DIAMOND RESORTS PARENT, LLC and Subsidiaries. Quarterly Report

Transcription

1 DIAMOND RESORTS PARENT, LLC and Subsidiaries Quarterly Report As of June 30, 2010 and December 31, 2009 and for the three and six months ended June 30, 2010 and 2009 Consolidated Financial Statements Management s Discussion and Analysis of Financial Condition and Results of Operations Furnished pursuant to Section 4.02(b) of the Indenture dated as of August 13, 2010 related to the 12% Senior Secured Notes due 2018

2 TABLE OF CONTENTS PAGE NUMBER Financial Statements: Consolidated Balance Sheets as of June 30, 2010 (Unaudited) and December 31, 2009 (Audited) 3 Unaudited Consolidated Statements of Operations for the three and six months ended June 30, 2010 and Unaudited Consolidated Statements of Member Capital (Deficit) and Comprehensive Income (Loss) for the six months ended June 30, 2010 and Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2010 and Notes to the Unaudited Consolidated Financial Statements 8-24 Management s Discussion and Analysis of Financial Condition and Results of Operations Page 2

3 FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS June 30, 2010 and December 31, 2009 (In thousands) (Unaudited) June 30, 2010 December 31, 2009 ASSETS Cash and cash equivalents $ 9,171 $ 17,186 Cash in escrow and restricted cash 39,740 40,544 Mortgages and contracts receivable, net of allowance of $51,930 and $60,911 at June 30, 2010 and December 31, 2009, respectively 255, ,273 Due from related parties, net 15,975 15,378 Other receivables, net 16,205 35,862 Income tax receivable 25 1,176 Prepaid expenses and other assets, net 51,368 28,828 Unsold Vacation Interests, net 198, ,225 Property and equipment, net 24,122 25,708 Assets held for sale Intangible assets, net 39,954 42,633 Total assets $ 650,330 $ 678,813 LIABILITIES AND MEMBER CAPITAL (DEFICIT) Borrowings under line of credit agreements $ 395,747 $ 393,954 Accounts payable 8,602 10,956 Due to related parties, net 52,430 36,695 Accrued liabilities 50,122 56,215 Income taxes payable 4, Deferred income taxes Deferred revenues 56,229 58,855 Securitization notes and conduit facilities 190, ,913 Derivative liabilities Notes payable 3,542 1,792 Total liabilities 762, ,674 Commitments and contingencies Member capital (deficit): Member capital 69,014 69,735 Accumulated deficit (161,853) (157,189) Accumulated other comprehensive loss (19,011) (16,407) Total member capital (deficit) (111,850) (103,861) Total liabilities and member capital (deficit) $ 650,330 $ 678,813 The accompanying notes are an integral part of these consolidated financial statements. Page 3

4 CONSOLIDATED STATEMENTS OF OPERATIONS Three and Six Months Ended June 30, 2010 and 2009 (In thousands) (Unaudited) Three Months Ended Six Months Ended June 30, 2010 June 30, 2009 June 30, 2010 June 30, 2009 Revenues: Vacation Interest sales, gross $ 54,845 $ 60,679 $ 103,712 $ $117,455 Provision for (recovery of) uncollectible Vacation Interest revenue 754 (3,878) (868) (7,679) Cash incentives (609) (605) (1,394) (1,931) Vacation Interest, net 54,990 56, , ,845 Management, member and other services 32,716 39,000 63,942 69,177 Interest 9,672 11,021 19,487 22,752 Gain on mortgage repurchase Total revenues 97, , , ,919 Costs and Expenses: Vacation Interest cost of sales 11,223 13,027 21,865 24,195 Advertising, sales and marketing 27,799 27,522 53,264 54,982 Vacation Interest carrying cost, net 6,747 7,069 14,182 15,693 Management, member and other services 11,925 13,968 23,950 27,109 Loan portfolio 2,628 2,627 5,230 4,866 General and administrative 16,947 17,165 32,641 35,312 (Gain) loss on sale of assets (758) 6 (760) (11) Depreciation and amortization 2,651 3,414 5,448 6,634 Interest, net of capitalized interest 15,731 18,523 31,410 34,304 Loss of extinguishment of debt ,593 Impairments and other write-offs Total costs and expenses 95, , , ,717 Income (loss) before provision for income taxes 1,544 2,912 (3,239) (13,798) Provision for income taxes ,425 1,036 Net income (loss) $ 824 $ 2,256 $ (4,664) $ (14,834) The accompanying notes are an integral part of these consolidated financial statements. Page 4

