Corporate Finance ­ Marriott ­ Section 3 ­ Group I Jorge Palma | Marina Pascual | Yifan Gu | Chelsey Hood Archit Garg | William Debost | Pascal Rehder The issue of the case at hand defines a decision that has to be made regarding the restructuring of Marriott, more specify the split­up into two separate entities. Recommendations to the board of directors regarding Project Chariot have to be delivered. The legal counsel confirmed that the Finally, cash flows for Host Marriott Corporation (HMC) were more than adequate to cover debt service requirements that would be faced. As an exit plan, Project Chariot could be abandoned without significant loss, if strategic and financial proceedings won’t turn out to be positive. 1. Why is Marriott management proposing Project Chariot? What is it trying to accomplish? Project Chariot is a financial maneuver that would separate Marriott’s property ownership and management operations into two distinct companies: HMC and MII, respectively. Stockholders of Marriott would receive a share of stock in the new company to match each share they held of MC. ​
The project is consistent with Marriott’s focus on contract and management opportunities, which included high­growth markets such as “life­care” for senior citizens, and required little capital input. Property ownership, on the other hand, was suffering from a real estate collapse and industry excess capacity, and was the source of large interest payments. The restructuring planned by Project Chariot is therefore a way of separating two activities with different growth dynamics and capital structures (one with very large fixed assets, the other with low fixed assets). How does this restructuring benefit Marriott as a whole? The main reason is by attracting investors to raise new capital, and use this capital to seize opportunities in the market. As a single entity, Marriott could confuse some investors who had trouble distinguishing and valuing its property and management activities. As a consequence, Marriott’s stock was undervalued and this could dissuade potential investors. With two separate entities, however, investors would be able to choose between two “Pure Plays” (companies with a single business focus) and allocate capital accordingly (the cost of capital is easier to estimate). Marriott International (MII), with its strong growth prospects, larger cash flow and lower level of debt (33% of book capital), would be able to attract fresh capital at lower interest rates than it if it were associated with property ownership, which involves higher capital investment (HMC’s debt would amount to 76% of book capital). It could use this capital to finance its growth or purchase the assets of struggling competitors. With regards to HMC, the restructuring would avoid pressure from investors to distress sale Marriott’s hotel properties, because investors would evaluate HMC on its ability to generate returns on its assets in the long run, as is the case with real estate developers. Fending off this pressure will benefit HMC’s financial performance because it will be able to focus on finding the right investments rather than pursuing short­term results. 1 Finally, the restructuring would benefit Marriott’s ability to retain talent in its management ranks. More top­level positions would be created, and MII’s strong growth prospects would attract the most ambitious. The expected increase in the value of the company’s stock will further benefit managers with stock holdings. In conclusion, Project Chariot is an effort by management to align its corporate strategy with shareholder expectations. It will attract investors and improve financial performance in the context of a real estate downturn, by splitting Marriott into two “leaner” entities. This would enable investors to adapt their investment strategy to each entities’ activities, and would empower managers to better focus on core business activities and create more value for Marriott as a whole. 2. If the proposed Project Chariot is implemented, how do you think this will affect the interests of… Please, provide numerical estimations for every sub­question.
