Interval Leisure - Too Good a Business at Too Cheap of a Valuation

Free Cash Flow Yield is Greater than 30% for a Stable Attractive Business

Interval Leisure Group currently has a trailing twelve month Free Cash Flow Yield of 38% and when adjusted for an atypical tax year the yield reaches exceeds 40%. A yield this high is typically reserved for companies in industries that are facing obsolescence such as Yellow Page book printers or companies that are about to lose their largest customer. Interval Leisure is not facing obsolescence and has no customer concentration risk. In fact, Interval is an attractive high margin, asset light business, with high barriers to entry, strong unit economics, network effects, duopoly status, and recurring revenues. The company clearly faces headwinds from a weakening economy, but were still able to grow members in 2008, and even for the first two months of 2009 their important metrics are essentially flat y/y while the stock has sold off 65% from its spinoff. The business model has been surprisingly resilient. Most investors are not familiar with Interval Leisure Group because it has been a public company for only seven months and hired an IR person last month. Interval was spun out of Barry Diller’s IAC in August of 2008 and only has coverage from two sell side analysts. Interval’s primary business is a timeshare exchange business which allows members to exchange their time share for another time share of comparable value that is either in a different location or a different week of the year. Interval is the second largest exchange after RCI which is owned by Wyndham.

Timeshares Have Positive Long Term Trends

Interval provides non capital intensive exposure to the timeshare sector which in the US had CAGR in excess of 13%, and did not have a down year in any of the last three recessions. Timeshares have benefitted from an aging US population and the emergence of higher quality developers such as Disney, Starwood, and Marriot. In 2007 in the US alone, 551.000 vacation interests were sold at over 1,600 resorts generating time share sales volume in excess of $10B. Consumers find timeshares an attractive value proposition, being significantly less expensive than purchasing a second home, or even staying in hotels. Clearly as the US consumer attempts to repair his balance sheet and financing has dried up for time share developers there will be challenges for the time share industry. This impacts Interval’s ability to add new members and replace the approximately 11% of members that leave per year. While there are short term financing challenges for developers and consumers, the value proposition and demographic trends remain positive for the industry.

Interval’s Business Model

Interval derives revenue from two primary sources, membership fees and transaction fees. Intervals almost 2M members pay an annual membership fee of approximately $67 after factoring developer discounts and multi-year discounts. Member retention has averaged 89% historically. As members in the network, they have the right to exchange their set week at a set resort for time in one of the other 2,400 resorts in more than 75 countries of comparable value. When members exchange their week, they pay a fee of $139. Approximately ½ of members bank their weeks per year. Even though members can wait up to two years to use their week, there are weeks that end up unused. Interval is able to sell these weeks to other members in packages that they refer to as “getaways”.

Business Drivers

Interval has two primary revenue drivers

• # of Members – There are currently 1.96M members. In the investor presentation, the company notes retention rates in excess of 80%. During their roadshow, management spoke to an 89% customer retention figure.
  
• Revenue Per Member – This is a combination of annual fees and fees associated with exchanging weeks. More discretionary leisure travel helps to increase this number. In 2007, the avg revenue per member was $158 up 5% from 2006. It increased another 5% in 2008 to $164.

Both of these metrics remain healthy for Interval, growth has moderated, but the business has held up. For the fourth quarter of 2008, members were down slightly sequentially, but ended the year up 1.8% and membership has remained stable. In terms of the number of exchanges, they were down 2% y/y for the January/February time frame which is remarkable given the decline in consumer confidence. One explanation of the resilience, is that a timeshare is effectively a pre-paid product so a challenged consumer will find it an attractive alternative to a vacation. In addition, because of the breadth of locations for exchange, an exchange can be done within driving distance, providing a low cost vacation where lodging has effectively been prepaid.
Interval has a smaller business that they recently acquired that manages properties in the Hawaiin market. The Aston division accounted for 12% of revenues and less than 5% of EBITDA, because it is such a small percentage of the business, this write-up does not focus on it. It should be noted that the drivers for the Hawaiian business are Revenue Per Available Room (RevPar) and number of room nights. RevPar was down over 10% last year and assumed to be down another 10% this year.
Bull Case

• Duopoly – The market is currently a duopoly dominated by RCI with 3.5M members and Interval with 1.96M members. There are network effects for the exchanges. The more properties available for exchange, the more valuable the network is. There are diminishing returns to the value of scale, but it is the largest barrier to entry in the vacation exchange marketplace.
• Positive Demographics for Vacation Ownership Industry - 76 million boomers will be retiring in the coming years. The average timeshare owner is 56, the majority of them are married with no children under 18 living at home, median income is $81,000, 30% have a graduate or professional degree.
• Quality Product/Value Proposition for Resort Developers and Consumers – For developers, the Interval fees have a very large perceived value relative to their actual cost. In a typical timeshare sale, the Interval fees make up approximately 1% of the sales and marketing budget. In exchange the developer transforms their property from a single unit in a single place – to a week at one of 2,400 possible resorts. From a consumer perspective, for roughly $89 per year (base fee) they have the access to 2,400 other locations. In addition, they gain the ability to “bank weeks” for use in future years. Once weeks are banked, the member has additional sunk costs, making giving up membership even more difficult.
• Ability to Grow Earnings by Cutting Costs – Currently 28% of vacations are confirmed on the internet, with the balance confirmed via call centers. There is a cost cutting opportunity as the mix shifts to more on-line confirmations.
  International Opportunities – As the quality and number of properties increase in the Middle East and Asia there are expansion opportunities for Interval.

