Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation.
Forward Looking Statements
Statements made in this Quarterly Report of the Castle Group, Inc. (“Castle” or the “Company”) which are not purely historical are forward-looking statements with respect to the goals, plan objectives, intentions, expectations, financial condition, results of operations, future performance and business of the Company, including, without limitation, (i) Castle’s ability to raise capital, and (ii) statements preceded by, followed by or that include the words “may,” “would,” “could,” “should,” “expects,” “projects,” “anticipates,” “believes,” “estimates,” “plans,” “intends,” “targets” or similar expressions.
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Forward-looking statements involve inherent risks and uncertainties, and important factors (many of which are beyond the Company’s control) that could cause actual results to differ materially from those set forth in the forward-looking statements, including the following: general economic or industry conditions, nationally and/or in the communities in which the Company conducts business; changes in the interest rate environment, legislation or regulatory requirements; conditions of the securities markets; the Company’s ability to raise capital; changes in accounting principles, policies or guidelines; financial or political instability; acts of war or terrorism; other economic, competitive, governmental, regulatory and technical factors affecting Castle’s operations, products, services and prices.
Factors that may affect forward-looking statements include a wide range of factors that could materially affect future developments and performance, including the following:
changes in Company-wide strategies, which may result in changes in the types or mix of businesses in which Castle is involved or chooses to invest; changes in U.S., global or regional economic conditions; changes in U.S. and global financial and equity markets, including significant interest rate fluctuations, which may impede Castle’s access to, or increase the cost of, external financing for its operations and investments; increased competitive pressures, both domestically and internationally; legal and regulatory developments, such as regulatory actions affecting environmental activities; the imposition by foreign countries of trade restrictions and changes in international tax laws or currency controls; adverse weather conditions or natural disasters, such as hurricanes and earthquakes, labor disputes, which may lead to increased costs or disruption of operations. This list of factors that may affect future performance and the accuracy of forward-looking statements are illustrative, but by no means exhaustive. Accordingly, all forward-looking statements should be evaluated with the understanding of their inherent uncertainty.
Overview
Principal products or services and their markets
General
Castle is a hospitality and hotel management company that prides itself on its ability to be both “Flexible and Focused,” which is the Company’s operations motto. Flexible, to meet the specific needs of property condo owners at the properties that it manages; and focused, in its efforts to achieve enhanced rental income and profitability for those owners. Castle earns its revenues by providing several types of services to property owners including, hotel and resort management and operations; reservations staffing and operations; sales and marketing; and accounting. In addition, Castle provides design services to properties that are furnishing, refurnishing or remodeling, as well as, pre-opening technical services for new hotel and resort properties being planned or under construction. Castle’s revenues are derived primarily from two sources: (1) the rental of hotel rooms and condominium accommodations; and food and beverage sales at the properties it manages and; (2) fees paid for services it provides to property owners. Castle also derives revenues from commissions and incentive payments, based on sales and performance criteria at each property.
Marketing Strategy
Most of our marketing efforts are focused towards acquiring and retaining guests for the properties we manage. Castle does not own any hotels or resorts; however, it has made real estate investments in the properties that it manages in Hilo, Hawaii and New Zealand. Marketing is done through a variety of distribution channels including direct internet sales, wholesalers, online and traditional travel agencies, and group tour operators. Unlike many other hotel and resort operators, we do not market the properties we manage under the Castle brand. Instead of emphasizing the “Flag” or “Chain” name, Castle’s strategy is to promote the name and reputation of the individual properties under management as we believe that “one standard does not fit all.” We believe that this allows the consumer to better choose the specific type of vacation experience desired based upon the specific attributes of the property selected.
Our website (www.CastleResorts.com) offers state-of-the-art functionalities, user-friendly navigation, interactive features and rich content, while offering attractive rates and a travel booking engine that supports a dynamic pricing model which maximizes revenues for all of our properties under management. We intend to continue to invest in optimizing our online presence directed specifically towards our own website, since revenue derived through our own branded website yields a higher margin utilizing retail rates. Castle supports its online presence with its own full service, reservation call center that provides a wide range of services from tour reservation processing and rooms control, to handling group bookings. The reservation center electronically connects resort property inventory and rates to the four major Global Distribution Systems (“GDS”). This connectivity displays rates and inventory of Castle’s properties to over 500,000 travel agents worldwide as well as Internet connectivity to over 1,200 travel websites worldwide.
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For customer convenience, we offer direct to consumer online booking reservations of guest rooms at resort and condominium properties under contract and also vacation packages with attractions and activities related to our hotels and condominiums through Castle’s interactive web site at www.CastleResorts.com.
