|Shares Out. (in M):||86||P/E||0||0|
|Market Cap (in $M):||1,497||P/FCF||0||0|
|Net Debt (in $M):||581||EBIT||0||0|
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Hilton Grand Vacations (HGV) Long
Intro / Preface
Fear and technical factors have overtaken many areas of the market in recent weeks, resulting in increased correlation, a lack of security-level analysis, and numerous price inefficiencies in select areas. Of all the long opportunities currently presented, we believe Hilton Grand Vacations (HGV) is the most compelling. While the idea has been written up previously on this site, we believe we have substantial material and analyses to add, both related to the current environment and as pertains to the long-term value of the enterprise.
Down nearly 50% YTD vs. the SPX -13%, HGV is perceived to be at the nexus of a trifecta of currently dreaded exposures – credit-exposed, discretionary travel, and complexity – however, reality upon a more discerning analysis reveals a business that is well positioned to navigate current disruptions and thrive on the other side. We believe the company’s conservative leverage, superfluous liquidity, and the recurring aspects of key business lines are being overlooked amidst the market mayhem, presenting an exceptionally attractive long opportunity. While there is certainly an element of complexity associated with its mix of balance sheet and services-based businesses, the underlying business model is simple and compelling, as we will elucidate below. This perception/reality gap, exacerbated by technical/ownership factors (merger-arb dynamics) and likely forced selling, have resulted in an extraordinary risk/reward that we have seldom seen.
HGV currently trades at 4.5x EV/pre-COVID EBITDA, CapEx is minimal, a significant portion of earnings are recurring, and unlevered cash flow is likely to snapback rapidly post-COVID and grow healthily from there. Our base case suggests 2.5x upside, with a realistic upside scenario providing >3x. Importantly, should HGV never sell an incremental timeshare unit (a scenario we view as implausible), we believe there is nearly 50% upside to intrinsic value. As an alternative means of assessing the margin of safety, if the market simply priced HGV at direct peer VAC’s unlevered multiple, the equity would be 75% higher by our math (we believe a premium to VAC is warranted for reasons we will outline). At current prices, the only scenario we can envisage where capital is permanently impaired would be if BOTH: (a) high-credit-quality customers go bankrupt at unprecedented rates AND (b) leisure travel is dramatically impaired, permanently.
While we normally wouldn’t spend much time discussing the credit profile of a company with such a conservatively capitalized balance sheet and robust liquidity position, given what is being priced in and the market’s seeming trepidation, we will walk through upfront the (fairly simple) capital structure, which upon a discerning review should provide significant comfort. This conclusion alone, which we believe the market will imminently appreciate when participants have time to come up for air, should drive a dramatic re-rating of the security. We’ll follow-up with the unique attributes of HGV that we believe are underappreciated and make it a long-term winner. Among the more salient historical data points demonstrating HGV’s position is its remarkably consistent track record of growth – including 27 consecutive years of growth in net owners – a testament to the power of the Hilton brand and the company’s compelling product offering within the space. This position of relative strength situates the company extremely well when travel returns.
Why Does this Unique Opportunity Exist?
Perception vs. Reality Disconnect: The Trifecta of Irrational Fear
Dislocation Exacerbated by Forced Selling / Turnover of Holder Base
During late 2019, HGV was “rumored” (heavily reported by multiple press outlets) to be undertaking a sales process, which was reported to be receiving robust interest from both financial and strategic buyers. While they reportedly received bids in the ~$40 range, newsflow has gone quiet and in all likelihood the process is on hold. This is likely due to some combination of: (i) HGV’s own confidence in its outlook suggesting these prices under-valued the company, (ii) potential hold-up by HLT (they have the effective right to approve or veto a sale), and (iii) recent market disruption.
The sale dynamic undoubtedly drew interest from the event-driven (merger-arb) community. As has been widely reported, deal spreads blew out to near unprecedented levels in March due to the market dislocation, with this community taking meaningful pain and de-grossing accordingly. In addition to the first-order impact of merger arb de-grossing, HGV has likely been particularly impacted. This disproportionate impact is related to: (i) the relative illiquidity of HGV (it has been trading ~$10 - $20mm ADV recently) and (ii) merger-arb funds refocusing on announced deals, with full spreads by historical standards, that have near certainty of closing.
The washing out of these short-term hands, many of which were unlikely to have done the deep fundamental work required (or to be interested in the long-term value proposition), has almost assuredly exacerbated recent pressure on HGV’s stock price.
