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INTERVAL LEISURE GROUP, INC. - 10-Q - 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 quarterly report on Form 10-Q 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 quarterly 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; failure to consummate a previously announced transaction; 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 our 2013 Annual Report on Form 10-K and in Part II 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 narrative of the results of operations and financial condition of ILG for the three and six months ended June 30, 2014. This section should be read in conjunction with the consolidated financial statements and accompanying notes included in this report as well as our 2013 Annual Report on Form 10-K, 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 Results of Operations º • º Financial Position, Liquidity and Capital Resources º • º Critical Accounting Policies and Estimates º • º ILG's Principles of Financial Reporting º • º Reconciliations of Non-GAAP Measures 33 -------------------------------------------------------------------------------- MANAGEMENT OVERVIEWGeneral 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 comprising our Membership and Exchange segment, has been a leader in the membership and exchange services industry since its founding in 1976. As of June 30, 2014, 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 approximately 2,900 resorts located in over 80 countries, including both leading independent resort developers and branded hospitality companies; and 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 (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, condominium resorts, timeshare resorts, vacation clubs and homeowners' associations through Aston, Aqua, VRI Europe, Vacation Resorts International (VRI), and Trading Places International (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, the 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. 34 -------------------------------------------------------------------------------- As of June 30, 2014, the businesses that comprise our Management and Rental segment provided various management and rental services to travelers and owners at more than 225 vacation properties, resorts and club locations. Revenue from the Management and Rental segment is derived principally from fees for hotel, condominium resort, timeshare resort, vacation clubs 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. International Revenue International revenue increased in the three and six months ended June 30, 2014 by 31.5% and 24.7%, respectively, compared to the same periods in 2013. As a percentage of our total revenue, international revenue increased in the three and six months ended June 30, 2014 to 23.0% and 22.7%, respectively, from 17.5% and 18.2% compared to the same periods in 2013. The increase in international revenue as a percentage of total revenue in 2014 is attributable to revenue from our VRI Europe joint venture established in November 2013. Other Factors Affecting Results Membership and Exchange The consolidation of resort developers driven by bankruptcies and the lack of receivables financing previously 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 2014 results to-date continue to be negatively affected by a shift in the percentage mix of our membership base from traditional, direct renewal members to corporate members, a tightening in the availability of exchange and Getaway inventory and, to a lesser extent, during the first quarter of 2014, severe weather throughout much of the United States which limited demand to certain destinations with availability. In addition, we secured multi-year renewals with several large developer clients that account for approximately two-thirds of the Interval Network corporate members; however, the terms associated with these renewals have resulted in reduced profitability. Our corporate developer accounts enroll and renew their entire active owner base which positively impacts our retention rate; however, 35 -------------------------------------------------------------------------------- these members tend to have a lower propensity to transact with us. Membership mix as of June 30, 2014 included 59.3% traditional and 40.7% corporate members, compared to 60.5% and 39.5%, respectively, as of June 30, 2013. 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 1.2% and 0.5% for the three and six months ended June 30, 2014, respectively, compared to the same periods in the prior year. Aston's occupancy in Hawaii for the three and six months ended June 30, 2014 declined from last year, which led to lower revenue per available room for the quarter but was offset by higher average daily rate in the year-to-date-period when compared to 2013. For comparative purposes, Aqua has been excluded from this analysis As of the latest forecast (May 2014), the Hawaii Department of Business, Economic Development and Tourism forecasts increases of 0.7% in visitors to Hawaii and 2.3% in visitor expenditures in 2014 over 2013. During the second quarter of 2014, we advanced with our restructuring plan of consolidating TPI and VRI's corporate office into one building. As part of this initiative, we incurred approximately $1.0 million in restructuring expense during the quarter, which is included in general and administrative expense within our consolidated statements of income, mainly resulting from estimated costs of exiting contractual commitments. As of June 30, 2014, approximately $0.9 million is accrued within accrued expenses and other current liabilities on our consolidated balance sheet pertaining to these restructuring costs. Business Acquisitions During the fourth quarter of 2013, we purchased the European shared ownership resort management business of CLC and all of the equity of Aqua, a Hawaii-based hotel and resort management company. These acquisitions were not individually significant; however, the year-over-year comparability for the three and six months ended June 30, 2014 was affected as further discussed in our Results of Operations section. 