Gary Yeowell
The following segment was excerpted from this fund letter.
Hilton Grand Vacations (NYSE:HGV)
HGV is the Hilton branded time share business that was spun off from Hilton Hotels in 2017. I first introduced HGV to LPs at the 2022 LWC LP meeting as a business that is often perceived as cyclical, yet is nowhere near as cyclical as one would expect. For a more detailed discussion of HGV, I would refer you to the transcript.
At present, HGV trades at a bit more than 8x my estimate of 2022 normalized FCF, which suggests the market believes that HGV is subject to a cyclical downturn and/or overearning due to a post Covid bounce. It is of course impossible to completely rule out these risks, but in my view they are unfounded. As for the cyclical risk, I believe HGV gets tossed into the same bucket as hotels, but in actuality 50% of EBITDA is recurring in nature, another 20% is highly predictable, and the last 30% is tied to a flexible cost structure. Additionally, the timeshare industry grew through every recession prior the Great Financial Crisis, and HGV revenue only declined 3% through the GFC. This of course does not guarantee there won’t be bumps in the road as we move forward. However, even if the Company is presently over earning, looking outa few years, earnings power is likely to be substantially higher than it is today.
First, the Company has 25 years of cohort data that demonstrates that members upgrade their spend very predictably over time as they add on more time, or utilize larger units. This suggests that members that joined over the last few years alone will drive earnings power higher as they mature. Additionally, at present HGV is in an enviable inventory position, with ~$12B in the pipeline.
Most exciting, HGV recently acquired Diamond Resorts, and is presently re-branding Diamond operations under the Hilton umbrella. While there are obvious cost savings tied to reducing duplicate functions, the real prize in this merger will be the improvements tied to overlaying HGV’s best in class sales practices on Diamond’s properties, as well as applying the benefits of the Hilton brand to the Diamond properties. Quite simply, Hilton is the #1 brand globally for hotel travel, which makes acquiring customers for HGV much easier and cheaper. Ask yourself this. If you were considering purchasing a time share, who would you trust more? Hilton, or Diamond?
There are other more tangible benefits as well. For example, in the time share business unused inventory is typically made available to the public. For Diamond, this has historically meant spending a fortune on Google keywords to advertise the inventory, and as a result Diamond has run their rental business at a loss. In contrast, when HGV has unused inventory, they simply make it available to the 139 million members of Hilton’s Loyalty program, which allows them to realize a nice profit. Applying HGV’s historic margin in Rental to Diamond’s historic revenue in Rental suggests well more than $100M of EBITDA can be un-locked by HGV in Rental alone.
To be fair, the Diamond transaction is not without risk. Most notably, Diamond’s customers have a slightly lower FICO score and lower average income than HGV customers, and these customers were underwritten by Diamond, not HGV, all of which suggest that these customers may be more susceptible in an economic downturn. Thus far however, there is no sign of softness in travel demand, with companies from American Express to Delta commenting that they expect travel to remain strong. It also may be worth noting that Blue Green Vacations (BVH), an industry player with even lower quality customers and brand than Diamond, recently attempted to repurchase ~23% of their existing equity through a tender offer. Considering that BVH is ~40% owned by insiders, this suggests that they are not worried by macro concerns in the near term.
Returning to how earnings power is likely to improve on a per share basis, there are early signs that HGV might become a “cannibal,” and aggressively shrink its share count in the years to come. From the Company’s 2017 debut as a public company until the 2021 purchase of Diamond Resorts which involved issuing equity, HGV shrank its share count by 13%. In early 2022 the company resumed this pattern with a $500M repurchase authorization, of which $290M still remains. I think the right mental model for this investment might be similar to Eddie Lampert with AutoZone in the early 2000s, which generated fantastic returns for investors. Every year, the top line can grow a bit, margins can widen a bit allowing EBITDA to grow a bit more, and the increased EBITDA can support a bit more debt, and the excess cash can be used to retire shares. Key to this potential path forward is the fact that HGV is currently under-levered, primed for significant increases in earnings power, engaged in capital efficient development, and trading at a low multiple.
If HGV does develop into a cannibal, this will likely contribute to a change in perception, which will eventually drive a re-rating of the stock. However, even without the cannibal angle, perception of HGV stock should improve on several levels in the years to come. Most obviously, at some point the market will move past cyclical fears, and shares will re-rate higher. I view this as a “when,” not an “if.” Additionally, I believe there is a chance that the entire industry is awarded with a higher “normal” multiple over time. First, with time and through normal cycles the market is likely to figure out that these businesses are not as cyclical as they appear at first glance. I think this is especially true as the Company has yet to face a non-Covid recession in the age of Instagram, which has placed a premium on travel and experiences, which theoretically will allow the industry to hold up better during downturns than it has historically.
Further, at present there is likely some ESG concern overhanging the industry, as historically the industry had multiple bad-actors at the low end, and there is a belief that people get “trapped” in time shares. That may have been true historically, and it was certainly true at the low end, but in my view there is too much reputation risk for branded players to engage in shenanigans with customers. Hilton hotels is the number one ranked hotel brand globally, and quite simply it is not worth putting that status at risk to trap people in a timeshare. Attrition at HGV runs in the low single digits, and the Company has an active inventory recapture program, which suggest that customers are both happy and able to leave when they want.
In sum, simply assuming a more normal multiple on current normalized FCF potential could lead our investment to significant upside. However, as the Diamond acquisition matures and as recent cohorts upgrade their spend, it is not hard to imagine FCF more than doubling in the years to come. A doubling in earnings power and significant multiple expansion can lead to potential multi-bagger returns with time.
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