Hilton's Breaking Up (Into Three New Companies)

In this episode of Industry Focus: Consumer Goods, Sean O'Reilly and Vincent Shen go over last week's biggest stories.

First, following up on episodes from the last few weeks: Deadpool is still blowing charts out of the water, and self-driving cars are no longer infallible.Then, a look at Lego's awesome annual report, and how they're growing fantastically while most of the toy industry is struggling. And finally, the story of the week: Hilton's (HLT 0.34%) split -- what the three new companies will be, and how well this move has worked for hotel companies that have tried it in the past.

A full transcript follows the video.

This podcast was recorded on March 1, 2016. 

Sean O'Reilly: It's Super Tuesday, and my write-in candidate? I'll give you a hint: he's sitting right next to me, on this consumer goods edition of Industry Focus.

Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is Tuesday, March 1st, 2016, and joining me to chat about hotel spinoffs and the politics of retaxation is the assiduous Vincent Shen. What's up?

Vincent Shen: How are you doing, Sean?

O'Reilly: Not too bad. You are my write-in candidate, by the way.

Shen: I appreciate the endorsement.

O'Reilly: I was going to go with Dylan on the Tech show, but I think you give a good speech, and it'll be good. Nothing personal, Dylan.

Shen: Thank you for the endorsement.

O'Reilly: The Shen-Lewis ticket. I like it.

Shen: (laughs) 

O'Reilly: So, hotel spinoffs and retaxation.

Shen: Yes.

O'Reilly: Big announcement out of Hilton. What an exciting topic, holy smokes!

Shen: (laughs) 

O'Reilly: First though, we wanted to revisit some topics from previous shows, because we've got some (laughs) pretty funny updates.

Shen: Alright, I promise this is the last time we're going to talk about this, because we've already touched on it two times--

O'Reilly: Listeners, we know you just groaned. We're sorry. Alright, go ahead.

Shen: But I just want to touch on this one more time, because it is really interesting. So, again... third weekend in a row now! Deadpool has topped the weekend box office. Beat out a bunch of releases...

O'Reilly: You didn't go see it again, did you?

Shen: No, of course not.

O'Reilly: Okay.

Shen: And...

O'Reilly: Wait, "Of course not?" What does that mean? (laughs)

Shen: Well, I saw Star Wars four times, but I'm not going to see Deadpool that many times in theaters.

O'Reilly: Alright.

Shen: So, the movie generated another $31.5 million in ticket sales. So, its domestic haul now is at $285 million, and its worldwide total is over $600 million; now it's $610. So, that officially makes Deadpool the third-highest-grossing R-rated film in the domestic box office. It only trails American Sniper and The Passion of the Christ.

O'Reilly: How much did those guys make? Do you know off the top of your head?

Shen: It's a small difference.

O'Reilly: Is it close?

Shen: I don't think it's that-that close. I don't recall. And..

O'Reilly: Okay, wow. Because, I remember The Passion of the Christ made, like, $1 billion or something.

Shen: Mm-hmm. And then, if the movie can maintain this pace, have another couple strong weeks ahead of it, it will potentially break into the top 10 list of highest-grossing comic book adaptations, according to Box Office Mojo. So, if it breaks in the top 10, other movies that have qualified for that list are huge. Think Avengers, Dark Knight, the original Spiderman trilogy, Guardians of the Galaxy. So, again...

O'Reilly: The original Spiderman trilogy before he went emo? (laughs) 

Shen: (laughs) So, for a lesser-known hero, it's very impressive.

O'Reilly: Yeah, that's a big deal. So, the next story -- this is really juicy.

Shen: (laughs) 

O'Reilly: Right after, a week or two after we do our autonomous car show, what does a Google (GOOGL 1.42%) (GOOG 1.43%) car go and do? Gets in a car accident with a bus. What the heck happened?!

Shen: I think, on our previous episode, we had mentioned the fact that Google has been testing some of its driverless cars...

O'Reilly: They've gone, like, 2 million miles, right?

Shen: It's logged many, many miles, and though it's been involved in some accidents, it was usually rear-ended at a red light, and it wasn't the driverless car that was at fault. So now there's been -- this accident itself actually happened on Valentine's Day, but the report from the DMV didn't come out until late February. This was in Mountain View, California. One of Google's autonomous cars was involved in an accident with a public transit bus, as you mentioned. The company has been testing with a fleet of over 20 of these cars, and the official number is over 1.5 million miles logged at this point.

