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.