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 leading to increased competition in our membership and exchange business and reduced availability of exchange and Getaway inventory. Also, we anticipate reduced profitability related to the several large corporate renewals discussed above to unfavorably impact year-over-year comparability for the remainder of 2014. For the Management and Rental segment, we expect year-over-year RevPAR to hold steady as the tourism recovery of its largest market, Hawaii, moderates. Additionally, airlift into the island chain remains a positive factor bolstering the Hawaiian tourism economy; however, increases in the cost of a Hawaiian vacation may continue to negatively impact visitor arrivals and temper growth. Business Acquisitions The completion of the VRI Europe and Aqua transactions during the fourth quarter of 2013 will affect the year-over-year comparability of our results of operations for the year ended December 31, 36-------------------------------------------------------------------------------- 2014 and respective interim periods. The VRI Europe transaction will continue to affect international revenue as a percentage of total revenue. In May 2014, we entered into an Equity Interest Purchase Agreement with Hyatt Corporation to acquire the Hyatt Residential Group business for approximately $190 million in cash at closing, subject to customary post-closing adjustments. Additionally, we will reimburse Hyatt for its capital contribution associated with its interest in a joint venture related to a 131-unit vacation ownership property in Maui (currently estimated to be $35 million based on an assumed early fourth quarter closing). In connection with this transaction we will enter into an exclusive master license agreement and become Hyatt's exclusive licensee in vacation ownership. The closing of this transaction is subject to obtaining specified consents, in addition to other customary closing conditions, and the Equity Interest Purchase Agreement may be terminated in certain circumstances, including, among others, if the transaction does not close by December 31, 2014. RESULTS OF OPERATIONS Revenue For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange Transaction revenue $ 47,315 (5.7 )% $ 50,174 Membership fee revenue 31,602 (14.2 )% 36,819 Ancillary member revenue 1,709 (5.6 )% 1,811 Total member revenue 80,626 (9.2 )% 88,804 Other revenue 6,314 (5.9 )% 6,713 Total Membership and Exchange revenue 86,940 (9.0 )% 95,517 Management and Rental Management fee and rental revenue 32,364 128.4 % 14,172 Pass-through revenue 24,224 58.4 % 15,294 Total Management and Rental revenue 56,588 92.0 % 29,466 Total revenue $ 143,528 14.8 % $ 124,983 Revenue for the three months ended June 30, 2014 increased $18.5 million, or 14.8%, from the comparable period in 2013. Management and Rental segment revenue increased $27.1 million, or 92.0%, in the quarter compared to 2013, while Membership and Exchange segment revenue decreased $8.6 million, or 9.0%, year-over-year. Membership and Exchange Membership and Exchange revenue decreased $8.6 million, or 9.0%, in the second quarter of 2014 compared to 2013. Of this decrease, $4.1 million represents the correction of an immaterial prior period net understatement recorded in the second quarter of 2013. Excluding the impact of this prior period item, Membership and Exchange revenue decreased $4.5 million, or 4.9%, in the quarter compared to prior year. This decrease of $4.5 million in segment revenue primarily resulted from lower transaction revenue and membership fee revenue of $2.9 million and $1.2 million, respectively. The decrease in transaction revenue is mainly related to a drop in revenue from exchanges and Getaways of $3.8 million, partly 37 -------------------------------------------------------------------------------- offset by an increase of $0.7 million related to our E-Plus product launched in the latter half of last year. Lower transaction revenue from exchanges and Getaways was caused by a decline in transaction volume of 12.8%, partly offset by an increase of 4.8% in average fee for exchanges and Getaways. Lower transaction volume is related to the shift in percentage mix of the membership base from traditional to corporate, which reduced transaction propensity. Total active members in the Interval Network at June 30, 2014 remained relatively consistent with the prior year at approximately 1.82 million members. The decrease of $1.2 million in membership fee revenue in the quarter largely reflects the impact of less favorable membership fees associated with the multi-year renewals of several large corporate developer clients in the first quarter of 2014 when compared to prior arrangements. Additionally, the period was negatively affected by the shift in percentage mix of our membership base from traditional to corporate members as well as a decline in average active Interval Network members. The unfavorable impact of these items was partly mitigated by continued improvement in the member base penetration of our Platinum and Club Interval Gold products. Overall Interval Network average revenue per member was $44.36 in the quarter, lower by 8.7% from $48.59 in the prior year period. Excluding the impact of the prior period item recorded in the second quarter of 2013, average revenue per member decreased 4.3% from $46.37 in the prior year to $44.38 this quarter. Management and Rental The increase of $18.2 million, or 128.4%, in management fee and rental revenue includes $18.1 million of incremental revenue from our VRI Europe and Aqua acquisitions. Aston and Aqua combined revenue per available room ("RevPAR") was $110.39, a decrease of 14.5% over the prior year. Excluding Aqua, Aston RevPAR in the quarter decreased to $125.41 compared to $129.17 in the prior year. The drop in RevPAR, when excluding Aqua, can be mainly attributed to a 2.3% decline in occupancy rate compared to 2013 and the inclusion of available room nights from Orlando, a lower ADR market. 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 $8.9 million, or 58.4%, in the quarter is predominately related to our acquisition of Aqua. 38 -------------------------------------------------------------------------------- For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange Transaction revenue $ 103,426 (7.1 )% $111,322 Membership fee revenue 63,420 (9.6 )% 70,183 Ancillary member revenue 3,332 (10.8 )% 3,736 Total member revenue 170,178 (8.1 )% 185,241 Other revenue 12,107 (2.1 )% 12,371 Total Membership and Exchange revenue 182,285 (7.8 )% 197,612 Management and Rental Management fee and rental revenue 68,955 118.1 % 31,617 Pass-through revenue 49,329 61.0 % 30,635 Total Management and Rental revenue 118,284 90.0 % 62,252 Total revenue $ 300,569 15.7 % $ 259,864 Revenue for the six months ended June 30, 2014 increased $40.7 million, or 15.7%, from the comparable period in 2013. Management and Rental segment revenue increased $56.0 million, or 90.0%, in the quarter compared to 2013, while Membership and Exchange segment revenue decreased $15.3 million, or 7.8%, year-over-year. Membership and Exchange Membership and Exchange revenue decreased $15.3 million, or 7.8%, in the first half of 2014 compared to 2013. Excluding the impact of the prior period item recorded in the second quarter of 2013, Membership and Exchange revenue decreased $11.3 million, or 5.8%, in the quarter compared to prior year. This decrease of $11.3 million in segment revenue primarily resulted from lower transaction revenue and membership fee revenue of $7.9 million and $2.7 million, respectively. The decrease in transaction revenue is mainly related to a drop in revenue from exchanges and Getaways of $8.4 million, partly offset by a rise of $0.5 million in other transaction related fees. Lower transaction revenue from exchanges and Getaways was caused by a decline in transaction volume of 12.8%, partly offset by an increase of 3.7% in average fee per transaction. Lower transaction volume is related to the shift in percentage mix of the membership base from traditional to corporate, which reduced transaction propensity, coupled with a tightening in the availability of exchange and Getaway inventory primarily in the first quarter of 2014. The decrease of $2.7 million in membership fee revenue in the six months largely reflects the impact of less favorable membership fees associated with the multi-year renewals of several large corporate developer clients in the first quarter of 2014 when compared to prior arrangements. Additionally, the period was negatively affected by the shift in the percentage mix of our membership base from traditional to corporate members as well as a decline in average active Interval Network members. This impact has been partly mitigated by continued improvement in the member base penetration of our Platinum and Club Interval Gold products. Overall Interval Network average revenue per member was $93.68 in 2014, lower by 7.6% from $101.39 in the prior year period. Excluding the impact of the prior period item recorded in the second quarter of 2013, average revenue per member decreased 5.5% from $99.17 in the prior year to $93.68 this period. 39-------------------------------------------------------------------------------- Management and Rental The increase of $37.3 million, or 118.1%, in management fee and rental revenue includes $37.6 million of incremental revenue from our VRI Europe and Aqua acquisitions. Aston and Aqua combined RevPAR was $125.85, a decrease of 14.6% over the prior year. Excluding Aqua, Aston RevPAR in for the first six months of 2014 decreased slightly to $146.28 compared to $147.39 in the prior year. The decrease in RevPAR, when excluding Aqua, can be mainly attributed to a 1.2% decline in occupancy rate compared to 2013 and the inclusion of available room nights from Orlando, a lower ADR market, partly offset by an improvement in ADR in Hawaii. The increase in pass-through revenue of $18.7 million, or 61.0%, in 2014 is predominately related to our acquisition of Aqua. Cost of Sales For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange $ 21,006 (7.8 )% $ 22,780 Management and Rental Management fee and rental expenses 14,531 171.8 % 5,347 Pass-through expenses 24,224 58.4 % 15,294 Total Management and Rental cost of sales 38,755 87.8 % 20,641 Total cost of sales $ 59,761 37.6 % $ 43,421 As a percentage of total revenue 41.6 % 19.8 % 34.7 % As a percentage of total revenue excluding prior period item 41.6 % 16.2 % 35.8 % As a percentage of total revenue excluding pass-through revenue 50.1 % 26.5 % 39.6 % Gross margin 58.4 % (10.6 )% 65.3 % Gross margin excluding prior period item 58.4 % (9.0 )% 64.2 % Gross margin without pass-through revenue/expenses 70.2 % (5.6 )% 74.4 % 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. Cost of sales in the second quarter of 2014 increased $16.3 million from 2013, consisting of an increase of $18.1 million from our Management and Rental segment, partly offset by a decrease of $1.8 million from our Membership and Exchange segment. Overall gross margin, adjusted to exclude the impact of the prior period item, decreased by 580 basis points to 58.4% this quarter compared to 2013. The decrease in overall gross margin is largely due to the incremental 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 in the second quarter of 2014 was largely consistent when compared to the prior year. Cost of sales for this segment decreased $1.8 million, or 7.8%, from 2013. The year-over-year decrease in cost of sales is a result of lower purchased inventory expense of $0.5 million, together with a decrease in call center costs and related member servicing activities. The decline in purchased inventory expense was principally due to lower purchased inventory volumes, partly offset by an increase in the average cost per unit of this purchased inventory. 40 -------------------------------------------------------------------------------- The increase of $18.1 million in cost of sales from the Management and Rental segment was primarily attributable to the inclusion of our fourth quarter 2013 acquisitions, which includes $9.5 million of incremental expenses and $8.7 million pass-through revenue related to Aqua. Gross margin for this segment increased by 156 basis points to 31.5% in the quarter compared to 2013. Excluding the effect of pass-through revenue, gross margin for this segment decreased by 717 basis points to 55.1% in the current quarter when compared to the prior year quarter, largely resulting from the incremental gross profit contribution from VRI Europe relative to total segment gross profit. VRI Europe's business model generally differs from our other management businesses with respect to the fee structure. Our other management businesses charge the association or property owner a management fee that is separate from the association/owner payments to maintain the property, while also recording pass-through revenues relating to certain reimbursed compensation and other employee-related costs directly associated with managing properties. Typically, VRI Europe fees are charged directly to the vacation owners and include amounts to cover property management and all resort operating expenses. Consequently, VRI Europe's business model normally operates at a lower gross margin than our other management businesses, when excluding pass-through revenue/expenses. For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange $ 44,975 (6.8 )% $ 48,237 Management and Rental Management fee and rental expenses 29,307 168.3 % 10,925 Pass-through expenses 49,329 61.0 % 30,635 Total Management and Rental cost of sales 78,636 89.2 % 41,560 Total cost of sales $ 123,611 37.7 % $ 89,797 As a percentage of total revenue 41.1 % 19.0 % 34.6 % As a percentage of total revenue excluding prior period