Howard Rosencrans, CFA, serves as the Chief Research Analyst for Value Advisory, LLC, a boutique firm that conducts detailed, fundamentals-based investment research. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors.
Thesis
We are introducing Interval Leisure Group
Company Description
Interval Leisure Group, through subsidiaries, operates time share exchange networks and provides hotel and resort management services, as well as other services, predominantly to the vacation industry. Time shares represent purchases of prepaid occupancy rights of resort units or vacation ownership interests (VOI). Interval International ("Interval"), the principal business, accounting for ~85% of revenues and ~97% of EBITDA, has been serving the vacation ownership market (time share industry) for 35 years. Interval operates a membership-based time share network comprising more than 2,500 resorts in over 75 nations. Through offices in 14 countries, Interval serves 1.8 million member families. For Interval, 16% of revenues are from members domiciled outside of the U.S. The smaller Aston Hotels & Resorts ("Aston") segment provides hotel and resort management and vacation rental services to vacationers and property owners primarily at ~50 Hawaiian resorts (with 4,500 rooms). In November 2010, Interval acquired Trading Places Int'l, a vertically integrated provider of exchange and leisure services to over 300,000 unaffiliated (non-membership) vacation owners, including onsite property management at more than 20 resorts located throughout the mainland United States, Hawaii, and Mexico.
Key Points
A few of the key points:
"Better than" No. 2 Position in Duopoly Industry. Interval has 1.8 million active members, whereas industry leader RCI, a division of Wyndham
Highly Scalable, Recession-Resistant Robust Business Model With Stellar EBITDA Margins and Significant Free Cash Flow. Reflecting Interval's "better than" No. 2 duopoly market position, strong management and the very significant scale efficiencies, Interval's EBITDA margins have continued to increase and, for the past nine months, ran 44%, up ~100 basis points year over year. For the two years, margins are up ~200 basis points, despite member declines. (RCI's margins are skewed by a large rental business in segment data.)
Time share buyers spent an average of about $25,000 in 2009 for a lifetime one-week resort ownership. As such, time shares represent a very compelling vacation value proposition ensuring sharply reduced vacation costs and virtually complete inflation-protection. Reflecting this, we believe that over time, time share sales will grow. Industry statistics suggest that of the core demographic containing 53 million households, the penetration rate is approximately 10%. Historically, time share sales have remained strong through recessions; however, during the Great Recession and lingering after, the credit freeze brought new sales to a standstill. However, time share owners continued to use their units. Occupancy rates remained near 80%, significantly above that of most lodging, and the membership exchange business remained sound.
With member and exchange fees of $89, representing just 0.3% of average unit cost, and exchange fees of an also nominal $159, owners are inclined to stay in network and maintain vacation flexibility. Also note that first-year membership is "free" (the developer pays) and, after, most members are somewhat reticent to drop off recognizing the exchange benefits. Member drop-off rates have continued to run around 12% per year; however, the differing point, until very recently, was that there were very few sales of new units that impeded the company's ability to offset the drop-off. While the industry saw member drop-offs during the recession and an inability to build the base due to the absence of new unit sales, member exchange propensity (velocity) remained largely unchanged.
IILG's results also evidence the recession-resistant nature of the business. Distorted only modestly by the '07 mid-year ~$70 million Aston acquisition, revenues, profitability, and free cash flows were largely sustained through the financial crisis. From '05-'09, revenues and adjusted EBITDA rose at compound annual growth rates (CAGR) of 12% and 10%, respectively, and '09 represented only a very modest downturn, which, as evidenced by the first nine months, was largely recaptured in '10. The FCF drop off from the '07 peak of $115 million to the '09 bottom of $72 million largely reflects public company costs and higher interest expense. While up modestly, reflecting a big IT upgrade, capital spending ran a very modest ~$16 million in '10. We also note that Interval revenue per member continued its upward trajectory and in '10 likely reached about $180 per member, vs. $157 in '07.
Limited History as a Public Company and Absence of Coverage. Spun-off from Internet conglomerate IAC in the summer of '08, the stock was quickly decimated in the immediately ensuing crisis, which was expected to make travel, vacations, and consumer spending nearly extinct. Clearly, the time share exchange business proved largely resilient (and, of course, the vacationing consumer has generally recovered). Even now, with a market cap approaching $1 billion (and a $700 million float cap when removing Liberty Media's
Aston Now Creates Upside. Aston was, simply, a horribly timed, top-of-the-market acquisition of a luxury market resort manager; however, it now seems poised for a meaningful cyclical bounce. The acquisition cost was a not-insignificant $100 million built on what turned out to be Aston's '07 peak EBITDA and revenues of about $12 million and $70 million, respectively. EBITDA now runs near the '09 trough of $5.0 million. We note that Q3 saw the beginning of a turn as the company registered EBITDA of $2.0 million, up ~100% year over year. Sharply improving Hawaii RevPar's and occupancy rates were the key drivers. Aston is also beginning to expand its management skill set beyond Hawaii and into the mainland. The company also represents condo owners.