O"Reilly: That's a lot of miles.

Shen: And though there's been a dozen collisions, at least, this is potentially the first one that they believe was actually the fault of the software in the car. I guess, obviously, that's what makes it a bit more notable.

O'Reilly: Didn't they say they were partially responsible? Weren't those the words? (laughs) 

Shen: So basically what happened is, the car was making a right turn, there were some sandbags blocking a storm drain. The car needed to get around it by changing into the next lane. It stopped, waited for some cars to pass. But the software, and also the person in that car, because the law currently states that someone needs to be in the car to take control in case there's an emergency, they both assumed or believed that the bus that was coming up would slow down or yield to them. So when they pulled out, it was only like 2 MPH, they kind of side-swiped the bus. No injuries, a small fender-bender kind of accident.

But the main thing is, Google acknowledged that there were definitely some assumptions made, the software was definitely partially responsible at the very least, because they did, ultimately, pull out into the lane and collide with the bus. But they're making adjustments; they're tweaking the software, basically, to potentially anticipate that larger vehicles, like buses, might not yield all the time. And overall, I just wanted to bring this up to touch on the fact that...

O'Reilly: Hilarious, yeah.

Shen: ... it was a fender bender, and it shows you how difficult it can be to always improve on this technology that's involved in a process that's as essentially dynamic and really unpredictable as the common roadway. So we'll see what kind of impacts this had; but overall, I think it's an interesting update after our two recent shows.

O'Reilly: And last little story here: Lego is building itself into the largest toy company. Did you read that article I wrote about investing on my son's behalf for the next 16 years? I joked at the end how I wished I could buy shares in Lego; so this is really funny.

Shen: Yes.

O'Reilly: And there's a reason. I would kill to own this company. Go ahead.

Shen: So, here's another one that ties into recent episodes where we covered Disney and Star Wars, for example, and other toy companies. So, Lego, privately held, but still a really amazing business -- incredible brand power. They report annual results, since they're privately held. And they enjoyed an amazing 2015, where revenue increased 25%, to 35.8 billion Danish krone, which is about $5.2 billion. Their net profit rose 31%, to about $1.3 billion. They enjoyed double-digit sales growth at pretty much all of their markets. And that, you have to keep in mind, is far outpacing most countries where they're seeing industry growth at maybe mid-single digits. And a lot of most evers for the company this year. They launched 350 new products in 2015, most ever for the company. They moved about 72 billion bricks, and 725 million mini-figures during the year.

O'Reilly: That's a lot of plastic.

Shen: And 100 million children interacted with the company through its toys and other initiatives. Interestingly enough, the bestsellers for the year for the company were actually a castle from Frozen, Elsa's Frozen Castle...

O'Reilly: (sighs)

Shen: ... and No. 2, which I thought would be No. 1, was the awesome Millennium Falcon from Star Wars.

O'Reilly: Wow.

Shen: And so, Lego, very quickly building up to potentially be the largest toy company in the world by revenue. That title is currently held by Mattel. So, as I mentioned, Lego logged $5.2 billion in revenue for 2015, Mattel had $5.7 billion. And the thing is, their trajectories are very different. Lego's been in a great growth path, Mattel's been on an opposite one. But the effects of that are a little different. They were grappling with the falling popularity of some of their bigger brands like American Girls and Barbie, and they've also been hit really hard by some of the currency fluctuations and strength of the U.S. dollar, obviously. But, they only had $540 million in operating income. Compare that to Lego, which had net profits of $1.3 billion. And Lego's been well known as being the most-profitable toy company in the world. 

O'Reilly: Right.

Shen: So Mattel has seen a turnaround in some of their other brands, but they're anticipating a pretty tough 2016, because they lost the Disney princess licensing deal. And overall, for Lego at least, looking ahead, the CFO, John Goodwin, he noted that, for this year, they're going to really focus on markets in Latin America and in Asia. It's really crazy, because China they think is the tip of the iceberg for them; but they saw 35% growth in that market last year.

O'Reilly: Wow.

Shen: And then, an issue that they had, with such incredible success on the back of Star Wars and...

O'Reilly: ... and The Lego Movie and all that stuff...