item 41.1 % 17.3 % 35.1 % As a percentage of total revenue excluding pass-through revenue 49.2 % 25.6 % 39.2 % Gross margin 58.9 % (10.0 )% 65.4 % Gross margin excluding prior period item 58.9 % (9.3 )% 64.9 % Gross margin without pass-through revenue/expenses 70.4 % (5.1 )% 74.2 % Cost of sales in the first half of 2014 increased $33.8 million from 2013, consisting of an increase of $37.1 million from our Management and Rental segment, partly offset by a decrease of $3.3 million from our Membership and Exchange segment. Overall gross margin, adjusted to exclude the impact of the prior period item, decreased by 606 basis points to 58.9% this year compared to 2013. The decrease in overall gross margin is largely due to the incremental 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 in the first six months of 2014 was largely consistent when compared to the prior year. Cost of sales for this segment decreased $3.3 million, or 6.8%, from 2013. The year-over-year decrease in cost of sales is a result of lower purchased inventory expense of $1.3 million, together with a decrease in call center costs and related member servicing activities. The decline in purchased inventory expense was principally due to lower purchased inventory volumes, partly offset by an increase in the average cost per unit of this purchased inventory. 41 -------------------------------------------------------------------------------- The increase of $37.1 million in cost of sales from the Management and Rental segment was primarily attributable to the inclusion of our fourth quarter 2013 acquisitions, which includes $19.1 million of incremental and an increase of $18.1 million in pass-through revenue related to Aqua. Gross margin of 33.5% for this segment was largely consistent when compared to the prior year. Excluding the effect of pass-through revenue, gross margin for this segment decreased by 795 basis points to 57.5% in the current year when compared to the prior year largely resulting from the incremental gross profit contribution from VRI Europe relative to total segment gross profit. VRI Europe's business model generally differs from our other management businesses with respect to the fee structure. Our other management businesses charge the association or property owner a management fee that is separate from the association/owner payments to maintain the property, while also recording pass-through revenues relating to certain reimbursed compensation and other employee-related costs directly associated with managing properties. Typically, VRI Europe fees are charged directly to the vacation owners and include amounts to cover property management and all resort operating expenses. Consequently, VRI Europe's business model normally operates at a lower gross margin than our other management businesses, when excluding pass-through revenue/expenses. Selling and Marketing Expense For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Selling and marketing expense $ 13,808 (3.3 )% $ 14,272 As a percentage of total revenue 9.6 % (15.8 )% 11.4 % As a percentage of total revenue excluding prior period item 9.6 % (16.2 )% 11.5 % As a percentage of total revenue excluding pass-through revenue 11.6 % (11.0 )% 13.0 % 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. Selling and marketing expense in the second quarter of 2014 decreased $0.5 million, or 3.3%, compared to 2013. The decrease in sales and marketing spend is largely attributable to lower printing and postage costs associated with a revision to the distribution timing and format of Interval Network member publications, partly offset by increased marketing fees related to developer contract renewals during the year. As a percentage of total revenue (excluding the impact of the prior period item) and total revenue excluding pass-through revenue, sales and marketing expense decreased 186 and 144 basis points, respectively, during the second quarter of 2014 compared to the prior year. 42-------------------------------------------------------------------------------- For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Selling and marketing expense $ 28,378 1.3 % $ 28,007 As a percentage of total revenue 9.4 % (12.4 )% 10.8 % As a percentage of total revenue excluding prior period item 9.4 % (12.5 )% 10.8 % As a percentage of total revenue excluding pass-through revenue 11.3 % (7.6 )% 12.2 % Selling and marketing expense in the first six months of 2014 increased $0.4 million, or 1.3%, compared to 2013. Higher sales and marketing spend is attributable to increased marketing fees related to developer contract renewals during the year, partly offset by lower printing and postage costs associated with a revision to the distribution timing and format of Interval Network member publications, as well as lower sales commissions as compared to the prior year. As a percentage of total revenue (excluding the impact of the prior period item) and total revenue excluding pass-through revenue, sales and marketing expense decreased 135 and 92 basis points, respectively, during the first half of 2014 compared to the prior year. General and Administrative Expense For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) General and administrative expense $ 31,251 10.7 % $ 28,227 As a percentage of total revenue 21.8 % (3.6 )% 22.6 % As a percentage of total revenue excluding prior period item 21.8 % (6.5 )% 23.3 % As a percentage of total revenue excluding pass-through revenue 26.2 % 1.8 % 25.7 % 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. General and administrative expense in the second quarter of 2014 increased $3.0 million from 2013, primarily due to incremental expenses of $2.2 million from the inclusion of our acquired businesses in our results of operations and an increase of $1.1 million in restructuring expenses consisting mainly of estimated costs of exiting contractual commitments and costs associated with workforce reorganizations. Additionally, we incurred higher professional fees of $0.5 million (excluding such incremental expenses from acquired businesses), an unfavorable year-over-year change of $0.6 million in our estimated accrual for European Union Value Added Tax ("VAT"), as further discussed in Note 12 accompanying our consolidated financial statements, and certain other miscellaneous cost increases. These increases were partly offset by a favorable year-over-year change of $1.5 million related to the estimated fair value of contingent consideration for acquisitions. As a percentage of total revenue (excluding the impact of the prior period item) and total revenue excluding pass-through revenue, general and administrative expense decreased 