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Marriott International, Inc. (MAR)

F2Q07 Earnings Call

July 12, 2007 10:00 am ET

Executives

Arne M. Sorenson - Chief Financial Officer, Executive Vice President, President - Continental European Lodging

Carl T. Berquist - Executive Vice President, Financial Information and Enterprise Risk Management, Chief Accounting Officer

Analysts

Felicia Kantor Hendrix - Lehman Brothers

Joseph R. Greff - Bear Stearns

Harry Curtis - J. P. Morgan

William Truelove - UBS

Celeste Mellet Brown - Morgan Stanley

Jeffrey J. Donnelly - Wachovia Securities

Bill Crow - Raymond James

William Marks - JMP Securities

Jeffrey Randall - A. G. Edwards

Michael Millman - Soleil Securities

Presentation

Operator

Good day and welcome to this Marriott International second quarter 2007 earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Executive Vice President, Chief Financial Officer, and President of Continental European Lodging, Mr. Arne Sorenson. Please go ahead, sir.

Arne M. Sorenson

Thank you, Jimmy. Good morning, everyone. Welcome to our second quarter 2007 earnings conference call. Joining me today are Laura Paugh, Senior Vice President of Investor Relations; Donna Blackman, Vice President of Investor Relations, and Carl Berquist, Executive Vice President, Financial Information and Enterprise Risk Management.

Before I get into the discussion of our results, let me remind everyone that many of our comments today are not historical facts and are considered forward-looking statements under federal securities laws. These statements are subject to numerous risks and uncertainties as described in our SEC filings, which could cause future results to differ materially from those expressed in or implied by our comments. Forward-looking statements in the press release that we issued earlier this morning, along with our comments today, are effective only today, July 12, 2007, and will not be updated as actual events unfold. You can find a reconciliation of non-GAAP financial measures referred to in our remarks at our website at www.marriott.com/investor.

Now, on to the quarter. We continued our impressive performance in the second quarter. Adjusted earnings per share totaled $0.57, up 36% over the same quarter last year, excluding the impact of our synthetic fuel business and the one-time charge for the employee stock ownership plan settlement. Compared to the midpoint of our guidance, we outperformed by about $0.04, excluding our synthetic fuel business and the ESOP settlement. Roughly $0.01 was due to incentive fees calculated on prior periods results but earned and due in the second quarter of this year; our timeshare segment contributed about $0.02, reflecting the favorable timing of sales recognition and a higher-than-expected mortgage note sales gain; and about $0.01 came from our owned, leased and other income line, in part due to strong performance at our new Ritz-Carlton hotel in Tokyo.

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Worldwide system-wide, we recorded REVPAR growth of 7.5% in the second quarter, or 6.4% on a constant dollar basis. This strong performance was led by our company-operated hotels outside North America, with REVPAR up 15.5% or 9.6% excluding the impact of foreign exchange.

In Beijing, we have six Marriott and Ritz-Carlton hotels, which continue to thrive in the run-up to the 2008 Olympics. We plan to open five more full service hotels in Beijing in time for the summer games. Overall in China, we have 18 hotels and over 7,000 rooms under construction as we speak.

Elsewhere in the Asia-Pacific market, both Australia and Singapore continue to do very well and in India, where we just announced that we would triple our presence over the next three years to more than 20 hotels, REVPAR rose by 40%.

Continental Europe also drove higher REVPAR during the quarter, led by Eastern Europe. Germany was strong in the second quarter, although we expect some REVPAR fall-off next quarter with tough comparisons to the World Cup last year.

The Middle East continues to perform just great, with REVPAR gains of about 17% during the quarter. We recently announced we would add 16 hotels and more than 3,500 rooms in that region over the next several years. Our hotels in Cairo are doing well and we’ve seen renewed demand at our Red Sea resorts.

Our Caribbean and Latin America hotels delivered strong results, led by especially favorable performance in Brazil, Panama, and the Dominican Republic. Our Island Destination resorts were a bit softer, in part because of returning demand to Cancun following last year’s impact of Hurricane Wilma.

North American company operated REVPAR increased 5.6%. This growth was paced by our full-service managed hotels, which grew REVPAR 6.4% during the second quarter. Our limited service brands reported a bit slower growth, impacted by the tough comparisons related to Hurricane Katrina. Among our limited service hotels, our franchise hotels reported stronger REVPAR growth at our managed properties, due both to geographic distribution and the beneficial impact of new franchise limited service hotels added in the past few years. Even after these new hotels become comp properties, the natural ramp-up of REVPAR in their early years of operation benefits the REVPAR growth of the portfolio as a whole.

Strong results continued in New York City, where REVPAR grew 16% and this just terrific story looks to continue as far as we can see. Philadelphia had a very strong quarter, largely due to in-house generated group business. Washington was a tale of two markets, with the in-town hotels doing better while the suburban areas were softer.

Compared to last year, Atlanta was softer due to fewer city wides. The L.A. market was also softer, although L.A. looks significantly better in the second-half of the year. Houston, Dallas and Denver riding the energy sector wave, all delivered strong REVPAR increases. Chicago continued to be solid. San Francisco was particularly strong from the peninsula south to the Silicon Valley. Our Hawaiian properties did very well in the quarter, with REVPAR up about 10%.

As expected, Marriott Hotels and Resorts REVPAR trended up from the first quarter, especially transient REVPAR. Weekend revenue growth, largely leisure business, was particularly strong. We sold more high-end corporate-rated business and offered fewer discounts to corporate customers. Overall, our full-service hotel transient business firmed during the second quarter and continues to look good going forward.

