• Accounts managed by Kerrisdale currently own shares of Interval Leisure (IILG on Nasdaq), which runs one of the two global timeshare exchanges.
• While we like various aspects of the business and continue to be holders of the stock, the declining customer count concerns us and we’re watching it closely to see if it stabilizes.

In this post, we’re going to write about Interval Leisure Group, Inc. (IILG on Nasdaq), one of the two global timeshare exchange operators. We own shares in Interval and have for over a year. There’s numerous things we like about IILG – it operates in a duopoly, has high free cash flow margins and returns on capital, is valued at a high free cash flow yield, and the company has unique barriers to entry that protect it from competitive threats. That said, IILG is one of our investments that’s “under review”, and although we own it and believe it currently deserves a place in our portfolio, there are several risks that we’re closely monitoring. This is one of those stocks where we like the historical trends, but find it difficult to determine whether those same trends will continue into the future. So far, our research has allowed us to remain comfortable with the stock in our portfolio.

Accounts managed by Kerrisdale currently hold IILG stock, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.

Introduction

IILG’s core business is to provide timeshare exchanges. There are two companies that comprise this sector: IILG and RCI LLC, which is owned by Wyndham Worldwide Corp.

Interval Leisure also owns a resort management business in Hawaii, but it constitutes less than 5% of EBITDA, so we’re not going to spend time on it.

When consumers purchases timeshare interests, they purchase the right to vacation at a certain resort for a specified period of time (ie. 1 week or 2 weeks) each year. They can also choose to swap their timeshare interests with different timeshare owners, allowing them to vacation at different resorts each year. To make that swap, they need to use a timeshare exchange. IILG and RCI are essentially the only two timeshare exchange providers, and virtually all timeshare resort providers belong to one of the two networks.

Click here for a nice chart from a Goldman Sachs research report on how timeshare exchanges operate.

A few features make the industry conducive to an effective duopoly. Each resort operator must enroll its members in a network that has a large number of other resorts. Since IILG and RCI are the only exchange providers, and the two feature 2,400 and 4,000 resorts respectively, it’s nearly impossible for a new exchange operator to break into the duopoly.

From a developer’s standpoint, the ability for members to exchange units is one of the major selling points for timeshares. Thus, it is critical to use an exchange provider with a large network of available properties for customers to swap. This makes Interval’s vast network of resorts a sustainable competitive advantage and barrier to entry; the more people in IILG’s network, the more valuable it becomes.

As a result, IILG and RCI, which have been operational for 30+ years, have enjoyed high margins, high returns on capital and strong pricing power for the past decade. We’ve tried to think through how their competitive advantage could be splintered in the modern era, where internet communication would allow some sort of web startup to break their duopoly. Thus far, no competitor has been successful, and we can’t think of a business model that could. Redweek.com, which is one of the most successful competitors, hasn’t been able to generate a sufficiently high inventory of timeshares to convince vacationers to leave Interval or RCI in large numbers. A look at IILG’s financial statements also gives no indication that online threats are weakening their lock on the timeshare exchange sector.

But we’ll admit that although we can’t conceive of a workable business model that would enable a new firm to steal market share from IILG and RCI, that doesn’t mean that it’s not possible. With innovation and an appropriate amount of funding, it’s possible that a new startup could find a more effective way to bring timeshare exchanges to consumers. This is one of the risks with an investment in IILG.

More Background on IILG

In 2009, approximately 31% of U.S. timeshare owners were Interval members and approximately 44% were members of RCI. Here is a quick comparison of Interval and RCI:

RCI and Interval are different in a number of ways, though it’s not particularly relevant to our thesis. Interval is considered to have more upscale properties than RCI, which results in segmentation of the market depending on price and location. While RCI has a broader range of properties, especially in urban settings, Interval is perceived to have more strength in regional and more rural areas.

IILG makes money in several different ways. Most significantly, it charges members an annual fee, and it charges a fee for each exchange.

The membership revenue refers to the annual dues while the transaction revenue refers to exchange fees that a member pays when making an exchange.

As we can see, revenue has remained stable. That said, revenue is driven by both member count and pricing, and the company has been able to steadily increase pricing to offset member declines since the credit crunch.

Here is a chart depicting their recent trends in members and revenue per member:

It’s the decline in active members that we’re concerned about. Although this decline hasn’t yet generated a substantial decline in EBITDA, IILG operates a relatively high fixed cost model. They have a relatively fixed headcount and IT-oriented cost base, and incremental volume to a large degree drops to the bottom line.

At some point, if the member decline continues, we believe the company would have increasing difficulty using price increases to offset volume reductions.

In my opinion, this steady loss of active members represents the most serious risk to this investment. The company’s view on its member attrition is that the decline in members is mainly a function of weak fundamentals in the timeshare industry. During the pre-2008 boom years, timeshare operators grew rapidly by relying on securitization financing. Similar to the subprime debacle, timeshare buyers would pay only small downpayments, such as 10% of the listed price of the timeshare interest, and would borrow the remainder. This loan would then get securitized. Now, many timeshares are worth much less than their listed price. Given that timeshare owners must pay annual maintenance fees, some timeshares are being sold for as little as $1. Google “timeshares for $1”. If you thought that walking away from a subprime loan was easy, imagine how much easier it is to default on a timeshare loan.

