Marriot Case

Project Chariot involves a conflict of interest between the shareholders and the bondholders since in this case the debt being held by Marriott Corporation (MC) is risky. Project Chariot aims to create MII with low debt and HMC with high debt. Thus bondholders will find that their investment gets tied to risky real estate assets whose appreciation is uncertain. Food management which is a major segment of MC remains with MII. Thus Project Chariot aims to give shareholders the business upside and bondholders the real-estate downside. Hence this appears to be a case of risk shifting. Shareholders stand to gain while bondholders will lose if Project Chariot is implemented. Ans. 2

This seems to be a case of ‘Cashing out’/’Wealth Transfer’ where the ‘overall’ wealth is being transferred from the bond holders to the equity holders. The following points lead us to the direction of it being a ‘wealth transfer’ type of conflict: * Chariot will result in a loss to bondholders and a gain to shareholders as the bonds will be downgraded by rating agencies and the returns of the bondholders will be attached to a heavily indebted duty * Total Debt will become more risky, and bonds will be downgraded to ‘below investment grade’ level * MC would be divided into two separate companies. MII would do MC’s lodging, food, and facilities management businesses, whereas HMC would retain MC’s real estate holdings and its concessions on toll roads and in airports, Hence bond holders will now have a claim on only the payoffs of HMC and not MII. So, because of the above reasons ‘Project Chariot’ seems like a case of ‘Wealth Transfer’ conflict of interest. Ans.

We believe in the broad view of manager responsibility. We think that managers should not only consider the interests of shareholders but also the interests of bondholders, employees, and other related parties. This responsibility is even more important in the case of a B2C company like Marriott. If they get bad publicity or are perceived to act unethically, it could affect customers’ desire to stay at their properties. Therefore, treating all parties fairly is not only a moral obligation but good business. We do not believe that Project Chariot is consistent with this broad definition of manager responsibility. It benefits shareholders but has an unclear impact on employees and a definite negative impact on bondholders. It benefits shareholders because MII will be able to achieve aggressive growth by separating itself from the financial distress of MC. This growth at MII will increase overall shareholder value.

The impact on employees is uncertain because it depends on the long-term solvency of HMC. If HMC is able to stay afloat then there will be more executive level positions at the two companies than at the one. This would be good for employees. However, if HMC is forced to sell off assets to meet their debt obligations, employees will be laid off and the overall effect of Project Chariot will be negative for them. It hurts bondholders because the bonds that were originally issued by MC will be downgraded to below investment grade quality when they are transferred to HMC. Many investors who face regulations regarding noninvestment securities will have to sell the bonds when they are downgraded. They will receive a lower price for them since they have a lower rating. In light of these facts, we do not believe that Project Chariot meets the broad requirements of manager responsibility. While it would benefit shareholders, it would decrease overall social welfare due to the potential consequences for employees and definite consequences for bondholders. Marriott should not undertake the project. Ans. 4

Our recommendation is for Mr. Marriott to reject Project Chariot. This decision is based on the following reasons:
Earnings Reasons:
1. Based on the 1992 estimates, the separate TCM corporation doesn’t even break even on net income basis. And even if asset sales cover debt service, half the reason for the breakup, is the idea that it would allow the TCM corporation to be a relatively stable, and a pure play real estate deal offering for the capital markets. The idea being that it will be able to appreciate quickly once the real estate bounces back. But TMC will be more highly leveraged as a separate entity, it will face much greater risk of financial distress. So, in the case were the economy does not recovery, and TMC continues it’s loses, it may be forced to sell assets before their prices had a chance to recover, negating the purposes of the separation

Another earnings problem, is that by splitting up MC, it means IIM will losing the tax shield for the profits of IIM, since it looks like TCM will continue with loses.

Ratings Reasons:
The current rating of MC is on the edge of becoming “junk” status. It is hovering between BBB to BB. While this may result in a selloff of bondholders, for practical purposes, it would only move the cost of debt by less than 30bps, since ratings are likely not to drop below BB due to the mix of stable revenue streams. At regardless, the maturity of most of the debt is almost 10 years away. There is a risk of the LYON notes redeeming early, but the amount seems to be manageable at about $230MM.

However, if the company is split, they may face a larger increase in total combined interest costs. If split off, IIM is likely to get a rating of AA to BBB, based on its ratios. This only moves its cost of debt lower by about 70bps. While, it is true, this may make it easier to get financing for projects, total difference in savings versus a combined MC is not that different.

The problem lies with TCM. Based on its ratios, it will likely get a speculative rate of CCC or worse. This will put its expected yield on debt at 10.81% or higher, which is already 200bps higher than what the combined MC gets. And it will face this rate increase on nearly all the remaining debt from the former MC. Although this may not be an issue in the short-term, since the maturities are far away, if TCM get into any short-term financial trouble, it will either be forced to sell assets at a faster pace, or borrow debt at a much, much higher interest rate to avoid full bankruptcy.

Legality:
Although lawsuits by debtors have not yielded much in recent years (only 10% of total investment lost), the recent Delaware Chancery decision for Credit Lyonnais makes it possible that the the corporate leaders need to take into account the other stakeholders, not just equity holders. Although the theory supporting that viewpoint is not orthodox, the fact that public opinion is currently supporting such a viewpoint can’t be ignored. In the case that TCM fails, IIM equity holders may still be at risk of a lawsuit and losses.

Alternative
The preferred choice is to maintain a combined company. It reduces financial risk the split off TCM would face if it was split off. This will allow it to sell its assets as a measured, hopefully for profitable, pace. Using this method, and based on assumptions in the case model, it allows for a gradual recovery of the strength of cash flow, as well as earnings per share.