Vail Resorts (MTN 3.85%) runs a highly seasonal operation that books profits in its fiscal second and third quarters (which cover the months of November through April) and shows losses in the first and fourth. Looking at yearly net income, which is used to calculate valuation metrics such as P/E, undersells the fundamental earning power of the business, and management is making efforts to turn the weak quarters around.
Three types of businesses
Let's imagine three types of businesses that all have the same net income. One operates like a metronome and generates $1 million in net income every day of the year, rain or shine. The second generates $2 million every day for the first half of the year and nothing in the second. This could be a capital-light business where the company would basically cease to operate for six months every year and incur no overhead. The third generates $3 million every day for six months and loses $1 million every day for the other six. This model fits Vail Resorts.
Each company in my hypothetical shows annual net income of $365 million, but this is why numbers only tell us part of the story when researching companies. For the first business to increase earnings by 50%, it needs to sell more or charge more to get up to $1.5 million a day. The second business needs to come up with a new idea to fill the other six months of its calendar. The third is losing money half the year because it has fixed costs connected to its facilities, which can hopefully be rejiggered into a profitable enterprise.
In the case of Vail, this is mountains, resorts, restaurants, real estate, and employee obligations. All it has to do to juice net income by 50% is stop losing money half the year. The earnings power of the business during its two profitable quarters is superior to that of both other businesses, and this is Vail Resorts' underappreciated advantage.
What is being done?
Vail is taking two paths toward toward turning its Q1 and Q4 around. The first is taking advantage of inverted seasonality in the Southern Hemisphere. Vail does well in Q2 and Q3 because it operates ski resorts in North America, and those quarters are when it's cold and snowy. In Australia, where it recently acquired the nation's largest ski resort, ski season generally begins in April (the end of Vail's fiscal Q3). Acquiring resorts in Australia, New Zealand, Chile, or Argentina would further bolster earnings for Q1 and Q4.
This would help to smooth out companywide earnings, but would still leave incredible natural locations such as Vail and Heavenly as drags during Q1 and Q4 (May through October). Management is undertaking an ambitious plan -- dubbed Epic Discovery -- to turn three mountains, for now, into spring and summer destinations. Vail has invested $27 million so far into the program. Most has gone to Vail and Heavenly, which are scheduled to open in 2016, and some to Breckenridge, which is expected to open the following year.
Epic Discovery involves canopy tours, alpine slides, 4x4 mountain tours, an interpretive outdoor learning curriculum, and an expanded trail system. These investments, made possible by legislation passed in 2011, are positioning Vail to deploy its biggest asset -- access to world-class mountains -- in a new way.Senior VP and COO of Vail Mountain Chris Jarnot explained the goal of the project in a press release: "Epic Discovery will provide an avenue for our summer guests to experience our alpine settings in a new, immersed way, similar to what our ski and snowboard guests experience in the winter."
It's hard to see a future where Q1 and Q4 are as profitable as Q2 and Q3 at the North American mountains, but getting closer to breakeven could have a dramatic impact on valuation. Right now, the company has a trailing P/E ratio of around 39. If Q1 and Q4 of last year had been breakeven, that P/E would drop to around 20. With profitability during those two quarters, the P/E ratio would be even lower.
I bought shares because of the wonderful ski business and the far-off promise that Epic Discovery might turn the first and fourth quarters around. The opening at Vail and Heavenly is only a few months away, and I'm excited to see the effect it will have on Vail Resorts' income statement. Its stock is up more than 150% over the past five years but has the looks of a market-beater going forward. I'll be holding on for the ride and looking to add more if Epic Discovery is as successful as management thinks it can be.