Description

Background to HGV

HGV has been written 4 times on VIC, the last one in April 2021 by Ray Palmer. The stock is pretty much where it was back then (April 2021), but the setup is significantly better. We see over 100% upside over the next 2-3 years. I’ll refer you to previous write ups for full business description and I’ll try to focus more on the specific opportunity at hand today.

On January 3rd, 2017, Hilton completed a tax-free spin-off of HGV and Park Hotels & Resorts. As a result of the spin-off, Hilton Grand Vacations became an independent publicly traded company. Hilton did not retain any ownership in HGV; HGV entered into a licensing agreement with Hilton to use the Hilton Grand Vacations brand. On August 2nd, 2021, HGV completed the acquisition of Dakota Holdings, Inc. (“Diamond”), the parent of Diamond Resorts International (the “Diamond Acquisition”), by exchanging 100 percent of the outstanding equity interests of Diamond for shares of HGV common stock. In November 2023, HGV announced the acquisition of Bluegreen Vacations, an independent publicly traded timeshare operator for c. $1.5bn in cash. As a result of the Diamond and Bluegreen acquisitions, HGV is now the largest time share operator in the world.

Summary investment thesis

Historically HGV exhibited market leading growth, market leading margins (EBITDA margins consistently in the 20s) and market leading profit growth. HGV’s market share grew from 5% in 2007 to 13% in 2017 through above average organic growth. Furthermore, HGV exhibited impressive resiliency having its sales declined only 3% in 2009 against -35% for the overall industry. HGV’s impressive track record continued well after the GFC, with 10% CAGR between 2011 and 2018.

Thanks to these desirable characteristics, HGV IPO’d at a valuation of c. 9x forward EV/EBITDA and in the 12 months following the listing, HGV traded on average at 10.5x EV/EBITDA and as high as 13x.

HGV is currently trading at an all-time low forward EV/EBITDA multiple of c. 6x just as it’s about to accelerate its earnings growth trajectory. We believe the current depressed valuation stems from a combination of seemingly negative yet transient factors:

·         Heightened inventory spending in 2018-19

·         Pandemic crisis affecting global travel in 2020-2021

·         Diamond Resorts acquisition distorting results and increasing leverage in 2022-2023

·         Hawaii fires depressing 2023 results and weak 2023 macro

·         Bluegreen acquisition

As the above overhangs dissipate / get fully understood and absorbed by the market, we see a clear path for the re-rating of the stock to at least its historical average valuation multiples. In this scenario, we see over 100% upside over the next 2 years.

What is timeshare and how does it work?

Buyers of timeshare purchase Vacation Ownership Intervals (“VOIs”), i.e., the right to use a certain property each year, typically for 1 week, at a convenient time for the owner, in perpetuity. Broadly speaking, there are 2 formats to timeshare:

1)       Deed-backed points (the legacy HGV model). Under this model, owners have a legal claim to a physical asset that can be passed down to future generations. It gives buyers guaranteed availability and therefore gives buyers the sense that they own the asset. This model typically attracts a higher pricing

2)      Real estate trust-backed points. Under this model, timeshare owners receive annual points that can be spent in the resorts of the group. It gives consumers access to a network of resorts without a commitment to a specific location. Pricing on these types of timeshares is typically lower

Legacy HGV properties typically go for c. $50k per week and Diamond Resorts typically go for half that:

HGV is therefore a premium timeshare operator. HGV makes money in 4 different ways:

1)       Real Estate – HGV makes money by selling VOIs to customers

2)      HGV makes money by offering consumer financing for the purchase of VOIs

3)      Club & Resort – HGV charges an annual membership fee to timeshare owners plus a cost-plus fee for managing the resorts

4)      Rental & Ancillary – HGV monetizes unsold inventory to non-owners

Owners can generally offer their VOIs for resale on the secondary market. Oowners who purchase VOIs on the secondary market will also become Club members and will be responsible for paying annual Club fees, annual maintenance fees, property taxes and any assessments that are levied by the relevant HOA (Homeowners Associations). HGV has a right of first refusal on secondary market sales.

