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Thursday, November 5, 1998

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Timeshares Clock Gains

The vacation ownership industry, a wonderful euphemism for "timeshare" resorts, got a much needed boost today as Sunterra Corp. (NYSE: OWN) gained $1 13/16 to $11 3/8, Vistana Inc. (Nasdaq: VSTN) shot up $1 1/16 to $13 3/16, Fairfield Communities (NYSE: FFD) rose $1 5/8 to $11 7/16 and Trendwest Resorts (Nasdaq: TWRI) moved up $1 1/8 to $11 3/8. Silverleaf Resorts (NYSE: SVR) was the only "loser" on the day, off slightly $7/16 to $13 9/16, but this came after a nice gain of 17% on Wednesday -- in conjunction with the release of its second quarter numbers. Both Sunterra and Vistana reported their third quarter financial results in the last 24 hours, and apparently investors are liking what they see.

The advent of exchange networks and numerous points-based timeshare programs, as well as the entry of many reputable "brands" (like Marriott, Four Seasons, and Hilton) into the business, has really invigorated the vacation-ownership industry -- in addition to helping eliminate some of the more sordid associations that consumers have with timeshare operators. Yeah, the hard sell is still there, but the price/value proposition is becoming increasingly compelling for many buyers (despite some of the nasty fixed rates).

Just how compelling is it to own a timeshare? In 1980, only 155,000 households owned a timeshare week, and there were only about 500 time-share resorts worldwide. At latest count, there are now over 4 million timeshare owners and more than 4,000 resorts in 80 countries -- that translates into a compound annual growth rate in sales for the industry of 16% for the last 27 years. In the last year alone, the business grew its sales by 25%.

In a very similar fashion to the auto industry (build the car, sell the car, and finance the car), vacation ownership companies finance a large amount of their sales (build the resort in saleable chunks, sell the resort, and finance the sale). When these companies sell the vacation intervals, they usually finance 80-90% of the sales in-house after receiving a 10% deposit from the customer. This financing generally bears interest at fixed rates and is collateralized by a first mortgage on the underlying vacation interest.

Timeshare companies derive income from their financing activities because their borrowings for initial resort construction usually bears interest at variable rates, and the firms' loans to vacation intervals purchasers bear interest at fixed rates. This shows up as "interest income" on an itemized revenue account on the income statement. The firms bear the risk of an increase in interest rates with respect to the loans they owe to lenders, so they often engage in interest rate hedging activities to reduce the risk and impact of potential increases. Despite the potentially favorable spread characteristics over the long term, timeshare firms often securitize their mortgage receivables (especially in a "show me the money" environment, and to allay investor fears about debt loads) -- which represents cash flow derived from a financing activity but shows up in part as a recognized "gain on sale of receivables" in yet another itemized revenue account on the income statement.

Of course, there is nothing wrong with this; it's simply a part of doing business. Investors that want insight into the exact nature of these movements should take a closer look at the cash flow statements. Sunterra was up today on news that it came in with Q3 EPS of $0.38, up from $0.27 last year and a penny above estimates. As well, operating margins improved to 27.5% from 22%, and the top line grew 33.7% year over year. Reserves for receivables matched the prior two quarters at 6.3%, and defaults increased to only 2.5%, from 2.4% in the second quarter. In the quarter the company successfully completed its second securitization (of roughly $100 million) in what can only be characterized as "volatile" market conditions -- which says a lot about the quality of their receivables. Looking at Sunterra's cash flows for the first six months of the year, a number of considerations come to the fore, though.


OPERATING ACTIVITIES:                                      6mos. '98   '97

Net income.............................................. $16,954 $8,103
Adjustments to reconcile net income to net cash:
Depreciation and amortization......................... 4,810 2,665
Provision for doubtful accounts....................... 6,160 3,735
Equity (gain) loss on investment in joint ventures.... (31) 120
Minority interest in income of consolidated limited
partnership........................................ -- 123
Changes in operating assets and liabilities:
Cash in escrow........................................ (16,371) (213)
Due from related parties.............................. 360 (1,464)
Prepaid expenses and other assets..................... (4,453) (9,319)
Real estate and development costs..................... (51,933) 4,423
Other receivables, net................................ (12,608) (7,217)
Accounts payable and accrued liabilities.............. (2,173) (15,988)
Income taxes.......................................... 8,886 (529)
Deferred income taxes................................. 4,011 333
Due to related parties................................ (862) (529)
-------- --------
Net cash used in operating activities................... (47,250) (15,757)



As is evident from the operating items, ongoing changes in operating accounts (like real estate and development costs) can dwarf net income, constituting a significant part of what it takes to do business in vacation ownership. In addition, traditional "capital expenditures" are aligned in investing activities. Sunterra is probably looking to continue to add to its resort portfolio through future acquisitions, which really makes this a part of its inventory-building business model (also to round out the firm's resort offerings).


INVESTING ACTIVITIES:
Cash paid for acquisition of subsidiaries............. (41,068) --
Property and equipment................................ (23,745) (6,342)
Intangible assets..................................... (17,094) (4,476)
Mortgages receivable.................................. (40,384) (49,025)
--------- ---------
Net cash used in investing activities................... (122,291) (59,843)



As previously discussed, the business relies on financing activities to generate cash, especially debt issuance and the occasional securitization.


FINANCING ACTIVITIES:
Proceeds from notes payable.......................... 2,299 22,347
Payments on notes payable............................ (38,032) (103,673)
Proceeds from publicly issued debentures............. 140,000 138,000
Proceeds from mortgage-backed securities, net of cash
reserve........................................... 99,940 --
Proceeds from equity offering........................ -- 52,990
Net proceeds from bank line of credit................ 15,000 0
Other................................................ (1,568) (2,627)
--------- ---------


Far from constituting a complete discussion of the business models of these companies, this brief look at Sunterra's Q2 Statement of Cash Flow should serve as a reminder to investors that in order to understand a business all the financial statements need to be looked at in a holistic fashion. Investors can't just isolate the income statement and expect to understand what's going on.

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