HEC Lausanne

Corporate Finance

Case 3: Marriott Corporation (A)

Spring Semester

1. Project Chariot is proposed by MC’s CFO, Stephen Bollenbach, to face the troubles that Marriott Corporation (MC) is currently facing. A glimpse of history is useful to understand the current situation. MC’s main business is to develop hotel properties, to sell them to outside investors and to conclude long-term contracts. In the 70’s MC began to finance its expansion by major borrowings under the impulsion of the new president J.W Marriott, Jr. that abandoned the conservative financing policy of its predecessor (and father). In 1981 the Economy Recovery Tax Act (ERTA) gave enormous incentives for companies to invest (tax write-offs were given for each $ invested in real estate). This pushed MC to develop even more its activities for instance in lodging services or in full service compact hotel. Even though ERTA was ended in 1986 MC continued its massive investments, which lead to a significant accumulation of debt. This was not an issue since the revenue growth was able to sustain the also growing interest payments. Until the drop of income in 1989, which froze capital expenditures. Unfortunately for MC, it was followed by the real estate collapse in 1990 that left MC with massive interest payments for properties that no one wanted to buy anymore given the current economic environment.

This situation results in an extremely limited ability for MC to raise funds in the capital market and therefore to finance its high growth market (like the life-care community facilities for which capital expenditure was decreased) and to seize all the good opportunities that were currently available in the distressed market. MC was somehow forced to invest in on contract and management opportunities that needed less capital. Before Project Chariot MC had already made significant efforts in the last exercises to diminish its debt burden but it was not an easy mission. For instance MC had decreased its work force and sold some of its properties but was a costly, long and difficult task given the current conditions in the real estate market. Indeed MC was somehow forced to sell its properties at discount to reduce its debt and hence renounce to possible profit if MC had the chance to wait for a recovery in the real estate market. The situation that was facing MC had also an impact on the view the investors had on the company. They saw MC as a company in a depressed industry that will need years to recover and go back to growth. Something needed to be done to signal the worthiness and potential of the company and this something had to be huge given the slow progress that MC had shown during the last exercises.

The financing limitation resulting from this debt accumulation is one of the main issues that Project Chariot is trying to fix. With the proposed restructuration MC would be split into two new companies: Marriott International Incorporated (MII) that will focus on lodging, food and life-care facilities management and Host Marriott Corporation (HMC) that will keep MC’s real estate holdings and undeveloped land. This radical restructuring could rebuild the trust that the investors had lost and give back MII the ability seize again the best opportunities given by the market. MII would have the capacity to raise fresh capital and restart the investments to get back to a higher growth. MII will be able to finance positive NPV projects that were frozen due to the high debt burden and inability to raise fresh cash resulting from it. This will also lower the pressure that is on the shoulder of HMC to sell his distressed assets. If the pressure is lower, it could let the time necessary for the market to recover and avoid unnecessary losses. Overall Project Chariot seemed to be, for the management, the best way to resolve MC’s current situation and to put MC back to the right track.

2. The impact of Project Chariot are multiple for the shareholders. There are a couple of significant advantages. First, the split of MC into two distinct companies will separate the property ownership from the hotel management business. A result could be an increase in the share’s liquidity and attractiveness since the two main activities of MC will be distinguishable. Indeed the split will allow pure plays. On one hand the management felt that the main added value came from the divisions under MII’s control. More investors may be interested to have MII shares than MC shares, since MII’s will represent what is MC’s DNA and growth potential: its corporate culture and management business. On the other hand HMC shares could also be very attractive for investors who just want to bet on the hotel real estate business. Therefore we clearly see that this split and the two “specialized” companies that will result from it unlock value by allowing investors to target more precisely which sector they want to invest in. We can also add that the split is a strong signal to the market that the management do what needs to be done for the firm to grow again, which could increase the market’s revenue expectations. All these elements could attract new investors and increase the demand for MII and HMC share that could drive shares prices up.