Diversity
Castle has a diverse portfolio of properties located in desired island resort destinations throughout the Pacific Region. We represent hotels, resort condominiums, and lodging accommodations throughout Hawaii, and in New Zealand.
In Hawaii, Castle represents properties on all of the five major Hawaiian Islands of Oahu (Waikiki), Maui, Kauai, Molokai and Hawaii (Big Island). This allows customers the option to island-hop, and provides Castle cross-selling opportunities. Our Honolulu headquarters serves as the epicenter for our international operation in New Zealand. Our diverse destinations offer customers the opportunity to discover new experiences and varying geographic areas and cultures.
Castle offers a wide range of accommodations at various price points from exclusive private villas, full-service all-suites hotels, oceanfront resort condominiums, to modestly priced hotels with hundreds of guest rooms. Our collection of all-suites condominium resorts, hotels, lodges and vacation rentals allows customers to select the best accommodation to suit their individual style and budget.
Our ability to deliver consistent financial returns to our property owners demonstrates Castle’s competency in managing and marketing a wide range of accommodations to our customers via multiple channels of distribution.
Brand Strategy
Castle does not brand the properties under its management. Each property Castle manages is individually marketed in order to extract maximum value from its unique strengths. Our strategy is that we do not promote Castle as a brand name but instead, we focus on our customers, the owners of the properties we manage. As Castle does represent a diverse range of properties it represents, its brand strategy is that one size does not fit all. The Castle brand stays in the background and our focus is on marketing the uniqueness of each property, while satisfying the needs and expectations of our owners. Each property we manage maintains its own brand identity and personality, while utilizing the Castle advantage of our powerful marketing resources, channel distribution, resort management expertise, industry partnerships, and networks.
Castle’s brand strategy is one of the areas that clearly differentiates us from the high profile branded hospitality companies. When a hotel owner or developer is considering contracting a large worldwide hospitality company for possible hotel management, there are several considerations that must be assessed. With major worldwide brands, usually come the high costs that the owner must bear to sustain the expensive marketing and operational expense that the brand demands to offset their marketing costs. The owner may also have to make a substantial investment in the property in order to fit into the “cookie cutter” mold that the brand desires. There are also some tangible differences from the guest’s or customer’s perspective as well.
Castle markets each property with its own independent brand identity and deploys customized marketing, operational and service programs to fit the specific demographics attracted to each of our properties. Through our individual property brand building efforts, we begin the process of positioning each of our resort brands to our key market segments, niche targeted customers and distribution channels.
We do not flag our properties with the Castle name. The advantages of doing so are several. There is a high demand for the independent smaller boutique hotels and condominiums, as travelers favor a more individualized and unique travel experience. This ongoing trend towards smaller, independent hotels, as opposed to the familiar chains, is not only occurring in Hawaii, but is also seen throughout the world tourism marketplace. This increased demand is fueled by the following traveler’s expectations:
· Travelers seek individualized recognition, attention, and service.
· Guests desire hotel and condominium accommodations that impart a sense of home and provide a unique, hospitable guest experience.
· Customers demand differing quality and personalized service and providing this creates high customer loyalty and repeat business.
· Customers seek Hawaii due to the feeling of “Ohana”, or family, experiencing the unique feeling of Aloha imparted by the people of Hawaii.
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Marketing Programs and Promotions
Castle has implemented numerous marketing programs and promotions directed towards both the consumer and trade markets to generate incremental revenue and market loyalty for the individual properties. We have developed a wide range of programs designed specifically to reflect the unique attributes of each of our resort properties, while also providing various incentives. At any given time, we may have a number of ongoing marketing programs and promotions in place, some of which are seasonal to drive incremental room night revenues during valley or shoulder periods and some of which are ongoing throughout the year.
Growth Strategy
The majority of the properties presently managed by Castle are located within the state of Hawaii. Significant opportunities for Castle to obtain additional contracts within the State of Hawaii are also available to us due to a myriad of factors that include sales of properties, foreclosures, underperformance, and dissatisfaction with the current management of our competitors. In addition, Castle manages a property in New Zealand, and is keeping the option to strategically expand operations into Thailand, Saipan and Guam. We believe that there are significant opportunities to expand Castle’s operations both in the markets it currently serves, as well as other Pacific Basin and Asian vacation destinations.
As part of Castle’s strategies to secure long term, multi-year management contracts, from time to time, we have found it advantageous to purchase or lease selected real property within a resort or condominium project. This occurred in 2004, when we purchased the front desk, restaurant, bar, ballroom, board room, conference rooms, back of the house facilities and other areas (collectively the “Podium”) at our New Zealand property that are necessary for the hotel’s operation. Through our ownership of the Podium and a ten year management contract for the Spencer on Byron hotel, Castle is assured of ongoing revenues in future years from this property. In January of 2015, we purchased the front desk unit at one of our condominium resort properties located on the island of Kauai. This ownership solidifies our on-site presence at the property, allowing us to better service both our guests and the condominium owners that we represent.
