Specializing in Corporate Events: Spinoffs, Part Two

Specializing in Corporate Events: Spinoffs, Part Two

Case Study:

Host Marriott / Marriott International

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During the 1980s, Marriott Corporation aggressively expanded its empire by building a large number of hotels. However, the cream of their business was not owning hotels, but charging management fees for managing hotels owned by others. Their strategy, which had been largely successful, was to build hotels, sell them, but keep the lucrative management contracts for those same hotels. When everything in the real-estate market hit the fan in the early 1990s, Marriott was stuck with a load of unsalable hotels in an overbuilt market and burdened with the billions in debt it had taken on to build the hotels.

Enter Stephen Bollenbach, financial whiz, with a great idea. Bollenbach, fresh from helping Donald Trump turn around his gambling empire, and then chief financial officer at Marriott (now CEO of Hilton), figured a way out for Marriott. The financial covenants in Marriott's publicly traded debt allowed (or rather, did not prohibit) the spinning off of Marriott's lucrative management-contracts business, which had a huge income stream but very few hard assets. Bollenbach's concept was to leave all of the unsalable hotel properties and the low-growth concession business—burdened with essentially all of the company's debt—in one company, Host Marriott, and spin off the highly desirable management-service business, more or less debt free, into a company to be called Marriott International.

According to the plan, Bollenbach would become the new chief executive of Host Marriott. Further, Marriott International (the "good" Marriott) would be required to extend to Host Marriott a $600-million line of credit to help with any liquidity needs and the Marriott family, owners of 25 percent of the combined Marriott Corporation, would continue to own 25-percent stakes in both Marriott International and Host. The spinoff transaction was scheduled to be consummated some time in the middle of 1993.

Keep in mind, no extensive research was required to learn all this. The Wall Street Journal (and many other major newspapers) laid out all this background information for me when Marriott first announced the split-up in October 1992. It didn't take more than reading this basic scenario in the newspapers, though, to get me very excited. After all, here was a case where in one fell swoop an apparently excellent hotel-management business was finally going to shed billions in debt and a pile of tough-to-sell real estate. Of course, as a result of the transaction creating this new powerhouse, Marriott International, there would be some "toxic waste." A company would be left, Host Marriott, that retained this unwanted real estate and billions in debt.

Obviously, I was excited about... the toxic waste. "Who the hell is gonna want to own this thing?" was the way my thinking went. No institution, no individual, nobody and their mother would possibly hold onto the newly created Host Marriott after the spinoff took place. The selling pressure would be tremendous. I'd be the only one around scooping up the bargain-priced stock.

Now, almost anyone you talk to about investing will say that he is a contrarian, meaning he goes against the crowd and conventional thinking. Clearly, by definition, everyone can't be a contrarian. That being said . .. I'm a contrarian. That doesn't mean I'll jump in front of a speeding Mack truck, just because nobody else in the crowd will. It means that if I've thought through an issue I try to follow my own opinion even when the crowd thinks differently.

The fact that everyone was going to be selling Host Marriott after the spinoff didn't, by itself, mean that the stock would be a great contrarian buy. The crowd, after all, could be right Host Marriott could be just what it looked like: a speeding Mack truck loaded down with unsalable real estate and crushing debt. On the other hand, there were a few things about this situation beyond its obvious contrarian appeal (it looked awful) that made me willing, even excited, to look a bit further.

In fact, Host Marriott had a number of characteristics that I look for when trying to choose a standout spinoff opportunity.

1) Institutions don't want it (and their reasons don't involve the investment merits).

There were several reasons why institutional portfolio managers or pension funds wouldn't want to own Host Marriott. We've already covered the issue of huge debt and unpopular real-estate assets. These arguments go to the investment merits and might be very valid reasons not to own Host. However, after the announcement of the transaction in October 1992 only a small portion of the facts about Host Marriott had been disclosed. How informed could an investment judgment at this early stage really be? From the initial newspaper accounts, though, Host looked so awful that most institutions would be discouraged from doing any further research on the new stock. Since a huge amount of information and disclosure was sure to become available before the spinoffs fruition (estimated to be in about nine months), I vowed to read it—first, to see if was going to be as bad as it looked and second, because I figured almost nobody else would.

