Marriott Corporation: Business Overview

Harvard Business School 9-282-042 Rev. September 15, 1986 Marriott Corporation The idea of repurchasing shares was no stranger to Bill Marriott by January 1980. Almost five million shares of common stock had been repurchased on the open market by Marriott Corporation during 1979 at a total cost of $74 million and an average price of $15. 16 in the belief that they were undervalued—a belief that still was not fully reflected in the market price. At $19 5/8, the stock was selling at only six times cash flow per share; and its price/earnings ratio of nine was a far cry from historical multiples as high as fifty times as recently as 1973.Its low price seemed to offer once again an obvious opportunity to benefit shareholders. However, the proposal to repurchase 10 million of the 32 million still outstanding shares aroused some uneasiness. If successful, it had the potential of enhancing Marriott's EPS and of increasing family and management control from 20% to 29% of outstanding sh ares. However, it represented a move that was almost entirely financial—one that would run the debt well above the levels advocated before the Board of Directors only two years earlier.The repurchase would also necessitate renegotiation of restrictive covenants in existing loan agreements. Lastly, the huge size of the proposed program would require a tender price of $23 1/2, a hefty premium of $4 over the current market price. All of this seemed somewhat out of character for a corporation known for caution and stability. Background Marriott Corporation was founded as a nine-seat A Root Beer Stand in Washington, D. C. , in 1927 by J. Willard Marriott. Mr.Marriott had a gift for anticipating, or helping to create, trends in public eating habits. Shortly after the first stand opened, a second was built, and soon a chain of Hot Shoppes was underway. In 1934, industrial cafeterias were opened at a General Motors plant in Georgia and at the Ford Motor Company plant in Virginia. In 1937, the airline industry was revolutionized when Mr. Marriott established an airline catering service, providing box lunches from a Hot Shoppe next to the old Hoover Airport, on the site of what is now the Pentagon. Seven years later, Mr.Marriott led the company into the hotel field, opening the Marriott Twin Bridges just over the Potomac River from Washington. It became known as a motor-hotel and helped to revolutionize the lodging industry, for it offered a drive-in registration desk, a restaurant on the premises, and a convention center. By 1964, there were 77 restaurants, 4 hotels, and 9,600 employees generating total sales of $85 million. This case was prepared for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.Copyright  © 1981 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www. hbsp. harvard. edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1 282-042 Marriott CorporationBill Marriott assumed the presidency from his father in 1964 and initiated further diversification into theme parks, cruise ships and international host services. In 1967 the company acquired the Big Boy Restaurants franchise based in the Los Angeles area. A year later, Marriott opened its first Roy Rogers Roast Beef Sandwich outlet, which would grow into the Roy Rogers Family Restaurant chain. Since 1964, growth was little short of phenomenal. From sales of $85 million 16 years earlier, sales in 1979 exceeded $1. 5 billion.Operations expanded to 476 company-operated restaurants, 55 hotels and resorts, a cruise ship line, two theme parks , and 66,000 employees. (See Exhibit 1 for financial information on Marriott's various businesses. ) Hotels (35% of sales)—Marriott Hotels was one of the world's leading and most successful operators of hotels and resorts. By 1980, more than 23,000 rooms were offered through 55 hotels and resorts located primarily in the U. S. Approximately 70% of company-operated rooms were owned by outside investors and managed by Marriott under agreements averaging 70 years in length.These management agreements contributed approximately $40 million to operating profits in 1979—profits that tended to rise with inflation. Contract Food Service (32% of sales)—Marriott operated almost 300 contract food units, providing a wide range of food service capabilities