150 basis points and increased 46 basis points, respectively, during the second quarter of 2014 compared to the prior year. 43-------------------------------------------------------------------------------- For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) General and administrative expense $ 62,688 15.0 % $ 54,532 As a percentage of total revenue 20.9 % (0.6 )% 21.0 % As a percentage of total revenue excluding prior period item 20.9 % (2.0 )% 21.3 % As a percentage of total revenue excluding pass-through revenue 25.0 % 4.9 % 23.8 % General and administrative expense in the first half of 2014 increased $8.2 million from 2013 primarily due to incremental expenses of $4.4 million from the inclusion of our acquired businesses in our results of operations and higher professional fees of $2.2 million (excluding such incremental expenses from acquired businesses). Additionally, in the first half of 2014, we incurred an increase of $1.1 million in restructuring expenses consisting mainly of estimated costs of exiting contractual commitments and costs associated with workforce reorganizations, an increase of $1.4 million in overall compensation and other employee related costs (excluding incremental expenses from acquired businesses) which were driven predominately by a higher health and welfare insurance expense, as well as certain other miscellaneous cost increases. These increases were partly offset by a favorable year-over-year change of $2.0 million related to the estimated fair value of contingent consideration for acquisitions. The $2.2 million increase in professional fees primarily related to accounting and legal services provided largely in connection with potential acquisition activities, together with additional costs related to certain IT initiatives. As a percentage of total revenue (excluding the impact of the prior period item) and total revenue excluding pass-through revenue, general and administrative expense decreased 43 basis points and increased 116 basis points, respectively, during the first six months of 2014 compared to the prior year. Amortization Expense of Intangibles For the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013 Three Months Ended June 30, Six Months Ended June 30, 2014 % Change 2013 2014 % Change 2013 (Dollars in thousands) (Dollars in thousands) Amortization expense of intangibles $ 2,895 52.7 % $ 1,896 $ 5,861 50.0 % $ 3,908 As a percentage of total revenue 2.0 % 33.0 % 1.5 % 1.9 % 29.7 % 1.5 % As a percentage of total revenue excluding prior period item 2.0 % 28.6 % 1.6 % 1.9 % 27.6 % 1.5 % As a percentage of total revenue excluding pass-through revenue 2.4 % 40.4 % 1.7 % 2.3 % 36.8 % 1.7 % Amortization expense of intangibles for the three and six months ended June 30, 2014 increased $1.0 million and $2.0 million, respectively, over the comparable 2013 period due to incremental amortization expense pertaining to intangible assets of our recently acquired businesses. 44-------------------------------------------------------------------------------- Depreciation Expense For the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013 Three Months Ended June 30, Six Months Ended June 30, 2014 % Change 2013 2014 % Change 2013 (Dollars in thousands) (Dollars in thousands) Depreciation expense $ 3,876 4.9 % $ 3,696 $ 7,669 4.2 % $ 7,360 As a percentage of total revenue 2.7 % (8.7 )% 3.0 % 2.6 % (9.9 )% 2.8 % As a percentage of total revenue excluding prior period item 2.7 % (11.6 )% 3.1 % 2.6 % (11.3 )% 2.9 % As a percentage of total revenue excluding pass-through revenue 3.2 % (3.6 )% 3.4 % 3.1 % (4.9 )% 3.2 % Depreciation expense for the three and six months ended June 30, 2014 increased $0.2 million and $0.3 million, respectively, over the comparable 2013 period largely due to additional depreciable assets being placed in service subsequent to June 30, 2013. These depreciable assets pertain primarily to software and related IT hardware. Operating Income For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange $ 26,043 (22.5 )% $ 33,596 Management and Rental 5,894 NM (125 ) Total operating income $ 31,937 (4.6 )% $ 33,471 As a percentage of total revenue 22.3 % (16.9 )% 26.8 % As a percentage of total revenue excluding prior period item 22.3 % (10.2 )% 24.8 % As a percentage of total revenue excluding pass-through revenue 26.8 % (12.3 )% 30.5 % Operating income in the second quarter of 2014 decreased $1.5 million from 2013, consisting of a $7.6 million decrease from our Membership and Exchange segment, offset in part by a $6.0 million increase from our Management and Rental segment. Operating income for our Membership and Exchange segment decreased $7.6 million to $26.0 million in the quarter compared to the prior year. Excluding the $3.5 million impact related to the prior period item recorded in the second quarter of 2013, operating income for this segment decreased $4.1 million over the comparable 2013 period. The decrease in operating income was driven primarily by gross profit contraction in the period, coupled with higher marketing fees largely resulting from developer contract renewals in the first quarter of 2014, partly offset by lower printing and postage costs associated with a revision to the distribution timing and format of Interval Network member publications, and to an unfavorable year-over-year change in our estimated accrual for VAT. The increase in operating income of $6.0 million in our Management and Rental segment is primarily due to the incremental contributions from our recently acquired businesses, partly offset by expenses related to restructuring activities. 45 -------------------------------------------------------------------------------- For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange $ 57,970 (20.9 )% $ 73,268 Management and Rental 14,392 381.0 % 2,992 Total operating income $ 72,362 (5.1 )% $ 76,260 As a percentage of total revenue 24.1 % (18.0 )% 29.3 % As a percentage of total revenue excluding prior period item 24.1 % (15.4 )% 28.4 % As a percentage of total revenue excluding pass-through revenue 28.8 % (13.4 )% 33.3 % Operating income in the first half of 2014 decreased $3.9 million from 2013, consisting of a $15.3 million decrease from our Membership and Exchange segment, offset in part by an $11.4 million increase from our Management and Rental segment. Operating income for our Membership and Exchange segment decreased $15.3 million to $58.0 million in the first half of 2013 compared to the prior year. Excluding the $3.5 million impact related to the prior period item recorded in the second quarter of 2013, operating income for this segment decreased $11.8 million over the comparable 2013 period. The decrease in operating income was driven primarily by gross profit contraction in the period, coupled with higher marketing fees, higher professional fees incurred in connection with potential acquisition activities, and the unfavorable year-over-year change in our estimated accrual for VAT. The increase in operating income of $11.4 million in our Management and Rental segment is primarily due to the incremental contributions from our recently acquired businesses, partly offset by higher professional fees largely related to potential acquisition activities and expenses related to restructuring activities. 