Over 95% of VOI sales are made during Tours. HGV “invites” prospective buyers in their resorts where they can spend up to a week for very little money in exchange for a 2-hour presentation where HGV will pitch their offering and showcase its resort. Historically, conversion rates stayed in a pretty tight range around 15%, i.e. 15% of annual tours converted into VOI sales:

Tours are therefore a critical component of the business. In Q2-20 there were no tours due to the pandemic so there were no VOI sales. An important metric to follow is VPG, or Volume Per Guest. This is an important KPI directly linked to tours. It represents the sales attributable to tours at our sales locations and is calculated by dividing Contract sales, excluding tele sales, by tour flow and it measure the effectiveness of HGV sales process, combining average transaction price and closing rates. VPG has consistently grew over time for HGV:

The final important KPI to monitor is the number of HGV members. This is an important metric because it drives recurring revenue streams included in the Club & Resort segment. HGV has a strong ownership base in the US and Japan:

Resort Development considerations

The development and construction of the resorts requires a large upfront investment of capital and can take several years to complete in the case of a ground-up project. This investment cannot be recovered until the individual VOIs are sold to purchasers, and while HGV generally begin sales prior to the opening of a newly constructed timeshare project, selling all of the intervals of a timeshare development can take several years. Traditionally, timeshare operators have funded 100 percent of the investment necessary to acquire land and construct timeshare properties. In 2010, HGV began sourcing VOIs through fee-for-service agreements with third-party developers. These agreements enabled HGV to generate fees from the marketing and sale of Hilton-branded VOIs and Club memberships and from the management of the timeshare properties without requiring them to fund up-front acquisition and construction costs or incur unsold inventory maintenance costs. The 3 models have very different cash flow and ROIC profiles:

1)       Developed – HGV takes full charge of the development of a resort and sells it to timeshare owners once completed. It’s capitally intensive and therefore generates the lowest ROIC

2)      Just in time – HGV contracts the construction to a 3rd party and acquires the asset just in conjunction with the sale of VOIs to customers

3)      Fee for Service – this is the most capital efficient solution, where HGV takes a fee for managing and selling the VOIs on behalf of large resort developers like Blackstone and other highlighted below:

The first 2 types of solutions are very efficient from a return on capital perspective. Over the last decade, HGV shifted its business to secure increasingly more inventory from capital efficient solutions:

The above shift enabled HGV’s ROIC to go from as low as 12.5% in 2011 to 20-30% today:

Why do we like the business model?

Timeshare has several desirable characteristics:

Growth – timeshare is a growing business

The industry is outgrowing the traditional travel market. The Timeshare industry grew at c. 5% CAGR in the last decade and HGV outgrew the market

Only Cruise grew faster than Timeshare and this was before Covid-19. The pandemic proved to be a boon for Timeshare as many travelers preferred the safety in their own accommodations rather than risking it in packed resorts. We expect the outperformance of timeshare over other forms of travel to continue as timeshare penetration is still very low.

There are 2 ways for a timeshare operator to grow: increase the number of owners and increase the average revenue per owner. HGV is going both successfully:

We therefore view this industry as a long-term structural winner in the travel space.

Recurring revenue stream gives business resilience

Financing fees and Club & Resort Management fees are effectively entirely recurring revenue stream not depending on VOI sales, occupancy and travel in general. Timeshare owners need to pay these fees no matter what or they lose their VOI. Following the HGV + Diamond merger, nearly 50% of EBITDA comes from recurring sources:

The best proof of this has been the pandemic. On an LTM basis, HGV margins never went negative, unlike other capital light travel businesses such as Expedia:

In 2020, as global travel stopped completely, HGV still managed to generate positive free cash flow. The 2020 pandemic was in some ways a very interesting test for HGV, proving what we already suspected: premium timeshare is a very resilient industry and should therefore attract a premium valuation.

Predictable evolution of existing cohorts

Timeshare operators can “invest” in securing new VOI owners knowing that over 60% of a customer’s lifetime value is generated after the initial purchase. Selling VOI’s is great, but the real “juice” comes from the highly recurring fees that come after the purchase:

Furthermore, existing owners are upgrading faster and more often. This means that the customer’s lifetime value continues to increase over time.

The higher the proportion of sales to existing customers, the higher the expected marginality in the business as less expenses are required to attract new customers. Over the last few years, HGV experienced a noticeable increase in the percentage of VOI sales to existing owners, which are typically higher value and higher margin.

Why do we like HGV specifically?