5 CONSOLIDATED STATEMENTS OF MEMBER CAPITAL (DEFICIT) AND COMPREHENSIVE INCOME (LOSS) Six Months Ended June 30, 2010 and 2009 (In thousands) (Unaudited) Member Capital Accumulated Deficit Accumulated Other Comprehensive Loss Total Member Capital (Deficit) Comprehensive Loss Balance at January 1, 2009 $ 69,549 $ (136,192) $ (21,103) $ (87,746) Second lien warrants Net loss for the six months ended June 30, (14,834) - (14,834) $ (14,834) Other comprehensive income: Currency translation adjustments, net of tax of $ ,693 6,693 6,693 Balance at June 30, 2009 $ 69,735 $ (151,026) $ (14,410) $ (95,701) Comprehensive loss for the six months ended June 30, 2009 $ (8,141) Balance at January 1, 2010 $ 69,735 $ (157,189) $ (16,407) $ (103,861) Guggenheim equity investment 25, ,000 Repurchase of equity previously held by another minority institutional investor (25,000) - - (25,000) Fee related to 2010 Equity recapitalization (721) - - (721) Net loss for the six months ended June 30, (4,664) - (4,664) $ (4,664) Other comprehensive loss: Currency translation adjustments, net of tax of $0 - - (2,604) (2,604) (2,604) Balance at June 30, 2010 $ 69,014 $ (161,853) $ (19,011) $ (111,850) Comprehensive loss for the six months ended June 30, 2010 $ (7,268) The accompanying notes are an integral part of these consolidated financial statements. Page 5

6 CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2010 and 2009 (In thousands) (Unaudited) Six Months Ended June 30, 2010 Six Months Ended June 30, 2009 Operating activities: Net loss $ (4,664) $ (14,834) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 5,448 6,634 Provision for uncollectible Vacation Interest revenues 868 7,679 Amortization of capitalized financing costs 550 1,594 Amortization of deferred loan and contract origination costs and mortgage discount 1,436 1,206 (Gain) loss on foreign currency exchange (1) 93 Gain on disposal of assets (760) (11) Gain on mortgage repurchase (92) (145) Loss on extinguishment of debt - 10,593 Deferred income taxes 80 (100) Unrealized gain on derivative instruments (201) (5,161) Changes in operating assets and liabilities: Mortgages and contracts receivable 10,638 15,668 Due from related parties 4,130 9,750 Other receivables, net 20,793 13,018 Prepaid expenses and other assets, net (22,490) (21,216) Unsold Vacation Interests, net 2,807 (16) Accounts Payable (2,336) 4,416 Due to related parties 16,253 19,811 Accrued liabilities (2,436) 6,463 Income taxes payable (receivable) 4,932 1,555 Deferred revenues (2,036) 97 Net cash provided by operating activities $ 32,919 $ 57,094 Investing activities: Fixed asset capital expenditures (2,214) (2,957) Proceeds from sale of assets 2 16 Net cash used in investing activities $ (2,212) $ (2,941) The accompanying notes are an integral part of these consolidated financial statements. Page 6

7 CONSOLIDATED STATEMENTS OF CASH FLOWS --Continued Six Months Ended June 30, 2010 and 2009 (In thousands) (Unaudited) Six Months Ended June 30, 2010 Six Months Ended June 30, 2009 Financing activities: Change in cash in escrow and restricted cash $ 759 $ (2,573) Proceeds from issuance of Diamond Resorts Quorum Proceeds from issuance of 2008 Conduit Facility 2,264 3,671 Payments on First and Second Lien Facility (1,138) - Payments on Diamond Resorts Owners Trust (25,427) - Payments on 2008 Conduit Facility (932) (30,374) Payments on 2007 Conduit Facility - (11,682) Payments on 2004 Securitization (4,525) (7,361) Payments on Polo Securitization (4,668) (5,412) Payments on notes payable (4,285) (4,814) Payments of debt issuance costs (559) (2,420) Guggenheim equity investment 25,000 - Repurchase of equity previously held by another minority institutional investor (25,000) - Payments of fees related to equity recapitalization (721) - Net cash used in financing activities $ (38,369) $ (60,965) Net decrease in cash and cash equivalents (7,662) (6,812) Effect of changes in exchange rates on cash and cash equivalents (353) 1,512 Cash and cash equivalents, beginning of period 17,186 22,707 Cash and cash equivalents, end of period $ 9,171 $ 17,407 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid for interest $ 31,220 $ 33,857 Cash paid for taxes, net of tax refunds $ (3,611) $ (261) SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Insurance premiums financed through issuance of note payable $ 6,052 $ 6,283 The accompanying notes are an integral part of these consolidated financial statements. Page 7