Group REVPAR in the quarter was less strong, especially corporate groups booked in the quarter for the quarter. But group attendance remained solid at second quarter meetings and meeting planner spending on food and beverage strengthened. We expect to see improvement in group REVPAR in the fourth quarter. In fact, group revenue already on the books at our comparable Marriott Hotels and Resorts, is up nearly 7% in the fourth quarter and up about 9% for 2008, compared to the same times last year.

Top-line growth at company-owned and leased properties, albeit a small portfolio, exceeded our expectations. In particular, our new Ritz-Carlton in Tokyo is doing great. Open just over three months, this leased property is already the leader in the Tokyo luxury market and has 250 weddings booked in 2007, with only nine months in that first year of operations.

While our top-line performance was good, our bottom-line was outstanding. House profit margins increased 130 basis points in North America and 160 basis points worldwide. Not only are we driving room rates higher, we are improving returns at the same time, on top of what we believe are already industry-leading margins.

One way to measure this profitability improvement is to look at house profit per available room, or HPPAR, as well as REVPAR. REVPAR at our full-service managed hotels in North America rose a respectable 6.4%, while HPPAR increased 9.3%. For our limited service hotels, we translated a 4.3% REVPAR growth into an astonishing 7.9% increase in HPPAR in the quarter. And across all our brands worldwide, house profit per available room jumped 10.4% on a constant dollar basis.

How did we accomplish this? We made great strides this year by rolling out toolkits to help identify and implement best practices throughout our system, improving productivity and profitability. We found savings in energy management, workforce scheduling systems, and procurement practices, to name a few.

Above property, our shared service center continues to lower transaction costs while Marriott.com both lowers costs and drives revenues. Incidentally, we’ve calculated that Marriott.com is the eighth largest consumer retail website globally among all industries and it is obviously the largest in the lodging sector. In the second quarter, our website generated 17% of booked room nights.

And, of course, we share in the profits of our managed hotels. Incentive fees rose 51% across our system in the second quarter. Approximately $15 million of our incentive fees were calculated based on prior periods results but became earned and due in the second quarter, when two portfolios representing 61 properties changed owners. Incentive fees in the quarter also reflected the receipt of $3 million for our share of business interruption insurance proceeds from two hotels in New Orleans. 63% of our managed hotels paid incentive fees in the second quarter compared to 58% in the year-ago quarter.

Time share revenue net of direct expense jumped 49% to $122 million, as better-than-expected sales at resorts in Maui and Frenchman’s Cove in the Virgin Islands combined with faster-than-expected construction in Las Vegas. We also outperformed our expectations due to lower-than-expected sales and marketing expenses and strong financing income.

We’ve increased the percentage of buyers taking our financing through Marriott Reward Incentives. We completed a $270 million note sale during the quarter, which resulted in a $45 million gain. Default rates on our time share notes have fallen significantly in the past two years, despite all the news and noise about residential mortgage problems. The credit scores of our borrowers continue to be quite strong.

Contract sales for our timeshare, interval and whole ownership projects, including sales from joint venture projects, were $359 million, 24% lower than the prior year. You may recall that last year we introduced projects in San Francisco, Kapalua Bay, and Maui to great acclaim and in one project, life-to-date deposits rolled into contract sales all at once, driving second quarter 2006 contract sales up 40%. Excluding these three projects, contract sales rose 5% in the second quarter. Elsewhere, sales were strong in Miami and Panama City but remained relatively weaker in Southern California.

Globally, we added 52 properties and about 7,000 rooms to our hotel system during the quarter. Almost a fifth were conversions from other brands, as Marriott continues to grow market share around the world. During the second quarter, we introduced Courtyards to El Salvador and Japan, and announced that the brand would enter Saudi Arabia, Thailand, and Hong Kong over the next several years. We also opened two Marriotts in Ireland and a Ritz-Carlton in Tokyo.

Our pipeline of hotels under construction awaiting conversion or approved for development increased to more than 110,000 rooms, a quarter of them outside North America.

One of the reasons we are so bullish about our future unit growth is the progress we have made with multi-unit partners outside the United States. We have at least 40 active multi-unit growth partners that own hotels already managed by us and have signed deals in their and our pipeline. This includes at least seven active partners in India, five in China, two in Russia, four in the Caribbean and Latin America, and many across Europe and the Middle East.

While there is more conversation across the industry about increasing pipelines, certainly in the full service segment supply growth seems very modest. Specifically, our review of our own data and discussions with our hotel general managers give us little reason for concern about supply in urban locations and in the full service segment. For the limited service segment, while we’re less confident about supply, we are comforted that in the U.S. the time required to develop hotels remains lengthy. With the exception of a very few suburban locations, bottom line we have not seen a meaningful impact on our business from U.S. supply group.

Our synthetic fuel business contributed approximately $0.08 to earnings per share in the second quarter, compared to $0.01 in the year-ago quarter. You may recall that last year, we suspended production of synthetic fuel in April and estimated a 38% phase-out of 2006 tax credits due to high oil prices. In the second quarter, we were at full production and given oil prices at quarter end, our second quarter results assume no phase-out of credits in 2007. Given the volatility of oil prices and the fact that the synthetic fuel tax credits program expires at the end of this year, we continue to exclude this business from our earnings guidance.

During the quarter, as we previously disclosed, we settled a number of issues with the IRS and Department of Labor involving a stock ownership plan. The settlement resulted in a $0.13 per share charge in the second quarter. Since this impacts several locations on the P&L, we have prepared a reconciliation on page 15 of the earnings release schedules.