Bear Case

• Consumer Recession –– Timeshares Fall off a Cliff - The timeshare industry has successfully grown sales of new units even in the last three recessions. However, the last two recessions have not been consumer lead recessions. The current situation of a weakened consumer, developers having trouble financing new projects, and increased defaults on existing timeshares will both impact the number of new members as well as the existing membership base. - Rebuttal, the declines have not shown up yet for interval. Growth has moderated, but customer retention and exchange volumes are steady one year into the recession. In addition, based on my model, the company could sustain a 35-40% decline in membership (flat ytd) and transaction volumes (down 2% ytd) and be break even or profitable on a cash basis depending on how successful they are in controlling their G&A and marketing expenses. The declines have to materially accelerate and be prolonged to justify the current share price.
  
• Risk of New Entrant – The large resorts have now reached a scale where they have the option of creating a parallel exchange. In fact the larger companies like Marriot already allow owners to exchange within Marriot properties without using the Interval Exchange.

Variant Perception
Investor’s have clearly focused on the bear case and are applying draconian declines to the exchange business. I believe that they are under appreciating two components of the story:

• Levers to Pull – Most investors do not seem to understand the importance of the recent price increases on both membership fees and exchange fees announced by the company. The company increased the price of membership for renewing members by $5 per year. This increase would not immediately impact multi-year members or developers, but should still translate into 5 cents per share earnings cushion which is meaningful when estimates are currently in $.50-$.68 range. In addition, Interval increased the fees for exchanges done over the telephone by $10 (approximately 70% of exchanges occur over the telephone). This should too also add approximately 5 cents per share of earnings cushion. In addition to price increases, the company is rolling out new products, such as the ability to use increments shorter than 1 week and a higher priced platinum offering.
  
• Non Cash Charges and Interest Hide True Profitability – There is a large difference between stated GAAP earnings and Free Cash Flow for Interval because of the large amount of Goodwill and intangibles on the Interval balance sheet. The company ended 2008 with $644M in goodwill on its balance sheet (vs EV 550M). In 2008 earnings were depressed by approximately $.70 per share for non cash expenses related to depreciation and goodwill. Earnings were also depressed by interest related to debt. It is important to note, that the debt is from the spinoff from IAC. When Interval was spun off, debt was raised and given to IAC. There is no debt required to run the business. The debt was not used to buy facilities or in any way grow the business. It is an asset light business with negligible working capital requirements. The debt was piled on Interval by IAC because it could be.

As the chart above demonstrates, when Free Cash flow as typically calculated (Cash From Operations – Maintenance Cap Ex) is adjusted for anomalous expenses such as deferred tax charges related to the spinoff or changes in working capital, underneath the extraneous debt and goodwill is a profitable and healthy business.

Strong Unit Economics – Positive Lifetime Value of a Customer

Interval does not explicitly break out their lifetime value of a customer, or even all of the inputs one needs to calculate it, such as customer acquisition costs. However using company provided data and making a few reasonable assumptions, it is clear that the value remains positive and that underlying Interval’s core exchange business are unit economics that allow growth to remain positive, which makes sense given that it is a high margin business.

Debt Covenants/Capital Structure
Interval has $126M in cash and $427M in debt which is a combination of $300M in notes that pay 9.5% interest and are due in 2016 and a $127M credit facility that is due in 2013. The company has not disclosed the covenants of their credit facility, but has indicated that they are well ahead of them. Currently, the company has enough cash on hand to pay off all but $1M of the credit facility. The company disclosed very light covenants related to the notes due in 2016 restricting certain acquisitions and divestments. For the company across all types of debt, the EBITDA/Interest coverage ratio for 2009, which should be the peak debt year, is almost 4. While it would be preferable in this credit constrained environment to have no debt. Interval’s interest payments are manageable, the covenants are light and manageable, and the earliest due date is 2013 for a credit facility that could be paid off today.

Intrinsic Value
Given that over $10 per share of goodwill and intangibles that currently reside on the Interval’s balance sheet, the PE ratio is not the most useful metric for valuing Interval. The risk in the current climate is to attach a trough multiple to trough earnings. Implied in earnings for 2009 are weakness in both the timeshare and Hawaii property management businesses and interest on what should be a peak amount of debt for the company. In a normal environment 8xEV/EBITDA would be a very reasonable multiple for a high barrier to entry, asset light business, which even on 2009 depressed earnings implies upside of 100% from current prices.