8 Note 1 Background, Business and Basis of Presentation Business and Background DIAMOND RESORTS PARENT, LLC AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Diamond Resorts Parent, LLC is a Nevada limited liability company created on March 28, 2007 through the contribution of $62.4 million cash by a third-party investor and $7.1 million of net assets from Cloobeck Diamond Parent, LLC, the Company's majority equity holder. The third-party investor was issued common and preferred equity with a liquidation preference as well as a priority return of 17% per annum, compounded quarterly, payable upon certain events. The preferred units do not provide to the holder any participation or conversion rights. Diamond Resorts Parent, LLC, together with its wholly-owned subsidiaries, is hereafter referred to as Diamond Resorts or the Company. The capitalization of the Company occurred on April 27, 2007 simultaneously with the acquisition of and merger with Sunterra Corporation ( Sunterra or the Predecessor Company ) and cancellation of Sunterra s outstanding common stock for $16.00 per share ( the Merger or the April 27, 2007 Merger ). The Company operates in the vacation ownership industry, with an ownership base of more than 360,000 families and a network of 167 resorts located in 26 countries throughout the continental United States, Hawaii, Canada, Mexico, the Caribbean, Europe, Asia, Australia and Africa. The Company s resort network includes 61 Diamond Resorts International-branded and managed properties and 106 affiliated resorts, which are a part of the Company s network and consequently are available for its members to use as vacation destinations, although the Company does not manage them. As used in these financial statements, Diamond Resorts International and THE Club are trademarks of the Company. The Company s operations consist of three interrelated businesses: (i) hospitality and management services; (ii) marketing and sales of Vacation Ownership Interests, or Vacation Interests ; and (iii) consumer financing for purchasers of the Company s Vacation Interests. Hospitality and Management Services. The Company manages 61 branded resort properties, which are located in the continental United States, Hawaii, the Caribbean and Europe. The Company also manages four multi-resort trusts (the Collections. ) Each Collection holds real estate in the Company s resort properties underlying the Vacation Interests that the Company sells. As manager of the Company s branded resorts and Collections, it provides billing services, account collections, accounting and treasury functions and information technology services. In addition, for branded resorts, the Company also provides an online reservation system and customer service contact center, operates the front desks and amenities and furnishes housekeeping, maintenance and human resources services. Management contracts typically have an initial term of three to five years with automatic renewals and are structured on a cost-plus basis, thereby providing the Company with a recurring and stable revenue stream. In addition, the Company earns recurring fees by operating THE Club, the points-based exchange and member services program that enables members to vacation at any of the 167 resorts in the Company s network. Marketing and Sales of Vacation Interests. The Company markets and sells Vacation Interests in its resort network. Sales prospects are generated by utilizing a variety of marketing programs. Currently, the Company sells Vacation Interests only in the form of points, which can be utilized for vacations for varying lengths of stay at any resort in its network. In the past, the Company also sold Vacation Interests in the form of deeded intervals, which provide the right to vacation at a particular resort for a specified length of time. Consumer Financing of Vacation Interests. The Company provides loans to eligible customers who purchase Vacation Interests through U.S. sales centers and choose to finance their purchase. These loans are collateralized by the underlying Vacation Interests and bear interest at a fixed rate. The Company s consumer finance servicing operations are vertically integrated and include underwriting, collection and servicing of its consumer loan portfolio. Page 8

9 Basis of Presentation DIAMOND RESORTS PARENT, LLC AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued The following is a list of entities included in the accompanying unaudited consolidated financial statements: AKGI St. Maarten, NV and subsidiaries Citrus Insurance Company, Inc. Diamond Resorts (Europe) Ltd. and subsidiaries Diamond Resorts Centralized Services Company and subsidiaries Diamond Resorts Corporation Diamond Resorts Developer and Sales Holding Company and subsidiaries Diamond Resorts Finance Holding Company and subsidiaries Diamond Resorts Holdings, LLC Diamond Resorts Management and Exchange Holding Company and subsidiaries Diamond Resorts Owner Trust Diamond Resorts Polo Development, LLC Diamond Resorts Services, LLC FLRX, Inc. and subsidiaries George Acquisition Subsidiary, Inc. Sunterra Owner Trust Some of the above entities, which include corporations, limited liability companies and partnerships, each have several subsidiaries. The accompanying unaudited consolidated financial statements of Diamond Resorts Parent, LLC and its subsidiaries have been prepared in accordance with the accounting policies described in the Company s annual consolidated financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, although the Company believes that the disclosures are adequate to make the information presented not misleading. In the opinion of management, all adjustments considered necessary for a fair presentation have been included and are of a normal, recurring nature. The accompanying unaudited consolidated financial statements should be reviewed in conjunction with the Company s annual consolidated financial statements as of December 31, 2009, 2008 and 2007 and for the years ended December 31, 2009 and 2008 and the period from April 27, 2007 to December 31, Operating results for the three months and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, Note 2 Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include all subsidiaries of the Company. With the exception of the hotel properties in Europe that the Company owns and provides to an off-balance sheet trust in Europe under a rental agreement, the Company does not have any interests in any variable interest entities for which the Company is considered the primary beneficiary under ASC 810, Consolidation (FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, as amended in December 2003 by Interpretation 46R). All significant intercompany transactions and balances have been eliminated from the accompanying consolidated financial statements. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates were used by the Company to estimate the fair value of the Predecessor Company s assets and liabilities acquired on April 27, These estimates included projections of future cash flows derived from vacation points sales, THE Club memberships, mortgages and contracts receivable, management services revenue and rental income. Additionally, the Company made significant estimates of costs associated with such projected revenues including but not limited to loan defaults, recoveries and discount rates. In preparation of its consolidated financial statements, the Company also made significant estimates which include: (1) mortgages and contracts receivable, allowance for loan and contract losses, and provision for uncollectible Vacation Interest revenue; (2) useful lives of property and equipment; (3) estimated useful lives of intangible assets acquired; (4) estimated costs to build or acquire any additional Vacation Interests, estimated total revenues expected to be earned on a project, related estimated provision for uncollectible Vacation Interest revenue and sales incentives, estimated projected future cost and volume of recoveries of Vacation Page 9

