Raymond
Bingham, C. Robert Enever, M.A. Ferrucci, Laurence S. Geller, Frederic
H. Gould, David E. Lambert, Edward H. Sondker and Paul Kazilonis,
Orange County Superior Court, California, Case No. CV 808233 (breach
of fiduciary duty; misrepresentation); Complaint filed on April 16,
1999.
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<PAGE> 28
The factual basis alleged to underlie all eight lawsuits are
essentially identical. Substantively, they assert that Robert A. Alter, Charles
L. Biederman and Paul Kazilionis, in conjunction with Westbrook Partners, LLC
(and other purported Westbrook affiliated entities), SHP Acquisition and the
Lessee, have offered an unfair buyout price for the outstanding shares of the
Company. The other directors and officers sued are alleged to have breached
their fiduciary duties by going along with or assisting the management group of
SHP Acquisition in perpetrating this purported "scheme." Plaintiffs assert that
defendants are in possession of material nonpublic information concerning the
Company's financial condition and prospects, and that the proposed acquisition
is designed to deny future benefits to members of the purported "class."
Plaintiffs in each of these lawsuits purport to seek both injunctive relief and
damages on behalf of the purported class based upon these allegations.
Procedurally, plaintiffs' counsel have agreed to stay the Maryland
actions pending a resolution of the California actions. The parties have agreed
to consolidate the California actions under the first filed California case
(Yuan); a proposed consolidation order is being negotiated among the parties.
The Company intends to defend the lawsuits vigorously. Among other things, the
Company believes that it engaged in a process of evaluating SHP's bid that was
fair and that satisfied the Company's and the Board's duties to the Company's
shareholders, including, as part of that process, the evaluation of competing
expressions of interest and offers from other interested or potentially
interested third parties.
ITEM 5. OTHER INFORMATION
RISK FACTORS
LIQUIDITY
Our hotels generate cash flow in the form of rent we receive from the
Lessee, the entity that leases and operates our hotels. The Lessee's rent is
tied to hotel operating performance and consists of base rent and rent that is a
percentage of certain hotel revenues. In addition, historically we have had
access to cash available from the Credit Facility with a maximum commitment of
$350.0 million with the actual availability based on our assets and financial
performance. We also have been able to raise cash by issuing equity securities
in the public markets. We use these three sources of cash -- from hotel
operations, from borrowings and from sales of stock -- to fund our acquisition
of hotels, renovation of hotels, recurring capital expenditures, operating
expenses and the payment of dividends to our shareholders. Our ability to access
the Credit Facility has been restricted by our non-compliance with the Leverage
Covenants under the Credit Facility as described in Liquidity and Capital
Resources. Finally, because of the recent conditions in the capital markets, it
is currently difficult for many companies, especially REITs, to raise capital by
issuing debt or equity securities. No assurances can be made regarding the
availability or terms of additional sources of capital for the Company in the
future and no assurances can be given regarding the Company's success in
securing an amendment to the Credit Facility whereby an existing breach of the
Leverage Covenant would be remedied. If the Merger does not close and the
Company is unable to secure additional sources of financing in the future, is
unable to successfully refinance existing indebtedness, or is unable to obtain
amendments to the Credit Facility, no assurance can be made that the Company
will be able to meet its financial obligations as they come due without
substantial disposition of assets outside the ordinary course of business,
restructuring of debt or revisions of the Company's and Lessee's operations.
Additionally, no assurances can be given that the lack of future financing
sources would not have a material adverse effect on the Company's financial
condition and results of operations.
TOTAL DEPENDENCE ON THE LESSEE AND PAYMENTS UNDER THE PERCENTAGE LEASES
Because of our status as a REIT, we are prohibited from operating
hotels and must lease them to the Lessee or other third parties. Our ability to
pay dividends to our shareholders depends on our Lessee's ability to generate
sufficient revenue to pay percentage rent required under the Percentage Leases.