In the second quarter, we repurchased nearly 9 million shares of our stock for $402 million. Year-to-date through this week, we have purchased 21 million shares for nearly $1 billion. While we still expect to invest $1.5 billion in share repurchases during 2007, such investments obviously will not be distributed equally throughout the year.

As you’ve probably seen over the last number of weeks, we’ve been very busy moving into new spaces, from Nickelodeon Green Slime to Ian Schrager’s innovative view of the lifestyle boutique experience. We believe these sectors will be very successful over the years. Our venture with Nickelodeon will provide gen-x’ers and the young-at-heart and their families with a great, branded upscale hotel experience at self-contained destination resorts. Water features will play a major role in these resorts, as will of course the Nick brand. We have a goal of opening 20 of our Nickelodeon by Marriott Resorts in great locations, both inside and outside the U.S., by 2020 and the first in San Diego is already well underway.

Just a few weeks ago, we launched with Ian Schrager what we believe will be a new, modern genre of hotels. It’s an exciting combination of a pioneering lifestyle boutique concept, with Marriott's global platform to create a new brand and something that has not yet been achieved -- the first global branded boutique lifestyle hotel available on a significant scale.

We expect that you’ll be able to find our hotels in major global destinations, from New York to Tokyo to London and Paris and Barcelona, just to name a handful of premier markets. We expect to have five transactions completed by the end of this year and plan to have 100 hotels open or in the pipeline within a decade. So far, the response from owners has been very positive, which would tend to underscore for us that we are not the only ones who believe we have some wide open space in this category. More to come on this, including the brand’s name.

In addition to these great new brands, we are working across the board to maintain the relevance of our current brands and appeal to customers of all generations. The new great room, which we are initially deploying in selected Marriott hotels and resorts and Renaissance hotels, is capturing the imagination of our owners who see its great possibilities.

We are making over our lobbies into dynamic spaces where you can grab breakfast in the morning, do business with your laptop in the afternoon, and enjoy a cocktail in the evening. We call it A.M. Comfort, P.M. Cool. You’ll see this design in action at our relaunched Renaissance in Times Square later this year.

As we’ve discussed before, we are making substantial efforts to increase the diversity of our ownership base. RLJ, owned by Robert L. Johnson, who founded BET, is one of our largest owners. Just yesterday we broke ground on our first Hispanic-owned hotel project here in the nation’s capital, a Courtyard located in a newly vibrant area of D.C. known as NOMA, north of Massachusetts Avenue. And we’ve also just raised the bar again with a goal of having 500 minority and women-owned hotels by 2010. We already have more than 400.

We are also making sure our customers know the exciting steps we and our owners are taking to enhance their hotel experience. In the first quarter, we began running ads on our major national cable networks, telling the story of our plug-and-play technology that we’re rolling out. We mentioned it last quarter.

You might have recently noticed our new Residence Inn ads. We’re really focused on capturing and conveying the distinct advantages of the Residence Inn experience, from spacious rooms and full kitchens to services such as grocery delivery and innovative use of outdoor space.

Now, let’s turn to our outlook. We are generally reaffirming the guidance we provided last quarter. We see no meaningful change in our booking pace that would cause us to significantly adjust our forecast. With domestic transient REVPAR continuing to strengthen, comparisons to last year easing, solid group bookings, and strong REVPAR growth outside North America, we remain positive about our business. Margins around the world are just outstanding and our unit growth machine continues globally.

During the third quarter, we expect REVPAR growth of 6% to 7% at North American company-operated hotels and fourth quarter growth of 7% to 8% which, when combined with the REVPARs for the first two quarters, yields 6% to 7% growth for the full year. You may ask how we can be so optimistic about strengthening REVPAR numbers in the third and fourth quarter, given the lower reported REVPAR number in the first-half of the year. Two reasons: first, comparisons to last year become easier. Last year, our North American managed properties reported REVPAR growth near or above 10% in each of the first and second quarters, but only 8% and 7% in the third and fourth quarters respectively. Second, 2007 group bookings already in place improve as the year progresses, reaching 7% in quarter four, as I mentioned earlier.

On the margin front, we are even more confident. We expect North American house profit margins to increase 150 to 200 basis points in the third quarter and for the full year. We expect to open nearly 30,000 rooms during the year and remove approximately 11,000 rooms, largely driven by our efforts to enforce brand standards and upgrade product. Room deletions should not have a material impact on earnings.

We believe 2007 base, franchise, and incentive fee revenue will total $1.405 billion to $1.415 billion. We expect timeshare contract sales to increase roughly 5% for the full year, a bit more conservative than last quarter’s view. We project timeshare sales and services net of direct expenses to total $335 million to $345 million for the full year, reflecting the higher mortgage note sales gains earned in the first-half.

Since some of the strong second quarter performance was related to the timing of revenue recognition, our timeshare forecast for the back-half of the year is a bit more tempered. We expect owned, leased, corporate housing and other revenue net of expense will total $180 million to $190 million, an increase of $15 million since our last forecast. Part of the increase is due to the ongoing strong performance of our new Ritz-Carlton hotel in Tokyo.

Excluding syn fuel, gains are expected to total approximately $60 million. Our net interest forecast is up a bit to $125 million to $135 million, excluding the ESOP settlement, as our debt levels continue to rise. Our guidance assumes we have purchased $1.5 billion worth of our shares during the year and investment spending totals $1.1 billion to $1.2 billion. We expect G&A to increase modestly to $695 million to $705 million, also excluding the ESOP settlement.