In addition to seeking new hotel and resort condominium management contracts, we will continue to seek investment opportunities with hotel developers and owners.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Certain statements contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Plan of Operation” including statements regarding the anticipated development and expansion of Castle’s business, the intent, belief or current expectations of the performance of Castle and the products and/or services it expects to offer and other statements contained herein regarding matters that are not historical facts, are “forward-looking” statements. Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements include, but are not limited to, the factors set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Plan of Operation.”
Revenues
Total revenues for the quarter ended June 30, 2016 were $5,919,287, a 10% increase over the $5,380,886 reported for the three months ended June 30, 2015; for the six months ended June 30, 2016, total revenues were $12,376,574, an 8% increase over the $11,474,757 reported for the six months ended June 30, 2015. The increase is attributed to a Gross Contract which we acquired in July of 2015, the signing of an association management agreement in July of 2015, and the signing of another property under a Net Contract in February of 2016.
Revenues attributed from properties showed an increase of 14%, to $3,051,639, for the three months ended June 30, 2016 from $2,680,728 for the three months ended June 30, 2015; for the six months ended June 30, 2016, revenues attributed from properties showed an increase of 6%, to $6,395,080 from $6,054,379 for the six months ended June 30, 2015. This increase is again due to a Gross Contract which we acquired in July of 2015. Management and service revenues increased by 6% for the three months ended June 30, 2016 to $2,867,048 in 2016 from $2,698,758 for the three months ended June 30, 2015; management and service revenues for the six months ended June 30, 2016 were $5,979,794, a 10% increase over the $5,418,578 reported for the six months ended June 30, 2015. The increase in Management and service revenue is attributed to the additional property which we signed on in February of 2016, the signing of an association management agreement in July of 2015, and an increase in fees generated from the properties we manage under a net contract.
Other revenue was $600 for the three months ended June 30, 2016 compared to $1,400 for the three months ended June 30, 2015. Other revenue was $1,700 for the six months ended June 30, 2016 compared to $1,800 for the six months ended June 30, 2015.
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The Company recorded investment income of $14,000 and $18,000, for the three months ended June 30, 2016 and 2015, respectively, which represents the Company’s 7% share of the income from the limited liability company that owns one of the hotels managed by the Company. For the six months ended June 30, 2016 and 2015, the Company reported investment income of $28,000 and $68,000, respectively.
Expenses
Attributed property expenses are those expenses related to the management of the resort and condominium properties which are operated on a Gross Contract basis. Attributed property expenses for the three months ended June 30, 2016 compared to 2015 increased by 2%, from $2,718,815 to $2,768,193; attributed property expenses for the six months ended June 30, 2016 compared to 2015 increased by 2%, from $5,546,108 to $5,643,985. The increase is attributed to the acquisition of a Gross Contract in July 2015.
Compared to the prior year, payroll and office expenses increased by 3% from $2,797,010 for the three months ended June 30, 2015 to $2,894,346 for the three months ended June 30, 2016; payroll and office expenses increased by 7%, from $5,554,172 for the six months ended June 30, 2015 to $5,969,494 for the six months ended June 30, 2016. The increase in cost is a result of additional payroll costs for Net Contracts which we acquired in February 2016 and July 2015.
Administrative and general expenses increased by 36% from $87,917 to $119,569 for the three months ended June 30, 2016 as compared to 2015; administrative and general expenses increased by 15% from $291,914 to $335,128 for the six months ended June 30, 2016 as compared to 2015. This increase was due to additional contracted labor costs related to converting our central reservations systems and higher Hawaii general excise tax expense related to the increase in our total revenue.
Depreciation
Our business is to provide services to our clients and as such does not require a great deal of capital expenditure for equipment or fixed assets. As a result, depreciation expense was $59,578 and $56,804 for the three months ended June 30, 2016 and 2015, respectively, and $121,570 and $113,225 for the six months ended June 30, 2016 and 2015, respectively.
Equity Method Investment Income
In 2010 the Company acquired a 7% common series interest in the ownership of a hotel located in Hawaii. The Company received the interest in exchange for the Company’s assistance to the buyers of the hotel in negotiating the purchase, performing due diligence work and other consulting services.