Assumptions

It should be noted that the earnings for 2009 assume that the volume of exchanges remain down 2% y/y for the remainder of the year and members see no growth (vs. 2% last year and 5%-6% historical growth), gross margins remain steady even with price increases, and SG&A and marketing go up approximately 12% even though the company has announced a cost cutting initiative. In terms of the viability of membership remaining flat, approximately 25% of members are paid by developers and billed as part of maintenance, so their fees are not discretionary. As long as they retain their time share they will be members. In addition, another 10% of membership fees are paid by developers and included in the first 1-5 years of the time share ownership and lastly, another 5%-7% of members are prepaid as part of multi-year membership plans. Thus 35-40% of the membership base is baked in for the year. If membership does remain flat, transaction volumes have to decrease 80% for the company to lose money on a cash basis.
Catalysts

• Improved Earnings from Price Increases – The price increases for both membership fees as well as exchange fees should offset declines in membership or number of exchanges. As investors gain greater understanding into the resiliency of the business model the company should receive a higher multiple on increased future earnings.
• Investor Relations/Investor Education – Interval has only had seven months to “tell their story” in that period they have done a limited job. Last month, the company filled its investor relations position. They have coverage from two sell side analysts, have attended few investor conferences, and have put limited effort into “getting the story out”. In addition, the company has not had a stable investor base. Like many spinoffs, Interval was not the primary reason IAC investors held the stock. As the investor base changes from IAC leftovers to investors who understand and are attracted to the business model a higher multiple and reduced volatility should follow.

I believe that Interval offers an asymmetric risk reward proposition. The shares are priced for a prolonged recession, which I believe that it can withstand because it is a high margin business with a strong value proposition. The shares should appreciate as investors see the stability of the membership base, impacts of the price increases, and its ability to generate cash. If and when the economy gains footing, Interval should see multiple expansion as well. Barring another “great depression”, Interval is trading at a trough multiple on trough earnings.

An Airline With Fewer Risks and More Upside

Who would want to own an airline with slumping business travel, a weakening consumer, and rising unemployment?

Warren Buffett fans know that he specifically singled out the airline industry as destroyer of capital in his last letter to Berkshire investors. There are several decades industry losses and numerous bankruptcies to support his claim. All that being said, recently, I have begun building a position in Pinnacle Airlines (PNCL) which is not a traditional airline and has a compelling valuation. Pinnacle Airlines currently trades at a less than 25% of tangible book value and less than 2X normalized free cash flow. At current prices the shares presents an attractive risk reward proposition for a growing airline that has significantly more stable earnings than a traditional airline.

COMPANY DESCRIPTION
Pinnacle Airlines is a regional jet operator with 135 jets and 56 turboprop aircraft flying over 1,000 flights per day serving 144 cities under the Northwest Link, Delta Express, Continental Express, and US Airways. Pinnacle was spun out of Northwest Airlines in 2003 where it flew under the name Northwest Link. At the time of the spinoff, Northwest was Pinnacle’s only customer. Today, Northwest is still their largest customer and will account for approximately 62% of 2008 revenue and Delta, who acquired Northwest this year, will account for another 11%. Like other Regional airlines serving the “major” carriers, Pinnacle’s value proposition is its lower cost structure.

LOWER RISK AIRLINE
In 2008, 75% of Pinnacle’s revenue was generated under “Capacity Purchase Agreements”. This is a cost plus model where Pinnacle’s airline customers such as Delta/Northwest assume many of the risks that typically make airline earnings cyclical and volatile. Pinnacle does not assume fuel risk or consumer demand risk and is reimbursed for costs such as insurance and airport landing fees. Pinnacle is paid based on the flight, not the passenger, with fuel provided by their airline partner. For “Capacity Purchase” flights Pinnacle makes virtually the same profit per flight if oil is at $145 a barrel or at $45 barrel. Likewise, they make the same profit if the plane is full or empty. There are some incentives in their contracts for items that are in their sphere of control, such as on-time arrival and customer satisfaction. For 75% of Pinnacle’s business, they have a far more predictable revenue and expense structure than a traditional airline.

In 2007 Pinnacle purchased Colgan, which operates under “Revenue Pro-Rate” agreements with Continental, United Air Lines, and US Airways Group. Colgan’s operations are focused primarily in the northeastern United States and in Texas. On “Revenue Pro-Rate” flights, Pinnacle assumes fuel risk and has the ability to set ticket prices. The earnings and operations are more like a traditional airline. For nine of the markets served by Colgan, there are guaranteed minimum payments from the Federal Government’s “ESA” program which guarantees Pinnacle minimum revenues to make serving smaller markets economically attractive.

POSITIVE RECENT DEVELOPMENTS
The airline industry has a long tradition of destroying investor capital. It is capital intensive and jet fuel is a large input that is volatile. In the past 6 months, Pinnacle’s stock price has declined 63%, however its operating earnings and earnings prospects have remained strong. Pinnacle is clearly in the penalty box because of its holding of Auction Rate Securities, debt that needs to be refinanced or paid off in 2010 and Delta threatening to cancel part of their contract in July. However, there are also a series of positive developments that do not appear to be priced into the stock.

Strong December Numbers – Despite the weakening economy, Pinnacle’s planes are actually carrying more customers y/y. For the Coglan flights where the company is paid by the passenger rather than the flight, their load factors were up 31% in December.