Hilton brand

HGV benefits from its licensing agreement with Hilton which enhances its brand and market positioning. Furthermore, it gives HGV access to a rapidly growing base of Hilton Honors customers that have advantages in purchasing an HGV VOIs. Hilton Honors is the fastest growing loyalty program in the world:

Premium pricing / highest margins

HGV is positioned at the high end of the timeshare spectrum and can extract significant pricing premium also thanks to its brand name. HGV has the highest VPG in the industry. VPG is short for “Volume per Guest”. VPG represents the sales attributable to tours at sales locations and is calculated by dividing Contract sales, excluding telesales, by tour flow. As shown above, not only is VPG consistently increasing for HGV but it’s also the highest in the industry:

HGV also has the highest relative sales to its current owner base amongst competitors:

The two KPIs combined makes HGV the most profitable timeshare company in the world:

Diamond merger

We believe the merger with Diamond offers numerous opportunities to HGV, both in terms of cost synergies as well as revenue synergies. We will touch on some of these below, but we like the fact that HGV is now able to offer a very wide range of products that cater to different consumers. From a price-point perspective, HGV now offers a full range, Upscale to Luxury resorts:

Why does the opportunity exist today? Review of overhangs

We believe HGV shares are today particularly undervalued as the market is failing to appreciate the positive financial benefits from the 2 large acquisition sin the last 3 years, at a time when the stock is still recovering from 2 important overhangs: normalization of HGV inventory investments in 2018-19 and post-pandemic recovery. We therefore believe we are at a very interesting inflection point in the equity story.

Normalization of inventory investments

During its Hilton ownership, HGV aggressively shifted its inventory plans from a capital intensive to an efficient one. While the strategy increased ROIC considerably, it also provided some sort of constraint to HGV’s growth plans which were subject to their 3rd party partners’ growth intentions. There were some specific locations that HGV wanted to develop but were constrained by the fee-for-service partners.

Following HGV’s IPO, its management recognized the need to “re-invest” some cash flow in specific highly accretive yet capital intensive projects. As per slide below, HGV signaled to the market the need to re-accelerate own inventory spending:

The strategy was sound, but its execution was far from perfect. The company underestimated the timing of completion of large projects which meant that they couldn’t sell as many VOIs as they wanted, resulting in a temporary free cash flow degradation. HGV historically guided FCF conversion of 50-60% of EBITDA over a normal business cycle. In 2018-19, HGV re-accelerated its inventory spending, leading to a significant worsening of its free cash flow generation. This rather unexpected turn of events significantly disappointed the market. Over 2018, as the market fully digested these developments, HGV’s valuation multiples cratered from as high as 13x EV/EBITDA in February 2018 to as low as 7x in December 2018.

For the first time in a decade, HGV exhibited negative free cash flow in 2018 and very low conversion in 2019. This proved to be an important overhang for the shares as the historically impeccable track record of strong cash flow generation came to an end. We believe the inventory spending normalized and HGV will exhibit going forward FCF conversion in the stated 50-60% range. As per chart below, following the 2018-19 years of outsized inventory spending, ordinary inventory capex normalized back to historical levels:

Pandemic impact

Just as the stock was recovering in 2019 from the inventory-related overhang (between January 2019 and January 2020, HGV valuation multiple expanded from c. 7.5x EV/EBITDA to c. 10x EV/EBITDA) COVID-19 struck and the share price collapsed from c. $30 to as low as $13. Pandemic worries were somewhat justified – Sales of VOIs went to zero in Q2-20:

However, if anything, the pandemic proved the resilience of the business model. The resilient side of the business proved to be just that: the decline in Q2-2020 was barely visible:

Remarkably, FCF generation turned out to be positive in 2020 notwithstanding the pandemic, with over 80% FCF conversion. 2021 was still a depressed year with lower-than-average FCF conversion but it still exhibited a positive FCF. The pandemic, if anything, validated the thesis that HGV is an incredibly resilient business.

Diamond Resorts acquisition

Just as the stock was recovering from the pandemic lows and valuation multiples came back up to above 10x EV / EBITDA, in line with pre-pandemic history, the stock started to de-rate again on the back of the Diamond Resorts acquisition. The acquisition somewhat changed the equity story – HGV changed from a premium timeshare operator to a somewhat hybrid business model, combining the lower end Diamond Resorts based on trusted points with the higher end deeded points-based HGV business. At first, it seemed to be a classic “empire-building” move aimed at creating the largest timeshare operator in the world:

We believe there is a sound strategic rationale behind the acquisition with clear revenue and cost synergies. The cost synergies are pretty obvious, with c. $150m in annualized G&A to come out. The revenue synergies are yet to be seen but we believe there is significant scope for up-selling and cross-selling to an entirely different category of buyers, catering to a broad proportion of the population:

Note how the median price point for HGV is so much higher than for Diamond Resorts: there is a clear case for upselling HGV timeshare to Diamond Resort customers:

The second issue which in our view caused some concern amongst investors was the leverage level. Pro-forma, at closing the net debt to EBITDA ratio stood at 6.5x, which was deemed as too high by equity investors. Combined with an upcoming recession, and a market correction in 2022, the above led to the EV / EBITDA multiple of the combined entity to drop to below 2x at the end of 2022, well below the targeted range.

