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INTERVAL LEISURE GROUP, INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement Regarding Forward-Looking Information This annual report on Form 10-K contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The use of words such as "anticipates," "estimates," "expects," "intends," "plans" and "believes," and similar expressions or future or conditional verbs such as "will," "should," "would," "may" and "could" among others, generally identify forward-looking statements. These forward-looking statements include, among others, statements relating to: our future financial performance, our business prospects and strategy, anticipated financial position, liquidity and capital needs and other similar matters. These forward-looking statements are based on management's current expectations and assumptions about future events, which are inherently subject to uncertainties, risks and changes in circumstances that are difficult to predict. Actual results could differ materially from those contained in the forward-looking statements included in this annual report for a variety of reasons, including, among others: adverse trends in economic conditions generally or in the vacation ownership, vacation rental and travel industries; adverse changes to, or interruptions in, relationships with third parties; lack of available financing for, or insolvency of developers; consolidation of developers; decreased demand from prospective purchasers of vacation interests; travel related health concerns; changes in our senior management; regulatory changes; our ability to compete effectively and successfully add new products and services; our ability to successfully manage and integrate acquisitions; impairment of assets; the restrictive covenants in our revolving credit facility; adverse events or trends in key vacation destinations; business interruptions in connection with our technology systems; ability of managed homeowners associations to collect sufficient maintenance fees; third parties not repaying advances or extensions of credit; and our ability to expand successfully in international markets and manage risks specific to international operations. Certain of these and other risks and uncertainties are discussed in our filings with the SEC, including in Item 1A "Risk Factors" of this report. In light of these risks and uncertainties, the forward looking statements discussed in this report may not prove to be accurate. Accordingly, you should not place undue reliance on these forward looking statements, which only reflect the views of our management as of the date of this report. Except as required by applicable law, we do not undertake to update these forward-looking statements. GENERAL The following Management Discussion and Analysis provides a comparative discussion of the results of operations and financial condition of ILG for the three years ended December 31, 2013. This section should be read in conjunction with the consolidated financial statements and accompanying notes included in this Form 10-K for the year ended December 31, 2013, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). This discussion includes the following sections: º • º Management Overview º • º Critical Accounting Policies and Estimates º • º Results of Operations º • º Financial Position, Liquidity and Capital Resources º • º ILG's Principles of Financial Reporting º • º Reconciliations of Non-GAAP Measures 32 -------------------------------------------------------------------------------- Table of Contents MANAGEMENT OVERVIEW History ILG was incorporated as a Delaware corporation in May 2008 in connection with a plan by IAC/InterActiveCorp, or IAC, to separate into five publicly traded companies, referred to as the "spin-off." ILG was formed to hold the membership and exchange and management and rental businesses, and commenced trading on The NASDAQ Stock Market in August 2008 under the symbol "IILG." The Membership and Exchange operating segment consists of Interval International Inc.'s businesses, referred to as Interval, and the membership and exchange related line of business of Trading Places International, or TPI, and Vacation Resorts International, or VRI. The Management and Rental operating segment consists of Aston Hotels & Resorts (referred to as Aston), Aqua Hospitality LLC and Aqua Hotels and Resorts, Inc. (referred to as Aqua), VRI Europe Limited and the management and rental related line of business of VRI and TPI. Basis of Presentation and Accounting Estimates The accompanying consolidated financial statements have been prepared in accordance with GAAP and reflect the financial position and operating results of ILG. ILG's management is required to make certain estimates and assumptions during the preparation of its consolidated financial statements in accordance with GAAP. These estimates and assumptions impact the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements. They also impact the reported amount of net earnings during any period. Actual results could differ from those estimates. Significant estimates underlying the accompanying consolidated financial statements include: the recovery of goodwill and long-lived and other intangible assets; purchase price allocations; the determination of deferred income taxes including related valuation allowances; the determination of deferred revenue and membership costs; and the determination of stock-based compensation. In the opinion of ILG's management, the assumptions underlying the historical consolidated financial statements of ILG and its subsidiaries are reasonable. General Description of our Business ILG is a leading global provider of membership and leisure services to the vacation industry. We operate in two segments: Membership and Exchange and Management and Rental. Membership and Exchange, offers leisure and travel-related products and services to owners of vacation interests and others primarily through various membership programs, as well as related services to resort developer clients. Management and Rental provides hotel, condominium resort, timeshare resort and homeowners' association management, and rental services to both vacation property owners and vacationers. Membership and Exchange Services Interval, the principal business in our Membership and Exchange segment, has been a leader in the membership and exchange services industry since its founding in 1976. As of December 31, 2013, Interval's primary operation is the Interval Network, a quality global vacation ownership membership exchange network with: º • º a large and diversified base of participating resorts consisting of nearly 2,900 resorts located in over 80 countries, including both leading independent resort developers and branded hospitality companies; and 33 -------------------------------------------------------------------------------- Table of Contents º • º approximately 1.8 million vacation ownership interest owners enrolled as members of the Interval Network. Interval typically enters into multi-year contracts with developers of vacation ownership resorts, pursuant to which the resort developers agree to enroll all purchasers of vacation interests at the applicable resort as members of an Interval exchange program. In return, Interval provides enrolled purchasers with the ability to exchange the use and occupancy of their vacation interest at the home resort/club system (generally for a period of one week) for the right to occupy accommodations at a different resort participating in an Interval exchange network. Through Interval's Getaways, members may rent resort accommodations for a fee without relinquishing the use of their vacation interest. In addition, Interval offers sales, marketing and operational support, consulting and back-office services, including reservation servicing, to certain resort developers participating in the Interval Network, upon their request and for additional consideration. The Membership and Exchange segment earns most of its revenue from (i) fees paid for membership in the Interval Network and (ii) Interval Network transactional and service fees paid primarily for exchanges, Getaways, reservation servicing, and related transactions collectively referred to as "transaction revenue." Management and Rental Services We also provide management and rental services to hotels as well as condominium and timeshare resorts and/or their homeowners associations through Aston, Aqua, VRI Europe, VRI, and TPI. Such vacation properties and hotels are not owned by us. Aston and Aqua are based in Hawaii and concentrate largely on hotel and condominium resort management primarily in Hawaii, as well as vacation property rental and related services (including common area and owner association management services for condominium projects). VRI Europe manages vacation ownership resorts in Spain, United Kingdom, France and Portugal. TPI and VRI provide property management, vacation rental and homeowners' association management services to timeshare resorts in the United States, Canada and Mexico. As of December 31, 2013, the businesses that comprise our Management and Rental segment provided management and rental services at over 250 vacation properties, resorts and club locations in North America. Revenue from the Management and Rental segment is derived principally from fees for hotel, condominium resort, timeshare resort and homeowners' association management and rental services. Management fees consist of a base management fee, incentive management fee, service fees, and annual maintenance fees, as applicable. Incentive management fees are generally a percentage of operating profits or improvement in operating profits. Service fee revenue is based on the services provided to owners including reservations, sales and marketing, property accounting and information technology services either internally or through third party providers. Annual maintenance fees are amounts paid by timeshare owners for maintaining and operating the respective properties, including management services. At Aston and Aqua, the majority of hotel and condominium resort management agreements provide that owners receive either specified percentages of the revenue generated under our management or, in limited instances, guaranteed dollar amounts. In these cases, the operating expenses for the rental operation are paid from the revenue generated by the rentals, the owners are then paid their contractual percentages or amounts, and the Management and Rental segment either retains the balance (if any) as its management fee or makes up the deficit. In other instances, fees for rental services generally consist of commissions earned on rentals. 34-------------------------------------------------------------------------------- Table of Contents International Revenue International revenue increased 10.3% in 2013 compared to 2012 and increased 3.1% in 2012 compared to 2011. As a percentage of our total revenue, international revenue increased to 19.2% in 2013, from 18.5% in 2012, which was a decrease from 19.8% in 2011. The increase in international revenue as a percentage of total revenue in 2013 is largely attributable to revenue from our VRI Europe joint venture commencing November 2013. The decrease in international revenue as a percentage of total revenue in 2012 is largely attributable to the February 2012 acquisition of VRI which operates entirely in the United States. Other Factors Affecting Results Membership and Exchange The consolidation of resort developers driven by bankruptcies and the lack of receivables financing has resulted in a decrease in the flow of new members from point of sale to our exchange networks. Access to financing has returned to the industry following the recession and slow recovery. While very few new projects have been constructed in the last several years, developers and homeowners' associations have been taking back vacation ownership interests which are again available to be sold. This allows developers to continue to generate sales revenues without significant capital expenditure for development and causes homeowners' associations at resorts that are no longer linked to a developer to look for efficient distribution channels to resell the inventory to preserve the maintenance fee paying owner base. Additionally, a high proportion of sales by developers are to their existing owners, which does not result in new members to the Interval Network. Our 2013 results were negatively affected by a shift in the percentage mix of our membership base from traditional, direct renewal members to corporate members. Our corporate developer accounts enroll and renew their entire active owner base which positively impacts our retention rate, however, these members tend to have a lower propensity to transact with us. Membership mix as of December 31, 2013 included 60% traditional and 40% corporate members, compared to 62% and 38%, respectively, as of December 31, 2012. Consequently, where possible, we structure our corporate membership arrangements to include reservation servicing and/or other revenue streams to mitigate the anticipated lower transaction propensity. Management and Rental Our Management and Rental segment results are susceptible to variations in economic conditions, particularly in its largest market, Hawaii. According to the Hawaii Tourism Authority, visitor arrivals by air in Hawaii increased 2.5% in 2013 compared to 2012. The increase in visitors correlates with an overall increase of 8.0% in revenue per available room ("RevPAR") at Aston and Aqua in Hawaii in 2013 compared to 2012. The combined increase in RevPAR in Hawaii was driven by higher average daily rates. As of the latest forecast (December 2013), the Hawaii Department for Business, Economic Development and Tourism, forecasts increases of 2.7% in visitors to Hawaii and 4.2% in visitor expenditures in 2014 over 2013. Business Acquisitions On February 28, 2012, we acquired VRI, a non-developer provider of resort and homeowners association management services to the shared ownership industry. VRI was consolidated into our financial statements as of the acquisition date and the financial effect of this acquisition was not material to our consolidated financial statements; however, the year-over-year comparability for the year ended December 31, 2013 was affected as further discussed in our Results of Operations section. 