Diamond Resorts (DRII) was written up in September 2014. While I hope this article provides a comprehensive overview of the company, you can see that article for a bit more background.

Diamond is a timeshare company. As I’ll discuss below, the company has been subject to a short thesis that I think is rather overblown. Most of the short thesis can be found in this NYT article, these two posts on SIRF, and these two posts on Buzzfeed.

The short thesis has driven Diamond down to bargain prices, as it trades for a discount to peers and a huge discount to any reasonable multiple given their massive cash flows and strong growth. Diamond is currently exploring strategic options, and a successful resolution could result in 50% or more upside over the next few months. Looking longer term, I actually think the upside could be larger if the company focused on using their substantial FCF to repurchase shares at today’s prices while continuing to pursue their roll up strategy, but I think it’s more likely than not the company is taken private at a substantial premium at this point.

Diamond’s business can be broken into two segments: selling and financing timeshares, and providing ongoing management services to those timeshares. Management services runs on a cost-plus model: basically, Diamond budgets how much it will cost to run a property (i.e. utilities, labor, maintenance, taxes, etc.) and charges timeshare owners that plus a ~15% management fee. This is a great business: significant visibility, high margins, stickiness, etc. Selling and financing timeshares is exactly what you’d expect: get people in the presence of sales person (often by offering them a cheap vacation or gift card), give them a high pressure sale, and try to get them to buy points.

It’s worth discussing the difference between points and fixed weeks. When people traditionally think of timeshares, they think of the old fixed week model where a consumer would purchase a particular week at one property (i.e. I buy the perpetual right to use a specific condo unit during the second week of June). Diamond was one of the first companies to switch to a points based model. Under this model, Diamond takes a group of properties and puts them into a trust. Diamond then sells access to these properties in the form of points to consumers. Consumers can use their points to book access to any of the properties in the trust whenever they want. This has great benefits for both the consumer and Diamond. The consumer benefits because they get access to variety; one year they can use their points to go to a beach property, the next to a ski property, etc. Diamond benefits because they can use the points system to smooth out demand: going to Hawaii during peak season at the end of December is going to cost a lot more points than going to, say, Virginia Beach at the same time. In many ways, the points model internalizes an exchange system like the one offered by Interval International (IILG), and there should be continued benefits to scale in the points system: adding more properties, particularly in new locations, increases the value of the rest of the system by increasing the diversity of properties a member can choose. In addition, a more cynical observer might suggest the main advantage to Diamond is points are easier to foreclose on when consumers default than fixed weeks.

Adding in new properties and locations should create incremental value for Diamond’s current customers; however, at its best, buying standalone timeshares and adding them to Diamond’s network should create significant value for both Diamond and the standalone timeshare customers. Standalone timeshare customers can get access to the network, while Diamond gains a group of customers who have already expressed interest in time shares and can be upsold more points and services. Diamond can also takeout significant costs though back office synergies (reservation systems, accounting, etc.). The recent purchase of Club Intrawest from Intrawest (SNOW) shows a good example of this value creation: Diamond bought the clubs for $85m. Intrawest had done ~$7.9m in EBITDA for SNOW in 2015 (see slide 3), so they were selling at a headline multiple just under 11x, a multiple that makes sense from SNOW’s perspective. Diamond estimates that the purchase price was ~3.9x EBITDA after accounting for synergies; in addition, Diamond purchased a $30m loan portfolio as part of the deal and can use the properties sales centers as another touch point for selling Diamond timeshares to both new customers and Club West’s existing customers. All in, the deal should create huge value for Diamond shareholders given the low after synergy multiple.

However, while their acquisitions have created a lot of value, they’ve also been a big piece of the Diamond short thesis. Part of Diamond’s strategy has been to buy timeshares in bankruptcy, take over the management contract (often after gaining control of the resort’s homeowners’ association), and raise management fees while simultaneously trying to cross sell the timeshare owners on buying Diamond points. Timeshare owners are then faced with the prospect of either paying significantly higher management fees or turning over the keys to their timeshares. Diamond points out that a lot of the bankrupt resorts they buy are in disrepair and the management fee increases are necessary to get them up to standards, but it’s a look that makes for a fantastic NYT consumer abuse article.

