Interval Leisure Group: Reverse Morris Trust with Starwood

The bidding war for Starwood Hotels (HOT) between Marriott International (MAR) and Chinese insurance company Anbang grabbed a lot of headlines in the past month as Marriott eventually won after Anbang mysteriously dropped out. Caught up in the bidding war and subsequent merger arb trading are shares of timeshare vacation company Interval Leisure Group ("ILG" shares trade under IILG).  ILG struck a separate deal on October 28, 2015 for Starwood's timeshare subsidiary named Vistana Signature Experiences (previously set to be spunoff by Starwood) in a reverse morris trust transaction where Starwood would spinoff Vistana and immediately merge it with ILG.  The transaction will be tax free to Starwood shareholders, and after the merger, Starwood shareholders will own 55% of the new ILG with pre-deal ILG shareholders owning the remaining 45% of the shares.

The two Starwood deals happening parallel creates two technical, maybe non-economic, reasons why ILG's share price has fallen 35% since the deal announcement (there are other reasons discussed below as well): 1) if a Starwood shareholder was going to sell the Vistana spinoff anyway, well now they have a currency in ILG stock to do so before the spin date, essentially pulling forward some of the typical spinoff selling dynamics, 2) merger arbitrage investors are shorting ILG along with Marriott shares to capture the Starwood/Marriott spread.  While in both cases, the ILG shares sold short will be covered with new shares issued at the end of April when the deal closes, thus not creating a short squeeze, but after the deal is completed investors will begin to look forward and see a cheap company trading at ~7x EBITDA while its closest peers trade 9-10x EBITDA.

Any timeshare related bull thesis has to first acknowledge this is an industry with a questionable end value to its customers.  Most timeshares are sold, not bought, via free seminars where high pressure salespeople pitch people while they're on vacation to drop tens of thousands of dollars on a timeshare so they can relive their vacation year after year in perpetuity.  For most travelers this transaction is dubious, but maybe for a small subset who want to return to a resort year after year and stay in a suite larger than your typical two queen hotel room, a timeshare might make some sense.  But for many I suspect that they fall for the romanticism of owning a tiny piece of paradise without fully considering the annual maintenance fees and quickly depreciating (in many cases to $0) initial investment, it's a vacation home for people who can't afford vacation homes.  Even so, billions worth of timeshares are sold annually and the business of servicing and managing those timeshare units can be a good profitable one.

Interval Leisure Group was a 2008 spinoff of Barry Dillar's IAC which at the time was 30% owned by John Malone's Liberty Media, that ILG ownership has since been transferred to Liberty Ventures (LVNTA, a tracking stock of Liberty Interactive).  Historically, ILG has operated in the asset lite timeshare exchange business where they run Interval International, the second largest exchange behind Wyndham's RCI, allowing timeshare owners who pay a $89-129 annual subscription fee to trade their weeks/points with other timeshare owners.  Developers sign up with Interval International and often pay the initial year or two subscription in order to sweeten the pot and make timeshare ownership a bit more appealing to buyers by giving them flexibility to visit other locations/resorts.  This is a sticky business with a 90% annual renewal rate.

Over the past several years, ILG has also gotten into the vacation rental business (primarily in Hawaii) and other attractive management fee revenue businesses around the timeshare ecosystem.  In 2014, they purchased the timeshare development and management business from Hyatt where they have a licensing agreement to use the Hyatt name to develop and manage more timeshares, they build resorts and sell off the timeshare units while collecting an ongoing management fee.  As the timeshare industry has continued to consolidate, ILG's exchange business has faced competitive pressures as larger developers create their own internal/closed exchange network and don't sign up with ILG.  In order to feed the exchange and management contract businesses, ILG needed to increase their development/sales arm as more timeshare companies become vertically integrated.

Vistana -  Starwood's timeshare resorts under the Sheraton, Westin, St. Regis brands - will give ILG exactly that, it dramatically increases the timeshare (vacation ownership) sales piece of ILG.  Timeshare sales is a capital intensive and cyclical business, much more so than the legacy ILG business, so this feels like a defensive merger to quickly vertically integrate and protect the fee revenue businesses going forward.

The less enticing reason why ILG has fallen significantly since the merger announcement is the market believes they overpaid, at least when looking at near term multiples.  It's a stock for stock deal, but at the time of the press release the deal was valuing Vistana at $1.5B on only $125MM of EBITDA, at least two turns above where peers were trading and it looked to dilute ILG shareholders.  But in order to get comfortable with the multiple paid you have look a little longer term, Vistana includes over $500MM in timeshare mortgages that could be securitized and turned into cash, 5 standard hotel resorts that will be refashioned into timeshare properties, and additional development opportunities at Vistana's 22 current resorts.  All in, they estimate that Vistana comes with $5.5B in future timeshare inventory that can be sold, and then added to ILG's recurring fee ecosystem.

Tucked away in the merger documents (page 98) Vistana breaks out their long term projections all the way out to 2024, likely in response to the market's reaction to the sticker price, but also to show the value in the inventory pipeline:

Be a little skeptical but it provides some perspective on the headline price tag.

Valuation
To keep things relatively simple, ILG is expected to do $185MM in EBITDA in 2016, Vistana is expected to do $148MM (both from the most recent prospectus), assuming no deal synergies (guided to $26MM annually after 5 years) and subtracting out $18MM of stock based compensation gets a proforma 2016 EBITDA run rate of $315MM.  The new share count will be just under a 130 million, at $13.35 per share, that's a market cap of $1.733 billion, the new ILG will have $464MM in net debt (ignoring non-recourse securitizations).

Proforma EV/EBITDA = ~7x

Marriott's timeshare business, Marriott Vacations Worldwide (VAC), is a good comparable for ILG, both will be a mixture of recurring management/exchange fees and development sales, both operate on the higher end of timeshare brands, and they're both pure play vertically integrated companies.  Marriott Vacations trades for ~9x 2015 EBITDA, at the same valuation using my EBITDA estimates gets you to a $18.35 share price for Interval shares, or 36% higher than today which would just about make up the difference in performance between Marriott Vacations and ILG shares since the 10/28 Vistana deal announcement.

Risks

• Regulatory - The Consumer Financial Protection Bureau (CFPB) is investigating timeshare operator Westgate, shining a light on the industry's sales practices.  Diamond Resorts is in a similar situation and was recently profiled in a long New York Times piece.
• AirBnB/HomeAway - Condo/homeowners in vacation towns can compete more effectively with timeshare developers thanks to AirBnB and HomeAway, provides a similar room option without the upfront and ongoing expense.
• Secondary Market - Most timeshares can be purchased at significant discounts to developer pricing in the secondary market which puts a lid on new unit pricing and/or really shows unsavory nature of the sales process.
• ILG shareholders still need to approve the deal, there's a shareholder meeting set for 4/20/16, Liberty and management have already agreed to vote for the deal.

Disclosure: I own shares of IILG