35-------------------------------------------------------------------------------- Table of Contents On November 4, 2013, VRI Europe Limited purchased the European shared ownership resort management business of CLC, for approximately £56 million (or approximately $90 million) in cash (subject to adjustment for working capital, actual 2013 results and other specified items) and issuance to CLC of shares totaling 24.5% of VRI Europe Limited, creating a joint venture. In connection with this arrangement, ILG has committed to issue a convertible secured loan for approximately $15 million to CLC which matures in five years with interest payable monthly. VRI Europe was consolidated into our financial statements as of the acquisition date and is included in our Management and Rental operating segment for segment reporting. On December 12, 2013, we acquired all of the equity of Aqua, a leading management company currently representing more than 25 properties in Hawaii and Guam, which provides full-service management, including sales, marketing, Internet distribution, individualized branding, and reservations. Aqua was consolidated into our financial statements as of the acquisition date and is included in our Management and Rental operating segment for segment reporting. The financial effect of these acquisitions on an individual basis was not material to our consolidated financial statements; however, the year-over-year comparability was affected as further discussed in our Results of Operations section. Liquidity On June 21, 2012, we entered into an amended and restated credit agreement which provides, among other things, a $500 million revolving credit facility, as further discussed in Note 6 of the consolidated financial statements included in this report. The interest rate on the amended and restated credit agreement is based on (at our election) either LIBOR plus a predetermined margin that ranges from 1.25% to 2.25%, or the Base Rate as defined in the amended credit agreement plus a predetermined margin that ranges from 0.25% to 1.25%, in each case based on our consolidated leverage ratio. On September 4, 2012, we redeemed all of our 9.5% senior notes at 100% of the principal amount plus accrued and unpaid interest to the redemption date, at which time the senior notes were no longer deemed to be outstanding and our obligations under the indenture, as previously supplemented, terminated. Additionally, the extinguishment of our senior notes resulted in a non-cash, pre-tax loss on extinguishment of debt of $17.9 million during the third quarter of 2012 principally pertaining to the acceleration of the original issue discount and the write-off of the related unamortized deferred debt issuance costs. This non-cash charge is presented as a separate line item within other income (expense) in our consolidated statement of income for the year ended December 31, 2012. Outlook The vacation ownership industry remains in a period of transition that resulted in the bankruptcy, restructuring and consolidation of developers as well as continued modifications to their business models. We expect additional consolidation and reorganizations within the industry. Additionally, we anticipate continued margin compression and increased competition in our membership and exchange business. For the Management and Rental segment, we expect Aston's RevPAR to continue to show year-over-year improvement as its largest market, Hawaii, continues its tourism recovery and benefits from increases in airlift into the island chain; however, increases in the cost of a Hawaiian vacation may negatively impact visitor arrivals and temper growth. Additionally, our completion of the VRI Europe and Aqua transactions will affect the year-over-year comparability of our results of operations for the year ended December 31, 2014. The VRI Europe transaction also will affect international revenue as a percentage of total revenue. 36-------------------------------------------------------------------------------- Table of Contents CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with GAAP requires management to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates which are based on historical experience and on various other judgments and assumptions that we believe are reasonable under the circumstances. Actual outcomes could differ from those estimates. Our significant accounting policies are discussed in Note 2 accompanying our consolidated financial statements and should be reviewed in connection with the following discussion. Set forth below are the policies and estimates that we have identified as critical to our business operations and an understanding of our results of operations, based on the high degree of judgment or complexity in their application. Revenue Recognition Membership and Exchange Revenue, net of sales incentives, from membership fees from our Membership and Exchange segment is deferred and recognized over the terms of the applicable memberships, typically ranging from one to five years, on a straight-line basis. When multiple member benefits and services are provided over the term of the membership, revenue is recognized for each separable deliverable ratably over the membership period, as applicable. Generally, memberships are cancelable and refundable on a pro-rata basis, with the exception of our Platinum tier, which is non-refundable. Direct costs of acquiring members (primarily commissions) and certain fulfillment costs related to deferred membership revenue are also deferred and amortized on a straight-line basis over the terms of the applicable memberships or benefit period, whichever is shorter. The recognition of previously deferred revenue and expense is based on estimates derived from an aggregation of member-level data. Revenue from exchange and Getaway transactions is recognized when confirmation of the transaction is provided as the earnings process is complete. Reservation servicing revenue is recognized when service is performed or on a straight-line basis over the applicable service period depending on the specific contractual terms. All taxable revenue transactions are presented on a net-of-tax basis. Management and Rental The Management and Rental segment's revenue is derived principally from fees for hotel, condominium resort, timeshare resort and homeowners association management and rental services. Management fees consist of base management fees, incentive management fees, service fees, and annual maintenance fees, as applicable. Base management fees are typically either (i) fixed amounts, (ii) amounts based on a percentage of adjusted gross lodging revenue, or (iii) various other revenue sharing arrangements with condominium owners based on stated formulas. Base management fees are recognized when earned in accordance with the terms of the contract. Incentive management fees for certain hotels and condominium resorts are generally a percentage of operating profits or improvement in operating profits. We recognize incentive management fees as earned throughout the incentive period based on actual results which are trued-up at the culmination of the incentive period. Service fee revenue is based on the services provided to owners including reservations, sales and marketing, property accounting and information technology services either internally or through third party providers. Service fee revenue is recognized when the service is provided. Annual maintenance fees are amounts paid by timeshare owners for maintaining and operating the respective properties, which includes management services, and is recognized on straight-line basis over the respective annual maintenance period. 37-------------------------------------------------------------------------------- Table of Contents In certain instances we arrange services which are provided directly to property owners. Transactions for these services do not impact our consolidated financial statements as they are not included in our results of operations. Additionally, in most cases, we employ on-site personnel to provide services such as housekeeping, maintenance and administration to property owners and homeowner associations under our management agreements. For such services and related reimbursements, we recognize revenue in an amount equal to the expenses incurred given we are principal in this aspect of the arrangement, pursuant to ASC 605-45, "Principal Agent Considerations." Multiple-Element Arrangements Additionally, when we enter into multiple-element arrangements, we are required to determine whether the deliverables in these arrangements should be treated as separate units of accounting for revenue recognition purposes and, if so, how the contract price should be allocated to each element. We analyze our contracts upon execution to determine the appropriate revenue recognition accounting treatment. Our determination of whether to recognize revenue for separate deliverables will depend on the terms and specifics of our products and arrangements as well as the nature of changes to our existing products and services, if any. The allocation of contract revenue to the various elements does not change the total revenue recognized from a transaction or arrangement, but may impact the timing of revenue recognition. Accounting for Business Combinations In accordance with ASC Topic 805, "Business Combinations," when accounting for business combinations we are required to recognize the assets acquired, liabilities assumed, contractual contingencies, noncontrolling interests and contingent consideration at their fair value as of the acquisition date. The purchase price allocation process requires management to make significant estimates and assumptions with respect to intangible assets, estimated contingent consideration payments and/or pre-acquisition contingencies, all of which ultimately affect the fair value of goodwill established as of the acquisition date. Goodwill acquired in business combinations is assigned to the reporting unit(s) expected to benefit from the combination as of the acquisition date and is then subsequently tested for impairment at least annually. Although we believe the assumptions and estimates we have made have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired entity and are inherently uncertain. Examples of critical estimates in accounting for acquisitions include but are not limited to: º • º the estimated fair value of the acquisition-related contingent consideration, which is performed using a probability-weighted income approach based upon the forecasted achievement of post-acquisition pre-determined targets; º • º the future expected cash flows from sales of products and services and related contracts and agreements; and º • º discount and long-term growth rates. Unanticipated events and circumstances may occur which could affect the accuracy or validity of our assumptions, estimates or actual results. Additionally, any change in the fair value of the acquisition-related contingent consideration subsequent to the acquisition date, including changes resulting from events that occur after the acquisition date, such as changes in our estimated fair value of the targets that are expected to be achieved, will be recognized in earnings in the period of the change in estimated fair value. 38-------------------------------------------------------------------------------- Table of Contents Recoverability of Goodwill and Other Intangible Assets Our Policy Goodwill and other intangible assets are significant components of our consolidated balance sheets. Our policies regarding the valuation of intangible assets affect the amount of future amortization and possible impairment charges we may incur. Assumptions and estimates about future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. They can be affected by a variety of factors, including external factors such as consumer spending habits and general economic trends, and internal factors such as changes in our business strategy and our internal forecasts. In accordance with ASC Topic 350, "Intangibles-Goodwill and Other," we review the carrying value of goodwill and other intangible assets of each of our reporting units on an annual basis as of October 1, or more frequently upon the occurrence of certain events or substantive changes in circumstances. Goodwill is tested for impairment based on either a qualitative assessment or a two-step impairment test. We consider our Membership and Exchange and Management and Rental segments to be individual reporting units which are also individual operating segments of ILG. Goodwill acquired in business combinations is assigned to the reporting unit(s) expected to benefit from the combination as of the acquisition date. During the year, we monitor the actual performance of our reporting units relative to the fair value assumptions used in our annual impairment test, including potential events and changes in circumstance affecting our key estimates and assumptions. Qualitative Assessment The qualitative assessment may be elected in any given year pursuant to ASU 2011-08, "Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment" ("ASU 2011-08"). ASU 2011-08 amended the testing of goodwill for impairment. Under the revised guidance, entities testing goodwill for impairment have the option of performing a qualitative assessment before calculating the fair value of a reporting unit. If entities determine, on the basis of qualitative factors, that it is more-likely-than-not (i.e., a likelihood of more than 50 percent) that the fair value of the reporting unit is below the carrying amount, the two-step impairment test would be required. The guidance also provides the option to skip the qualitative assessment in any given year and proceed directly with the two-step impairment test at our discretion. Two-step Impairment Test The first step of the impairment test compares the fair value of each reporting unit with its carrying amount including goodwill. The fair value of each reporting unit is calculated using the average of an income approach and a market comparison approach which utilizes similar companies as the basis for the valuation. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. The impairment loss is determined by comparing the implied fair value of goodwill to the carrying value of goodwill. The implied fair value of goodwill represents the excess of the fair value of the reporting unit over amounts assigned to its net assets. The determination of fair value utilizes an evaluation of historical and forecasted operating results and other estimates. Fair value measurements are generally determined through the use of valuation techniques that may include a discounted cash flow approach, which reflects our own assumptions of what market participants would use in pricing the asset or liability. 39-------------------------------------------------------------------------------- Table of Contents Indefinite-Lived Intangible Assets Our intangible assets with indefinite lives relate principally to trade names, trademarks and certain resort management contracts. Pursuant to ASC 350, if an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its useful life is determined to no longer be indefinite. Accordingly, we evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events or circumstances continue to support an indefinite useful life. As of December 31, 2013, there have been no changes to the indefinite life determination pertaining to these intangible assets. In addition, an intangible asset that is not subject to amortization shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of an intangible asset with its carrying amount. If the carrying amount of an indefinite-lived intangible asset exceeds its estimated fair value, an impairment loss equal to the excess is recorded. However, subsequent to July 2012, entities testing an indefinite-lived intangible asset for impairment have the option of performing a qualitative assessment before calculating the fair value of the asset. If entities determine, on the basis of qualitative factors, that the likelihood of the indefinite-lived intangible asset being impaired is below a "more-likely-than-not" threshold (i.e., a likelihood of more than 50 percent), the entity would not need to calculate the fair value of the asset. 2013 Annual Impairment Test As of October 1, 2013, we reviewed the carrying value of goodwill and other intangible assets of each of our two reporting units. Goodwill assigned to the Membership and Exchange and Management and Rental reporting units as of that date was $483.5 million and $22.3 million, respectively. We elected to bypass the qualitative assessment for the 2013 annual test and performed the first step of the impairment test on both our reporting units. At the conclusion of that impairment test, we concluded that each reporting unit's fair value exceeded its carrying value and, therefore, the second step of the impairment test was not necessary. As of December 31, 2013, we did not identify any triggering events which required an interim impairment test subsequent to our annual impairment test on October 1, 2013. Key Estimates and Assumptions The determination of fair value utilizes an evaluation of historical and forecasted operating results and other key assumptions made by management, including discount rates, utilized in the valuation of certain identifiable assets. Deterioration in macroeconomic conditions or in our results of operations or unforeseen negative events could adversely affect either of our reporting units and lead to a revision of the estimates used to calculate fair value. These key estimates and forecasted operating results may or may not occur or may be revised by management which may require us to recognize impairment losses in the future. With respect to our Membership and Exchange reporting unit's step one analysis, the primary examples of key estimates include our discount rate and forecasted sales growth rates. As previously noted, we use the average of an income approach and a market comparison approach to calculate the fair value of our reporting units. As a measure of sensitivity on the income approach, as of the date of our last annual impairment test, a hypothetical 10% change in both our discount and long-term growth rates would result in a change of $150 million in the income approach fair value of the reporting unit, or approximately 9% of the excess of the fair value of the reporting unit over its carrying value. In regards to the market comparison approach, a change in our selected EBITDA multiple by 10% would result in a change of approximately $130 million in the Membership and Exchange reporting unit's 40-------------------------------------------------------------------------------- Table of Contents market comparison approach fair value, or approximately 8% of the excess of the reporting unit's fair value over its carrying value. With respect to our Management and Rental reporting unit's step one analysis, the primary examples of key estimates include forecasted available and occupied room nights, average daily rates and long-term growth rates. As a measure of sensitivity on the income approach, as of the date of our last annual impairment test, a hypothetical 10% change to all four forecasted key estimates would result in a change of approximately $19 million in our Management and Rental's income approach fair value, or approximately 28% of the excess of the fair value of the reporting unit over its carrying value. In regards to the market comparison approach, a change in our selected EBITDA multiple by 10% would result in a change of approximately $24 million in the reporting unit's market comparison approach fair value, or approximately 16% of the excess of the reporting unit's fair value over its carrying value. Key estimates and assumptions for both our reporting units can be impacted by certain potential events and changes in circumstances, as follows: Events and trends in the vacation ownership, vacation rental and travel industries that could adversely affect consumers travel to and vacation in certain destinations and regions in which vacation rental and managed properties are located, including events such as: º • º Declines in discretionary spending levels during general economic downturns. º • º Inclement weather and/or natural disasters. º • º Travel health concerns. º • º Concerns related to terrorism, enhanced travel security measures and/or geographical conflicts. Additionally, key estimates and assumptions for both our reporting units can be impacted by certain potential events and changes in circumstances specific to each reporting unit, such as: Membership and Exchange º • º A downturn or a weakening of the economy may cause decreased demand for purchases of vacation ownership interests, may increase default rates among current owners and may increase refund requests from our members. º • º Lack of available financing for vacation property developers and consumers or the potential insolvency or consolidation of developers could adversely affect our ability to maintain and grow our exchange network membership which could adversely affect our business, financial condition and results of operations. º • º Our ability to maintain and renew contractual relationships with vacation ownership developers that provide new or corporate members and supply of resort accommodations for use in exchanges or Getaways. º • º Our ability to motivate members to renew their existing memberships and/or otherwise engage in transactions. Management and Rental º • º A downturn or a weakening of the economy may cause decreased demand for vacation rentals. º • º The failure to maintain existing hotel, condominium resort and timeshare resort management and/or rental services arrangements with vacation property owners/homeowners associations, and/or insolvency of several properties managed by or marketed by the Management and Rental segment. 41 -------------------------------------------------------------------------------- Table of Contents º • º A significant decrease in the supply of available vacation rental accommodations due to ongoing property renovations. º • º Inability of our managed homeowners' associations to levy and collect sufficient maintenance fees to cover the costs to operate and maintain the resort properties; such properties may be forced to close or file bankruptcy and may terminate our management. Recoverability of Long-Lived Assets Our Policy We review the carrying value of all long-lived assets, primarily property and equipment and definite-lived intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying value of a long-lived asset (asset group) may be impaired. In accordance with guidance included within ASC Topic 360, "Property, Plant and Equipment," recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset (asset group) to future undiscounted cash flows expected to be generated by the asset (asset group). An asset group is the lowest level of assets and liabilities for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. When estimating future cash flows, we consider: º • º only the future cash flows that were directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset group; º • º our own assumptions about our use of the asset group and all available evidence when estimating future cash flows; º • º potential events and changes in circumstance affecting our key estimates and assumptions; º • º the existing service potential of the asset (asset group) at the date tested. If an asset (asset group) is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset (asset group) exceeds its fair value. When determining the fair value of the asset (asset group), we consider the highest and best use of the assets from a market-participant perspective. The fair value measurement is generally determined through the use of independent third party appraisals or an expected present value technique, both of which may include a discounted cash flow approach, which reflects our own assumptions of what market participants would utilize to price the asset (asset group). Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Assets to be abandoned, or from which no further benefit is expected, are written down to zero at the time that the determination is made and the assets are removed entirely from service. Recoverability Test For the years ended December 31, 2013 and 2012, we did not identify any events or changes in circumstances indicating that the carrying value of a long lived asset (or asset group) may be impaired; accordingly, a recoverability test has not been warranted. Stock-Based Compensation Stock-based compensation is accounted for under ASC Topic 718, "Compensation-Stock Compensation" ("ASC 718"). On May 21, 2013, ILG adopted the Interval Leisure Group, Inc. 2013 Stock and Incentive Plan and stopped granting awards under the ILG 2008 Stock and Annual Incentive Plan. Both plans provide for the grant of stock options, stock appreciation rights, restricted stock, restricted stock units, and other stock-based awards. Restricted stock units ("RSUs") are awards in the form of phantom shares or units, denominated in a hypothetical equivalent number of shares of 42-------------------------------------------------------------------------------- Table of Contents ILG common stock and with the value of each award equal to the fair value of ILG common stock at the date of grant, except for RSUs subject to relative total shareholder return performance criteria, for which the fair value is based on a Monte Carlo simulation analysis as further discussed in Note 10 accompanying our consolidated financial statements. Each RSU is subject to service-based vesting, where a specific period of continued employment must pass before an award vests. We grant awards subject to graded vesting (i.e. portions of the award vest at different times during the vesting period) or to cliff vesting (i.e. all awards vest at the end of the vesting period). In addition, certain RSUs are subject to attaining specific performance criteria. ILG recognizes non-cash compensation expense for all RSUs held by ILG's employees. For RSUs to be settled in stock, the accounting charge is measured at the grant date fair value of ILG common stock and expensed as non-cash compensation over the vesting term using the straight-line basis for service awards and the accelerated basis for performance-based awards with graded vesting. Certain cliff vesting awards with performance criteria are tied to anticipated future results of operations in determining the fair value of the award, while other cliff vesting awards with performance criteria are tied to the achievement of relative total shareholder return criteria. This value is recognized as expense over the service period, net of estimated forfeitures, using the straight-line recognition method. The expense associated with RSU awards to be settled in cash is initially measured at fair value at the grant date and expensed ratably over the vesting term, recording a liability subject to mark-to-market adjustments for changes in the price of the respective common stock, as compensation expense. Stock-based compensation is recorded within the same line item in our consolidated statements of income as the employee-related compensation of the award recipient, as disclosed in tabular format in Note 10 accompanying our consolidated financial statements. The amount of stock-based compensation expense recognized in the consolidated statements of income is reduced by estimated forfeitures, as the amount recorded is based on awards ultimately expected to vest. The forfeiture rate is estimated at the grant date based on historical experience and revised, if necessary, in subsequent periods for any changes to the estimated forfeiture rate from that previously estimated. To the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. For any vesting tranche of an award, the cumulative amount of compensation cost recognized is at least equal to the portion of the grant-date value of the award tranche that is actually vested at that date. As of December 31, 2013, ILG had approximately $14.5 million of unrecognized compensation cost, net of estimated forfeitures, related to all equity-based awards, which is currently expected to be recognized over a weighted average period of approximately 1.8 years. Of the $14.5 million of unrecognized compensation cost, 55.4% relates to an employee class group comprised of certain key employees for which we do not expect RSUs to be forfeited. For awards in which we expect forfeitures to occur, a 10% change to our estimated forfeiture rate would have an impact of less than $100,000 to our unrecognized compensation cost as of December 31, 2013. Income Taxes Accounting for our income taxes requires significant judgment in the evaluation of our uncertain tax positions and in the calculation of our provision for income taxes. Pursuant to ASC Topic 740 "Income Taxes" ("ASC 740"), we adopted a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate available evidence to determine if it appears more likely than not that an uncertain tax position will be sustained on an audit by a taxing authority, based solely on the technical merits of the tax position. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settling the uncertain tax position. 43 -------------------------------------------------------------------------------- Table of Contents Although we believe we have adequately reserved for our uncertain tax positions, the ultimate outcome of these tax matters may differ from our expectations. We adjust our reserves in light of changing facts and circumstances, such as the completion of a tax audit, expiration of the applicable statute of limitations, the refinement of an estimate, and interest accruals associated with uncertain tax positions until they are resolved. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. See Note 11 accompanying our consolidated financial statement. Our future effective tax rates could be affected by changes in our deferred tax assets or liabilities, the valuation of our uncertain tax positions, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. RESULTS OF OPERATIONS Revenue Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Membership and Exchange Transaction revenue $ 198,933 0.3 % $ 198,434 3.2 % $ 192,297 Membership fee revenue 135,198 3.4 % 130,784 1.0 % 129,477 Ancillary member revenue 6,852 (1.8 )% 6,976 (5.4 )% 7,371 Total member revenue 340,983 1.4 % 336,194 2.1 % 329,145 Other revenue 24,024 11.5 % 21,538 6.2 % 20,282 Total Membership and Exchange revenue 365,007 2.0 % 357,732 2.4 % 349,427 Management and Rental Management fee and rental revenue 71,550 30.2 % 54,946 69.4 % 32,441 Pass-through revenue 64,658 6.6 % 60,661 29.3 % 46,926 Total Management and Rental revenue 136,208 17.8 % 115,607 45.7 % 79,367 Total revenue $ 501,215 5.9 % $ 473,339 10.4 % $ 428,794 2013 Compared to 2012 Revenue for the year ended December 31, 2013 of $501.2 million increased $27.9 million, or 5.9%, compared to revenue of $473.3 million in 2012. Membership and Exchange segment revenue of $365.0 million increased $7.3 million, or 2.0%, and Management and Rental segment revenue of $136.2 million increased $20.6 million, or 17.8%, in the year compared to 2012. Membership and Exchange Membership and Exchange revenue increased $7.3 million, or 2.0%, in 2013 compared to 2012. This increase is primarily driven by increases in membership fee revenue of $4.4 million and other revenue of $2.5 million, coupled with a rise in transaction revenue of $0.5 million. The increase of $4.4 million in membership fee revenue in 2013 compared to 2012 is mainly the result of a correction of an immaterial prior period understatement of membership revenue amounting to $4.1 million recorded during the second quarter of 2013, coupled with further adoption of Platinum and Club Interval products. The increase in transaction revenue is mainly related to higher other transaction related fees and reservation servicing revenue of $0.9 million and $0.5 million, respectively, partly offset by a drop in 44-------------------------------------------------------------------------------- Table of Contents revenue from exchanges and Getaways of $0.9 million. Lower transaction revenue from exchanges and Getaways was caused by a decrease in transaction volume of 2.0%, partly offset by an increase of 2.3% in average fee per transaction. Lower transaction volume is related to the continued shift in percentage mix of the membership base from traditional to corporate, which reduced transaction propensity. The increase in other revenue for the current period is primarily attributable to transaction activity and other membership programs outside of the Interval Network, coupled with higher sales of marketing materials primarily for point-of-sale developer use. Overall Interval Network average revenue per member was $187.13 in 2013, which was higher by 2.6% over the prior year period. Management and Rental The increase of $16.6 million, or 30.2%, in management fee and rental revenue includes $9.2 million of incremental revenue from our VRI Europe joint venture which commenced on November 4, 2013, coupled with $4.6 million of two additional months of VRI's results included in the 2013 period. Fee income earned from managed hotel and condominium resort properties at Aston and Aqua increased $2.9 million, or 10.6%, in 2013, partly driven by our acquisition of Aqua on December 12, 2013. Combined RevPAR was $138.90, an increase of 6.6% attributable to an 8.6% higher average daily rate during 2013 compared to prior year. Pass-through revenue represents reimbursed compensation and other employee-related costs directly associated with managing properties that are included in both revenue and expenses and that are passed on to the property owners or homeowners association without mark-up. The increase in pass-through revenue of $4.0 million, or 6.6%, in 2013 is largely related to our acquisition of Aqua and two additional months of VRI included in the 2013 period, together with an increase resulting from the addition of new Aston properties under management. 2012 Compared to 2011 Revenue for the year ended December 31, 2012 of $473.3 million increased $44.5 million, or 10.4%, compared to revenue of $428.8 million in 2011. Membership and Exchange segment revenue of $357.7 million increased $8.3 million, or 2.4%, in 2012 compared to the prior year period and Management and Rental segment revenue of $115.6 million increased $36.2 million, or 45.7% from 2011. Membership and Exchange The increase of $8.3 million in Membership and Exchange revenue in 2012 is primarily driven by increases in transaction revenue and membership fee revenue of $6.1 million and $1.3 million, respectively, coupled with a rise in other revenue of $1.3 million. The rise in transaction revenue is mainly related to higher revenue from exchanges and Getaways of $1.9 million and increases in reservation servicing and other transaction related fees of $1.9 million and $2.3 million, respectively. Higher transaction revenue from exchanges and Getaways was due to a 4.7% increase in average fee per transaction, partially offset by a 3.5% decrease in exchange and Getaway transaction volume. Lower transaction volume is related to a shift in the percentage mix of our membership base from traditional to corporate members. Total active members in the Interval Network at December 31, 2012 increased to approximately 1.82 million members as compared to approximately 1.78 million members at December 31, 2011, an increase of 2.4%. Membership fee revenue during 2012 rose $1.3 million, or 1.0%, compared to the prior year. This increase is largely due to greater penetration of Platinum memberships. The increase in other revenue for the year is primarily attributable to the membership and exchange related activities of TPI and the inclusion of VRI subsequent to our acquisition in February 2012. Overall Interval Network average revenue per member of $182.39 for 2012 is consistent with the prior year. 45-------------------------------------------------------------------------------- Table of Contents Management and Rental The increase of $22.5 million, or 69.4%, in management fee and rental revenue includes $18.2 million of incremental VRI management fee revenue and a $2.0 million contribution from TPI largely related to property management contracts secured in August of 2011. Fee income earned from managed hotel and condominium resort properties at Aston increased $2.3 million, or 9.2%, in 2012 due to a 16.9% increase in RevPAR to $130.28 driven by a 9.8% higher average daily rate and a 6.5% improvement in occupancy rates during 2012 compared to 2011. The increase of $13.7 million, or 29.3%, in pass-through revenue in 2012 is mostly related to our acquisition of VRI and, to a lesser extent, increases at Aston and TPI attributable to higher occupied room nights and new property management contracts, respectively. Cost of Sales Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Membership and Exchange $ 87,740 (0.1 )% $ 87,868 7.4 % $ 81,812 Management and Rental Management fee and rental expenses 27,112 37.4 % 19,730 55.6 % 12,682 Pass-through expenses 64,658 6.6 % 60,661 29.3 % 46,926 Total Management and Rental cost of sales 91,770 14.2 % 80,391 34.9 % 59,608 Total cost of sales $ 179,510 6.7 % $ 168,259 19.0 % $ 141,420 As a percentage of total revenue 35.8 % 0.8 % 35.5 % 7.8 % 33.0 % As a percentage of total revenue excluding pass-through revenue 41.1 % 0.9 % 40.8 % 10.1 % 37.0 % Gross margin 64.2 % (0.4 )% 64.5 % (3.8 )% 67.0 % Gross margin without pass-through revenue/expenses 73.7 % (0.3 )% 73.9 % (1.8 )% 75.3 % Cost of sales consists primarily of compensation and other employee-related costs (including stock-based compensation) for personnel engaged in servicing members of the Membership and Exchange segment and providing services to property owners and/or guests of the Management and Rental segment's managed vacation properties, as well as cost of rental inventory used primarily for Getaways included within the Membership and Exchange segment. 2013 Compared to 2012 Cost of sales for the year ended December 31, 2013 of $179.5 million increased $11.3 million from 2012, consisting of an increase of $11.4 million from our Management and Rental segment, partly offset by a decrease of $0.1 million from our Membership and Exchange segment. Overall gross margin of 64.2% for 2013 remained relatively consistent year-over-year. Gross margin for the Membership and Exchange segment in 2013 was relatively consistent when compared to the prior year. Cost of sales for this segment decreased $0.1 million, or 0.1%, compared to the prior year. The relatively flat year-over-year comparable was a result of lower costs pertaining to our membership fulfillment activities, partly offset by an increase in purchased inventory expense of $0.9 million. The increase in purchased inventory expense was due to a higher proportion of purchased inventory utilized during 2013, coupled with an increase in the average cost per unit of this purchased inventory. 46-------------------------------------------------------------------------------- Table of Contents The increase of $11.4 million in cost of sales from the Management and Rental segment was primarily attributable to $5.3 million of incremental expenses resulting from the inclusion of VRI Europe's results, an increase of $4.0 million in segment pass-through revenue driven in large part by our acquisition of Aqua in December 2013, together with other incremental expenses related to the additional two months of VRI's results included in the 2013 period and higher compensation and other employee related costs. Gross margin for this segment increased by 216 basis points to 32.6% in 2013 compared to 2012. Excluding the effect of pass-through revenue, gross margin for this segment decreased by 199 basis points to 62.1% during 2013 compared to the prior year. 2012 Compared to 2011 Cost of sales in 2012 increased $26.8 million from 2011, consisting of an increase of $6.1 million from our Membership and Exchange segment and $20.8 million from our Management and Rental segment. Overall gross margin decreased by 257 basis points to 64.5% in 2012 compared to 67.0% in 2011, primarily due to increased gross profit contribution from our lower-margin Management and Rental segment relative to total ILG gross profit. Gross margin for the Membership and Exchange segment decreased by 115 basis points during 2012 compared to the prior year. Cost of sales for this segment increased $6.1 million primarily due to an increase of $3.1 million in compensation and other employee related costs and $1.2 million in the cost of purchased inventory. The increase in compensation and other employee related costs mainly pertained to our call center and related member servicing activities which, coupled with an increase of $0.7 million in membership fulfillment related expenses, were in part attributable to an increase in the number of active members in our Interval Network resulting from the affiliation of two corporate accounts during the first half of 2012. The increase in the cost of purchased inventory was due to a higher proportion of purchased inventory utilized during 2012, partly offset by a decrease in the average cost per unit of this purchased inventory. The increase of $20.8 million in cost of sales from the Management and Rental segment was primarily attributable to an increase of $13.7 million in segment pass-through revenue coupled with an increase of $6.1 million in other incremental expenses related to VRI and an increase of $0.6 million in compensation and other employee related costs at TPI. Gross margin for this segment increased by 557 basis points to 30.5% in 2012 compared to 2011. Our Management and Rental segment has lower gross margins than our Membership and Exchange segment largely due to the effect of pass-through revenue. Excluding the effect of pass-through revenue, gross margin for this segment increased by 318 basis points to 64.1% during 2012 compared to the prior year. Selling and Marketing Expense Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Selling and marketing expense $ 53,722 0.3 % $ 53,559 0.1 % $ 53,504 As a percentage of total revenue 10.7 % (5.3 )% 11.3 % (9.3 )% 12.5 % As a percentage of total revenue excluding pass-through revenue 12.3 % (5.2 )% 13.0 % (7.4 )% 14.0 % Selling and marketing expense consists primarily of advertising and promotional expenditures and compensation and other employee-related costs (including stock-based compensation) for personnel engaged in sales and sales support functions. Advertising and promotional expenditures primarily include printing costs of directories and magazines, promotions, tradeshows, agency fees, marketing fees and related commissions. 