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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 2008
Or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
 
Commission File Number: 001-33738
 
MORGANS HOTEL GROUP CO.
(Exact name of registrant as specified in its charter)
     
Delaware   16-1736884
(State or other jurisdiction of   (I.R.S. employer
incorporation or organization)   identification no.)
     
475 Tenth Avenue    
New York, New York   10018
(Address of principal executive offices)   (Zip Code)
212-277-4100
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o   Accelerated filer þ   Non-accelerated filer o   Smaller reporting company o
        (Do not check if a smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The number of shares outstanding of the registrant’s common stock, par value $0.01 per share, as of November 7, 2008 was 29,397,841.
 
 

 

 


 

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 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

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FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for “forward-looking statements” made by or on behalf of a company. We may from time to time make written or oral statements that are “forward-looking,” including statements contained in this report and other filings with the Securities and Exchange Commission and in reports to our stockholders. These forward-looking statements reflect our current views about future events and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ materially from those expressed in any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Important risks and factors that could cause our actual results to differ materially from any forward-looking statements include, but are not limited to, the risks discussed in the Company’s Annual Report on Form 10-K under the section titled “Risk Factors” and in this Quarterly Report on Form 10-Q under the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; downturns in economic and market conditions, particularly levels of spending in the business, travel and leisure industries; hostilities, including future terrorist attacks, or fear of hostilities that affect travel; risks related to natural disasters, such as earthquakes and hurricanes; risks associated with the acquisition, development and integration of properties; the seasonal nature of the hospitality business; changes in the tastes of our customers; increases in real property tax rates; increases in interest rates and operating costs; the impact of any material litigation; the loss of key members of our senior management; general volatility of the capital markets and our ability to access the capital markets; and changes in the competitive environment in our industry and the markets where we invest.
We are under no duty to update any of the forward-looking statements after the date of this report to conform these statements to actual results.

 

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PART I—FINANCIAL INFORMATION
Item 1. Financial Statements
Morgans Hotel Group Co.
Consolidated Balance Sheets
(in thousands, except share data)
                 
    September 30,     December 31,  
    2008     2007  
    (unaudited)        
Assets
               
Property and equipment, net
  $ 569,742     $ 535,609  
Goodwill
    73,698       73,698  
Investments in and advances to unconsolidated joint ventures
    85,081       110,208  
Cash and cash equivalents
    59,683       122,712  
Restricted cash
    30,772       28,604  
Accounts receivable, net
    9,865       10,333  
Related party receivables
    5,851       3,422  
Prepaid expenses and other assets
    9,821       11,369  
Deferred income taxes
    28,190       27,636  
Other, net
    16,211       19,532  
 
           
Total assets
  $ 888,914     $ 943,123  
 
           
Liabilities and Stockholders’ Equity
               
Long-term debt and capital lease obligations
  $ 730,070     $ 729,199  
Accounts payable and accrued liabilities
    21,423       36,126  
Other liabilities
    25,809       27,979  
 
           
Total liabilities
    777,302       793,304  
Minority interest
    19,030       19,833  
Commitments and contingencies Common stock, $.01 par value; 200,000,000 shares authorized; 36,277,495 shares issued at September 30, 2008 and December 31, 2007, respectively
    363       363  
Treasury stock, at cost, 5,388,056 and 3,057,581 shares of common stock at September 30, 2008 and December 31, 2007, respectively
    (87,439 )     (54,361 )
Additional paid-in capital
    228,838       216,494  
Comprehensive income
    (7,736 )     (7,771 )
Accumulated deficit
    (41,444 )     (24,739 )
 
           
Stockholders’ equity
    92,582       129,986  
 
           
Total liabilities and stockholders’ equity
  $ 888,914     $ 943,123  
 
           
See accompanying notes to consolidated financial statements.

 

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Morgans Hotel Group Co.
Consolidated Statements of Operations and Comprehensive Income (Loss)
(in thousands, except share data)
(unaudited)
                                 
    Three Months     Three Months     Nine Months     Nine Months  
    Ended     Ended     Ended     Ended  
    Sept. 30, 2008     Sept. 30, 2007     Sept. 30, 2008     Sept. 30, 2007  
Revenues
                               
Rooms
  $ 45,500     $ 39,974     $ 138,521     $ 132,502  
Food and beverage
    23,269       24,221       76,392       76,572  
Other hotel
    3,133       3,182       9,957       10,425  
 
                       
Total hotel revenues
    71,902       67,377       224,870       219,499  
Management fee-related parties and other income
    5,799       4,721       14,887       13,691  
 
                       
Total revenues
    77,701       72,098       239,757       233,190  
Operating Costs and Expenses
                               
Rooms
    12,097       11,061       37,162       36,044  
Food and beverage
    16,817       16,185       54,538       50,977  
Other departmental
    1,792       1,846       5,801       5,816  
Hotel selling, general and administrative
    15,003       13,742       45,375       43,845  
Property taxes, insurance and other
    5,447       3,534       13,229       13,490  
 
                       
Total hotel operating expenses
    51,156       46,368       156,105       150,172  
Corporate expense
    12,355       18,115       35,002       36,729  
Depreciation and amortization
    7,587       5,055       19,696       14,739  
 
                       
Total operating costs and expenses
    71,098       69,538       210,803       201,640  
Operating income
    6,603       2,560       28,954       31,550  
Interest expense, net
    10,222       10,690       31,053       32,504  
Equity in loss of unconsolidated joint ventures
    7,617       5,931       16,526       12,867  
Minority interest in consolidated joint ventures
    683       461       3,282       2,583  
Other non-operating expenses (income)
    3,473       3,228       5,940       (888 )
 
                       
Loss before income tax expense and minority interest
    (15,392 )     (17,750 )     (27,847 )     (15,516 )
Income tax benefit
    (6,109 )     (7,415 )     (10,621 )     (6,498 )
 
                       
Loss before minority interest
    (9,283 )     (10,335 )     (17,226 )     (9,018 )
Minority interest
    (284 )     (314 )     (520 )     (274 )
 
                       
Net loss
  $ (8,999 )   $ (10,021 )   $ (16,706 )   $ (8,744 )
 
                       
Other comprehensive income (loss)
                               
Unrealized (loss) gain on interest rate swap, net of tax
  $ (748 )   $ (7,327 )   $ 388     $ (3,844 )
Foreign currency translation (loss) gain
    (388 )     117       (353 )     183  
 
                       
Comprehensive loss
  $ (10,135 )   $ (17,231 )   $ (16,671 )   $ (12,405 )
 
                       
Loss per share:
                               
Basic and diluted
  $ (0.29 )   $ (0.29 )   $ (0.52 )   $ (0.27 )
Weighted average number of common shares outstanding:
                               
Basic and Diluted
    31,231       34,068       31,953       32,771  
See accompanying notes to consolidated financial statements.

 

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Morgans Hotel Group Co.
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
                 
    Nine Months     Nine Months  
    Ended     Ended  
    Sept. 30, 2008     Sept. 30, 2007  
Cash flows from operating activities
               
Net loss
  $ (16,706 )   $ (8,744 )
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation
    19,159       14,285  
Amortization of other costs
    537       454  
Amortization of deferred financing costs
    2,106       1,526  
Stock based compensation
    12,130       16,068  
Accretion of interest on capital lease obligation
    1,114       671  
Equity in loss from unconsolidated joint ventures
    16,526       12,867  
Write off of development costs
    503        
Loss on disposal of property and equipment
    2,086       695  
Deferred income taxes
    (10,621 )     (13,434 )
Change in value of interest rate caps and swaps, net
          3,018  
Minority interest
    2,762       (703 )
Changes in assets and liabilities:
               
Accounts receivable, net
    468       (695 )
Related party receivables
    (2,428 )     (1,108 )
Restricted cash
    (4,616 )     (2,985 )
Prepaid expenses and other assets
    849       (3,549 )
Accounts payable and accrued liabilities
    (3,536 )     10,431  
Other liabilities
    (721 )     (904 )
 
           
Net cash provided by operating activities
    19,612       27,893  
 
           
Cash flows from investing activities
               
Additions to property and equipment
    (55,377 )     (42,866 )
Withdrawals from (deposits into) capital improvement escrows, net
    2,449       (845 )
Return of investment from unconsolidated joint ventures
    30,670       12,690  
Investments in unconsolidated joint ventures
    (23,656 )     (46,693 )
 
           
Net cash used in investing activities
    (45,914 )     (77,714 )
 
           
Cash flows from financing activities
               
Proceeds from long-term debt
          67,673  
Payments on long-term debt and capital lease obligations
    (244 )     (40,394 )
Cash paid in connection with vesting of stock based awards
    (84 )     (3 )
Proceeds from issuance of common stock, net of costs
          59,518  
Repurchase of Company’s common stock
    (33,654 )     (21,587 )
Distributions to holders of minority interest in consolidated subsidiaries
    (2,692 )      
Financing costs
    (53 )     (175 )
 
           
Net cash (used in) provided by financing activities
    (36,727 )     65,032  
 
           
Net (decrease) increase cash and cash equivalents
    (63,029 )     15,211  
Cash and cash equivalents, beginning of period
    122,712       27,549  
 
           
Cash and cash equivalents, end of period
  $ 59,683     $ 42,760  
 
           
Supplemental disclosure of cash flow information
               
Cash paid for interest
  $ 26,137     $ 28,401  
 
           
Cash paid for taxes
  $ 1,198     $ 1,197  
 
           
See accompanying notes to consolidated financial statements.

 

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Morgans Hotel Group Co.
Notes to Consolidated Financial Statements
1. Organization and Formation Transaction
Morgans Hotel Group Co. (the “Company”) was incorporated on October 19, 2005 as a Delaware corporation to complete an initial public offering (“IPO”) that was part of the formation and structuring transactions described below. The Company operates, owns, acquires and redevelops hotel properties.
The Morgans Hotel Group Co. predecessor (the “Predecessor”) comprised the subsidiaries and ownership interests that were contributed as part of the formation and structuring transactions from Morgans Hotel Group LLC, now known as Residual Hotel Interest LLC (“Former Parent”), to Morgans Group LLC, our operating company. The Former Parent was owned approximately 85% by NorthStar Hospitality, LLC, a subsidiary of NorthStar Capital Investment Corp. (“NorthStar”), and approximately 15% by RSA Associates, L.P.
In connection with the IPO, the Former Parent contributed the subsidiaries and ownership interests in nine operating hotels in the United States and the United Kingdom to Morgans Group LLC in exchange for membership units. Simultaneously, Morgans Group LLC issued additional membership units to the Predecessor in exchange for cash raised by the Company from the IPO. The Former Parent also contributed all the membership interests in its hotel management business to Morgans Group LLC in return for 1,000,000 membership units in Morgans Group LLC exchangeable for shares of the Company’s common stock. The Company is the managing member of Morgans Group LLC, and has full management control. On April 24, 2008, 45,935 outstanding membership units in Morgans Group LLC were redeemed in exchange for 45,935 shares of the Company’s common stock. As of September 30, 2008, 954,065 membership units in Morgans Group LLC remain outstanding.
On February 17, 2006, the Company completed its IPO. The Company issued 15,000,000 shares of common stock at $20 per share resulting in net proceeds of approximately $272.5 million, after underwriters’ discounts and offering expenses. On February 17, 2006, the Company paid down $294.6 million of long-term debt which included principal and interest, and paid in full the preferred equity in Clift due a related party of $11.4 million, which included outstanding interest and distributed $9.5 million to certain stockholders.
These financial statements have been presented on a consolidated basis and reflect the Company’s assets, liabilities and results from operations. The assets and liabilities are presented at the historical cost of the Former Parent. The equity method of accounting is utilized to account for investments in joint ventures over which the Company has significant influence, but not control.
The Company has one reportable operating segment; it operates, owns, acquires and redevelops boutique hotels.
Operating Hotels
The Company’s operating hotels as of September 30, 2008 are as follows:
                     
        Number of        
Hotel Name   Location   Rooms     Ownership  
Delano Miami
  Miami Beach, FL     194       (1 )
Hudson
  New York, NY     807       (5 )
Mondrian Los Angeles
  Los Angeles, CA     237       (1 )
Morgans
  New York, NY     113       (1 )
Royalton
  New York, NY     168       (1 )
Sanderson
  London, England     150       (2 )
St Martins Lane
  London, England     204       (2 )
Shore Club
  Miami Beach, FL     309       (3 )
Clift
  San Francisco, CA     363       (4 )
Mondrian Scottsdale
  Scottsdale, AZ     194       (1 )
Hard Rock Hotel & Casino
  Las Vegas, NV     646       (6 )
 
     
(1)  
Wholly-owned hotel.
 
(2)  
Owned through a 50/50 unconsolidated joint venture.

 

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(3)  
Operated under a management contract, with an unconsolidated minority ownership interest of approximately 7%.
 
(4)  
The hotel is operated under a long-term lease, which is accounted for as a financing.
 
(5)  
The hotel is structured as a condominium, in which the Company owns approximately 96% of the square footage of the entire building.
 
(6)  
Operated under a management contract and owned through an unconsolidated joint venture, of which the Company owned approximately 20.5% at September 30, 2008 based on cash contributions.
Restaurant Joint Venture
The food and beverage operations of certain of the hotels are operated under a 50/50 joint venture with a third party restaurant operator.
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The Company consolidates all wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Financial Accounting Standards Board (“FASB”) Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51, as amended (“FIN 46R”), requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Pursuant to FIN 46R, the Company consolidates five ventures that provide food and beverage services at the Company’s hotels as the Company absorbs a majority of the ventures’ expected losses and residual returns. FIN 46R has been applied retroactively. These services include operating restaurants including room service at five hotels, banquet and catering services at four hotels and a bar at one hotel. No assets of the Company are collateral for the venturers’ obligations and creditors of the venturers have no recourse to the Company.
Derivative Instruments and Hedging Activities
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted (“SFAS No. 133”), establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As required by SFAS No. 133, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. The Company assesses the effectiveness of each hedging relationship by comparing the changes in fair value or cash flows of the derivative hedging instrument with the changes in fair value or cash flows of the designated hedged item or transaction.

 

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The Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements or other identified risks. To accomplish this objective, the Company primarily uses interest rate swaps and caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. During 2008, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt.
The Company has interest rate caps that are not designated as hedges. These derivatives are not speculative and are used to manage the Company’s exposure to interest rate movements and other identified risks, but the Company has elected not to designate these instruments in hedging relationships based on the provisions in SFAS No. 133. The changes in fair value of derivatives not designated in hedging relationships have been recognized in earnings.
A summary of the Company’s derivative and hedging instruments that have been recognized in earnings as of September 30, 2008 and December 31, 2007 is as follows (in thousands):
                                         
                            Estimated     Estimated  
                            Fair Market     Fair Market  
                            Value at     Value at  
        Type of   Maturity     Strike     September 30,     December 31,  
Notional Amount     Instrument   Date     Rate     2008     2007  
$ 285,000    
Sold interest cap
  July 9, 2010       4.25 %   $ (878 )   $ (1,793 )
  285,000    
Interest cap
  July 15, 2010       4.25 %     907       1,831  
  85,000    
Interest cap
  July 15, 2010       7.00 %     19       15  
  85,000    
Sold interest cap
  July 15, 2010       7.00 %     (22 )     (15 )
       
 
                           
Fair value of derivative instruments not designated as hedges 
                      $ 26     $ 38  
       
 
                           
A summary of the Company’s derivative instruments that have been designated as hedges under SFAS No. 133 as of September 30, 2008 and December 31, 2007 is as follows (in thousands):
                                         
                            Estimated     Estimated  
                            Fair Market     Fair Market  
                            Value at     Value at  
        Type of   Maturity     Strike     September 30,     December 31,  
Notional Amount     Instrument   Date     Rate     2008     2007  
$ 285,000    
Interest swap
  July 9, 2010       5.04 %   $ (8,846 )   $ (9,409 )
  85,000    
Interest swap
  July 15, 2010       4.91 %     (2,493 )     (2,537 )
  18,000    
Interest swap
  June 1, 2009       6.00 %            
  22,000    
Interest swap
  June 1, 2009       6.00 %            
       
 
                           
Fair value of derivative instruments designated as effective hedges
                      $ (11,339 )   $ (11,946 )
                                 
Total fair value of derivative instruments 
                      $ (11,313 )   $ (11,908 )
       
 
                           
Total fair value included in other assets 
                      $ 925     $ 1,846  
       
 
                           
Total fair value included in other liabilities
                      $ (12,238 )   $ (13,754 )
       
 
                           
On January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.

 

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SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which is typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
Currently, the Company uses interest rate caps and interest rate swaps to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. To comply with the provisions of SFAS No. 157, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.
Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2008, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the total value of the interest rate caps and swaps valued under SFAS No. 157 included in other assets is approximately $0.9 million and the amounts included in other liabilities is approximately $12.2 million as of September 30, 2008.
Stock-based Compensation
The Company accounts for stock based employee compensation using the fair value method of accounting described in SFAS No. 123R, Accounting for Stock-Based Compensation (“SFAS No. 123”) (as amended by SFAS No. 148 and SFAS No. 123(R)). For share grants, total compensation expense is based on the price of the Company’s stock at the grant date. For option grants, the total compensation expense is based on the estimated fair value using the Black-Scholes option-pricing model. Compensation expense is recorded ratably over the vesting period, if any.
Income (Loss) Per Share
Basic net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders, less any dividends on unvested restricted common stock, by the weighted-average number of common stock outstanding during the period. Diluted net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders, less dividends on unvested restricted common stock, by the weighted-average number of common stock outstanding during the period, plus other potentially dilutive securities, such as unvested shares of restricted common stock and warrants.

