Bridgepoint Education (BPI) - Posted Sum Zero 9/2/2010 - price 13.44

Warren Buffet once said “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well."

It is fair to say that education stocks are unpopular right now. I myself have shorted two for profit colleges in the past year. There is a lot not to like with the industry - including a tendency to spend more on marketing than instruction, low graduation rates, a perception (perhaps well deserved) of poor quality. In addition, the Department of Education (DOE) has targeted high growth for profit schools with proposed regulations that could restrict or eliminate access to Title IV loans which are the lifeblood of for-profit providers. A proposed set of rules which is generally referred to as “Gainful Employment” impacts schools whose graduates are not repaying loans (repayment rate below 45%) and/or saddle their students with loans far greater than their earning power (debt burden> 8% of income) the schools will either be restricted from the loans if they fail both criteria, and forced to provide warnings to incoming students if they fail one of the criteria. The loss of Title IV loans for most for profit colleges would be devastating as many providers derive between 80%-90% of their revenue from these loans.

The proposed regulations will be effective at stopping schools that saddle students with the most debt and provide the poorest job prospects to graduates. The popular press including 60 minutes and Frontline have highlighted abuses and Steve Eisman has a short thesis on the space.

(http://myinvestingnotebook.blogspot.com/search?q=Eisman)

The gist of the short thesis is that many providers will have to significantly reduce tuition so as to not violate the debt burden stipulations. These tuition cuts will directly impact profitability. Schools will also have to be more selective in the students that they recruit, because their survival is partially tied to loan repayment. Greater selectivity could lead to slower growth or enrollment declines – creating a triple storm of lower profitability per student, fewer students, and a lower multiple for an enterprise with declining earnings and prospects. It is a solid thesis and may very well play out in the earnings/operations eventually.

There are a couple of macro points to be made before diving into the specifics of Bridgepoint Education. The first is that the regulations are not yet approved (target date of November 1, 2010). The second is that even if the regulations are approved, the penalties do not go into effect until 2012-2013. This gives the industry more than a year to lobby for regulatory reform which has already begun:

(http://online.wsj.com/article/SB10001424052748703418004575455773289209384.html?mod=wsjcrmain).

As an industry, the companies spend billions on marketing, diverting 5%-10% of the marketing budgets to lobbying could take teeth out of the bill. There are also arguments against the regulations including the philosophical one – why should the tests and penalties only apply to for profits? For example, of the 96 Historically Black Colleges – all non profit – only 1 would pass the 45% of students repaying debt threshold of 45%. If the industry can broaden the scope of the regulations, they will be closer to softening them. There is also the argument that schools with lower repayment rates are more driven by student demographics than anything else and ultimately you will be limiting choice and quality for those most in need.
(http://www.magicdiligence.com/articles/gainful-employment-hurts-low-income).
In my opinion, the pessimism driven by the proposed “Gainful Employment” regulations has created an interesting risk reward proposition in Bridgepoint Education. Bridgepoint has been a remarkable growth story. In 2004 a management team and Warburg Pincus bought an accredited university with the premise that if they stressed affordability (low tuition), ease of enrollment (ability to transfer more credits than competitors – and start any week you want), they could fill a void in the market between more expensive for profits and slower less aggressive facility based non profits. They rebranded the school, Ashford University, and have been able to grow enrollment from under 1,000 to over 60,000 in less than 6 years. They have also grown revenue from under $10M to almost $700M per year. Clearly their product positioning and marketing have been effective.

Bridgepoint has been able to have hyper growth while maintaining profitability since 2007. The company has several attractive features:

Operating Leverage: With 99% of student receiving services on-line, the business has significant operating leverage. For example in the first half of 2010 the company grew revenue by 56% and Net Income by over 300% (excluding one-time items).
Not Currently Impacted By Regulations: As indicated in the press release for the last quarter “While several complexities remain with respect to the Department of Education’s proposed gainful employment rules, our initial analysis indicates that all programs at Ashford University would satisfy both the 8% debt-to-income ratio and the 45% repayment threshold, reaffirming our confidence that our academic institutions are well positioned to meet the proposed new requirements.”
1st Stock Buy Back – The company has announced a $60M buyback to be executed in the next year. At current prices, this is roughly 8% of the outstanding equity and less than what the company will generate in the back half of the year. In addition, the company has $60M in unrestricted cash and $80M in receivables – so additional buybacks are plausible and provide some downside protection.
Warburg Pincus Ownership – Some analysts claim there is a Warburg overhang because eventually Warburg will eventually have to sell its 60%+ stake. However, in this period of turmoil I rather have Warburg with two board seats and a large ownership stake making capital allocation decisions and growth decisions than an unchecked CEO feeding at the shareholder trough. Warburg has a long time-horizon and incentives that are aligned with equity investors.
Conservative Guidance – Modeling Bridgepoint is not overly complex, the largest imputs are enrollment, sales and marketing, and G&A. Management has guided to earnings in the back half of the year being down 18% despite guiding to revenue being up 15% for a business with operating leverage. In addition, despite announcing a buyback for what amounts to almost 8% of the company their guidance assumes a flat share count. There are three ways to win here – on the revenue side, cost side, or share count side – my belief is that at least one of these comes in.
Growing Industry – The for profit education sector has had hyper growth for the last 10 years.
Cheap Valuation – Bridgepoint is currently trading at less than 6X this years earnings (ex cash) which is based on conservative guidance and less than five times next year for a company in a growing industry with operating leverage, a management team with a history of impressive execution, in the midst of a buyback.
Better Positioned than Peers: The passage and implementation of the gainful employment regulations in their current form would likely not be a positive for Bridgepoint – but given their “affordable” positioning and low student debt level relative to peers the company should not have to lower pricing to comply.

Risks The biggest risk is clearly not multiple compression. In the long term, this business has no “moats” – it’s positioning as affordable and easy to transfer into with courses starting weekly is clearly replicable. In addition, the gainful employment regulations could be the first step in an increasingly negative regulatory environment. I think the most significant risk in the next 1-2 years is that fraud is revealed during the “high growth” phase. There is an outstanding OIG investigation that has not been positioned as terminal – but of all the risks – I think the greatest is the OIG or a whistle blower uncover something that restricts Title IV loans and causes repayment of prior loans. Of slightly less concern is that the quality of the students has deteriorated over time and even though according to the USDOE calculations existing graduates are repayment rates are over 45% as more students from the “hyper growth” phase graduate – IF they are of lower quality – it would drag BPI below the 45% threshold.

Republic Airlines RJET - Posted on Sum Zero 2/8/2010

Sometimes, in the rubble of hated industries lie companies at valuations where holding your nose and pulling the trigger can be handsomely rewarded. We can all agree that the airline industry has been a destroyer of capital, has a propensity for irrational competition, and has a major input, fuel, which is highly volatile. Within the airline industry, Republic Airlines is a “special situation” that has done a poor job communicating their “story”. Before we get into the details, here are a couple of tidbits. The shares now trade at $4.85 per share which is less than 1/3 of book value, the company has no major debt maturities in 2010 and $9 per share in cash (a little over $4 per share is restricted for credit card holdbacks).

THE BUSINESS - Republic Airways (RJET) offers scheduled passenger service on approximately 1,600 flights daily to 121 cities in 44 states, Canada, Costa Rica, and Mexico under branded operations at Frontier, Midwest, and through fixed-fee airline services agreements with five major U.S. airlines. The fixed-fee flights are operated under an airline partner brand, such as American Connection, Continental Express, Delta Connection, United Express, and US Airways Express. The airlines currently employ approximately 11,000 aviation professionals and operate 288 aircraft.


Republic Airlines has been profitable for 31 straight quarters and 33 of 35 years of operation. Until 2009 Republic’s history as a public company was primarily that of a successful and profitable regional airline operating flights on behalf of the “major” airlines on a fixed fee basis. Like other regional airlines, Republic has a better cost structure than the major airlines and is able to arbitrage the cost difference, and allow the majors to keep the plane lease liabilities off of their balance sheets. On the fixed fee business, Republic gets paid a set fee for operating the flight, plus the cost of fuel, regardless of how many seats are sold on the flights. The result is that a fixed fee airline is a much lower risk airline without the volatility of fuel prices, changes in consumer demand, and fare wars. In the past five years, one of the biggest risks for Republic Airlines as a fixed fee operator of flights on behalf of the majors has been the financial viability of Republic’s partners. The fixed fee business is a stable and attractive business, until a partner goes into bankruptcy voiding the contract and Republic is left with expensive idle planes and no simple way to redeploy them. As a result, regional airlines such as Republic and Pinnacle Airlines have been diversifying and adding “Branded” operations. For these flights, Republic operates like a conventional airline taking responsible for the booking of the reservations and assumes both demand risk (they have to sell the seats) as well as responsibility for all fuel related expenses. The branded operations are higher risk, but also provide an outlet to redeploy aircraft in the event that a fixed fee customer such as United goes into bankruptcy.