The Lessee was chosen because Messrs. Alter and Biederman, who own the Lessee,
were involved in the management of certain hotels contributed as part of our
initial public offering ("IPO") in 1995.
The Lessee has incurred significant losses since its inception in 1995.
At June 30, 1999, the Lessee's stockholders' deficit amounted to $9.6 million.
At June 30, 1999, the Lessee's rent payable to the Company amounted to $12.1
million. Also at June 30, 1999, the Lessee's current liabilities exceeded its
current assets by $9.0 million. The ability of the Lessee to fund its daily
operations and continue to remain current on its substantial rent obligation to
the
28
<PAGE> 29
Company is a result of the original terms under the Percentage Leases, for
the payment of rent to the Company, which allow monthly base rent to be paid in
arrears and monthly percentage rent to be paid within 45 days after the
respective month-end. There can be no assurances, however, that the Lessee will
continue to make its rent payments in a timely fashion.
According to the Lessee, the losses are due to several factors,
including:
o the substantial number of renovations we undertook adversely affected
occupancy rates and revenues at the hotels;
o renovations caused greater revenue losses than expected; and
o poorer performance at certain hotels than expected.
There can be no assurance that the Lessee will generate adequate
operating cash flows to meet its obligations. Other than its cash flow generated
by operating the hotels, the Lessee has no financial resources or other assets
to pay its operating obligations or its rent under the Percentage Leases.
Messrs. Alter and Biederman have pledged a subordinated interest in 481,955
Units to secure the Lessee's obligations under the Percentage Leases. However,
if the Lessee defaults under the Percentage Leases, the value of these Units and
other assets of the Lessee will be insufficient to satisfy our claims against
the Lessee.
RISKS RELATED TO DEVELOPMENT AND RENOVATION OF HOTELS
Our growth strategy of acquiring hotels needing substantial renovation
or redevelopment affecting the Company's results of operations and financial
condition include the following:
o We may continue to incur significant renovation and construction cost
overruns and time delays due to:
- labor shortages;
- changes in the scope of a project;
- requirements imposed by local building inspectors;
- discovery of defects in the building once renovation has
begun; and
- compliance with the Americans with Disabilities Act of 1990,
which may require expensive modifications to existing hotels
to bring them into compliance.
o We may purchase a hotel or contract to acquire a hotel (after a third
party completes construction) when market conditions are favorable but
then face deteriorated local demand for hotel rooms when the hotel is
available for occupancy resulting in revenues that are less than
projected;
o We may complete our renovation after significant delays reducing the
amount of revenues expected to be received during the delay period;
and
o We may spend more than budgeted for a renovation project reducing our
anticipated return on the investment.
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<PAGE> 30
CONFLICTS OF INTEREST BETWEEN THE COMPANY AND CERTAIN OFFICERS AND DIRECTORS
The relationship among Mr. Alter and Mr. Biederman, the Lessee, the
Management Company and us creates several inherent conflicts of interest that
may result in decisions being made by our management that are not in the best
interests of our stockholders. The most significant conflicts of interest
include the following:
o As owners of SHP Acquisition LLC, Messrs. Alter and Biederman have
several conflicts of interest arising from the Merger proposed with
us including the following:
o Mr. Alter, our President and Chief Executive Officer and the
Chairman of our Board of Directors, will serve as chief
executive officer of SHP Acquisition immediately after
consummation of the Merger and, through his affiliates, will
hold significant equity in SHP Acquisition and will be entitled
to receive a disproportionate amount of the profits from SHP
Acquisition after certain other members of SHP Acquisition have
received a specified return on their investment;
o Mr. Alter has entered into a five-year employment agreement with
SHP Acquisition (to serve as its chief executive officer), which
will provide for, among other things, an annual salary of
$500,000 and a bonus of up to $920,000;
o Mr. Biederman, the Vice Chairman of our Board of Directors, has
entered into a five-year employment agreement with SHP
Acquisition, which will provide for, among other things, an
annual salary of $200,000 and a bonus of up to $80,000, will
hold equity in SHP Acquisition through his affiliates and will
be entitled to receive a disproportionate amount of the profits
from SHP Acquisition after certain other members of SHP
Acquisition have received a specified return on their
investment;
o In connection with the sale of Lessee and the Management Company
to SHP Acquisition, which sale will be completed immediately
prior to the Merger, Messrs. Alter and Biederman (or their
affiliates) will receive, as the stockholders of the Lessee and
the Management Company, in addition to the equity in SHP
Acquisition referred to above, an aggregate amount of $8.45
million in cash (of which Mr. Alter will receive $3 million),
and as well as the release of certain personal guarantees and
indemnities and the termination of certain obligations to us;
o As the owners of the Lessee, Mr. Alter and Mr. Biederman will benefit
from any profits the Lessee may generate from the operation of the
hotels and retain for itself, even though under the Unit Purchase
Agreement, Messrs. Alter and Biederman have agreed to reinvest the
Lessee's profits (net of tax liabilities) in additional units or
retain the profits as security for future rent payments.