Trading Places. Trading Places reaches two markets that Interval did not: direct to consumer, non-member exchange customers and vacation ownership interest (VOI) Resort Home Owners' Associations. As this was a non-material acquisition of a private company, virtually no detail was disclosed. IILG management indicates that Interval does as many exchanges in a day as Trading Places does in a year. For IILG, Trading Places provides the all-important owner access at sold-out VOI resorts that they did not reach through their developer point-of-sale affiliations and, as such, serves a somewhat defensive capacity (against those members opting for RCI). At this point in time, Trading Places will be a separate "network" not integrated with Interval. Over time, we believe management's objective is to have Trading Places upsell unaffiliated members to Interval. Trading Places also provides a "laboratory" for developing a non-membership, direct-to-consumer business model that will supplement the existing Interval International model.
Impressive and Long-Tenured Management Team. The company has a senior management team with more than 125 years of combined experience at IILG. Management has driven impressive growth in building this highly scalable business, driving growth and guiding it through the Great Recession with but a limited impact. CMN/CEO Craig Nash has been an executive with the company for 28 years and held one of the top operational positions since 1989, dating almost to the launch of Interval's industry-first membership upgrade program in 1987. COO Jeanette Marbert has been with the company for 26 years, while EVP of Interval Americas has a 23-year tenure. The long tenures are particularly impressive when one recognizes the myriad ownership changes; since the company's founding in '76, IILG has had four different subsequent owners, including, in the '90s, CUC and then an investment group, followed by the early decade purchase by IAC, prior to becoming a stand-alone company through the August '08 spin-off. The Aston acquisition, at least to date, stands as the only small mark on management's outstanding record.
Potential for Member Growth. We believe that IILG stands as a compelling value investment as a no-growth entity. However, we believe member growth is on the cusp of returning and believe this could drive the stock higher. We believe Q4 may represent the inflection point as Q3 saw a net member bleed of just 2,000, down from the 15,000-25,000/quarterly that it had been running throughout the downturn and through Q2 of 2010.
We note the following keys to driving member growth.
- The financing environment has very sharply improved. (Time shares are typically sold with 80%-90% financing, thus requiring deposits of just a few thousand dollars.) While demands have increased for higher credit scores, all of the major time share developers now have the ability and are aggressively securitizing portfolios. Smaller time share developers remain constrained in their ability to finance receivables, though this has improved modestly.
- In the U.S., fully 1.5 million time share interests, of 8.7 million, remain unsold. It's important to note that time shares do not go "stale," even in bankruptcy, as HOAs will often do the needed maintenance. Whereas typically time share exchanges must wait for property to be developed to produce new members, it is now already built. Investors seem to view this as "overhang," but, in fact, it is the converse to an exchange operator!
- Time share developers are employing new methods to sell product. After 40 years of the same, time share developers are changing sales tactics, albeit slowly. In the spring of '10, Marriott introduced a new points-based program; in the past, everyone in the vast majority of exchange membership networks simply swapped "equivalent" weeks. However, now Marriott has gone to existing time share owners and is allowing them to exchange a week for "points," thereby adding marked flexibility. The main benefit to Interval is that there will be 100% retention of points owners in good standing (current on dues) with Marriott, thus effectively adding members that may not have been in network. Additionally, there is no need for "internal exchanges" in the new points product.
We note that member growth ran for many years at 100k and that peak membership was 2.0 million.
Strong Finances Set to Markedly Improve. At Sept. 30, net debt stood at $178 million, reflecting gross long-term debt of $367 million and cash of $189 million, which is a very modest 1.2x trailing-12-month (TTM) EBITDA. Moreover, $300 million of the long-term debt carries a 9.5% rate. The balance is a senior tranche that the company has been paying down. With free cash flow generation of $80 million annually, the company could be debt-free in '13 when the high rate notes are callable. This would translate to annual pre-tax savings of $36 million (based on Q3's annualized run-rate) and after-tax cash flow of approximately $22 million (EPS of $0.38). (We note that the Trading Places acquisition reduced cash modestly; however, barring acquisitions, the company is still on track to be debt-free in '13.) Management indicated on the Q3 call that share repurchases and dividends were considered "feasible"; however, it's clear that the first priority is to invest in the business and/or seek out M&A targets likely of the tuck-in nature. Given the poorly timed Aston acquisition, this represents a concern, albeit a minor one, as barring a significant acquisition it is unlikely, in our eyes, to diminish the allure of the core business. Also note that membership exchange is a negative-working-capital business with members paying in advance for services. Not surprisingly, we would be a huge advocate of a buyback at or near current prices, which would be both meaningfully accretive to cash flow per share and, thereby, shareholder value. We note that Liberty, the legacy near-30% shareholder, has indicated that IILG is not a strategic fit. As the stock is not in the float, we'd argue for IILG to buy this block.