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. For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange $ 32,880 (8.9 )% $ 36,089 Management and Rental 8,594 222.6 % 2,664 Total adjusted EBITDA $ 41,474 7.0 % $ 38,753 As a percentage of total revenue 28.9 % (6.8 )% 31.0 % As a percentage of total revenue excluding prior period item 28.9 % (9.8 )% 32.0 % As a percentage of total revenue excluding pass-through revenue 34.8 % (1.6 )% 35.3 % 46 -------------------------------------------------------------------------------- Adjusted EBITDA in the second quarter of 2014 increased by $2.7 million, or 7.0%, from 2013, consisting of a $5.9 million increase from our Management and Rental segment, offset in part by a $3.2 million decrease from our Membership and Exchange segment. Adjusted EBITDA of $32.9 million from our Membership and Exchange segment declined by $3.2 million, or 8.9%, compared to the prior year. The drop in adjusted EBITDA is mainly correlated with a weakening in transaction revenue in the quarter, as well as lower membership fee revenue and reduced profitability resulting from securing multi-year renewals from several of our largest corporate developer clients during the first quarter of 2014. These items were partially offset by the positive contributions from our Platinum and Club Interval Gold products. Transaction revenue was adversely affected in the period by the shift in percentage mix of the membership base from traditional to corporate, which reduced transaction propensity. These items were partly mitigated in the quarter by lower printing and postage costs associated with a revision to the distribution timing and format of Interval Network member publications. Adjusted EBITDA from our Management and Rental segment rose by $5.9 million, or 222.6%, to $8.6 million in the quarter from $2.7 million in 2013. The growth in adjusted EBITDA in this segment is driven primarily by the incremental contribution from our recently acquired businesses coupled with positive contributions from our other vacation ownership management businesses. For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Membership and Exchange $ 71,410 (12.8 )% $ 81,908 Management and Rental 20,354 136.3 % 8,615 Total adjusted EBITDA $ 91,764 1.4 % $ 90,523 As a percentage of total revenue 30.5 % (12.4 )% 34.8 % As a percentage of total revenue excluding prior period item 30.5 % (13.7 )% 35.4 % As a percentage of total revenue excluding pass-through revenue 36.5 % (7.5 )% 39.5 % Adjusted EBITDA in the first half of 2014 increased by $1.2 million, or 1.4%, from 2013, consisting of an $11.7 million increase from our Management and Rental segment, offset in part by a $10.5 million decrease from our Membership and Exchange segment. Adjusted EBITDA of $71.4 million from our Membership and Exchange segment declined by $10.5 million, or 12.8%, compared to the prior year. The drop in adjusted EBITDA is mainly correlated with a deterioration in transaction revenue in the period, as well as lower membership fee revenue and reduced profitability resulting from securing multi-year renewals from several of our largest corporate developer clients. These items were partially offset by the positive contributions from our Platinum and Club Interval Gold products. Transaction revenue was adversely affected in the period by the shift in percentage mix of the membership base from traditional to corporate, which reduced transaction propensity, coupled with a tightening in the availability of exchange and Getaway inventory during the first quarter of 2014. Additionally, adjusted EBITDA in the period was unfavorably impacted by an increase in overall compensation and other employee-related costs partly attributable to an increase health and welfare insurance costs resulting from higher self-insured claim activity when compared to last year. Adjusted EBITDA from our Management and Rental segment rose by $11.7 million, or 136.3%, to $20.4 million in the first half of 2014 from $8.6 million in the prior year. The growth in adjusted 47-------------------------------------------------------------------------------- EBITDA in this segment is driven by the incremental contribution from our recently acquired businesses. Other Income (Expense), net For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 Three Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Interest income $ 55 (23.6 )% $ 72 Interest expense $ (1,628 ) 1.1 % $ (1,611 ) Other income, net $ (280 ) (118.9 )% $ 1,479 Interest income of $0.1 million in the second quarter of 2014 was relatively consistent with the prior year. Interest expense in the second quarter of 2014 and 2013 relates to interest and amortization of debt costs on our amended and restated revolving credit facility. The relatively flat interest expense for the second quarter of 2014 compared to prior year is a function of a lower average interest rate applicable to the period being applied against a higher average balance outstanding on our revolver. Other 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 net loss was $0.3 million in the second quarter of 2014 compared to a net gain of $1.5 million in 2013. The unfavorable fluctuations during the current quarter were principally driven by U.S. dollar positions held at June 30, 2014 affected by the weaker dollar compared to the Colombian peso and British pound. The favorable fluctuations during the prior year quarter were U.S. dollar positions held at June 30, 2013 affected by the stronger dollar compared to the Mexican and Colombian peso. For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 Six Months Ended June 30, 2014 % Change 2013 (Dollars in thousands) Interest income $ 99 (55.6 )% $ 223 Interest expense $ (2,952 ) (9.6 )% $ (3,264 ) Other income (expense), net $ (416 ) (143.4 )% $ 959 Interest income decreased $0.1 million in the first half of 2014 compared to 2013 due to certain loans receivable being outstanding and accruing interest for a portion of the first quarter of 2013 prior to settlement during that quarter. Interest expense in the first half of 2014 relates to interest and amortization of debt costs on our amended and restated revolving credit facility. Lower interest expense in the quarter is primarily a function of a lower average interest rate applicable to the period compared to prior year, partly offset by higher average balance outstanding on our revolver. Other 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 net loss was $0.1 million in the first half of 2014 compared to a net gain of $1.3 million in 2013. The unfavorable fluctuations during the year were principally driven by U.S. dollar positions held at June 30, 2014 affected by the weaker dollar compared to the Colombian peso and British pound, partly offset by the stronger dollar compared to the Egyptian pound. The favorable fluctuations during the 2013 period were principally driven by U.S. dollar positions held at June 30, 2013 affected by the stronger dollar compared to the Colombian peso and the Egyptian pound. 