Better Routes – Pinnacle has renegotiated contracts, stopped flying out of Pittsburgh and has gotten better routes out of Dulles Washington , increasing traffic and reducing maintenance and overhead costs.

Transition to larger more fuel efficient planes – Over the past year, Pinnacle has begun a transition to larger more fuel efficient planes. In particular, they are retiring their smallest eleven passenger planes from the Colgan acquisition and adding 74 seat Bombadier Q400 planes under the Continental Contract.

Higher ESA reimbursements – In the fall of 2008 Pinnacle renegotiated higher ESA rates in nine markets from the Federal Government. Pinnacle threatened to pull out of eleven markets and got to rebid them with the Federal Government.

Lower Fuel Costs/Healthier Partners – Pinnacle was profitable in the 3rd quarter of 2009 with an economy in recession and oil well over $100 per barrel. Of greatest concern was the economic viability of its largest customer, Delta Airlines.

Recent Contract Expansions – This month, Continental Airlines agreed to expand their partnership with Pinnacle by adding 15 additional planes starting next year.

Large Tax Refund – Pinnacle had a large one time gain from the sale of a claim related to Northwest’s bankruptcy. The net result was a $100M tax bill. Under current tax law, the company is able to “claw back” their payment if they are able to generate a tax loss. Due to the structure of their new contracts and the planes which they are taking on their books, Pinnacle is able to generate $30M in tax refunds that should be received in 2008 and 2009. Almost $4 per share in cash will be returned to the company in the form of a tax refund in the next year and a half.

RISKS
Customer Concentration: The recent combination of Delta and Northwest was a merger of Pinnacle’s two largest customers. For 2009 approximately 73% of Pinnacle’s revenue will come from the combined company. The business is secured by a contract which expires in 2017. However, there are several situations where the contract can be renegotiated. In particular, a Delta bankruptcy, would provide Delta with the opportunity to renegotiate. In addition, this past summer when oil was $145 a barrel and Delta was bleeding cash, they threatened the cancellation of a portion of the contract for performance related issues. As oil prices declined, Delta and Pinnacle resolved the issue and even temporarily increased the number of planes Pinnacle flies for Delta. It is inescapable, that currently, the long term viability of Pinnacle Airlines is tied to the financial health of Delta Airlines. This risk can be largely hedged out through puts, credit default swaps on Delta debt, or shorting of Delta shares. In the short term, there is little correlation between the share prices of the two companies. In the past six months Delta has benefitted from the decline in oil prices and its shares are is up 26% while Pinnacle has declined 63%.

Convertible Notes Feb 2010 – Pinnacle has $121M in convertible notes due in February 2010. The company should have ample liquidity to meet this obligation in 2010. The company exited the last quarter with $68M in cash. In addition, there is $100M in equity in airplanes, a $30M tax refund due in 2009, $50M in spare engines and parts, $45M in unencumbered Auction Rate securities. In addition, they should be cash flow positive in 2009 and be due a similarly large tax refund in the coming year. However, in the current environment where debt coming due is a red flag, Pinnacle appears to be overly penalized for their debt. This seems to be the most intense area of focus for investors.

Pilots Contract – Pinnacle is currently operating without a pilots contract, they are in mediation with their union. The company has stated that their salaries are approximately 5% below the industry average for regional carriers. There is both the possibility of higher wages as well as a retroactive payment to the union. Bringing pilot salaries to their peer average will cost the company between $5M and $10M per year. A retroactive payment covering three years could be higher.

CATALYSTS
Resolution of ARS Holdings – Pinnacle Airlines holds $136M in Auction Rate Securities. These securities were purchased before the market seized up as the company reached for yield. Pinnacle has taken a $9M write down and moved the securities to the long term investments section of the balance sheet. Citigroup was their broker and has provided $80M line of credit against the securities, leaving $45M unencumbered and not written down, which is substantial given the $37M market capitalization of the company.

Stock Buyback - Pinnacle has the flexibility on their balance sheet to repurchase a substantial number of outstanding shares given the company trades at a discount to the cash on hand, and has significant assets in ARS, tax refunds due, spare parts, and equity in their planes.

Repurchase of Convertible Notes – Shares should react positively to any news of Pinnacle buying back their convertible notes in the open market. The notes have been trading at 30% below par. Pinnacle can both retire debt at 70% on the dollar, as well as reduce the size of the debt coming due. There is some precedent for this within the industry, as Jet Blue has recently been a purchaser of their debt.

Continued Earnings Growth, Revenue Growth, and Cash Generation - As Pinnacle continues to earn even in a weakening economy and build their cash reserves , their ability to repay their short term debt should diminish and provide less of an overhang on the stock.

Insider Buying – Due to the timing of their quarter ends, conference calls, earnings releases and audits, the window for insiders to purchase stock is currently closed and may not open again until April, however at current prices insider buying would serve as a strong signal to the market regarding the viability of the model.