Conclusion
We are recommending IILG and establishing a blended one- to two-year target of $30. With Interval's "better than" No. 2 duopoly market position, the recession-resistant nature of the business, a robust, highly scalable business model with stellar margins and top-drawer, long-seasoned time share management, we believe IILG is an extremely attractive niche company. An emerging cyclical rebound at Aston and the benefit of Trading Places add to the allure. We believe a return to growth is on the horizon, which will serve to substantially energize interest in the stock.
Our growth scenario calls for potential '13 EBITDA of $200 million. This is not "pie in the sky." As we're not on the sell-side and constrained by the career risk of being overly optimistic, we're happy to share our back-of-the-envelope thoughts, which, often, the sell-side will migrate as data develops to support it. With bumps of 5% per annum in average fees (due to pricing, increased exchanges, or additional services), the member average will move to $200. (A headwind on this, new Marriott points members remain at a discounted corporate rate and "internal" -- within the Marriott network -- exchange fees are sharply lower to Interval.) Predicated on member count of 2.0 million and a 47% margin produces Interval EBITDA of $188 million. In the highly scalable member exchange business, we do not view a 300 basis point increase as a leap, particularly as the past two years, with member erosion, margins improved 200 basis points. Add to this prior peak Aston EBITDA of $12 million (and comforted by a Trading Places contribution), brings us to $200 million out-year potential. Valuing this at a then seemingly modest 10x (on a 6% FCF yield) -- remember it's a growth business so this may be conservative -- produces a $2.0 billion enterprise value (EV) and market value (this will be a debt-free entity at that time), or $34/share.
Our more conservative no-growth EBITDA scenario produces a $23 target, predicated on a 9x multiple and reflecting the $160 million FCF-driven EV reduction, producing $350 million of accretion potential, or $6. Blending the two targets and viewing the probability of a return to at least modest growth as fairly high, we arrive at our "formal" IILG target of $30, up 76% from current levels.
Risks
A rundown of the risks:
- Adverse trends in the vacation ownership industry would negatively impact Interval's business.
- Interval depends on relationships with developers, members, and other vacation property owners, and if those relationships sour it would adversely affect Interval's business. There is also no guarantee that Interval can renew affiliation agreements with resorts and developers.
- IILG's participating time share resorts are heavily concentrated in a few states (Florida, Hawaii, Las Vegas, Mexico, and Southern California). If travel shifts out of these states, demand for IILG's services would reduce.
- IILG's only real competitor, RCI, is larger and because of its affiliation with Wyndham Worldwide, has more significant financial resources and greater access to new time share purchasers.
- Another credit crisis or weakening in the securitization market could very adversely affect the time share industry, though we would again expect the impact on the exchange business to be much more muted.
- The 30% block of stock held by Liberty could represent over hang if they became an announced seller.
Variant View
With IILG trading near its all-time high, up almost 50% from the 52-week low (and up more than four times from the crisis low of around $4) and trading at upwards of 8x Street-projected flat '11 EBITDA, most investors view the name as somewhat fully priced.
However, we'd suggest that even without growth, the risk/reward is very compelling, reflecting the all-important free cash flow generation and modest multiple. Looking 24 months out and using flat EBITDA for '11 of $145 million and assuming flat again for '12, thereby producing two-year FCF of around $160 million, this is a net-debt-free entity. With (1) a "better than" a duopolistic market position (a very wide moat), (2) stellar EBITDA margins, (3) a now-demonstrated largely recession-resistant business, (4) a very low leverage, basically asset-free model with negative working capital, and (5) a very long tenured superior management team, we'd suggest a small increment valuation to 9x EBITDA (an 8% FCF yield actually supports higher) is likely, thereby allowing more than the cash accretion to equity investors.
Using a 9x multiple and reflecting the FCF-driven EV reduction, produces $350 million of accretion potential or $6, representing a 35% return; as investors increasingly recognize this company (and, again, it is only regularly covered by one sell-side analyst), we believe investors will look more to the out-year and the FCF generation.
Better yet, as we've outlined, we believe the following factors -- in order of importance -- have the potential to more than likely return this company to a growth entity:
- Growth in exchange member volumes driven by (a) new methods of time share selling (e.g., Marriott) and (b) the very marked improvement in the time share securitization market which will enable a sharp cyclical upturn in sales of the now record unsold VOI interests.
- A cyclical rebound for Aston's Hawaii properties.
- Aston's expansion of property management to new markets.
- Benefits from the newly acquired Trading Places.
With the likelihood of continued growth in annual member revenues, which, most notably, continued the upward trajectory through the Great Recession, we arrive at potential '13 EBITDA of $200 million. Ascribing what we would suggest is a conservative 10x multiple on a debt-free company produces a $34 target. Among the many very widely overlooked allures of IILG are the high cost of the company's debt, the opportunity for it to be called in just two years and prospects for the company to be debt-free.
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