 

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Minority Interest
The percentage of membership units in Morgans Group LLC, our operating company, owned by the Former Parent is presented as minority interest in Morgans Group LLC in the consolidated balance sheet and was approximately $17.9 million as of September 30, 2008 and $19.2 million as of December 31, 2007. The minority interest in Morgans Group LLC is (i) increased or decreased by the limited members’ pro rata share of Morgans Group LLC’s net income or net loss, respectively; (ii) decreased by distributions; (iii) decreased by redemptions of membership units for the Company’s common stock; and (iv) adjusted to equal the net equity of Morgans Group LLC multiplied by the limited members’ ownership percentage immediately after each issuance of units of Morgans Group LLC and/or shares of the Company’s common stock and after each purchase of treasury stock through an adjustment to additional paid-in capital. Net income or net loss allocated to the minority interest in Morgans Group LLC is based on the weighted-average percentage ownership throughout the period.
Additionally, $1.1 million and $0.6 million was recorded as minority interest as of September 30, 2008 and December 31, 2007, respectively, which represents our third-party food and beverage joint venture partner’s interest in the restaurant venture at certain of our hotels.
New Accounting Pronouncements
On February 15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”). This statement permits companies to make a one-time election to carry eligible types of financial assets and liabilities at fair value, even if fair value measurement is not required under GAAP. SFAS No. 159 must be applied prospectively, and the effect of the first re-measurement to fair value, if any, should be reported as a cumulative effect adjustment to the opening balance of retained earnings. SFAS No. 159 was effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 had no material impact on the Company’s consolidated financial statements as the Company did not elect the fair value measurement option for any of its financial assets or liabilities.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (“SFAS No. 160”) which, among other things, provides guidance and establishes amended accounting and reporting standards for a parent company’s noncontrolling or minority interest in a subsidiary and the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. The Company is currently evaluating the impact of adopting the Statement.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS No. 141R”), which replaces SFAS No. 141. SFAS No. 141R, among other things, establishes principles and requirements for how an acquirer entity recognizes and measures in its financial statements the identifiable assets acquired (including intangibles), the liabilities assumed and any noncontrolling interest in the acquired entity. Additionally, SFAS No. 141R requires that all transaction costs of a business acquisition will be expensed as incurred. SFAS No. 141R is effective for fiscal years beginning on or after December 15, 2008. Adoption is prospective and early adoption is not permitted. This Statement will only have an impact on our consolidated financial statements if we are involved in a business acquisition in fiscal year 2009 or later years.
In February 2008, the FASB issued Staff Position No. FAS 157-2 which provides for a one-year deferral of the effective date of SFAS No. 157 for non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133 (“SFAS No. 161”). SFAS No.161 requires enhanced disclosures related to derivative and hedging activities and thereby seeks to improve the transparency of financial reporting. Under SFAS No. 161, entities are required to provide enhanced disclosure related to (i) how and why an entity uses derivative instruments; (ii) how derivative instruments and related hedge items are accounted for under SFAS No.133, Accounting for Derivative Instruments and Hedging Activities, and its related interpretations; and (iii) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No.161 must be applied prospectively to all derivative instruments and non-derivative instruments that are designated and qualify as hedging instruments and related hedged items accounted for under SFAS No. 133 for all financial statements issued for fiscal years and interim period beginning after November 15, 2008 with early application encouraged. We are currently evaluating the impact that SFAS No. 161 will have on the Company’s financial statements.

 

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In May 2008, the FASB issued FASB Staff Position No. APB 14-1 (“FSP APB 14-1”) which clarifies the accounting for the Company’s convertible notes payable. FSP APB 14-1 requires the initial debt proceeds from the sale of the Company’s convertible notes to be allocated between a liability component and an equity component. The resulting debt discount must be amortized over the period the debt is expected to remain outstanding as additional interest expense. FSP APB 14-1 will require retroactive application to all periods presented and would be effective for fiscal years beginning after December 15, 2008. The FSP APB 14-1 is effective for us as of January 1, 2009 and early adoption is not permitted. The Company is currently evaluating the impact that FSP APB 14-1 will have on its consolidated financial statements once adopted.
In October 2008, the FASB issued FASB Staff Position No. FAS 157-3 which clarifies the application of FASB Statement No. 157, Fair Value Measurements. Staff Position No. FAS 157-3 provides guidance in determining the fair value of a financial asset when the market for that financial asset is not active.
Reclassifications
Certain prior year financial statement amounts have been reclassified to conform to the current year presentation.
3. Income (Loss) Per Share
Basic earnings per share is calculated based on the weighted average number of common stock outstanding during the period. Diluted earnings per share include the effect of potential shares outstanding, including dilutive securities. Potential dilutive securities may include shares and options granted under the Company’s stock incentive plan and membership units in Morgans Group LLC, which may be exchanged for shares of the Company’s common stock under certain circumstances. The 954,065 outstanding Morgans Group LLC membership units (which may be converted to common stock) at September 30, 2008 have been excluded from the diluted net income (loss) per common share calculation, as there would be no effect on reported diluted net income (loss) per common share. All unvested restricted stock units, LTIP Units (as defined in Note 7), stock options and contingent convertible Notes (as defined in Note 6) are excluded from loss per share as they are anti-dilutive.
The table below details the components of the basic and diluted loss per share calculations (in thousands, except for per share data):
                                                 
    Three months ended     Nine months ended  
    September 30, 2008     September 30, 2008  
            Weighted                     Weighted        
            Average     EPS             Average     EPS  
    Loss     Shares     Amount     Loss     Shares     Amount  
Basic loss per share
  $ (8,999 )     31,231     $ (0.29 )   $ (16,706 )     31,953     $ (0.52 )
Effect of dilutive stock compensation
                                   
 
                                   
Diluted loss per share
  $ (8,999 )     31,231     $ (0.29 )   $ (16,706 )     31,953     $ (0.52 )
 
                                   
On July 1, 2008, the Company’s Board of Directors authorized the repurchase of up to $30.0 million of the Company’s common stock, or approximately 9% of its outstanding shares based on the then current market price. The Company repurchased its stock through the open market or in privately negotiated transactions. The timing and actual number of shares repurchased depended on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. As of October 9, 2008, the Company had completed this share repurchase program and purchased 2,794,653 shares for approximately $30.0 million. This repurchase authorization was in addition to the $75.0 million that was previously authorized by our Board of Directors under separate plans in 2006 and 2007. The Company repurchased a total of 4,277,412 shares for approximately $74.8 million under these previous plans which have expired or been fully utilized.

 

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4. Investments in and Advances to Unconsolidated Joint Ventures
The Company’s investments in and advances to unconsolidated joint ventures and its equity in earnings (losses) of unconsolidated joint ventures are summarized as follows (in thousands):
Investments
                 
    As of     As of  
    September 30,     December 31,  
Entity   2008     2007  
Morgans Hotel Group Europe Ltd.
  $ 13,987     $ 13,679  
Restaurant Venture — SC London
    (957 )     (479 )
Mondrian South Beach
    17,328       13,373  
Hard Rock Hotel & Casino
    21,116       36,767  
Shore Club
    57       57  
Echelon Las Vegas
    17,366       40,826  
Mondrian SoHo
    6,563       5,051  
Mondrian Chicago
    2,471       834  
Ames Boston
    7,049       834  
Other
    101       100  
 
           
Total
  $ 85,081     $ 110,208  
 
           
Equity in income (losses) from unconsolidated joint ventures
                                 
    Three Months     Three Months     Nine Months     Nine Months  
    Ended     Ended     Ended     Ended  
    Sept. 30, 2008     Sept. 30, 2007     Sept. 30, 2008     Sept. 30, 2007  
Morgans Hotel Group Europe Ltd.
  $ (2,527 )   $ (1,254 )   $ 897     $ 1,991  
Restaurant Venture — SC London
    (131 )     (42 )     184       (529 )
Mondrian South Beach
    (369 )     (151 )     (1,083 )     (2,194 )
Hard Rock Hotel & Casino
    (4,468 )     (4,486 )     (15,796 )     (12,141 )
Echelon Las Vegas
    (124 )           (735 )      
Other
    2       2       7       6  
 
                       
Total
  $ (7,617 )   $ (5,931 )   $ (16,526 )   $ (12,867 )
 
                       
Morgans Hotel Group Europe Limited
As of September 30, 2008, the Company owned interests in two hotels in London, England, St Martins Lane, a 204-room hotel, and Sanderson, a 150-room hotel, through a 50/50 joint venture known as Morgans Hotel Group Europe Limited (“Morgans Europe”) with Walton MG London Investors V, L.L.C.
Under a management agreement with Morgans Europe, the Company earns management fees and a reimbursement for allocable chain service and technical service expenses. The Company is also entitled to an incentive management fee and a capital incentive fee. The Company did not earn any incentive fees during the nine months ended September 30, 2008 or 2007.
Net income or loss and cash distributions or contributions are allocated to the partners in accordance with ownership interests. The Company accounts for this investment under the equity method of accounting.
Mondrian South Beach
On August 8, 2006, the Company entered into a 50/50 joint venture (the “South Beach Venture”) with an affiliate of Hudson Capital. The South Beach Venture is renovating and converting an apartment building on Biscayne Bay in South Beach Miami into a condominium hotel operated under the Company’s Mondrian brand. The Company expects to operate Mondrian South Beach under a long-term incentive management contract. The hotel, which is scheduled to open in December 2008, expects to have approximately 330 units comprised of studios, one and two-bedroom units, and four penthouse suites.

 

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The South Beach Venture acquired the existing building and land for a gross purchase price of $110.0 million. The South Beach Venture expects that ongoing renovations will cost a total of approximately $130.0 million. An initial equity investment of $15.0 million from each of the Company and Hudson Capital was funded at closing. Additionally, the South Beach Venture received financing of approximately $124.0 million at a rate of LIBOR, based on the rate set date, plus 300 basis points, or 5.5% at September 30, 2008. The South Beach Venture has paid down a portion of this debt with proceeds obtained from condominium sales. The balance of this loan at September 30, 2008 was $87.9 million. This loan matures in August 2009.
During the nine months ended September 30, 2008, the Company and Hudson Capital each funded an additional $5.3 million of equity. Further, in April 2008, the South Beach Venture obtained a mezzanine loan of $28.0 million bearing interest at LIBOR, based on the rate set date, plus 600 basis points, or 8.5% at September 30, 2008. The mezzanine loan also matures in August 2009.
The South Beach Venture is in the process of selling units as condominiums, subject to market conditions. The South Beach Venture anticipates that unit buyers will have the opportunity to place their units into the hotel’s rental program. In addition to hotel management fees, the Company could also realize fees from the sale of condominium units.
Hard Rock Hotel & Casino
On May 11, 2006, the Company and its wholly-owned subsidiary, MHG HR Acquisition Corp. (“Acquisition Corp”), entered into an Agreement and Plan of Merger with Hard Rock Hotel, Inc. (“HRH”) pursuant to which the Acquisition Corp agreed to acquire HRH in an all cash merger (the “Merger”). Additionally, an affiliate of the Company entered into several asset purchase agreements with HRH or affiliates of HRH to acquire a development land parcel adjacent to the Hard Rock Hotel & Casino in Las Vegas (“Hard Rock”) and certain intellectual property rights related to the Hard Rock (such asset purchases, together with the Merger, the “Transactions”). The aggregate consideration for the Transactions was $770.0 million.
On November 7, 2006, the Company entered into a definitive agreement with an affiliate of DLJ Merchant Banking Partners (“DLJMB”), as amended in December 2006, under which DLJMB and the Company agreed to form a joint venture in connection with the acquisition and development of the Hard Rock. The joint venture agreement included certain affiliates of DLJMB and Morgans Group LLC as additional members. DLJMB and such affiliates are referred to as the DLJMB Parties. The Company and Morgans Group LLC are referred to as the Morgans Parties.
The closing of the Transactions and completion of the Merger occurred on February 2, 2007. The Morgans Parties funded one-third of the equity, or approximately $57.5 million, and the DLJMB Parties funded two-thirds of the equity, or approximately $115.0 million, through a joint venture. The remainder of the $770.0 million purchase price was financed with mortgage financing under a credit agreement entered into by the joint venture. The credit agreement provides for a secured term loan facility, due in February 2010 with two one-year extension options subject to certain conditions, consisting of a $760.0 million loan for the acquisition, including $35.0 million of renovation costs, $48.2 million of financing costs and $56.3 million of cash reserves and working capital, and a loan for future expansion of the Hard Rock, discussed further below. On November 6, 2007, the joint venture entered into an amended and restated credit agreement in which the lender exercised its right to split the loan made pursuant to the original credit agreement into a mortgage loan, which is comprised of a construction loan component and an acquisition loan component, and three mezzanine loans. The proceeds of the mezzanine loans were used to prepay the acquisition loan portion of the mortgage loan made pursuant to the original credit agreement.
On June 6, 2008, the joint venture closed on the construction financing for the expansion of the Hard Rock. The construction financing consists of a construction loan of up to $620.0 million under the Hard Rock’s existing loan facility. The Morgans Parties and DLJMB Parties also amended their joint venture agreement to reflect DLJMB’s commitment to make additional capital contributions to the Hard Rock of up to $144.0 million for the expansion project and up to $110.0 million to satisfy the minimum sales price or amortization payment requirements under the loan facility relating to the approximately 15.0 acres of excess land held for sale by the Hard Rock.
As of September 30, 2008, the Company has issued approximately $11.1 million of letters of credit toward the expansion following the closing of the Transactions.

 

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On August 1, 2008, a subsidiary of the Hard Rock joint venture obtained a loan to finance $50.0 million of the $110.0 million necessary to purchase an 11-acre parcel of land located adjacent to the Hard Rock from another subsidiary of the joint venture. The loan becomes due and payable no later than the maturity date of August 9, 2009, subject to two six-month extension options, and is subject to acceleration upon the occurrence of events of default, as set forth in the loan agreement. NorthStar Realty Finance Corp. is a participant lender in the loan. In connection with the loan, Morgans Group LLC, together with DLJMB, as guarantors, entered into a non-recourse carve-out guaranty agreement in favor of Column Financial, Inc., the lender.
The DLJMB Parties contributed an aggregate of approximately $74.0 million to the Hard Rock joint venture to fund the remaining portion of the $110.0 million of proceeds necessary to complete the intercompany land purchase and to pay for all costs and expenses in connection with its closing and related financing. The proceeds from the financing, together with the equity contribution from the DLJMB Parties, were used to fully satisfy the $110.0 million amortization payment under the joint venture’s commercial mortgage backed securities loan facility.
As a result of the contributions by the DLJMB Parties, the Company holds approximately a 20.5% ownership interest in the joint venture as of September 30, 2008.
Also on August 1, 2008, the DLJMB Parties and the Morgans Parties amended the joint venture agreement. Among other things, the amended joint venture agreement clarifies certain obligations of the parties in the event that capital contributions are required for additional costs and expenses relating to the 11-acre parcel. In general, any decision to call for such additional capital contributions will be in the discretion of the Hard Rock joint venture’s board of directors. Subject to certain terms and conditions, the DLJMB Parties could also cause the joint venture to seek such additional capital contributions from third parties. However, each member that is not in default under the joint venture agreement will be given an opportunity to participate in the funding. The amended joint venture agreement also clarifies certain provisions used to calculate each member’s percentage interest in the joint venture in the event that such additional capital contributions are funded.
Under an amended property management agreement, the Company operates the hotel, retail, food and beverage, entertainment and all other businesses related to the Hard Rock, excluding the casino until March 1, 2008, as discussed below. Under the terms of the agreement, the Company receives a management fee and a chain service expense reimbursement of all non-gaming revenue including casino rents and all other rental income. The Company can also earn an incentive management fee based on EBITDA, as defined, above certain levels. The term of the management contract is 20 years with two 10-year renewals. Beginning in 2009 or 12 months following completion of the expansion, whichever is later, the Company’s management fees are subject to certain performance tests.
At the closing of the Merger and Transactions, the joint venture had entered into a lease agreement with Golden Gaming Inc. (“Golden Gaming”) to operate the casino at the Hard Rock. Under the lease, the joint venture was entitled to receive base rent plus reimbursements for certain expenses and Golden Gaming was entitled to an annual management fee. The lease agreement with Golden Gaming was terminated effective February 29, 2008 and on March 1, 2008, the Company began operating the casino at Hard Rock.
Echelon Las Vegas
In January 2006, the Company entered into a 50/50 joint venture with a subsidiary of Boyd Gaming Corporation (“Boyd”), through which the joint venture plans to develop Delano Las Vegas and Mondrian Las Vegas as part of Boyd’s Echelon project.
On August 1, 2008, Boyd announced that it will delay the entire Echelon project due to the difficult environment surrounding today’s capital markets and current economic conditions. On September 23, 2008, the Company and Boyd amended their joint venture agreement to, among other things, extend the deadline by which the joint venture must obtain construction financing for the development of Delano Las Vegas and Mondrian Las Vegas to December 31, 2009. The amended joint venture agreement also provided for the immediate return of the $30.0 million deposit the Company had provided for the project, plus interest, the elimination of the Company’s future funding obligations of approximately $41.0 million and the elimination of any obligation by the Company to provide a construction loan guaranty. The amended joint venture agreement also limits the amounts that the Company and Boyd are required to continue to fund for pre-development and related costs to approximately $0.4 million each. Each partner has the right to terminate the joint venture for any reason prior to December 31, 2009. Additionally, the terms of the management agreement, which provide for the Company to operate the joint venture hotels upon their completion, remain unchanged.