o As the owner of the Management Company, Mr. Alter is entitled to the
profits of the Management Company, which receives from the Lessee
management fees (1% to 2% of gross revenues of the hotels) and
reimbursements for certain accounting expenses.
o The Percentage Leases generally require us to pay a termination fee to
the Lessee if we elect to sell a hotel and not replace it with a
Percentage Lease for another hotel. As a result, our decisions about
which hotels to sell may be influenced by the conflict of interest of
Messrs. Alter and Biederman who, as owners of the Lessee, would
benefit from the termination fee.
o In connection with our IPO, Messrs. Alter and Biederman contributed
tax free certain hotels that had a tax basis less than their fair
market value. Significant taxable gains that would arise if we were to
sell these hotels would be specifically allocated to Messrs. Alter and
Biederman. Further, in order to prevent adverse tax consequences to
Messrs. Alter and Biederman, we must maintain mortgage debt at certain
minimum levels. Because of these conflicts, our decisions concerning
whether to sell certain hotels or to incur or repay debt will be
influenced by the tax consequences for Messrs. Alter and Biederman.
o We did not negotiate the Percentage Leases on an arm's length basis
with the Lessee. The base rent, percentage rent and the economic terms
of each Percentage Lease are determined by us and approved by the
Lessee based on historical financial data and projected operating and
financial data for each hotel. See "Total Dependence on the Lessee and
Payments under the Percentage Leases."
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RELIANCE ON MR. ALTER AND OTHER KEY PERSONNEL
Our success depends in large part upon our ability to attract and
retain highly qualified personnel. Further, because our sole source of operating
revenue is base and percentage rent paid by the Lessee, our success is also
dependent on the Lessee's management's ability to effectively operate the
hotels. Competition for qualified employees for us and the Lessee is extremely
intense and there is no assurance that we or the Lessee can attract and retain
qualified employees. In particular, we substantially rely on the hotel and real
estate knowledge and experience and continuing services of Mr. Robert Alter, our
Chairman, Chief Executive Officer and President. Our inability (or the Lessee's)
to attract and retain qualified employees could negatively affect our ability to
generate revenues and pay distributions to our shareholders.
INVESTMENT CONCENTRATION IN SINGLE INDUSTRY
Our investment strategy is to focus exclusively on acquiring and owning
hotels. This strategy concentrates all our investment in a single industry and
therefore does not diversify our sources of revenues. As a result, a downturn in
the hotel industry will have a greater impact on our revenues and funds from
operations than if we had a diversified portfolio of properties. In addition,
because we have focused on the western United States and in the luxury, upscale
and mid-price segments of the hotel industry, economic or other conditions that
affect this geographic region or these segments may disproportionately impact
us.