to a variety of clients. It was the world's leading supplier of catering services to airlines, with 62 flight kitchens serving domestic and international air travelers. The Food Service Management Division also managed rest aurants, cafeterias, conference centers and other facilities for over 200 clients, including business, health care, and educational institutions.Restaurants (25% of sales)—Marriott's Restaurant Group consisted of 476 company-owned units offering a variety of popularly priced food in 46 states. Roy Rogers fast food restaurants and Big Boy coffee shops accounted for 92% of the total units. Theme Parks and Cruise Ships (8% of sales)—The two Great America theme parks, located in Gurnee, Illinois, between Chicago and, Milwaukee, and in Santa Clara, California, were opened in 1976. Both parks combined a wide variety of thrill and family rides, live musical productions and stage shows, arcades and games, merchandise and food.The attractions were set in five authentically recreated areas of America's past and have strong appeal for the entire family. The Sun Line fleet, consisting of three vessels, offered luxury sailing in both the Aegean/Mediterranean and Caribbean cruise ma rkets, and was widely recognized as the leader in quality in the Aegean market. Past Performance Marriott had always been a strong performer in profit terms. Over the entire 25 years ended 1979, there were only two down years and only three other years in which earnings per share grew at less than a 15% rate.Profits doubled on average every 3 to 4 years. A major return on investment improvement program, initiated in 1975, accelerated the earnings growth. The program consisted of three parts: (1) the sale or liquidation of $92 million of marginal assets, including land, 38 restaurants, a security services business, 2 European airplane flight kitchens, and a travel division, (2) a major effort to turn around the Sun Line operation and to develop volume in the recently opened Theme Parks, and (3) the shift of Marriott's hotel strategy from ownership to leasing and management contracts.The shift in the hotel strategy reflected management's belief that its comparative advantage was in ho tel development and management, and not in long-term hotel ownership. 2 Marriott Corporation 282-042 The results were dramatic. Net income as a percentage of sales rose from 3. 1% to 4. 7%. The company's return on average equity improved from 9. 5% in 1975 to 17. 0% in 1979. Earnings per share soared from 69? to $1. 95. (See Exhibit 2 for a summary of Marriott's historical performance. ) Profitability—An Elusive NotionWhile the trend in profitability seemed clear and encouraging, the actual level was a matter of debate and uncertainty for Marriott, as well as for American business in general. Double-digit inflation cast doubts on the usefulness of numbers based on historical costs, and the Financial Accounting Standards Board (FASB) recently issued guidelines which required firms to present, beginning in 1979, supplemental financial information that reflects the effects of general inflation. Marriott even though they reported these adjustments as required by Financial Account ing Standards No. 3 felt the numbers were misleading since they only adjusted for general inflation. Marriott also reported a second method of adjusting for inflation which they called Current Value and which they explained in the annual report: The Financial Accounting Standards Board has recently addressed the problem of financial reporting during inflationary periods. However, each industry and company is impacted differently by inflation and the choice of measurement must reflect the specific situation. Current Value is the best method for tracking Marriott's economic performance, and it differs from either historic costs or the present FASB definition.According to Current Value accounting, the value of shareholders' equity increased by $125 million in 1979 alone, and the increase would have been $199 million more if not for the $74 million share repurchase. (See Exhibit 3 for Current Value Figures). Current Value accounting differs from historic cost accounting in four areas. F irst, it values most fixed assets on a discounted cash flow basis, net of anticipated future capital requirements, thereby eliminating