Description

Sunterra Corporation (SNRR), a post-reorg equity, is the largest independent vacation ownership company in the world, with more than 300,000 owner families vacationing at 94 resorts in 12 countries in North America, Europe and the Caribbean. Originally founded as Signature Resorts, prior management built the company through multiple acquisitions that were never integrated. As a result, poor operations and controls, combined with an overly leveraged balance sheet, forced the company to file for bankruptcy in 2000. During Chapter 11, a new management team was assembled, with the CEO slot filled by the chief of its successful European operations. Although Sunterra emerged as a public company from bankruptcy in 2002, the company required a continued turnaround in operations, including unifying its systems, re-building its sales force, improving its credit processes and opening a new headquarters.

By the third quarter of 2003, the evidence of a turnaround clearly emerged, as operating margins improved substantially from 3% in Q3 2002 to 16% in Q3 2003. Also significant by late 2003, money losing US operations, which had been depressing overall results, turned profitable for the first time in years. Following the release of 2003 results, management provided guidance for 2004 that projected sales growth of approximately 17%, but due to the full year impact of improved operations, margins and refinancings, an almost doubling of net income (fully taxed and excluding non-cash, reorg related expenses) from approximately $0.52/share to $0.97/share.

In addition to the positive trends specific to Sunterra, the company also benefits from positive industry fundamentals. The vacation ownership industry has shown consistent annual growth, even during recessions and the aftermath of terrorist attacks. Also significant, the industry has evolved into a more professionally managed and institutionally driven market. In addition to Sunterra, industry leaders include major lodging and leisure companies, such as Cendant, Starwood, Marriot, Hilton and Disney, among others. The vacation ownership industry should continue to enjoy strong fundamentals, with a market penetration rate of about 7% domestically and less than 3% in Europe, coupled with the positive demographics of aging baby boomers.

Furthering Sunterra’s momentum will be the nationwide availability by the third quarter of a global “points-based” marketing and sales format. Currently in the U.S., customers purchase vacation ownership units through a deeded interest in a property for a certain number of weeks of usage per year at specific resorts. By selling on a global points based system, in which customers purchase points rather than weeks, Sunterra will significantly enhance its value proposition and its marketing capability to the existing customer base (the best source of new sales) and decrease marketing expenses. (The European unit has operated under a points system for many years and has historically shown marketing expenses as a percentage of sales lower than the U.S. by over 300bps.)

Other factors highlight Sunterra’s solid business characteristics. These include a strong recurring revenue base (about 30% of revenues), including property management fee income (about $30mm); resort rental revenues ($11mm-$15mm); interest income on a $230mm+ receivables portfolio ($26mm+); and other income, including annual Club Sunterra, travel agency commissions and other fees ($20mm). In addition, about 40% of the balance of revenues (comprised of the sale of VOIs, or “vacation ownership interests”), comes from existing customers. Solid barriers to entry exist in the increasingly institutionalized vacation ownership industry, including the significant capital and scale required for multiple properties and global operations, as well as state regulatory hurdles in creating a global points- based system (SNRR labored for two+ years to implement it). Smaller, regional players are finding it difficult to compete, providing opportunities for Sunterra to acquire inventory, portfolios and customers at attractive prices (two deals closed in the last five months). Alternatively, since SNRR is the largest independent operator in the industry, it offers a compelling strategic asset to other lodging and leisure industry companies.

On the acquisition front, SNRR recently announced the purchase of 100% of a premier Hawaii resort that it managed and in which it owned a 23% stake. This property boosts an already impressive amount of resort inventory from about $600m at retail to $835mm at retail, representing almost 2.5 years of inventory. While the company has stated (without specifics) that this acquisition will be accretive, we estimate that it will add about $0.04 per share annually on a fully taxed basis. Importantly, there is no integration risk, since SNRR already manages and sells this property as part of its vacation network.

Based on a stock price of $12.40, a market capitalization of $248mm and net corporate debt of $135mm (excludes debt secured by the mortgage receivable portfolio), SNRR has an enterprise value of $383mm. We estimate EBITDA (our definition of which, consistent with the view of strategic buyers, is after interest expense on debt secured by mortgage receivables) to be $55mm for 2004 and $74mm for 2005, implying multiples of 7.0 and 5.2x, respectively. We estimate fully taxed EPS (excluding non-cash charges related to the reorganization and certain non-cash interest amortization) of $0.99 for 2004 and $1.44 for 2005, implying P/E multiples of 12.5x and 8.6x. A domestic NOL of $137.5mm, worth more than $1.00/share on a present value basis, makes these multiples even more attractive.

Industry transaction multiples have ranged from 7-11x EBITDA; we believe that SNRR would garner a premium multiple, but even applying the low end of the range of 7x 2005 EBITDA implies a $17.50 stock price (based on fully diluted shares included a recently issued convert, warrants and options and including corporate debt related to the Hawaii acquisition). The high end multiple would suggest a $28 stock price. Book value per share of about $10 ($7/share tangible book) also provides support for the stock. In any case, the stock appears attractively valued with earnings expected to grow organically at 25%+ for the near future.

Finally, we note that management has strong incentives to create shareholder value, with two million options struck at $15.25 per share. Following the release of Q1 earnings, management further proved its commitment and incentives, with the CEO and CFO both reporting purchases of the stock at approximately $11.00 per share.

Catalyst

1. Increased research coverage/sponsorship
2. Notes receivable portfolio securitization in July, will free up additional capital
3. Continued strong positive earnings comps
4. Raised guidance at Q2 earnings call to incorporate recent Hawaii acquisition
5. Further strategic property acquisitions