 

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Mondrian SoHo
In June 2007, the Company contributed approximately $5.0 million for a 20% equity interest in a joint venture with Cape Advisors Inc. to acquire and develop a Mondrian hotel in the SoHo neighborhood of New York City. The Mondrian SoHo is currently expected to have approximately 270 rooms, a restaurant, bar, ballroom, meeting rooms, exercise facility and a penthouse suite with outdoor space that can be used as a guest room or for private events. Upon completion, the Company is expected to operate the hotel under a 10-year management contract with two 10-year extension options.
Mondrian Chicago
In June 2007, the Company formed a joint venture with M Development to lease and develop a Mondrian hotel in Chicago. The Company has a 49% equity interest in the joint venture and expects to contribute approximately $15.0 million to the project, of which approximately $2.3 million was contributed as of September 30, 2008. The Mondrian Chicago is currently expected to have 216 rooms and feature a restaurant and bar, meeting rooms, an exercise facility, as well as outdoor food and beverage operations. Upon completion, the Company is expected to operate the hotel under a 20-year management contract with two five-year extension options.
The development of Mondrian Chicago is expected to be financed by a construction loan, which has not yet been obtained. Given the current state of the credit markets, the joint venture may not be able to obtain adequate project financing in a timely manner or at all. If adequate project financing is not obtained, the joint venture may seek additional equity investors to raise capital, limit the scope of the project, defer the project or cancel the project altogether.
Mondrian Palm Springs
On January 14, 2008, the Company announced a new joint venture with Re:Loft Partners Palm Springs, LLC to develop Palm Springs Hotel & Residences, or the Resort, in downtown Palm Springs, California. The Resort plans call for a Mondrian hotel with approximately 200 rooms, as well as residences available for sale. Upon completion, the Company expects to operate the hotel under a 10-year management contract with two five-year extension options and to have some equity ownership in the Resort.
The development of Mondrian Palm Springs is expected to be financed by a construction loan, which has not yet been obtained. Given the current state of the credit markets, the joint venture may not be able to obtain adequate project financing in a timely manner or at all. If adequate project financing is not obtained, the joint venture may seek additional equity investors to raise capital, limit the scope of the project, defer the project or cancel the project altogether.
Ames Boston
On June 17, 2008 the Company, Normandy Real Estate Partners, and Ames Hotel Partners entered into a joint venture agreement as part of the development of the Ames Boston hotel in Boston, Massachusetts, located near Government Center, Boston Common and Faneuil Hall. Upon completion, the Company expects to operate the hotel under a long-term management contract. Ames Boston is expected to open in the latter half of 2009 and to have approximately 115 guest rooms, a restaurant, bar and exercise facility.
The total development budget for the project is approximately $71.1 million with the Company committing approximately $10.0 million for a 35% interest in the joint venture. The project is expected to qualify for federal and state historic rehabilitation tax credits, which may reduce the equity investment. Normandy Real Estate Partners has closed on a development loan from UBS for up to $46.5 million.

 

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5. Other Liabilities
Other liabilities consist of the following (in thousands):
                 
    As of     As of  
    September 30,     December 31,  
    2008     2007  
Interest swap liability (Note 2)
  $ 12,238     $ 13,754  
Designer fee payable
    13,000       12,478  
Clift pre-petition liabilities
    571       1,746  
Other
          1  
 
           
 
  $ 25,809     $ 27,979  
 
           
6. Long-Term Debt and Capital Lease Obligations
Long-term debt consists of the following (in thousands):
                         
    As of     As of     Interest rate at  
    September 30,     December 31,     September 30,  
Description   2008     2007     2008  
Notes secured by Hudson and Mondrian(a)
  $ 370,000     $ 370,000     LIBOR + 1.25%
Clift debt(b)
    81,207       80,092       9.6 %
Promissory note(c)
    10,000       10,000       8.5 %
Note secured by Mondrian Scottsdale(d)
    40,000       40,000     LIBOR + 2.30%
Liability to subsidiary trust(e)
    50,100       50,100       8.68 %
Revolving credit(f)
                (f )
Convertible Notes(g)
    172,500       172,500       2.375 %
Capital lease obligations
    6,263       6,507     various  
 
                   
Total long-term debt
  $ 730,070     $ 729,199          
 
                   
(a) Mortgage Agreement — Notes secured by Hudson and Mondrian Los Angeles
On October 6, 2006, subsidiaries of the Company entered into mortgage financings, consisting of two separate mortgage loans and a mezzanine loan. These loans, a $217.0 million first mortgage note secured by Hudson, a $32.5 million mezzanine loan secured by a pledge of the equity interests in the Company’s subsidiary owning Hudson, and a $120.5 million first mortgage note secured by Mondrian Los Angeles (collectively, the “Mortgages”), all mature on July 15, 2010.
The Mortgages bear interest at a blended rate of 30-day LIBOR plus 125 basis points. The Company has the option of extending the maturity date of the Mortgages to October 15, 2011 provided that certain extension requirements are achieved, including but not limited to maintaining a debt service coverage ratio for the two fiscal quarters preceding the maturity date of 1.55 to 1.00 or greater. The Company maintains interest rate swaps that effectively fix the LIBOR rate on the debt at approximately 5.0% through the maturity date.
The Company may prepay the Mortgages in whole or in part on any business day, along with a spread maintenance premium (equal to the amount of the prepayment multiplied by the applicable LIBOR margin multiplied by the ratio of the number of months between the prepayment date and October 31, 2007 divided by 12).
The Mortgages require the Company’s subsidiary borrowers to fund reserve accounts to cover monthly debt service payments. Those subsidiary borrowers are also required to fund reserves for property, sales and occupancy taxes, insurance premiums, capital expenditures and the operation and maintenance of those hotels. Reserves are deposited into restricted cash accounts and are released as certain conditions are met. The Company’s subsidiary borrowers are not permitted to have any liabilities other than certain ordinary trade payables, purchase money indebtedness and capital lease obligations.

 

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The Mortgages prohibit the incurrence of additional debt on Hudson and Mondrian Los Angeles. Furthermore, the subsidiary borrowers (entities owning Hudson and Mondrian Los Angeles) are not permitted to incur additional mortgage debt or partnership interest debt. In addition, the Mortgages do not permit (1) transfers of more than 49% of the interests in the subsidiary borrowers, Morgans Group LLC or the Company or (2) a change in control of the subsidiary borrowers or in respect of Morgans Group LLC or the Company itself without, in each case, complying with various conditions or obtaining the prior written consent of the lender.
The Mortgages provide for events of default customary in mortgage financings, including, among others, failure to pay principal or interest when due, failure to comply with certain covenants, certain insolvency and receivership events affecting the subsidiary borrowers, Morgans Group LLC or the Company, and breach of the encumbrance and transfer provisions. In the event of a default under the Mortgages, the lender’s recourse is limited to the mortgaged property, unless the event of default results from insolvency, a voluntary bankruptcy filing or a breach of the encumbrance and transfer provisions, in which event the lender may also pursue remedies against Morgans Group LLC.
(b) Clift Debt
In October 2004, Clift Holdings LLC sold the hotel to an unrelated party for $71.0 million and then leased it back for a 99-year lease term. Under this lease, the Company is required to fund operating shortfalls including the lease payments and to fund all capital expenditures. This transaction did not qualify as a sale due to the Company’s continued involvement and therefore is treated as a financing.
The lease payment terms are as follows:
     
Years 1 and 2
  $2.8 million per annum (completed in October 2006) 
 
   
Years 3 to 10
  $6.0 million per annum 
 
   
Thereafter
  Increased at 5-year intervals by a formula tied to increases in the Consumer Price Index. At year 10, the increase has a maximum of 40% and a minimum of 20%. At each payment date thereafter, the maximum increase is 20% and the minimum is 10%.
(c) Promissory Note
The purchase of the building across the street from Delano Miami was partially financed with the issuance of a $10.0 million three-year interest only promissory note by the Company to the seller, which matures on January 24, 2009. The note bore interest at 8.5% through January 24, 2008 and currently bears interest at 10.0%. In November 2008, the Company extended the maturity of the note until January 24, 2010 and agreed to pay the 11.0% interest for the year in full at the time of the extension.
(d) Mondrian Scottsdale Debt
In May 2006, the Company obtained mortgage financing on Mondrian Scottsdale. The $40.0 million loan, which accrues interest at LIBOR plus 2.3%, matures in May 2009 and the Company has two remaining one-year extension options. These extensions are subject to certain performance tests. The Company purchased an interest rate cap which limits the interest rate exposure to 6.0%. This interest rate cap expires on June 1, 2009.
(e) Liability to Subsidiary Trust Issuing Preferred Securities
On August 4, 2006, a newly established trust formed by the Company, MHG Capital Trust I (the “Trust”), issued $50.0 million in trust preferred securities in a private placement. The Company owns all of the $0.1 million of outstanding common stock of the Trust. The Trust used the proceeds of these transactions to purchase $50.1 million of junior subordinated notes issued by the Company’s operating company and guaranteed by the Company (the “Trust Notes”) which mature on October 30, 2036. These Trust Notes represent all of the Trust’s assets. The terms of the junior subordinated notes are substantially the same as preferred securities issued by the Trust. The Trust Notes and the trust preferred securities have a fixed interest rate of 8.68% per annum during the first 10 years, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.25% per annum. The securities are redeemable by the Trust, at the Company’s option, after five years at par. To the extent the Company redeems the Trust Notes, the Trust is required to redeem a corresponding amount of trust preferred securities. The Trust Note agreement requires that the Company maintain a fixed charge coverage ratio, as defined as Consolidated EBITDA excluding Clift over consolidated interest expense excluding Clift, of not less than 1.4 to 1.0.

 

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FIN 46R requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Company has identified that the Trust is a variable interest entity under FIN 46R. Based on management’s analysis, the Company is not the primary beneficiary since it does not absorb a majority of the expected losses, nor is it entitled to a majority of the expected residual returns. Accordingly, the Trust is not consolidated into the Company’s financial statements. The Company accounts for the investment in the common stock of the Trust under the equity method of accounting.
(f) Revolving Credit Facility
On October 6, 2006, the Company and certain of its subsidiaries entered into a revolving credit facility in the initial amount of $225.0 million, which includes a $50.0 million letter of credit sub-facility and a $25.0 million swingline sub-facility (collectively, the “Revolving Credit Agreement”).
The amount available from time to time under the Revolving Credit Agreement is contingent upon the amount of an available borrowing base calculated by reference to collateral described below. The available borrowing base is currently approximately $64.0 million, but that amount may be increased up to $225.0 million at the Borrower’s (defined below) option by increasing the amount of the mortgage on Delano Miami granted by the Delano Miami mortgage lender (discussed below) and upon payment of the related additional recording tax, assuming financial ratios are maintained, as discussed below. Had the Borrower exercised this option, the available borrowing base as of September 30, 2008 (assuming an increase in the Delano Miami mortgage and payment of the related additional recording tax) would have been approximately $182.4 million, based on current covenant calculations. That availability may also be increased through procedures specified in the Revolving Credit Agreement for adding property to the borrowing base and for revaluation of the property that constitutes the borrowing base.
The commitments under the Revolving Credit Agreement terminate on October 5, 2011, at which time all outstanding amounts under the Revolving Credit Agreement will be due and payable. A subsidiary of the Company, Morgans Group LLC (the “Borrower”), may, at its option, with the prior consent of the lender and subject to customary conditions, request an increase in the aggregate commitment under the Revolving Credit Agreement to up to $350.0 million.
The interest rate per annum applicable to loans under the Revolving Credit Agreement is a fluctuating rate of interest measured by reference to, at the Company’s election, either LIBOR or a base rate, plus a borrowing margin. LIBOR loans have a borrowing margin of 1.35% to 1.90% determined based on the Borrower’s total leverage ratio (with an initial borrowing margin of 1.35%) and base rate loans have a borrowing margin of 0.35% to 0.90% determined based on the Borrower’s total leverage ratio (with an initial borrowing margin of 0.35%). The Revolving Credit Agreement also provides for the payment of a quarterly unused facility fee equal to the average daily unused amount for each quarter multiplied by 0.25%.
The Revolving Credit Agreement requires the Borrower to maintain for each four-quarter period a total leverage ratio (total consolidated indebtedness, which does not include indebtedness related to the Convertible Notes, the liability to the subsidiary trust or Clift debt to consolidated EBITDA excluding Clift) of no more than 7.0 to 1.0 at any time during 2008, and 6.0 to 1.0 at any time after December 31, 2008, and a fixed charge coverage ratio (consolidated EBITDA excluding Clift to consolidated interest expense excluding Clift) of no less than 1.75 to 1.00 at all times. Under the agreement, as of September 30, 2008, the Company’s leverage ratio was 4.6 times and its fixed charge coverage ratio was 2.4 times. The Revolving Credit Agreement contains negative covenants, subject in each case to certain exceptions, restricting incurrence of indebtedness, incurrence of liens, fundamental changes, acquisitions and investments, asset sales, transactions with affiliates and restricted payments, including, among others, a covenant prohibiting the Company from paying cash dividends on its common stock.
The Revolving Credit Agreement provides for customary events of default, including failure to pay principal or interest when due, failure to comply with covenants, any representation proving to be incorrect, defaults relating to other indebtedness of at least $10.0 million in the aggregate, certain insolvency and receivership events affecting the Company or its subsidiaries, judgments in excess of $5.0 million in the aggregate being rendered against the Company or its subsidiaries, the acquisition by any person of 40% or more of any outstanding class of capital stock having ordinary voting power in the election of directors of the Company, and the incurrence of certain ERISA liabilities in excess of $5.0 million in the aggregate.

 

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Obligations under the Revolving Credit Agreement are secured by, among other collateral, a mortgage on Delano Miami and the pledge of equity interests in the Borrower and certain subsidiaries of the Borrower, including the owners of Delano Miami, Morgans and Royalton, as well as a security interest in other significant personal property (including trademarks and other intellectual property, reserves and deposits) relating to those hotels.
The Revolving Credit Agreement is available on a revolving basis for general corporate purposes, including acquisitions. As of September 30, 2008, there were no borrowings outstanding under the Revolving Credit Agreement.
(g) October 2007 Convertible Notes Offering
On October 17, 2007, the Company issued $172.5 million aggregate principal amount of its 2.375% Senior Subordinated Convertible Notes (the “Notes”) in a private offering. Net proceeds from the offering were approximately $166.8 million.
The Notes are senior subordinated unsecured obligations of the Company and are guaranteed on a senior subordinated basis by the Company’s operating company, Morgans Group LLC. The Notes will be convertible into shares of the Company’s common stock under certain circumstances and upon the occurrence of specified events.
Interest on the Notes is payable semi-annually in arrears on April 15 and October 15 of each year, beginning on April 15, 2008, and the Notes will mature on October 15, 2014, unless previously repurchased by the Company or converted in accordance with their terms prior to such date. The initial conversion rate for each $1,000 principal amount of Notes is 37.1903 shares of the Company’s common stock, representing an initial conversion price of approximately $26.89 per share of common stock. The initial conversion rate is subject to adjustment under certain circumstances.
In connection with the issuance of the Notes, the Company entered into convertible note hedge transactions with respect to the Company’s common stock (the “Call Options”) with Merrill Lynch Financial Markets, Inc. and Citibank, N.A. (collectively, the “Hedge Providers”). The Call Options are exercisable solely in connection with any conversion of the Notes and provide for the Company to receive shares of the Company’s common stock from the Hedge Providers equal to the number of shares issuable to the holders of the Notes upon conversion. The Company paid approximately $58.2 million for the Call Options.
In connection with the sale of the Notes, the Company also entered into separate warrant transactions with Merrill Lynch Financial Markets, Inc. and Citibank, N.A., whereby the Company issued warrants (the “Warrants”) to purchase 6,415,327 shares of common stock, subject to customary anti-dilution adjustments, at an exercise price of approximately $40.00 per share of common stock. The Company received approximately $34.1 million from the issuance of the Warrants.
The Company recorded the purchase of the Call Options, net of the related tax benefit of approximately $20.3 million, as a reduction of paid-in-capital and the proceeds from the Warrants as an addition to paid-in-capital in accordance with EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock, and other relevant literature.
In February 2008, the Company filed a registration statement with the Securities and Exchange Commission to cover the resale of shares of the Company’s common stock that may be issued from time to time upon the conversion of the Notes.

 

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7. Omnibus Stock Incentive Plan
On February 9, 2006, the Board of Directors of the Company adopted the Morgans Hotel Group Co. 2006 Omnibus Stock Incentive Plan (the “2006 Stock Incentive Plan”). The 2006 Stock Incentive Plan provides for the issuance of stock-based incentive awards, including incentive stock options, non-qualified stock options, stock appreciation rights, shares of common stock of the Company, including restricted stock units (“RSUs”) and other equity-based awards, including membership units in Morgans Group LLC which are structured as profits interests (“LTIP Units”), or any combination of the foregoing. The eligible participants in the 2006 Stock Incentive Plan included directors, officers and employees of the Company. An aggregate of 3,500,000 shares of common stock of the Company were reserved and authorized for issuance under the 2006 Stock Incentive Plan, subject to equitable adjustment upon the occurrence of certain corporate events. On April 23, 2007, the Board of Directors of the Company adopted, and at the annual meeting of stockholders on May 22, 2007, the stockholders approved, the Company’s 2007 Omnibus Incentive Plan (the “2007 Incentive Plan”), which amended and restated the 2006 Stock Incentive Plan and increased the number of shares reserved for issuance under the plan by up to 3,250,000 shares to a total of 6,750,000 shares. Awards other than options and stock appreciation rights reduce the shares available for grant by 1.7 shares for each share subject to such an award. On April 10, 2008, the Board of Directors of the Company adopted, and at the annual meeting of stockholders on May 20, 2008, the stockholders approved, an amended and restated 2007 Omnibus Incentive Plan (the “Amended 2007 Incentive Plan”) which, among other things, increased the number of shares reserved for issuance under the plan by 1,860,000 shares from 6,750,000 shares to 8,610,000 shares.
In April 2008, the Company issued an aggregate of 344,217 stock options, 159,432 RSUs and 399,384 LTIPs to the Company’s executive officers and other senior executives and newly appointed non-employee directors under the 2007 Incentive Plan. All grants made to executive officers and other senior executives vest one-third of the amount granted on each of the first three anniversaries of the grant date so long as the recipient continues to be an eligible participant. All grants made to newly appointed non-employee directors were immediately vested upon grant. The fair value of each such RSU and LTIP granted in April 2008 ranged between $15.42 and $15.39 at the grant date. The fair value for each such option granted was estimated at the date of grant using the Black-Scholes option-pricing model, an allowable valuation method under SFAS No. 123R with the following assumptions: risk-free interest rate of approximately 2.9%, expected option lives of 5.85 years, 40% volatility, no dividend rate and 10% forfeiture rate. The fair value of each such option was $6.56 at the date of grant.
In May and June 2008, the Company issued an aggregate of 329,100 RSUs and 74,913 LTIPs to the Company’s executive officers, other senior executives, employees and non-employee directors under the Amended 2007 Incentive Plan. All grants made to employees vest one-third of the amount granted on each of the first three anniversaries of the grant date so long as the recipient continues to be an eligible participant. All LTIP grants made to non-employee directors were immediately vested upon grant. The fair value of each such RSU and LTIP granted in May and June 2008 ranged between $13.80 and $12.59 at the grant date.
During the three months ended September 30, 2008, the Company issued 6,016 RSUs to its newly appointed non-employee directors under the Amended 2007 Incentive Plan. All grants made to newly appointed non-employee directors immediately vested upon grant. The fair value of each such RSU was $16.62.
A summary of stock-based incentive awards as of September 30, 2008 is as follows (in units, or shares, as applicable):
                         
    Restricted Stock              
    Units     LTIP Units     Stock Options  
Outstanding as of January 1, 2008
    572,460       1,210,875       1,873,811  
Granted during 2008
    495,848       474,297       344,217  
Distributed/exercised during 2008
    (67,567 )           (7,085 )
Forfeited during 2008
    (36,399 )           (50,759 )
 
                 
Outstanding as of September 30, 2008
    964,342       1,658,172       2,160,184  
 
                 
Vested as of September 30, 2008
    38,050       824,990       932,021  
 
                 
Total stock compensation expense, which is included in corporate expense on the accompanying financial statements, was $4.8 million and $10.7 million for the three months ended September 30, 2008 and 2007, respectively, and $12.1 million and $16.1 million for the nine months ended September 30, 2008 and 2007, respectively.