Another reason why institutions weren't going to be too hot to own Host was its size. Once again, not exactly the investment merits. According to analysts quoted in the initial newspaper reports, Host would account for only about 10 or 15 percent of the total value being distributed to shareholders, with the rest of the value attributable to the "good" business, Marriott International. A leveraged (highly indebted) stock with a total market capitalization only a fraction of the original $2 billion Marriott Corporation was probably not going to be an appropriate size for most of Marriott's original holders.

Also, Host was clearly in a different business than most institutional investors had been seeking to invest in when they bought their Marriott shares. Host was going to own hotels; whereas the business that attracted most Marriott investors was hotel management. Though owning commercial real estate and hotels can be a good business, the Marriott group of shareholders, for the most part, had other interests and were likely to sell their Host shares. Sales of stock solely for this reason would not be based on the specific investment merits and therefore, might create a buying opportunity.

(Note: For reasons unique to the Marriott case, the spinoff was actually considered, at least technically, to be Marriott International—even though its stock would represent the vast majority of the value of the combined entities. For purposes of this illustration (and for the purposes of being accurate in every sense other than technical), it will be more helpful to think of Host—the entity comprising 10 to 15 percent of Marriott's original stock market valuation—as the spinoff.)

2) the Insiders want it.

Insider participation is one of the key areas to look for when picking and choosing between spinoffs—for me, the most important area. Are the managers of the new spinoff incentivized along the same lines as shareholders? Will they receive a large part of their potential compensation in stock, restricted stock, or options? Is there a plan for them to acquire more? When all the required public documents about the spinoff have been filed, I usually look at this area first.

In the case of Host Marriott, something from the initial press reports caught my eye. Stephen Bollenbach, the architect of the plan, was to become Host's chief executive. Of course, as the paper reported, he had just helped Donald Trump turn around his troubled hotel and gambling empire. In that respect, he seemed a fine candidate for the job. One thing bothered me, though: It didn't make sense that the man responsible for successfully saving a sinking ship—by figuring out a way to throw all that troubled real estate and burdensome debt overboard—should voluntarily jump the now secured ship into a sinking lifeboat, Host Marriott.

"Great idea, Bollenbach!" the story would have to go. "I think you've really saved us! Now, when you're done throwing that real estate and debt overboard, why don't you toss yourself over the side as well! Pip, pip. Use that wobbly lifeboat if you want. Cheerio!"

It could have happened that way. More likely, I thought, Host might not be a hopeless basket case and Bollenbach was going to be well incentivized to make the new company work. I vowed to check up on his compensation package when the SEC documents were filed. The more stock incentive, the better. Additionally, the Marriott family was still going to own 25 percent of Host after the spinoff. Although the chief reason for the deal was to free up Marriott International from its debt and real estate burden, after the spinoff was completed it would still be to the family's benefit to have the stock of Host Marriott thrive.

3) A previously hidden investment opportunity is created or revealed.

This could mean that a great business or a statistically cheap stock is uncovered as a result of the spinoff In the case of Host, though, I noticed a different kind of opportunity: tremendous leverage.

If the analysts quoted in the original press reports turned out to be correct, Host stock could trade at $3-5 per share but the new company would also have somewhere between $20-25 per share in debt. For purposes of our example, let's assume the equity in Host would have a market value of $5 per share and the debt per Host share would be $25. That would make the approximate value of all the assets in Host $30. Thus a 15 percent move up in the value of Host's assets could practically double the stock (.15 X $30 = $4.50). Great work if you can get it. What about a 15-percent move down in value? Don't ask.

I doubted, however, that Host Marriott would be structured to sink into oblivion—at least not immediately. I knew that all the new Host shareholders had good reason to dump their toxic waste on the market as soon as possible. With the prospect of liability and lawsuits from creditors, employees, and shareholders, though, I suspected that a quick demise of Host Marriott, the corporation, was not part of the plan. Add to this the facts that Marriott International, the "good" company, would be on the hook to lend Host up to $600 million, the Marriott family would still own 25 percent of Host, and Bollenbach would be heading up the new company—it seemed in everyone's best interest for Host Marriott to survive and hopefully thrive. At the very least, after I did some more work, it seemed likely that with such a leveraged payoff it had the makings of an exciting bet.

Believe it or not, far from being a one-time insight, tremendous leverage is an attribute found in many spinoff situations. Remember, one of the primary reasons a corporation may choose to spin off a particular business is its desire to receive value for a business it deems undesirable and troublesome to sell. What better way to extract value from a spinoff than to palm off some of the parent company's debt onto the spinoffs balance sheet? Every dollar of debt transferred to the new spinoff company adds a dollar of value to the parent

The result of this process is the creation of a large number of inordinately leveraged spinoffs. Though the market may value the equity in one of these spinoffs at $1 per every $5, $6, or even $10 of corporate debt in the newly created spinoff, $1 is also the amount of your maximum loss. Individual investors are not responsible for the debts of a corporation. Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances.

In case you haven't been paying attention, we've just managed to build a very viable investment thesis or rationale for investing in Host Marriott stock. To review, Host could turn out to be a good pick because:

• Most sane institutional investors were going to sell their Host Marriott stock before looking at it, which would, hopefully, create a bargain price.

• Key insiders, subject to more research, appeared to have a vested interest in Host's success, and

• Tremendous leverage would magnify our returns if Host turned out, for some reason, to be more attractive than its initial appearances indicated.

If events went our way, with any luck these attributes would help us do even better than the average spinoff.

So, how did things work out? As expected (and hoped), many institutions managed to sell their Host stock at a low price. Insiders, according to the SEC filings, certainly ended up with a big vested interest, as nearly 20 percent of the new company's stock was made available for management and employee incentives. Finally, Host's debt situation, a turn-off for most people—though a potential opportunity for us—turned out to be structured much more attractively than it appeared from just reading the initial newspaper accounts.

So, how'd it work out? Pretty well, I think. Host Marriott stock (a.k.a. the "toxic waste") nearly tripled within four months of the spinoff. Extraordinary results from looking at a situation that practically everyone else gave up on.

Are you ready to give up? Too much thinking? Too much work? Can't be bothered with all those potential profits? Or, maybe, just maybe, you'd like to learn a little bit more.

Digging for buried treasure

So far the only work we've really discussed has been reading about a potentially interesting situation in the newspaper. Now (you knew there was a catch), it gets a bit more involved. You're about to be sent off on a mind-numbing journey into the arcane world of investment research, complete with multi-hundred-page corporate documents and mountains of Securities and Exchange Commission (SEC) filings.

Before you panic, take a deep breath. There's no need to quit your day job. Sure there will be some work to do—a little sleuthing here, some reading over there—but nothing too taxing. Just think of it as digging for buried treasure. Nobody thinks about the actual digging—insert shovel, step on shovel, fling dirt over shoulder—when a little treasure is on the line. When you're "digging" with an exciting goal in sight, the nature of the task changes completely. The same thinking applies here.

Essentially, it all boils down to a simple two-step process. 

First, identify where you think the treasure (or in our case the profit opportunity) lies. 

Second, after you've identified the spot (preferably marked by a big red X), then, and only then, start digging. No sense (and no fun) digging up the whole neighborhood.

So at last you're ready to go. You're prospecting in a lucrative area: spinoffs. You have a plausible investment thesis, one that may help you do even better than the average spinoff, Now, it's time to roll up your sleeves and do a little investigative work. Right? Well, that is right—only not so fast.

In the Marriott example, the spinoff plan was originally announced in October 1992. Although the deal garnered plenty of press coverage over the ensuing months, the relevant SEC filings were not available until June and July 1993. The actual spinoff didn't take place unit! the end of September—nearly a year after initial disclosure. While six to nine months is a more usual time frame, in some cases the process can stretch to over a year.

If you have m impatient nature and are partial to fast action, waiting around for spinoffs to play out fully may not be for you. Horse racing never succeeded in Las Vegas because most gamblers couldn't wait the two minutes it took to lose their money. The same outcome, only more immediate, was available in too many other places.

The financial markets have also been known to accommodate those who prefer instant gratification. On the other hand, having the time to think and do research at your own pace and convenience without worrying about the latest in communication technologies has obvious advantages for the average nonprofessional investor. Besides, once you've spent a year prospecting in The Wall Street journal (or in countless other business publications) for interesting spinoff opportunities, there should, at any given time, be at least one or two previously announced and now imminent spinoffs ripe for further research and possible investment.

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You Can Be a Stock Market Genius,

Joel Greenblatt