FAILURE TO REALIZE BENEFITS OF RECENT ACQUISITIONS
We have grown rapidly since our IPO. This growth has required us, and,
to a greater extent, the Lessee to develop scaleable operating systems, develop
construction management procedures and systems and other procedures and systems
to operate our multi-state hotel portfolio. If we, or the Lessee, fail to
effectively integrate the acquired hotels into our operating systems, then we
will not achieve the expected benefits of the acquisition.
The revenues generated by the hotels we acquire are used to pay the
debt service on the funds we borrow to fund these acquisitions. If the acquired
hotels do not generate sufficient cash flow to fund debt service on the money
borrowed to purchase those hotels, we will be required to service the debt with
cash flows from other hotels which might adversely affect our cash available for
other purposes, including distributions to our shareholders. Further, as
discussed under Liquidity and Capital Resources, the failure of acquired hotels
to generate sufficient net operating income may cause non-compliance with
financial covenants in our Credit Facility.
FAILURE TO MAINTAIN REIT STATUS
We intend to operate so as to be taxed as a REIT under the Internal
Revenue Code of 1986, as amended. As long as we qualify for taxation as a REIT,
with certain exceptions, we will not be taxed at the corporate level on our
taxable income that is distributed to our shareholders. A REIT is subject to a
number of organizational and operational requirements, including requirements as
to the nature of its income and assets, distribution requirements, diversity of
stock ownership requirements and record-keeping requirements. We intend to
satisfy all of these requirements for treatment as a REIT. It is possible that
we may fail to satisfy one or more of these requirements. Failure to qualify as
a REIT would render us subject to tax on our income at regular corporate rates
and we could not deduct distributions to our shareholders. Unless entitled to
relief under certain Internal Revenue Code provisions, we also would be
disqualified from treatment as a REIT for the four taxable years following the
year during which qualification was lost. Even if we qualify for taxation as a
REIT, we may be subject to certain state and local taxes on our income and
property.
In order for us to be taxed as a REIT, the Partnership must be
classified as a partnership for federal income tax purposes. If the Partnership
were to be taxable as a corporation, because our ownership interest in the
Partnership constitutes more than 10% of the Partnership's voting securities and
exceeds 5% of the value of our assets, we would cease to qualify as a REIT. The
imposition of corporate income tax on us and the Partnership would substantially
reduce the amount of cash available for distribution to our shareholders.
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<PAGE> 32
OWNERSHIP LIMITATION
In order for us to maintain our qualification as a REIT, not more than
50% in value of our outstanding stock may be owned, directly or indirectly, by
five or fewer individuals (which includes certain entities). Furthermore, if any
shareholder or group of shareholders of the Lessee owns, actually or
constructively, 10% or more of our stock we would likely lose our REIT status.
To protect our REIT qualification, our Articles of Incorporation prohibit direct
or indirect ownership of more than 9.8% of the outstanding shares of our stock
by any person or group. Generally, the capital stock owned by affiliated owners
will be aggregated for purposes of this ownership limitation. Subject to certain
exceptions, any stock subject to a purported transfer that would prevent us from
continuing to qualify as a REIT will be designated as "Shares-in-Trust" and
transferred automatically to a trust effective on the day before the purported
transfer of such stock. The record holder of the common or preferred stock that
are designated as Shares-in-Trust will be required to submit such number of
shares of stock to the trust and the beneficiary of the trust will be one or
more charitable organizations that are named by us.
INABILITY TO RETAIN EARNINGS
In order to qualify as a REIT, we generally are required each year to
distribute to our shareholders at least 95% of our net taxable income (excluding
any net capital gain). In addition, we are subject to a 4% nondeductible excise
tax on the amount, if any, by which certain distributions paid by us with
respect to any calendar year are less than the sum of (i) 85% of our ordinary
income, (ii) 95% of our capital gain net income for that year, and (iii) any
undistributed taxable income from prior periods. We intend to continue to make
distributions to our shareholders to comply with the 95% distribution
requirement and to avoid the nondeductible excise tax. Differences in timing
between taxable income and cash available for distribution to our shareholders
due to the seasonality of the hospitality industry could require us to borrow
funds on a short-term basis to meet the 95% distribution requirement and to
avoid the nondeductible excise tax.