10 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued Interests, estimated uncollectible Vacation Interest sales revenue, estimated sales price per point and estimated number of sales transactions used to allocate certain unsold Vacation Interests to Vacation Interest cost of sales under the relative sales value method; and (5) the valuation allowance recorded against deferred tax assets. It is at least reasonably possible that a material change in one of these estimates may occur in the near term and cause actual results to differ materially. Recently Adopted Accounting Pronouncements In January 2010, the FASB issued ASU No , Improving Disclosures about Fair Value Measurements, which, among other things, amends Accounting Standards Topic 820 Fair Value Measurements and Disclosures (ASC 820) to require entities to separately present purchases, sales, issuances, and settlements in their reconciliation of Level 3 fair value measurements (i.e., to present such items on a gross basis rather than on a net basis), and which clarifies existing disclosure requirements provided by ASC 820 regarding the level of disaggregation and the inputs and valuation techniques used to measure fair value for measurements that fall within either Level 2 or Level 3 of the fair value hierarchy. ASU No is effective for interim and annual periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The Company s adoption of this standard had no impact on its consolidated financial position, results of operations or cash flows. The adoption did not have a material impact on the Company s consolidated financial statements or its disclosures, as the Company did not have any transfers between Level 1 and Level 2 fair value measurements and did not have material classes of assets and liabilities that required additional disclosure. In February 2010, the FASB issued ASU No , Amendments to Certain Recognition and Disclosure Requirements, which amends Accounting Standards Topic 855 Subsequent Events (ASC 855). ASU No removes the requirement for an SEC filer to disclose a date in both issued and revised financial statements. Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. GAAP. Additionally, FASB clarified that if the financial statements have been revised, then an entity that is not an SEC filer should disclose both the date that the financial statements were issued or available to be issued and the date the revised financial statements were issued or available to be issued. ASU No is effective for the first reporting period after issuance. The Company adopted ASU No on June 30, 2010, which did not have a material impact on the Company s financial condition or results of operations. Note 3 Cash in Escrow and Restricted Cash Cash in escrow and restricted cash consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Securitization and conduit collection and reserve cash $ 22,455 $ 26,953 Escrow 4,654 5,152 Bonds and deposits 1,930 5,025 Rental trust 2,613 2,023 Restricted bank operating accounts Collected on behalf of HOAs and other 7,842 1,279 Total cash in escrow and restricted cash $ 39,740 $ 40,544 Note 4 Mortgages and Contracts Receivable and Allowance for Loan and Contract Losses The Company provides financing to purchasers of Vacation Interests at U.S. sales centers that is collateralized by their Vacation Interests. The mortgages and contracts bear interest at fixed rates between 6.0% and 17.9%. The term of the mortgages and contracts are from five years to fifteen years, and may be prepaid at any time without penalty. The weighted average interest rate of outstanding mortgages and contracts receivable was 15.2% at June 30, 2010 and 15.1% at December 31, Mortgages and contracts receivable in excess of 60 days past due at June 30, 2010 and December 31, 2009 were 4.8% and 5.1%, respectively, of gross mortgages and contracts receivable. Mortgages and contracts receivable originated by the Company are recorded at amortized cost, including deferred loan and contract origination costs, less the related allowance for loan and contract losses. Loan and contract origination costs incurred in connection with providing financing for Vacation Interests are capitalized and amortized over the term of the mortgages or contracts receivable as an adjustment to interest revenue using the effective interest method. Amortization of deferred loan and contract Page 10

11 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued origination costs charged to interest revenue was $0.8 million for both the three months ended June 30, 2010 and 2009 and was $1.7 million and $1.6 million for the six months ended June 30, 2010 and 2009, respectively. The Company recorded a $3.3 million discount at April 27, 2007 on the acquired mortgage pool, which is being amortized over the life of the related acquired mortgage pool. At June 30, 2010 and December 31, 2009, the net unamortized discount was $1.0 million and $1.2 million, respectively. During the three months ended June 30, 2010 and 2009, amortization of $0.1 million and $0.1 million, respectively, was recorded as an increase to interest revenue. During the six months ended June 30, 2010 and 2009, amortization of $0.2 million and $0.4 million, respectively, was recorded as an increase to interest revenue. Mortgages and contracts receivable, net, consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Acquired mortgage pool April 27, 2007 Merger $ 87,469 $ 106,682 Contributed mortgages 14,647 18,672 Mortgages and contracts receivable originated 197, ,195 Mortgages and contracts receivable, gross 300, ,549 Allowance for Loan and Contract Losses (51,930) (60,911) Deferred profit on Vacation Interest transactions (2,742) (2,693) Deferred loan and contract origination costs, net of accumulated amortization 3,114 3,672 Inventory value of defaulted mortgages that were previously contributed and acquired 7,652 7,888 Discount on mortgages and contracts receivable, net of accumulated amortization (988) (1,232) Mortgages and contracts receivable, net $ 255,210 $ 268,273 At June 30, 2010 and December 31, 2009, $243.4 million and $275.2 million, respectively, of the gross amount of the mortgages and contracts receivable were collateralized against the Company s various debt instruments. See Note 12 Borrowings for further detail. Deferred profit on Vacation Interest transactions represents the revenues less the related direct costs (sales commissions, sales incentives, cost of revenues and allowance for loan losses) related to sales that do not qualify for revenue recognition under the provisions of ASC 978. See Note 2 Summary of Significant Accounting Policies of the Company s annual consolidated financial statements for description of revenue recognition criteria. Inventory value of defaulted mortgages that were previously contributed and acquired represents the inventory underlying mortgages that have defaulted. Upon recovery of the inventory, the value is transferred to Unsold Vacation Interests, net. Activity in the allowance for loan and contract losses associated with mortgage and contract originations during the three and six months ended June 30, 2010 and 2009 is as follows (in thousands): Three Months Ended Six Months Ended June 30, 2010 June 30, 2009 June 30, 2010 June 30, 2009 Balance, beginning of period $ 56,806 $ 69,360 $ 60,911 $ 71,467 Provision for uncollectible Vacation Interest revenue 2,393 2,699 3,817 5,244 Mortgages and contracts receivable charged off (4,171) (5,341) (9,589) (9,959) Effect of translation rate (111) 252 Change in estimate (3,098) - (3,098) - Balance, end of period $ 51,930 $ 67,004 $ 51,930 $ 67,004 The provision for uncollectible Vacation Interest revenues in the allowance schedule above does not agree to the accompanying consolidated statements of operations due to ASC 978 adjustments. The ASC 978 adjustments offset the provision for uncollectible Page 11