Project Chariot involves a conflict of interest between shareholders and bondholders of Marriott Corp. Bondholders will find that their investment gets tied to the risky real estate assets (whose appreciation is uncertain) of HMC, which would retain nearly all of MC’s long­term debt (total of $3 billion). Thus Project Chariot aims to give shareholders the business upside and bondholders the real­estate downside. Hence this appears to be a case of risk shifting. A. Shareholders ­ ​
Shareholder’s interests lie in the value of the company. As explained by BMA, the value of a company is determined by its real assets. Modigliani and Miller (MM) argued this and showed that the firm’s capital structure (and mix of debt securities) is irrelevant when determining the firm’s value, assuming perfect capital markets. Viewed from this perspective, we can say that Project Chariot does not change the size of the pie (the asset side), but rather the way it is sliced. In its immediate aftermath, Project Chariot would therefore have no effect on the overall value. But MM’s theory does not inform us about the longer run impacts of the spinoff and its potential to create value for investors. In fact the purpose of Project Chariot is precisely to increase the size of the pie, by allowing for better access to capital and greater efficiencies in the now “leaner” companies. Marriott’s shareholders would receive a share of MII to match each share of MC they already own. This special stock dividend would be tax­free, and shareholders would benefit from the anticipated appreciation of MII’s shares. With an easier access to credit, MII will be able to expand its business and thus create value for shareholders. Shares in HMC are likely to suffer from the restructuring because the company will be saddled with debt and will operate at a loss, but the question is whether the gains to be had from MII’s newly created shares will outweigh this. We make projections for the two separate entities (HMC and MII) in 1992. For MII, using the EPS indicated in Exhibit 1, we assume a P/E ratio of 25 (which is common in the market) and end up with a market price of $35. As for HMC, by operating at a loss, it would underperform the expectations of the market for Marriott Corp. as a whole. Its shares must plunge, and we assume it goes below its low of $10.50 in 1991, to $9 a share. 2 1992 Marriott Corp 1992 HMC 1992 MII Market Price $16 $9 $35 EPS $ 0.75 ($0.69) $1.40 P/E Ratio 21.3 ­­ 25 Spinoffs are known to outperform the markets especially in their early years, and in this particular case we see that MC’s shareholders receive very valuable stocks from MII as part of the special stock dividend. While they suffer losses on their holdings in HMC, we can expect this to be a temporary result of the cyclical downturn in real estate. We can expect shares in HMC to recover in the longer run, while MII shares will prove to be an attractive position as the spinoff generates strong cash flows with relatively little debt. B. Bondholders ­ ​
Under the plan, HMC would retain most of MC’s long­term debt of $3 billion. MC has many levels of debt (exhibit 2): secured notes, unsecured debt, capital lease obligations etc. Although MC execs stated that HMC would be able to meet interest payments, the spin­off of MII would affect the security of MC debt holders as debt rating would be most likely lowered to below investment grade. Institutional investors such as banks, insurance companies, pension funds would have to sell their bonds because of the law restricting them from holding any assets below investment grade. Furthermore, the US. courts stated that corporations have no responsibilities to safeguard the interest of bondholders other than those spelled out by the terms of the bond indenture. In the case of MC, the bonds lacked an "event risk" covenant that would have blocked restructuring (page 6, “legal considerations”). When analyzing the restructuring plan, it becomes obvious that the restructuring comes at the expense of bondholders. The assets that generate the cash to service the interest payments on the debt have been, for the most part, moved into MII. The perceived riskiness of the bonds would therefore increase. This would lead to a lower rating from agencies. To apprehend the effect on the bonds, we locked at multiple criteria: First, we calculated the new interest coverage ratio of HMC. HMC would have $123 million in earnings before interest and tax and interest payment of $210 million in 1992 (Exhibit 1). This gives HMC a ratio of 0.59, which puts the debt below CCC rating. A conservative estimate of the effect on price could assume a drop in price of 2% per rating level. In this case, going from BBB to CCC, the bonds would go down three levels on the scale, and we can estimate that bondholders would lose 6% on the value of their bonds. If the creditors planned to hold the bonds until maturity, however, this would be irrelevant to them. C. Management (Marriott brothers) ­ ​
After separating MC, ​
J.W. Marriott, Jr.​
, would be chairman, president, and chief executive officer of MII, while his brother ​
Richard Marriott ​
(currently vice chairman of MC) would be chairman of HMC. The two companies would also 3 COMPANY FTE SALES OP CF SALES/FTE PROFIT/FTE HMC 23.000 $1,8 bn $363 mn $78.261 $15.782 MII 182.000 $7.9 bn $408 mn $43.406 $2.241 As we can see from the comparison above, HMC is the smaller company on paper, however also more effective one in regard to sales and profit per FTE. The question is, whether HMC is able to cover all of MC’s long­term debt of nearly $3 billion as this is part of the spin­off contract. Although, it would have access through December 1997 to a revolving line of credit of $600 million from MII, if we aren’t able to attract enough investors to increase working capital and elevate growth and profits to repay the outstanding debt. The interest of the Marriott brothers is to improve the financial situation of MII and HMC to secure growth for both companies in the future. Since both of them are in the board of directors and can influence the decisions of each company, they can create synergy effects if they cooperate. Both companies can also help each other when it comes to cost of capital (figure 4). They can give each other loans at lower interest rates for example. D. The value of the whole company ­ ​
In the first place, MC management had long felt that the financial markets undervalued the company’s stock because of the difficulty investors had in distinguishing and separately valuing property ownership and management. As this obstacle is removed, the Marriott Group including the two single entities will be reevaluated by investors. Both companies focus on their core business and their advantages in comparison to competitors. Furthermore, MII could participate in the consolidation of the hotel industry by purchasing the assets of competitors in financial difficulty after raising money. These new acquisitions would strengthen MII from a customer service point of view. In conclusion, both companies are able to generate additional equity funds and corporate valuation is improved by providing strong incentives to employees who work in MII. For example, publicly traded stock options are available for employees of MII, which should provide motivation and reward. In addition, the division enables management of HMC focus on core operations and shareholders are better informed due to separate financial statements. As a result, Marriott would be able to issue new shares and increase their capital to generate further growth. In conclusion, creating shareholder value through capital structure optimization is the mission to tackle to generate sustainable growth. Calculations in regard to the WACC or EVA should help as a guidance to steer the company in the right way and a good mix of the capital structure (figure 3) will elevate the company’s ability to react to market changes or merger transactions. The debt to equity ratio should be around 35%. 3. Is the proposed restructuring consistent with management’s responsibilities?
