Description

Investment Thesis:
Wyndham Worldwide Corporation (“WYN”) is a deeply out of favor lodging business that offers dramatic upside potential in almost all scenarios if you have the stomach to ride it out.  Most of you are probably familiar with this business, so I won’t spend much time describing the various components.  The elephant in the room with this stock is how the financing markets will impact the operations of the timeshare business and whether the timeshare business could somehow bankrupt the entire Company in the absence asset backed financings.  I believe that while there may be significant uncertainty as to how the timeshare business will play out, the scenarios that I can concoct (even a liquidation of the timeshare business at a big discount to book value) suggest meaningfully higher market valuations for the Company.

Brief Business Overview:
WYN has three business segments which are as follows:

• Lodging:  WYN is the largest hotel franchisor in the world, operating franchises including Ramada, Days Inn, Super 8, Howard Johnson  and Travelodge.  The hotel brands operated by WYN are primarily concentrated in the low price “economy” segment of the lodging industry with ADR and RevPar for these hotels in the $60 and $33 range.  The business model is excellent as the Company’s revenues are driven by ongoing royalties and to a much lesser extent initial franchise fees.  Everyone here knows the lodging industry is under extreme pressure so I won’t go into the bloody details on this topic, but I would offer that if you’re going to be in the hotel business the economy segment is probably a relatively decent price point to be positioned at.  I’m not arguing that business will be fine, but I think economy segment is likely to benefit from a small trade down effect.  Further, the business model in this segment is very resilient and will generate excellent free cash flow even in a downturn.
• Vacation Exchange and Rentals:  Vacation exchange refers to Group RCI, which is the largest timeshare vacation exchange business.  Timeshare owners join exchange programs so that they can trade their timeshare week at a resort in Florida for a week in Hawaii or vice versa.  The revenue model here consists of annual membership fees and exchange fees.  Note that even in a downturn, you still own your timeshare and are likely to participate in the exchange program (in many cases you’re automatically signed up for a number of years when you buy your timeshare).  Timeshare has a funny characteristic in that its an owned product – you’ve already bought it, so even if you’re out of a job you’re probably still going to use the week that you already own.  For this reason, exchange revenues have been very consistent even in Q3 for both RCI and Interval (I recommend that you read the VIC writeup on Interval (IILG) for background on the other player in the industry).  In the vacation rental business, the Company acts as an agent on behalf of owners in the rental of vacation properties.  Like the lodging business, these are high cash flow generating business models with high barriers to entry.
• Vacation Ownership:  This is the timeshare business, the source of severe investor anxiety.  WYN is the largest timeshare developer in the world, with other major industry players being MAR, Hilton, Hyatt, Starwood, Bluegreen, Diamond Resorts, ILX Resorts, Westgate and Consolidated Resorts.  WYN will develop resorts (frequently using a developer partner) and then sell those properties in the form of weeklong timeshare interests.

Vacation Ownership Financing

I’ll briefly review the various steps in how timeshares have been built and financed over the last few years (this is in the process of changing):

1)      WYN develops timeshare resort along with adjacent sales offices to market the units

2)      WYN attract visitors to the resorts through adjacent hotels or other marketing activities (“Tours”) and sells timeshare units (representing one week of use in a specific resort) for an average price of about $20,000

3)      WYN will typically extend financing to purchasers of timeshare units in an amount equal to about 90% of the purchase price and a weighted average interest rate of 12.5% and a maturity of up to 10 years

4)      WYN finances this activity through an asset backed revolving conduit facility (“Conduit”) which has an advance rate of 80% on gross receivables

5)      WYN sets up special purpose entities (“SPEs”) which buy a block of timeshare receivables out of the Conduit referened in (5) and finance these purchases by issuing asset backed securities (“Term Securitizations”).  These SPEs typically have 80% advance rates, similar to the conduit facility.  Historically, WYN would do a few of these Term Securitizations per year to make room for new receivables going into the Conduit.

A few notes regarding the foregoing:

• Both the Conduit and SPEs are non-recourse to WYN, yet they are consolidated on the Company’s balance sheet.  So when you look at the balance sheet, you see a lot of non-recourse debt which makes the Company look more leveraged than it really is. 
• WYN acts as servicer for the SPEs, yet there are no potential liabilities that come along with being a servicer for the receivables like was the case with other similar business models such as mortgage servicers.
• Timeshare financing is not subprime mortgage lending.  As the mortgage bubble was forming, the timeshare industry was maintaining or increasing its lending requirements.  There are no teaser rates, negative amortization loans, interest rate adjustments or balloon payments. 
• Timeshare is also not a speculative product that is bought and then sold at a higher price, it’s a product that is bought for use – so unlike the housing market, there is no speculative element that was built into the values and related loans on timeshare units. 