Outline of Key Thesis Points
Quick Business Overview
HGV effectively operates four interdependent-yet-distinct businesses, which align with its reporting segments. While the mix of both service-based and balance-sheet-driven business activities within HGV does create somewhat above-average complexity, the company provides enough information for a discerning investor to assess and value each business more-or-less independently, something the market does not currently (but certainly should eventually) seem willing to do.
Below is a brief overview of HGV’s core business lines, and the primary ways each makes money:
Importantly, we see scope for high-return long-term growth in each of these business lines. Further, while some activities are likely to experience short-term travel-related cyclicality, we believe the market is grossly underestimating the durability of much of the business, and in particular the fee-based Management segment, which benefits from contractually obligated and essentially fixed fee arrangements. In our view, the market is far too fixated on potential near-term variation in VOI contract sales, and as a result overlooking: (i) the financial stability of key business lines in the short-term and (ii) the long-term growth prospects of the business as a whole.
THESIS POINT 1: Well-Positioned to Weather Current Disruption: on absolute basis, vs. timeshare peers, and particularly vs. the broader travel & leisure
1a) Fortress Balance Sheet: Conservative Financial Leverage and Superfluous Liquidity
We admittedly feel a bit silly discussing in such excruciating detail the credit and liquidity situation of a company we believe to be so conservatively positioned upon a legitimate analysis; however, given the market context, here goes…
As background, HGV has two components of true (i.e. recourse) debt. In addition, HGV has non-recourse debt (reported on balance sheet, but totally non-recourse to HGV and held in bankruptcy-remote trusts) used to monetize/finance its timeshare receivables at favorable rates.
The non-recourse debt, which is backed by financing receivables, is held in bankruptcy remote trusts, and interest on this debt is included as an expense in EBITDA. As such, it is properly excluded from parent company leverage ratios. Importantly, as of 12/31/2019 (the most recent balance sheet, which one would see on Bloomberg), HGV had under-utilized its financing receivables balance. This was evidenced by HGV’s Non-Recourse Debt / Financing Receivables balance of 65% (vs. peers at 80 – 90%), and its undrawn Warehouse Facility. During Q1, HGV rectified this temporarily under-utilized asset, drawing down ~$200mm of its Warehouse Facility. Notably, this simply brings HGV in-line with peers (actually 540 bps lower than VAC) at 82% Non-Recourse Debt / Financing Receivables. If anything, we believe this asset (Financing Receivables) is still under-utilized, but have not assumed increased utilization. If we were to assume HGV’s utilization were to be in-line with VAC, it would increase the 75% upside previously cited to VAC’s multiple (one of many sources of conservatism included throughout our analyses).
Conservative Financial Leverage: 1.3x Net Debt / EBITDA and Plentiful Covenant Cushion
HGV benefits from entering the year with a conservatively capitalized balance sheet both on an absolute basis and relative to industry peers, with both lower net debt / EBITDA and a lower proportion of its net receivables balance monetized via securitization transactions. This advantaged starting point allowed HGV to meaningfully bolster liquidity in March while also decreasing its net leverage ratios.
Prior to drawing down its Warehouse Facility, HGV had 1.7x Net Debt / EBITDA (vs. peers at 2.5x). Following the drawdown, HGV had leverage of 1.3x Net Debt / EBITDA (again, vs. peers at 2.5x). As discussed above, this drawdown on its Warehouse Facility simply moved HGV’s utilization of its Financing Receivables asset to the low-end of peers. In the table below, we walk through the impact of 1Q20 actions below to illustrate this dynamic, which highlights the advantage of HGV’s previously preserved receivables-backed firepower.
In terms of covenants, our analysis again suggests more than ample cushion. Even the stress test we will outline further below, which we believe to be extreme and unrealistic, suggests a material cushion. The key insights are that: (i) the only financial maintenance covenants that could in theory cause an acceleration to HGV are in the bank debt, and (ii) the primary such covenant is a first lien covenant. While the notes do contain financial ratio covenants (which we believe would also require unrealistic scenarios to breach), these would only trigger certain benign restricted payment provisions.
While we believe many of the above/below conclusions would readily be reached in a normal market environment, perhaps the combination of market chaos and investor turnover has overwhelmed rational analyses in recent weeks.