12 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued Vacation Interest revenue by $(0.1) million and $1.2 million for the three months ended June 30, 2010 and 2009, respectively. The ASC 978 adjustments offset the provision for uncollectible Vacation Interest revenue by $0.1 million and $2.5 million for the six months ended June 30, 2010 and 2009, respectively. Note 5 Transactions with Related Parties Due from Related Parties, Net and Due to Related Parties, Net Amounts due from related parties, net and due to related parties, net consist primarily of transactions with homeowners associations ( HOAs ) at properties at which the Company acts as the management company or Collections that hold the real estate underlying the Vacation Interests that the Company sells. Due from related parties, net transactions include management fees for the Company s role as the management company, certain pass-through expenses, and the allocation of a portion of the Company s resort management and general and administrative expenses according to a pre-determined schedule approved by the board of directors at each HOA. Due to related parties, net transactions include (1) the amounts due to HOAs under interval recovery and remarketing agreements the Company enters into regularly with certain HOAs and similar agreements with the Collections pursuant to which the Company recaptures Vacation Interests, either in the form of vacation points or vacation intervals, and brings them into the Company s inventory for sale to customers; (2) the maintenance fee and special assessment fee liability owed to HOAs for Intervals or to the Collections for points owned by the Company; (3) cleaning fees owed to HOAs for room stays incurred by the Company s customers; and (4) subsidy liabilities owed to certain HOAs to fund the negative cash flows at these HOAs according to certain subsidy agreements, which ceased as of December 31, Amounts due from related parties and due to related parties are due on demand and carry no interest. Due to the fact that the right of offset exists between the Company and the HOAs, the Company evaluates amounts due to and from each HOA at each reporting period to present the balances as either a net due to or a net due from related parties in accordance with the requirements of ASC , Balance Sheet-Offsetting. In 2008, an arbitration demand was filed against the Company for enforcement of a $4.0 million settlement agreement entered into by the Company and a Board of Director s family member. On October 2, 2009, the arbitrator entered an arbitration award against the Company in the amount of $4.0 million plus interest. On December 8, 2009, a court in District Court, Clark County, Nevada confirmed the arbitration award plus pre-judgment interest and costs. During the year ended December 31, 2008, the Company recorded a $4.0 million increase to general and administrative expense in the accompanying consolidated statement of operations with a corresponding increase to due to related parties in the accompanying consolidated balance sheet. During the year ended December 31, 2009, the Company recorded a $0.5 million increase to general and administrative expense in the accompanying consolidated statement of operations with a corresponding increase to the related party payable for accrued interest and costs associated with the arbitration award. On June 10, 2010, the award was paid in full for $4.4 million. Due from related parties, net consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Amounts due from HOAs $ 15,953 $ 14,887 Amounts due from off-balance sheet trusts Other 22 5 Total due from related parties, net $ 15,975 $ 15,378 Due to related parties, net consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Amounts owed to HOAs $ 39,162 $ 27,565 Amounts owed to off-balance sheet trusts 13,268 4,630 Other - 4,500 Total due to related parties, net $ 52,430 $ 36,695 Page 12