During the three months ended June 30, 2016 and 2015, the Company recorded investment income of $14,000 and $18,000, respectively, representing the Company’s allocation of net income from its investment; for the six months ended June 30, 2016 and 2015, the Company recorded investment income of $28,000 and $68,000, respectively. The decrease is due to the investment receiving a smaller dividend from its hotel during the quarter and six months ended June 30, 2016 as compared to the prior year.
Interest Expense
Interest expense was $77,442 and $88,104 for the three months ended June 30, 2016 and 2015, respectively, and $159,391 and $179,912 for the six months ended June 30, 2016 and 2015, respectively. Included in interest expense is interest that is imputed on the mortgage note for our Podium located in New Zealand of $50,010 for the three months ended June 30, 2016 and 2015, and $100,020 for the six months ended June 30, 2016 and 2015.
Income Taxes
Income tax benefit for the three months ended June 30, 2016 and 2015 was $2,203 and $86,520, respectively. Income tax expense for the six months ended June 30, 2016 and 2015 was $77,746 and $6,239, respectively. The decrease in tax benefits for the three months ended June 30, 2016 as compared to 2015 is due to a reduction in the loss reported by our domestic operations. The increase in tax expense for the six months ended June 30, 2016 as compared to 2015 is due to an increase in the net taxable income reported by our domestic operations.
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Net (Loss) Income
Net income for the three months ended June 30, 2016 was $16,362 compared to a net loss of $263,244 for the three months ended June 30, 2015; net income for the six months ended June 30, 2016 was $97,260 compared to a net loss of $148,813 for the six months ended June 30, 2015. The improvement in net income is attributed to the higher revenues for the properties under management and additional properties managed during the six months ended June 30, 2016 as opposed to the prior year.
Foreign Currency Translation Adjustment
For consolidated entities whose functional currency is not the U.S. dollar, Castle translates their financial statements into U.S. dollars. Assets and liabilities are translated at the spot rate currently in effect as of the financial statement date, and results of operations are translated using the weighted average exchange rate for the period.
Translation adjustments from foreign exchange are included as a separate component of stockholders’ equity. Changes in the carrying value of the assets and liabilities of the consolidated entities outside of the United States due to foreign exchange changes are reflected as Foreign Currency Adjustments. Foreign Currency Translation Loss totaled $5,279 compared to a gain of $15,022 for the three months ended June 30, 2016 and 2015, respectively; foreign currency translation loss totaled $428 compared to a gain of $10,987 for the six months ended June 30, 2016 and 2015, respectively.
Total Comprehensive (Loss) Income
Total comprehensive income for the three months ended June 30, 2016 was $11,083 as compared to a loss of $248,222 for the three months ended June 30, 2015; total comprehensive income for the six months ended June 30, 2016 was $96,832 as compared to a loss of $137,826 for the six months ended June 30, 2015. This is primarily a result of the changes in revenue and operating expenses, investment income, and foreign exchange rates noted above.
EBITDA
Earnings before Interest, Depreciation, Taxes and Amortization (“EBITDA”) reflects the Company’s earnings without the effect of depreciation, interest income or expense, taxes, or certain other non-cash income or expense items. EBITDA is a non-GAAP measure. The presentation of the financial information, which is not prepared under any comprehensive set of accounting rules or principles, is not intended to be considered in isolation of, or as a substitute for, the financial information prepared and presented in accordance with GAAP. Castle’s management believes that in many ways EBITDA it is a good alternative indicator of the Company’s financial performance. It removes the effects of non-cash depreciation and amortization of assets, as well as the fluctuations of interest costs based on the Company’s borrowing history and increases and decreases in tax expense brought about by changes in the provision for future tax effects rather than current income. A comparison of EBITDA and net income is shown below.
Comparison of Net Income (Loss) to EBITDA:
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Three months ended June 30,
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Six months ended June 30,
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2016
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2015
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2016
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2015
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Net Income (Loss)
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$ 16,362
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$ (263,244)
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$ 97,260
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$ (148,813)
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Add Back:
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Income Tax (Benefit) Provision
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(2,203)
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(86,520)
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77,746
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6,239
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Net interest expense
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77,442
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88,104
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159,391
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179,912
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Depreciation
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59,578
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56,804
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121,570
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113,225
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EBITDA
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$ 151,179
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$ (204,856)
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$ 455,967
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$ 150,563
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EBITDA totaled $151,179 as compared to an EBITDA loss of $204,856 for the three months ended June, 2016 and 2015, respectively. EBITDA totaled $455,967 and $150,563 for the six months ended June 30, 2016 and 2015, respectively, representing a 203% increase. The increases in EBITDA are attributable to new contracts we have signed in both mid-2015 and early 2016, together with an overall increase in revenue and fees at the properties we represent.