 

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8. Related Party Transactions
The Company earned management fees, chain services fees and fees for certain technical services and has receivables from unconsolidated joint ventures. These fees totaled approximately $5.8 million and $4.7 million for the three months ended September 30, 2008 and 2007, respectively, and $14.9 million and $13.7 million for the nine months ended September 30, 2008 and 2007, respectively.
As of September 30, 2008 and December 31, 2007, the Company had receivables from these affiliates of approximately $5.9 million and $3.4 million, respectively, which are included in receivables from related parties on the accompanying consolidated balance sheets.
Insurance Proceeds Sharing Agreement
In connection with the Settlement (as defined and discussed below in Note 9), the Company and NorthStar entered into an Insurance Proceeds Sharing Agreement on January 18, 2008, pursuant to which NorthStar paid the Company one-half of the aggregate insurance proceeds received by NorthStar in connection with the Litigations (as defined in Note 9) under the Insurance Policies (as defined in Note 9) as of the date of the Insurance Proceeds Sharing Agreement. The parties have also agreed that all future insurance proceeds received from the Insurance Policies in connection with the Litigations will be allocated equally among the parties.
David Hamamoto, the Chairman of the Board, and Marc Gordon, a member of the Board and the Company’s Chief Investment Officer and Executive Vice President, Capital Markets, are beneficial owners of equity interests in NorthStar and Mr. Hamamoto is the Co-Chairman of the Board of Directors and Co-Chief Executive Officer of NorthStar. In addition, NorthStar, through its status as an affiliate of NorthStar Partnership, L.P., has certain rights to request, subject to certain limitations, that the Company register shares of the Company’s common stock owned by NorthStar pursuant to a registration rights agreement.
Guaranty to Column Financial, Inc. for Hard Rock
On August 1, 2008, Morgans Group LLC, together with DLJMB, as guarantors, entered into a $50.0 million non-recourse carve-out guaranty, as discussed above in Note 4. David T. Hamamoto, the Company’s Chairman of the Board, is also Chairman of the Board, President, Chief Executive Officer and equity holder of NorthStar Realty Finance Corp., which is a participant lender in the loan. The Company believes that this guaranty does not pose a material risk to the Company’s financial position or results.
9. Litigation
Shore Club Litigation
In 2002, the Company, through a wholly-owned subsidiary, Shore Club Holdings, LLC, invested in the Shore Club, and the management company, Morgans Hotel Group Management LLC (“MHG Management Company”), took over management of the property. The management agreement expires in 2022.
In January 2006, an action was brought in New York state court against several defendants, including two subsidiaries of the Company and certain officers and directors of NorthStar and the Company, including David Hamamoto, the Company’s Chairman of the Board and the Co-Chairman of the Board of Directors and Co-Chief Executive Officer of NorthStar, styled Philips South Beach, LLC v. Morgans Hotel Group Management, LLC et al., Index No. 06/600147 (N.Y. Sup. Ct.), which we refer to as the Shore Club Litigation. An additional action was commenced in March 2006 in New York state court against several defendants, including the company, NorthStar, David Hamamoto, and certain other individuals and entities, styled Century Operating Associates v. NorthStar Hospitality LLC, et al., Index No. 601007/06-E (N.Y. Sup. Ct.), which we refer to as the Century Litigation (together with the Shore Club Litigation, the “Litigations”).

 

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On April 4, 2008, the Company and certain of its subsidiaries entered into a global settlement agreement with Philips South Beach, LLC, Century Operating Associates, Philip Pilevsky and certain of his affiliates, Residual Hotel Interest LLC and certain of its affiliates, Becker-Paramount LLC, W. Edward Scheetz, David T. Hamamoto, RSA Associates, L.P., NorthStar and certain of its subsidiaries, Clark SB II LLC, Clark SB LLC, The Clark Foundation, The Scriven Foundation, Jane Clark and Kevin Moore, pursuant to which the Shore Club litigation, regarding the management of Shore Club, and the Century Litigation, regarding the structuring transactions that were part of the Company’s IPO and the IPO itself, along with related litigations and an additional litigation in which we are not involved, have been settled (the “Settlement”).
The Company was not required to make any cash payments as part of the Settlement. Under the terms of the Settlement, the management agreement pursuant to which MHG Management Company manages Shore Club was amended to provide for, among other things, a reduction beginning in 2009 in the management and chain services fees, a reduction beginning in 2012 in the termination payment to be made by the owner of Shore Club to MHG Management Company upon termination of the management agreement, and certain changes to operating procedures at Shore Club.
The Litigations have been submitted for coverage by NorthStar under certain primary and excess insurance policies (“Insurance Policies”), issued to NorthStar under which certain subsidiaries of the Company and certain individual defendants in the Litigations, including Mr. Hamamoto, are also insured. The insurers have paid certain amounts to NorthStar in connection with the Litigations under the Insurance Policies.
Hard Rock Financial Advisory Agreement
In July 2008, the Company received an invoice from Credit Suisse Securities (USA) LLC (“Credit Suisse”) for $9.4 million related to the Financial Advisory Agreement the Company entered into with Credit Suisse in July 2006. Under the terms of the Financial Advisory Agreement, Credit Suisse received a transaction fee (the “Transaction Fee”) for placing DLJMB, an affiliate of Credit Suisse, in the Hard Rock joint venture. The Transaction Fee was paid by the Hard Rock joint venture at the closing of the Transactions, as defined above in Note 4, and was based on an agreed upon percentage of the initial equity contribution made by DLJMB in entering into the joint venture. The invoice received in July 2008 alleges that as a result of events subsequent to the closing of the Transactions, Credit Suisse is due additional transaction fees. The Company believes this invoice is invalid, and would moreover be a Hard Rock joint venture liability.
Other Litigation
The Company is involved in various lawsuits and administrative actions in the normal course of business. In management’s opinion, disposition of these lawsuits is not expected to have a material adverse effect on the Company’s financial positions, results of operations or liquidity.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to, those set forth under “Risk Factors” and elsewhere in our Annual Report on Form 10-K.
Overview
We are a fully integrated hospitality company that operates, owns, acquires, develops and redevelops boutique hotels primarily in gateway cities and select resort markets in the United States and Europe. Over our 24-year history, we have gained experience operating in a variety of market conditions.
The historical financial data presented herein is the historical financial data for:
   
our Owned Hotels, consisting of Morgans, Royalton and Hudson in New York, Delano Miami in Miami, Mondrian Los Angeles in Los Angeles, Clift in San Francisco, and Mondrian Scottsdale in Scottsdale;
 
   
our Joint Venture Hotels, consisting of the London hotels (Sanderson and St Martins Lane), Shore Club and Hard Rock;
 
   
our investments in hotels under construction, such as Mondrian South Beach, Mondrian SoHo, and Ames Boston and our investment in other proposed properties;
 
   
our investment in certain joint ventures food and beverage operations at our Owned Hotels and Joint Venture Hotels, discussed further below;
 
   
our management company subsidiary, MHG Management Company; and
 
   
the rights and obligations contributed to Morgans Group LLC in the formation and structuring transactions described in Note 1 to the Consolidated Financial Statements, included elsewhere in this report.
We consolidate the results of operations for all of our Owned Hotels. Certain food and beverage operations at five of our Owned Hotels are operated under 50/50 joint ventures with restauranteur Jeffrey Chodorow. The Asia de Cuba restaurant at Mondrian Scottsdale is operated under license and management agreements with China Grill Management, a company controlled by Jeffrey Chodorow. We believe that we are the primary beneficiary of these entities because we are responsible for the majority of the entities’ expected losses or residual returns. Therefore, these entities are consolidated in our financial statements with our partner’s share of the results of operations recorded as minority interest in the accompanying consolidated financial statements. This minority interest is based upon 50% of the income of the applicable entity after giving effect to rent and other administrative charges payable to the hotel.
We own partial interests in the Joint Venture Hotels and certain food and beverage operations at two of the Joint Venture Hotels, Sanderson and St Martins Lane. We account for these investments using the equity method as we believe we do not exercise control over significant asset decisions such as buying, selling or financing, nor are we the primary beneficiary of the entities. Under the equity method, we increase our investment in unconsolidated joint ventures for our proportionate share of net income and contributions and decrease our investment balance for our proportionate share of net losses and distributions.

 

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On February 2, 2007, we began managing the hotel operations at the Hard Rock. We also have signed agreements to manage the Mondrian South Beach, Mondrian SoHo, and Ames Boston once development is complete. We have signed agreements to manage Mondrian Las Vegas, Delano Las Vegas, Mondrian Chicago and Mondrian Palm Springs, but as discussed below in “Recent Trends and Events — Recent Trends”, we are unsure of the future of the development of these hotels as financing has not yet been obtained. Additionally, in September 2008, we signed an agreement to manage Delano Dubai. As of September 30, 2008, we operated the following Joint Venture Hotels under management agreements which expire as follows:
   
Sanderson — April 2010 (with two 10-year extensions at our option);
 
   
St Martins Lane — September 2009 (with two 10-year extensions at our option);
 
   
Shore Club — July 2022; and
 
   
Hard Rock — February 2027 (with two 10-year extensions).
These agreements are subject to early termination in specified circumstances.
Factors Affecting Our Results of Operations
Revenues. Changes in our revenues are most easily explained by three performance indicators that are commonly used in the hospitality industry:
   
occupancy;
 
   
average daily rate, or ADR; and
 
   
revenue per available room, or RevPAR, which is the product of ADR and average daily occupancy, but does not include food and beverage revenue, other hotel operating revenue such as telephone, parking and other guest services, or management fee revenue.
Substantially all of our revenue is derived from the operation of our hotels. Specifically, our revenue consists of:
   
Rooms revenue. Occupancy and ADR are the major drivers of rooms revenue.
 
   
Food and beverage revenue. Most of our food and beverage revenue is earned by our 50/50 restaurant joint ventures and is driven by occupancy of our hotels and the popularity of our bars and restaurants with our local customers.
 
   
Other hotel revenue. Other hotel revenue, which consists of ancillary revenue such as telephone, parking, spa, entertainment and other guest services, is principally driven by hotel occupancy.
 
   
Management fee related parties revenue and other income. We earn fees under our management agreements. These fees may include management fees as well as reimbursement for allocated chain services. Additionally, we earn branding fees related to the use of our Delano brand in the selling of condominium units associated with the Delano Dubai development project.
Fluctuations in revenues, which tend to correlate with changes in gross domestic product, are driven largely by general economic and local market conditions but can also be impacted by major events, such as terrorist attacks or natural disasters, which in turn affect levels of business and leisure travel.
The seasonal nature of the hospitality business can also impact revenues. We experience some seasonality in our business. For example, our Miami hotels are generally strongest in the first quarter, whereas our New York hotels are generally strongest in the fourth quarter.
In addition to economic conditions, supply is another important factor that can affect revenues. Room rates and occupancy tend to fall when supply increases, unless the supply growth is offset by an equal or greater increase in demand. One reason why we focus on boutique hotels in key gateway cities is because these markets have significant barriers to entry for new competitive supply, including scarcity of available land for new development and extensive regulatory requirements resulting in a longer development lead time and additional expense for new competitors. Additionally, hotel owners have begun to convert hotel rooms to condominium apartments which further reduces the available supply of hotel rooms resulting in increased demand for the remaining hotels.

 

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Finally, competition within the hospitality industry can affect revenues. Competitive factors in the hospitality industry include name recognition, quality of service, convenience of location, quality of the property, pricing, and range and quality of food services and amenities offered. In addition, all of our hotels, restaurants and bars are located in areas where there are numerous competitors, many of whom have substantially greater resources than us. New or existing competitors could offer significantly lower rates or more convenient locations, services or amenities or significantly expand, improve or introduce new service offerings in markets in which our hotels compete, thereby posing a greater competitive threat than at present. If we are unable to compete effectively, we would lose market share, which could adversely affect our revenues.
Operating Costs and Expenses. Our operating costs and expenses consist of the costs to provide hotel services, including:
   
Rooms expense. Rooms expense includes the payroll and benefits for the front office, housekeeping, concierge and reservations departments and related expenses, such as laundry, rooms supplies, travel agent commissions and reservation expense. Like rooms revenue, occupancy is a major driver of rooms expense, which has a significant correlation with rooms revenue.
 
   
Food and beverage expense. Similar to food and beverage revenue, occupancy of our hotels and the popularity of our restaurants and bars are the major drivers of food and beverage expense, which has a significant correlation with food and beverage revenue.
 
   
Other departmental expense. Occupancy is the major driver of other departmental expense, which includes telephone and other expenses related to the generation of other hotel revenue.
 
   
Hotel selling, general and administrative expense. Hotel selling, general and administrative expense consist of administrative and general expenses, such as payroll and related costs, travel expenses and office rent, advertising and promotion expenses, comprising the payroll of the hotel sales teams, the global sales team and advertising, marketing and promotion expenses for our hotel properties, utility expense and repairs and maintenance expenses, comprising the ongoing costs to repair and maintain our hotel properties.
 
   
Property taxes, insurance and other. Property taxes, insurance and other consist primarily of insurance costs and property taxes.
 
   
Corporate expenses. Corporate expenses consist of the cost of our corporate office, net of any cost recoveries, which consists primarily of payroll and related costs, stock-based compensation expenses, office rent and legal and professional fees and costs associated with being a public company.
 
   
Depreciation and amortization expense. Hotel properties are depreciated using the straight-line method over estimated useful lives of 39.5 years for buildings and five years for furniture, fixtures and equipment.
Other Items
   
Interest expense, net. Interest expense, net includes interest on our debt and amortization of financing costs and is presented net of interest income and interest capitalized.
 
   
Equity in (income) loss of unconsolidated joint ventures. Equity in (income) loss of unconsolidated joint ventures constitutes our share of the net profits and losses of our Joint Venture Hotels and our investments in hotels under development.
 
   
Minority interest. Minority interest expense constitutes the third-party food and beverage joint venture partner’s interest in the profits of the restaurant ventures at certain of our hotels.

 

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Other non-operating expenses include gains and losses on sale of assets and asset restructurings, costs of abandoned development projects and financings, certain litigation costs, gain on early extinguishment of debt and other items that do not relate to the ongoing operating performance of our assets.
 
   
Income tax expense. One of our foreign subsidiaries is subject to United Kingdom corporate income taxes. Income tax expense is reported at the applicable rate for the periods presented. The Company is subject to Federal and state income taxes. Income taxes for the nine months ended September 30, 2008 and 2007 were computed using our calculated effective tax rate. We also recorded net deferred taxes related to cumulative differences in the basis recorded for certain assets and liabilities.
Most categories of variable operating expenses, such as operating supplies and certain labor such as housekeeping, fluctuate with changes in occupancy. Increases in RevPAR attributable to increases in occupancy are accompanied by increases in most categories of variable operating costs and expenses. Increases in RevPAR attributable to improvements in ADR typically only result in increases in limited categories of operating costs and expenses, primarily credit card and travel agent commissions. Thus, improvements in ADR have a more significant impact on improving our operating margins than occupancy.
Notwithstanding our efforts to reduce variable costs, there are limits to how much we can accomplish because we have significant costs that are relatively fixed costs, such as depreciation and amortization, labor costs and employee benefits, insurance, real estate taxes and other expenses associated with owning hotels that do not necessarily decrease when circumstances such as market factors cause a reduction in our hotel revenues.
Recent Trends and Events
Recent Trends.
During the quarter ended September 30, 2008, the overall weakness in the U.S. economy resulted in considerable negative pressure on both consumer and business spending. As a result, lodging demand, which is primarily driven by growth in GDP, business investment and employment growth continued to weaken during the third quarter of 2008 and we believe these trends will continue for the remainder of the year. We anticipate that lodging demand will not improve, and will likely weaken further, until the current economic trends reverse course, particularly the expected weakness in the overall economy and the lack of liquidity in the credit markets.
To help mitigate the effects of these trends, we are managing costs and each of our properties has implemented certain contingency plans. Further, during October 2008, we implemented certain cost reduction plans at the corporate office. We believe that these cost reduction plans will result in significant savings through the end of 2008 and in 2009.
While demand growth is expected to diminish as a result of slowing economic drivers, projections for new supply in the markets in which we own hotels suggest that supply growth will continue to fall short of long-term historical averages. Although the pace of new lodging supply in various phases of development has increased over the past several quarters, the majority of new projects scheduled for completion in the near-term are largely concentrated in the economy and mid-scale segments and are located outside of major urban markets. We also believe the timing of some of these projects may be affected by the current economic crisis, increased building costs and the reduced availability of financing. These factors may further dampen the pace of new supply development, including ours, beyond 2008.
For 2009, we believe that the economic forecasts for weak growth in GDP, increasing unemployment and declines in business investment and profits, when combined with the turmoil in the credit markets, will continue to negatively affect both leisure and business travel and, accordingly, decrease lodging demand. As such, there can be no assurances that any increases in hotel revenues or earnings at our properties will continue or that any losses will not increase for these or any other reasons. We are in the early stages of our budget process and the complexity and uncertainty of the current economic environment makes it difficult to accurately forecast our operating results. However, based on preliminary management discussions, as well as a review of hotel-specific and broad economic metrics, we believe that our results will be adversely affected in 2009 as compared to the results of 2008.