the valuation distortions caused by conventional depreciation accounting.In contrast with manufacturing facilities, Marriott's high-quality building structures, properly maintained, do not physically wear out at the depreciation rates assumed by industry accounting standards. In fact, Marriott's real estate assets actually increase in value during inflation, as demonstrated by actual property sales. For example, Marriott's Essex House Hotel is 50 years old, yet it remains one of America's finest real estate values due to its location in New York City and its excellent maintenance program.Second, Current Value reports an improved measure of annual economic profit— Discretionary Cash Flow—which disregards accounting depreciation and substitutes the actual required capital expenditures made for maintenance of property, plant and equipment. Third, Current Value accounting recognizes the annual gains in purchasing power from repaying debt in cheaper, inflated dollars. Accounting convention charges the inflation component of interest against current earnings, but does not reflect the benefits of debt.Fourth, Current Value reflects the gains from holding debt borrowed at comparatively low interest rates. According to Marriott's calculations the current value price per share of Marriott's stock was $27. 83 versus the historic book value of $12. 88. Prospects Stock price, of course, is based on more than book or replacement value; it is also based on future earnings potential. Marriott's prospects for growth and profitability seemed excellent. Marriott's major chain competitors were not expanding on an ownership basis and only selectively on 3 282-042 Marriott Corporation management basis; and independents were unable to obtain financing for new hotels without a chain affiliation and a management contract from a successful national operator. This presented management with a major opportunity to accelerate the planned annual hotel room growth to 20%-25% per year. There were already over 50,000 hotel rooms, representing nearly 100 properties, in the development â€Å"pipeline. † This was 2 1/2 times the current number of company-operated rooms. Management was optimistic about the future and expected profitability to improve from an aftertax return on assets of 6. 6% in 1979 to 8. 7% by 1983.Furthermore the company seemed ahead of schedule in achieving its goal of a 20% ROE by 1983. Main contributors would include a continued buildup of attendance at the two Theme Parks and a continued shift from hotel ownership to outside ownership and Marriott management contracts. All management contracts provided at a minimum a constant percentage of hotel profits, and most new contracts would provide Marriott with an increased share in profits after achieving certain targeted levels. Financial Policies Marri ott's success seemed certain to present management with a problem of too much cash and underutilized debt capacity. . . a situation almost totally the reverse of what Gary Wilson, chief financial officer, found when he joined Marriott as treasurer in 1974. At that time, he found a company with a high debt burden, heavy debt repayments due to short maturities, and access to only a limited number of funding sources. Wilson immediately went to work at broadening the potential lenders, opening up the commercial paper market, refinancing with longer maturities, and reducing the total debt load from 55% of total capital in 1975 to 41% at year-end 1979.His financial policy guidelines won approval by the board of directors in 1978 and included the following: 1. Maintain senior funded debt to total capital in the 40%-45% range; maintain this ratio including capitalized financing leases below 50%. 2. Maintain the P-1 Moody's commercial paper rating, as it lends credibility to Marriott's claim of prime credit worthiness and impacts the availability and rate of its commercial bank and privately placed bond debt. Among the 500 companies with P-1 rated commercial paper and rated bond debt, only one has a bond rating of less than â€Å"A. â€Å") 3. Position the company further in the domestic, unsecured, long-term, fixed-rate bond market as the principal source of future debt financing. 