Value Investors Club / HILTON GRAND VACATIONS (HGV)

Description

HGV was written up almost exactlyayearago by Ruby831. That writeup does a good job of going

through the fundamentals, but we think it’s time to revisit the name after its second guidance reduction

in 6 months and subsequent nosedive.

Note: Ruby831 and others added some great color recently on the message thread to that idea, I’m not

clear on how to link the two ideas/threads but that thread definitely worth reading.

The Business:

First, we want to briefly go through the different business lines to clarify what generated the miss:

Real EstateSegment: This what people may classicallythink of as “timeshare”. The company develops

inventory (either greenfield or project add-on) and then sells the units as Vacation Ownership Intervals,

essentially the right to stay at a location for a week of the year. Given the difference in pricing of various

units and the fact that inventory can’t be made instantly, it is a lumpy segment. This has since been

exacerbated by the new 606 accounting standards, which forces them to defer revenue from un-opened

properties until official launch. More about this later.

Financing: For owned inventory development,the company will offer financing of VOI sales.Typically,

65% of owners finance on 10-year paper. The average FICO is over 700, and the company does an ABS

sale once a year, monetizing at a 10% spread. While this is large, they are the only ones who can finance

their own sales (banks wont do it) and the paper has performed well over a very long time. The only

time the ABS market was frozen was briefly in the financial crisis.

Resort and Club Management: Given you are buying physical property, you need to spend to maintain

this. HGV collects various fees, though many are simply passed through as actual maintenance or fund

reserves. This comes through at a very high margin, is very stable, and has been growing. Very similar to

Hotel C-corp fees.

Rental and Ancillary: the company rents out unused units as a hotel,as well as operates F&B in the

resorts. This is effectively like a running an actual hotel,as many guests are simply HHonors members.

When you break down EBITDA,roughly 2/3rds ofit is highly sticky or recurring fee streams, while the

remaining 1/3 is volatile,based on in-year sales (though they have a very good track record over the

long-term). The balance of the guidance reduction was entirely due to the lumpiness of the 1/3, which is

effectively in an air pocket of higher quality inventory after finishing a prime Hawaiian property in 2018.

What Has Changed:

Without a doubt, this has been an epic failure in communication over the past 12 months. Management

went through an inventor day in which they didn’t hit LT guidance (new CFO has just started), then

subsequently had to lower guidance again after Q1 (conversion rates were lower than expected), and

again after Q2 (mix shift caused avg. price to be lower than expected). We know it sounds like complete

amateur hour, though we find reason to believe these thing are more “we screwed up” than “the

business is under pressure”.

One of the biggest changes since the previous write up is the shift from asset-light to more asset-

intensive. After doing the whole dog and pony show for the past 3 years on how they aren’t taking much

building risk, they started aggressively spending capital on new development. The street, ever wary of a

capital-intensive leisure company late into a cycle, reacted poorly at best. We think it’s pretty apparent

now that management realized two things: first, they didn’t have the inventory in the pipeline to grow

like they wanted, and second, taking on financing partners stunted the longer-term economics and

networks effects running a vacation as a service company. You can speak to said financing partners

about these deals or build out a basic model as we have, but the unlevered IRR of putting capital into

the ground appears to range between high teens and low twenties. Not a shabby return and worth

doing on your own/controlled balance sheet.

The second big change is that management got wise on capital allocation.With an effectively unlevered

balance sheet, they decided to start buying back stock. People will have many opinions on this, though

at least in the short term, they were aggressively buying stock right before two guidance reductions. Not

a good look. However, on the call yesterday management appeared undaunted. They will be receiving

another ~$300mm of cash from ABS securitizations in a few weeks. While this will not go 100% to

buybacks,you could easily see them buy $150-$200mm across thecourse of the year, another 7% of the

market cap (they have already bought 9%).

A final note is that the introduction of new accounting standards has really convoluted the reported economics.

This can be seen bright as day in that they just reduced EBITDA guidance by $60mm,but FCF guidance

by $10mm… This flows through the statements via deferrals, which are basically pre-sales on not

yet open properties. One thing to note is that they defer 100% of revenue and direct costs, but you can’t

defer indirect costs,so deferrals look likethey have 50%+margin.This is why margins looked so low

Thursday. The reversal then comes through at a similarly high margin. This is all to

say that the lumpiness has been made larger, but as investors, we need to adjust for that in our modeling/

valuation.

What HAS NOT Changed:

Conversion/macro: The way this company builds to revenue is tours * conversion rate* average price

per unit. This conversion rate has oscillated between 13% and 17% for the past 30 years. In 2016 and

2017 that rate was in the mid 14%s. In 2018 that rate was just under 16%. For 1H2019 that rate whas in

the mid 14%s again. For all the hubbub regarding a potential slowdown in the macro,conversion is still

in its healthy range, albeit down from near the peak last year. They still grew net owners by over 6%

(literally new people into the platform). In places where they launched new product, we saw growth

well into the double digits. Far be it from us to call cycles, but this doesn’t feel like a material slowdown

in outside forces.

Pricing: Management did a poor job explaining the concept of “VPG” or Volume per Guest on the call.

This metric is effectively total contract sales / tours. It was down >5% in Q2, and management kept

saying that they had seen “reduced pricing”. What they did NOT do is reduce price. They had a mix shift

problem. By not having premium inventory,they were selling more lower priced units. Its not like they

were reducing price to stoke demand.

The“stable”fee streams: These pretty much all beat, and are still growing in the HSD+range

The long-term algorithm: We do think it’s likely that management modestly adjusts their long-term

guidance. Specifically, they have a credibility problem and a new CFO who didn’t bless the previous

numbers. However, mechanically the long-term numbers shouldn’t really change. To again break the

business into recurring vs. RE sales: the recurring should go down modestly because they are selling less

this year, which will have a knock-on effect to the following years. But given this years contribution to

the total member base is ~6% and that number is coming in ~5% light, it really doesn’t move the needle

that much. The 1/3 that is real estate in-year has basically no relationship to the earnings of that

segment the year prior. They have a set amount of inventory coming online and a conversion rate at

which they sell that inventory.When they launch new projects in 2020, the fact that they missed in 2019

shouldn’t influence their ability to sell the new stuff. So while everyone across the street is taking down

numbers, we believe it more to be out of blind conservatism than hard logic in the model.

So where do they go from here? We’ve (finally) had what feels like a kitchen sink clearing event in

guidance, with extremely strong product launches coming in the next two years and some interesting catalysts.

1) Management is going to be buying a boatload of stock back at now pretty depressed prices. 2) Let’s be

honest, this is a lumpy business and the space has a long history of financial sponsors, so it probably has

some buyers circling around it. 3) management is finally talking about a “points-based” product which

would smooth volatility (new COO was old President ofRCI and knows trust-products well).

From a valuation perspective, you are about 9x 2020 EPS, with 2/3 of the business growing DD and 1/3

about to have a huge rebound from new product over the next two years. It bottomed out in December

at 6x EBITDA,which would put it in the neighborhood of a low $20s downside. If it works and the sell

through is as good as a we/they think it will be over the next 2-3 years, they will be doing well over $4.00 of EPS,

which we think should trade at a low to mid-teens P/E, so a high-$40s to mid-$50s upside.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Buybacks with proceeds of ABS transaction.

New inventory coming on-line in 2020 and 2021.

Possible strategic/PE interest.

Ponts/Hybrid Product offering.

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			2019	2020
Price:	26.46	EPS	0	0
Shares Out. (in M):	87	P/E	0	0
Market Cap (in $M):	2,300	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0