 

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Finally, global credit markets continue to tighten, with less credit available generally and on less favorable terms than were obtainable in the recent past. Given the current state of the credit markets, some of our joint venture projects, such as the Echelon project, Mondrian Chicago and Mondrian Palm Springs, may not be able to obtain adequate project financing in a timely manner or at all. If adequate project financing is not obtained, the joint ventures may seek additional equity investors to raise capital, limit the scope of the project, defer the project or cancel the project altogether.
Recent Events.
Share Repurchase. On July 1, 2008, our Board of Directors authorized the repurchase of up to $30.0 million of our common stock, or approximately 9% of our outstanding shares based on the then current market price. We repurchased our stock through the open market. The timing and actual number of shares repurchased depends on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. As of October 9, 2008, we had completed this share repurchase program and purchased 2,794,653 shares for approximately $30.0 million.
Expansion of the Board of Directors. On July 25, 2008, our Board of Directors increased its size from seven to ten members and appointed David J. Moore, Deepak Chopra and Marc Gordon, the Company’s Chief Investment Officer and Executive Vice President, Capital Markets, to fill the newly created directorships on the Board.
There is no arrangement or understanding between either Messrs. Moore or Chopra and any other persons pursuant to which either of them was selected as director of the Company. Mr. Gordon was appointed to the Board, in part, in consideration of his Amended and Restated Employment Agreement, effective as of April 1, 2008, which provides that the Company shall recommend Mr. Gordon’s addition as a director upon the expansion of the Board to include additional independent directors.
Stockholder Protection Rights Agreement. Also on July 25, 2008, the Board of Directors resolved to amend our Stockholder Protection Rights Agreement (the “Rights Agreement”) to extend the date on which the Rights Agreement will expire from October 9, 2008 to October 9, 2009 (assuming there is no earlier redemption or triggering of the rights). The Rights Agreement was not adopted in response to any specific effort to obtain control of the Company but rather to continue to deter abusive takeover tactics that otherwise could be used to deprive stockholders of the full value of their investment. The terms of the Rights Agreement provide that the Board of Directors may amend the agreement in any respect without shareholder approval at any time before a triggering event. The Rights Agreement is otherwise unchanged.
Hard Rock Land Sale. On August 1, 2008, a subsidiary of our Hard Rock joint venture obtained a loan to finance $50 million of the $110 million necessary to purchase an 11-acre parcel of land located adjacent to the Hard Rock from another subsidiary of the joint venture. The loan becomes due and payable no later than the maturity date of August 9, 2009, subject to two six-month extension options, and is subject to acceleration upon the occurrence of events of default, as set forth in the loan agreement. NorthStar Realty Finance Corp. is a participant lender in the loan. In connection with the loan, Morgans Group LLC, together with DLJMB, as guarantors, entered into a non-recourse, carve-out guaranty agreement in favor of Column Financial, Inc., the lender.
The DLJMB Parties contributed an aggregate of approximately $74.0 million to the Hard Rock joint venture to fund the remaining portion of the $110.0 million of proceeds necessary to complete the intercompany land purchase and to pay for all costs and expenses in connection with its closing and related financing. The proceeds from the financing, together with the equity contribution from the DLJMB Parties, were used to fully satisfy the $110.0 million amortization payment under the joint venture’s commercial mortgage backed securities loan facility.
As a result of contributions by the DLJMB Parties, the Company holds approximately a 20.5% ownership interest in the joint venture as of September 30, 2008.

 

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Also on August 1, 2008, the DLJMB Parties and the Morgans Parties amended their joint venture agreement. Among other things, the amended joint venture agreement clarifies certain obligations of the parties in the event that capital contributions are required for additional costs and expenses relating to the 11-acre parcel. In general, any decision to call for such additional capital contributions will be in the discretion of the Hard Rock joint venture’s board of directors. Subject to certain terms and conditions, the DLJMB Parties could also cause the joint venture to fund such additional capital contributions from third parties. However, each member that is not in default under the joint venture agreement will be given an opportunity to participate in the funding. The amended joint venture agreement also clarifies certain provisions used to calculate each member’s percentage interest in the joint venture in the event that such additional capital contributions are funded.
Echelon Las Vegas. On August 1, 2008, Boyd Gaming Corporation (“Boyd”) announced that it will delay the entire Echelon project due to the difficult environment surrounding today’s capital markets and current economic conditions. On September 23, 2008, the Company and Boyd amended their joint venture agreement to, among other things, extend the deadline by which the joint venture must obtain construction financing for the development of Delano Las Vegas and Mondrian Las Vegas to December 31, 2009. The amended joint venture agreement also provided for the immediate return of the $30.0 million deposit the Company had provided for the project, plus interest, the elimination of the Company’s future funding obligations of approximately $41.0 million and the elimination of any obligation by the Company to provide a construction loan guaranty. The amended joint venture agreement also limits the amounts that the Company and Boyd are required to continue to fund for pre-development and related costs to approximately $0.4 million each. Each partner has the right to terminate the joint venture for any reason prior to December 31, 2009. Additionally, the terms of the management agreement, which provide for the Company to operate the joint venture hotels upon their completion, remain unchanged.
Delano Dubai. In September 2008, the Company announced the development of Delano Dubai by a leading Middle Eastern real estate development firm. Delano Dubai will be located on the Dubai Waterfront. The hotel is expected to have approximately 200 guest rooms and 100 branded residences, and to include a restaurant, bar and spa. Upon completion, which is expected in 2012, the Company is expected to operate the hotel under a 20-year management contract with two 10-year extension options. In addition to hotel management fees, the Company would also realize fees from the developer’s sale of both branded and unbranded residences, of which we recognized $1.5 million during September 2008.
Extension of the Gale Promissory Note. On November 4, 2008, the Company extended the maturity of the $10.0 million interest only promissory note issued to purchase the Gale in South Beach for an additional year. As a result, this promissory note matures on January 24, 2010. As part of the extension terms, the Company paid the annual interest payment at 11.0% in full at the time of the extension.

 

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Operating Results
Comparison of Three Months Ended September 30, 2008 to September 30, 2007
The following table presents our operating results for the three months ended September 30, 2008 and the three months ended September 30, 2007, including the amount and percentage change in these results between the two periods. The consolidated operating results for the three months ended September 30, 2008 is comparable to the Company’s consolidated operating results for the three months ended September 30, 2007, with the exception of the renovation of Mondrian Los Angeles and closure for renovation of Morgans in New York during the three months ended September 30, 2008 and the closure for renovation of Royalton during the three months ended September 30, 2007. The consolidated operating results are as follows:
                                 
    Three Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
    (in thousands, except percentages)  
Revenues
                               
Rooms
  $ 45,500     $ 39,974     $ 5,526       13.8 %
Food and beverage
    23,269       24,221       (952 )     (3.9 )%
Other hotel
    3,133       3,182       (49 )     (1.5 )%
 
                       
Total hotel revenues
    71,902       67,377       4,525       6.7 %
Management fee—related parties and other income
    5,799       4,721       1,078       22.8 %
 
                       
Total revenues
    77,701       72,098       5,603       7.8 %
 
                       
Operating Costs and Expenses
                               
Rooms
    12,097       11,061       1,036       9.4 %
Food and beverage
    16,817       16,185       632       3.9 %
Other departmental
    1,792       1,846       (54 )     (2.9 )%
Hotel selling, general and administrative
    15,003       13,742       1,261       9.2 %
Property taxes, insurance and other
    5,447       3,534       1,913       54.1 %
 
                       
Total hotel operating expenses
    51,156       46,368       4,788       10.3 %
Corporate expense
    12,355       18,115       (5,760 )     (31.8 )%
Depreciation and amortization
    7,587       5,055       2,532       50.1 %
 
                       
Total operating costs and expenses
    71,098       69,538       1,560       2.2 %
 
                       
Operating income
    6,603       2,560       4,043       157.9 %
Interest expense, net
    10,222       10,690       (468 )     (4.4 )%
Equity in loss of unconsolidated joint ventures
    7,617       5,931       1,686       28.4 %
Minority interest in joint ventures
    683       461       222       48.2 %
Other non-operating expense
    3,473       3,228       245       7.6 %
 
                       
Loss before income tax expense and minority interest
    (15,392 )     (17,750 )     2,358       (13.3 )%
Income tax benefit
    (6,109 )     (7,415 )     1,306       17.6 %
 
                       
Loss before minority interest
    (9,283 )     (10,335 )     1,052       10.2 %
Minority interest
    (284 )     (314 )     30       9.6 %
 
                       
Net loss
    (8,999 )     (10,021 )     1,022       10.2 %
Other comprehensive income (loss):
                               
Unrealized loss on interest rate swap, net of tax
    (748 )     (7,327 )     6,579         (1)
Foreign currency translation (loss) gain
    (388 )     117       (505 )       (1)
 
                       
Comprehensive loss
  $ (10,135 )   $ (17,231 )   $ (7,096 )     (41.2 )%
 
                       
 
     
(1)  
Not meaningful.

 

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Total Hotel Revenues. Total hotel revenues increased 6.7% to $71.9 million for the three months ended September 30, 2008 compared to $67.4 million for the three months ended September 30, 2007. RevPAR from our comparable Owned Hotels, which excludes Mondrian Los Angeles and Morgans which were both under renovation during the three months ended September 30, 2008 and Royalton, which was under renovation during the three months ended September 30, 2007, increased by 9.4% to $238 for the three months ended September 30, 2008 compared to $217 for the same period in 2007. The components of RevPAR from our comparable Owned Hotels for the three months ended September 30, 2008 and 2007 are summarized as follows:
                                 
    Three Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
Occupancy
    84.8 %     81.2 %           4.4 %
ADR
  $ 281     $ 268     $ 13       4.8 %
RevPAR
  $ 238     $ 217     $ 21       9.4 %
Rooms revenue increased 13.8% to $45.5 million for the three months ended September 30, 2008 as compared to $40.0 million for the three months ended September 30, 2007. The overall increase in rooms revenue was primarily attributable to an increase in room revenues at Royalton which was closed for renovations during the comparable period in 2007, partially offset by disruptions due to renovations at Mondrian Los Angeles and Morgans during the quarter ended September 30, 2008.
Food and beverage revenue decreased 3.9% to $23.3 million for the three months ended September 30, 2008 as compared to $24.2 million for the three months ended September 30, 2007. The food and beverage revenues at Mondrian Los Angeles and Morgans decreased 22.1% and 16.8%, respectively, for the three months ended September 30, 2008 as compared to the same period in 2007 due to hotel renovations underway at both properties during the quarter. Offsetting this decrease were increases in food and beverage revenues of 24.8% and 100.0% at Delano Miami and Royalton, respectively. Delano Miami benefitted from The Florida Room nightclub and lounge which opened in December 2007. The increase in revenues at Royalton is due primarily to the new restaurant, Brasserie 44 and the recently renovated bar, both of which opened in October 2007 when the hotel reopened.
Other hotel revenue decreased by 1.5% to $3.1 million for the three months ended September 30, 2008 as compared to $3.2 million for the three months ended September 30, 2007. Our Owned Hotels experienced a decline in telephone revenues for the three months ended September 30, 2008 as compared to the same period in 2007, which we believe is generally consistent across the industry due to increased cell phone usage.
Management Fee—Related Parties and Other Income. Management fee — related parties and other income increased 22.8% to $5.8 million for the three months ended September 30, 2008 as compared to $4.7 million for the three months ended September 30, 2007. This increase is primarily due to a $1.5 million fee earned in September 2008 relating to the use of the Delano brand for the sale of branded residences to be constructed in connection with the Delano Dubai project.
Operating Costs and Expenses
Rooms expense increased 9.4% to $12.1 million for the three months ended September 30, 2008 as compared to $11.1 million for the three months ended September 30, 2007. This increase was primarily due to an increase in rooms expenses at Royalton for the three months ended September 30, 2008 as compared to the same period in 2007 which was directly related to the increase in rooms revenues noted above. Offsetting this increase was a decrease in rooms expense, consistent with decreased rooms revenues noted above at Mondrian Los Angeles and Morgans.
Food and beverage expense increased 3.9% to $16.8 million for the three months ended September 30, 2008 as compared to $16.2 million for the three months ended September 30, 2007. Increases in food and beverage expenses were experienced at Delano Miami and Royalton. Delano Miami’s expenses increased as a result of the increase in revenues noted above related to The Florida Room nightclub and lounge which opened in December 2007. The increase in expenses at Royalton is due primarily to the new restaurant, Brasserie 44 and the recently renovated bar, both of which opened in October 2007 when the newly renovated hotel reopened. Offsetting these increases, food and beverage expenses at Mondrian Los Angeles and Morgans decreased, in line with the decrease in revenues noted above.
Other departmental expense decreased 2.9% to $1.8 million for the three months ended September 30, 2008 as compared to $1.8 million for the three months ended September 30, 2007. This decrease was consistent with the decrease in other hotel revenues, noted above.

 

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Hotel selling, general and administrative expense increased 9.2% to $15.0 million for the three months ended September 30, 2008 as compared to $13.7 million for the three months ended September 30, 2007. This increase was primarily due to the increase in expenses at Royalton as a result of being closed for renovation during the three months ended September 30, 2007. Slightly offsetting these increases, the closing of Morgans for renovation reduced hotel, selling, general and administrative expenses for the three months ended September 30, 2008 as compared to the same period in 2007.
Property taxes, insurance and other expense increased 54.1% to $5.4 million for the three months ended September 30, 2008 as compared to $3.5 million for the three months ended September 30, 2007. The increase is primarily related to an increase in expenses at Royalton, Hudson, Mondrian Los Angeles and Morgans. Royalton’s increases are a result of being closed for renovation during the three months ended September 30, 2007. The increases at Hudson are a result of the expiration of a property tax abatement which will be phased out over the next four years. Mondrian Los Angeles and Morgans both incurred pre-opening expenses as a result of their re-launch after renovation during the three months ended September 30, 2008. Slightly offsetting these increases is the capitalization of cost from the closing of Morgans for renovation for the three months ended September 30, 2008 as compared to the same period in 2007.
Corporate expense decreased 31.8% to $12.4 million for the three months ended September 30, 2008 as compared to $18.1 million for the three months ended September 30, 2007. This decrease is primarily related to a decrease in stock compensation of $5.9 million during the three months ended September 30, 2008 as compared to the same period in 2007 due to a one-time additional expense recognized in September 2007 in connection with the resignation of our former president and chief executive officer. Slightly offsetting this decrease was an increase in stock compensation expense during the three months ended September 30, 2008 as compared to the same period in 2007 due to additional annual equity grants to eligible employees in 2008.
Depreciation and amortization increased 50.1% to $7.6 million for the three months ended September 30, 2008 as compared to $5.1 million for the three months ended September 30, 2007. This increase is a result of the renovations at Delano Miami and Royalton, which both took place during 2007, and renovations at Mondrian Los Angeles and Morgans, which were both completed in early September 2008.
Interest Expense, net. Interest expense, net decreased 4.4% to $10.2 million for the three months ended September 30, 2008 as compared to $10.7 million for the three months ended September 30, 2007, primarily due to lower overall rates for the three months ended September 30, 2008 as compared to the same period in 2007.
Equity in loss of unconsolidated joint ventures increased 28.4% to $7.6 million for the three months ended September 30, 2008 as compared to $5.9 million for the three months ended September 30, 2007. This increase was primarily the result of increased losses recognized from the London joint venture due to decreased RevPAR, as disclosed below.
The components of RevPAR from our comparable Joint Venture Hotels, which excludes the Hard Rock which is currently under renovation and expansion, for the three months ended September 30, 2008 and 2007 are summarized as follows:
                                 
    Three Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
Occupancy
    68.0 %     70.7 %           (3.8 )%
ADR
  $ 393     $ 424     $ (31 )     (7.3 )%
RevPAR
  $ 268     $ 300     $ (32 )     (10.8 )%

 

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The components of RevPAR from the Hard Rock for the three months ended September 30, 2008 and 2007 are summarized as follows:
                                 
    Three Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
Occupancy
    92.4 %     96.1 %           (3.9 )%
ADR
  $ 190     $ 224     $ (34 )     (15.0 )%
RevPAR
  $ 176     $ 215     $ (39 )     (18.3 )%
As is customary for companies in the gaming industry, the Hard Rock average occupancy rate and average daily rate includes rooms provided on a complimentary basis. Like most operators of hotels in the non-gaming lodging industry, we do not follow this practice at our other hotels, where we present average occupancy rate and average daily rate net of rooms provided on a complimentary basis.
Other non-operating expense decreased 7.6% to $3.5 million for the three months ended September 30, 2008 as compared to $3.2 million for the three months ended September 30, 2007. The expense recognized in the three months ended September 30, 2008 primarily relates to the write-off of furniture and fixtures at Mondrian Los Angeles and Morgans as a result of the hotels’ renovations. The expense recognized in the three months ended September 30, 2007 primarily relates to costs incurred as a result of the resignation of our former president and chief executive officer in September 2007, the Shore Club litigation, and the write-off of furniture and fixtures at Royalton.
Income tax benefit was a benefit of $6.1 million for the three months ended September 30, 2008 as compared to $7.4 million for the three months ended September 30, 2007. This change was a result of the loss recognized by the Company in the three months ended September 30, 2008 as compared to the loss recognized in the three months ended September 30, 2007.