With these assumptions, we expect 2007 EPS will total $1.88 to $1.96 per share, excluding any impact from our synthetic fuel business and the ESOP settlement. This rolls forward our second quarter out-performance, tempered a bit by timing of timeshare revenue recognition.

Looking at sales side models, you are generally a little bit heavy for the third quarter and light for the fourth. In the third quarter, we expect fee revenue to total $295 million to $300 million. You may recall we reversed a $15 million timeshare contingency reserve related to marketing incentives in the 2006 third quarter, so our timeshare will have a tough comparison in this year’s third quarter. As a result, we expect timeshare profits to total $35 million to $40 million in the third quarter.

All in all, excluding synthetic fuel, we expect fully diluted EPS to be $0.27 to $0.31 in the third quarter.

In all, we’ve just reported a great quarter. We have steadily built our business and refined our systems to deliver great results to our hotel owners and shareholders. Owner investment in our brands and hotels continues to expand as we innovate and renovate. The famous New York Yankee, Yogi Berra once said: “If you don’t know where you are going, you might wind up someplace else”. Well, we think we know where we are going and with the best people in the hotel industry, we’ll work as hard as we can to get there.

Now, Jimmy, we’ll be pleased to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Felicia Hendrix with Lehman Brothers.

Felicia Kantor Hendrix - Lehman Brothers

Good morning. Glad to see your ability to give us quotes hasn’t been stifled.

Arne M. Sorenson

But no joke.

Felicia Kantor Hendrix - Lehman Brothers

No joke. I just have a few quick questions for you. First question a bit bigger picture; given your international exposure, the strength that you are seeing there, I’m wondering why you are not also providing or you haven’t moved to also providing us with either worldwide REVPAR guidance or maybe just international REVPAR guidance.

Arne M. Sorenson

You are talking about guidance for Q3 and Q4 really?

Felicia Kantor Hendrix - Lehman Brothers

Yes, just going forward.

Arne M. Sorenson

We have -- it’s probably a fair question and I think to be fair, we’ve probably not been entirely consistent about whether we give worldwide guidance or not. You can tell from this year’s or this quarter’s numbers, there’s often a significant impact on exchange as well as core local performance, which makes it a little bit harder to forecast but it’s something I think we should look at and we’ll probably do more on as we go forward as it gets to be a bigger part of our business.

Felicia Kantor Hendrix - Lehman Brothers

And then, I was wondering if you could just touch upon the weakness in the group sector in group segment you saw in the quarter.

Arne M. Sorenson

It’s an instant dynamic and it’s probably the only point of real weakness that we saw in the second quarter, though it’s relative. It was really focused on group business booked in the quarter for the quarter, less on group business already on the books. Group business on the books showed up, performed well at the hotels, came if anything at the high side of their expected size, spent well on S&B.

When we look at the data about what happened in the quarter for the quarter, it looks like it’s more driven by a few markets than it is an indication of any sort of weakness overall. Orlando, Atlanta, D.C. tended to be among those that seemed to have fewer city-wise, therefore a weaker group business generally.

Obviously one of the things we looked at hard was whether or not that group performance in the second quarter ought to give us any particular pause about our future expectations. We take great comfort from the group business on the books for Q4 and 2008 particularly and view those as a better indication of the underlying strength of the group demand.

Felicia Kantor Hendrix - Lehman Brothers

Great, and just finally, you’ve obviously given us guidance for total fee revenues. I’m wondering if you can give us a feel for what incentive fees might look like in the third quarter and fourth quarter.

Arne M. Sorenson

You know, I don’t have that in front of me. I think probably the right thing to do would be to back out the -- I’ll say that differently. Probably base management fees and franchise fees, given our REVPAR expectations, would be growing in the 10% to 11% range. You have to do the math to figure out what that leaves for incentive fee. That will get you close.

Felicia Kantor Hendrix - Lehman Brothers

Okay, that’s great. Thanks so much.

Operator

Joe Greff with Bear Stearns has our next question.

Joseph R. Greff - Bear Stearns

Good morning. Kind of a qualitative question; how much more do you have to go do you think, or how much more margin improvement is there on the limited service side? Obviously with this HPPAR, the result there have been -- and it’s very strong, probably more strong than the full service side and I guess the limited service hotels are catching up. I guess what inning do you think you are in in terms of improving the house profit margins along the service side?

Arne M. Sorenson

It’s in our DNA here to say it’s never good enough, and so I don’t think there will be a time when we say we’re done on margins. I think one of the reasons the limited service margins perform so well relative to fairly modest REVPAR growth was they are a little bit behind where our full service hotels are in terms of the toolkits and the productivity and the profitability enhancements that we’ve been rolling out over the next year or two. But as your question would imply, it’s going to get harder to have dramatically out-sized margin performance and it will be a bit more driven by REVPAR and how much that REVPAR comes from rate. But w expect we’ll continue to see over the next few years positive margin performance, probably not as dramatic as what we’ve seen over the last couple.

Joseph R. Greff - Bear Stearns

And then one more question -- can you just remind us, one percentage change in REVPAR equals what change in fees?

Arne M. Sorenson

We think it’s about $20 million full year, all fee categories. Pretax, obviously.

Joseph R. Greff - Bear Stearns

Great. Thank you.

Operator

Our next question will come from Harry Curtis with J. P. Morgan.

Harry Curtis - J. P. Morgan

Two quick questions; a follow-up on Felicia’s question with respect to worldwide REVPAR, it’s been running around 100 basis points ahead of North America. Is it likely to continue on that trend?