13 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued Management Services Included within the amounts reported as management, member and other services revenue are revenues from resort management services provided to the HOAs, which totaled $7.7 million and $6.6 million for the three months ended June 30, 2010 and 2009, respectively. Included within the amounts reported as management, member and other services revenue are revenues from resort management services provided to the HOAs, which totaled $15.2 million and $13.6 million for the six months ended June 30, 2010 and 2009, respectively. See Due from Related Parties, Net and Due to Related Parties, Net section above for detail of these services performed. Also included within the amount reported as management, member and other services revenue are revenues earned from managing the off-balance sheet trusts which hold legal title to the vacation property real estate out of which the Company conveys vacation points to its customers. These amounts total $4.1 million and $3.5 million for the three months ended June 30, 2010 and 2009, respectively. These amounts total $8.3 million and $6.7 million for the six months ended June 30, 2010 and 2009, respectively. Allocation of Expenses In addition to management services revenues, the Company also has entered into agreements with the HOAs to pass through a portion of the Company s resort management and general and administrative expenses to the HOAs. The following table presents the amounts passed through to the HOAs for the three months and six months ended June 30, 2010 and 2009, respectively (in thousands): Three Months Ended Six Months Ended June 30, 2010 June 30, 2009 June 30, 2010 June 30, 2009 Reduction of management, member, and other services expense $ 1,416 $ 1,012 $ 2,851 $ 2,071 Reduction of general and administrative expenses 4,635 3,353 9,366 6,974 Total allocation of expenses $ 6,051 $ 4,365 $ 12,217 $ 9,045 Note 6 Other Receivables, Net Other receivables, net consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 THE Club dues receivable $ 8,410 $ 26,076 Mortgage interest receivable 3,454 3,925 Rental receivables and other resort management-related receivables 2,817 2,686 THE Club conversion receivable 1,937 2,101 Owner maintenance fee receivable 2,835 1,647 Mini-vacations and sampler program receivables Insurance claims receivable Proceed receivable related to sale of assets 1,641 - Other receivables 2,971 3,884 Total other receivables, gross 25,001 41,893 Provision for doubtful accounts (8,796) (6,031) Total other receivables, net $ 16,205 $ 35,862 Note 7 Prepaid Expenses and Other Assets, Net Prepaid expenses are charged to expense as the underlying assets are used or are amortized. The nature of selected balances included in prepaid expenses and other assets, net of the Company includes: Unamortized maintenance fees unamortized portion of annual maintenance fees billed by the homeowners associations on unsold Vacation Interests owned by the Company, which are to expense ratably over the year. Deferred exchange fees deferred portion of exchange fees related to Club members Interval International memberships, which are charged to expense ratably over the year. Page 13

14 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued Deferred commissions commissions paid to sales agents related to deferred mini-vacations and sampler program revenue, which are charged to expense as the associated revenue is recognized. Vacation Interest purchases in transit open market purchases of vacation points from prior owners for which the titles have not been officially transferred to the Company. These Vacation Interest purchases in transit are reclassified to unsold Vacation Interest, net, upon successful transfer of title. Prepaid rent portion of rent paid in advance and charged to expense in accordance with lease agreements. Prepaid expenses and other assets, net consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Debt issuance costs, net $ 8,264 $ 8,227 Unamortized maintenance fees 19,385 6,035 Deferred exchange fees 3,167 - Other inventory/consumables 2,859 2,543 Prepaid insurance 3,823 2,461 Prepaid commissions 2,249 2,334 Assets to be disposed (not actively marketed) 1,541 1,628 Deposits and advances 2,319 1,462 Vacation Interest purchases in transit 1,184 1,384 Deferred interval recovery and remarketing agreement expenses Prepaid rent Prepaid sales and marketing costs Other 5,141 2,268 Total prepaid expenses and other assets, net $ 51,368 $ 28,828 Financing and debt issuance costs incurred in connection with obtaining funding for the Company have been capitalized and are being amortized over the lives of the related funding agreements as a component of interest expense using a method which approximates the effective interest method. Amortization of capitalized financing and debt issuance costs included in interest expense was $0.2 million and $0.5 million for the three months ended June 30, 2010 and 2009, respectively. Amortization of capitalized financing and debt issuance costs included in interest expense was $0.5 million and $1.2 million for the six months ended June 30, 2010 and 2009, respectively. Note 8 Unsold Vacation Interests, Net Unsold Vacation Interests, net consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Completed unsold Vacation Interests, net $ 165,652 $ 170,443 Undeveloped land 31,878 31,970 Vacation Interest construction in progress Total unsold Vacation Interests, net $ 198,314 $ 203,225 Estimated costs to complete improvements and promised amenities, excluding unit construction, as of December 31, 2009 were $0.4 million. As of June 30, 2010, there had been no material changes in estimated costs to complete since December 31, Note 9 Property and Equipment, Net Property and equipment are recorded at historical cost. The costs of improvements that extend the useful life of property and equipment are capitalized when incurred. These capitalized costs may include structural costs, equipment, fixtures, floor and wall coverings. All repair and maintenance costs are expensed as incurred. Page 14

