Diamond Resorts (DRII) is in the timeshare business. There, I wrote the dreaded word: T-I-M-E-S-H-A-R-E. The company both manages resorts and sells interests in timeshares. The story here is clear – the company is a predator. Timeshares are terrible products that people only buy after being tricked into attending a sales pitch. Every parent who loves their child should emphasize brushing teeth and warn their babies to never, ever, ever buy a timeshare. We could argue where timeshare companies sit in the hierarchy of corporate sleaze. Conventional wisdom has them above tobacco and guns and about even with gambling. Conventional wisdom also holds that this industry will grind to a halt either through the government finally putting an end to it or consumers just waking up. There is no doubt that the “ick” factor is high with timeshares. So how and why did we end up buying shares in Diamond Resorts? Are we on our way to investing in the seven deadly sins? The short answer is that I think the numbers reveal something very different than the popular story. The power of math leads us to a non-consensus conclusion. Let me also mention that Adam Wyden of ADW Capital helped me understand the company. Adam is as sharp as they come and has a fantastic track record. We both own Fiat and were introduced by a mutual friend.

Let’s start with a few basics. The timeshare industry has grown every year but two since the 1970s, so this “terrible industry” has had a growth trajectory that just about every other industry would envy. Moving to Diamond Resorts, in particular, there are two numbers that I think are particularly telling. Would you have guessed that the largest purchaser of timeshares for Diamond Resorts is existing customers? Sixty-five percent of sales are made to families who already own at Diamond Resorts; this is arguably the most informed customer on the planet – an existing customer who chooses to buy more. Another 15% of customers are time shareholders at resorts that Diamond has purchased – so their initial purchase was not with Diamond Resorts, but now that Diamond owns their resort, they are purchasing more weeks (or points). Combining these figures, 80% of sales are to customers who are intimately familiar with Diamond Resorts and own a timeshare/points for one of their resorts. This does not sound predatory to me.

So, if the people purchasing these timeshare interests are informed (since they are typically already an owner), they just must be financially irresponsible – sub-prime borrowers drunk on easy credit, right? For the company to be predatory, this must be a simple case of a big, bad company repeatedly taking advantage of overwhelmed consumers like payday loan companies. Here again, the numbers tell a different story. The average credit score (FICO) for a Diamond resorts customer is 756. For our international limited partners that may not mean much, but take my word for it — it is far higher than anybody has guessed when I have discussed the company with them. A 756 FICO score is well into the upper half of consumers and miles away from sub-prime.

With Diamond Resorts, we have addressed the “ick” factor and some misconceptions about who the customers are and why they are buying. That is a start, but Diamond has become a top five position in the fund. What else is there? Why such a large investment? For starters, as with many of our investments, the stock shows high insider ownership of more than 30%. These insiders have a history of treating shareholders fairly; management incentives are aligned and the team has avoided dilutive transactions in favor of preserving equity over the years.

The customer value proposition is another criterion I find important. Given that 80% of Diamond Resorts buyers are existing customers, they must believe the value proposition holds up. As an outsider looking at the product and the industry, I came to the conclusion that the emotional benefits of “owning” a piece of vacation has great psychological value. People love being able to give weeks to their children and grandchildren. Financially, larger families can find savings when compared to renting multiple hotel rooms and eating out every meal. There are also opportunities to make exchanges, which can be attractive to owners, as well as the ability to monetize years that a family cannot use their interest/points. Diamond Resorts claims the payback on a timeshare is 8-10 years. Reasonable people can differ on the assumptions to reach the 8-10 year number, but overall I believe that there is a reasonable value proposition for their customers. The largest downside to the customer that I see is the undeveloped secondary/resale market for all timeshares. There are a few websites and specialized brokers in timeshare hotbeds like Maui, but timeshares are hard to sell in general, and when they do sell, it is often at a very significant discount to the original price paid. In summary, customers experience a reasonable value proposition tempered by the lack of a secondary market.

The secondary market has undoubtedly had its growth stunted because the absence of the market creates an opportunity for the timeshare companies. The secondary market is the primary place where the interests of the company and customer diverge. Diamond Resorts and the other major companies, such as Marriot and Wyndham, have the right of first refusal on every timeshare resale. Every year 3-4% of property owners walk away from their timeshare because of a change in financial circumstances, death, divorce, or lack of usage and an inability to navigate the secondary market. Diamond Resorts will typically repurchase these units for maintenance fees owed, which is a tiny fraction of what it would cost to build a new unit. For example, a timeshare interest that would sell for $25,000 can often be purchased by the company for $3,000 in back maintenance fees. A robust secondary market would clearly yield higher resale values. For Diamond Resorts, it is cheaper to recapture inventory than to build new projects. This practice of “recapturing” inventory is done across the industry, and in the case of Diamond Resorts allows them to keep their current rate of sales without building new properties. They don’t have to build another resort to maintain current sales and profitability levels. This low-cost source of inventory does come at the expense of those who no longer value their timeshare, but is beneficial for the company since it improves the margins and lowers the capital intensity of the business.