Arne M. Sorenson

We generally have the same expectations for relatively stronger performance internationally than we’ve seen domestically. You’ve got in the third quarter the World Cup comp. We’ve got fairly good distribution in Germany, so that will temper the third quarter numbers to some extent. But beyond that, we’d expect to continue to see a relatively stronger performance internationally.

Harry Curtis - J. P. Morgan

So overall, if the blended rate is somewhere around 7% in the back-half of the year in North America then somewhere around 8 is a reasonable number?

Arne M. Sorenson

That should be about ballpark, yes.

Harry Curtis - J. P. Morgan

Okay, that’s pretty good. The other question is related to the prior period catch-ups in your incentive management fees. The sense I’m getting is that there’s some impression out there that these are non-recurring, but what’s interesting is that in three of the last six quarters, they’ve recurred. I’m wondering if you could describe them and give us a sense of your view as to whether or not they are recurring or should we be thinking of them as kind of one-time items and not giving you credit for it?

Arne M. Sorenson

It sounds a lot like the question we asked internally at the budget table yesterday. It is -- I think the better way to think about them is they are mostly non-recurring. It’s obviously -- we’ve got a big portfolio of hotels. The incentive fees are important to us. They are the part of our fee stream which is least standard in terms of their formulas. In the second quarter, the $15 million that we talked about in our prepared remarks really were two transactions driven by portfolios trading hands as opposed to the profitability change in those hotels during the quarter.

One of them we had anticipated and built into our guidance, which is why you heard us say only about $0.01 of our out-performance was based on incentive fee performance. Those $15 million, because we really can’t forecast portfolios trading hands with any reliability at all, the best thing to do is think about it as really being non-recurring.

Having said that, we’re hopeful that there will always be a few bits of upside in incentive fee performance, particularly as business strengthens going forward.

Harry Curtis - J. P. Morgan

And then last question, if you could give us a sense of what percentage of your portfolio is generating a management fee?

Arne M. Sorenson

In the quarter, I think 63% compared to 58% last year.

Harry Curtis - J. P. Morgan

Very good. Thank you.

Operator

Next we’ll hear from William Truelove with UBS.

William Truelove - UBS

Good quarter. I have a couple of questions. First, how much of your earnings now on a full-year basis, not just second quarter, are coming from international exposure at this point?

Arne M. Sorenson

25 to high 20s, probably something like that.

William Truelove - UBS

That’s mostly on the fee side, right? Not on the owned?

Arne M. Sorenson

Yes, it’s both but it’s -- overwhelmingly it’s fees, not owned and leased.

William Truelove - UBS

Second question is on the timeshare side -- could you just go over with us again the issues with -- is it just a timing factor or are there any kind of underlying trends in timeshare that you are seeing that have been different in the past few years? What is your outlook for the demand side on the timeshare front?

Arne M. Sorenson

It’s mostly quite reassuring. The biggest trends that we’ve seen in timeshare, remember our timeshare business includes three distinct kinds of products. One is the traditional one-week classic timeshare product for vacation alternative, and you’ve got fractional, usually Ritz-Carlton, usually three to four weeks and it begins to look like a second home alternative. And then we’ve got some projects that have whole residential, which are obviously residential markets overwhelmingly second-home focused, obviously.

Different dynamics across the three. The timeshare demand seems to be very solid. The percentage of buyers who finance with us has gone up meaningfully in the last couple of years. We suspect that’s driven in part by a relative reduction in home refinancings, which would be an alternative for many of those buyers to finance their purchase of timeshare units. We obviously watch that very carefully and make sure that that increase in propensity to finance is not an indication of a weaker borrower, and as you could hear from our prepared remarks default rates are down, credit scores are up and so we are pretty reassured that actually that’s a very good trend, because that’s a profitable piece of the business for us.

The fractional demand has been quite strong but when you look at both fractional and residential, we don’t have that many projects where we are in sales today. We’ve got a few in our pipeline and I think one of the other trends that we’ve seen generally across the business is it is taking longer to get construction projects going and to get into sales. It is probably the biggest reason that we are moving from a 5%-ish -- moving to about a 5%-ish contract sales growth compared to last year from where we were before, which was 5 to 10.

Those are the major trends.

William Truelove - UBS

I know you mentioned about the third quarter year-over-year comparison in I think it was timeshare. What exactly was that again? Could you remind us?

Arne M. Sorenson

We had a reserve in place on some sales and marketing expenses that became unnecessary in the third quarter of 2006 for the time share business.

William Truelove - UBS

The amount was?

Arne M. Sorenson

That was $15 million.

Carl T. Berquist

And it was disclosed at the time.

William Truelove - UBS

I’m sure it was. I just forgot it. Sorry. Thanks.

Operator

We’ll take our next question from Celeste Brown with Morgan Stanley.

Celeste Mellet Brown - Morgan Stanley

Good morning. Is it safe to say that this firming up of the full service transient business increases your confidence in the ability to see sort of the progression you’ve talked about, sort of the back-end loading of the year?

Arne M. Sorenson

It is comforting to us -- transient business on the books looks pretty good here over the next few weeks, but probably more important than that would be the group business. Remember, the transient business is a fairly good indicator when you look out over the next week or two but most of that transient business is coming in pretty shortly before the customer shows up in the hotel. So as you get even a month or two out, the transient bookings on the books are not very reliable. But you know, very encouraging at the moment.

Celeste Mellet Brown - Morgan Stanley

Why do you think they firmed up in the second quarter versus the first?