The process of taking over defaulted timeshares is common industry practice (typically referred to as inventory recapture or sometimes low-cost inventory), and it makes for great economics. Diamond points out that actually building a timeshare out costs a significant amount of money and exposes you to project level risk. In contrast, recapturing a week from a defaulted consumer has no project risk and provides for a constantly replenishing inventory source (~3% of owners default each year). Diamond estimates the cost of building a development is ~$8k/week equivalent, while the cost of recapturing a defaulted time share is ~$1.5k/week equivalent. Since both weeks sell for the same amount, the inventory recapture is both lower risk and higher margin. Again, this is common industry practice, but Diamond’s practice of buying bankrupt timeshares and raising management fees makes for much worse headlines.

The bankrupt resorts purchase is not the only sign that Diamond is more aggressive than most of their publicly traded peers on a variety of metrics. Diamond charges cost plus 10-15% (their average is 13.9%, per slide 9 of their Q1 investor presentation) for their management contracts, which is at the higher end of most of their peers (Vistana, for example, charges cost plus 9%, and VAC is cost plus 10%, both from their IR presentations). Diamond’s average interest rate on their loans is 14.5% with a FICO score of 756 (Q1’16 slides, p. 12) versus VAC at 12.5% interest and 730 FICO score (2015 annual slides, p. 96) and Hyatt at >715 FICO and 14% interest rates (IILG March Investor Presentation, slide 14). None of that is fraudulent, but it is obviously a sign of a more aggressive management team. Diamond’s management has actually been asked about the higher interest rates and indicated they’ve studied it and given the loans smaller dollar figure and shorter duration (most are paid off in 3-4 years), they’ve discovered that a slightly lower or higher interest rate really doesn’t impact consumer demand (this makes plenty of sense if you think of timeshares as products that are sold, not bought).

Diamond’s aggression expands to the way they report finances as well. Their adjusted EBITDA number is more useless than most, as they capitalize and then amortize the cost of recapturing timeshares. Because they capitalize and then amortize that cost, it gets added back in adjusted EBITDA, making their reported adjusted EBITDA a true “earnings before expenses” metric. None of their peers make this adjustment. However, this is a simple enough problem to solve for: the company reports cash spent on inventory purchases in reporting their cash flow metric, so simply backing that out of EBITDA gets a more apples to apples EBITDA number.

In addition to the aggressive points noted above, most of the short thesis rests on three other points: the possibility of a crackdown by the Consumer Financial Protection Bureau (CFPB), disruption from Airbnb, and allegations that their securitization of timeshare financing is structured as a house of cards on the verge of collapse. You could probably throw the risk of a massive consumer recession in here as well- selling timeshares isn’t going to do to well if consumers are truly crunched, but Diamond did alright during the last recession (adjusted EBITDA of ~$66m in 2008 and $103m during 2009) and the stickiness / cash flow from their management contracts should give them the cash flow to weather another.

The CFPB risk is definitely real. As linked in the buzzfeed article, the CFPB has requested documents from Westgate, and given the liberties this administration has taken with regulation (GM bankruptcy, inversions, antitrust, etc.) it wouldn’t completely shock me to see some form of crackdown, either under this administration or the next one (Hillary might go after them, particularly if Warren is her running mate. Sanders, if he somehow won, would almost certainly do so.  I suspect consumer protection and rule of law would cease to exist under Trump and he has had his name attached to timeshares before so I’m sure he would make timeshares great again). However, all in, I think the CFPB risk is real but low. The industry is already highly regulated and public companies have been pointing out the recent investigations have been targeting private peers, who are much more aggressive in their sales tactics. In addition, the CFPB recently published their policy priorities for the next two years and timeshares were not included. All in, the CFPB risk is more than priced in at today’s prices.

