Blackstone's (NYSE:BX) Hilton (NYSE:HLT) deal is widely heralded as one of the most profitable leveraged-buy-out (LBO) deals ever. However, a closer look at Hilton's numbers reveals deep holes, the size of half the profits or even more.
Blackstone bought Hilton in July 2007, investing roughly $6.2B overall and borrowing about $20.5B. By the end of December, Blackstone will complete Hilton's third public offering, holding on to 56% of Hilton's stock, worth roughly $14B, and cashing in about $4.4B revenues from stock sales. These two together provide an on-paper profit of $12.2B on the $6.2B investment.
The main explanation offered for this profit is Hilton's 2013 performance improvement from 2010-11 (other explanations can account for roughly $2B profits). However, Blackstone bought Hilton in 2007, at the peak of the market. If improved performance explains the profits, it should be improvements in 2013 compared to 2007, not 2010.
Before Blackstone, Hilton's market cap was $13.5B and its debt $6.5 for an enterprise value of $20B. Enterprise value, or EV, is the sum of the firm's debt and the value of its shares and is the accepted way to represent a firm's market value. Today, with roughly $12B of remaining debt, Hilton's $25B market cap puts Hilton's EV at $37B, more than 80% increase from the pre-Blackstone days.
What did Blackstone do with Hilton since 2007 to nearly double its value? Hilton's earnings (EBITDA) were essentially identical in 2006 and 2013 -- $1.67B, so that's not it (here's a screenshot of a CapitalIQ summary report - pdf download). Hilton didn't buy or sell any major assets. How about room count and rates? Those (owned and franchised) changed quite like Marriott's (NYSE:MAR) did. Marriott, Hilton's closest rival, was valued in 2013 roughly as in 2006.
Comparing Hilton to Marriott and Starwood (HOT) in earnings and industry specific measures (total rooms, ADR, RevPAR) supports one conclusion: From 2007 to 2013, Hilton didn't change much compared to its rivals. These two also slumped in 2010, and recovered roughly to the 2006-07 levels. Starwood's 2013 EBITDA was also as it was in 2006 ($1.14B). Marriott suffered a 10% decline, from $1.27B to $1.12B.
The thing is that both Marriott's and Starwood's EV in 2013 was within 5% of their 2006-07 values. If we use these as a benchmark, Hilton's value should be well below $30B, and Blackstone's position worth $5B to $13B less than currently valued. Yes, even a loss is possible. (Marriott is having an excellent year in 2014, and is currently worth about 25% more than in 2013. Still, it's nowhere as close to the 80% increase Hilton needs.)
So how can Hilton be worth so much ($37B) and so little ($26B) at the same time? What does this mean for Blackstone's profit?
I believe that roughly $8B of Hilton's unexplained EV, and Blackstone's profit, lies in the remaining LBO liabilities (most of the remainder can be explained by Hilton's 2010 debt restructuring). This was a leveraged buyout after all. Hilton's debt today is $12B, up from $6.5B in 2007 before the deal and just $3.5B in 2005, before Hilton U.S. took on debt to merge with Hilton U.K. (and worldwide). There's also a deal-related increase of over $2B in deferred taxes. In comparison, Marriott's long-term debt and liabilities are a quarter of Hilton's, and Starwood's are about a sixth.
Hilton's current plans are to pay this $8B from its earnings. Said differently: from shareholders' dividends. Current EBITDA suggests it will take Hilton roughly eight dividend-free years to reduce its debt to pre-Blackstone levels, global economic downturn notwithstanding. Marriott and Starwood have been paying handsome yearly dividends.
It is difficult to explain why the market is paying such an apparent premium for Hilton's stock, essentially taking on the LBO debt for free. Perhaps there's hope that Blackstone, which is still the majority owner, has a plan. Perhaps there's some Hilton magic that I can't see. I suggest that Hilton's new investors expect Blackstone to worry about Hilton's share price and debt even more, and that sooner rather than later Blackstone will want to cash out.
Blackstone should finish 2014 with about 56% of Hilton, more than double the position it committed to hold as part of Hilton's debt deals. Blackstone reportedly even borrowed $2B last June to pay back private investors on the Hilton deal, instead of selling Hilton stock.
However, holding on to Hilton's stock is very expensive for Blackstone, drastically reducing its profit from the deal. $18B revenue on a $6B investment in seven years may qualify as the best in LBO history. Waiting eight more years reduces annual returns from 17% to around 10%, even if Hilton's stock price rises about 4% a year. Nowhere near as impressive and quite risky with half the distance left to go and the worldwide economy as it is.
To see how costly this is for Blackstone, consider that Blackstone's investors expect over 15% of annual returns on average. If Blackstone reinvests its $14B of Hilton equity in whatever new venture that will give it 15% APR, it will have $42.8B in eight years. The same equity yielding 5% APR will be worth only $20.7B. That's over $20B revenue loss for not selling Hilton's stock.
What can Blackstone do and what does it mean for Hilton? Broadly speaking, there are four paths:
Blackstone can of course figure out how to actually increase Hilton's value. Selling underperforming assets seems a natural candidate given Hilton's high asset-to-earnings ratio, dating back to 2006. It can also use the high stock price to merge with a smaller player. This would be good news for Hilton, but seem inconsistent with Hilton's position in recent investor meetings.
Another alternative is for Blackstone to pay back $8B of Hilton's debt now. This will reduce uncertainty for investors and allow Blackstone to cash out and put its funds to better use. That $8B payment today will increase Blackstone's profits by over $20B in just eight years. Not bad for an investment this size. It will also be terrific news for Hilton's stockholders. However, it will make the Hilton deal seem less impressive. It also gives up on the chance that the market will be willing to just take on Hilton's LBO debt for free. If you believe Blacktone will do this, Hilton's stock seem a promising investment.
Blackstone can certainly continue holding on to Hilton's stock and forgo the future revenue. This is probably the least profitable avenue for Blackstone, and, under the current analysis, implies that Hilton's stock is overvalued by about 30% ($8B market cap). However, Blackstone's losses from this strategy are all of future revenue and so won't appear in any books, and it does serve well anyone in Blackstone that is interested in the current profits of the Hilton deal, so this is hard to rule out.
Finally, Blackstone can also cash out, letting the market fully price Hilton and its debts. If my analysis is correct, after the dust settles this will decrease Hilton's market cap by about $8B, with the losses split roughly even between Blackstone and Hilton's current stock holders. Blackstone will have to wait through June 2015 to do this, as it committed to hold at least 25% of Hilton until then. This strategy will cost Blackstone more than just the $4B of lower stock value and profits from the deal. It can make future similar IPOs a bit harder to the extent that reputation has a role. This scenario is, clearly, very bearish on Hilton even in the short term, and not at all unlikely.
The value of Hilton's stock rests largely in the hands of Blackstone. Whatever Blackstone may choose, the accolades for this deal seem premature for now.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.