Analysis: Marriott Corporation’s Spinoff of Real Estate & Service Business

Written by Teddy Smith

Marriott Corporation’s business model can be grouped into two lines of business: its real estate business and its service
business. Its real estate business plans, develops, and sells properties; whereas, its services business provides services
such as food and facilities management. However, this may not be exactly clear when viewing MC’s consolidated
statements of income, which simply reports lodging and contract services as its main source of income (exhibit 3).

Because MC is in the real estate investing business, they will need to acquire, construct, and maintain properties. This
is evident in MC’s 1991 balance sheet (exhibit 4), where property and equipment and assets held for sale represent
roughly 63% of its total assets. MC used debt to help fund its real estate investing business. On the liabilities and
equity side, long-term debt was the largest item for 1990 and 1991 (exhibit 3).

The Economic Recovery Tax Act of 1981 provided tax benefits for real estate investors. This sparked a period of
growth for MC. However, these tax benefits came to an end a few years later as a result of the 1986 Tax Reform Act.
While this may have led to a lower demand for investing in real estate, MC was undeterred by this and still continued
to focus and invest on its high-paced development activities to sustain their rapid growth. A look at the investing
activities of the firm’s consolidated statement of cash flows shows that in 1989 the firm spent $1.61 billion in capital
expenditures and acquisitions (exhibit 5). However, in the years that followed, these items decreased significantly as
a result of the 1990 real estate crash, which made it difficult for MC to sell its properties. Consequently, MC shifted
its focus from capital spending and stated in its 1990 Annual Report that the firm will place more emphasis on reducing
debt. By 1991, capital expenditures and acquisitions reached a low of $427 million, of which zero was used for
acquisitions (exhibit 5).

It is also worth noting that cash received from sales of assets was the largest source of cash for Marriott in 1989. For
that year, the firm obtained $1.39 billion in cash from the sales of assets (exhibit 5). But, as a result of the 1990 crash,
cash received from sales of assets dropped sharply to $975 million in 1990 and $84 million in 1991 (exhibit 5).
Subsequently, this made long-term and convertible subordinated debt issuances the largest source of cash for the
firm in 1990 and 1991.

Because of the 1990 real estate crash, MC had to slow down on their borrowings. We can see this in MC’s financing
activities in 1991, which indicate a sharp drop in long-term and convertible subordinated debt issuances compared to
the previous year (exhibit 5).

MC also had non-controlling interest in over 200 hotels. However, they were not profitable (exhibit 8). Fortunately,
MC still earned income from these hotels through grounds rents, management contracts, and interest income. For
instance, despite the losses experienced by unconsolidated affiliates in 1990, Marriott still earned a pre-tax income of
$98 million from them. This is quite a noteworthy strategy by MC and is reflective of how MC’s income is not so
much from its ownership in hotels, but from its services for hotels. In fact, its services business was actually offsetting
the losses stemming from their real estate business.

MC’s Core Competencies and Key Resource:

What MC does best is in operating its properties. Their excellent services have given them a good reputation amongst
customers and hotel guests, which is evident in MC’s occupancy rates. In 1992, MC’s occupancy rate was 76%-80%,
which is above the industry average of about 65%. Because of MC’s focus on providing quality services, investors
want to work with them. This is shown by how in 1980, 70% of MC's hotel rooms were owned by external investors.

We believe that MC’s excellent corporate culture is its key resource. MC’s founder, J.W. Marriott, Sr. believed in the
importance of taking care of his employees. He believed that if employees are taken care of, they too will take care of
the customers. This all translates to our previous point on MC’s reputation for service excellence. However, this would
not be sustainable without competent members of management such as J.W. Marriott, Jr., who replaced J.W. Marriott,
Sr. as president in 1964.

There are four phases in the real estate cycle: recovery, expansion, hyper supply, and recession. In the recovery phase,
there is an oversupply of inventory that was left from the previous cycle, there is little to no new construction, and
demand is just beginning to pick up again. The Economic Recovery Tax Act of 1981 had provided tax incentives for
investing in real estate. This sparked a demand for real estate investments, and MC, being the reputable firm that it
was, became an excellent choice for investors looking to invest in real estate. MC would plan, develop, and eventually
sell properties to investors. This period in the real estate cycle is what is known as the expansion phase. It is in this
phase that demand increases, vacancy declines, and rents increase, thereby making new construction feasible and
supply to go up. For MC, this is evident in its revenue growth rate, which continued to go up each year from 19% in
1983 to 29% in 1986 (exhibit 6).