Arne M. Sorenson

I think economic activity generally among business travelers was strong. It’s not anymore complicated than that, so they were on the road. I think the leisure business also is relatively strong. I think people looked at the consumer a lot with some bits of anxiety but the consumer is performing pretty well at our business. That’s obviously less significant than the business traveler though.

Celeste Mellet Brown - Morgan Stanley

Are we done now with Katrina, with Katrina comps? Is this the last quarter we’re going to see pressure there?

Arne M. Sorenson

You’re asking whether we pledge never to refer to Katrina again?

Celeste Mellet Brown - Morgan Stanley

Yes.

Arne M. Sorenson

We think it’s mostly behind us. There could be a little bit of a tail in a couple of markets but by and large, we think we’re beyond that.

Celeste Mellet Brown - Morgan Stanley

Okay, and then finally in Hawaii, I know that the first quarter was tough as there was a lot of the Japanese business went away. Were you able to replace that with other business and that’s what drove your strong REVPAR growth in the quarter?

Arne M. Sorenson

Generally, yes. Westbound business.

Celeste Mellet Brown - Morgan Stanley

Thank you.

Operator

The next question will come from Jeffrey Donnelly with Wachovia Securities.

Jeffrey J. Donnelly - Wachovia Securities

Good morning. I guess to start off, I’d be interested in your take on the Hilton transaction, specifically do you think the change in ownership there could bring a more aggressive operating style? Is that a positive catalyst for rate growth maybe, or perhaps increased competition from management and franchise contract?

Arne M. Sorenson

Let me stand back a little bit and answer a little bit more broadly, if I can. We’ve had questions from a bunch of you over the last week, I guess, week and a day or two, about that transaction specifically and what it means for Marriott.

With our board, probably for at least a year, five or six quarters, I would guess, we’ve been watching the private equity phenomenon and talking with them about what we saw as a likely transaction like this one. Our focus in our discussions with the board has really been around the competitive impact, trying to see around the corner, if you will. In other words, what does it mean if one of our competitors is owned by a private equity for the kind of competition we have on a day-to-day basis for hotel and timeshare customers, what does it mean for the competition we have on a day-to-day basis for owners and franchisees?

We think there are probably positives and negatives in both of those areas, but when we think about what’s most fundamental, which is attractiveness of product and the service equation to our customer, we feel pretty good about the lead that we have today and about that lead continuing to expand in the face of transactions like this one.

We’ve also talked about what does it mean for Marriott as a seller or a buyer from transactions like this one. Obviously we are not going to speculate or comment about that until there is any reason to. But that’s generally our -- I guess our comment about this whole area.

Jeffrey J. Donnelly - Wachovia Securities

Thanks, and then, if I could, two quarters in a row you guys have fallen a little shy of your REVPAR forecast for North America. I’m not interested in necessarily what’s driving REVPAR, but what specifically is leading to that disconnect between your forecast and actual results and what are you guys doing to correct that?

Arne M. Sorenson

I think in Q2, and this is repetitive, I suspect, but the difference between our 5, 6 reported actually North American REVPAR number and the lower end of the 6 to 8 -- we’ll call it 5, 6 and 6 -- is by and large driven by relatively weaker performance in the limited service portfolio. That was offset to some extent by relatively greater strength in -- let me do the second point -- in relatively weaker group business in full service hotels.

That second was offset meaningfully by a bit stronger transient business than we thought we’d achieve. So when you look at the full service REVPAR numbers, we are about where we thought we’d be a quarter ago when we gave you guidance. But because that transient business is less likely to drive compression in some of those big markets, it was less capable of pushing business into some of the limited service hotels which are in nearby markets. And as a consequence, those benefited less than they would have had there been more group business on the books.

What are we doing about it? I wish we could be perfect with our forecast. We can’t. We won’t be. Our approach historically has been to be pretty fulsome in the disclosure we give you and to tell you exactly what we are thinking internally and that’s what we did a quarter ago. We came in a couple of points shy in North America. We were relatively stronger globally probably than we thought we would be and feel great about the way that generated fees, essentially exactly in line with the guidance that we gave you before.

We can’t tell you that we’re going to be right on every one of the assumptions that goes into the financial guidance that we are giving you every quarter, as much as we will continue to try to be.

Jeffrey J. Donnelly - Wachovia Securities

Last question, just anecdotally; I’ve been hearing from general managers that Marriott is I guess call it testing or right-sizing staffing at the Marriott Hotels. Can you talk a little bit about that program maybe and maybe where you are at in that process?

Arne M. Sorenson

We’re well along on that process and it is -- it’s really -- it’s not very complicated. Obviously we’ve got a lot of hotels out there that are in our system, both run by us and in many instances run by our partners, who are franchisees. So we have a lot of opportunities to experiment with staffing models and not just staffing models but other tools that we are using to run these hotels. There are lots of things that we found as opportunities. Mostly overwhelmingly we found those opportunities in our system where hotels we had and we were running were engaging in some best practices that we thought we could roll around. Many of those have very, very small impacts but collectively they’ve been pretty significant.

I think in terms of staffing, one thing I would say on a generic basis is we tended to find that when we got to medium to smaller full service hotels, so think about that as full service hotels in the 250 to 350 room range, probably more suburban or secondary markets as opposed to the key global gateway cities in the United States, that if anything maybe we had borrowed a little bit too much from the full executive team and management staffing model of the big box group hotels and we found that probably wasn’t necessary in every one of those hotels, and that we could, without having any impact on the customer frontage and the customer service equation, that we could probably find some productivity opportunities there. That’s well underway. Most of those changes actually were made in the last year or two.