The management’s core responsibility is to maximize shareholder value, and the Project Chariot is consistent with this responsibility. The restructuring project divides MC’s business into two parts: MII for lodging, food and facilities management, and HMC for real estate properties. By separating management operations 4 and property ownership, HMC could focus more on core operations, and shareholders could be better informed due to separate financial statements. MC’s shareholders will be given a special share of stock in the new company MII. Considering that MII would have little long­term debts, it would be more profitable, raise more capital, and even be able to merge their competitors. High profit in MII would release the burden of Marriott Corporation and bring more benefit to stockholders. Meanwhile, since HMC would be valued more on the basis of the chance of appreciation in property holdings, corporate valuations would be improved, which will also benefit stockholders. Project Chariot would also help optimize MC’s management team. Since MII and HMC will have two different and independent management teams, such division means twice as many executive positions, which can prevent the departure of “fast­track” executives. Moreover, expected growth of value could attract more managers to stay, especially managers with stock holdings. However, since HMC would inherit most of the debt, it would be more risky with lower ratings on long­term bonds in bond rating agencies, so that security of debt holders would be affected. Thus, bondholders would suffer a loss. 4. If you were a board member of Marriott, would you advise for or against Project Chariot (you may take both legal, ethical, and economic arguments into account)?
The Marriott Corporation (MC) had been struggling with debt and cash flows due to the Real­Estate slowdown that started in late 1990’s. The company approached Stephen Bollenbach, the then CFO of the MC, to find a solution. Bollenbach recommended Project Chariot, the initiative that he believed could bring the company back to its previous growth rate and help MC with the billion dollars stuck in debt. If I was a board member, I would make a decision after weighing the pros and cons of the Project. Pros: 1. The split enables each management to focus on its core operations: HMC on real estate and MII on services and operations. 2. Both companies would be able to generate additional equity funds by functioning independently. 3. With MII set­up as a debt­free entity, we can expect its corporate valuation and credit rating to grow substantially. This will prove to be good for the shareholders who can expect a respective increase in their investments. 4. The decision also allows for better management within the corporation as the two bodies would not have any internal competition for allocation of funds. 5. The transaction also allows MII to focus on expanding its management businesses as those individual opportunities require relatively small amounts of capital." 5 Cons: 1. Bondholders will be the worst affected if HMC is given all the debt. 2. Splitting such a large corporation into two smaller entities will make it difficult for both companies to look for institutional investors and would ultimately make financing more expensive than before. 3. The credit rating of HMC will be downgraded. If we look at the valuation of the companies, we see that the valuation of MC group in 1991 was around $3.65 Billion, while it was about $3.8 Billion for HMC and MII combined. As we see its a small increase from the original valuation. Therefore, the MC’s board member should not be too worried about the problems that result from the separation. Project Chariot solves more problems than it creates. All problems created are relatively short term and can be worked on once MII becomes debt free and independant. The bondholder’s will not be happy with the decision but once the real estate market comes out of the slowdown, HMC will be able to start paying back its debt. Therefore, if I were a board member at MC, I would prioritize the long­term health of the company and give my full support to Project Chariot. 6 Appendix Figure 1: Sales Growth vs EBIT vs Long­Term Debt per Year 1983­1991
Figure 2: EPS vs Share Price per Year 1982­1991
7 Figure 3: Optimal Capital Structure Figure 4: Cost of Capital 8