THE COMPANY MAY NOT BE ABLE TO CONTINUE ITS EXTERNAL GROWTH RATE
Our growth strategy has been to acquire underperforming and
undercapitalized hotels located in strong markets where we believe significant
barriers to entry exist. We then seek to improve the hotels' financial
performance by renovating, redeveloping, and repositioning the hotels and
requiring the Lessee to implement a focused sales and marketing program. The
current conditions in the equity and debt capital markets limit our ability to
access new capital on favorable terms. Because of the reasons discussed under
"Risk Factors Liquidity," we do not have access on acceptable terms to
additional capital to fund acquisitions of additional hotels. Therefore, we do
not currently anticipate acquiring any additional hotel assets for the remainder
of 1999. Accordingly, we cannot assure you that our external growth rate will
equal or exceed our recent historical external growth rate.
ENVIRONMENTAL RISKS
Various federal, state and local laws subject property owners or
operators to liability for the costs of removal or remediation of certain
hazardous substances released on property. These laws often impose liability
without regard to whether the owner or operator knew of, or was responsible for,
the release of the hazardous substances. The presence of or the failure to
properly remediate hazardous substances may adversely affect occupancy of a
contaminated hotel property, the ability to operate hotels, and our ability to
sell or borrow against contaminated properties. In addition to the costs
associated with investigation and remediation actions brought by governmental
agencies, the presence of hazardous waste on a property could result in personal
injury or similar claims or lawsuits.
Various laws also impose, on persons who arrange for the disposal or
treatment of hazardous or toxic substances, liability for the cost of removal or
remediation of hazardous or toxic substances at the disposal or treatment
facility. These laws often impose liability whether or not the person arranging
for the disposal ever owned or operated the disposal facility. The obligation to
pay for these costs or our inability to pay for such costs, could adversely
affect our operating costs and the value of our properties.
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<PAGE> 33
Phase I environmental site assessments have been obtained on all of our
owned properties. The purpose of Phase I environmental site assessments is to
identify potential sources of contamination for which an owner may be
responsible and to assess the status of environmental regulatory compliance.
None of the environmental site assessments revealed any environmental condition,
liability or compliance concern that we believe would have a material adverse
affect on our business, assets or results of operations. Nor are we aware of any
such condition, liability or concern by any other means. However, it is possible
that the environmental site assessments relating to any one of the properties
did not reveal all environmental conditions, liabilities or compliance concerns
that arose at a property before or after the related review was completed.
REAL ESTATE INVESTMENT RISKS IN GENERAL
Each of our hotels are subject to a variety of risks associated with
real estate ownership. Some of these risks include:
o Changes in national and local economic conditions;
o Changes in interest rates;
o Changes in costs of, or terms of, loans from lenders;
o Changes in environmental laws;
o The ongoing requirement to make capital improvements, repairs or
maintenance;
o Changes in the tax rates or laws;
o The continuing requirement to pay operating expenses;
o Changes in governmental requirements or zoning laws;
o Occurrences beyond the control of an owner, such as natural disasters
like earthquakes and weather, civil unrest or so-called "acts of God;"
o The possibility of unexpected, uninsured or under-insured losses; and
o Condemnation by a government agency seeking to use a property for a
public purpose.
Risks such as those listed above, and other risks which may occur from
time to time, may adversely affect our profit from the property because they
cause increased costs, expenses, liabilities, restrictions and operational
delays. Such risks may also affect the price we may obtain on a sale of a
property or whether the property can be sold at all.