INEXPENSIVE VALUATION
Pinnacle Airlines is inexpensive by any objective measure. For example, the company currently has a forward PE of 1.21. Pinnacle also trades at a substantial discount to tangible book value when the appropriate adjustments are made to the stated book value. The largest adjustment is the removal of their deferred revenue liability of $216M. This relates to the sale of Northwest Airlines bankruptcy claim that Pinnacle sold two years ago. There is no obligation to deliver any services associated with the deferred revenue. There is however a deferred tax asset associated with the revenue that should be eliminated as well to get a more precise picture of Pinnacle’s current financial health.

At first pass, Pinnacle appears to have weak free cash flow. The traditional calculation of Free Cash Flow that simply subtracts capital expenditures from operating cash flow yields negative $12M free cash flow. However, this calculation understates the free cash flow because it includes two one-time events, $20M in hedging payments related to the financing of aircraft acquired and approximately $15M of the capital expenditures were related to growth. On a normalized basis, the company would have generated over $1.25 per share in cash YTD, or a Free Cash yield in excess of 50%. The one metric Pinnacle trades at a premium to its regional jet peers of Republic and Sky is on an EV/EBITDAR basis where Pinnacle trades at 6.6 vs. 5.9 for Republic and 4.8 for Sky West. However 2/3 of the calculated EV for Pinnacle relates to capitalized leases which Pinnacle has no obligation for if Northwest cancels their contract, making it a difficult comparison with traditional airlines that retain the capital lease obligation.

Pinnacle should earn approximately $1.75 per share next year on approximately $900M in revenue. Since becoming a public company, Pinnacle has traded as high as 12X forward earnings with a historical mean of 5X. In the current environment of multiple compression and a decimated consumer, a lower multiple is appropriate. However, a forward multiple of 1.21 should rise as the financing cloud lifts off of Pinnacle. Applying a modest 3.5X forward multiple yields over a 200% return. Valuing the company based on its tangible book value would yield a return in excess of 300%. Given the stability of the capacity purchase agreement contracts and strong cash flows, at current prices Pinnacle presents an interesting risk reward, particularly for investors that hedge out the Delta risk via puts.

Gevity - A Ben Graham Special with Hidden Assets, Margin of Safety and Multi Bagger Potential

In a stock market that is down over 35% YTD the rational investor has sold first and asked questions later, particularly with cyclical names. I argue that it is now time to start asking some questions and look for names that maybe oversold. Names where a little bit of work can reveal a compelling risk reward opportunity. One such name in my opinion, is Gevity HR. Gevity is down 85% YTD and 84% in the last 3 months and is currently trading for $1.24 per share giving it a market capitalization of $31M. It is priced for a complete wipeout of the equity holders, which I do not think is likely based on their balance sheet which has a $122M hidden asset in the form of over collateralized workers compensation insurance plans.

PRODUCT

Investor concern and skepticism for Gevity is well founded. It is a cyclical company with overweight exposure to the Florida economy. The following description is from Reuters, “Gevity specializes in providing small- and medium-sized businesses nationwide with a range of payroll, insurance and human resource (HR) outsourcing services. Gevity is a professional employer organization (PEO), which means the Company provides certain HR-related services and functions for clients under what is referred to as a co-employment arrangement. Under the co-employment arrangement, Gevity assumes certain HR/employment-related responsibilities, as provided for by a professional services agreement (PSA) and as may be required under certain state laws. The core services typically provided by a PEO are payroll processing, access to health and welfare benefits and workers' compensation coverage. In addition to these core offerings, the Company's Gevity Edge PEO solution provides HR services, such as employee retention programs, new hire support, employment practices liability insurance coverage and performance management programs. Gevity has field-based HR Consultants.”

In essence, Gevity allows a small business to offer benefits packages that are comparable to a Fortune 500 companies with Gevity assuming the administrative details for a modest monthly cost. Their average customer is a small business with 17 employees and pays $97 per employee per month. Their typical customer comes from a large payroll company such as Paychex or ADP that charge roughly $50 per employee per month for payroll processing – so the net cost for the access to benefits is $47 per employee per month. In some instances, Gevity is able to save their customers enough on workers compensation and health insurance to more than offset the price difference between Gevity and a traditional payroll processor such as ADP, and the employer can truly offer more for less.

HIDDEN VALUE 3.5X THE CURRENT SHARE PRICE

As part of their strategy to offer savings on workers compensation insurance, Gevity is self insured for the first $1M in losses on each claim. As a result, the company puts up collateral for a period of seven years with their worker’s compensation insurance provider, AIG. Each year, an evaluation is made of the claims to date and likelihood of future claims and adjustments are made to the required collateral. Currently Gevity is over-collateralized by $122M or $4.80 per share (over 3.5x the current share price). The following is from their last 10K “As of December 31, 2007, we have a workers' compensation receivable from AIG of approximately $122.3 million for premium payments made to AIG for program years 2000- 2007 in excess of the present value of the estimated claims liability and the related accrued interest receivable on those payments.” The company does an excellent job of breaking out the over collateralization by year, as well as the number of outstanding claims. As long as the company continues to operate, there will be a level of over collateralization, so the full $122M will not be returned to shareholders. However, as their levels of claims continue to decline, the amount of required collateral should decrease, providing a return of cash to the shareholders. It is also very important to note, that this asset can be sold. In this environment, the company would take a haircut, but this asset is very good protection against bankruptcy wiping out the equity. It could also be the source of financing in the event of a buyout.

