Marriott Vacations Worldwide (MVW), stock symbol VAC, is the recent spinout by Marriott International of their Marriott and Ritz-Carlton branded timeshare business.  Some of the usual spin dynamics are at work, in particular the creation of an orphaned stock, as the ten to one stock spin has resulted in close to a twenty to one ratio of market caps.  Post-spin enterprise value of under $600 million contrasts with $550 million of already completed and/or incurred new construction, not to mention the over $1.3 billion worth of net historical Marriott investment—a number which has already been written down to current market levels so that the parent could recognize the tax losses before the spin. 

In addition, the company has considerable excess undeveloped land and assets that it has chosen to sell over the next few years, targeting disposition of $150 million to $200 million in surplus assets.  On top of that, drawing down the excess inventory of recently completed construction can result in $300 million of further cash flow.  As a result, there is the potential for tremendous cash flow from this combination of inventory draw down and surplus asset sales, before normalizing back to an annual $50 million cash flow on EBITDA of greater than $100 million. 

On a forward basis, this has the potential to drive forward EV/EBITDA from currently 2012e 4.0x (excluding the monetization of excess undeveloped land) down toward even more compressed levels.

In addition, MVW has several possibilities for significant operating improvement, as the Luxury and European divisions combine for recent operating losses, and the company operates at less than half the adjusted profit margins of the timeshare division of industry leader Wyndham (WYN).  While some investors believe that Marriott is using this spin to exit the timeshare business, the Marriott family retains substantial ownership interests in the spin.  For those with a long memory, this isn’t Marriott’s first foray into spinoffs.  In 1993, Marriott spun off Host Hotels and Resorts, which today has annual revenues approaching five billion dollars.  Three years after that split, both Marriott and Host stocks had more than doubled.  The former CEO of Host is on the board of directors, as is Bill Marriott’s daughter.  I’ve read that the Marriott family owns about 20% of the business, and Bill Marriott stated that he has no plans to sell any shares in the spin.

FIRST, A WORD ABOUT CATEGORIES AND VALUATION:

My first thought about the timeshare business as an investment is Really?  Can I get these days and hours back of my life?  How does one even classify this business?  Is it a consumer lending business, with a product whose attractiveness is overstated, a product that is sold, not bought?  Is it a land bank, stuck with expansion plans and excess property going back to 2007’s high ambitions?  Is it a lodging business for the Hotel California, where the customers can check out but they can never leave, because they own it and can’t sell it?  And if they want to rent it, they have to pay a cut to the company to do so?

I’ve looked at land banks—St. Joe, Howard Hughes Corp, Tejon Ranch, etc., and the assumptions around monetizing the land always seems like guesswork.  VAC makes the land bank part of the valuation easier by having marked down the assets to current market values, and committing to the monetization of some of these assets. 

While the loan spreads seem outrageous at first glance, the financing business is not as one-sided as you might think.  First of all, many customers pay cash, or pay off the loan rather quickly.  Secondly, one of the highest sources of revenue are repeat customers, particularly in points programs, where the owner can use time at any number of properties rather than just be committed to one specific time segment as a fractional owner in a deeded property. 

Finally, is it a lodging business?  After all, VAC is a spin out from a reputable lodging business.  The dynamics are a natural extension for many of these lodging businesses, as Marriott, Wyndham, Disney, Hilton, and Starwood all have decent footholds in this very fragmented industry.  However, no analyst gives the timeshare business a lodging multiple.

LET’S TALK ABOUT TIMESHARES WITHOUT ANY SALES PEOPLE AROUND:

Marriott Vacations Worldwide sells vacation ownership products, i.e., timeshares.  In 2010, this represented 50% of revenues.  They also manage the resorts and provide services for owners/members (18%).  They finance the consumer purchases of the timeshares (15%).  They also rent timeshare inventory (15%). 

These are quality locations, often closely located with other Marriott or Ritz-Carlton properties.  While timeshares have a reputation for aggressive salesmanship and exaggerated economic benefits, the basic value proposition for customers, in my opinion, is slightly positive.  About a decade ago, I looked at a Walt Disney World timeshare, and I concluded that if one was committed toward vacationing every other year at one of their eligible properties, which admittedly is quite an assumption, then it was straightforward to calculate the investment merits.  The corresponding hurdle rate for buying the timeshare versus paying one vacation at a time and then investing the difference was about an eight percent IRR. 