Jeffrey J. Donnelly - Wachovia Securities

Thanks.

Operator

Our next question will come from Bill Crow with Raymond James.

Bill Crow - Raymond James

Good morning. A couple of questions here. Just looking at the Smith travel data, it looks like mid-scale without food and beverage was up 6%, 6.5% in the second quarter. Your limited service data is obviously showing lower growth. Is that just because of the way we slice and dice the numbers, or is that reflective of your portfolio performing slightly worse than the overall industry? Any feedback there?

Arne M. Sorenson

I think the biggest factor here is relatively newer franchised and ramping hotels, and I referred to this a little bit in the prepared remarks but it is not intuitively obvious, I guess. When you look at our courtyard managed REVPAR versus franchised REVPAR, franchised REVPAR was about a point-and-a-half higher than managed REVPAR. When you look at Residence Inn, I think the franchise portfolio was about 1.9 points higher.

The Smith travel numbers on mid-scale without food and beverage includes not just these brands but some of our competitors’ brands and where those portfolios are growing by adding new units, they get a significant benefit from hotels which are comp, technically, because they are in their second year or later of operation but they are still ramping up.

So you take, for example, our Courtyard franchise portfolio, I think during the second quarter 12% or 13% maybe of those hotels had opened within the last three years. Hotels that had opened within the last three years, they could be comp but they were probably posting REVPAR growth in the 12% range, something like that. Residence Inn, I think it was probably more like high-teens of the percentage of the franchise portfolio was open within the last three years and they too were posting REVPAR growth in the low double-digit range. What that does when you look at the impact on the franchise portfolios, it significantly moved the average performance of the portfolio as a whole.

When you look at the Courtyard managed and the Residence Inn managed portfolios, there is some growth. I think we’re maybe 2% or 3% or 4%, I suppose, growth versus in the same regard -- in other words, hotels opened in the last few years -- but dramatically lower percentage wise than the franchise portfolio. That’s delivered by us but it has the impact of depressing a little bit those aggregate numbers that we are reporting now.

Bill Crow - Raymond James

All right, fair enough. On the buy-back, you have reiterated the intent to buy back $1.5 billion worth of stock this year but you are two-thirds done for the year and the stock obviously has been an underperformer relative to peers and the broader market and I’m guessing where you anticipated it would be when you laid out the plan. Any sense that you might front-end load the three-year plan with buy-backs this year?

Arne M. Sorenson

Really nothing to say other than what we’ve said. I think the right assumptions for review going forward is $1.5 billion for this year.

Bill Crow - Raymond James

And then you’ve been outspoken in the past about where you think we are in the cycle and talked about extra innings and that sort of thing and a lot of people are starting to really doubt where we are and predicting the near-term end of the cycle. Can you just refresh us where you think we are, especially given your comments that you’re not seeing really any impact at the urban or the full service hotels in the U.S. from new supply?

Arne M. Sorenson

Let’s stand back for a second and establish how little we know, how little I know. The cycle is overwhelmingly going to be driven by demand characteristics as well as supply characteristics. Demand is driven by economic activity generally. Global travel, business travel, group business, and the single biggest factor in the length of this cycle is something that we have absolutely no expertise about and no more visibility than you do, and that is how is the economy going to perform, primarily in the United States but how it is going to perform in the rest of the world where we are performing well?

When we look at that data today, we don’t see any reason to presume that we don’t have a years worth of demand growth going forward. But to be fair, we don’t know a lot about that. That’s unique and we’re relying on what economists say and what we are seeing in the short-term and those sorts of things.

On the supply side, we see very little relevant full service supply growth. Given that that’s the case today and given how long it takes to build full service hotels, get them permitted, constructed, opened, stabilized, we think we’ve got a good number of years where the supply threat, if you will, on the full service supply is not terribly relevant.

So when you put those two things together, it would tell you that we think we’ve got some years left of positive run. Now, you won’t hear us saying -- we obviously are not in this call providing forecast for next year or giving you our new three-year plan or any of those sorts of things, but to state the obvious we are not going to see a years worth of 8% to 10% REVPAR growth.

One of the reasons we probably saw those great years in 2004, 5 and 6 was we were making up some of the ground we lost in 2001, 2 and 3 where we dropped dramatically from where we had performed previously. Those comparisons all get tougher generally and so we’ll see more modest REVPAR growth but it ought to still be a pretty good equation going forward.

Limited service is going to be probably a little bit different. We’ll probably see more supply growth over the next year or two, percentage wise, than we will in the full service segments. That may mean that their REVPAR numbers are tempered a bit but ultimately that’s going to depend a lot on what happens to that older limited service suburban product. When you look at the Smith travel data on midscale with food and beverage, which in many respects means old midscale hotels, the size of that segment has been shrinking. We may see that that continues to shrink and the shrinkage accelerates as we see more of this new built, purposeful product coming out.

Carl T. Berquist

If I could add to that, recall that our incentive fees also are far more dependent on full-service trends than they are on limited service trends, and far more dependent on international as well.

Bill Crow - Raymond James

One final quick question on the timeshare and timeshare note sales, given the dynamics of the positive credit statistics, et cetera, and the yield that you could achieve by holding on to those notes in what is a still strong but decelerating fundamental environment for lodging, do you get tempted at some point to sell fewer of the notes and retain that interest income going forward?