UNINSURED AND UNDER-INSURED LOSSES
We carry comprehensive policies of insurance for our hotels which
include liability for personal injury, property damage, fire and extended
coverage. We believe the coverage we carry is typical and customary for owners
of hotels such as ours. Even though we carry the insurance referenced above,
certain losses may be uninsurable by virtue of the type or amount of loss.
Losses which result from catastrophes, such as hurricanes, tornadoes,
earthquakes, floods or so-called "acts of God," may fall within that category.
More than half of our hotels are located in California and the Pacific
northwest, an area which is subject to a high degree of seismic activity and
risk. Although we carry earthquake insurance for our hotels, there is no
assurance that such insurance will be available in the future under terms and
amounts which are sufficient to provide adequate protection. It also could be
possible that the current insurance coverage we carry would not be sufficient to
pay the full market value or replacement cost of an affected hotel with a
resulting loss of our entire investment. Therefore, a possibility does exist for
substantial uninsured or under-insured losses as a result of an earthquake.
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<PAGE> 34
Other factors also affect whether a loss is uninsured or under-insured
and may include inflation, changes in law or environmental contamination. Such
factors may affect whether insurance proceeds received by us are adequate to
restore our entire investment in the property. Factors such as these may also
make it impractical to use insurance proceeds to replace or repair our property
after it has been damaged or destroyed.
BECAUSE REAL ESTATE INVESTMENTS ARE ILLIQUID, WE MAY NOT BE ABLE TO SELL
PROPERTIES WHEN APPROPRIATE
Real estate investments generally cannot be sold quickly. We may not be
able to vary our portfolio promptly in response to economic or other conditions.
Further, in order to cure our non-compliance with the financial covenants in our
Credit Facility, we may need to sell assets and use the proceeds to pay down the
outstanding balance. This inability to quickly sell our assets on favorable
terms could adversely affect our financial condition and ability to service debt
and make distributions to our shareholders.
OUR EARNINGS AND CASH DISTRIBUTIONS WILL AFFECT THE MARKET PRICE OF OUR PUBLICLY
TRADED SECURITIES
We believe that the market value of a REIT's equity securities is based
primarily upon the market's perception of the REIT's growth potential and its
current and potential future cash distributions, and is secondarily based upon
the real estate market value of the underlying assets. For that reason, REIT
shares may trade at prices that are higher or lower than the net asset value per
share. In particular, if we reduce or suspend our distributions to stockholders,
which we are doing pending closing of the Merger with SHP as evidenced by our
failure to pay a dividend for the quarter ended June 30, 1999; the price of our
shares may decline.
YEAR 2000 ISSUE
The term "Year 2000 Issue" is a general term used to describe the
complications that may be caused by existing computer hardware and software that
were designed by the respective manufacturers without consideration of the
upcoming change in the century. Many computer systems recognize calendar years
by the last two digits in the date code field. Beginning in the year 2000, these
date code fields will need to accept four digit entries to distinguish
twenty-first century dates from twentieth century dates. If not corrected,
computer systems may fail or create erroneous results which could have
significant negative operational and financial consequences. We have adopted a
Year 2000 Compliance Program (the "Compliance Program") to minimize disruptions
to our business which could be caused by computer system error or failure. These
computerized systems include information and non-information technology systems
and applications, as well as, financial and operational reporting systems. For
discussion of the Company's and the Lessee's efforts to address the Year 2000
issue and the related Compliance Program see "Management's Discussion and
Analysis of Financial Condition and Results of Operations, Year 2000 Issue."