 

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Comparison of Nine Months Ended September 30, 2008 to September 30, 2007
The following table presents our operating results for the nine months ended September 30, 2008 and the nine months ended September 30, 2007, including the amount and percentage change in these results between the two periods. The consolidated operating results for the nine months ended September 30, 2008 is comparable to the consolidated operating results for the nine months ended September 30, 2007, with the exception of the renovation of Mondrian Los Angeles and closure for renovation of Morgans in New York during a portion of the nine months ended September 30, 2008, the closure for renovation of Royalton during a portion of the nine months ended September 30, 2007, and the investment in the Hard Rock in February 2007 and renovation and expansion work at the Hard Rock during the nine months ended September 30, 2008. The consolidated operating results are as follows:
                                 
    Nine Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
    (in thousands, except percentages)  
Revenues
                               
Rooms
  $ 138,521     $ 132,502     $ 6,019       4.5 %
Food and beverage
    76,392       76,572       (180 )     (0.2 )%
Other hotel
    9,957       10,425       (468 )     (4.5 )%
 
                       
Total hotel revenues
    224,870       219,499       5,371       2.4 %
Management fee—related parties and other income
    14,887       13,691       1,196       8.7 %
 
                       
Total revenues
    239,757       233,190       6,567       2.8 %
 
                       
Operating Costs and Expenses
                               
Rooms
    37,162       36,044       1,118       3.1 %
Food and beverage
    54,538       50,977       3,561       7.0 %
Other departmental
    5,801       5,816       (15 )     (0.3 )%
Hotel selling, general and administrative
    45,375       43,845       1,530       3.5 %
Property taxes, insurance and other
    13,229       13,490       (261 )     (1.9 )%
 
                       
Total hotel operating expenses
    156,105       150,172       5,933       4.0 %
Corporate expense
    35,002       36,729       (1,727 )     (4.7 )%
Depreciation and amortization
    19,696       14,739       4,957       33.6 %
 
                       
Total operating costs and expenses
    210,803       201,640       9,163       4.5 %
 
                       
Operating income
    28,954       31,550       (2,596 )     (8.2 )%
Interest expense, net
    31,053       32,504       (1,451 )     (4.5 )%
Equity in loss of unconsolidated joint ventures
    16,526       12,867       3,659       28.4 %
Minority interest in joint ventures
    3,282       2,583       699       27.1 %
Other non-operating expense (income)
    5,940       (888 )     6,828         (1)
 
                       
Loss before income tax expense and minority interest
    (27,847 )     (15,516 )     (12,331 )     79.5 %
Income tax benefit
    (10,621 )     (6,498 )     (4,123 )     (63.4 )%
 
                       
Loss before minority interest
    (17,226 )     (9,018 )     (8,208 )     (91.0 )%
Minority interest
    (520 )     (274 )     (246 )       (1)
 
                       
Net loss
    (16,706 )     (8,744 )     (7,962 )     (91.1 )%
Other comprehensive (loss) income:
                               
Unrealized gain (loss) on interest rate swap, net of tax
    388       (3,844 )     4,232         (1)
Foreign currency translation (loss) gain
    (353 )     183       (536 )       (1)
 
                       
Comprehensive loss
  $ (16,671 )   $ (12,405 )   $ (4,266 )     (34.4 )%
 
                       
 
     
(1)  
Not meaningful.

 

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Total Hotel Revenues. Total hotel revenues increased 2.4% to $224.9 million for the nine months ended September 30, 2008 compared to $219.5 million for the nine months ended September 30, 2007. RevPAR from our comparable Owned Hotels, which excludes Mondrian Los Angeles and Morgans which were both under renovation during the nine months ended September 30, 2008 and Royalton, which was under renovation during the nine months ended September 30, 2007, increased by 6.2% to $247 for the nine months ended September 30, 2008 compared to $233 for the same period in 2007. The components of RevPAR from our comparable Owned Hotels for the nine months ended September 30, 2008 and 2007 are summarized as follows:
                                 
    Nine Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
Occupancy
    82.5 %     80.9 %           2.0 %
ADR
  $ 299     $ 288     $ 11       4.1 %
RevPAR
  $ 247     $ 233     $ 14       6.2 %
Rooms revenue increased 4.5% to $138.5 million for the nine months ended September 30, 2008 as compared to $132.5 million for the nine months ended September 30, 2007. The overall increase was primarily attributable to an increase in room revenues at Royalton, which was closed for renovation during part of the comparable period in 2007, partially offset by disruptions due to renovations at Mondrian Los Angeles and Morgans during the nine months ended September 30, 2008.
Food and beverage revenue decreased 0.2% to $76.4 million for the nine months ended September 30, 2008 as compared to $76.6 million for the nine months ended September 30, 2007. The food and beverage revenues at Mondrian Los Angeles and Morgans decreased 24.4% and 9.4%, respectively, for the nine months ended September 30, 2008 as compared to the same period in 2007 due to hotel renovations which were underway during 2008 at both properties in 2008. Partially offsetting this decrease were increases in food and beverage revenues at Delano Miami and Royalton, respectively. Delano Miami benefitted from The Florida Room nightclub and lounge which opened in December 2007. The increase in revenues at Royalton is due primarily to the new restaurant, Brasserie 44 and the recently renovated bar, both of which opened in October 2007 when the hotel reopened.
Other hotel revenue decreased by 4.5% to $10.0 million for the nine months ended September 30, 2008 as compared to $10.4 million for the nine months ended September 30, 2007, primarily due to a 12.4% decline in telephone revenues over the nine months ended September 30, 2008 as compared to the same period in 2007 which we believe is generally consistent across the industry due to increased use of cell phones by our guests.
Management Fee—Related Parties and Other Income. Management fees — related parties and other income increased 8.7% to $14.9 million for the nine months ended September 30, 2008. This increase is primarily due to a $1.5 million branding fee earned in September 2008 relating to the use of the Delano brand for the sale of branded residences to be constructed in connection with the Delano Dubai project. Slightly offsetting this increase is a decrease in management fees earned at Hard Rock as a result of reduced revenues due to disruption from the expansion and renovations currently underway.
Operating Costs and Expenses
Rooms expense increased 3.1% to $37.2 million for the nine months ended September 30, 2008 as compared to $36.0 million for the nine months ended September 30, 2007. This increase was consistent with the increased rooms revenues noted above and primarily due to an increase in rooms expense at Royalton for the nine months ended September 30, 2008 as compared to the same period in 2007, when the hotel was closed for renovation. Offsetting this increase were decreases in rooms expense at Mondrian Los Angeles and Morgans which were both under renovation during the nine months ended September 30, 2008.
Food and beverage expense increased 7.0% to $54.5 million for the nine months ended September 30, 2008 as compared to $51.0 million for the nine months ended September 30, 2007. Increases in food and beverage expenses were experienced at Delano Miami and Royalton. Delano Miami’s expenses increased as a result of the increase in revenues noted above related to The Florida Room nightclub and lounge which opened in December 2007. The increase in expenses at Royalton is due primarily to the new restaurant, Brasserie 44 and the recently renovated bar, both of which opened in October 2007, compared to the same period in 2007 when the hotel was closed for renovation. Offsetting these increases, the food and beverage expenses at Mondrian Los Angeles decreased, in line with the decrease in revenues noted above, for the nine months ended September 30, 2008 as compared to the same period in 2007.
Other departmental expense remained relatively flat for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007.

 

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Hotel selling, general and administrative expense increased 3.5% to $45.4 million for the nine months ended September 30, 2008 as compared to $43.8 million for the nine months ended September 30, 2007. This increase was primarily due to the increase in expenses at Royalton as a result of being closed for renovation for a period during the nine months ended September 30, 2007. Slightly offsetting these increases, the closing of Morgans for renovation reduced hotel, selling, general and administrative expenses for the nine months ended September 30, 2008 as compared to the same period in 2007.
Property taxes, insurance and other expense decreased 1.9% to $13.2 million for the nine months ended September 30, 2008 as compared to $13.5 million for the nine months ended September 30, 2007. The decrease is primarily related to preopening expenses incurred during early 2007 after the repositioning and opening of Mondrian Scottsdale. Slightly offsetting this decrease were increases at Royalton. Royalton’s increases are a result of being closed for renovation for a period during the nine months ended September 30, 2007.
Corporate expense decreased by 4.7% to $35.0 million for the nine months ended September 30, 2008 as compared to $36.7 million for the nine months ended September 30, 2007. This decrease is primarily related to a decrease in stock compensation of $3.9 million during the nine months ended September 30, 2008 as compared to the same period in 2007 due to a one-time additional expense recognized in September 2007 in connection with the resignation of our former president and chief executive officer. Partially offsetting this decrease was an increase in stock compensation expense during the three months ended September 30, 2008 as compared to the same period in 2007 due to additional annual equity grants in 2008, including the initial grant to our new president and chief executive officer in December 2007.
Depreciation and amortization increased 33.6% to $19.7 million for the nine months ended September 30, 2008 as compared to $14.7 million for the nine months ended September 30, 2007. This increase is a result of the renovations at Delano Miami and Royalton, which both took place during 2007, and renovations at Mondrian Los Angeles and Morgans, which were both completed in early September 2008.
Interest Expense, net. Interest expense, net decreased 4.5% to $31.1 million for the nine months ended September 30, 2008 as compared to $32.5 million for the nine months ended September 30, 2007. The decrease in interest expense, net was primarily due to lower average rates during the nine months ended September 30, 2008 as compared to the same period in 2007.
Equity in loss of unconsolidated joint ventures increased by 28.4% to $16.5 million for the nine months ended September 30, 2008 as compared to $12.9 million for the nine months ended September 30, 2007. This loss was primarily driven by increased losses at the Hard Rock for the nine months ended September 30, 2008 as compared to the same period in 2007, which is primarily due to disruptions as a result of the current renovation and expansion underway at the Hard Rock.
The components of RevPAR from the comparable Joint Venture Hotels, which excludes the Hard Rock, as the Company invested in this hotel in February 2007 and it is currently under renovation and expansion, for the nine months ended September 30, 2008 and 2007 are summarized as follows:
                                 
    Nine Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
Occupancy
    71.3 %     72.1 %           1.1 %
ADR
  $ 437     $ 457     $ (20 )     (4.4 )%
RevPAR
  $ 312     $ 329     $ (17 )     (5.4 )%

 

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The components of RevPAR from the Hard Rock for the nine months ended September 30, 2008 and 2007 are summarized as follows:
                                 
    Nine Months Ended              
    Sept. 30,     Sept. 30,              
    2008     2007     Change ($)     Change (%)  
Occupancy
    93.6 %     95.4 %           (1.9 )%
ADR
  $ 197     $ 221     $ (24 )     (10.7 )%
RevPAR
  $ 185     $ 211     $ (26 )     (12.4 )%
As is customary for companies in the gaming industry, the Hard Rock presents average occupancy rate and average daily rate including rooms provided on a complimentary basis. Like most operators of hotels in the non-gaming lodging industry, we do not follow this practice at our other hotels, where we present average occupancy rate and average daily rate net of rooms provided on a complimentary basis.
Other non-operating expense (income) reflected expense of $5.9 million for the nine months ended September 30, 2008 compared to income of $0.9 million in the nine months ended September 30, 2007. Other non-operating expense recognized in the nine months ended September 30, 2008 relates primarily to legal costs incurred related to the Shore Club litigation, the write-off of furniture and fixtures at Mondrian Los Angeles and Morgans as a result of the hotels’ renovations, and costs related to development projects which were not capitalizable. The income recognized during the nine months ended September 30, 2007 relates to consideration of $6.1 million in cash received from the transfer of our joint venture partners’ 50% share of the London hotels to an unrelated third party, offset by legal expenses incurred related to the Shore Club litigation and the write-off of furniture and fixtures at Royalton.
Income tax benefit was a benefit of $10.6 million for the nine months ended September 30, 2008 as compared to $6.5 million for the nine months ended September 30, 2007. This change was a result of the loss recognized by the Company in the nine months ended September 30, 2008 as compared to the loss recognized in the nine months ended September 30, 2007.

 

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Liquidity and Capital Resources
As of September 30, 2008, we had approximately $59.7 million in cash and cash equivalents. The Company’s liquidity, as measured by cash and cash equivalents and availability under its revolving credit facility was $242.1 million as of September 30, 2008. The Company has both short-term and long-term liquidity requirements as described in more detail below. In addition, our share of excess cash at our London joint venture is approximately $15.0 million at September 30, 2008 exchange rates. We have not been able to distribute the cash in the past due to regulatory restrictions, and we are in the process of implementing a structure which we believe may enable us to distribute these funds in December 2008.
Liquidity Requirements
Short-Term Liquidity Requirements. We generally consider our short-term liquidity requirements to consist of those items that are expected to be incurred within the next 12 months and believe those requirements consist primarily of funds necessary to pay operating expenses and other expenditures directly associated with our properties, including the funding of our reserve accounts. Our reserve accounts consist of restricted cash that is swept by our lenders beginning on the ninth day of each month to fund monthly debt service payments, property, sales and occupancy taxes and insurance premiums of our hotels. After funding these reserve accounts, we fund operating expenses and our furniture, fixtures and equipment reserve (generally, approximately 4% of total revenues at each hotel). We expect to meet our short-term liquidity needs through existing cash balances and cash provided by our operations and, if necessary, from borrowings under our line of credit.
Long-Term Liquidity Requirements. We generally consider our long-term liquidity requirements to consist of those items that are expected to be incurred beyond the next 12 months and believe these requirements consist primarily of funds necessary to pay scheduled debt maturities, renovations and other non-recurring capital expenditures that need to be made periodically to our properties and the costs associated with acquisitions and development of properties under contract and new acquisitions and development projects that we may pursue. Our long-term liquidity requirements are also affected by a potential liability to a designer for which we have accrued $13.0 million. Historically, we have satisfied our long-term liquidity requirements through various sources of capital, including our existing working capital, cash provided by operations, equity and debt offerings, borrowings under our line of credit, and long-term mortgages on our properties. The Company has three unencumbered hotels — Delano, Royalton and Morgans — which are collateral for our revolving credit line. The Company may seek permanent mortgage financing on one or more of these hotels.
We believe that these sources of capital will continue to be available to us in the future to fund our long-term liquidity requirements. However, our ability to incur additional debt is dependent upon a number of factors, including our degree of leverage, the value of our unencumbered assets, borrowing restrictions imposed by existing lenders and general market conditions. In addition, our ability to raise funds through the issuance of equity securities is dependent upon, among other things, general market conditions and market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but the equity markets may not be consistently available on terms that are attractive or at all.
We may require additional borrowings, including borrowings under our line of credit, to satisfy our long-term liquidity requirements. Other sources may be sales of common or preferred stock and/or cash generated through property dispositions and joint venture transactions.
Anticipated Capital Expenditures and Liquidity Requirements
Stock Repurchase. On July 1, 2008, the Company’s Board of Directors authorized the repurchase of up to $30.0 million of the Company’s common stock, or approximately 9% of its outstanding shares based on the then current market price. We repurchased our stock through the open market. The timing and actual number of shares repurchased depended on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. As of October 9, 2008, we had completed this share repurchase program and purchased 2,794,653 shares for approximately $30.0 million.
Property Renovations. In addition to amounts spent to date during 2008 on renovations of existing owned hotels, such as Mondrian Los Angeles and Morgans, we anticipate spending approximately $5.0 million for the conversion of single room occupancy rental units at Hudson into guestrooms, in the last quarter of 2008 and during 2009. The majority of our capital expenditures are expected to be funded from existing cash balances.

 

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Development Projects. In addition to amounts spent to date during 2008 to fund investments in unconsolidated joint ventures, we anticipate spending a total of approximately $25.0 million during the last quarter of 2008 and during 2009 to fund investments in unconsolidated joint ventures. This includes funding for joint venture hotels under construction, such as Mondrian SoHo and Ames Boston, additional equity at Mondrian South Beach of approximately $11.0 million, of which $5.0 million was funded in October 2008, as the closing of condominium sales has not occurred as planned due to the recent changes in the mortgage market, and the funding of the $11.1 million of letters of credit at Hard Rock discussed below. As of November 5, 2008, we had funded $10.3 million of additional equity at Mondrian South Beach during 2008.
Hard Rock. On June 6, 2008, the joint venture closed on the construction financing for the expansion of the Hard Rock. The construction financing consists of a construction loan of up to $620.0 million under the Hard Rock’s existing loan facility. The Morgans Parties and DLJMB Parties also amended their joint venture agreement to reflect DLJMB’s commitment to make additional capital contributions to the Hard Rock of up to $144.0 million for the expansion project and up to $110.0 million to satisfy the minimum sales price or amortization payment requirements under the loan facility relating to the approximately 15.0 acres of excess land held for sale by the Hard Rock.
As of September 30, 2008, we have issued approximately $11.1 million of letters of credit toward the expansion. Except for funding these letters of credit, we do not currently intend to fund any portion of future expansion costs.
Echelon Las Vegas. In January 2006, we entered into a 50/50 joint venture with a subsidiary of Boyd, through which the joint venture plans to develop Delano Las Vegas and Mondrian Las Vegas as part of Boyd’s Echelon project. On August 1, 2008, Boyd announced that it will delay the entire Echelon project due to the difficult environment surrounding today’s capital markets and current economic conditions. On September 23, 2008, the Company and Boyd amended this joint venture agreement to, among other things, extend the deadline by which the joint venture must obtain construction financing for the development of Delano Las Vegas and Mondrian Las Vegas to December 31, 2009.
The amended joint venture agreement also provides for the immediate return of the $30.0 million deposit the Company had provided for the project, plus interest, which the Company received in September 2008. Additionally, the amended joint venture agreement eliminated approximately $41.0 million of the Company’s future funding obligations and eliminated any obligation by the Company to provide a construction loan guaranty. The amended joint venture agreement also limits the amounts that the Company and Boyd are required to continue to fund for pre-development and related costs to approximately $0.4 million each, which the Company expects to fund during the fourth quarter of 2008 and in early 2009.
Other Estimated Uses of Capital. We have a number of owned projects under consideration at our discretion including the Gale in South Beach and the development of the lower level at Hudson. We also have a number of joint venture projects including a potential Mondrian Chicago and Mondrian Palm Springs which may require equity investments. The Mondrian Chicago, Mondrian Palm Spring and Echelon projects do not currently have debt financing. Given the current state of the credit markets, the joint ventures may not be able to obtain adequate project financing in a timely manner or at all. If adequate project financing is not obtained, the joint ventures may seek additional investors to raise capital, limit the scope of the project, defer the project or cancel the project altogether.
Comparison of Cash Flows for the Nine Months Ended September 30, 2008 to September 30, 2007
Operating Activities. Net cash provided by operating activities was $19.6 million for the nine months ended September 30, 2008 compared to $27.2 million for the nine months ended September 30, 2007. The decrease in cash is primarily due to changes in working capital.
Investing Activities. Net cash used in investing activities amounted to $45.9 million for the nine months ended September 30, 2008 as compared to $77.7 million for the nine months ended September 30, 2007. The decrease in cash used in investing activities primarily relates to the $30.0 million deposit the Company made in February 2007 related to its investment in Echelon Las Vegas which was returned to the Company in September 2008 as a result of the amended joint venture agreement with Boyd. This decrease was offset by increases in our capital expenditures relating to ongoing renovations at Mondrian Los Angeles and Morgans.