Superfluous Liquidity: $700m Cash Balance, >5 years in Unrealistically Dire Stress Test
Reflective of the liquidity actions taken in March (PRs here and here) HGV now holds ~$700m of cash, more than enough to see it through the current crisis. We estimate that even in an unrealistically dire scenario where sales activity and rental income remains at zero, but the company continues to invest in new inventory development (which is unrealistically punitive), HGV’s current cash position could allow it to operate without tapping the capital markets for >5 years due to this significant cash balance and more resilient earnings streams discussed below. While our base case anticipates that sales and resort operations start to ramp back up in the third quarter, there is clearly uncertainty, and HGV’s ability to operate for the foreseeable future without needing to access fickle financial markets is a key source of downside protection, and rules out any potential for a disadvantageous capital raise which could impair current equity-holders’ ability to participate in the forthcoming recovery.
1b) Underappreciated Business Model Resiliency
Substantial Recurring Earnings Streams Independent from Incremental Timeshare Sales
Unlike many of its peers in the broader travel and leisure comp set, HGV has substantial earnings streams which are effectively recurring in nature, and which are likely underappreciated by many investors. Among these are annual fees paid by owners for property maintenance and club membership, which are due irrespective of usage and paid at the beginning of the year. These fees contribute the bulk of earnings in the “Club and Resort Management” segment, and on 03/21 HGV disclosed that it had already collected 90% of member fees for 2020. Accordingly, we expect this segment to be largely insulated from the current travel hiatus.
Next is financing, which represents interest paid to HGV on financed timeshare purchases, net of the interest expense associated with securitized receivables. While this earnings stream is insulated from the first-order impacts of the travel restrictions, there may be concern that HGV will be subject to a wave of defaults triggered by Coronavirus-induced economic hardships, impairing earnings. While defaults may tick up marginally, history and our diligence suggest the impact will be easily manageable. HGV has premium product within the industry, and a credit book that reflects this, include 730 average FICO scores, best in class historical default rates, and average borrower household income of ~$150k. According to the company, quarterly defaults during the Great Financial Crisis peaked at an annualized rate of 6.8% (compared to peak quarterly credit card charge-offs of 10.5%).
Together, these two segments generated >$250m of EBITDA in 2019, or 45% of segment EBITDA. Out of conservatism, we meaningfully haircut this figure in our stress test below.
Highly Variable Cost Structure with Low Capital Intensity
In addition to these recurring earnings streams, HGV benefits from a substantially variable cost structure. The largest single bucket of expenses is Sales & Marketing (61% of non-license fee expense base), which primarily consists of sales commissions and the costs associated with prospective owner resort visits. These expenses effectively go away for as long as sales activity is suspended, and resorts are closed. Additionally, royalties payable to Hilton (“Licensing Fees”) are largely calculated as a percentage of revenues, and as such will fall in lock-step with revenue.
The key bucket of “fixed” expenses is G&A, which represents ~$90m of cash expenses annually, and here the company has already taken significant steps to reduce costs in the near-term, including reducing executive and director compensation and furloughing employees during the second quarter.
Finally, we believe the capital intensity of the business is potentially misunderstood by the market. While HGV has been investing in significant inventory in excess of COGs, which has been a drag on FCF on at trailing basis, the economic expense of this inventory is reflected in EBITDA, as inventory costs associated with contract sales are booked in COGs. Actual capex requirements for HGV’s business are quite minimal at ~$50-60m per annum or <15% of EBITDA.
When considering the largely variable cost structure and the cost reduction actions being taken by HGV corporate, we believe that the disrupted segments of HGV’s business (Real Estate sales & Rentals) can likely operate at close to breakeven during the crisis, and are very unlikely to incur substantial losses.
Taken together, we expect the cash flow streams from HGV’s recurring business, limited (if any) losses in the disrupted segments due to variable cost structures, and G&A reduction actions to allow HGV to continue to generate positive EBITDA and FCF through the crisis, before accounting for growth inventory spending. While these inventory investments (now expected to be $200m in 2020, down from $400m pre-COVID) represent real cash outlays, they are not recurring into perpetuity, and could likely be modulated significantly further downward in the event of prolonged disruption from the virus. However, even if HGV maintained its $200m / year inventory spending, we estimate that cash on hand gives the company >5 years of runway in the current environment. We’ve outlined this sensitivity below:
THESIS POINT 2: Structural Advantages Position HGV to Continue Industry-Leading Growth and Value Creation Post-Pandemic
Long-term Track Record of Outperformance
It’s important to emphasize that HGV is a differentiated operator within the timeshare industry. This is evidenced by a broad mosaic of data, including past financial results, owner satisfaction rates, and industry surveys. A prominent industry study backed by Cornell University’s prominent School of Hotel Administration found HGV to be the top reviewed Upper Upscale brand, and the only one to exceed a >90% “online reputation score”, based on online guest reviews from across the internet. Importantly this is not a timeshare industry exercise but compares HGV to a broad pool of similar caliber resorts and hotels.