There can be no assurances that our Compliance Program will be properly
and timely completed, and failure to do so could have a material adverse effect
our business operations and financial condition. We cannot predict the actual
effects of the Year 2000 Issue on our business operations and financial
condition. The actual effects may be impacted by: (i) whether significant third
parties properly and timely address the Year 2000 Issue; and (ii) whether
broad-based or systemic economic failures may occur. We are also unable to
predict the severity and duration of any such failures, which could include
disruptions in passenger transportation or transportation systems generally,
loss of utility and telecommunications services, the loss or disruption of hotel
reservations made on centralized reservation systems and errors or failures in
financial transactions or payment processing systems such as credit cards. Due
to the general uncertainty inherent in the Year 2000 Issue and our dependence on
third parties, we are unable to determine at this time whether the consequences
of Year 2000 failures will have a material impact on us. Our Compliance Program
is expected to significantly reduce the level of uncertainty about the Year 2000
Issue and we believe that the possibility of significant interruptions of normal
operations should be reduced.
MARKET INTEREST RATES MAY HAVE AN EFFECT ON THE VALUE OF OUR PUBLICLY TRADED
SECURITIES
One of the factors that investors consider important in deciding
whether to buy or sell shares of a REIT is the distribution rate on such shares
(as a percentage of the price of such shares) relative to market interest rates.
If market interest rates go up, prospective purchasers of REIT shares may expect
a higher distribution rate. Higher interest rates
34
<PAGE> 35
would not, however, result in more funds for us to distribute and, in fact,
would likely increase our borrowing costs and potentially decrease funds
available for distribution. Thus, the higher market interest rates could cause
the market price of our publicly traded securities to go down.
HOTEL INDUSTRY RISKS
Operating Risks. In addition to the investment risks associated with
investing all of our resources in the hotel industry, we face operating risks
associated with hotels. These risks include, among others, the following:
o Competition for customers at our hotels from other hotels, many of
which are owned by competitors who have significantly greater
financial resources and marketing power and therefore compete with our
hotels;
o The risk of loss of market share in areas in which overbuilding occurs
and adversely affects occupancy, ADR and REVPAR;
o Erosion of operating margins arising from an increase in operating
costs due to inflation or other factors that may exceed increases in
REVPAR;
o Dependence on demand for our accommodations from both business
travelers, commercial travelers and tourism, each of which may be
affected in different markets by different economic factors;
o Strikes and other labor disturbances by the Lessee's employees which
would seriously disrupt the Lessee's ability to provide services to
hotel guests;
o The deterioration of economic conditions either generally or in
particular markets in which our hotels are located causing a reduction
in demand for our accommodations.
The Lessee's operating results at our hotels are directly affected by
the factors described above and a significant decrease in operating revenues by
the Lessee will adversely affect the Lessee's ability to make payments of rent
under the percentage leases. Any reduction in such rent will reduce our cash and
could adversely affect our ability to make distributions to our stockholders.
Seasonality of Hotel Business and Our Hotels. The hotel industry in
general is seasonal with certain periods generating greater revenues than
others. In particular, our revenues are greater in the second and the third
quarters than in the first and the fourth quarters. In addition, winter weather
in the markets in which our hotels operate can severely impact the operating
results of particular hotels. The Lessee's revenues can vary significantly from
quarter to quarter. It is possible that the significant fluctuation of revenues
in a particular quarter due to weather or other factors could cause us to earn
less percentage rent than we had originally anticipated which could have an
adverse effect on our ability to make distributions to our shareholders.
Increased Competition from Overbuilding. The hotel industry has
historically experienced cycles of overbuilding in certain geographic markets
and product segments. This overbuilding increases competition for hotel guests,
resulting in lower occupancies and lower ADRs thereby reducing revenues of the
hotels effected by the increased competition. While our investment strategy is
to acquire underperforming hotels in markets where we believe there are
significant barriers to entry, we can give no assurance that the current hotel
development activities, particularly in the limited service segment, will not
create additional significant competition for our hotels. This increased
competition would reduce the revenues generated by the Lessee at the effected
hotel, thus reducing percentage rent we receive and therefore potentially
adversely effecting our distributions to our shareholders.