 

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Financing Activities. Net cash used in financing activities amounted to $36.7 million for the nine months ended September 30, 2008 as compared to net cash provided by financing activities of $65.0 million for the nine months ended September 30, 2007. The decrease is primarily due to borrowings on our credit facility during the nine months ended September 30, 2007, which was used to fund the Echelon Las Vegas deposit discussed above, and the proceeds from the issuance of common stock in 2007 for which there was no comparable issuance in 2008. Slightly offsetting these decreases was an increase in the repurchases of the Company’s common stock during the nine months ended September 30, 2008 as compared to the same period in 2007.
Debt
Revolving Credit Agreement. On October 6, 2006, we and certain of our subsidiaries entered into a revolving credit facility in the initial amount of $225.0 million, which includes a $50.0 million letter of credit sub-facility and a $25.0 million swingline sub-facility (collectively, the “Revolving Credit Agreement”), with Wachovia Capital Markets, LLC and Citigroup Global Markets Inc.
The amount available from time to time under the Revolving Credit Agreement is contingent upon the amount of an available borrowing base calculated by reference to collateral described below. The available borrowing base is currently approximately $64.0 million, but that amount may be increased up to $225.0 million at the Borrower’s (defined below) option by increasing the amount of the borrowing capacity on Delano Miami granted by the Delano Miami mortgage lender (discussed below) and upon payment of the related additional recording tax, assuming financial ratios are maintained, as discussed below. Had the Borrower exercised this option, the available borrowing base as of September 30, 2008 (assuming an increase in the Delano Miami mortgage and payment of the related additional recording tax) would have been approximately $182.4 million, based on current covenant calculations. That availability may also be increased through procedures specified in the Revolving Credit Agreement for adding property to the borrowing base and for revaluation of the property that constitutes the borrowing base.
The commitments under the Revolving Credit Agreement terminate on October 5, 2011, at which time all outstanding amounts under the Revolving Credit Agreement will be due and payable. The borrower may, at its option, with the prior consent of the lender and subject to customary conditions, request an increase in the aggregate commitment under the Revolving Credit Agreement to up to $350.0 million.
The interest rate per annum applicable to loans under the Revolving Credit Agreement is at a fluctuating rate of interest measured by reference to, at our election, either LIBOR or a base rate, plus a borrowing margin. LIBOR loans have a borrowing margin of 1.35% to 1.90% determined based on the borrower’s total leverage ratio (with an initial borrowing margin of 1.35%) and base rate loans have a borrowing margin of 0.35% to 0.90% determined based on the borrower’s total leverage ratio (with an initial borrowing margin of 0.35%). The Revolving Credit Agreement also provides for the payment of a quarterly unused facility fee equal to the average daily unused amount for each quarter multiplied by 0.25%.
The Revolving Credit Agreement requires the borrower to maintain for each four-quarter period a total leverage ratio (total consolidated indebtedness, which does not include indebtedness related to the Convertible Notes, the liability to the subsidiary trust or Clift debt to consolidated EBITDA excluding Clift) of no more than 7.0 to 1.0 at any time during 2008, and 6.0 to 1.0 at any time after December 31, 2008, and a fixed charge coverage ratio (consolidated EBITDA excluding Clift to consolidated interest expense excluding Clift) of no less than 1.75 to 1.00 at all times. Under the agreement, as of September 30, 2008, our leverage ratio was 4.6 times and its fixed charge coverage ratio was 2.4 times. The Revolving Credit Agreement contains negative covenants, subject in each case to certain exceptions, restricting incurrence of indebtedness, incurrence of liens, fundamental changes, acquisitions and investments, asset sales, transactions with affiliates and restricted payments, including, among others, a covenant prohibiting us from paying cash dividends on its common stock.
The Revolving Credit Agreement provides for customary events of default, including failure to pay principal or interest when due, failure to comply with covenants, any representation proving to be incorrect, defaults relating to other indebtedness of at least $10.0 million in the aggregate, certain insolvency and receivership events affecting us, judgments in excess of $5.0 million in the aggregate being rendered against us, the acquisition by any person of 40% or more of any outstanding class of capital stock having ordinary voting power in the election of our directors, and the incurrence of certain ERISA liabilities in excess of $5.0 million in the aggregate.

 

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As of September 30, 2008, we were in compliance with the covenants of the Revolving Credit Agreement.
Obligations under the Revolving Credit Agreement are secured by, among other collateral, a mortgage on Delano Miami and the pledge of equity interests in the borrower and certain subsidiaries of the borrower, including the owners of Delano Miami, Morgans and Royalton, as well as a security interest in other significant personal property (including trademarks and other intellectual property, reserves and deposits) relating to those hotels.
The Revolving Credit Agreement is available on a revolving basis for general corporate purposes, including acquisitions. As of September 30, 2008, there were no borrowings outstanding under the Revolving Credit Agreement.
Mortgage Agreement. Also on October 6, 2006, our subsidiaries entered into mortgage financings with Wachovia Bank, National Association, as lender, consisting of two separate mortgage loans and a mezzanine loan. These loans, a $217.0 million first mortgage note secured by Hudson, a $32.5 million mezzanine loan secured by a pledge of the equity interests in our subsidiary owning Hudson, and a $120.5 million first mortgage note secured by Mondrian Los Angeles, which we refer to collectively as the Mortgages, all mature on July 15, 2010.
The Mortgages bear interest at a blended rate of 30-day LIBOR plus 125 basis points. We have the option of extending the maturity date of the Mortgages to October 15, 2011 provided that certain extension requirements are achieved, including but not limited to maintaining a debt service coverage ratio for the two fiscal quarters preceding the maturity date of 1.55 to 1.00 or greater. We maintain swaps that will effectively fix the LIBOR rate on the debt under the Mortgages at approximately 5.0% through the maturity date.
The prepayment clause in the Mortgages permits us to prepay the Mortgages in whole or in part on any business day, along with a spread maintenance premium (equal to the amount of the prepayment multiplied by the applicable LIBOR margin multiplied by the ratio of the number of months between the prepayment date and October 31, 2007 divided by 12).
The Mortgages require our subsidiary borrowers to fund reserve accounts to cover monthly debt service payments. Those subsidiary borrowers are also required to fund reserves for property, sales and occupancy taxes, insurance premiums, capital expenditures and the operation and maintenance of those hotels. Reserves are deposited into restricted cash accounts and are released as certain conditions are met. Our subsidiary borrowers are not permitted to have any liabilities other than certain ordinary trade payables, purchase money indebtedness, capital lease obligations and certain other liabilities.
The Mortgages prohibit the incurrence of additional debt on Hudson and Mondrian Los Angeles. Furthermore, the subsidiary borrowers are not permitted to incur additional mortgage debt or partnership interest debt. In addition, the Mortgages do not permit (i) transfers of more than 49% of the interests in the subsidiary borrowers, Morgans Group LLC or the Company or (ii) a change in control of the subsidiary borrowers or in respect of Morgans Group LLC or the Company itself without, in each case, complying with various conditions or obtaining the prior written consent of the lender.
The Mortgages provide for events of default customary in mortgage financings, including, among others, failure to pay principal or interest when due, failure to comply with certain covenants, certain insolvency and receivership events affecting the subsidiary borrowers, Morgans Group LLC or the Company, and breach of the encumbrance and transfer provisions. In the event of a default under the Mortgages, the lender’s recourse is limited to the mortgaged property, unless the event of default results from insolvency, a voluntary bankruptcy filing or a breach of the encumbrance and transfer provisions, in which event the lender may also pursue remedies against Morgans Group LLC.
As of September 30, 2008, we were in compliance with the covenants of the Mortgages.

 

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Notes to a Subsidiary Trust Issuing Preferred Securities. In August 2006, we formed a trust, MHG Capital Trust I, or the Trust, to issue $50.0 million of trust preferred securities in a private placement. The sole assets of the Trust consist of the Trust Notes due October 30, 2036 issued by Morgans Group LLC and guaranteed by us. The proceeds of the issuance of the Trust Notes were used to repay our then-existing credit agreement and to fund the equity contribution on Mondrian South Beach with the remainder available for general corporate purposes. The Trust Notes have a 30-year term, ending October 30, 2036, and bear interest at a fixed rate of 8.68% for the first 10 years, ending October 2016, and thereafter will bear interest at a floating rate based on the three-month LIBOR plus 3.25%. These securities are redeemable by the Trust at par beginning on October 30, 2011.
The Trust Note agreement requires that we maintain a fixed charge coverage ratio of 1.4 to 1.0. As of September 30, 2008, we were in compliance with the covenants of the Trust Note agreement.
Clift. We lease Clift under a 99-year non-recourse lease agreement expiring in 2103. The lease is accounted for as a financing with a balance of $81.2 million at September 30, 2008. The lease payments are $6.0 million per year through October 2014 with inflationary increases at five-year intervals thereafter beginning in October 2014.
Hudson. We lease two condominium units at Hudson which are reflected as capital leases with balances of $6.1 million at September 30, 2008. Currently, annual lease payments total approximately $800,000 and are subject to increases in line with inflation. The leases expire in 2096 and 2098.
Promissory Note. The purchase of the Gale, the property across from the Delano Miami, was partially financed with the issuance of a $10.0 million three-year interest only promissory note by us to the seller, which matures on January 24, 2009. At September 30, 2008, the note bore interest at 10.0%, effective January 2008 through maturity. In November 2008, we extended the maturity of the note until January 24, 2010 and agreed to pay the 11.0% interest for the year in full at the time of the extension.
Mondrian Scottsdale Debt. In May 2006, we obtained mortgage financing on Mondrian Scottsdale. The $40.0 million loan, which accrues interest at LIBOR plus 2.30%, matures in May 2009 with two remaining one-year extension options. We have purchased an interest rate caps which limit the interest rate exposure to 6.0% through June 1, 2009.
Convertible Debt. On October 17, 2007, we completed an offering of $172.5 million aggregate principal amount of 2.375% Senior Subordinated Convertible Notes, or the Notes, in a private offering, which included an additional issuance of $22.5 million in aggregate principal amount of Notes as a result of the initial purchasers’ exercise in full of their overallotment option. The Notes are the senior subordinated unsecured obligations of the Company and are guaranteed on a senior subordinated basis by our operating company, Morgans Group LLC. The Notes are convertible into shares of our common stock under certain circumstances and upon the occurrence of specified events.
In connection with the private offering, the Company entered into certain convertible note hedge and warrant transactions. These transactions are intended to reduce the potential dilution to the holders of our common stock upon conversion of the Notes and will generally have the effect of increasing the conversion price of the Notes to approximately $40.00 per share, representing a 82.23% premium based on the sale price of our common stock of $21.95 per share on October 11, 2007. The net proceeds to us from the sale of the Notes were approximately $166.8 million (of which approximately $24.1 million was used to fund the note call options and warrant transactions).
Seasonality
The hospitality business is seasonal in nature. Our Miami hotels are strongest in the first quarter, whereas our New York hotels are strongest in the fourth quarter. Quarterly revenues also may be adversely affected by events beyond our control, such as extreme weather conditions, terrorist attacks or alerts, natural disasters, airline strikes, economic factors and other considerations affecting travel.
To the extent that cash flows from operations are insufficient during any quarter, due to temporary or seasonal fluctuations in revenues, we may have to enter into additional short-term borrowings or draw on our line of credit to meet cash requirements.

 

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Capital Expenditures and Reserve Funds
We are obligated to maintain reserve funds for capital expenditures at our hotels as determined pursuant to our debt and lease agreements. These capital expenditures relate primarily to the periodic replacement or refurbishment of furniture, fixtures and equipment. Our debt and lease agreements require us to reserve funds at amounts equal to 4% of the hotel’s revenues and require the funds to be set aside in restricted cash. In addition, the restaurant joint ventures require the ventures to set aside restricted cash of between 2% to 4% of gross revenues of the restaurant. As of September 30, 2008, $7.7 million was available in restricted cash reserves for future capital expenditures.
The lenders under the Revolving Credit Agreement and Mortgages require the Company’s subsidiary borrowers to fund reserve accounts to cover monthly debt service payments. Those subsidiary borrowers are also required to fund reserves for property, sales and occupancy taxes, insurance premiums, capital expenditures and the operation and maintenance of those hotels. Reserves are deposited into restricted cash accounts and are released as certain conditions are met. The Company’s subsidiary borrowers are not permitted to have any liabilities other than certain ordinary trade payables, purchase money indebtedness, capital lease obligations, and certain other liabilities.
In addition to amounts spent to date during 2008 on renovations of existing owned hotels, such as Mondrian Los Angeles and Morgans, we anticipate spending approximately $5.0 million for the conversion of single room occupancy rental units at Hudson into guestrooms, in the last quarter of 2008 and during 2009. The majority of our capital expenditures are expected to be funded from existing cash balances.
Derivative Financial Instruments
We use derivative financial instruments to manage our exposure to the interest rate risks related to our variable rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. We determine the fair value of our derivative financial instruments using models which incorporate standard market conventions and techniques such as discounted cash flow and option pricing models to determine fair value. We believe these methods of estimating fair value result in general approximation of value, and such value may or may not be realized.
On February 22, 2006, we entered into an interest rate forward starting swap that effectively fixes the interest rate on $285.0 million of debt from June 2007 through June 2010. This derivative qualifies for hedge accounting treatment per SFAS No. 133 and accordingly, the change in fair value of this instrument is recognized in other comprehensive income.
In connection with the Mortgages (defined and discussed above), the Company entered into an $85.0 million interest rate swap that effectively fixes the LIBOR rate on the $85.0 million of debt at approximately 5.0% with an effective date of July 9, 2007 and a maturity date of July 15, 2010. This derivative qualifies for hedge accounting treatment per SFAS No. 133 and accordingly, the change in fair value of this instrument is recognized in other comprehensive income.
In May 2006, we entered into an interest rate cap agreement with a notional amount of $40.0 million, the expected full amount of debt secured by Mondrian Scottsdale, with a LIBOR cap of 6.00% through June 1, 2008, which has since been extended through June 1, 2009. This derivative qualifies for hedge accounting treatment and accordingly, the change in fair value of this instrument is recognized in other comprehensive income.
Off-Balance Sheet Arrangements
Morgans Europe. We own interests in two hotels through a 50/50 joint venture known as Morgans Europe. Morgans Europe owns two hotels located in London, England, St Martins Lane, a 204-room hotel, and Sanderson, a 150-room hotel. Under a management agreement with Morgans Europe, we earn management fees and a reimbursement for allocable chain service and technical service expenses.
Morgans Europe’s net income or loss and cash distributions or contributions are allocated to the partners in accordance with ownership interests. At September 30, 2008, our investment in Morgans Europe was $14.0 million. We account for this investment under the equity method of accounting. Our equity in income of the joint venture amounted to $0.9 million and $2.0 million for the nine months ended September 30, 2008 and 2007, respectively.

 

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South Beach Venture. We own a 50% interest in a building on Biscayne Bay in South Beach Miami through the South Beach Venture. The South Beach Venture is in the process of renovating and converting the building into a condominium and hotel to be operated under our Mondrian brand. We will operate Mondrian South Beach under a long-term incentive management contract.
We account for this investment under the equity method of accounting. At September 30, 2008, our investment in the South Beach Venture was $17.3 million. Our equity in loss of the South Beach Venture amounted to $1.1 million and $2.2 million for the nine months ended September 30, 2008 and 2007, respectively.
Hard Rock. As of September 30, 2008, we owned a 20.5% interest in the Hard Rock, based on cash contributions, through a joint venture with DLJMB. We also manage the Hard Rock under a management agreement, for which we receive a management fee and a chain service expense reimbursement of all non-gaming revenue including casino rents and all other rental income. The Company can also earn an incentive management fee based on EBITDA, as defined, above certain levels. We account for this investment under the equity method of accounting. At September 30, 2008, our investment in the Hard Rock venture was $22.1 million. Our equity in loss of this venture was $15.8 million and $12.1 million for the nine months ended September 30, 2008 and 2007, respectively.
Echelon Las Vegas. In January 2006, we entered into a limited liability company agreement with a subsidiary of Boyd through which it will develop, as 50/50 owners, Delano Las Vegas and Mondrian Las Vegas. We account for this investment under the equity method of accounting. At September 30, 2008, our investment in the Echelon Las Vegas venture was $17.4 million. This investment balance was reduced during the three months ended September 30, 2008, by approximately $30.0 million as a result of the return of the deposit made to Boyd upon consummation of the Hard Rock transaction. Our equity in loss of the Echelon Las Vegas venture was $0.7 million and $0 for the nine months ended September 30, 2008 and 2007, respectively.
Mondrian SoHo. In June 2007, we contributed approximately $5.0 million for a 20% equity interest in a joint venture with Cape Advisors Inc. to acquire and develop a Mondrian hotel in the SoHo neighborhood of New York City. Upon completion, we are expected to operate the hotel under a 10-year management contract with two 10-year extension options. In July 2008, we contributed an additional $1.5 million in equity toward our 20% interest. As of September 30, 2008, our investment in the Mondrian SoHo venture was $6.6 million.
Mondrian Chicago. In June 2007, we formed a joint venture with M Development to lease and develop a Mondrian hotel in Chicago. We will have a 49% equity interest in the joint venture and expect to contribute approximately $15.0 million to the project, of which approximately $2.3 million was contributed as of September 30, 2008. Upon completion, we are expected to operate the hotel under a 20-year management contract with two 5-year extension options. As of September 30, 2008, our investment in the Mondrian Chicago venture was $2.5 million.
Ames Boston. On June 17, 2008 the Company, Normandy Real Estate Partners, and local partner Ames Hotel Partners entered into a new joint venture to develop the Ames Boston hotel in Boston, Massachusetts. Upon completion, we expect to operate Ames Boston under a long-term management contract. Ames Boston is expected to open in the third quarter of 2009. We expect to commit approximately $10.0 million for a 35% economic interest in the joint venture. As of September 30, 2008, our investment in the Ames Boston joint venture was $7.1 million, of which $6.8 million funded our capital account. The project is expected to qualify for federal and state historic rehabilitation tax credits, which may reduce the equity investment.
For further information regarding our off balance sheet arrangements, see Note 4 to the Consolidated Financial Statements.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.