So what has changed?

As the credit market melted away, so did the asset backed financing markets which are the lifeblood of the vacation ownership business.  The Conduit facility is renewed annually on 10/31, which happened to coincide closely with the peak of fear in the credit markets.  Ultimately, WYN was able to get a new Conduit in place, albeit at significantly less favorable terms including a 50% advance rate (vs. 80%) and an interest rate hike of 400bps.  As onerous as the terms were, it actually speaks to the strength of the underlying receivables and the good underwriting practices of the Company that they were able to renew the facility at all.  I haven’t seen many companies be able to raise new asset backed facilities for really any purpose on any set of terms.  So if and when the asset backed financing markets come back to life, WYN will pretty far out in front as an issuer.

The Company’s response to this problem has been to dramatically slow the pace of development and sales in order to maximize the cash flow runoff from existing receivables and limit the amount of new capital that must be deployed to support new receivables.  Initially the Company guided towards a sales pace for 2009 15% below that of this year, which would require the Company to be able to complete one Term Securitization transaction this year.  As credit markets have not improved, on December 8^th, the Company announced a new plan that eliminates the Company’s need to access ths asset backed financing markets this year.  The plan includes a 40% reduction in volume of vacation ownership interests sold.  The Company will therefore be able to maintain liquidity in its vacation ownership business purely by selling down existing timeshare inventory and generating cash from the runoff of the existing portfolio of timeshare receivables.

Valuation

The first step in understanding the value thesis on WYN is to pick apart the different components of the balance sheet to separate out the bankruptcy-remote debt and securitized assets.  I have done this as follows based on the balance sheet at 9/30/08:

In the chart above, column A represents the Company’s balance sheet as stated.  Column B represents the SPEs, which are consolidated for GAAP purposes but as discussed previously represents non-recourse debt.  The resulting balance sheet (C) shows that the Company has $1.5b in net debt that is recourse to the Company.  Note that the Company’s recent guidance for EBITDA in 2009 is $790-840mm (2.1x Total Debt/EBITDA). 

In column D, I calculate an adjusted book value for the Vacation Ownership business.  The purpose of this exercise is to think about value in a liquidation scenario, which is the worst case scenario for valuation purposes.  The main assets here are unsecuritized vacation ownership receivables and inventory.  For the vacation ownership receivables I value these at 80%, which corresponds to the advance rates that banks have lended at until recently (I view the recent 50% advance rate as more a function of dislocation in the credit markets than an indicator of value).  Also note that the balance sheet numbers are net of the Company’s normal level of reserves that they take against receivables, which has been conservative historically.  So, I’m taking a 20% haircut that is in addition to the 10% haircut that the Company uses for its own reserves.  With respect to the timeshare inventory, these assets are more speculative, but I think some value is justified.

The table above shows my assumptions on inventory valuation.  It is worth noting that VOI inventory typically represents only about 25% of the related timeshare sales (the $645mm of completed inventory would typically represent ~$2.5 billion of timeshare unit sales). 

The enterprise value of the Company is as follows and I also show the implied valuation of the Lodging and Exchange business as the enterprise value less the adjusted book value of the timeshare business.

The combined EBITDA of the loding and vacation exchange businesses is $537mm ($229 and $308 respectively).  Using a range of assumptions on appropriate multiple for each business, I calculate the following range of values for the stock:

For me what makes this investment really interesting is that the Company doesn’t have to do anything spectacular to achieve some of the outcomes shown above.  The securitized assets are tucked safely away in bankruptcy remote entities.  All we’re talking about here is getting a small recovery on the unencumbered timeshare assets that have no debt on them – so you can make assumptions about cumulative default rates on the consumer finance portfolio or recovery values on the inventory, but they’re not leveraged and they are pretty decent assets, so I think the chances of getting zero value out of timeshare is pretty remote (and if you did, I still think there is a strong case that this stock is worth much more than the current price).

So there are lots of obvious reasons to sell this stock right now: 1) seemingly high leverage, 2) exposure to asset backed securities, 3) exposure to consumer finance, 4) exposure to consumer spending, 5) exposure to a struggling hospitality industry etc…  But as I look at the numbers, I see perhaps a lot of uncertainty as to how this situation plays out, but I don’t see a tremendous amount of risk to the downside looking a little farther out.  After all 2/3 of the business are excellent, high cash flow generating business models.  With respect to liquidity, if the asset backed markets never come back and the end markets are even weaker than the already weak expectations, all the Company has to do is continue to retreat from the business and focus on liquidating the assets – a path the Company is already taking. 

Oh, and how could I forget – management is in the market buying stock, both the CEO and also the head of the timeshare business - a nice confidence booster in the market!

Look forward to your questions…

Catalyst