Impact of Increased Operating Costs and Capital Expenditures. Our
hotels need to be periodically renovated and furniture, fixtures and equipment
replaced in order to remain competitive in their markets and to comply with the
terms of franchise agreements under which our hotels are operated. Under our
Percentage Leases, we are obligated to make available to the Lessee for periodic
refurbishment of furniture, fixtures and equipment an amount equal to four
percent (4%)
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<PAGE> 36
of the room revenues of each hotel. Our ability to fund these and other capital
expenditures including periodic replacement of furniture, fixtures and equipment
will depend in part on the financial performance of the Lessee and our hotels.
If these expenditures exceed our estimates, then the increased costs would
adversely effect the cash available for other purposes such as making
distributions to our stockholders. Alternatively, if we fail to make these
expenditures, we may adversely effect the competitive position of the hotels and
have an adverse effect on occupancy rates, ADRs and REVPAR. In certain
instances, our failure to make certain capital expenditures may constitute a
default under the applicable franchise agreement.
RISKS OF OPERATING UNDER FRANCHISE AGREEMENTS
Of our 59 hotels, 57 are operated under franchise agreements with
national franchisors. The Lessee is the franchisee and is responsible for
complying with the franchise agreements. Under these arrangements, a franchisor
provides marketing service and room reservations and certain other operating
assistance, but requires the Lessee to pay significant fees as well as maintain
the hotel in a certain condition. If the Lessee fails to maintain these required
standards or we fail to make required capital expenditures (or to fund the
Lessee's expenditures) then there may be a termination of the franchise
agreement and possible liability for damages. If the Lessee were to lose a
franchise on a particular hotel, it could have a material adverse effect upon
the operation, financing or value of that hotel due to the loss of the franchise
name, marketing support and centralized reservation system. In addition, adverse
publicity affecting a franchisor could reduce the revenues we receive from the
hotels subject to such franchise. Any loss of revenues by the Lessee at a hotel
because of loss of the franchise agreement would adversely effect the Lessee's
ability to pay rent and could effect our ability to make distributions to our
stockholders.
OUR DEGREE OF LEVERAGE COULD LIMIT OUR ABILITY TO OBTAIN ADDITIONAL FINANCING
Our Articles of Incorporation limits consolidated indebtedness to 50%
of our investment in hotel properties, at cost on a consolidated basis, after
giving effect to our use of proceeds from the indebtedness. As of June 30, 1999,
our ratio of debt to total investment in hotel properties and other real estate
investments was approximately 45%. Our Credit Facility has further restrictions
on the amount of Company indebtedness. The degree of leverage could have
important consequences to our stockholders, including, effecting our ability to
obtain additional financing in the future for working capital, capital
expenditures, acquisitions, development or other general corporate purposes
including the payment of distributions and could make us more vulnerable to a
downturn in business or the economy. Further, increases in our cost of borrowing
will reduce the cash available to make distributions to our stockholders
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 27 - Financial Data Schedule
(b) Report on Form 8-K:
(1) Current report on Form 8-K dated April 8, 1999 with disclosure
under Item 5 regarding an offer from SHP Acquisition, LLC, formed
by Robert A. Alter, certain management personnel of Sunstone
Hotel Properties, Inc. and Westbrook Funds III to acquire all of
the outstanding shares of common stock of the Company for a price
of $9.50 to $10.00 per share.
(2) Current report on Form 8-K dated July 13, 1999 with disclosure
under Item 5 regarding the Company and SHP Acquisition LLC and
SHP Investors Sub, Inc. entering into an Agreement and Plan of
Merger dated as of July 12, 1999 providing for the merger of the
Buyer with and into the Company.
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<PAGE> 37
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of San
Clemente, State of California, on August 13, 1999.
SUNSTONE HOTEL INVESTORS, INC.
By: /s/ Robert A. Alter
-----------------------------------
Robert A. Alter
President, Secretary and
Chairman of the Board of Directors
By: /s/ R. Terrence Crowley
-----------------------------------
R. Terrence Crowley
Chief Operating Officer
(Principal Financial and Accounting
Officer)
37
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