47-------------------------------------------------------------------------------- Table of Contents 2013 Compared to 2012 Selling and marketing expense in 2013 remained relatively in line with 2012. As a percentage of total revenue and total revenue excluding pass-through revenue, sales and marketing expense decreased 60 and 67 basis points, respectively, during 2013 compared to the prior year. 2012 Compared to 2011 Selling and marketing expense in 2012 remained relatively flat compared to 2011, increasing less than $0.1 million. As a percentage of total revenue and total revenue excluding pass-through revenue, sales and marketing expense decreased 116 and 103 basis points, respectively, during 2012 compared to the prior year. General and Administrative Expense Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) General and administrative expense $ 112,574 6.9 % $ 105,270 11.4 % $ 94,508 As a percentage of total revenue 22.5 % 1.0 % 22.2 % 0.9 % 22.0 % As a percentage of total revenue excluding pass-through revenue 25.8 % 1.1 % 25.5 % 3.1 % 24.7 % General and administrative expense consists primarily of compensation and other employee-related costs (including stock-based compensation) for personnel engaged in finance, legal, tax, human resources, information technology and executive management functions, as well as facilities costs, fees for professional services and other company-wide benefits. 2013 Compared to 2012 General and administrative expense in 2013 increased $7.3 million from 2012, primarily due to incremental expenses of $2.8 million in the 2013 period from the inclusion of acquired businesses in our results of operations, higher professional fees of $4.9 million (excluding such incremental expenses from acquired businesses), and unfavorable year-over-year net changes of $1.2 million primarily related to the estimated fair value of contingent consideration for an acquisition, and certain other miscellaneous cost increases. These cost increases were partly offset by lower overall compensation and other employee related costs of $2.3 million, excluding incremental expenses from acquired business. The $4.9 million increase in professional fees primarily related to accounting and legal services provided largely in connection with the VRI Europe transaction and the acquisition of Aqua, together with additional costs related to certain IT initiatives. The $2.3 million decrease in overall compensation and other employee-related costs, excluding incremental expenses from acquired businesses, was primarily due to $2.2 million of lower health and welfare insurance expense primarily resulting from a drop in self-insured claim activity during 2013 compared to the prior year, $1.3 million of higher capitalized internal labor costs pertaining to internally developed software, and a $0.7 million decrease in non-cash compensation expense. This $0.7 million decrease was mainly due to certain awards vesting fully during the third quarter of 2012 through the first quarter of 2013, which was partially offset by the incremental expense related to new awards granted in the first quarter of 2013. These decreases were partly offset by higher salary and incentive related compensation. As a percentage of total revenue and total revenue excluding pass-through revenue, general and administrative expense during 2013 increased 22 and 28 basis points, respectively, over the prior year. 48-------------------------------------------------------------------------------- Table of Contents 2012 Compared to 2011 General and administrative expense in 2012 increased $10.8 million from 2011, primarily due to an increase of $8.5 million in overall compensation and other employee-related costs, other incremental expenses of $2.9 million from VRI and higher IT maintenance and support services of $1.2 million, partly offset by a favorable net change of $1.7 million in the estimated fair value of contingent consideration related to an acquisition. The $8.5 million increase in overall compensation and other employee-related costs was primarily due to $5.4 million of incremental compensation and other employee-related expenses from VRI, an increase of $1.6 million in health and welfare insurance expense due to higher self-insured claim activity in 2012, and various other increases in compensation and employee-related costs. These higher employee-related costs were partly offset by a decrease of $1.0 million in non-cash compensation expense mainly due to awards granted at spin-off, vesting fully during the third quarter of 2012, and $1.4 million of higher capitalized internal labor costs pertaining to internally developed software. As a percentage of total revenue and total revenue excluding pass-through revenue, general and administrative expense during 2012 increased 20 and 76 basis points, respectively, over the prior year. Amortization Expense of Intangibles Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Amortization expense of intangibles $ 8,133 (64.7 )% $ 23,041 (15.6 )% $ 27,301 As a percentage of total revenue 1.6 % (66.7 )% 4.9 % (23.5 )% 6.4 % As a percentage of total revenue excluding pass-through revenue 1.9 % (66.6 )% 5.6 % (21.9 )% 7.1 % 2013 Compared to 2012 Amortization expense of intangibles for 2013 decreased $14.9 million from 2012 primarily due to certain intangible assets related to the acquisition by IAC of our Interval International business in 2002 being fully amortized by the end of the third quarter of 2012, partly offset by the incremental amortization expense in 2013 pertaining to intangible assets resulting from recently acquired businesses. 2012 Compared to 2011 Amortization expense of intangibles for 2012 decreased $4.3 million from 2011 primarily due to certain intangible assets fully amortized by the end of the third quarter of 2012, partly offset by the incremental amortization expense pertaining to intangible assets resulting from the acquisition of VRI. Depreciation Expense Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Depreciation expense $ 14,531 8.2 % $ 13,429 1.1 % $ 13,277 As a percentage of total revenue 2.9 % 2.2 % 2.8 % (8.4 )% 3.1 % As a percentage of total revenue excluding pass-through revenue 3.3 % 2.3 % 3.3 % (6.4 )% 3.5 % 49 -------------------------------------------------------------------------------- Table of Contents 2013 Compared to 2012 Depreciation expense for 2013 increased $1.1 million over 2012 largely due to additional depreciable assets being placed in service subsequent to December 31, 2012. These depreciable assets pertain primarily to software and related IT hardware. 2012 Compared to 2011 Depreciation expense for 2012 was relatively consistent compared with 2011, increasing by $0.2 million or 1.1%. Operating Income Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Membership and Exchange $ 125,881 20.8 % $ 104,245 5.8 % $ 98,562 Management and Rental 6,864 24.0 % 5,536 NM 222 Total operating income $ 132,745 20.9 % $ 109,781 11.1 % $ 98,784 As a percentage of total revenue 26.5 % 14.2 % 23.2 % 0.7 % 23.0 % As a percentage of total revenue excluding pass-through revenue 30.4 % 14.3 % 26.6 % 2.8 % 25.9 % 2013 Compared to 2012 Operating income in 2013 increased $23.0 million from 2012, consisting of increases of $21.6 million from our Membership and Exchange segment and $1.3 million from our Management and Rental segment. Operating income for our Membership and Exchange segment increased $21.6 million to $125.9 million in 2013 compared to the prior year. The increase in operating income was driven primarily by $14.8 million of lower amortization expense of intangibles and stronger year-over-year gross profit contribution. The increase in operating income of $1.3 million in our Management and Rental segment is primarily due to the incremental contributions from our recently acquired businesses together with improved operating results at our other management businesses driven largely by stronger management fee and rental revenue. These increases were partly offset by higher professional fees largely related to the VRI Europe and Aqua transactions, in addition to an unfavorable year-over-year net change of $0.7 million mainly related to the estimated fair value of contingent consideration for an acquisition. 2012 Compared to 2011 Operating income in 2012 increased $11.0 million from the comparable period in 2011, consisting of an increase of $5.7 million from our Membership and Exchange segment and an increase of $5.3 million from our Management and Rental segment. Operating income for our Membership and Exchange segment increased $5.7 million to $104.2 million in 2012 from 2011 due to $5.5 million of lower amortization expense of intangibles as a result of certain intangible assets becoming fully amortized by the end of third quarter of 2012, the positive contributions from the membership and exchange activities of TPI and VRI, and a favorable net change of $0.9 million in the estimated fair value of contingent consideration related to an acquisition. This was partly offset by higher general and administrative expense primarily due to employee related costs, including health and welfare benefits. 50-------------------------------------------------------------------------------- Table of Contents The increase in operating income of $5.3 million at our Management and Rental segment is primarily due to improved operating results at Aston and TPI during the year, coupled with the incremental contribution from VRI and a favorable net change of $0.9 million in the estimated fair value of contingent consideration related to an acquisition. Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization Adjusted earnings before interest, taxes, depreciation and amortization (adjusted EBITDA) is a non-GAAP measure and is defined in "ILG's Principles of Financial Reporting." Prior period amounts have been recast to conform to the current period definition of Adjusted EBITDA. Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Membership and Exchange $ 146,899 3.0 % $ 142,652 (0.8 )% $ 143,765 Management and Rental 19,344 34.2 % 14,416 67.9 % 8,584 Total adjusted EBITDA $ 166,243 5.8 % $ 157,068 3.1 % $ 152,349 As a percentage of total revenue 33.2 % NM 33.2 % (6.6 )% 35.5 % As a percentage of total revenue excluding pass-through revenue 38.1 % NM 38.1 % (4.6 )% 39.9 % 2013 Compared to 2012 Adjusted EBITDA in 2013 increased by $9.2 million, or 5.8%, from 2012, consisting of increases of $4.2 million from our Membership and Exchange segment and $4.9 million from our Management and Rental segment. Adjusted EBITDA of $146.9 million from our Membership and Exchange segment grew by $4.2 million, or 3.0%, compared to the prior year. The improvement in adjusted EBITDA is primarily driven by revenue growth largely attributable to the positive contributions from our Platinum and Club Interval products and higher transaction revenue and other membership programs outside of the Interval Network. Additionally, adjusted EBITDA in the period benefitted from lower compensation and employee-related costs within general and administrative expense. Adjusted EBITDA from our Management and Rental segment rose by $4.9 million, or 34.2%, to $19.3 million in 2013 from $14.4 million in 2012. The growth in adjusted EBITDA in this segment is principally driven by the incremental contribution from our recently acquired businesses together with delivering higher gross profit on a year-over-year comparable basis. These items were partly offset by higher professional fees incurred for services provided in connection with the property management infrastructure at Aston. 