I’ve seen other calculations that assume for a typically financed timeshare, the real rate hurdle represents about a five percent real return.  For someone who was tied to a particular destination (or sets of destinations for points-based programs), premium timeshares make sense as a second-home alternative.

Of course, second homes have dubious financial merit—but you can’t take it with you, and hopefully, we all vacation and enjoy favorite destinations.  A friend was looking into one of their Ritz-Carlton properties, and it too had its economic merits.  I throw all of this out there because without these merits, the whole timeshare business is built on shaky ground.  This isn’t the place to convince anyone, but it does make sense to examine the unit economics for the purchaser before dismissing this entire industry.  Beyond that, it is an emotional purchase—the commitment to vacation, the familiarity of a destination, or the quality of a group of destinations.  If you talk to someone with a timeshare, they often cite reasons that are typical of vacation home owners. 

A FEW KEY NUMBERS:

2010 Contract Sales: Total $705 million

• North America: $530 million—sell existing inventory, complete phases under construction, and monetize excess undeveloped land.  Add new inventory over time.
• AsiaPacific: $68 million—expand.
• Europe: $63 million—sell remaining inventory and then just manage the properties.
• Luxury: $44 million—monetize excess land, and expand through affiliations (asset light).

VAC has a large amount of finished ownership inventory on hand—North America Inventory:

                                                                Year End 2011E

                                                Incurred               Potential Spend

                                                -----------------    -------------------

Completed                              $320 million                       --

Under construction                $230 million                       --

Cost to complete                          --                     $125 million

Futures phases                     $275 million                       --

Cost to complete                         --                     $1,335 million

                                              -----------------      -------------------

Total                                      $825 million          $1,460 million

What jumps out here is that with an additional $125 million spend, they will have $675 million in incurred completed construction—which they estimate has future contract sales of $1,770 million.  (See any of their spin-out filings or presentations for more information.)

Capital Efficiency of Points Program—Launched in June, 2010:

• Switching from specific time slots to a points program generated $46 million of enrollment fees (the cost of switching).
• VAC has over 365,000 owners with 550,000 weeks—over 83,000 owners enrolled over 153,000 weeks in the points program so far.
• Allows any location to sell points, regardless of inventory availability at their particular site. 
• High conversion rates for those who tour onsite—47% enrollment, of which 30% purchased an average $17,000 of additional points.
• Allows owners to bank/borrow points, which increases timing and destination flexibility.

 Ownership Demographics and Data:

• 95% are homeowners
• $150,000 average household income
• 80% college educated
• 75% married
• Average age is 56
• Owners purchasing additional product has ranged between 4.3% and 4.6% from 2005 through 2010, with the exception of a dip down to 3.3% in 2009.

 Optimization Potential:

• In theNorth Americasegment, VAC has 10,810 units, 94% of which are sold and 6% are unsold.  But owner usage is just 75%, leaving 5.5 million keys available.  This leaves optimization potential for the lodging business. 
• VAC has 12,764 total units, with plans to add an additional 2,716 units.  900 units are currently available for sale with 69% in North America, and the rest spread somewhat evenly across their other three operating segments (Asia Pacific,Europe, and Luxury).

Consumer Financing Key Data:

• Loan coupon of 12.5% to 13.5%, with no prepayment penalties, average term of 10 years, minimum down payment of 10%, low monthly payments (approx. $315), and average FICO score of 737.
• Note securitization terms: first half of 2010, sold $229 million of notes, advance rate of 95%, weighted average coupon of 13.2%, investor return of 3.6%, excess spread of 9.6%.
• At the end of the first quarter of 2011, only one pool of thirteen securitized notes receivable pools outstanding was not meeting performance thresholds.  As a result of performance triggers, a total of $2 million in cash of excess spread was used to pay down debt.
• Non-recourse debt on March 25, 2011 totaled $944 million.  As of 2010, the accounting treatment for time share securitizations changed due to changes in FAS 166/167.  This brought these vehicles back on the books, whereas before, they were moved off balance sheet with a gain on sale.  Currently, everything remains on the balance sheet and interest income and expense is recognized on the income statement.  Many investors are familiar with the changes brought about by this accounting treatment, which typically resulted in no cash flow impact.