4. Issue no convertible debt or preferred stock. In addition, while Marriott had begun paying a cash dividend in 1977 and had increased it twice, the firm's policy was not to increase payout substantially as explained in its Annual Report: 5. The company has a good record of reinvesting cash flow at high returns.Marriott will continue this reinvestment strategy, so that shareholders should profit through share appreciation taxed at advantageous capital gains rates, rather than through higher dividends taxed at ordinary rates. Too Much Cash By 1979, Marriott's four-year-old program of impro ving its returns through hotel management fees and the divestiture of low return operations was working so well that it was producing an embarrassment of cash-flow riches. The company was rapidly moving in the direction of unused debt capacity, which Wilson deemed â€Å"imprudent† in an inflationary environment. 4 Marriott Corporation 82-042 By 1983, the debt to capital ratio would fall to roughly 20% if the projected excess cash flow, $125 million over the 4-year period, were merely used to pay down debt while the equity base continued to grow through the retention of earnings. Wilson explained his dislike for low debt ratios: I'm a great believer in prudent leverage. Many other companies aren’t. But in the next decade, inflation will make them come around to my viewpoint. Leverage is attractive for a very simple reason. Capital, which is the stuff by which investments are made, is comprised of two components—equity and debt.Equity in the case of Marriott costs about 17% after tax; that is, the investor expects to earn 17% on an investment in Marriott's stock. Debt costs only about 5% after tax. Given an investment that earns 10% after tax, it is evident that the more debt that I have in my capital structure, the lower will be the cost of my capital, and the more return I will have left over for the holders of my common stock. Since debt is so cheap relative to equity, it would seem attractive to use as much debt as possible in a capital structure. In fact, if cost were the sole criteria for selection, one would use 100% debt.This brings us to the second component of the determinants of capital structure and that is coverage. Debt unlike equity has a fixed interest charge that must be met or the equity holders' investment will be jeopardized. It is common to speak of the firm's ability to meet its interest payments in terms of coverage, or the number of times the pretax cash flow from the firm meets the interest charges. Coverage is proba bly the most important quantitative measure used in the rating of debt instruments by rating agencies; as coverage rises, so does the bond rating.Highly rated firms also tend to have low debt ratios which are more representative of the fact that these firms tend to be exceedingly large, in mature industries, with limited reinvestment opportunities, rather than demonstrative of prudent financial policy. It can be reasonably argued that growth companies should be positioned in the triple-B range or lower, as opposed to the higher ranges. The firm's annual report expanded on this theme by stating: Maintaining excess debt capacity is inconsistent with the goal of maximizing shareholder wealth for three reasons; (1) Unused debt capacity is comparable to unused plant capacity.Fully utilizing this capacity maximizes shareholder's returns. (2) High proportions of debt reduce a company's weighted cost of capital and increase the real returns to shareholders. (3) Debt-financed real estate pro vides distinct advantages in an inflationary environment. Repurchase of 10 million shares would, with one move, eliminate Wilson's concern. In fact, it would push the debt ratio back above the 1975 high and also above the policy guidelines passed less than two years before. Further, it would result in interest coverage of less than three times—well below the six times deemed necessary for an â€Å"A† rating. See Exhibit 4 for pro forma statements based on the proposed share repurchase. ). Bill Marriott's Concerns Bill Marriott had great respect for the judgment of his financial team. However, a $235 million debt issue used to repurchase 10 million shares would put Marriott's debt ratio well outside the range of other food and lodging firms, and would necessitate renegotiation of several restrictive covenants under existing loan agreements. (See Exhibits 5 and 6 