2012 Compared to 2011 Adjusted EBITDA in 2012 increased $4.7 million from 2011, or 3.1%, consisting of an increase of $5.8 million from our Management and Rental segment, partly offset by a decrease of $1.1 million from our Membership and Exchange segment. Adjusted EBITDA from our Membership and Exchange segment decreased $1.1 million to $142.7 million in 2012 from $143.8 million in 2011. Adjusted EBITDA for this segment reflects a shift in percentage mix of the membership base which has negatively affected transaction propensity and average membership fee per member. Additionally, the segment experienced higher overall compensation and employee-related costs, particularly driven by rising health and welfare insurance expense due to higher self-insured claim activity and higher call center costs and related member 51-------------------------------------------------------------------------------- Table of Contents servicing activities mainly resulting from the affiliation of two corporate accounts during the first half of 2012. This was partly offset by the inclusion of VRI's results and the favorable contribution from the membership and exchange activities of TPI. Adjusted EBITDA from our Management and Rental segment increased $5.8 million to $14.4 million in 2012 from $8.6 million in 2011. The improvement in adjusted EBITDA in this segment is primarily driven by higher gross profit of $15.5 million delivered mainly from the inclusion of VRI in our results of operations, together with improvement in Aston's RevPAR during the year and new property management contracts secured at TPI in the third quarter 2011. This was partly offset by higher general and administrative expenses of $8.5 million due to the inclusion of VRI's general and administrative expenses in our results. Other Income (Expense), net Year Ended December 31, 2013 % Change 2012 % Change 2011 (Dollars in thousands) Interest income $ 362 (79.8 )% $ 1,792 41.9 % $ 1,263 Interest expense $ (6,172 ) (75.9 )% $ (25,629 ) (28.0 )% $ (35,575 ) Other income (expense), net $ 259 (110.5 )% $ (2,456 ) (255.4 )% $ 1,580 Loss on extinguishment of debt $ - 100.0 % $ (18,527 ) NM $ - 2013 Compared to 2012 Interest income decreased $1.4 million in 2013 compared to 2012 primarily as a result of the repayment of certain loans receivable subsequent to August 2012. Interest expense in the first nine months of 2012 primarily relates to interest and amortization of debt costs on our term loan and senior notes, which were extinguished on June 21, 2012 and September 4, 2012, respectively. Interest expense incurred from the fourth quarter of 2012 through December 31, 2013 relates to interest and amortization of debt costs on our amended and restated revolving credit facility entered into on June 21, 2012. Lower interest expense in 2013 is primarily due to lower average balance outstanding and interest rate under the revolving credit facility compared to the term loan and senior notes. Other income (expense), net primarily relates to net gains and losses on foreign currency exchange related to cash held in certain countries in currencies other than their local currency. Non-operating foreign exchange for the year ended December 31, 2013 resulted in a net gain of $0.6 million compared to a net loss of $2.2 million in 2012. The favorable fluctuations during the 2013 period were principally driven by U.S. dollar positions held at December 31, 2013 affected by the stronger dollar compared to the Colombian peso and the Egyptian pound, partly offset by the weaker dollar compared to the British pound. The unfavorable fluctuations during 2012 were principally driven by U.S. dollar positions held at December 31, 2012 affected by the weaker dollar compared to the Mexican and Colombian pesos. 2012 Compared to 2011 Interest income increased $0.5 million in 2012 compared to 2011 primarily as a result of interest earned on loans issued in 2012. Interest expense primarily relates to interest and amortization of debt costs on the term loan and senior notes, which were extinguished on June 21, 2012 and September 4, 2012, respectively, and our amended and restated revolving credit facility entered into on June 21, 2012. The senior notes were initially recorded with an original issue discount of $23.5 million of which $1.8 million and $2.5 million were amortized in 2012 and 2011, respectively. Lower interest expense during 2012 is primarily due to 52-------------------------------------------------------------------------------- Table of Contents the extinguishment of our term loan on June 21, 2012, redemption of our senior notes on September 4, 2012, and lower prevailing interest rates compared to the extinguished indebtedness. Non-operating foreign exchange net loss was $2.2 million in 2012 compared to a net gain of $1.8 million in 2011. The unfavorable fluctuations during 2012 were principally driven by U.S. dollar positions held at December 31, 2012 affected by the weaker dollar compared to the Mexican and Colombian peso. The favorable fluctuations during 2011 were principally driven by U.S. dollar positions held at December 31, 2011 affected by the stronger dollar compared to the Mexican peso, partly offset by a weaker dollar compared to the Colombian peso. Additionally, in connection with the repayment of our term loan on June 21, 2012 and the redemption of our senior notes on September 4, 2012, we recognized a loss of $18.5 million in 2012 on the early extinguishment of this indebtedness resulting from the acceleration of related unamortized debt issuance costs and the remaining original issue discount on the senior notes. This loss is presented as a separate line item within other income (expense) in our consolidated statement of income for the year ended December 31, 2012. Income Tax Provision 2013 Compared to 2012 For the years ended December 31, 2013 and 2012, ILG recorded income tax provisions for continuing operations of $45.4 million and $24.3 million, respectively, which represent effective tax rates of 35.7% and 37.3%, respectively. These tax rates are higher than the federal statutory rate of 35% due principally to state and local income taxes partially offset by foreign income taxed at lower rates. In addition, during the fourth quarter of 2013, ILG recorded income tax benefits of $3.5 million associated with state income tax items attributable to the impact of a binding technical advisement that was issued by a state taxing authority, as discussed further below. ILG also recorded income taxes of $0.8 million associated with the U.S. tax consequences of certain of ILG's foreign operations and other income tax items, the most significant of which related to the effect of changes in tax laws in the U.K., as discussed further below. In 2012, ILG recorded income tax benefits of $0.9 million associated with the U.S. tax consequences of certain of ILG's foreign operations and other income tax items, the most significant of which related to the tax impact of ILG's redemption of the senior notes. As of December 31, 2013 and 2012, ILG had unrecognized tax benefits of $0.5 million and $0.7 million, respectively, which if recognized, would favorably affect the effective tax rate. Also included in the balance of unrecognized tax benefits as of December 31, 2013 and 2012 are $0.2 million and $0.4 million, respectively, of unrecognized tax benefits related to the acquisition of TPI. In connection with our acquisition of TPI, the former shareholders have agreed to indemnify us for all tax liabilities and related interest and penalties for the pre-acquisition period. The net decrease of $0.2 million in 2013 in unrecognized tax benefits is due principally to a decrease in foreign taxes as a result of the expiration of the statute of limitations partly offset by other income tax items. Additionally, during the first quarter of 2013, the unrecognized tax benefits increased by approximately $1.1 million related to state income tax items. During the fourth quarter of 2013, we received the expected favorable binding technical advisement issued by a state taxing authority on state income tax items, which allowed us to decrease our unrecognized tax benefits by the $1.1 million, as discussed further below. The net decrease of $0.2 million in 2012 in unrecognized tax benefits is due principally to both a decrease in foreign taxes as a result of the expiration of the statute of limitations and settlements with taxing authorities related primarily to certain tax credits, partly offset by other income tax items. ILG recognizes interest and, if applicable, penalties related to unrecognized tax benefits in income tax expense. There were no material accruals for interest during 2013. During 2013, interest and penalties decreased by approximately $0.2 million as a result of the expiration of the statute of 53-------------------------------------------------------------------------------- Table of Contents limitations related to foreign taxes. There were no material accruals for interest during 2012. During 2012, interest and penalties decreased by approximately $0.2 million as a result of the expiration of the statute of limitations related to foreign taxes. At December 31, 2013 and 2012, ILG has accrued $0.4 million and $0.6 million, respectively, for the payment of interest and, if applicable, penalties. ILG believes that it is reasonably possible that its unrecognized tax benefits could decrease by approximately $0.2 million within twelve months of the current reporting date due primarily to the expiration of the statute of limitations related to foreign taxes. An estimate of other changes in unrecognized tax benefits cannot be made, but is not expected to be significant. ILG has routinely been under audit by federal, state, local and foreign taxing authorities. These audits include questioning the timing and the amount of deductions and the allocation of income among various tax jurisdictions. Income taxes payable include amounts considered sufficient to pay assessments that may result from examination of prior year returns; however, the amount paid upon resolution of issues raised may differ from the amount provided. Differences between the reserves for tax contingencies and the amounts owed by ILG are recorded in the period they become known. Under a tax sharing agreement entered into in connection with the spin-off transaction, IAC indemnifies ILG for all consolidated tax liabilities and related interest and penalties for the pre-spin period. No other open tax years are currently under examination by the IRS or any material state and local jurisdictions. During 2012, the U.K. Finance Act of 2012 was enacted, which further reduced the U.K. corporate income tax rate to 24%, effective April 1, 2012 and 23%, effective April 1, 2013. The impact of the U.K. rate reduction to 24% and 23%, which reduced our U.K. net deferred tax asset and increased income tax expense, was reflected in the reporting period when the law was enacted. During the third quarter of 2013, the U.K. Finance Act of 2013 was enacted which further reduced the U.K. corporate income tax rate to 21%, effective April 1, 2014 and 20%, effective April 1, 2015. The impact of the U.K. rate reduction to 21% and 20% has been reflected in the current reporting period. It reduced our U.K. net deferred tax asset and increased income tax expense by approximately $0.6 million. The change in the corporate tax rate initially negatively impacts income tax expense as the future benefit expected to be realized from our U.K. net deferred tax assets decreases; however, going forward, the lower corporate tax rate will decrease income tax expense and favorably impact our effective tax rate. During the fourth quarter of 2013, we received the expected favorable binding technical advisement issued by a state taxing authority on state income tax items, which allowed us to use a more favorable apportionment methodology in that state. This advisement allowed us to decrease our unrecognized tax benefits, as discussed above, lower state income taxes for all prior open tax years following the spin-off from IAC, for which amended returns were filed, and reduce our U.S. net deferred tax liability, which further decreased income tax expense. State income tax benefits attributable to these items of approximately $3.5 million were recorded in the fourth quarter of 2013, all of which favorably impacted our effective tax rate. Additionally, this change in apportionment methodology lowered our current state effective tax rate, which reduced current year state income taxes and will continue to decrease income tax expense going forward and favorably impact our effective tax rate. 2012 Compared to 2011 For the years ended December 31, 2012 and 2011, ILG recorded income tax provisions for continuing operations of $24.3 million and $24.9 million, respectively, which represent effective tax rates of 37.3% and 37.7%, respectively. These tax rates are higher than the federal statutory rate of 35% due principally to state and local income taxes partially offset by foreign income taxed at lower rates. In addition, as it relates to 2012, ILG recorded income tax benefits of $0.9 million associated with the U.S. tax consequences of certain of ILG's foreign operations and other income tax items, the most significant of which related to the tax impact of ILG's redemption of the senior notes. As it 54 -------------------------------------------------------------------------------- Table of Contents relates to 2011, ILG recorded income taxes of $0.4 million associated with non-deductible non-cash compensation and other income tax items. As of December 31, 2012 and 2011, ILG had unrecognized tax benefits of $0.7 million and $0.9 million, respectively, which if recognized, would favorably affect the effective tax rate. Also included in the balance of unrecognized tax benefits as of December 31, 2012 and 2011 are $0.4 million and $0.6 million, respectively, of unrecognized tax benefits related to the acquisition of TPI. In connection with our acquisition of TPI, the former shareholders have agreed to indemnify us for all tax liabilities and related interest and penalties for the pre-acquisition period. The net decrease of $0.2 million in 2012 in unrecognized tax benefits is due principally to both a decrease in foreign taxes as a result of the expiration of the statute of limitations and settlements with taxing authorities related primarily to certain tax credits, partly offset by other income tax items. The net decrease of $0.1 million in 2011 in unrecognized tax benefits is due principally to the decrease in foreign taxes as a result of the expiration of the statute of limitations. ILG recognizes interest and, if applicable, penalties related to unrecognized tax benefits in income tax expense. There were no material accruals for interest during 2012. During 2012, interest and penalties decreased by approximately $0.2 million as a result of the expiration of the statute of limitations related to foreign taxes. There were no material accruals for interest during 2011. During 2011, interest and penalties decreased by approximately $0.1 million as a result of the expiration of the statute of limitations related to foreign taxes. At December 31, 2012 and 2011, ILG has accrued $0.6 million and $0.8 million, respectively, for the payment of interest and, if applicable, penalties. ILG believes that it is reasonably possible that its unrecognized tax benefits could decrease by approximately $0.2 million within twelve months of the current reporting date due primarily to the expiration of the statute of limitations related to foreign taxes. An estimate of other changes in unrecognized tax benefits cannot be made, but is not expected to be significant. ILG has routinely been under audit by federal, state, local and foreign taxing authorities. These audits