15 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued Buildings and leasehold improvements are depreciated using the straight-line method over the lesser of the estimated useful lives, which range from four to forty years, or the remainder of the lease terms, respectively. Furniture, office equipment and computer equipment are depreciated using the straight-line method over their estimated useful lives, which range from three to seven years. Property and equipment, net consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Land and improvements $ 1,140 $ 1,140 Buildings and leasehold improvements 16,345 16,800 Furniture and office equipment 7,449 7,714 Computer software 7,994 6,972 Computer equipment 4,551 4,290 Construction in progress 1, Property and equipment, gross 38,616 37,526 Less accumulated depreciation (14,494) (11,818) Total property and equipment, net $ 24,122 $ 25,708 Depreciation expense related to property and equipment was $1.5 million and $1.7 million for the three months ended June 30, 2010 and 2009, respectively. Depreciation expense related to property and equipment was $3.1 million and $3.3 million for the six months ended June 30, 2010 and 2009, respectively. Note 10 Intangible Assets, Net Intangible assets, net consisted of the following as of June 30, 2010 (in thousands): Gross Carrying Cost Accumulated Amortization Net Book Value Management contracts $ 42,318 $ (7,807) $ 34,511 Member relationships 25,793 (20,778) 5,015 Distributor relationships and other 576 (148) 428 Total intangible assets, net $ 68,687 $ (28,733) $ 39,954 The Company did not acquire or dispose of any intangible assets during the six months ended June 30, The decrease in gross carrying amount from December 31, 2009 to June 30, 2010 is due to foreign currency exchange rate fluctuation. Amortization expense for management contracts is recognized on a straight-line basis over the estimated average useful life of 21 years. Amortization expense for management contracts was $0.4 million for both the three months ended June 30, 2010 and 2009 and $0.9 million for both the six months ended June 30, 2010 and Amortization expense for member relationships, distributor relationships and other is amortized over the period of time that the relationships are expected to produce cash flows. Amortization expense for member relationships, distributor relationships and was $0.7 million and $1.2 million for the three months ended June 30, 2010 and 2009, respectively and $1.5 million and $2.5 million for the six months ended June 30, 2010 and 2009, respectively. Membership relationships and distributor relationships have an estimated average useful life of 28 years and 20 years, respectively. However, the Company expects to generate significantly more cash flows during the earlier years of the relationships than the later years. Consequently, amortization expenses on these relationships decrease significantly over the lives of the relationships. Note 11 Assets Held for Sale Assets held for sale are recorded at the lower of cost or their estimated fair value less costs to sell and are not subject to depreciation. Sale of the assets classified as such is probable, and transfer of the assets is expected to qualify for recognition as a completed sale, within one year of the balance sheet date. During 2010, the Company decided to sell certain units at the Benal Beach Resort and a portion of the units were sold by June 30, The $0.2 million balance in assets held for sale as of June 30, 2010 consisted of unsold units at the Benal Beach Resort. Page 15

16 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued Note 12 Borrowings The Company s 2008 Conduit Facility matured on February 25, 2010 and was extended to January 10, See Note 21 Subsequent Events for further discussion of 2010 developments related to the 2008 Conduit Facility. See the following table for selected information on the borrowings as of June 30, 2010 (dollars in thousands): Principal Balance Interest Rate First and Second Lien Facilities $ 395, % 13.5% 2008 Conduit Facility 19, % Diamond Resorts Owners Trust Series , % 12.0% Diamond Resorts Quorum % Sunterra SPE , % 4.9% Polo Towers Lines of Credit 6, % Polo Towers Securitization Notes Payable 2, % 7.7% Notes Payable - insurance policies 3, % 4.2% Notes Payable % 5.0% Total borrowings $ 589,805 In September 2007, the Company entered into an interest rate swap agreement ( Swap Agreement ) that matures on March 20, 2011 to manage its exposure to the fluctuation in interest rates. The Company pays interest at a fixed rate of 4.7% based on a floating notional amount according to a pre-determined amortization schedule and received interest based on one-month LIBOR. On the same date, the Company paid $0.1 million for an interest rate cap agreement ( Cap Agreement ) to further limit its exposure to interest rate increases. The cap agreement bears a strike rate of 5.5% and a one-month LIBOR based on a variable notional amount according to a pre-determined amortization schedule. Neither the Swap Agreement nor the Cap Agreement qualified for hedge accounting under ASC 815, Derivatives and Hedging (SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities). Consequently, for the three months ended June 30, 2010 and 2009, the Company recorded $0.1 million and $2.0 million in reduction of interest expense, respectively, associated with the fair value adjustment of the Swap Agreement and the Cap Agreement with a corresponding decrease in derivative liabilities. Likewise, for the six months ended June 30, 2010 and 2009, the Company recorded $0.2 million and $5.2 million in reduction of interest expense, respectively, associated with the fair value adjustment of the Swap Agreement and the Cap Agreement with a corresponding decrease in derivative liabilities. During the quarter ended June 30, 2010, one of the Company s wholly owned subsidiaries, DRI Quorum 2010 LLC (DRI Quorum ) entered into a Loan Sale and Security Agreement (the LSSA ) with Quorum Federal Credit Union ( Quorum ) as purchaser, Wells Fargo, National Association, as back-up servicer, and another one of the Company s wholly owned subsidiaries, Diamond Resorts Financial Services, Inc., as servicer. The LSSA and related documents provide for an aggregate minimum $40 million loan sale facility and joint marketing venture (the Quorum Facility ) where DRI Quorum may sell eligible consumer loans and in-transit loans to Quorum on a non-recourse, permanent basis, provided that the underlying consumer obligor is a Quorum credit union member. The joint marketing venture has a minimum term of two years and the LSSA provides for a purchase period of two years. The purchase price payment and the program purchase fee are each determined at the time that the loan is sold to Quorum, and to date the purchase price payment has been 80% of the note amount and the program purchase fee has been 8.0%. Diamond Resorts Financial Services, Inc. receives a 2.0% servicing fee. To the extent excess funds remain after payment in full of the sold loans, such excess funds shall be remitted to Quorum as a deferred purchase price payment. Borrowing Restrictions and Limitations All of the Company s borrowing under line of credit agreements, securitization notes, and conduit facilities contain various restrictions and limitations that may affect its business and affairs. These include, but are not limited to, restrictions and limitations relating to its ability to incur indebtedness and other obligations, to make investments and acquisitions and to pay dividends. The Company is also required to maintain certain financial ratios and comply with other financial and performance covenants. The failure of the Company to comply with any of these provisions, or to pay its obligations, could result in foreclosure by the lenders of their Page 16

