- Long: Marriott International (NASDAQ:MAR)
- Current share price: $32.00
- Potential Upside: $8 to $10
- Dividend Yield: 1.10%
- Market Capitalization: $11B
- Cash: $117M; Total debt: $2.90B
- Shares Outstanding: Approximately 335M
- Sector: Services Industry: Lodging
- 2012 FCF/Share:$2.77
- Trading timeline: 12 to 18 months
- Spin-off date: 21-Nov-2011
- Situation – Marriott International is spinning off its timeshare business (VAC).
- Numbers – 12.8% - Timeshare as % of total revenue; 14.73% - Timeshare as % of total cost
- Main Catalyst: Change of business model to 100% high margin franchisee business; Spin-off of high cost timeshare business accretive to earnings; property management contracts, Share buybacks and fundamentals.
Why the spin-off is positive for MAR shareholders – story so far?
Marriott decided to spin-off its timeshare business in 2011, touting it as a value creation opportunity for investors who want to invest in a pure play timeshare business. The firm followed a similar offloading strategy when it executed another spin-off in 1993 leading to separation of all its real estate holdings into a new entity named Host Marriot. Similarly, this spin-off might be motivated by desire to offload real estate and loan portfolio to create a pure service business. The motivation might stem from changes in the 2010 accounting rules. This rule required MAR to consolidate timeshare loans that were originally placed in off-balance sheet entities as well as the debt issued by these entities, onto MAR’s balance sheet. The consolidation of additional debt forced MAR to increase provisions for bad loans thereby impacting earnings. For example - MAR’s debt jumped by around $ 1bn in the 1Q10 to account for the debt used by the off-balance sheet structures to finance the timeshare loans. Current default assumptions by the company on these loans have been around 8% range. With the spin-off, all the consolidated debt, in addition to real estate holdings and future defaults on VAC loans will go on VAC’s balance sheet, thereby lowering MAR’s leverage to approximately 2.2x. MAR’s management has stated that it intends to keep leverage around 3x. This difference of 80 basis points might help it raise additional $600M of debt. This capital in addition to approximately $1B in FCF could be used to expand MAR’s business or be returned to shareholders in form of buybacks or dividends. Furthermore, the separation of the timeshare business would allow MAR to collect franchise fees of 4% to 6% of VAC’s hotel and food revenues, adding approximately $70M- $80M to MAR’s earnings.
VAC business that is saddled with still declining real estate on its balance sheet and loans with high default rates may not make for a good investment if consumer spending does not pick up in the next 4 quarters. I do not believe it significantly will. Additionally, the entity does not plan on paying dividends and plans to remain below investment grade in the medium term. The act of the management to separate the asset heavy timeshare business that has been played once before in 1993 creates an opportunity for investors to play a pure services business. Investors may gain by investing in MAR and enjoy the upside, as this separation becomes accretive to earnings and generates higher FCF, leading to higher valuation. The capital appreciate will come in addition to the current dividend yield of 1.1%.
What are the Main Catalysts?
Focus on high margin services business and Reduction of leverage
The separation of the Timeshare business from Marriott allows Marriott to move to a full service and high margin business, which will positively impact its earnings. Marriott will be able to focus on being a lodging management organization without the complexity of running either a financing operation (part of timeshare business where the company earns the spread on the loans to customers but also faces high defaults) or managing the real estate of the timeshare business. After the accounting changes, MAR was managing a portfolio of timeshare loans and dealing with a capital structure not aligned with a lodging servicing company. The spin-off would allow MAR to refocus on managing its properties and eliminate the distraction of evaluating the credit risk of timeshare loans. Additionally, MAR will be shifting around $1B of debt to VAC, reducing its leverage to 2.18x. Since management has indicated that its optimal leverage ratio is 3x, the company can potentially raise another $600M to return to shareholders or reinvest in its operations.
Management contracts, Brand Rights and Tax Benefits
Post spin-off, even though VAC retains certain exclusive brand rights to operate properties under the Ritz-Carlton and Marriott brand names, MAR retains all of VAC’s property management contracts. The contracts usually last 20 to 30 years and generated $ 47M in revenue in 2010. Additionally, MAR will receive $50M a year of royalties from VAC. If the timeshare business expands, MAR investors can share the upside due to the increased management fee that these contracts will generate for the low risk MAR business. In addition, MAR expects to realize $325M - $350M of tax benefits by 2015. Some industry analysts estimate the PV of these benefits, if realized, to be approximately $.065 -$0.75 per share. The Marriott family will retain a stake of 21% in both businesses through a special dividend, while Steve Weisz, a 37- year MAR veteran, will take over as the CEO of VAC.
Share Buybacks and Franchise Fees Provide Upside Potential
According to management, after planned capital expenditures of $500M to $700M, MAR will have $1B of free cash flow available for buybacks and dividends. The company has been emphasizing the use of buybacks to return capital to shareholders. At current share prices, $1B can repurchase approximately 9% of MAR’s equity. If the firm executes, then these buybacks will create additional upside for shareholders. Moreover, MAR expects to receive franchise fees from VAC that will amount to 4% to 6% of VAC’s hotel & food revenues, resulting in $70M to $80M in fees from the timeshare business. These factors will add to MAR’s earnings and create additional shareholder upside.
Fundamentals – 30% upside for earnings accretion due to VAC separation
MAR had $2.9B in debt ($1B of debt consolidated from VAC) and $117M in cash. If we calculate how much MAR stands to gain from reduction of expense due to the timeshare spin-off, including benefits to MAR from reduction in operating cost, gain from franchisee fee, savings on interest expense from separation of consolidated VAC debt and charge offs from potential defaults on timeshare loans, while subtracting revenue and interest earnings on VAC loans that MAR will lose because of the spin-off, then the spin-off will add approximately $0.45 to $0.50 per share to MAR’s earnings. This is in addition to industry estimates of MAR’s EPS expected to be approximately $1.60 in 2012. While MAR trades at a P/E of 20x, its competitors trade at a median P/E of 21.3x. Using the P/E and EV/EBITDA ratios, MAR should trade at $41 - $43 a share after the spin-off occurs.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.