Second it will also give the opportunity to both companies to get a better management team as it will give better incentives to the talented managers to come and stay because the opportunities to get promotions will be higher in comparison to the current situation that was more locked. Moreover, as HMC and MII will have distinct business models, it will be possible to recruit specialized managers for each firm and therefore increase even more the management quality and the growth potential. That means that the expectation of the market for future revenue and returns will be higher and lead to an increase in stock prices.

The split could also solve the issue of investments freezing that was currently undermining MC’s growth potential and ability to do business in optimal conditions. Indeed MII will have almost no long-term debt and therefore an increased ability, in comparison to MC, to raise capital to finance growth with positive NPV projects and acquisitions. For instance, since the real estate hotel industry was going through a though path many of MC’s competitors were struggling, there was many opportunity on the market to acquire their assets with significant discount given their competitors’ financial distress. Moreover, some divisions of MII’s had a great potential for growth, like the life-care facilities, and investments in these areas could lead to significant returns. This will also increase the diversification of MII and therefore stabilize its revenue stream. Once again the expectation for future profits will increase as well as the stock prices. Moreover, since HMC would be valued as a real estate investment company, it would be under less pressure to sell its properties since HMC will be prized given the appreciation of its properties and not given its income expectations. This can give the time necessary for the real estate market to recover and lead to the opportunity to sell the properties for very good price in comparison to the distressed prices that MC is currently facing.

Nevertheless it is important to keep in mind that this project will also lead to a couple of negative outcomes. First the combined after tax revenue will be lower after the split than before since the hypothetic negative earnings of HMC would no longer offset the positive ones of MII. Then, as MII would have almost no long-term debt the tax shield resulting from it will be very low. Moreover, as most of the long-term assets would be retained by HMC, the access to the credit could be lowered for MII given its lack of covenants. But the fact that MII will have almost no debt and a high revenue will certainly offset this. The fact that HMC would retain almost all the long term debt could also be an issue since its credit rating following the restructuration was likely to decrease which will result in an extremely high cost of debt. There may also be a reputational issue that will be explained in more detail in the next question.
Overall the advantages of the split for the shareholders seem to do more than just offsetting the disadvantages if it goes through. But the splitting will also impact the other stakeholders and especially the bondholders, which will be worst off given the deterioration of the credit condition that will arise from the split, as will be explained in the next section. This will also illustrate that the different stakeholders have different needs and that the decision taken could have antagonist effect on them.

3. Even if the Project Chariot may look appealing from the point of view of the shareholders, it is a possibility that bondholders have an opposite point of view. As explained before, the managers generally try to increase the value of the equity. This is especially the case when the managers have shares of their own. Implementing the Project Chariot can result in a conflict of interest. Indeed, in our case, the outcomes from Project Chariot are likely to deteriorate the credit worthiness of the current debt. In our situation, bondholders and shareholders should have opposite expectation regarding the Project Chariot that seems to favor the shareholders.
One can notice that one of the greatest risks associated with this project is that Host Marriott Corporation (HMC) would assume almost the whole current debt of Marriott Corporation (MC), the actual existing organization. On the other hand Marriott International, Incorporated (MII) will be almost debt free. One has to recall that the source of the current existing debt is bond notes. With the implementation of Project Chariot, it is likely that the net revenues form HMC will be negative. Such a performance is likely to lead to a downgrading. As the bond rating is based on criteria such as the debt ratio, the financial situation of HMC will probably lead to a downgrading. If the new rating of the existing bond is below the investment grade, it is likely that some institutional creditors will have to sell their holdings. This could push HMC in a vicious circle. As institutional creditors sell their holdings, it could generate an even more important drop. Moreover, new investments from institutional creditors will n be possible anymore. In addition, if the Marriott’s bonds are seen as junk bonds, investors will assume a higher default risk and only a few investors will be interested in owning such securities. It would become more difficult for the company to attract new investors. One of the only solutions to attract external financing would be to offer a compensation for the lower investment grade. Indeed, since a low grade can be interpreted as a higher default risk, investors will ask for higher return. Offering higher return will increase the cost of debt for HMC. It is important to notice that traditionally, corporations have no legal responsibilities to safeguard the interest of bondholders. However, a recent Delaware Chancery Court decision could change the situation. Indeed, this decision seems to extend the duty of the corporate board of directors towards the holders of corporate bonds in case of financial distress. Because the Marriott’s direction could have a legal duty towards bonds holders, it is likely that a downgrading could lead to some potential legal issues. Another important concern is the public opinion about the Project Chariot. Financial engineering is not well accepted by the public opinion, especially when the purpose of such massive-wealth transfer is not the creation of real value. Because the brand of Marriott Corporation is a real asset for the company, the management should be concerned about the public opinion. The reputation of a company, especially for them active in the tertiary, has a real impact one the global results. One can also highlight that in such scenario – implementation of Project Chariot – HMC will be in a premium position for a hostile take over. In a LBO scenario, a group of investors may issue debt in order to acquire HMC. Issuing debt based on the value of HMC, respectively the target company’s assets, the investors take the control of HMC and then sell the assets to repay the debt. The possibility that such action occurs should be taking into consideration.
Regarding the previous considerations, the management should be concerned by the loss of the market value of the bonds if Project Chariot is implemented.