 

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We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. No material changes to our critical accounting policies have occurred since December 31, 2007.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Quantitative and Qualitative Disclosures About Market Risk
Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Some of our outstanding debt has a variable interest rate. As described in “Management’s Discussion and Analysis of Financial Results of Operations — Derivative Financial Instruments” above, we use some derivative financial instruments, primarily interest rate caps, to manage our exposure to interest rate risks related to our floating rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. As of September 30, 2008, our total outstanding debt, including capitalized lease obligations, was approximately $730.1 million, of which approximately $410.0 million, or 56.2%, was variable rate debt.
We entered into hedging arrangements on $285.0 million of debt which became effective on July 9, 2007 and cap LIBOR at approximately 5.0%. At September 30, 2008, the one month LIBOR rate was 3.9%. If market rates of interest on this variable rate debt increases by 1.0%, or 100 basis points, the increase in interest expense would reduce future pre-tax earnings and cash flows by approximately $2.9 million annually. The maximum annual amount the interest expense would increase on this variable rate debt is $3.2 million due to our interest rate cap agreement. If market rates of interest on this variable rate debt decrease by 1.0%, or 100 basis points, the decrease in interest expense would increase pre-tax earnings and cash flows by approximately $2.9 million annually.
We also entered into hedging arrangements on $40.0 million of debt secured by Mondrian Scottsdale, with a LIBOR cap of 6.0% through June 1, 2009. If market rates of interest on this variable rate debt increases by 1.0%, or 100 basis points, the increase in interest expense would reduce future pre-tax earnings and cash flows by approximately $0.4 million annually. The maximum annual amount the interest expense would increase on this variable rate debt is $0.8 million due to our interest rate cap agreement. If market rates of interest on this variable rate debt decrease by 1.0%, or 100 basis points, the decrease in interest expense would increase pre-tax earnings and cash flows by approximately $0.4 million annually.
If market rates of interest increase by 1.0%, or approximately 100 basis points, the fair value of our fixed rate debt would decrease by approximately $16.0 million. If market rates of interest decrease by 1.0%, or approximately 100 basis points, the fair value of our fixed rate debt would increase by $53.5 million.
Interest risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments and future cash flows. These analyses do not consider the effect of a reduced level of overall economic activity. If overall economic activity is significantly reduced, we may take actions to further mitigate our exposure. However, because we cannot determine the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.

 

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Currency Exchange Risk
As we have international operations with our two London hotels, currency exchange risk between the U.S. dollar and the British pound arises as a normal part of our business. We reduce this risk by transacting this business in British pounds. We have not repatriated earnings from our London hotels because of our historical net losses in our United Kingdom operations and our joint venture agreement. As a result, any funds repatriated from the United Kingdom are considered a return of capital and require court approval. We may consider repatriating certain funds in 2008. A change in prevailing rates would have, however, an impact on the value of our equity in Morgans Europe. The U.S. dollar/British pound currency exchange is currently the only currency exchange rate to which we are directly exposed. Generally, we do not enter into forward or option contracts to manage our exposure applicable to net operating cash flows. We do not foresee any significant changes in either our exposure to fluctuations in foreign exchange rates or how such exposure is managed in the future.
Item 4. Controls and Procedures.
As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including the chief executive officer and the chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rule 13a-15 of the rules promulgated under the Securities and Exchange Act of 1934, as amended. Based on this evaluation, our chief executive officer and the chief financial officer concluded that the design and operation of these disclosure controls and procedures were effective as of the end of the period covered by this report.
There were no changes in our internal control over financial reporting (as defined in Rule 13a-15 of the Securities and Exchange Act of 1934, as amended) that occurred during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II—OTHER INFORMATION
Item 1. Legal Proceedings.
Litigation
In 2002, we, through a wholly-owned subsidiary, Shore Club Holdings, LLC, invested in Shore Club, and our management company, MHG Management Company, took over management of the property. The management agreement expires in 2022.
In January 2006, an action was brought in New York state court against several defendants, including two subsidiaries of the Company and certain officers and directors of NorthStar and the Company, including David Hamamoto, the Company’s Chairman of the Board and the Co-Chairman of the Board of Directors and Co-Chief Executive Officer of NorthStar, styled Philips South Beach, LLC v. Morgans Hotel Group Management, LLC et al., Index No. 06/600147 (N.Y. Sup. Ct.), which we refer to as the Shore Club Litigation. An additional action was commenced in March 2006 in New York state court against several defendants, including the company, NorthStar, David Hamamoto, and certain other individuals and entities, styled Century Operating Associates v. NorthStar Hospitality LLC, et al., Index No. 601007/06-E (N.Y. Sup. Ct.), which we refer to as the Century Litigation (together with the Shore Club Litigation, the “Litigations”).
On April 4, 2008, the Company and certain of its subsidiaries entered into a global settlement agreement with Philips South Beach, LLC, Century Operating Associates, Philip Pilevsky and certain of his affiliates, Residual Hotel Interest LLC and certain of its affiliates, Becker-Paramount LLC, W. Edward Scheetz, David T. Hamamoto, RSA Associates, L.P., NorthStar and certain of its subsidiaries, Clark SB II LLC, Clark SB LLC, The Clark Foundation, The Scriven Foundation, Jane Clark and Kevin Moore, pursuant to which the Shore Club litigation, regarding the management of the Shore Club hotel, and the Century Litigation, regarding the structuring transactions that were part of the company’s IPO and the IPO itself, along with related litigations and an additional litigation in which we are not involved, have been settled (the “Settlement”).
We were not required to make any cash payments as part of the Settlement. Under the relevant terms of the Settlement, the management agreement pursuant to which MHG Management Company manages Shore Club was amended to provide for, among other things, a reduction beginning in 2009 in the management and chain services fees, a reduction beginning in 2012 in the termination payment to be made by the owner of Shore Club to MHG Management Company upon termination of the management agreement, and certain changes to operating procedures at Shore Club.
The Litigations have been submitted for coverage by NorthStar under certain primary and excess insurance policies, or Insurance Policies, issued to NorthStar under which certain subsidiaries of the company and certain individual defendants in the Litigations, including Mr. Hamamoto, are also insured. The insurers have paid certain amounts to NorthStar in connection with the Litigations under the Insurance Policies.
The Company and NorthStar entered into an Insurance Proceeds Sharing Agreement on January 18, 2008, pursuant to which NorthStar paid us one-half of the aggregate insurance proceeds received by NorthStar in connection with the Litigations under the Insurance Policies as of the date of the Insurance Proceeds Sharing Agreement. The parties have also agreed that all future insurance proceeds received from the Insurance Policies in connection with the Litigations shall be allocated equally among the parties.
David Hamamoto, the Chairman of the Board, and Marc Gordon, a member of the Board and the Company’s Chief Investment Officer and Executive Vice President, Capital Markets, are beneficial owners of equity interests in NorthStar and Mr. Hamamoto is the Co-Chairman of the Board of Directors and Co-Chief Executive Officer of NorthStar. In addition, NorthStar, through its status as an affiliate of NorthStar Partnership, L.P., has certain rights to request, subject to certain limitations, that the Company register shares of the Company’s common stock owned by NorthStar pursuant to a registration rights agreement.

 

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Hard Rock Financial Advisory Agreement
In July 2008, the Company received an invoice from Credit Suisse Securities (USA) LLC (“Credit Suisse”) for $9.4 million related to the Financial Advisory Agreement the Company entered into with Credit Suisse in July 2006. Under the terms of the Financial Advisory Agreement, Credit Suisse received a transaction fee (the “Transaction Fee”) for placing DLJMB, an affiliate of Credit Suisse, in the Hard Rock joint venture. The Transaction Fee which was paid by the Hard Rock joint venture at the closing of the Transactions, as defined above in Note 4, and was based upon an agreed upon percentage of the initial equity contribution made by DLJMB in entering into the joint venture. The invoice received in July 2008 alleges that as a result of events subsequent to the closing of the Transactions, Credit Suisse is due additional transaction fees. The Company believes this invoice is invalid, and would otherwise be a Hard Rock joint venture liability.
Other Litigation
We are involved in various lawsuits and administrative actions in the normal course of business. In management’s opinion, disposition of these lawsuits is not expected to have a material adverse effect on our financial position, results of operations or liquidity.
Item 1A. Risk Factors
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 and the following additional risk factor:
Recent disruptions in the financial markets could affect our ability to obtain financing for development of our properties and other purposes on reasonable terms and have other adverse effects on us and the market price of our common stock.
The global stock and credit markets have recently experienced significant price volatility, dislocations and liquidity disruptions, which have caused market prices of many stocks to fluctuate substantially and the spreads on prospective debt financings to widen considerably. These circumstances have materially impacted liquidity in the financial markets, making terms for certain financings less attractive, and in some cases have resulted in the unavailability of financing. Continued uncertainty in the stock and credit markets may negatively impact our ability to access additional financing for development of our properties and other purposes at reasonable terms, which may negatively affect our business. A prolonged downturn in the financial markets may cause us to seek alternative sources of potentially less attractive financing, and may require us to adjust our business plan accordingly. These events also may make it more difficult or costly for us to raise capital through the issuance of our common stock or preferred stock. The disruptions in the financial markets may have a material adverse effect on the market value of our common stock and other adverse effects on us and our business.
We believe that the following risk factor no longer applies to the Company: “We are currently involved in litigation regarding our management of Shore Club. This litigation may harm our business or reputation and defense of this litigation may divert management resources from the operations of our business.” Otherwise, we do not believe that there have been any material changes to the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. These risks and uncertainties have the potential to materially affect our business, financial condition, results of operations, cash flows, projected results and future prospects.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Third Quarter 2008 Purchases of Equity Securities
The following table provides information about the Company’s purchases of its common stock during the quarter ended September 30, 2008:
                                 
                            Approximate Dollar  
                    Total Number of     Value of Common  
                    Common Shares     Shares that May Yet Be  
    Total Number of             Purchased as Part of     Purchased Under the  
    Common Shares     Average Price Paid per     Publicly Announced     Plans or Programs  
Period   Purchased (1)     Common Share     Plans or Programs     (in thousands)  
July 1 — 31, 2008
    1,099,900     $ 11.05       1,099,900     $ 17,822  
August 1 — 31, 2008
        $           $ 17,822  
September 1 — 30, 2008
    191,800     $ 11.98       1,291,700     $ 15,519  
Total
    1,291,700     $ 11.19       1,291,700     $ 15,519  
 
     
(1)  
All shares were repurchased under our 2008 stock repurchase program. Our 2008 stock repurchase program was authorized by our Board of Directors and announced by the Company on July 1, 2008. Under the 2008 stock repurchase program, we were authorized to repurchase up to $30.0 million of our common stock through the open market or in privately negotiated transactions from time to time on or before July 1, 2009. The timing and actual number of shares repurchased depended on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. As of October 9, 2008, the Company has completed this share repurchase program and purchased 2,794,653 shares for approximately $30.0 million.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
Item 6. Exhibits.
The exhibits listed in the accompanying Exhibit Index are filed as part of this report.

 

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
         
  Morgans Hotel Group Co.
 
 
November 7, 2008  /s/ Fred J. Kleisner    
  Fred J. Kleisner   
  President and Chief Executive Officer   
 
November 7, 2008  /s/ Richard Szymanski    
  Richard Szymanski   
  Chief Financial Officer and Secretary  

 

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Exhibit Index
         
Exhibit No.   Description of Exhibit
  2.1    
Agreement and Plan of Merger, dated May 11, 2006, by and among Morgans Hotel Group Co., MHG HR Acquisition Corp., Hard Rock Hotel, Inc. and Peter Morton (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on May 17, 2006)
       
 
  2.2    
First Amendment to Agreement and Plan of Merger, dated as of January 31, 2007, by and between Morgans Hotel Group Co., MHG HR Acquisition Corp., Hard Rock Hotel, Inc., (solely with respect to Section 1.6 and Section 1.8 thereof) 510 Development Corporation and (solely with respect to Section 1.7 thereof) Peter A. Morton (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on February 6, 2007)
       
 
  3.1    
Amended and Restated Certificate of Incorporation of Morgans Hotel Group Co. (incorporated by reference to Exhibit 3.1 to Amendment No. 6 to the Company’s Registration Statement on Form S-1 (File No. 333-129277) filed on February 9, 2006)
       
 
  3.2    
By-laws of Morgans Hotel Group Co. (incorporated by reference to Exhibit 3.2 to Amendment No. 6 to the Company’s Registration Statement on Form S-1 (File No. 333-129277) filed on February 9, 2006)
       
 
  4.1    
Specimen Certificate of Common Stock of Morgans Hotel Group Co. (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the Company’s Registration Statement on Form S-1 (File No. 333-129277) filed on January 17, 2006)
       
 
  4.2    
Junior Subordinated Indenture, dated as of August 4, 2006, between Morgans Hotel Group Co., Morgans Group LLC and JPMorgan Chase Bank, National Association (incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on August 11, 2006)
       
 
  4.3    
Amended and Restated Trust Agreement of MHG Capital Trust I, dated as of August 4, 2006, among Morgans Group LLC, JPMorgan Chase Bank, National Association, Chase Bank USA, National Association, and the Administrative Trustees Named Therein (incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on August 11, 2006)
 
  4.4    
Stockholder Protection Rights Agreement, dated as of October 9, 2007, between Morgans Hotel Group Co. and Mellon Investor Services LLC, as Rights Agent (incorporated by reference to Exhibit 4.1 of the Company’s Current Report on Form 8-K filed on October 10, 2007)
       
 
  4.5    
Indenture related to the Senior Subordinated Convertible Notes due 2014, dated as of October 17, 2007, by and among Morgans Hotel Group Co., Morgans Group LLC and The Bank of New York, as trustee (including form of 2.375% Senior Subordinated Convertible Note due 2014) (incorporated by reference to Exhibit 4.1 of the Company’s Current Report on Form 8-K filed on October 17, 2007)
       
 
  4.6    
Registration Rights Agreement, dated as of October 17, 2007, between Morgans Hotel Group Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by reference to Exhibit 4.2 of the Company’s Current Report on Form 8-K filed on October 17, 2007)
 
  4.7    
Amendment to the Stockholder Protection Rights Agreement, dated July 25, 2008, between the Company and Mellon Investor Services LLC, as Rights Agent (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on July 30, 2008)
       
 
  10.1    
Third Amendment to Morgans Las Vegas, LLC Limited Liability Company Agreement, dated September 23, 2008, by and between Morgans/LV Investment LLC and Echelon Resorts Corporation (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on September 25, 2008)

 

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Exhibit No.   Description of Exhibit
  31.1    
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
       
 
  31.2    
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
       
 
  32.1    
Certificate of Chief Executive Officer pursuant to 18 U.S.C. 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002*
       
 
  32.2    
Certificate of Chief Financial Officer pursuant to 18 U.S.C. 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002*

 

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Exhibit 31.1
CERTIFICATION BY THE CHIEF EXECUTIVE OFFICER PURSUANT TO
17 CFR 240.13a-14(a)/15(d)-14(a),
AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Fred J. Kleisner, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Morgans Hotel Group Co. for the fiscal quarter ended September 30, 2008;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
         
  /s/ Fred J. Kleisner    
  Fred J. Kleisner   
  President and Chief Executive Officer   
Date: November 7, 2008

 

 

Exhibit 31.2
CERTIFICATION BY THE CHIEF FINANCIAL OFFICER PURSUANT TO
17 CFR 240.13a-14(a)/15(d)-14(a),
AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Richard Szymanski, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Morgans Hotel Group Co. for the fiscal quarter ended September 30, 2008;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
         
  /s/ Richard Szymanski    
  Richard Szymanski   
  Chief Financial Officer   
Date: November 7, 2008

 

 

Exhibit 32.1
CERTIFICATION BY THE CHIEF EXECUTIVE OFFICER PURSUANT TO
RULE 13a-14(b) UNDER THE SECURITIES EXCHANGE ACT OF 1934
AND 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report on Form 10-Q of Morgans Hotel Group Co. (the “Company”) for the fiscal quarter ended September 30, 2008, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Fred J. Kleisner, as Chief Executive Officer of the Company hereby certifies, pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge:
1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities and Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all material aspects, the financial condition and results of operations of the Company.
         
  /s/ Fred J. Kleisner    
  Fred J. Kleisner   
  Chief Executive Officer   
Date: November 7, 2008
A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.

 

 

Exhibit 32.2
CERTIFICATION BY THE CHIEF FINANCIAL OFFICER PURSUANT TO
RULE 13a-14(b) UNDER THE SECURITIES EXCHANGE ACT OF 1934
AND 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report on Form 10-Q of Morgans Hotel Group Co. (the “Company”) for the fiscal quarter ended September 30, 2008 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Richard Szymanski, as Chief Financial Officer of the Company hereby certifies, pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge:
1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities and Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all material aspects, the financial condition and results of operations of the Company.
         
  /s/ Richard Szymanski    
  Richard Szymanski   
  Chief Financial Officer   
Date: November 7, 2008
A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.