A more financial-oriented indication of this outperformance is HGV’s substantial and long-dated track record of outgrowing industry contract sales, resulting in persistent market share gains. HGV’s market share of contract sales has expanded from ~5% in 2007 to ~14% in 2018. Impressively, while the timeshare industry as a whole saw sales fall -35% in 2009, HGV’s sales fell just 3%, and while industry sales have yet to recover from pre-crisis levels, HGV’s sales have more than doubled with HGV capturing more than 20% of total industry growth during this timeframe. This is well illustrated by the following slide from a recent HGV investor presentation:
Hilton Affiliation: Preeminent Leisure Brand & Massive Customer Acquisition Funnel
A key driver of this success, and the primary reason we expect outperformance to endure, is the strength of the Hilton brand itself, and HGV’s exclusive marketing access to Hilton’s 99 million (and growing) loyalty program members.
Per consultancy Brand Finance, Hilton not only owns the world’s most valuable portfolio of hotel brands, but the Hilton Hotels & Resorts brand specifically (with which HGV is most closely aligned) is the single most valuable in the industry. The strength of the Hilton brand, its association with luxury travel and the trust this implies consumers have in the brand are huge advantages for HGV and are effectively impossible for competitors who aren’t affiliated with major brands to replicate. Financially, we believe the Hilton affiliation is a key reason HGV commands industry-leading transaction values and sales conversion rates, which together drive leading sales volume per tour (VPG) which translates into development margins which are best in class on a reported basis, and even higher when adjusted for HGV’s mix of lower-margin fee-for-service business (which we will discuss further below):
Moreover, Hilton Worldwide (HLT) has leveraged this brand strength into a sustained position as the fastest growing major hotel system in the industry, with system-wide rooms growing 6-7% per annum in recent years, and members of Hilton’s Honors loyalty program growing at a 20% CAGR the last three years. As the global hotel industry continues its organic consolidation, HLT is very well positioned to continue to gain share within the industry, further benefiting HGV as an increasing number of travelers become familiar with the brand, engage with its loyalty program, and thus become increasingly likely to consider an HGV tour package, and ultimately a VOI purchase.
The Under-Appreciated Key Value Driver: NOG and Building the Base of High Value, Recurring Fees
In addition to the structural advantages conferred by HGV’s access to the Hilton brand, we believe the company has an underappreciated strategic advantage in the form of its long-term focus on net owner growth (“NOG”). While other timeshare owners have seen flat-to-declining numbers of total owners, HGV has delivered a remarkable 27 consecutive years of growth in net owners, and growth has remained robust at 7% per annum over the last five years. We believe HGV’s long-running track record of owner growth is also a powerful indication of the value that customers find in the company’s product offering, and the satisfaction they get from their purchase.
The trade-off to HGV’s strategy is that it defers profit dollars in the near-term in exchange for stronger growth and higher margins over the long-term. This is because sales to new owners are more marketing intensive than sales to existing owners. As an aside, this makes HGV’s previously discussed market-leading VPG all the more impressive, as adjusted for the new-vs-existing sales mix, HGV’s like-for-like sales efficiency advantage would be even greater. The long-term benefits of HGV’s strategy choice, however, are numerous. New owners highly predictably generate incremental future VOI sales, as they buy additional, or upgrade their existing, VOIs. More importantly, net owner growth is the key driver of HGV’s recurring Resort and Club Management earnings stream. Through steady annual price increases and increased customer utilization of HGV’s resort network and points system, the company has very consistently driven growth in annual fees per owner, which compounds with owner growth to result in very substantial growth in this highly attractive, capital-light fee stream:
This segment in particular is important to the long-term potential of HGV, as its economic characteristics are effectively similar to a growing annuity, replete with annual price increases and negligible capex. If the reader were to have one takeaway from this write-up (aside from how well-capitalized the business is), it would be the underappreciated value of this recurring cash flow stream (particularly in a 1% interest rate world!). We believe an appropriate comp is property-services business FirstService (FSV), which has historically traded for 16-22x EBITDA. Capitalizing HGV’s Resort and Club Management earnings at a similar multiple implies $1.6-2B of value for this segment alone, compared to a current total Enterprise Value of ~$2bn.