include questioning the timing and the amount of deductions and the allocation of income among various tax jurisdictions. Income taxes payable include amounts considered sufficient to pay assessments that may result from examination of prior year returns; however, the amount paid upon resolution of issues raised may differ from the amount provided. Differences between the reserves for tax contingencies and the amounts owed by ILG are recorded in the period they become known. Under the tax sharing agreement, IAC indemnifies ILG for all consolidated tax liabilities and related interest and penalties for the pre-spin period. During the fourth quarter of 2012, the IRS also completed its examination of ILG's Federal consolidated tax return for the short period following the spin-off and ended December 31, 2008. Additionally during 2012, the State of Florida completed its examination of ILG's consolidated state tax return for the short period following the spin-off and ended December 31, 2008 as well as for the tax year ended December 31, 2009. During 2011, the U.K. Finance Act of 2011 was enacted, which further reduced the U.K. corporate income tax rate to 26%, effective April 1, 2011 and 25%, effective April 1, 2012. The impact of the U.K. rate reduction to 26% and 25%, which reduced our U.K. net deferred tax asset and increased income tax expense, was reflected in the reporting period when the law was enacted. During the third quarter of 2012, the U.K. Finance Act of 2012 was enacted which further reduced the U.K. corporate income tax rate to 24%, effective April 1, 2012 and 23%, effective April 1, 2013. The impact of the U.K. rate reduction to 24% and 23% has been reflected in the current reporting period. It reduced our U.K. net deferred tax asset and increased income tax expense by approximately $0.4 million. The change in the corporate tax rate initially negatively impacts income tax expense as the future benefit expected to be realized from our U.K. net deferred tax assets decreases; however, going forward, the lower corporate tax rate will decrease income tax expense and favorably impact our effective tax rate. 55 -------------------------------------------------------------------------------- Table of Contents FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2013, we had $48.5 million of cash and cash equivalents, including $37.7 million of U.S. dollar equivalent or denominated cash deposits held by foreign subsidiaries which are subject to changes in foreign exchange rates. Of this amount, $23.3 million is held in foreign jurisdictions, principally the U.K. Earnings of foreign subsidiaries, except Venezuela, are permanently reinvested. Additional tax provisions would be required should such earnings be repatriated to the U.S. Cash generated by operations is used as our primary source of liquidity. Additionally, we are also exposed to risks associated with the repatriation of cash from certain of our foreign operations to the United States where currency restrictions exist, such as Venezuela and Argentina, which limit our ability to immediately access cash through repatriations. These currency restrictions had no impact on our overall liquidity during the year ended December 31, 2013 and, as of December 31, 2013, the respective cash balances were immaterial to our overall cash on hand. We believe that our cash on hand along with our anticipated operating future cash flows and availability under our $500 million revolving credit facility, which may be increased to up to $700 million subject to certain conditions, are sufficient to fund our operating needs, quarterly cash dividend, capital expenditures, development and expansion of our operations, debt service, investments and other commitments and contingencies for at least the next twelve months. However, our operating cash flow may be impacted by macroeconomic and other factors outside of our control. Cash Flows Discussion Net cash provided by operating activities increased to $109.9 million in 2013 from $80.4 million in 2012 which was down from $95.9 million in 2011. The increase of $29.4 million in 2013 from 2012 was principally due to lower interest paid of $26.0 million and higher net cash receipts, partially offset by higher income taxes paid of $17.1 million. Lower interest expense in 2013 is primarily due to lower average balance outstanding and interest rate under the revolving credit facility compared to the term loan and senior notes which were extinguished during 2012. The decrease of $15.5 million in 2012 from 2011 was principally due to higher income taxes paid of $8.6 million, net higher payments of $3.9 million made in connection with long-term agreements, higher interest payments of $0.8 million and higher net cash expenses. The higher interest payments are primarily related to the shift in the timing of interest payments under our new credit facility. Due to the semi-annual scheduled timing of interest payments on our redeemed senior notes, we paid twelve months of interest in both 2012 and 2011. Net cash used in investing activities of $134.0 million in 2013 primarily related to the acquisitions, net of cash acquired, of $127.3 million, as well as the acquisition of certain property management contracts and other assets by our management and rental segment, and capital expenditures of $14.7 million primarily related to IT initiatives, all partially offset by the early repayment of an existing loan receivable totaling $9.9 million. In 2012, net cash used in investing activities of $47.3 primarily related to the VRI acquisition, net of cash acquired, of $40.0 million, disbursements totaling $9.5 million for investments in loans receivable, and capital expenditures of $15.0 million primarily related to IT initiatives, all partly offset by the early repayments of existing loans receivable totaling $17.0 million. Interest on the loans receivable are due monthly or quarterly and in some instances may be paid in kind. As of December 31, 2012, an additional $2.6 million was available to be drawn in connection with our financing receivables. In 2011, net cash used in investing activities of $35.2 million related to disbursements totaling $16.5 million for loans to third parties, capital expenditures of $13.0 million, primarily related to IT 56-------------------------------------------------------------------------------- Table of Contents initiatives, and the acquisition of certain management agreements by our Management and Rental segment for $5.6 million. Free cash flow is a non-GAAP measure and is defined in "ILG's Principles of Financial Reporting." For the years ended December 31, 2013, 2012 and 2011, free cash flow was $95.2 million, $65.4 million and $82.9 million, respectively. The change is mainly a result of the variance in net cash provided by operating activities as discussed above. Net cash used in financing activities of $27.5 million in 2013 primarily related to principal payments of $70.0 million on our revolving credit facility, cash dividends totaling $18.9 million, and withholding taxes paid on the vesting of restricted stock units of $5.2 million. These uses of cash were partially offset by the $63.0 million drawn on our revolving credit facility in 2013, proceeds from excess tax benefits from stock-based awards and the exercise of stock options. In 2012, net cash used in financing activities of $131.8 million was principally due to the redemption of our senior notes, principal payments of $56.0 million on the term loan, of which we paid $51.0 million from cash on-hand in June 2012 to fully extinguish the term loan, cash dividends totaling $28.4 million, payments of debt issuance costs of $3.9 million in connection with entering into our amended and restated credit agreement in June 2012, withholding taxes paid on the vesting of restricted stock units of $6.2 million and $1.1 million of the total $1.5 million contingent consideration payment related to an acquisition. These uses of cash were partially offset by proceeds of the $290.0 million drawn on our revolving credit facility to fund the redemption, proceeds from excess tax benefits from stock-based awards and the exercise of stock options. In 2011, net cash used in financing activities of $43.6 million was principally due to repurchases of our common stock at market prices totaling $20.9 million, including commissions, which settled during the year as well as voluntary principal prepayments on the term loan totaling $20.0 million, withholding taxes paid on the vesting of restricted stock units of $3.5 million and $0.9 million of the total $1.5 million contingent consideration payment related to an acquisition, all partially offset by excess tax benefits from stock-based awards and proceeds from the exercise of stock options. Effective, August 3, 2011, ILG's Board of Directors authorized a share repurchase program for up to $25.0 million, excluding commissions, of our outstanding common stock. As of December 31, 2012, the remaining availability for future repurchases of our common stock was $4.1 million. On June 21, 2012, we entered into an amended and restated credit agreement which, among other things (1) provides for a $500 million revolving credit facility, (2) extends the maturity of the credit facility to June 21, 2017, (3) provides for an interest rate on borrowings, commitment fees and letter of credit fees based on ILG and its subsidiaries' consolidated leverage ratio, and (4) may be increased to up to $700 million, subject to certain conditions. As of December 31, 2013, $253.0 million of borrowings were outstanding under the revolving credit facility, with $247.0 million available to be drawn. On September 4, 2012, we redeemed all of our $300 million senior notes, issued on August 19, 2008, at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest, amounting to $314.5 million. We funded the redemption through the use of $290.0 million, drawn on our $500 million revolving credit facility, and cash on hand. Any principal amounts outstanding under the revolving credit facility are due at maturity. The interest rate on the amended credit agreement is based on (at our election) either LIBOR plus a predetermined margin that ranges from 1.25% to 2.25%, or the Base Rate as defined in the amended credit agreement plus a predetermined margin that ranges from 0.25% to 1.25%, in each case based on the our consolidated leverage ratio. As of December 31, 2013, the applicable margin was 1.50% per annum for LIBOR revolving loans and 0.50% per annum for Base Rate loans. The revolving credit facility has a commitment fee on undrawn amounts that ranges from 0.25% to 0.375% per annum 57-------------------------------------------------------------------------------- Table of Contents based on our consolidated leverage ratio and as of December 31, 2013 the commitment fee was 0.275%. The revolving credit facility has various financial and operating covenants that place significant restrictions on us, including our ability to incur additional indebtedness, to incur additional liens, issue redeemable stock and preferred stock, pay dividends or distributions or redeem or repurchase capital stock, prepay, redeem or repurchase debt, make loans and investments, enter into agreements that restrict distributions from our subsidiaries, sell assets and capital stock of our subsidiaries, enter into certain transactions with affiliates and consolidate or merge with or into or sell substantially all of our assets to another person. The revolving credit facility requires us to meet certain financial covenants regarding the maintenance of a maximum consolidated leverage ratio of consolidated debt, less credit given for a portion of foreign cash, over consolidated Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"), as defined in the amended credit agreement, of 3.50 through December 31, 2013 and 3.25 thereafter. Additionally, we are required to maintain a minimum consolidated interest coverage ratio of consolidated EBITDA over consolidated interest expense, as defined in the Amended Credit Agreement, of 3.0. As of December 31, 2013, ILG was in compliance in all material respects with the requirements of all applicable financial and operating covenants, and our consolidated leverage ratio and consolidated interest coverage ratio under the amended credit agreement were 1.25 and 36.56, respectively. Dividends In May, August and November 2013, our Board of Directors declared quarterly dividend payments of $0.11 per share paid in June, September and December 2013, respectively, of $6.3 million each. For the year ended December 31, 2013, we paid $18.9 million in cash dividends. In February 2014, our Board of Directors declared a $0.11 per share dividend payable March 27, 2014 to shareholders of record on March 13, 2014. In March, May, August and November 2012, our Board of Directors declared a quarterly dividend of $0.10 per share paid in April, June, September and December 2012, respectively, of $5.7 million each. Additionally, in December 2012, our Board of Directors accelerated the first quarter of 2013 expected dividend, declaring quarterly dividend payments of $0.10 per share paid in December 2012 of $5.7 million. For the year ended December 31, 2012, we paid $28.4 million in cash dividends. Contractual Obligations and Commercial Commitments We have funding commitments that could potentially require our performance in the event of demands by third parties or contingent events. At December 31, 2013, guarantees, surety bonds and letters of credit totaled $28.6 million. The total includes maximum exposure under guarantees of $25.3 million, which primarily relates to the Management and Rental segment's hotel and resort management agreements, including those with guaranteed dollar amounts, and accommodation leases supporting the segment's management activities, entered into on behalf of the property owners for which either party generally may terminate such leases upon 60 to 90 days prior written notice to the other. In addition, certain of the Management and Rental segment's hotel and resort management agreements provide that owners receive specified