48-------------------------------------------------------------------------------- Income Tax Provision For the three months ended June 30, 2014 compared to the three months ended June 30, 2013 For the three months ended June 30, 2014 and 2013, ILG recorded income tax provisions for continuing operations of $10.7 million and $12.8 million, respectively, which represent effective tax rates of 35.5% and 38.4%, 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. The effective tax rate in the second quarter of 2014 is lower than the prior year period primarily due to the shift in the projections of the proportion of income earned and taxed between the various jurisdictions. For the six months ended June 30, 2014 compared to the six months ended June 30, 2013 For the six months ended June 30, 2014 and 2013, ILG recorded income tax provisions for continuing operations of $25.0 million and $28.6 million, respectively, which represent effective tax rates of 36.2% and 38.6%, 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. For the six months ended June 30, 2014, the effective tax rate is lower than the prior year period due to the shift in the projections of the proportion of income earned and taxed between the various jurisdictions. As of June 30, 2014 and December 31, 2013, ILG had unrecognized tax benefits of $0.4 million and $0.5 million, respectively, which if recognized, would favorably affect the effective tax rate. There were no material increases or decreases in unrecognized tax benefits for the three months ended June 30, 2014. During the six months ended June 30, 2014, the unrecognized tax benefits decreased by approximately $0.1 million related to the decrease in unrecognized tax benefits as a result of the expiration of the statute of limitations related to foreign taxes. ILG recognizes interest and, if applicable, penalties related to unrecognized tax benefits in income tax expense. There were no material accruals for interest for the three and six months ended June 30, 2014. During the six months ended June 30, 2014, interest and penalties decreased by approximately $0.1 million during the first quarter of 2014 as a result of the expiration of the statute of limitations related to foreign taxes. As of June 30, 2014, ILG had accrued $0.3 million for interest and 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 and other tax credits. 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, IAC indemnifies ILG for all consolidated tax liabilities and related interest and penalties for the pre-spin period. During 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%, 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. The change in the corporate tax rate initially negatively impacted income tax expense as the future benefit expected to be realized from our U.K. net deferred tax assets decreased; however, going forward, the lower corporate tax rate will decrease income tax expense and favorably impact our effective tax rate. 49 -------------------------------------------------------------------------------- FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES As of June 30, 2014, we had $74.6 million of cash and cash equivalents, including $57.2 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, $41.2 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 six months ended June 30, 2014 and, as of June 30, 2014, 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 $600 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 Operating Activities Net cash provided by operating activities decreased to $55.7 million in the six months ended June 30, 2014 from $61.3 million in the same period of 2013. The decrease of $5.5 million from 2013 was principally due to payments made in connection with long-term agreements in the first quarter of 2014, as well as higher cash disbursements, including a $1.2 million contingent consideration payment, partly offset by higher cash receipts. Investing Activities Net cash used in investing activities of $9.9 million in the six months ended June 30, 2014 pertain to capital expenditures of $9.1 million primarily related to IT initiatives, and to an investment in loan receivable of $0.8 million. Net cash provided by investing activities of $3.3 million in the six months ended June 30, 2013 primarily related to the early repayment of an existing loan receivable totaling $9.9 million, partly offset by capital expenditures of $6.6 million primarily related to IT initiatives. Financing Activities Net cash used in financing activities of $19.5 million in the six months ended June 30, 2014 primarily related to cash dividend payments of $12.7 million, repurchases of our common stock which settled during the year at market prices totaling $11.0 million (including commissions), withholding taxes on the vesting of restricted stock units of $4.0 million, payment of $1.8 million of debt issuance costs related to the amendment of our credit facility in April 2014, and $7.3 million of contingent consideration payments relating to acquisitions. These uses of cash were partially offset by $15.0 million of net borrowings on our revolving credit facility, excess tax benefits from stock-based awards, and the proceeds from the exercise of stock options. Net cash used in financing activities of $52.8 million in the six months ended June 30, 2013 primarily related to principal payments of $45.0 million on our revolving credit facility, $6.3 million of dividends paid, and withholding taxes on the vesting of restricted stock units. These uses of cash were partially offset by excess tax benefits from stock-based awards and the proceeds from the exercise of stock options. 