respectively for financial information on competitors and for information on restrictive covenants. ) Repurch ase also seemed to 5 282-042 Marriott Corporation be a negative move. . . a cutting back of resources . . . . very different from the tone of aggressive expansion of operations. Maybe Finance was right about the potential leverage benefits; maybe the proposal to repurchase all shares held outside of the family and management was more than jest. But was it obvious that paying a premium of $4 per share to bring in 10 million shares was wise? What was the correct price for Marriott's stock and would a repurchase help increase it? The Street certainly seemed divided on the attractiveness of the stock at $19 5/8. (See Exhibit 7 for a summary of the forecasts and opinions of several leading analysts on Wall Street. 6 Marriott Corporation 282-042 Exhibit 1 Sales Summary of Operations by Principal Business Segment (dollars in millions) 1975 $238 256 268 – 14 $776 1976 $281 289 296 64 17 $947 1977 $335 342 317 72 24 $1,090 1978 $408 388 347 76 31 $1,250 1979 $535 480 377 84 34 $1,510 Hotel group Contract food Restaurants Theme parks Cruise ships and other Total Operating Profit Hotel Group Contract food Restaurants Theme parks Cruise ships and other Total Interest (net) Corporate expenses Income before taxes $33 19 22 – (3) 71 23 8 $40 $38 19 20 15 1 93 27 13 $53 $54 21 26 10 4 115 30 16 $69 $66 23 28 12 5 134 24 15 $95 87 32 29 17 6 171 28 20 $123 Net Assets 1978 Hotel Group Contract food Restaurants Theme parks Cruise ships and other Corporate Total $304 99 162 161 32 69 $827 Employed 1979 $372 124 175 158 32 31 $892 Capital 1978 $63 11 34 9 0 22 $139 Expenditures 1979 $81 20 45 6 1 5 $158 Depreciation 1978 1979 $15 8 12 9 2 1 $47 $16 8 15 9 1 2 $51 7 282-042 Marriott Corporation Exhibit 2 Summary of Historical Performance (dollars in millions, except per share amounts) 1975 1976 $ 947 32 3. 4% $ 326 378 48% 3. 0 10. 4% $ . 86 0 8. 95 13. 54 36. 5 14,765 52,900 1977 $1,090 39 3. 6% $ 366 370 45% 3. 3 11. 1% $ 1. 04 . 03 10. 02 11. 75 36. 15,383 56,100 1 978 $1,250 54 4. 3% $ 419 310 38% 5. 0 13. 9% $ 1. 43 . 13 11. 40 12. 13 36. 7 17,987 63,600 1979 $1,510 71 4. 7% $ 414 365 41% 5. 4 17. 0% $ 1. 95 . 17 12. 88 17. 38 32. 1 20,956 65,700 Sales Net Income % of sales Shareholders' equity Senior debt and capital lease obligations % of total capitala Times interest earnedb Return on average shareholders' equity after taxes Earnings per sharec Cash dividends per share Book Value per share Year-end market price Number of shares outstanding (millions) Company-operated hotel rooms Employees $ 776 24 3. 1% $ 264 406 55% 2. 7 9. 5% $ . 69 0 7. 68 15. 46 34. 4 12,987 47,600 Total capital is defined as total assets less current liabilities. b Times interest earned is calculated by dividing earnings before interest and taxes by interest expense net of interest on projects under construction. c Fully diluted earnings per share based upon the average number of shares outstanding for the year. 8 Marriott Corporation 282-042 Exhibit 3 Current Value Statement (dollar figures in thousands) Changes in Shareholders' Current Value Equity for 1979 Current value, December 28, 1978 Increase in current value of assets Discretionary cash flow Reduction in current value of debt Cash dividends Purchase of sharesCommon stock issued Current value, December 28, 1979 Change in current value during 1979 Change in current value during 1979 before cash dividends, share repurchase and issuance of new common stock $ 767,719 77,227 99,123 25,287 (5,776) (74,187) 3,810 $ 893,203 $ 125,484 201,637 Shareholders' Equity Historical Cost Non-monetary assets (primarily plant and equipment) Less: net monetary liabilities Senior debt and capital leases Convertible debt Other monetary liabilities Shareholders' equity, December 28, 1979 $ 927,287 365,279 26,918 121,587 $ 413,503 Current Value $1,356,244 320,736 20,718 121,587 $ 893,203 282-042 Marriott Corporation Exhibit 4 Pro Forma Financial Statements Based on Repurchase of 10 Million Shares of Common Stoc k, Funded with a $235 Million Debt Issue (dollar figures in millions, except earnings per share) Year Ended December 28, 1979 Actual Pro Forma Earnings before interest and taxes Interest: existing debt $235 million in new debt Profit before tax Income taxes Net income Average number of shares (millions) Earnings per sharea $ 151 28 – $123 52 $71 36 $1. 96 $151 28 31 $92 36 $56 26 $2. 14 Consolidated Balance Sheet, December 28, 1979 ASSETS Cash & Mkt.Securities Accounts receivable Inventories Other Total current Net fixed assets Other Total Actual $ 21 100 47 10 $ 178 825 77 $1,080 Pro Forma $ 21 100 47 10 $ 178 825 77 $1,080 LIABILITIES & EQUITY Short-term loans Current portion, longterm debt Accounts payable Accrued liabilities Income taxes payable Total current Senior debt Capital lease Subordinated debt Other liabilities Equity Total a Fully diluted based upon the average number of shares outstanding for the year. Actual $ 4 10 72 80 22 $ 188 341 24 27 86 414 $1,080 Pro Fo rma $ 4 10 72 80 22 $ 188 576 24 27 86 179 $1,080 10 Marriott Corporation 282-042 Exhibit 5Financial Information on Competitors Holiday Inns $17 1/4 1. 75 9. 9 3. 50 4. 9 . 66 17. 50 Marriott Stock Price January 1980 1979 epsa P/E Ratio 1979 Cash Flow per share a Price/Cash Flow Dividend per share Book Value per share Avg. Annual Growth (1974-1979) Sales Earnings Return on Equity, 1979a Total Long term debt % Book Capital Times Interest Earned Rating of Senior debt Beta a Estimated Hilton $29 1/2 3. 75 7. 9 4. 80 6. 1 1. 09 14. 91 McDonalds $ 44 4. 70 9. 4 6. 80 6. 4 . 51 23. 69 Disney $ 45 3. 50 12. 9 4. 80 9. 4 . 48 29. 75 $19 5/8 1. 95 10 3. 80 5. 2 . 17 12. 88 18. 7% 23. 4% 17% 45% 5. 4 NR 1. 25 6. 2% 41. % 26% 24% 15. 0 NR 1. 30 2. 45% 11. 4% 9% 33% 5. 6 BBB 1. 45 21. 6% 22. 9% 20% 50% 5. 2 A 1. 05 13. 1% 18. 7% 12% 0% – NR 1. 15 Note: Yields on 91-day Treasury bills, 5 yr. Treasury notes and 30 yr. Treasury Bonds were 12. 5%, 10. 4%, and 10. 1%, respectively, as of Janu ary 1980. 11 282-042 Marriott Corporation Exhibit 6 Selected Restrictive Covenants Under the $40 Million Loan Agreement Dated 1977 With Six Life Insurance Companies, 8-3/4% Rate, Due in 15 Equal Annual Installments Beginning December 15, 1983 1. Total book assets shall be at least 155% of the sum of consolidated funded debt plus consolidated capital leases.Funded debt shall mean all indebtedness having a final maturity of more than one year. 2. Consolidated net working capital shall be at least equal to $6 million. 3. Consolidated senior funded debt shall be less than the sum of 66 2/3% of consolidated net hotel assets plus 50% of all other consolidated assets. 4. Consolidated tangible net worth shall be maintained at all times in an amount of least equal to the sum of $240 million plus 25% of consolidated net income for the period from July 31, 1976. Tangible net worth shall mean shareholders' equity minus all intangible items. 5.Net income available for fixed charges for the past year shall have been at least 175% of pro forma annual fixed charges. Net income available for fixed charges shall mean EBIT plus the imputed interest in all capital leases. Source: Casewriter 12 Marriott Corporation 282-042 Exhibit 7 Summary of Forecasts and Opinions of Several Leading Analysts from Major Investment Firms Firm A Est. 1980 eps Est. 1983 eps Est. 1980 return on equity Est. 1983 return on equity Est. long-term eps growth Riskiness of stock $1. 95 3. 00 14% 14% 15% average Firm B $2. 20 3. 80 16% 17% 20% average Firm C $2. 0 3. 25 14% 15% 16% average Firm D $2. 10 3. 60 15% 16% 20% low Firm E $2. 15 3. 25 15% 15% 15% low Avg. $2. 08 3. 38 14. 8% 15. 4% 17. 2% – Recommendation Long-term Hold Long-term Buy Long-term Hold Hold Long-term Hold – Marriott and Market Information Marriott Return on Equity Earnings per share Dividends per share Price/Earnings (Average) Market value/Book value (Avg. ) Standard & Poor's Industrials Return to Equity Earnings per shar e Dividends per share Price/earnings Market value/Book value Interest Rates (Year-end) 91-Day Treasury Bill 5-Year Treasury Note 30-Year Treasury Bonds 7. % 7. 2% 8. 0% 5. 3% 7. 4% 8. 0% 4. 4% 6. 2% 7. 3% 6. 3% 7. 5% 8. 0% 9. 6% 9. 3% 8. 9% 12. 5% 10. 4% 10. 1% 14. 8% $9. 69 4. 72 10 1. 4 12. 3% $8. 55 3. 78 11 1. 4 14. 5% $10. 68 4. 25 11 1. 5 14. 6% $11. 57 4. 96 9 1. 3 15. 2% $13. 12 5. 35 8 1. 2 17. 1% $16. 08 6. 04 7 1. 2 1974 10. 6% $ . 70 0 18 2. 1 1975 9. 5% $ . 69 0 17 1. 6 1976 10. 4% $ . 86 0 17 1. 8 1977 11. 1% $1. 04 . 03 12 1. 2 1978 13. 9% $1. 43 . 13 10 1. 3 1979 17. 0% $1. 95 . 17 8 1. 2 13