On the Airbnb risk, I think this is overblown. Industry sales over the past few years have continued to increase, and Diamond’s number of tours, close %, and average transaction size are all at or near all-time highs. It’s possible that Airbnb’s effect is understated to date, or that they’ll open up new offerings that are more threatening to timeshares, but so far their impact on the timeshare industry has been negligible and I don’t see much to change that (I think the threat is much more on the lower end hotel segment targeting younger consumers travelling on more of a budget than the core timeshare customer).

Lastly, let’s discuss the house of cards risk. This is the argument most prominent in the SIRF report and the one that I think is farther from reality. The risk can be boiled down to three points 1) DRII is increasingly dependent on selling to current customers, not new customers, 2) Diamond is covering up the weak performance of their borrowers by continuously upselling and refinancing them, and 3) DRII is going to get locked out of the securitization market and it will cripple them.

The new versus old consumer question focuses on Diamond’s sales to new consumers dropping to 21% of last years’ VOI revenue, down from mid-30s in 2011 and versus peers in the mid-30s as well. The argument here is that at some point Diamond can’t upgrade their current customers anymore and the whole thing collapses. While it’s obviously true that Diamond can’t upgrade customers forever, I think a big piece of the difference is caused by Diamond’s acquisition focused strategy, as buying smaller / bankrupt resorts and integrating them gives them a bunch of customers who are ripe for upselling.

The mass default argument has a few points, but the main contention is that Diamond’s borrowers are doing poorly and Diamond is covering this up by upselling customers and using the new loans issued with the upsell to pay off their old, poorly performing loans. I think Diamond’s response to SIRF does a really nice job of laying out why they can’t upgrade their way out of poorly performing loans, but the bottom line is they don’t modify loans that are delinquent or in default into a new loan and the terms of the securitization and warehouse facilities wouldn’t let them even if they wanted to. In addition, loan upgrades and modification still have a cash down payment requirement of 10% of the loan total (i.e. the amount getting refinanced plus the new loan), and it’s difficult to see how a distressed consumer could come up with that down payment. The other piece of the bear argument is that Diamond’s loan book is deteriorating. There is something to this: loans <60 days past due has fallen from 97% at the end of 2014 to 96.4% at the end of 2015 and 94.5% at the most recent quarter. It’s worth noting that most of Diamond’s write offs have historically come from loans that they acquired, so their recent acquisitions could be driving a bit of that weakness; in addition, industry peers have also noted some increase in past due loans, so while the slight increase is less than ideal it’s not earth shattering. I’ll also note that the SIRF piece stresses that DRII’s securitization debt ($642m at 12/31/2015) exceeds the receivables net of reserves on DRII’s books ($622m at 12/31/2015, or $605m if you use SIRF’s number and takeout deferred loan costs) as evidence of potential issues and suggests Diamond would need to fund the difference to make bondholders whole. These are non-recourse so Diamond would have no obligation to come up with cash to fund a shortfall, but Diamond should never have to prove that point as the analysis fails to give Diamond credit for the restricted cash on their balance sheet that would belong to the securitizations (see note 4 of their 10-K; $51m as of 12/31/2015). Adding that amount to the net receivables amount shows Diamond’s securitization holders should have nothing to fear. You can also check peer financials and see that a deficit between the net notes receivable in a securitization and securitization debt is common; for example, VAC reports $681m in net securitizations receivables and $688m in securitization debt (per p. 19 of their 10-Q).