Shen: ... Frozen and The Lego Movie and all this was, they're having a hard time, honestly, keeping up with demand. They encountered some operational difficulties, especially during the holiday season. So the company, in another of their most evers, poured about $410 million into their manufacturing facilities in 2015, with expansions in China and their other facilities. It's the most they've ever spent in their company history. And they've also increased their workforce 20% during the year.

O'Reilly: Wow!

Shen: And then, long term, the company has had an incredible run. They've had a decade of 15% annual growth. So management is, I guess, trying to temper expectations a bit, saying, "This isn't going to be sustainable forever." But they're expecting a really strong 2016, again with double-digit growth. And they managed to quadruple sales in the past decade, which has otherwise been a period that's hurt a lot of the other toy companies, because you've got mobile devices, electronics, taking a lot of mind share and market share away from traditional toys. And I think Lego's going to be riding some of these trends pretty well, because they had the really successful 2014 Lego Movie, they have some games coming out, more on the electronics video-games side to build up on.

O'Reilly: Now, I've got multiple fairly large tubs in my parents' basement from when I was a kid, full of Legos. It was kind of a big deal then, and what it's become, and the pandemonium that you see... I took my two year-old to the Lego store at Tysons Corner mall, and I was worried about his safety, because he's smaller than all the other kids, and we were trying to navigate through there, and it was just like...

Shen: Well, it's funny you mention that. I was home last weekend at my childhood home...

O'Reilly: Did you build your old Legos, Vince?

Shen: ... and I had to do a lot of cleaning up around the house and garage, and I found so many of our old Legos. It is...

O'Reilly: You wanted to sit down, say it.

Shen: ... definitely a brand, and a toy, that, despite its simplicity and how popular it's been, it's not seeing any decrease. 

O'Reilly: Right.

Shen: Kids still love it, even with all the electronics and other competition that seems to be taking away from the traditional toy segment.

O'Reilly: Cool. Well, before we move on to talking about Hilton's big news, I wanted to point our listeners to focus.fool.com. There you'll discover a special offer to join The Motley Fool's Stock Advisor newsletter to start your year off Foolishly. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription. Just go to focus.fool.com to take advantage of this offer. Once again, that's focus.fool.com. 

So, moving on to our big story of the day, I think the actual news broke on February 26th?

Shen: Yeah, they announced it with their earnings.

O'Reilly: Hilton is officially making the split, following in the footsteps of Marriott (MAR 0.60%), although Marriott took considerably longer to do it. So they're splitting into what three businesses, Vince?

Shen: So, just to give you a little bit of background...

O'Reilly: Oh.

Shen: No, that's fine. For, I think it was October of last year, the CEO, his name's Chris Nassetta, he had announced that Hilton was pursuing some strategic alternatives, looking into what options they potentially had...

O'Reilly: My favorite two words in corporate America.

Shen: (laughs) And specifically, they had requested a ruling from the IRS for its REIT spinoff not long after October, and they actually did it. The timing worked out very well for them, where they were able to get that ruling just before legislation went into effect where, basically, Congress banned the further use of these tax-free REIT spinoffs. And it's really the tax-free ones that are so attractive, and have been so attractive to companies. Some big, high-profile ones that have happened recently -- at the behest, often by the way, of activists investors. MGM did their REIT spinoff, Darden Restaurants did, some other companies have been pressured by shareholders to do so -- I think McDonald's and Macy's -- but they chose not to. Now that avenue is closed.

O'Reilly: It's always amazing to me -- we won't get too much into the politics here, obviously, but one, I didn't know that was the case. I didn't know that Congress closed that loophole as part of the budget deal. I was like, what? Do you think they're mad because multiple casino companies, I think, have done this? And I was very, very surprised.

Shen: I think, overall, people like REITs for two core reasons. One, they're taxed very little or not at all at the corporate entity level.

O'Reilly: Right, as long as they pay out 90% of distributable...

Shen: ... their taxable income. Yeah. And generally, REITs have better multiples than their traditional parent companies. So you combine that, and Congress commented specifically that by no longer allowing these tax-free REIT spinoffs, they're going to be able to recoup several billion dollars in tax revenue in the next several years, and I think that's a big driver of this.