percentages of the revenue generated under management. In these cases, the operating expenses for the rental operations are paid from the revenue generated by the rentals, the owners are then paid their contractual percentages, and we either retain the balance (if any) as our management fee or make up the deficit. Although such deficits are reasonably possible in a few of these agreements, as of December 31, 2013, future amounts are not expected to be significant, individually or in the aggregate. Certain of our Management and Rental businesses also enter into agreements, as principal, for services purchased on behalf of property owners 58 -------------------------------------------------------------------------------- Table of Contents for which they are subsequently reimbursed. As such, we are the primary obligor and may be liable for unreimbursed costs. As of December 31, 2013, amounts pending reimbursements are not significant. Contractual obligations and commercial commitments at December 31, 2013 are as follows: Payments Due by Period Up to More than Contractual Obligations Total 1 year 1-3 years 3-5 years 5 years (Dollars in thousands) Debt principal(a) $ 253,000 $ - $ - $ 253,000 $ - Debt interest(a) 17,277 4,975 9,959 2,343 - Purchase obligations(b) 28,137 14,086 11,075 2,976 - Operating leases 61,430 13,345 21,037 14,562 12,486 Unused commitment on loans receivable and other advances 15,147 15,147 - - - Total contractual obligations $ 374,991 $ 47,553 $ 42,071 $ 272,881 $ 12,486 -------------------------------------------------------------------------------- º (a) º Debt principal and projected debt interest represent principal and interest to be paid on our revolving credit facility based on the balance outstanding as of December 31, 2013. In addition, also included are certain fees associated with our revolving credit facility based on the unused borrowing capacity and outstanding letters of credit balances, if any, as of December 31, 2013. Interest on the revolving credit facility is calculated using the prevailing rates as of December 31, 2013. º (b) º The purchase obligations primarily relate to future guaranteed purchases of rental inventory, operational support services, marketing related benefits and membership fulfillment benefits. Amount of Commitment Expiration Per Period Total Amounts Less than More thanOther Commercial Commitments(c) Committed 1 year 1-3 years 3-5 years 5 years (Dollars in thousands) Guarantees, surety bonds and letters of credit $ 28,583 $ 15,756 $ 9,710 $ 2,441 $ 676 -------------------------------------------------------------------------------- º (c) º Commercial commitments include minimum revenue guarantees related to hotel and resort management agreements, accommodation leases entered into on behalf of the property owners, and funding commitments that could potentially require performance in the event of demands by third parties or contingent events, such as under a letter of credit extended or under guarantees. Off-Balance Sheet Arrangements Except as disclosed above in our Contractual Obligations and Commercial Commitments (excluding "Debt principal"), as of December 31, 2013, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of SEC Regulation S-K. Recent Accounting Pronouncements Refer to Note 2 accompanying our consolidated financial statements for a description of recent accounting pronouncements. Seasonality Refer to Note 1 accompanying our consolidated financial statements for a discussion on the impact of seasonality. 59-------------------------------------------------------------------------------- Table of Contents ILG'S PRINCIPLES OF FINANCIAL REPORTING Definition of ILG's Non-GAAP Measures Earnings before interest, taxes, depreciation and amortization (EBITDA) is defined as net income attributable to common stockholders excluding, if applicable: (1) interest income and interest expense, (2) income taxes, (3) depreciation expense, and (4) amortization expense of intangibles. Adjusted EBITDA is defined as EBITDA excluding, if applicable: (1) non-cash compensation expense, (2) goodwill and asset impairments, (3) acquisition related and restructuring costs, (4) other non-operating income and expense and (5) the impact of correcting prior period items. Non-GAAP net income is defined as net income attributable to common stockholders excluding the impact of correcting a prior period net understatement in the current year-to-date financials and excluding the prior year non-cash loss on extinguishment of our indebtedness, net of tax. Non-GAAP earnings per share (EPS) is defined as non-GAAP net income divided by the weighted average number of shares of common stock outstanding during the period for basic EPS and for diluted EPS, inclusive of dilutive securities. Free cash flow is defined as cash provided by operating activities less capital expenditures. Our presentation of above-mentioned non-GAAP measures may not be comparable to similarly-titled measures used by other companies. We believe these measures are useful to investors because they represent the consolidated operating results from our segments, excluding the effects of any non-cash expenses. We also believe these non-GAAP financial measures improve the transparency of our disclosures, provide a meaningful presentation of our results from our business operations, excluding the impact of certain items not related to our core business operations and improve the period-to-period comparability of results from business operations. These non-GAAP measures have certain limitations in that they do not take into account the impact of certain expenses to our statement of operations; including non-cash compensation for adjusted EBITDA. We endeavor to compensate for the limitations of the non-GAAP measures presented by also providing the comparable GAAP measure with equal or greater prominence and descriptions of the reconciling items, including quantifying such items, to derive the non-GAAP measure. We report these non-GAAP measures as supplemental measures to results reported pursuant to GAAP. These measures are among the primary metrics by which we evaluate the performance of our businesses, on which our internal budgets are based and by which management is compensated. We believe that investors should have access to the same set of metrics that we use in analyzing our results. These non-GAAP measures should be considered in addition to results prepared in accordance with GAAP, but should not be considered a substitute for or superior to GAAP results. We provide and encourage investors to examine the reconciling adjustments between the GAAP and non-GAAP measures which are discussed below. Items That Are Excluded From ILG's Non-GAAP Measures (as applicable) Amortization expense of intangibles is a non-cash expense relating primarily to acquisitions. At the time of an acquisition, the intangible assets of the acquired company, such as customer relationships, purchase agreements and resort management agreements are valued and amortized over their estimated lives. We believe that since intangibles represent costs incurred by the acquired company to build value prior to acquisition, they were part of transaction costs. Depreciation expense is a non-cash expense relating to our property and equipment and is recorded on a straight-line basis to allocate the cost of depreciable assets to operations over their estimated service lives. 60-------------------------------------------------------------------------------- Table of Contents Non-cash compensation expense consists principally of expense associated with the grants of restricted stock units. These expenses are not paid in cash, and we will include the related shares in our future calculations of diluted shares of stock outstanding. Upon vesting of restricted stock units, the awards will be settled, at our discretion, on a net basis, with us remitting the required tax withholding amount from our current funds. Goodwill and asset impairments are non-cash expenses relating to adjustments to goodwill and long-lived assets whereby the carrying value exceeds the fair value of the related assets, and are infrequent in nature. Acquisition related and restructuring costs are transaction fees, costs incurred in connection with performing due diligence, subsequent adjustments to our initial estimate of contingent consideration obligations associated with business acquisitions, and other direct costs related to acquisition activities. Additionally, this item includes certain restructuring charges primarily related to workforce reductions and estimated costs of exiting contractual commitments. Other non-operating income and expense consists principally of foreign currency translations of cash held in certain countries in currencies, principally U.S. dollars, other than their functional currency, in addition to any gains or losses on extinguishment of debt. 61-------------------------------------------------------------------------------- Table of Contents RECONCILIATIONS OF NON-GAAP MEASURES The following tables reconcile EBITDA and adjusted EBITDA to operating income for our operating segments, and to net income attributable to common stockholders in total for the years ended December 31, 2013, 2012 and 2011 (in thousands). The noncontrolling interest relates to the Management and Rental segment. Year Ended December 31, 2013 Membership Management and and Exchange Rental Consolidated Adjusted EBITDA $ 146,899 $ 19,344 $ 166,243 Non-cash compensation expense (9,344 ) (1,084 ) (10,428 ) Other non-operating income (expense), net 427 (168 ) 259 Prior period item 3,496 - 3,496 Acquisition related and restructuring costs (668 ) (3,799 ) (4,467 ) EBITDA 140,810 14,293 155,103 Amortization expense of intangibles (1,347 ) (6,786 ) (8,133 ) Depreciation expense (13,155 ) (1,376 ) (14,531 ) Less: Net income attributable to noncontrolling interest - 565 565 Less: Other non-operating income (expense), net (427 ) 168 (259 ) Operating income $ 125,881 $ 6,864 132,745 Interest income 362 Interest expense (6,172 ) Other non-operating income, net 259 Income tax provision (45,412 ) Net income 81,782 Net income attributable to noncontrolling interest (565 ) Net income attributable to common stockholders $ 81,217 62 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2012 Membership Management and and Exchange Rental Consolidated Adjusted EBITDA $ 142,652 $ 14,416 $ 157,068 Non-cash compensation expense (9,904 ) (1,027 ) (10,931 ) Other non-operating expense, net (2,303 ) (153 ) (2,456 ) Acquisition related and restructuring costs (62 ) 169 107 Loss on extinguishment of debt (18,527 ) - (18,527 ) EBITDA 111,856 13,405 125,261 Amortization expense of intangibles (16,147 ) (6,894 ) (23,041 ) Depreciation expense (12,294 ) (1,135 ) (13,429 ) Less: Other non-operating expense, net 2,303 153 2,456 Less: Net income attributable to noncontrolling interest - 7 7 Less: Loss on extinguishment of debt 18,527 - 18,527 Operating income $ 104,245 $ 5,536 109,781 Interest income 1,792 Interest expense (25,629 ) Other non-operating expense, net (2,456 ) Loss on extinguishment of debt (18,527 ) Income tax provision (24,252 ) Net income 40,709 Net income attributable to noncontrolling interest (7 ) Net income attributable to common stockholders $ 40,702 63 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2011 Membership Management and and Exchange Rental Consolidated Adjusted EBITDA $ 143,765 $ 8,584 $ 152,349 Non-cash compensation expense (10,638 ) (998 ) (11,636 ) Other non-operating income (expense), net 1,705 (125 ) 1,580 Acquisition related and restructuring costs (545 ) (806 ) (1,351 ) EBITDA 134,287 6,655 140,942 Amortization expense of intangibles (21,689 ) (5,612 ) (27,301 ) Depreciation expense (12,331 ) (946 ) (13,277 ) Less: Other non-operating income (expense), net (1,705 ) 125 (1,580 ) Less: Net income attributable to noncontrolling interest - - - Operating income $ 98,562 $ 222 98,784 Interest income 1,263 Interest expense (35,575 ) Other non-operating income, net 1,580 Income tax provision (24,926 ) Net income 41,126 Net loss attributable to noncontrolling interest - Net income attributable to common stockholders $ 41,126 The following table reconciles cash provided by operating activities to free cash flow for the years ended December 31, 2013, 2012 and 2011 (in thousands). Year Ended December 31, 2013 2012 2011 Net cash provided by operating activities $ 109,864 $ 80,438 $ 95,907 Less: Capital expenditures (14,700 ) (15,040 ) (13,038 ) Free cash flow $ 95,164 $ 65,398 $ 82,869 64 -------------------------------------------------------------------------------- Table of Contents The following tables reconcile net income attributable to common stockholders to non-GAAP net income, and to non-GAAP earnings per share for the years ended December 31, 2013, 2012 and 2011 (in thousands). Year Ended December 31, 2013 2012 2011 Net income attributable to common stockholders $ 81,217 $ 40,702 $ 41,126 Prior period item (3,496 ) - - Income tax provision on prior period item(1) 1,355 - - Loss on extinguishment of debt - 18,527 - Income tax benefit of loss on extinguishment of debt(1) - (7,270 ) - Non-GAAP net income $ 79,076 $ 51,959 $ 41,126 Earnings per share attributable to common stockholders: Basic $ 1.42 $ 0.72 $ 0.72 Diluted $ 1.40 $ 0.71 $ 0.71 Non-GAAP earnings per share: Basic $ 1.38 $ 0.92 $ 0.72 Diluted $ 1.37 $ 0.91 $ 0.71 Weighted average number of common stock outstanding: Basic 57,243 56,549 56,981 Diluted 57,832 57,248 57,775 Year Ended December 31, 2013 2012 2011 Basic Diluted Basic Diluted Basic Diluted Earnings per share $ 1.42 $ 1.40 $ 0.72 $ 0.71 $ 0.72 $ 0.71 Prior period item (0.06 ) (0.06 ) - - - - Income tax provision on prior period item(1) 0.02 0.02 - - - - Loss on extinguishment of debt - - 0.33 0.33 - - Income tax benefit of adjusting items(1) - - (0.13 ) (0.13 ) - - Non-GAAP earnings per share $ 1.38 $ 1.37 $ 0.92 $ 0.91 $ 0.72 $ 0.71 -------------------------------------------------------------------------------- º (1) º Tax rate utilized is the applicable effective tax rate respective to the period to the extent amounts are deductible. |