4. First at all, given a Debt/Total Capital ratio of 82% in December 1991, we would like to define stress tests. In the first scenario, we would like to test the required constant EBIT as percentage of sales in order to obtain a cumulative debt repayment of zero. One assumes that the 0.28 $ common dividend per share is constant through years. Indeed, in order to keep the share price stable, one assumes that the dividend policy should be at least stable –or increasing- over the year. One assumes this 0.28$ DPS because a decreasing in DPS is a very negative signal that could lead to a significant fall in shares price. A variation in the dividend policy could lead to an important decrease of the share price. Regarding the last years dividend per share payment, one notices a constant increase in the dividend per share. With a stable figure of 0.28$, we stabilize this source of cash outflow but continue to provide a positive signal to the market. Another assumption is the zero-asset selling for the period from 1992 to 1995. This could be due to collapse of the market, especially the real estate one. Another reason could be the refusal of Marriott Corporation to sell asset with a too important discount. To obtain such situation, i.e. cash available for repayment of zero, it needs a constant EBIT as percentage of sale of 4.9851%. Given that the historical mean for the EBIT is around 7%, one can assumes that such situation is quite implausible. The situation of our first scenario is too pessimistic to be realistic.

In order to be closer from realistic assumption, we now assume that the dividend policy is still stable (0.28$ DPS), that MC is able and is willing to sale each year around 70 million of assets held for sale (which is 5% of the previous year’s asset held for sale). Finally, we assume a 5% EBIT as percentage of sales, which seems to be reasonable since the average over the 10 years is 6.95%. Under these assumptions, MC is able to reduce its Debt to Total Capital ratio from 82% to 72% in 5 years. According this scenario, one can notice that the financial situation of MC is not that bad. Even under some pessimistic assumptions, the firm is able to reduce its Debt to Total Capital ratio, i.e. is able to improve its financial health by reducing its debt.

To conclude, it is certain that the implementation of this project would lead to several benefits such as the possibility for management of MC to focus on core operations, the fact that shareholders are better informed due to separate financial statements, etc. Even if the Project Chariot has a real potential to improve MC business capacities, one has to keep in mind it stay potential since many uncertainties would arises following the restructuration. Project Chariot could have been a matter of survival if the existing entity, Marriott Corporation, was likely to collapse. But given the current financial situation and our previous considerations, Marriott Corporation is in no such a situation. The main issue of this case is probably the concept of risk shifting, i.e. the shareholders are gambling with the creditors ‘money. The firm, through the shareholders, around 25% of the equity is hold by the family, could adopt excessively risky strategies. Since the shareholders are mainly concern by the dividend policy and the firm value, Project Chariot is a risky bet in order to increase these two variables at the bondholders’ expense. s