Diamond Resorts is well positioned within the timeshare industry and has opportunities for continued growth through acquisitions. Timeshare management and sales are businesses where there are economies of scale and network effects. For example, a sales office in a mountain location becomes more productive when it can sell the dream of vacationing in the mountains and at the beach as opposed to just the mountains. There are also economies of scale in the back office, state regulations and compliance, and in IT systems. I was surprised to learn that the software used to manage the timeshare interests and exchanges of weeks cost $50M to develop. Despite there being network effects and economies of scale, the industry is very fragmented and has evolved with entrepreneurial developers developing single properties or small clusters of properties. This leaves a large opportunity for consolidation. Diamond Resorts has been an active acquirer and can effectively execute acquisitions at 8X existing EBITDA, which becomes 4-5X EBITDA after realizing synergies. In a zero interest rate environment, a long profitable growth trajectory at 4X EBITDA is attractive. Diamond Resorts has recently completed such an acquisition with the InterWest timeshare properties in Banff, Alberta, Canada. These are highend, attractive properties. A path to sustained growth through synergistic acquisitions at reasonable multiples is not emphasized in the story of a predator.

A well-aligned management team, history of growth, clear runway to additional growth through acquisition, and asset light model would lead many to believe that the shares must be expensive. However, thanks to aggressive and vocal short sellers, they are not. The short thesis has several variants but two primary themes. The first is that this is a good industry that looks cheap until the financing for timeshares disappears. Most buyers secure mortgages for their interests, and the company packages these loans and resells them twice a year. If they cannot resell the loans, the machine grinds to a halt. I believe this is a very unlikely scenario given the fact that timeshare mortgages actually performed very well in the financial crisis and the credit profile of borrowers is excellent. In addition, demand to purchase timeshare loans from the company is strong in this zero interest rate environment. Therefore, I personally discount the likelihood of the loan securitization market halting in the fashion that short sellers would like you to believe. In addition, the loan securitization market could close for a year or potentially longer without dramatically impacting the company. Diamond Resorts has levers to pull, such as changing the amount of financing available by requiring larger down payments or changing the terms such that they are more attractive to note buyers. The other short seller theme is that government regulation is imminent; the Consumer Finance Protection Board (CFPB) should gut the industry. However, the industry is 40+ years old and has significant regulation at the state level. Consumers have a cooling off period that allows them to exit the transaction, for any reason, several days after the purchase is made in the timeshare offices. The notion of the CFPB gutting the Diamond Business is fighting the fights of yesteryear. The current business practices, in my opinion, do not need additional regulation. The magnitude of price decline caused by CFPB rumors relative to the likelihood of action and damage caused by CFPB action to Diamond Resorts and their current business practices creates an interesting buying opportunity.

Management has been very conservative in guidance and has a long history of exceeding it. When I consider management guidance as well as the improved economics from the new acquisitions, we acquired our shares in Diamond Resorts for approximately 3X EBITDA, which is growing double digits per year. This affords a lot of flexibility to continue to aggressively buy back stock.

Where does this all end? I believe that Diamond Resorts eventually will become a private company and will continue to prosper outside of the spotlight. There is little reason for the company to be public. They do not need capital. Given the strong cash flows and high insider ownership, the current management team can pursue an LBO. When does it happen? Timing is hard to predict. However, when connecting the dots, I think there is a reasonable likelihood it occurs in the next three months. There are obviously dozens of impediments to a transaction happening at all, let alone in the next three months, but several data points point to the possibility. Diamond Resorts announced the initiation of a strategic review, the Board has formed a special independent committee, and Centerbridge Partners has been engaged to oversee a process. These actions mean there is at least some heightened potential for a transaction. This is well understood by the investment community and was announced on the last earnings call. What is less well understood, and appears in no sell side research, is something called 1818 Partners.

1818 Partners should really be called “Management has options for 5 million shares (6% of the company) struck at $12.56 that expire in July 2016.” I told you Adam Wyden was bright. As someone who focuses on insider ownership and management incentives, this is a nice cherry on top. Given that management already owns almost 30% of the company and that the options are currently “in the money” and can be exercised, these options are meaningful but not the sole driver to consummate a sale. However, in the absence of a transaction, management will have to come up with more than $60M and will incur a tax bill to exercise the options. If they pursue a “cashless” exercise, their ownership in the business will decline. Therefore, their optimal scenario is a transaction before the expiration. When we factor in the benefits of being private, the valuation, the ownership, the options, and the announced process, I would not bat an eye if this company was sold for $30 per share (almost a 50% premium to our purchase) before the options expire in July.

Scott Miller is an instructor at Wide-Moat Investing Summit 2016.

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This post has been excerpted from the Greenhaven Road Capital Q1 2016 Letter.

Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Greenhaven Road Capital Fund 1 LP and MVM Funds makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors, appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Greenhaven Road Capital Fund 1 LP and MVM Funds. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Greenhaven Road Capital Fund 1 LP and MVM Funds, which are subject to change and which Greenhaven Road Capital Fund 1 LP and MVM Funds do not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption thereunder. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.