As a result, the easy financing that indirectly helped IILG generate 10% to 20% revenue growth in 2005 to 2008 is essentially gone. Instead, the timeshare industry has been struggling to grow in the past two years, particularly at the low-to-medium-end segment of the timeshare industry.

The future impact on Interval is hard to quantify. Management reported an 88% customer renewal rate in the most recent quarter; this means that approximately 12% of members don’t renew their Interval memberships annually. As a result, Interval must enroll a steady stream of new customers each year to keep membership flat, and its recent declines in membership has been due to muted growth within the timeshare industry. While the company’s retention rate of existing customers has kept steady, new customer enrollment has slowed down. The company is trying to expand internationally to Asia and Dubai.

The key question is whether this muted membership growth is a cyclical or secular trend. It’s safe to say that the timeshare industry will not enjoy the same growth going forward that it experienced prior to the downturn. But IILG’s valuation is low enough that we don’t necessarily need customer growth at this stage. If the customer count can merely stabilize, the company should be worth 8x to 10x trailing EBITDA, compared to its current 7x EBITDA. Given its low capital expenditures, the company is trading at approximately an 8% free cash flow yield.

Another risk to the company is the increasing desire of large resort operators to shift customers to a private label system whereby vacationers are encouraged to simply exchange their timeshares within the operator’s resorts, as opposed to external exchange channels. Marriott, one of IILG’s largest resort operators, recently announced a new program designed to increase intake within Marriott clubs. While no operator is likely to abandon exchange operators altogether, club programs can reduce the proportion of members that decide to enroll with Interval.

The difficulty for us is quantifying the trends. It’s difficult to determine just how much of the timeshare industry was fueled by easy financing. It’s also difficult to quantify how many customers IILG could lose by Marriot or other large resort operators shifting a portion of their customers to points-based systems. It’s furthermore difficult to get a sense of how many of IILG’s customers are being lost to web operators like redweek.com. Here is a chart showing the rate of decline of active members. A lower red and blue line indicate lower decline rates.

As we can see, the decline of active members appears to be stabilizing. But a 4% year-over-year drop in active members, which is what we’ve been seeing for the past two quarters, is still a bit too high for our liking. Management argues that it’s cyclical, not secular, trends that are accounting for the decline rate. Unfortunately, it’s just not sufficiently easy to verify their claims, so the best we can do is to monitor the active member count closely each quarter.

While the number of active members isn’t the only driver of the IILG story, we think that the declining member count will take its toll on IILG’s fixed-cost business model over the long-term. Pricing power and ancillary product revenue can help offset volume reductions for only so long.

Valuation

Here is the company’s capitalization structure:

Next is LTM EBITDA and EBITDA Less Capex for the past 5 years and the most recent twelve months. Note that the company has low working capital usages (as long as it’s not suffering member declines, which would cause large cash outflows due to reductions in deferred revenue).

The company is trading at an approximately 10% unlevered FCF yield and an 8% levered FCF yield. If EBITDA grows even steadily at a 3% normalized annual rate, this is an attractive valuation. Under this EBITDA growth scenario, a more appropriate valuation would be a 6%+ levered FCF yield (ie. a 9.5x EBITDA multiple), which would give us a $20+ stock price.

Management

Interval has been run by Craig Nash since 1999, and Nash has been with the company since 1982. The management team has a strong track record and understands the business well. We like seasoned management teams that have demonstrated over time that they know what they’re doing, and IILG’s team fits that bill. While the company has been public for only a few years (it was spun off in 2008 from InterActiveCorp, which had bought it in 2002 from private equity owners, who in turn had purchased the company from Cendant in 1998), it has been run as a steadily growing and profitable standalone business for the past 10+ years.

Deferred Revenue

For its membership fee revenue, the company receives cash up-front and recognizes revenue over the term that the customer enrolls (customers can enroll for annual terms or for multi-year terms).

Large deferred revenue liabilities can lead to misleading income statements. Specifically, a decline in the business would not necessarily lead to lower membership revenue, because much of membership revenue is based on historical bookings. At the end of the day, it’s essential to monitor the total customer count, as well as the cash flow statement, because the income statement can show stable revenue and EBITDA, whereas the underlying business could be deteriorating rapidly.

Thus far, deferred revenue has remained stable.

Conclusion

For now, we’re holding our shares. There are numerous aspects of the company that we like, and the valuation seems reasonable. But we’re watching quarterly numbers closely.

As usual, this email does not constitute investment advice or a recommendation of any sorts. Kerrisdale Capital may buy, sell or short any of the stocks mentioned at any time. We may be wrong; it would not be the first or last time.

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