POSSIBLE BUYOUT

The private equity firm, General Atlantic Partners, purchased 10% of Gevity on the open market earlier this year at an average price of over $4 per share, with the stated intent of pursuing a strategic combination with their own private PEO, Trinet. At the current share price, Gevity is valued with an Enterprise Value/client employee of less than $500 per client employee. Each client employee generates approximately $97 per month in service fees. Even at 3X the current share price, General Atlantic has a compelling buy vs. build opportunity with Gevity. They would be purchasing client employees at less than $1500 per client employee – or less than 1X annualized service fees and should be able to expand margins through economies of scale. All of this could be financed through the liquidation of the workers compensation receivable. The same logic would hold for other strategic acquirers such as ADP and Paychex which have small PEO operations.

MANAGEMENT AND SHAREHOLDER’S INTERESTS MAY NOT BE ALIGNED

Given the new tenure and minute equity holdings of the management team, their incentives may not be aligned with the common share holders. The company has not been actively courting the investment community and trying to increase the share price. It would be rational from a personal gain perspective for management to focus on selling the company to a strategic acquirer and securing equity and an operating role in the new entity. Realistically management could secure a larger equity stake at a very low valuation in a private equity transaction. One logical scenario would be for management and the two largest shareholders to take Gevity private and then merge it with General Atlantic’s own PEO TriNet. The deal would have 25% of outstanding shares and management backing it. At current prices, down 85% for the year, a large premium to current share prices would be required, and provides attractive upside at current prices.

OTHER RISKS

Counterparty Risk: There is some counterparty risk on the workers compensation receivable, as AIG is the counterparty. I take comfort in the fact the the government has currently deemed AIG too big to fail, and the fact that as I understand it AIG issues are at the parent company, and that the state regulated subsidiaries are sufficiently capitalized and not at risk.

Lack of Organic Growth: Gevity has not been successful at generating any organic growth in the last five years. Given the current jobs environment, generating organic growth will be even more challenging.

TURNAROUND

Gevity has gone through management changes and product changes. Their two largest challenges in the past two years have been sales leadership and and non competitive health insurance rates. There was a disastrous decision to make the CFO the head of sales. This lasted less than a year. Not surprisingly, the individual had trouble making the transition. Gevity sales team is now lead by a veteran from IBM and the company is actively hiring sales reps from other PEO’s. Interviews with sales reps in the North East indicate that there is a dramatic improvement in the quality of the sales force as well as the support from the central team in FL. In the last earnings press release, the company also sited strength in sales, “For the third quarter, the Company continued its selling momentum by generating a 29% sequential increase in quarterly sales production over the second quarter. Additionally, the number of client-initiated terminations declined for the third consecutive quarter. The increased sales volume and lower client-initiated terminations were more than offset by a higher level of client employee attrition, which was principally driven by economic related conditions and seasonality among existing clients.”

The second major change that the sell side has not picked up on is the importance of, is the company’s health insurance offering. For 2007, Gevity selected a series of non competitive health plans. At the time I was the CFO of a Gevity client. We saw our health insurance rates increase 25% without any commensurate increase in quality. In 2007 Gevity saw a 20% decline in the participation in their health insurance plan. For most of their clients, including myself, the plans Gevity offered went from being below market to above market. Gevity went from saving their clients money to costing them money. As a result clients either dropped out of the health insurance and kept Gevity for other benefits, or dropped Gevity entirely as I did. Their value proposition was dramatically muted. I went from paying $100 an employee per month for Gevity services but getting a $50 per month savings on health insurance – for a net cost of $50 (less than ADP) to paying the full freight of $100. The pricing issues combined with some idiosyncratic reporting requirements we had that Gevity could not fill forced us to leave. Not surprisingly, Gevity had historically high customer attrition in 2007 and weak sales production. Both of those issues are largely fixed with their new health insurance offerings.

VALUATION

Just focusing on the balance sheet, Gevity appears to be dramatically undervalued. The company ended the last quarter with a net debt of $20M and a current market capitalization of $32M for an enterprise value of $52M. Ignoring the earnings power of 6,000 customers paying almost 100,000 employees, the current valuation severely discounts the value of the workers compensation receivable of $122M. Below is a chart comparing Gevity to Administaff, a similarly sized PEO. Administaff has better growth and a higher margin book of business, however this large a discount is not justified.

Given the management changes, product changes, and cyclical challenges facing Gevity determining normalized earnings is challenging. In the past nine years, Gevity has made money in eight of them. In its best year it made 97 cents per share. There is operating leverage in the business and Gevity is at their low end of client employees. Other factors to consider are the mix of client employees, average fees per employee which have improved. According to Capital IQ Gevity’s average P/E for trailing normalized earnings is 15.5. I estimate that normalized earnings are in the 50 cent range. Assuming 50% of the historical average PE of 15.5 and applying that multiple to normalized earnings of 50 cents yields an intrinsic value of approximately $3.85 per share – or approximately three times the current share price.