FRONTIER SOLID ACQUISITION NOT RELECTED - In the second half of 2009, Republic acquired two “branded” operations, Frontier and Midwest. The two situations were quite different. Frontier was a profitable airline. Frontier was forced into bankruptcy through a combination of $140 oil and their credit card processor with very little warning instituting a 100% holdback on all credit card sales until after the completion of travel. Frontier used the bankruptcy process to restructure and based on their monthly filings during bankruptcy became quite profitable. During a horrible consumer recession, in the first nine months of 2009, Frontier generated $80M in pretax earnings (excluding bankruptcy and one time charges). Through Sept 2009 Frontier had 10% pre-tax operating margins.


The Frontier acquisition closed on October 1st and none of the operating results are included in Republics results YTD. However, the Frontier acquisition on a normalized basis could have a substantial impact on Republics earnings. A little back of the envelope math, Frontier will do $1.3B in revenue in 2010, let’s assume that in 2009 even though there was a consumer recession, the 10% operating margins were peak because of lower fuel prices and perhaps the company delayed maintenance (there is not a consensus on this point) – and that margins should be 6%. At 6% margins and a 37% tax rate – Frontier would generate $1.40 per share in earnings. At 3% margins it would generate $.70 (remember this is a $5 stock and the core fixed fee business generates in excess of $1 per share). At 10% operating margins Frontier would generate over $2.30 in earnings. As a point of reference South West had operating margins below 3% in 2009 and average operating margins of 7.5% from 2005 through 2008. In the short term results will be depressed because there are restructuring charges related to moving Frontier front office operations from Denver to Indianapolis. On the back end, there are tax breaks that should enhance profitability.


MIDEWEST AIRLINES - The second branded acquisition that Republic made is not as attractive as Frontier. Republic purchased Midwest Airlines for $31M plus the assumption of $72M in debt. Unlike Frontier, Midwest was losing money and is a turnaround situation. Midwest has historically had a strong presence in Milwaukee, high customer satisfaction (rated #1 domestic carrier by Zagat survey), and commands a pricing premium. Unfortunately, Midwest has traditionally had a poor cost structure so despite getting more revenue per mile, they had substantially higher costs per mile - and no economies of scale. This has been a formula for losses. Republic is creating a “virtual airline”, keeping the Midwest name but stripping out the high cost structure. They have replaced all Midwest pilots with Republic pilots and mechanics at a 40% savings. They also intend to consolidate back offices and eliminate duplicate staffing at common airports They are attempting to layer in their lower cost structure while retaining the brand and the price premium. Unfortunately Republic/Midwest is attempting this strategy in the face of fierce competition in Midwest’s primary market of Milwaukee. Southwest has entered the market and increased capacity by 30%. Republic has indicated that Midwest will lose money in 2010 along with other carriers operating out of Milwaukee. Over the summer, before any of the cost savings measures or Southwest arrival, Midwest was losing approximately $8M per month.


NON CASH AND NON RECURRING CHARGES IMPACTING GUIDANCE - On Thursday the company provided an update to guidance at the Raymond James conference. The midpoint of the guidance was $.66 per share in 2010 EPS. This is still not a normalized earnings number. There are two moving parts for investors to be aware of, and thus creates the opportunity. Embedded in this number is $35M ($1/share) in purchase accounting costs related to the writeoff of goodwill from the Midwest acquisition. There are also restructuring charges related to integrating thinfs such as integrating IT systems and moving HQ to Indianapolis. So there is one dollar in non cash charges related to a purchase and non recurring restructuring costs. It takes little imagination to see $2/share in normalized cash flow for a company with $5 per share in unrestricted cash per share and $10 per share in total cash - with less than $3 per share in non asset backed debt.