So with the mass default risk (hopefully) addressed, the other risk would be getting locked out of the securitization and/or financing market. This would hurt DRII because running a timeshare company involves a big cash miss-match if customers buy with financing: Diamond sells a timeshare for ~$20k, but with financing they only get $4k upfront and need to pay ~$10k upfront in marketing costs and commissions, so if they were suddenly locked out of financing the business could face a big liquidity crunch. I’m not concerned by this risk for several reasons. First, the securitization market remains strong: Wyndham recently completed a securitization at just over 3% interest, and Westgate just securitized notes at <4% interest right after the CFPB document request / Buzzfeed article. Second, a big piece of the SIRF follow up piece is DRII needed their warehouse facility to finance their loan book while building up to a securitization, and their warehouse partner was unreliable and unlikely to renew and no big bank would step into their place. DRII recently entered into $100m warehouse with Capital One, so their warehouse access should be safe. Lastly, even if DRII were completely shut out of the securitization and warehousing market, they could still operate their business by either self-financing the loans with their balance sheet (>$200m in cash on balance sheet plus their FCF generation would allow them to completely self-finance) or by providing consumers incentives to pay the purchase price fully in cash or pay down loans faster. It’s worth noting the company emphasized cash sales from 2008 to 2011 (financing only ~1/3 of sales) in response to the recession without undue pressure on the business.

There’s one more thing that I think is worth mentioning. At the margins of the short case seems to be a feeling that timeshares are a dirty business. And I can understand that thesis: they are products made to be sold and they’re sold in high pressure situations. But just because they are sold doesn’t mean consumers don’t like them: research shows most consumers who buy timeshares are happy with their purchase (an industry report showed 83% of timeshare owners rate their experience as good to excellent), and anecdotally I’ve talked to several friends who have timeshares and really enjoy them. You can also see consumers like the numbers by looking at their numbers: <5% of costumers default / churn each year, and a big piece of their business is upgrading / making multiple sales to current customers. None of those numbers are consistent with a product consumers don’t like / are stuck with.

So, with all of those risks discussed, let’s talk about upside. At today’s price of ~$20, DRII’s EV (fully adjusted for in the money options) is ~$1.8B. LTM adj. EBITDA is $401m, and management has guided to $430-450m in EBITDA for 2016 (though based on Q1 numbers and the Intrawest deal they’re tracking to beat guidance pretty easily). After adjusting for stock comp and cash spent on inventory, I get LTM EBITDA of $330m and 2016 EBITDA of $350m on the low end. Capex, interest, and taxes (not much here this year given $140m in NOLs) are projected at $85-105m for 2016. That includes some growth capex, but let’s call it $100m to get to ~$250m in after tax FCF. At today’s prices, investors are paying just over 5x EBITDA and ~7x after tax cash flow for Diamond. Diamond’s best comp is probably VAC, as all of their other comps have exchanges or a hotel business attached. VAC is currently trading for ~6.5x 2016E EBITDA adjusted for stock comp and ~9x normalized FCF. Applying a similar EBITDA multiple to DRII would get to a stock price in the high $20s.

Looking at deal comps, IILG recently bought Vistana. When the deal was announced, it was for ~12x adjusted EBITDA. There are a lot of reasons to take issues with using that multiple when comparing to DRII (on the bad multiple side: Vistana came with a bunch of extra goodies that will lower the effective EV and it was a stock deal the saw IILG’s stock drop enough to lower the multiple by 3-4x; on the good multiple side: Vistana was on Starwood’s system and is still on fixed weeks with a plan to switch them to points in the next two years, so the integration risk here is going to be pretty high), but both the IILG deal and Diamond’s own purchase of Intrawest indicate that takeout multiples would result in a share price much higher than today’s. A takeout price anywhere close to either of those multiples would result in a return from here that’s so silly it’s not discussing, but a takeout price at IILG’s post share drop ~9x EBITDA would seem reasonable and would result in a share price in the high $30s.

The company is obviously going through strategic alternatives right now, so a sale is within play, but there’s even more reason to think that a takeout is coming and that the management team might be particularly time sensitive. Management owns a stake in 1818 Partners, which has an option to acquire 4.5m shares (more than 5% of the company) for $12.56 that expires on July 21, 2016 (see p. 53 of the proxy). Management should be highly incentivized to announce a deal at a premium before those options expire so they can maximize the value of those options. Both Marriott and Wyndham have been rumored buyers, but I think an MBO is the most likely route.