Gevity is trading at a discount to its net assets, its peers and its historic multiples. Given the magnitude of the workers compensation receivable the company has, there is very little likelihood of bankruptcy and a high margin of safety.

Sino Biopharmaceutical (HK1177) manufactures and distributes pharmaceutical drugs that combat cardio-cerebral diseases and hepatitis. The company operates in China. Historically, it has been difficult to find any of the following metrics in a company: 1) Selling at a discount to cash, 2) 11% dividend yield for a well capitalized company, 3) 50%+ earnings growth for a P/E of 6. Surprisingly, Sino provides an investor all three metrics and has gross margins in excess of 80%, net profit margins in excess of 20%, and a diversified set of patented products with accelerating growth.
Chinese Pharmaceutical Market
The company is well positioned to benefit from the continued increase in healthcare spending in China. There are several characteristics that make the Chinese drug industry attractive from an investor perspective including:
- Growing Significantly Faster than GDP - Over the past 10 years the Chinese Pharmaceutical industry has grown revenues at a compounded annual growth rate of 17% and profits at 22%. Thus revenues grew at 1.7x GDP and profits grew at 2.2x GDP according to DBS Vickers.
- Strong Underlying Demographics – China has the world’s largest population with 1.3 billion people. The percentage of the population over 65 has increased from 7% in 2000 to 9% in 2006 and is equal to Japan’s population.
Fragmented but Consolidating – There are currently 4,000 domestic drug manufacturers and 6,000 drug distributors. It is estimated that the top 100 firms account for just 34% of total revenue. There government is leading a drive towards improving quality and raising standards which should lead to significant consolidation. This can be seen by both the implementation of the GMP manufacturing standards as well as the execution of the head of the Chinese equivalent of the FDA (SFDA) for the fraudulent approval of ineffective drugs.
- Enormous Potential from Small Base – China’s spending on all levels of healthcare is very low by Western standards on both a relative and absolute basis. According to the World Health Organization China spends less than 4% of GDP on healthcare vs. 6% for Mexico, 10% for Germany and 15% for the US. On a per capita basis, drug spending is roughly $10 per person per year. The Chinese drug market is approximately 2% of the size of the US drug market at $13B annually. As the Chinese economy matures and the country builds out its social safety net, healthcare is likely to be a large beneficiary. In addition, as incomes rise, healthcare is one of the first uses of discretionary income and is very defensive in nature.
Policy Changes Helping to Drive Growth - China uses two basic insurance schemes. The NCMS for rural areas covers roughly 50% of the rural population. The urban population is covered by BMIS which covers 70% of the urban population. The government has announced the intention to cover 100% of the country by 2010. Both insurance schemes have significant copayment and burdens on the individual. In fact, according to the Ministry of Health, the government currently represents 18% of healthcare funding, employers represent 30% of healthcare spending and individuals represent 52%. Given the large uncovered population and the percentage funded by individual, healthcare in China is not being propped up by the government at unsustainably high levels.
Management Team
Sino Biopharmaceutical is lead by President and Chairman Tse Ping. According to the Prospectus issued in 2000, he has been involved in the Pharmaceutical industry since 1991 as an investor. He has been CEO of another publicly traded Chinese drug company. He controls and is involved with at least three other smaller private pharmaceutical companies. Sino Biopharmaceutical is the only public company and is the largest. Mr. Ping currently controls in excess of 47% of Sino Biopharmaceutical stock.
Overview of Products - Chinese drugs are generally segmented into “Traditional Chinese Medicine” (TCM) which are based on natural herbs and tradition, and the pharmaceutical industry which has SFDA approvals and patents. Sino Biopharmaceutical participates in the intellectual property intensive pharmaceutical industry. Their breakdown of products is as follows:
Hepatitis is the highest revenue drug segment. Hepatitis drugs currently generate 48% of sales with 20% of sales coming from a single capsule product called Mingzheng.
Cardio Cerebral is the second strongest revenue generating segment at 19% of 2008 H1 revenue.
Oncology, Diabietes and Other constitute the balance of the drugs produced.
There is also a strong pipeline of new drugs including 5-6 drugs to be released in the next two years, each of which could contribute in excess of 10% of incremental revenue. The pipeline is difficult to value. Fortunately, at current valuations and growth of existing products, a strong pipeline is not necessary for an attractive investment return.
Recent Performance and Historical Growth
In the first half of 2008, Sino Biopharmaceutical increased sales 109% y/y and profits 56%. Profit growth trailed revenue growth primarily because of an increased tax rate. Interfax China, an independent Chinese research firm, reported that in the first half of 2008 Chinese hospitals increased prescriptions by 10% y/y and drug expenditures by 32%. This is not a perfect comparison since not all of Sino Biopharmaceutical products are distributed in hospitals, however, it is illustrative that the drug industry’s growth has remained strong and that Sino Biopharmaceutical has significantly outpaced its growth. Below are charts showing consistent five year sales growth CAGR of 21% and profit from continuing operations five year CAGR of 34%. By all metrics, this is a healthy business that should command higher multiples.