17 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued security interests in the Company s assets, and could otherwise have a material adverse effect on the Company. The Company was in compliance with all financial covenants as of June 30, Note 13 Accrued Liabilities The Company records estimated amounts for certain accrued liabilities at each period end. Accrued liabilities are obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events. The nature of selected balances included in accrued liabilities of the Company includes: Accrued marketing expenses expenses for travel vouchers and certificates used as sales incentives to buyers as well as attraction tickets as tour incentives. Accrued escrow liability deposits in escrow received on Vacation Interests sold. Accrued contingent litigation liabilities estimated settlement costs for existing litigation cases. Accrued operating lease liabilities difference between straight-line operating lease expenses and cash payments associated with any equipment, furniture, or facilities leases classified as operating leases. Accrued call center cost expenses associated with the out-sourced customer service call center operations. Accrued construction costs estimated remaining costs accrued for construction renovation projects. Accrued liabilities consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 Accrued payroll and related $ 10,861 $ 13,599 Accrued marketing expenses 5,371 6,080 Accrued other taxes 5,408 5,763 Accrued escrow liability 4,130 4,821 Accrued exchange company fees 6,517 4,107 Accrued commissions 5,283 4,029 Accrued interest 608 3,699 Accrued contingent litigation liabilities 3,002 2,889 Accrued professional fees 1,283 2,708 Accrued operating lease liabilities 1,992 1,917 Accrued insurance 1,277 1,475 Accrued call center cost 949 1,196 Accrued construction costs 607 1,050 Other 2,834 2,882 Total accrued liabilities $ 50,122 $ 56,215 Note 14 Deferred Revenues The Company records deferred revenues for payments received or billed but not earned for various activities. THE Club deferred revenue THE Club annual membership fees paid or billed to members and amortized ratably over a oneyear period and optional reservation protection fees recognized over an approximate life of the member s reservation (approximately six months on average). Deferred maintenance and reserve fee revenue maintenance fees billed as of January first each year and earned ratably over the year in the Company s capacity as the HOA for the two resorts in St. Maarten. In addition, the HOA will periodically bill the owners for capital project assessments to repair and replace the amenities or to reserve the out-of-pocket deductibles for hurricanes and other natural disasters. These assessments are deferred until refurbishment activity occurs, at which time the amounts collected are Page 17

18 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- Continued recognized as a direct reduction to refurbishment expense in management, member and other services expense. See Note 5 Transactions with Related Parties for further discussion. Deferred mini-vacations and sampler programs revenue sold but unused trial Vacation Interests, ranging from three days to one week. This revenue is recognized when the purchaser completes their respective stay at one of the Company s resorts or the trial period expires. Such revenue is recorded as a reduction to Vacation Interest carrying cost in accordance with ASC 978, with the exception of the Company s European sampler product, which is three years in duration and is treated as Vacation Interest revenue. Deferred revenue from an exchange company in consideration for several agreements entered into with an exchange company in 2008, the Company received $5 million. This amount is being amortized over ten years, the term of agreements. Deferred management and HOA allocation revenue From time to time, HOAs prepay management fees for the Company s role as the management company, certain pass-through expenses, and the allocation of a portion of the Company s resort management and general and administrative expenses management fees. These advance payments are recorded as deferred revenues when they are received and recognized as revenue during the period that they are earned. Deferred revenues consisted of the following as of June 30, 2009 and December 31, 2009 (in thousands): June 30, 2010 December 31, 2009 THE Club deferred revenue $ 16,043 $ 32,948 Deferred maintenance and reserve fee revenue 21,676 11,759 Deferred mini-vacations and sampler program revenue 8,196 9,029 Deferred revenue from an exchange company 3,454 3,742 Deferred management and HOA allocation revenue 5,060 - Other 1,800 1,377 Total deferred revenues $ 56,229 $ 58,855 Note 15 Income Taxes The provision for income taxes for the three and six months ended June 30, 2010 was determined based on pretax book loss (adjusted for book-tax differences) for the three and six month periods at the approximate statutory rates. Note 16 Commitments and Contingencies Lease Agreements The Company conducts a significant portion of its operations from leased facilities, which include regional and global administrative facilities as well as off-premise booths and tour centers near active sales centers. The longest of these obligations extends into Many of these agreements have renewal options, subject to adjustments. In most cases, the Company expects that in the normal course of business, such leases will be renewed or replaced by other leases for inflation. Typically, these leases call for a minimum lease payment that increases over the life of the agreement by a fixed percentage or an amount based upon the change in a designated index. All of the facilities lease agreements are classified as operating leases. In addition, the Company leases office and other equipment under both long-term and short-term lease arrangements, which are generally classified as operating leases. Purchase Obligations The Company has entered into various purchase obligations relating to construction commitments totaling $0.4 million as of December 31, As of June 30, 2010, there had been no material changes outside the ordinary course of the Company s business in such purchase obligations since December 31, Page 18