It was only in 1987 that the revenue growth fell to 26% (exhibit 6) because of the 1986 Tax Reform Act, which took
away much of the tax benefits that the 1981 act provided. This marked MC’s entry into the hyper supply phase, where
demand decreases, but supply continues to increase. Note that in this phase, MC’s revenue growth went down even
further to 13% in 1988. MC’s entry into this phase is also supported by the reading, which states, “the market for its
limited partnerships was drying up, and in 1989 the company [MC] experienced a sharp drop in income” (Marriott,
3).

In the event that supply continues to rise faster than demand and the occupancy drops below its long-term average,
the market will enter into the fourth phase: recession. This phase is characterized by massive oversupply, declining
demand, declining occupancy rates, and lower rents. This happened in 1990 and during this phase, MC suffered from
the industry’s oversupply, which lowered occupancy and room rates. For MC specifically, their revenues from contract
services declined substantially in 1990 ($3.70 billion in 1990, compared to $3.99 billion in 1989), which hurt
profitability margins immensely during that year (exhibit 3 and 6). As an example, MC’s EBIT as a percent of sales
declined from 6.4% in 1989 to 3.4% in 1990 (exhibit 6). In addition, the firm had to lower its capital expenditure in
1990 and in 1991 as a result ($1.1 billion in 1990 and $427 million in 1991, from $1.4 billion in 1989). It was also in
1991 that the firm began to focus more on its contract and management business, which required less capital
investment (exhibit 6). By 1991 MC began to recover from the crisis of the year before (EBIT as a percent of sales
went up to 4.9% in 1991).

In the mid 1970s, following the retirement of Marriott Sr., the founder of MC, his son took over and “turned to major
borrowing to finance expansion that would maintain its historical 20% annual revenue growth.” MC began to use bank
credit and unsecured debt instead of mortgages to finance development. In 1978, MC engaged in its first joint venture.
The agreement made it so that MC would plan and develop hotels, sell properties to investors and still retain
management contracts for these properties. At the time, this seemed like a powerful, high-growth strategy. In fact, this
lead to a five-year period in which MC sustained 30% annual growth, while outside investors owned 70% of all rooms
constructed.

In 1981, the Economic Recovery Tax Act incentivized investors to purchase real estate. It provided very large tax
write offs to individuals who invested in real estate, which fueled their hotel-developing activities further.
Unfortunately for MC, the Tax Reform Act of 1986 countered the act of 1981 and ended the tax incentives for
investment in real estate. MC’s troubles were due to the industry’s excess capacity and the removal of the Economic
Tax Recovery Act of 1981. These factors lowered buyers’ demand for MC’s properties. However, MC did not heed
the warning of the end of the expansion phase of the real estate cycle and continued to invest in its “high-paced
development activities (Marriott, 3).” This end of the tax reform started deterring investors from allocating more
money into real estate. Investors were no longer interested in entering limited partnerships, and MC experienced a
large decline in income in 1989. Saddled by a mountain of interest and principal payments for their debt, coupled with
the large decline in income, MC was forced to begin selling off their long term assets in order to pay for their debt
obligations.

Because MC was unable to pay for their debt, MC was forced to begin selling their long term assets at depressed
prices, even though these would be better off (and have a larger value) if they were held to appreciate. This is shown
on the balance sheet as a decrease of property and equipment of $289 million and the decrease in long-term debt
between 1990-1991 of $619 million (Exhibit 2). Because the sale of these properties and equipment was insufficient
to cover the debt, MC also had to use up 87% ($247 million) of its cash reserves. These cash reserves and cash proceeds
from the sale of assets were also used to pay off accounts payable and other payables and accruals. This led to a
decrease of $287 million total in liabilities (Exhibit 4). Additionally, in order to offset some of its losses from its real
estate business, MC began focusing more on its contract and management opportunities. These opportunities offered
higher margins with lower necessary capital expenditure. This allowed MC to lower its capital expenditure to $350
million, which was only the amount necessary to maintain and refurbish existing properties. MC also began to cut
their workforce, which allowed MC to decrease its accrued payroll and benefits.

MC does not face imminent cash flow insolvency in the fall of 1992. Given that only the revolving loans, which are
at a relatively low interest rate, are maturing through 1995, the corporation still has time to make enough to pay off
their debts. By 1991, MC was able to cut their capital expenditures in half and pick up their sales growth by 8%. This
allowed the firm to free up cash and pay off some of the outstanding debt load. The firm's long-term debt as a percent
of capital is at 59% (a 9% decrease from the year prior), still within the range it had years prior to the real estate market
crash. Although the ratings of these bonds (Baa3 and BBB) suggest the firm has a relatively high default risk and a
good possibility to be cash flow insolvent, the core business of the firm is still generating sufficient income.

