Free Cash Flow Conversion & Marriott International Inc (MAR)

As part of our search for "royalty-like" businesses that are good at converting revenue to free cash flow that can be distributed to shareholders (like Lamar Advertising), we recently did a screen of the companies in the S&P 500 index.

Now while our royalty partnerships and trusts convert 90-100% of revenue to free cash flow, we are interested in finding other businesses that are royalty-like (accepting lower margins than true royalties) for two reasons. First, to diversify away from commodity price exposure and volatility. (Nobody said it is easy being an oil man.) Second, because mineral properties are depleting while some types of royalty-like or "tollboth" businesses can exist almost in perpetuity. As long as there is human activity and commerce, there is the possibility that Visa will be getting a cut of it, whether the energy for it is coming from fossil fuels or from the sun.

Speaking of Visa, in doing this screen we excluded the financials sector, so it does not include Visa (V), even though that company's cash from operations of $21 billion over the past twelve months (ending Sept 2023) was an astounding 64% of its total revenue of $33 billion. Visa has a market cap of $500 billion and returned $18 billion of capital to investors over the past twelve months (mostly via share repurchases). But if we could live off of a 3.6% shareholder yield, we wouldn't need this blog.

Which S&P 500 companies have royalty-like businesses at more attractive valuations? Historically, big tobacco companies were the epitome of this: very high gross margin businesses employing not much capital. Altria's free cash flow is north of 40% of its revenue. Unfortunately, they are being crushed by serious competition for the first time in a century and investors are only beginning to wake up.

Another example of high gross margins and low capital expenditures is the pharmaceutical industry. The Abbott Labs spinoff AbbVie (ABBV) has the third highest free cash flow margin (43%) in the S&P 500, and a healthy 9% free cash flow yield on the enterprise value to boot. But their primary product is Humira (adalimumab) injections (comprising almost 40% of their total business) which are approved to treat autoimmune diseases such as rheumatoid arthritis, Crohn's disease, plaque psoriasis, and ulcerative colitis. The patent on Humira expired in 2016 and now (finally) at least eight biosimilar drugs are going to hit the market. Some think that other AbbVie products will be able to compensate, but for us it goes in the "too hard" pile.

A "tech" company is at the very top of the entire S&P 500 index: Verisign (VRSN). It bought Network Solutions in 2000 and it operates two of the 13 global internet root servers and provides authoritative resolution for the .com and .net top-level domains. This is Verisign's primary business, and there were 174 million of those registrations at the end of 2022, which was a 5% increase over the prior year. Verisign has an agreement with the Internet Corporation for Assigned Names and Numbers (“ICANN”) that allows them to raise their wholesale price of .com domain name registrations by 7% per annum. The gross margin on this business is 86%.

Verisign's total revenue of $1.4 billion in 2022 translated to $831 million of cash from operations in 2022 (10-K). There was only $27 million of capital expenditure for the entire year, so the company bought back $1 billion of its own shares. There is no technology in this "tech business" - certainly nothing compared to deep sea oil exploration. Verisign has a cozy monopoly running a simple database. Their free cash flow for the year was $804 million, which was 57% of revenue. A great business, but the enterprise value of $21 billion means the free cash flow yield is only a 3.8% yield since everyone knows it's a great business.

We see two birds of a feather near the top of the screen: Hilton Worldwide Holdings (HLT) and Marriott International (MAR). That might be puzzling. How can the labor intensive hotel business be as high margin as charging people $10 to add their domain name and IP address to a database? The answer is that these companies pivoted their businesses. The hotel properties are owned by third parties such as hotel REITs. See how Marriott describes its business:

Terms of our management agreements vary, but we earn a management fee that is typically composed of a base management fee, which is a percentage of the revenues of the hotel, and an incentive management fee, which is based on the profits of the hotel. Our management agreements also typically include reimbursement of costs of operations (both direct and indirect). Such agreements are generally for initial periods of 20 to 30 years, with options for us to renew for up to 10 or more additional years.

This is an "asset-light" business model:

Marriott led the way in 1993 by spinning off its real estate into an investment trust (Host Marriott). Not only did this free Marriott from the burden of debt during the industry downturn of the late 1980s, but it spurred the company’s aggressive growth into the largest lodging business in the world, from 500 properties to around 7,000.

Other hotel groups followed, notably IHG, whose sale of the landmark InterContinental Hong Kong in 2015 completed the disposal of its major owned assets and thus the release of almost $8bn in gross proceeds from around 200 hotels since 2003 and the return of over $10bn to shareholders.

More recently, in early 2017 Hilton focused its model on its capital-efficient fee business by completing spin-offs of a portfolio of hotels and its timeshare business into two independent, publicly traded companies: Park Hotels & Resorts and Hilton Grand Vacations.

If you don't need a lot of capital to run a business, or if you do (hotels) but you get other people to make the capital investments yet still benefit from them, you can have very high free cash flow conversion.

In 2022, Marriott had $5.6 billion of net revenue (excluding $15 billion of cost reimbursement), earned $2.4 billion of net income, and generated about $2 billion of cash from operations net of stock-based compensation. So that's 36% conversion of net revenue to operating cash flow. Almost as high as selling cigarettes. Marriott had only $330 million of capital expenditures, so they paid $321 million of dividends and bought back $2.6 billion of stock. That gives a shareholder yield of 5.1% based on 2022 shareholder returns and the current market capitalization of $57 billion. 

Looking at this quarter's results:

• With the operating leverage inherent in our business, adjusted EBITDA rose 16% to $1.14 billion. After another quarter of meaningful share buybacks, diluted adjusted EPS grew 25% year-over-year to $2.11.
• Our powerful asset-light business model continues to generate a large amount of cash. And our capital allocation philosophy has not changed. We're committed to our investment-grade rating, investing in growth that is accretive to shareholder value, while returning excess capital to shareholders through a combination of a modest cash dividend and share repurchases. In the first nine months of this year, we returned $3.4 billion to shareholders. Over the last seven years, which included two years of no share repurchases as a result of COVID, we have reduced our outstanding share count by 23%.
• Over the next few years, our net rooms growth is anticipated to be squarely in the mid-single digit range. During the quarter our pipeline reached a new record high of nearly 557,000 rooms, a record even excluding the MGM rooms. Strong interest in conversions continues, including multi-unit opportunities.

For Q3 2023, Marriott's net fee revenues were $1.17 billion, up 13% year-over-year. Cash from operations was $881 million and free cash flow was $757 million (65% of revenue). During the quarter they repurchased $942 million of stock and paid $154 million in dividends.

Something to emphasize about the model: the number of rooms in the Marriott system keeps growing without Marriott shareholders needing to pay for them. In the third quarter, their room count was up 5% year-over-year. Their ecosystem has 1.5 million rooms (around a quarter of the worldwide total), but since third parties own and pay for 99% of them, cash is available for distribution to shareholders.

The business is royalty-like, because other investors are building the hotels and Marriott is getting percentages of revenue (and profits) to manage them. That is what allows Marriott to be in the top 2% of free cash flow margin in the S&P 500.