Margins have room to improve:

• Management is targeting marketing and sales expenses to return to historical 42% to 46%, from 2011e of 49%-51%, and versus 2008-2010 average of 55%.  (See slide 102 of their October 28^th analyst day presentation.)
• 2011e profit margins are 9% to 13%, with management targeting the long term goal of 20% margins.  This will be aided by decreasing marketing and sales expense while also reducing the product mix contribution of the lower margin luxury brand business (Ritz-Carlton), which along withEurope, is being operated without growth initiatives, unless they were to come from affiliate branding via an asset-light approach.  (ibid, slide 103.)
• At least one competitor (Wyndham) has profit margins that make VAC’s long term goals seem quite attainable.

TAKING A STAB AT VALUATION:

There are some very sharp analysts on VIC.  I don’t pretend to be among them.  I never use targets, except when I want to embarrass myself.  I don’t understand most of the writeups on this site.  If you took five analysts or VIC members and sat them at the table with me, I have no doubt I’d be the top candidate to be the patsy.  Most of you who have read this far won’t argue with me.

Therefore, something has to be relatively simple for me to feel that there is an investment case.  Ideally, the company would own readily marketable excess assets and/or inventory that would justify most of the valuation.  Furthermore, these assets should have current earnings power, lest they be value traps.

With a current enterprise value of under $600 million, and incurred construction costs of $550 million inNorth Americaalone, it feels like the asset base is part way there.  Furthermore, even after a writedown to current market values, post spin, the book value appears to be just over $38 per share. 

While a discount to book value is generally attractive, it has particular appeal in this case as VAC seeks to monetize the excess inventory and land.  After the current construction is complete, VAC will have approximately three years of inventory, and can harvest excess cash flow by drawing that down.

Company guidance for 2011 estimated total pro forma adjusted EBITDA is $95 - $105 million.  With no contract sales increase, this would rise to $116 million in 2012.  With 10% sales growth in 2012, adjusted EBITDA would be $138 million.

For a quick and dirty number, one can extrapolate from slide number 111 of the company’s analyst day for guidance on assigning multiples by division (lodging and timeshare).  One pre-spin sell-side report that I read used a SOTP EBITDA target multiple for Marriott of 11.5x on Core Lodging, and 6.0x on Timeshare.  Granted, these are targets, but as a hybrid, they are interesting:

SOTP pro forma adjusted EBITDA for 2011E, combined with the above multiples:

General and admin expenses:            $135 million, allocated proportionately below--

Management fee revenue:                  $63 million (minus $36m) at 11.5x multiple = $310m

Timeshare:                                          $172 million (minus $99m) at 6.0x multiple = $438m

Total:                                                   $748 million / 33.7 million shares = $21.90 /share

Add $150 million from the monetizing of excess undeveloped land = $4.45 / share

Plus $200 million in excess inventory sales, which further reduces EV by $5.95 / share

Minus $40 million in preferred shares (approximately $1.20 / share)

Add $29 million in cash (approximately $0.85 / share)

Adjusted total: $31.95 / share.  (Note, the excess inventory and undeveloped land sales have not been discounted, but instead, the low end of expectations was used.)

The shares are trading for just about half that.  While this rough estimate admittedly lacks any semblance of precision, the valuation gap caught my eye.  Let’s make another adjustment:

Double adjusted total: I typically take sell-side target multiples and discount them by 1/3^rd, which brings that SOTP lower by just over $7.00 / share.  That would represent approximately 8x and 4x multiples on the business lines, which sounds more conservative to me.  That still puts a valuation of $25 on the stock, looking out a few years. 

The investment case is that VAC is an orphaned stock with an unappealing sounding business that trades at a lower multiple than the parent, and is probably an after thought to most major investors given its paltry relative size.  Both these businesses, MAR and VAC, will probably benefit from the spin, and hopefully someone will address the MAR investment case.  However, VAC seems to be in a good position to monetize assets over the next couple years that could dramatically increase its visible margin-of-safety.  Cash on the balance sheet always looks better than excess inventory.  While we wait for this improvement, the underlying business is sound and modestly profitable, and full of potential efficiency gains.  It has gone through a rough period, when most investors would consider its product to be facing a challenging consumer environment, and come out of it transformed and fairly healthy. 

The key challenges will be monetizing the assets, and dealing with any disruptions in theU.S.economy, asNorth Americaremains their biggest segment.  For investors, the post-spin period is likely to be volatile, as investor preferences for the timeshare business are unknown, and quarter-end approaches.  I hope that I’m right on value, but wrong on price, and the coming month provides an opportunity to buy this business at an even more compelling price.

Disclaimer: This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned.