The Marriott Acquisition of Starwood Hotels

It was not fun writing with the gloves of an autopsist when giving my opinion that shareholders of Plum Creek will be in for a disappointing future if they hold onto their stock after it is tucked into the tree-farming operations of Weyerhaeuser. With Thanksgiving fast approaching, I’ll share a more cheery forecast: I think the shareholders of Starwood Hotels will do quite well over the coming decades as part of their stock will soon be converted into a mega-hotelier with Marriott.

The specific terms of the deal: Each share of Starwood Hotels will turn into 0.92 shares of Marriott Class A stock and there will be $2 in cash received for each share. The combined company will have 1,000,000 rooms across almost six thousand hotels. This strikes me as a win-win deal for both. Marriott gets some high-quality franchises at a fair price–no small feat six years into an economic expansion–and Starwood gets to join forces with an unquestionably better operator.

If message board activity is an indicator of overall Starwood Hotel shareholder sentiment, many of them are not pleased with the terms of the deal–they wanted more. My guess is that it is the result of an anchoring bias. The stock traded at $86 per share last year, and traded as high as $88 this year. Rumblings of a heist tend to emerge anytime a company is acquired for a price less than its all-time high. If Starwood’s previous high was $60 per share, I doubt that the Starwood shareholders would be acting like John Rutledge at the Philadelphia Convention–sensing foul play and shouting angrily about it.

The reason why I regard Starwood’s objections as irrational is due to the poor performance of the Sheraton brand. Starwood has invested $100 million into advertising costs to perk up interest in Sheraton, and it is still only growing at 4% (compared to its twenty-year average of 7% sales growth.) Starwood has only delivered 5% annual returns since the end of 2005, and those poor returns have been justified–expected cash flow of $4.45 per share this year is less than the cash flow Starwood generated in 1999 of $4.60 per share.

Marriott, meanwhile, continues to perform like the best cash machine in the industry. Over that same 1999 through 2015 period, it has grown cash flow from $1.15 to $3.80. J.W. Marriott Jr. is good at intelligent expansion, and has mastered the art of bolt-on acquisitions that generate high occupancy while having relatively low maintenance costs. In the past 22 years, Marriott has been the clear winner in the hotel industry, delivering the best overall returns of 14% annualized. A $62,000 investment in Marriott on October 12, 1993 would have grown into $1 million today.

If Marriott is doing just fine, what does it gain by acquiring Starwood? Really, it’s a bet on the Sheraton. The brand, even while slumping is still profitable. Overall, Starwood is pumping out $465 million in annual profits, with over a third of it coming from Sheraton. Marriott, meanwhile, makes $835 million. If Marriott is able to improve the brand equity of the Sheraton, and the rest of Marriott’s portfolio continues to grow consistently with its fifteen-year record, then the combined entity could be making $2 billion within three years (if there is a deep recession in the interim, this figures will absolutely need to be downwardly revised substantially).

This deal strikes me as a win-win. Starwood has only been able to grow by one point better than inflation during the course of the most recent business cycle (2006-2015), and it is generating less cash flow than it did in 1999. It doesn’t deserve a premium, as earnings fall sharply during recessions and the signature Sheraton brand is delivering slow growth. It doesn’t deserve an outrageous acquisition premium.

Meanwhile, it will be interesting to see if Marriott can work the same value-creating magic that it did with Courtyard, Renaissance, Residence Inn, and the Ritz-Carlton. Successful redevelopment of the Sheraton brand will be essential for the long-term success of the deal. And given that it got a fair price on the acquisition, it can turn out satisfactory returns in hindsight even if a mild recession happens in the near future or the Sheraton brand only delivers moderate improvement.

An important caveat: although I conclude that Starwood shareholders will be well served over the long run by transitioning into the Marriott stock and holding thereafter, this does not mean that I am recommending investors should go out and buy Marriott stock right now. Marriott is valued at $18.2 billion and Starwood at $12.2 billion, suggesting a market cap of $30.4 billion upon completion of this deal.

Even if Marriott successfully integrates Starwood, it will only be making $2 billion in three years or so. Given that I would expect a P/E ratio around 20, I only expect growth from $30.4 billion to $40 billion. I would expect Marriott’s buybacks to slow down as it has overleveraged the balance sheet while interest rates have been low to reduce the share count from 366 million to 266 million, which has benefited shareholders by giving them 27.3% more ownership in the enterprise since 2010. But this wasn’t funded from free cash flow–it was financial engineering.

A best case scenario is 33% capital appreciation in the next thirty months plus a dividend of one percent thrown in there. That’s not a bad trade, but given the reasonable likelihood of a recession that would lower these expectations, I wouldn’t consider this a margin of safety investment at this time.

The short version? By handing over the operational reigns to Marriott, Starwood shareholders will be in a better position than they have been in for the past sixteen years. Marriott shareholders, too, will see their prospects improved if the Sheraton brand picks up the pace of growth. Given Marriott’s long-term success in building brands, shareholders should be cautiously optimistic about this deal. However, the time for new shareholders to enter the hotel industry is deep in a recession, as these stocks tend to get irrationally undervalued in poor economic conditions, and I would recommend sitting on the sidelines until then if you are not an existing hotel investor.

Originally posted 2015-11-25 22:39:08.

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