RISKS: The bear case for Republic is almost exclusively focused on the branded business. There are four primary concerns.


1)Branded Business Kills the Fixed Fee Business - The branded business will hurt Republic’s chances of getting new business on the fixed fee side because they are becoming a direct competitor of their customers (Counterpoint – Republic still enjoys a significant cost advantage over the major carriers and no contract renews before 2013)


2)Branded Business Perpetually Underperforms - The branded business will perpetually lose money and offset the continued profits of the fixed fee business. (Counterpoint – Frontier was actually very profitable going into Republic and December traffic figures that were released were actual up y/y making a complete implosion unlikely. The fixed business has historically earned in excess of $1.40 per share. The company has guided to -2% to -2% Pre tax margins in 2010 with restructuring costs and integration costs in the front half and some savings realized in the back half. )


3)Execution - The skill set of running a branded business (scheduling, pricing, equipment deployment, and marketing) are not native to Republic since they were not required for the Fixed Fee business because the partners handle this roll. In addition, the senior leader of this initiative, Sean Menke, just left the company (Counterpoint – Sean Menke went from CEO of Frontier to running a portion of Republic and staying with the company would have required moving from Denver to Indianapolis. Clearly his departure is a negative and this is a legitimate risk but there is other talent within the company and the industry.)


4)Fuel Price Fluctuations – The company is partially hedged on the branded side of the business, but as a consumer of over 200M gallons of fuel/yr, the airline is clearly vulnerable to large swings in the cost of fuel. The company is15% hedged for 2010. Each $1 move in oil prices translates into $5.5M in additional costs (34.4M shares outstanding).


Catalysts –
•RENEGOTIATION OF CREDIT CARD HOLDBACK – The company currently has more than $6 per share in restricted cash which is being held back by their credit card processor. The company is in the process of renegotiating its processing agreement. Reducing the holdback to 50% would increase the non restricted cash per share to almost $6 per share (in excess of the current share price). The company does have $2.7B in debt, however all but $85M of the debt is asset backed aircraft debt.


•IMPROVED GUIDANCE – The company has several moving parts right now as it transitions from a fixed fee business to a blended business. Their guidance has been very imprecise as they have admitted they are still grappling with purchase accounting, the scope of the restructuring, and the impact of Midwest Airlines. The net effect is that in the absence of clear guidance, people have assumed the worst. For example, the Avondale analyst has modeled that Midwest will lose $100M (on rev of $400M – which is a slight acceleration of losses – pre any restructuring). In addition, he has modeled Frontier only being break even in 2010, even though it was profitable coming into Republic.


• STOCK BUYBACK/CAPITAL STRUCTURE - The company has indicated that it would like additional cash on its balance sheet making a large purchase of stock difficult. However, the company is selling at less than 35% of book value and has engines and other spare parts that it can consider selling to free up capital for share repurchases. Clearly at this valuation, repurchasing shares is one of the best uses of capital - as a company they repurchased over $100M in shares in 2007.

Variant View
My basic belief is that management is overwhelmed by the acquisition, the accounting, and the number of moving parts. I believe that they have given conservative EPS guidance that buries in non cash charges, one-time restructuring expenses, and back loads the cost saving/synergy so that investors have a poor picture of how the pieces fit together and what cash flow or normalized earnings will look like. Assuming management continues to behave rationally and does not let MidWest destroy profitability for years to come, Republic on a normalized basis in 2011 should earn in excess of $2/share and have a 50% reduction in the credit card holdback which would give them $7 per share in cash. Putting a six multiple on normalized earnings gets you a $12 stock (with $7 in cash).


The analyst from Avondale put out a report indicating that losses from Midwest would accelerate even though the cost structure will be completely revamped (Crews make 40% less under Republic). He has a company with a market capitalization of $170M losing a $100M on Midwest which only has $400M in revenue and the company indicated it would cost $30M to idle the planes. Perhaps he is correct and management will drive the company over a cliff, but RJET is trading at a significant discount to book, has a core fixed fee business which remains profitable, has numerous operating levers to pull, and a cost advantage over competitors. Management has been profitable for 31 quarters and 33 of 35 years if management can execute patience will be rewarded in this sub $5 stock.

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.