Those fears of over-leverage were clearly exaggerated considering HGV closed FY 2022 with only 2x turns leverage. Furthermore, following buyback suspension in 2021 to finance the Diamond acquisition, HGV resumed its share repurchase program in 2022, buying back $278m in stock in 2022 and c. $300m in 2023.

Hawaii fires depressing 2023 results and weak 2023 macro

Even before the announcement of Bluegreen Vacations, HGV share price fell from as high as $50 in Q1-23 to as low as $35 by October 2023 on the back of 2 temporary issues affecting profitability in 2023: Hawaii fires and weak macro conditions. As per the chart below, consensus EBITDA fell in the period by as much as 10%. Concurrently, valuation multiples compressed by c. 1x turn, for nearly 30% share price decline over the period.

Neither of these issues seems to be particularly worrying going forward.

In 2023, Hawaii experienced some of the worst wildfires in its history. HGV has 13 properties in the Hawaiian Islands. Due to the fires, several resorts were closed, and VOI sales were therefore deferred to future periods. C. 20-25% of the EBITDA shortfall compared to original guidance is due to Maui closures. The rest is due to lower than previously expected VOI sales in Q4-23. The magnitude of the implied Q4 downgrade scared off several investors. I believe an economic slowdown (read soft landing) is by now the consensus scenario for 2024 and investors will eventually start looking forward to a re-acceleration in 2025 and 2026. While 2024 is clearly going to be choppy, the real upside in the equity story is linked to EBITDA acceleration and re-rating in 2025 and 2026.

Acquisition of Bluegreen Vacations

On November 6th, HGV announced the acquisition of Bluegreen Vacations, e publicly listed company, for c. $1.5bn including net debt. The market didn’t react to this acquisition very positively (stock price fell on the day of the announcement), but we believe that just as with Diamond Resorts, this deal is both strategically and financially sound.

From a strategic perspective, Bluegreen adds a new type of customer, typically Gen X or younger, with an average FICO score of 739, so a very sound credit rating. It brings HGV 48 resorts in 14 new geographies and 8 new states. It complements nicely with HGV, adding interesting new locations such as Texas and Louisiana and Georgia where HGV did not have any presence. The transaction further broadens HGV’s offering and price points, making HGV the most varied timeshare operators in the world from an offering perspective. Furthermore, it reinforces HGV as the largest vacation owner in the world from Tour Count, Contract Sales and EBITDA perspective, ahead of Travel + Leisure, the second largest in the world. Finally, the move further consolidates an industry that has been consolidating for years making HGV and Travel + Leisure the only publicly listed timeshare operators in an industry which is now dominated by 5 operators operating under 5 brand umbrellas: Hilton, Disney, Marriott, Holiday Inn and Wyndham.

From a financial perspective, the deal was struck at a reasonable 6x EV / EBITDA multiple including cost synergies. This does not include the $75-100m incremental revenue synergies which have been identified but not included yet in projected pro-forma combination. The transaction is double digit accretive in year 1 from an adjusted FCF/share perspective. Finally, thanks to cost synergies and the seemingly better business mix at Bluegreen (~50% of segment adjusted EBITDA generated through recurring fee streams like club membership, property management and financing income), HGV seems to have upgraded its long term adjusted EBITDA free cash flow conversion range from 50-60% to 55-65%.

The above should lead to both acceleration in earning growth as well as enhanced valuation multiples.

Valuation considerations and returns assumptions

Since its IPO in January 2017, HGV traded on average on 9x EV / EBITDA, if we exclude the pandemic period. We believe that over the next 2 years, the stock will re-rate to at least 7x EV / EBITDA from at c. 6x EV / EBITDA 2024 excluding Bluegreen acquisition today. At 7x EV / EBITDA, this multiple would represent the very low end of the historical valuation range.

Assuming HGV trades back towards an undemanding 7x EV / EBITDA multiple by 2026, we see over 100% upside from current levels.

Summary Financials

Catalyst

* Closing acquisition

* Time...