Sales Growth of Continuing Operations Growth of Profit from Continuing Operations







Risk
Given the valuation at net cash and reported sales growth in excess of 100%, questioning if this company is simply a fraud is fair and prudent. A couple of facts limit the likelihood. Ernest and Young is company’s auditor. This is not the norm for Chinese companies, many have smaller and far less reputable auditors. In addition, the company pays a significant dividend. A fraud would typically not pay a dividend, and would generally issue additional shares on a frequent basis, which has also not happened since 2002. Lastly, in addition to strong insider ownership, Goldman Sachs has a 9% ownership stake. There are several tangible risks to a Sino Biopharmaceutical investment including:
Policy Changes – Current policies driving increased access to healthcare as well as consolidation around drug companies are helpful to Sino Biopharmaceutical. The government has a “Nationally Essential Drug List” (NELP). This is a list of approved drugs. There is a restructuring of the healthcare industry being debated in China. To the extent that there are large cuts in prices the government will pay for drugs could significantly hurt Sino Biopharmaceuticals profitability. The government is actively encouraging domestic R&D and the development of its pharmaceutical industry, so draconian cuts are not expected, however, there is a risk.
Poor Intellectual Protection – Sino Biopharmaceutical owns a total of 132 invention patents. China has a poor history of protecting intellectual property. There is a risk of unenforced patent infringement. With the focus on improving the quality of manufacturing and supporting the pharmaceutical industry, infringement is less rampant, however it remains a risk.

Use of Cash - The company currently trades for less than the value of the net cash on the books. There are three potential risks. The first is that management invests the money poorly. There is some evidence of this. The company has proposed using up to 1/3 of the cash balance on a project turning coal into methane gas. Given the governments current reluctance to approve these types of projects and the decline in oil prices it is unlikely that the project is funded. However, it is indicative of a willingness to explore the use of cash on unrelated activities. The second risk is that the cash figure could be overstated because a large portion belongs to their minority interest holders. The leading sell side analyst which has covered the company for several years claims the cash is attributable to Sino and not the minority interests because the vast majority of it came from the sale of a subsidiary to Bausch and Lomb and cash generated from earnings is generally paid out in the form of dividends (60% payout). The company issued financials are not transparent enough on this issue and the company has not responded to two separate inquiries. To be conservative, one could discount the cash by 15%, which is in proportion to the minority interests equity on the balance sheet. This still yields $.70 per share. The third risk is that management takes the company private. Insiders own or beneficially control just over 50% of the outstanding shares and could take the company private at the currently depressed valuation using the strong balance sheet and only a very modest amount of leverage. This scenario limits the upside of any investment.
Governance – The company’s chairman controls two companies which have drug research and development deals with Sino Biopharmaceutical. In addition, the chairman’s wife is on the board of directors. Both of which are indicative to potential self dealing. In addition, minority interests share of profits are increasing and there is almost no transparency into how or why this is happening.
Liquidity/Hong Kong Discount – Sino Biopharmaceutical is listed on the Hong Kong stock exchange. Trading volumes on a US dollar basis are quite low. Ranging from $250K to $1M USD. This creates barriers to establishing a large position and can increase volatility.
Valuation
Shares of Sino Biopharmaceutical have sold off significantly since September 1st along with the Hong Kong markets. Sino is down 42% vs. 32% for the Hang Seng Index, despite reporting strong earnings and beginning with multiples far below the index.
PEG - Using the historical sales growth rates from continuing operations of 21% implies a current year PEG ratio of .31. This is conservative given the 109% growth in the first half of 2008.
Dividend Yield – The company typically pays out 50-60% of earnings in the form of dividends. The current estimated dividend yield is 11%. In June, the implied dividend yield was 5% and in the past year it has traded below 3%.
Price to LTM Normalized Earnings – The company currently trades at 6X trailing normalized earnings. According to Capital IQ, the company reached its lowest point on October 27th at 5.5. In the past four years the high has been 48 and the average has been 20.
Discount to Tangible Book Value – The company has $.87 cents per share of tangible book value, implying a 10% discount to book value – historically shares trades at 1.5 to 2.0 tangible book value.
Intrinsic Value - Given the high gross and net margins, strong balance sheet, and rapid revenue growth, even in a depressed multiple market, a valuation of 6X forward earnings + cash (discounted by 30%) would be a very reasonable valuation. This would imply a price of $1.74 or a 120% return. A more aggressive valuation of 15X earnings + cash (discounted by 30%) would imply a price of $3.36 and a return of 325%. For an investor with a longer time horizon, if the company continues to compound earnings growth at 34% (5 yr CAGR of profits from continuing operations) and the company and gets a 20 multiple on earnings Sino Biopharmaceutical has the opportunity to be an 8 bagger in three years for a company with limited downside selling below cash on the books.
Catalysts• Cancelling of the cash intensive non-core coal project
• Continued strong earnings growth