50 -------------------------------------------------------------------------------- On April 8, 2014, we entered into the first amendment to our amended and restated credit agreement which increases the revolving line of credit from $500 million to $600 million, extends the maturity of the credit facility to April 8, 2019 and provides for certain other amendments to covenants. The terms related to interest rates and commitment fees remain unchanged. As of June 30, 2014, borrowings outstanding under the revolving credit facility amounted to $268 million. 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 our leverage ratio. As of June 30, 2014, 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 based on our leverage ratio and as of June 30, 2014, 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. Additionally, we were required to maintain a minimum consolidated interest coverage ratio of consolidated EBITDA over consolidated interest expense, as defined in the Amended Credit Agreement. Currently, the maximum consolidated leverage ratio is 3.5x and the minimum consolidated interest coverage ratio is 3.0x. As of June 30, 2014, 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 1.43 and 33.08, respectively. Free Cash Flow Free cash flow is a non-GAAP measure and is defined in "ILG's Principles of Financial Reporting." For the six months ended June 30, 2014 and 2013, free cash flow was $46.5 million and $54.7 million, respectively. The change is mainly a result of the variances in net cash provided by operating activities and capital expenditures as discussed above. Dividends and Share Repurchases In February 2014 and May 2014, our Board of Directors declared a quarterly dividend of $0.11 per share for shareholders of record on March 13, 2014 and June 4, 2014, respectively. On each of March 27, 2014 and June 18, 2014, a cash dividend of $6.3 million was paid. Based on the number of shares of common stock outstanding as of March 31, 2014, at a dividend of $0.11 per share, the anticipated cash outflow would be $6.3 million in the third quarter of 2014. In August 2014, our Board of Directors declared a $0.11 per share dividend payable September 17, 2014 to shareholders of record on September 3, 2014. Additionally, effective August 3, 2011 and June 4, 2014, ILG's Board of Directors authorized a share repurchase program for up to $25.0 million and $20.0 million, respectively, excluding commissions, of our outstanding common stock. During the six months ended June 30, 2014, we repurchased 0.2 million shares of common stock for $4.1 million, including commissions, under the 51-------------------------------------------------------------------------------- August 2011 repurchase program, and 0.4 million shares of common stock for $9.5 million, including commissions, under the June 2014 repurchase program. As of June 30, 2014, the remaining availability for future repurchases of our common stock was $10.5 million. 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 June 30, 2014, guarantees, surety bonds and letters of credit totaled $23.0 million. The total includes maximum exposure under guarantees of $20.4 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 June 30, 2014, 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 for which they are subsequently reimbursed. As such, we are the primary obligor and may be liable for unreimbursed costs. As of June 30, 2014, amounts pending reimbursements are not significant. Contractual obligations and commercial commitments at June 30, 2014 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) $ 268,000 $ - $ 268,000 $ - $ - Debt interest(a) 25,855 5,418 10,836 9,601 - Purchase obligations(b) 79,721 13,821 24,423 27,285 14,192 Operating leases 61,348 13,028 20,729 14,895 12,696 Unused commitment on loans receivable and other advances(c) 15,147 15,147 - - - Total contractual obligations $ 450,071 $ 47,414 $ 323,988 $ 51,781 $ 26,888 -------------------------------------------------------------------------------- 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 June 30, 2014. 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 June 30, 2014. Interest on the revolving credit facility is calculated using the prevailing rates as of June 30, 2014. On April 8, 2014, our revolving credit facility was amended to increase the borrowing capacity from $500 million to $600 million and to extend the maturity of the credit facility to April 8, 2019. 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. º (c) º Relates to a loan agreement entered into in connection with the VRI Europe transaction whereby ILG has made available to CLC a convertible secured loan facility of $15.1 million. 52 -------------------------------------------------------------------------------- Amount of Commitment Expiration Per Period Total Amounts Less than More than Other Commercial Commitments(d) Committed 1 Year 1 - 3 Years 3 - 5 Years 5 Years (In thousands) Guarantees, surety bonds and letters of credit $ 22,950 $ 13,068 $ 7,409 $ 2,368 $ 105 -------------------------------------------------------------------------------- º (d) 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 June 30, 2014, 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. 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. We have discussed those estimates that we believe are critical and required the use of significant judgment and use of estimates that could have a significant impact on our financial statements in our 2013 Annual Report on Form 10-K. There have been no material changes to our critical accounting policies in the interim period. 53 -------------------------------------------------------------------------------- ILG'S PRINCIPLES OF FINANCIAL REPORTINGDefinition 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. Adjusted net income is defined as net income attributable to common stockholders, excluding the impact of (1) acquisition related and restructuring costs, (2) other non-operating foreign currency remeasurements, (3) correcting an immaterial prior period net understatement in the prior period financials, and (4) other special items, as applicable. Adjusted earnings per share (EPS) is defined as adjusted net income divided by the weighted average number of shares of common stock outstanding during the period for basic EPS and, additionally, inclusive of dilutive securities for diluted EPS. 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. 54 -------------------------------------------------------------------------------- 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. 55-------------------------------------------------------------------------------- |