As a result of the financial distress, MC does experience some costs of financial distress. In 1986, when the U.S.
government decided to enact a Tax Reform act, it caused an increase in costs to invest in real estate. The government
was no longer providing “investors $9 in tax write offs for every $1 invested” in real estate, thus, causing demand for
real estate to decrease. As real estate asset value began to decrease, MC’s asset value began to decrease along with it
as a bulk of their business involved real estate. Given MC’s revenue growth was heavily debt driven in the years prior
to the crash, this left MC and its management with overhanging debt. With obligations to payoff approaching, and
pressure from stockholders to maintain its growth rates, MC needed a way to increase their profits and payoff their
debt obligations given weaker demand. As a result, MC began to engage in a fire sale in which they inefficiently and
prematurely sold their long term assets. In 1989, MC had proceeds from sales of assets totalling $1,648 million,
illustrating the massive sell off the firm had to undergo to stay afloat and appease investors.

Furthermore, as a result of the financial distress, the firm had to engage in cost cutting behavior such as cutting their
capital expenditure to $350 million and trimming their workforce. Throughout the case, it was repeatedly stated that
MC had a unique corporate culture which separated it from its competition. In an attempt to cut costs and restore
profitability, “MC had reduced its workforce significantly in response to its difficult economic situation (Marriott,
5).” Being in the services business, having intelligent, hard-working and independent employees is very valuable. MC
was first started partly on the principle that “People are No.1-their development, loyalty, team spirit… Marriott
believes that the customer is great, but you come first. Mr. Marriott knows that if he takes care of his employees,
they’ll take care of his customers(Marriott, 4).” Losing large masses of valuable employees can be very costly. Often
times, these employees have to be trained and groomed in order to be ready to join the MC workforce. Additionally,
the loss of experience and trained workers, although cannot be quantified, can also be very costly as the quality of
care and service the remaining employees provide may not be up to par.

Project Chariot would increase total firm value. By engaging in the legal and structural separation of entities (AKA
spinoff), MC will be able to split its main business lines into two separate entities: MII and HMC. Because MC’s real
estate development portion of the business is largely saddled with debt overhang, the value of any equity injection
will partially go to the creditors of MC. Due to the fact that MC’s executives are meant to act in the interest of
stockholders, taking on more equity to increase value for bondholders is not an ideal situation. Rather than increasing
the value of bondholders, engaging in Project Chariot would actually dilute debt, thus weakening the debtholders’
claim and allows the corporation to have more power during negotiations. MC is able to relieve the effect of the debt
overhang by separating existing debt away from their growth assets (MII) to its stable assets (HMC).

Through Project Chariot, it allows MC to engage in a related party transaction. By splitting the two entities, MC is
able to shift the ownership of its currently more profitable business line to a firm without overhanging debt. As a result
of this, MC is risk shifting by putting the debt load solely on the real estate firm (HMC). Furthermore, with the
assurance from MC that “HMC would have the financial strength to make all payments of interest and principal on
long-term obligations when due,” the debt burden only affects one company’s balance sheet. For that reason, MII
becomes more strategically and financially flexible, which would then allow MII to raise new capital to finance further
growth, and possibly engage in predation of other firms as the new capital will allow them to purchase their
competitors assets at depressed prices. Additionally, HMC will also be better off and valued higher because it will no
longer be under heavy pressure from investors to sell off their properties to fuel their growth. Rather, HMC will now
be able to hold on to their prized, long-term assets and allow them to appreciate for the future sale of these assets.
The proposal for Project Chariot would split Marriott Corporation into two separate companies. The lodging, food and
facilities (including life-care), would be separated from the real estate holdings and concessions from tollroads and
airports. Marriott Corporation would split on the basis of a special stock dividend. This dividend would provide
existing Marriott Corporation shareholders stock in the new firm on a 1-1 basis. The two conditions of the dividend
were that the dividend would be tax-free for shareholders and that the dividend were to be subject to approval by
Marriott Corporation shareholders who would be in favor of the transaction.

Once the transaction was complete, MII would retain the bulk of employees from MC with 182,000. HMC would
have 23,000 employees, so there were no job cuts to be expected but the transaction would lead to increased
opportunities for management (Marriott 5). MII cash flow before expenses and other items was projected at $408m
on $7.9b in sales for 1992 (Marriott 5). This compares to HMC with $363m in cash flow before expenses and other
items on $1.8b in sales (Marriott 5). In the proposed plan HMC was to take on virtually all of the long-term debt of
the Marriott Corporation which amounted to $3b and would have $600m line of credit from MII (Exhibit 1). MII
would benefit as they would have only a small amount of long-term debt (Exhibit 1). The goal of the transaction was
to unlock value from investment opportunities and developing/managing locations. This would differ from the
traditional way Wall Street valued Marriott Corporation, which was on the basis of real estate ownership. In theory,
HMC would be valued on the appreciation of the property holdings. We estimate the share price for MII at $29.4 per
share assuming a P/E ratio of 21 and EPS of $1.4.