Arne M. Sorenson

No, not really. Generally we’d like to sell all the notes that we can sell. There is a great market out there to buy this stuff. The yields to the buyers, which is in effect what we are giving up, what we would be giving up by not selling is a very modest spread over comparable risk-free government securities. There’s no reason for us to stay in that business.

Bill Crow - Raymond James

Thanks, guys.

Operator

We’ll take our next question from Will Marks with JMP Securities.

William Marks - JMP Securities

Good morning. A couple of quick questions. One is on the limited service versus full service, you mentioned how it breaks out a little bit in incentive fees. What about just your full fee structure? Is it two-thirds, one-third?

The second question relates to you said you have board conversations about what happens when the competitors go private, how do these -- do you have board discussions about, given the weakness in your stock if you would be better off in a private structure? I know it is hard for you to comment on that but if you can give us any thoughts at all why you may be better public than private.

Arne M. Sorenson

On the first question, I would encourage you to look at the segment schedules in the press release, which will break down limited service, extended stay and full service, as well as international and luxury. That will give you some indication of how significant this is. By all means, give us a holler back if there is more you’d like from that.

On the question about M&A styled -- I don’t really have much to add, other than what we said before, which is these are all subjects that we’ve discussed with our board. Beyond that, I don’t think there’s really anything that can be gained by musing more about this publicly.

William Marks - JMP Securities

Thank you.

Operator

We’ll take our next question from Jeff Randall with A. G. Edwards.

Jeffrey Randall - A. G. Edwards

Good morning. You guys changed the language slightly related to the number of room additions for ’07 from approximately 30,000 to nearly 30,000. I just wondered what’s behind the change posture. Are projects still moving more slowly through the pipeline and maybe more slowly due to just -- not just higher construction costs but higher interest rates?

Arne M. Sorenson

No, it’s construction pace, period. We continue to see the intake into the pipeline strengthen. We continue to feel really good about these hotels opening but everything seems to be taking a little longer to get completed. I shouldn’t say everything but enough projects seem to be taking a little bit longer to get completed that -- yes, you are perceptive to pick up that slight word difference. While we think we are going to be in the same ballpark, today we’re a bit less confident that we’ll actually ring the bell on the 30,000 number opened in 2007. We should be very, very close.

Jeffrey Randall - A. G. Edwards

Do you think developer sentiment has changed at all as a result of the higher interest rates, or do you think they are just essentially immune to that at this point?

Arne M. Sorenson

They are certainly not immune to it but we’ve not seen any negative impact on developer sentiment.

Jeffrey Randall - A. G. Edwards

Great, thanks.

Operator

Next we’ll take a question from Michael Millman with Soleil Securities.

Michael Millman - Soleil Securities

Thank you. That’s actually Soleil Securities. Regarding the timeshare, I think over time the growth has been some -- revenue growth has been double-digits for the industry. You’re talking about 5%. Can you give us some idea of what you think is underlying demand when you try to give some weight to what’s -- or take -- reduce the weight given to what you have available, what the building schedule is?

Arne M. Sorenson

I think I understand your question. If I don’t hit it, please come back and push us on it. The 5% forecast we talked about for contract sales this year, and that’s sort of the best measure that’s not overly influenced by fairly complicated accounting, is contract sales. Those are the real transactions that are happening in the year. Being up 5%, we think the 5% would be a significant understatement of non-inventory influence demand, if you will.

You are right. The industry has seen revenue growth, contract sales growth in double-digits for 25 years or so, which is as long as we’ve been in the business since the early ’80’s. We continue to see great growth. We continue to see more and more interest in this internationally. We’re doing a bit in Asia. We have a time share resort in Phuket in Thailand. We’ve also got a points program that we’re selling out of Singapore to Asian customers with significant receptivity and feel really good about that. And we’re finding in the United States even in the most established markets, beachfront, Orlando, ski destinations, strong demand, demand that’s really capable of picking up and buying everything that we can find that works from a financial perspective.

If anything, the challenge we’ve got is making sure we can grab the resorts and get them developed at economic terms that make sense for us. It is not the demand side of the equation.

Michael Millman - Soleil Securities

That would be true not only in the traditional timeshare but the fractional and residence, which might be more skewed to housing demand?

Arne M. Sorenson

Fractional would be quite a bit like the timeshare product in the sense of the comments I just raised. Residential is going to be much more like the general residential markets.

Michael Millman - Soleil Securities

Are you seeing any shifts in demographics? Are your marketing costs going up? What are you seeing in tour yields?

Arne M. Sorenson

Mostly positive there. Marketing expenses have probably come down a bit, like for like product. More technology, more economies of scale, broader acceptability of the product in many respects. The product continues to benefit from higher and higher levels of credibility going forward.

Michael Millman - Soleil Securities

Just to switch on the group business, why were you surprised by second quarter group business? Presumably the group business is on the books and shouldn’t change.

Arne M. Sorenson

It was really a little less group business booked in the quarter for the quarter than we would have thought when the quarter began. A lot of group business is on the books when the quarter begins but depending on the hotel, you’ve got a lot of groups. Tend to be smaller groups but still relatively significant business for the hotels that book short-term.

Michael Millman - Soleil Securities

Thank you.

Arne M. Sorenson

We’re going to take one more if you’ve got one, Jimmy, but otherwise we’re wrap it up here.

Operator

Actually, at this time, Mr. Sorenson, there are no further questions.

Arne M. Sorenson

All right, perfect. Thank you all very much. We appreciate your time this morning.

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Source: Marriott F2Q07 (Qtr End 6/15/07) Earnings Call Transcript
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