Liquidity
Our primary sources of liquidity include available cash and cash equivalents, and borrowing under the credit facility which was secured in October 2008, consisting of a $300,000 line of credit. As of June 30, 2016 the full amount of the line of credit was available to use. Additionally, our New Zealand subsidiary has an available NZ$300,000 (US$213,264) line of credit which was
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also fully available as of June 30, 2016. These facilities contain representations and warranties, conditions, covenants and events of default that are customary for this type of credit facility but do not contain financial covenants. The Company is in compliance with the terms and conditions of these borrowing covenants. We do not believe the limitations contained in the credit facility will, in the foreseeable future, adversely affect our ability to use the credit facility and execute our business plan.
In June 2015, the Company also received a term loan of $200,000 from a local bank which was used to pay the licensing fees for our new central reservations system. The loan is for a fixed interest rate of 5.875% with monthly payments of $3,855 and matures in June 2020 and the Company is in full compliance with the terms and conditions of the loan.
In January of 2015, the Chairman and CEO of the Company agreed to extend the due date of the $117,316 note due to him to December 31, 2017. In addition to this extension, the Chairman and CEO agreed to forgive $14,000 of the accrued interest and the Company agreed to make monthly payments of $3,334 per month in order to fully amortize the loan through December 31, 2017. We recorded the $14,000 forgiveness of debt as additional paid in capital.
Expected uses of cash in fiscal 2016 include funds required to support our operating activities, including continuing to selectively expand the number of properties under our management. We are also in the installation phase of upgrading our central reservations system, front office systems and ecommerce systems which will allow us to better compete with the growing vacation rental industry, allowing guests to book their stays by a specific individual unit rather than by unit category.
We experienced net income of $97,260 for the six months ended June 30, 2016 compared to a loss of $148,813 for the six months ended June 30, 2015. We have established a trend of operating profitability in recent quarters as we reported positive EBITDA in ten of our last eleven quarters, and positive net income for our last five fiscal years. We anticipate stabilization of the current occupancy levels, together with a slight increase in average rate trends and levels for the properties currently under contract for the remainder of 2016 when compared to 2015. We will continue our efforts to expand the number of properties under management through the remainder of 2016, which will increase the overall revenue stream in 2016. The specific impact of these additions on revenue depends on the timing of when and if new properties are added during the year. We have implemented a number of revenue enhancement and cost saving programs that will improve our profitability and cash flow. We project that we will continue to improve the overall profitability, cash flow, and working capital liquidity through 2016. This view is based on the following assumptions:
· The maintaining of current occupancy levels in our Hawaii and New Zealand markets.
· A continuation of increases in average daily rates at the properties we manage as compared to recent years.
· Focus on increasing our properties room revenue through increased sales, advertising and marketing efforts.
· Maximizing other sources of revenue from our guests.
· Careful monitoring of our costs and expenses, providing the basis for improved operating margins throughout 2016.
· Expansion of the number of properties under management, with emphasis on Hawaii and New Zealand.
· A stabilization of the United States / New Zealand exchange rates.
· The successful installation of our new reservations platform, allowing us to effectively penetrate the vacation rental market
Our plans to manage our liquidity position in fiscal 2016 include:
· Reducing our existing debt.
· Accessing our available sources of debt if needed and seeking additional debt or equity financing at competitive rates.
· Expenditures to replace and upgrade our existing technological equipment.
We have considered the impact of the financial outlook on our liquidity and have performed an analysis of the key assumptions in our forecast such as sales, gross margin and expenses; an evaluation of our relationships with our travel partners and property owners; and an analysis of cash requirements, other working capital changes, capital expenditures and borrowing availability under our credit facility. Based upon these analyses and evaluations, we expect that our anticipated sources of liquidity will be sufficient to meet our obligations without disposition of assets outside of the ordinary course of business or significant revisions of our planned operations through 2016 and our foreseeable future.
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Off-balance sheet arrangements
None; not applicable.
Critical Accounting Policies and Estimates
A summary of our significant accounting policies and estimates is discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Note 1 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2015. There have been no material changes to those policies during the six months ended June 30, 2016. The preparation of the financial statements in accordance with U.S. generally accepted accounting principles requires us to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts of assets and liabilities. Significant areas of uncertainty that require judgments, estimates and assumptions include the accounting for income taxes, asset impairment and collectability of accounts receivable. We use historical and other information that we consider to be relevant to make these judgments and estimates. However, actual results may differ from those estimates and assumptions that are used to prepare our financial Statements.
New Accounting Pronouncements
See discussion under Note ,
New Accounting Pronouncements
, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q, for information on new accounting pronouncements.