Margin Tailwind from Business Mix Shift to Owned Development
After several fits and starts, and notwithstanding the current industry disruption, we believe that HGV is poised to finally see the benefits of its strategic decision to bring an incremental portion of its resort development back on balance sheet. This has been widely covered by management, and sell-side, so we won’t go too deep into the weeds here, but after operating with a largely fee-for-service development model while owned by Blackstone and subsequently as a subsidiary of HLT, HGV has decided to recapture the benefits of this high-return development spending for itself, ramping investment in owned resorts over the last several years (which spend is now an asset, not a liability). As a result, whereas <50% of contract sales in 2019 were VOIs at owned resorts, >60% of HGV’s current inventory and >76% of its long-term pipeline consist of HGV-owned developments, implying a substantial future mix shift of VOI sales towards owned properties.
This mix shift will benefit HGV in two ways. First, HGV will capture the full developer profit pool, rather than just a sales commission. We believe for a given $1 of contract sales, an owned property contributes $0.10-$0.15 higher profits than a fee-for-service sale. All else equal, shifting the contract sales mix from 45% owned to 75% owned would have driven a 10% uplift to consolidated Adj. EBITDA in 2019 (excluding any financing benefit).
Second, HGV does not have the opportunity to finance the VOI purchase unless it owns the property, so this mix shift will also significantly increase the financing opportunity available to HGV. This is not only further accretive to EBITDA, but when considered on an NPV basis, materially increases the total value captured by HGV in a given transaction, as illustrated below:
Insulated from Historical Industry Reputational and Operational Issues: Premium Product, High Income and Credit Customers, Sound Marketing Practices, and High Customer Satisfaction
The timeshare industry as a whole has a bit of a checkered history and is rightfully regarded with skepticism by many communities. Here, we think there are two important points as it relates to HGV. First, as a result of regulatory intervention, many of the most objectionable sales practices of the past have been largely addressed. That’s not to say there aren’t still bad actors, but the industry has clearly come along way from its wild west origins.
Second, and more importantly, all evidence suggests that HGV is a responsible player, and that its owners are largely very satisfied with their purchases. As previously discussed, HGV’s robust NOG, and the propensity of owners to upgrade are powerful indicators of this. The Cornell study and other ad hoc owner surveys are as well. Another interesting measure of owner satisfaction is the high typical utilization rate HGV sees for its properties – typically north of 80% -- much higher than comparable chain-scale hotels.
Additionally, HGV’s credit metrics tell a similar story. Its owners are affluent ($150k average income), and credit-worthy (740 FICO). Historical annualized default rates have been low ~5% or lower, and as previously mentioned peaked at an annualized quarterly rate of just 6.8% during the Great Financial Crisis.
Improved Competitive Dynamics and Value Proposition Post-Pandemic
Finally, while there are understandable concerns regarding how the significant ongoing economic disruption could impact discretionary travel spending, there are a number of reasons to believe that timeshare activity will bounce back faster than other verticals.
First, and most powerfully, is that current owners already have equity in their timeshares – they have effectively prepaid for their vacations, and therefore have a huge incentive to return to HGV’s resorts as soon as it is safe and practicable to do so. HGV’s CEO made this case on the company’s recent 4Q earnings call (emphasis added):
Moreover, there is a more qualitative, though still potentially powerful case that timeshare could be a relative share gainer within travel. Cruises as an alternative are likely to be challenged by safety concerns given the high profile instances of COVID-19 spreading among cruise passengers (although, remarkably, there is evidence that forward cruise bookings are proving resilient, which we view as a positive read-through for timeshares). Additionally, Airbnb is not only in borderline financial distress, but we would expect that heightened safety concerns will likely cause consumers to increasingly value branded institutions such as HGV over independent homeowners with unknown cleaning and sanitization policies.
While impossible to quantify, we see these factors as supportive of a base case in which the timeshare industry leads the forthcoming leisure travel recovery.
THESIS POINT 3: 4.6x EBITDA Entry Point Creates Exceptional Return Skew (Base Case: >150%, Upside Case: >200%, Run-Off Scenario: +48%)
We will frame HGV’s valuations using several methodologies below. Ultimately, all these methodologies lead to similar conclusions: we don’t have to believe much to return multiples of our money, and the security has significant downside protection at current prices. This second point, in particular, differentiates HGV from other beaten-down, travel exposed names.
Margin of safety:
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