Bondholders were not protected by the U.S. courts as the courts ruled that corporations have no further obligations to
bondholders except for the terms of the bond indenture (Marriott 7). Around the time the transaction was to take place,
the real estate market was in poor shape and junk bonds had collapsed. Unloading the long-term debt onto HMC was
justified by MC through the cash flows ($363m) to repay the $3b in debt. Project Chariot would cause the bond price
to decline and a higher required rate of return as the bond rating would be lowered to account for the increased risk.

Focusing on HMC, for 1992 EBIT of $123m and interest of $210m puts them at an EBIT/Interest ratio of .585 (Exhibit
1). The debt that has been moved from legacy MC to HMC creates heightened risk and the bond rating decreases from
BBB to B. The risk is partly the result of the bond repayment being linked to the appreciation (not guaranteed) of real
estate assets within HMC. After the transaction, the bondholder value decreases by 19.5% to 2.4b (Exhibit 2).

MII and HMC would not be managed collectively but would have their own management teams with J.W. Marriott
Jr., running MII and his brother Richard Marriott would serve as chairman of HMC. Bollenbach was to serve as CEO
and president of HMC. Under the proposed Project Chariot HMC and MII would have their own independent boards.
Richard Marriott and J.W. Marriott Jr. would serve on both boards. Having both brothers on the boards can be seen
as a positive if they work together to identify strategies that help both firms. For example, MII could lend money to
HMC at lower interest rates than HMC would find on the market. In turn, HMC could provide favorable terms to MII
in their contractual agreements. Effectively, synergies can be created from undertaking Project Chariot. The synergies
would be in addition to the unlocked potential value of splitting the operations.

The management of the firms are consistent with the responsibilities expected of them. Project Chariot would actually
help attract and retain more top talent as there are opportunities at both firms. Retaining top talent had been a pain
point for MC in the past. Therefore, retaining top talent and the possible synergies associated with the transaction,
make Project Chariot a worthy transaction from a shareholder and management perspective. From a bondholder
perspective, Project Chariot would not be welcome due to the majority of the debt landing on HMC. From a
management perspective, MC would be within their duties to restructure. U.S. courts ruled in Katz v. Oak Industries
that organizations have no responsibilities outside of the terms agreed upon in the bond indenture (Marriott 7). While
in Credit Lyonnais Bank N.V. v. Pathe Communications the court ruled the board must act in the interest of the
community and to exercise on informed judgement and in good faith (Marriott 7-8). The lawyers of MC could make
the argument that HMC would have enough cash flow to pay back the debt and acted in good faith by structuring a
$600m line of credit from MII to HMC to help with the repayment. Taking into account the potential synergies,
unlocked value, and the retaining of top talent, Project Chariot is consistent with management’s responsibilities and
we would recommend the implementation.

At the time, “U.S. courts had held that corporations have no responsibilities to safeguard the interests of bondholders
other than those spelled out by the terms of the bond indenture (Marriott, 7).” Thus, creditors had to look out for their
own interests and could not leave it up to corporate executives to look out for them. In our opinion, if bondholders
had been protected by a covenant that allows them to veto any spinoff, there would not have been a spinoff. A
separation of entities would dilute bondholders claims, thus making them weaker and more susceptible to negotiations
when the time comes to pay off the debt. If bondholders allow the entities to split, it increases the risk of default for
HMC as it would take the burden of the majority of the debt and be less profitable. Because debtholders are not
stockholders, the creditors do not experience the increase in overall value because they do not receive the special
dividend paid out as a result of the spin off. Additionally, resulting from the increased risk of default, bond rating
agencies will begin to downgrade MC’s bonds, thus classifying them as non-investment grade.

The firm has been heavily fueled by debt in the years prior to crash. As a result, over 50% of its liabilities on its
balance sheet are from long term debt ($3,598 million). With so much of its liability structure comprised of debt, these
creditors would only vote on a decision that was beneficial for them. With the proposed Project Chariot structure,
creditors actually lose out on the created value and experience higher risks as a result. Luckily for MC, none of its
long-term debt indentures included event-risk covenants that would allow creditors to veto this action.