O'Reilly: Oh yeah, and that was my other comment. It always amazes me how many corporate actions that involve billions of dollars and hundreds of thousands of workers are done because of the tax code. Because in the eighties, in the buyout boom, one of the rationales was, "Oh, load these companies up with debt because the debt expense is tax deductible! Yay!" And it's funny to me. Anyway, what are Hilton's exact plans? Because they haven't been super specific yet.

Shen: So getting back to your original point of what the three entities are. So, you have Hilton Worldwide now. Then there'll be two spinoffs. The first is the REIT, and the REIT's going to get about 70 owned and leased properties from Hilton Worldwide's portfolio, about half of its portfolio, actually. Those 70 properties include mostly upscale U.S. hotels. It represents a total of about 35,000 rooms. And then, in addition to that, they're also splitting off their timeshare business. The timeshare company takes about 50 properties in the U.S. and Europe, and it's also going to run with the current management team of that business.

O'Reilly: That division's huge, by the way. It's way bigger than I thought it was. What, 12% of their top line or something?

Shen: Twelve percent of total revenue, exactly. So that business is going to enjoy an exclusive agreement with Hilton, so they can mark and operate results under the Hilton Grand Vacations brand. And then, Hilton itself is going to largely run as an operating company for its namesake hotels, and also some of the other brands in its portfolio, like DoubleTree, Waldorf Astoria, Conrad. And so, that one company, three new entities. They're hoping to complete the deal by year end. 

There's not as many details as I would like to share with our listeners right now. They basically, during the earnings call, everybody was asking questions about this, and they're answering as much as they can; but ultimately, they're saying, "Listen, we have filings coming in the second quarter where it's going to be much heavier in terms of the numbers, and allow you to do your analysis." 

But just to present this in a different way, in a proxy or precedent that we have, as you mentioned, is through Marriott actually. So Marriott International is actually going to unseat Hilton soon as the No. 1 hotel operator in the world, once they finish their acquisition of Starwood Hotels & Resorts.

O'Reilly: Not only that, I don't know if you came up with this in your research at all, but actually, Marriott's really expanding in Africa.

Shen: Oh, I didn't know that.

O'Reilly: They're really stepping it up. They had a deal last year to buy a bunch of properties from an African-based hotel chain; they're in South Africa. Anyways, sorry to interrupt.

Shen: No, that's fine. They're about to reign supreme. They announced the $12 billion acquisition of Starwood, not too long ago. I think it was in December.

O'Reilly: Yeah.

Shen: Interestingly, Marriott is kind of a test case for what Hilton is planning. Their timeline is very different, but ultimately, how they operate now is very similar to the structure that Hilton will have. So Marriott spun off its real estate business in 1993, so, way back when. And then, that company eventually converted to a REIT in 1999; it's called Host Hotels & Resorts. Interestingly enough, actually, Chris Nassetta, who's the CEO of Hilton now, was the CEO of Host Hotels & Resorts.

O'Reilly: Ooh, they snagged him.

Shen: He was poached by Blackstone in 2007, after the private equity company had bought out Hilton.

O'Reilly: Did they give him a sack of money, like $50 million or something? (laughs) 

Shen: Probably something very attractive. But I guess, it's just not all that surprising in this instance.

O'Reilly: Oh, yeah.

Shen: You have a guy here who's very familiar with this type of entity.

O'Reilly: Yeah. It's a small club running global hotel brands. But anyway.

Shen: So, going even further beyond that, Marriott also spun off its timeshare business into Marriott Vacations Worldwide in 2011. And if there's any indication of the potential there, Marriott Vacations Worldwide's stock has tripled since its creation, over the past four-to-five years, and the Hilton timeshare business, like you mentioned, it's only 12% of revenue, but it's been logging strong, strong growth.

O'Reilly: It's a way bigger chunk of their profits, as I recall.

Shen: Exactly. Much more substantial piece of the profits, and much better growth than the broader hotel business. And so, we expect way more details once the filings are in. But it's definitely an interesting move. One of the last, probably, major tax-free REIT spinoffs that we're going to see, in the Hilton.

O'Reilly: Right. Do you want to invest in a timeshare with me before we go? No?

Shen: (laughs) 

O'Reilly: Alright. Well, thanks, Vince, for your thoughts.

Shen: Thank you.

O'Reilly: If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that is [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening and Fool on!