Thursday, June 05, 2008

Getting Caught in the Trap? Part I

Evaluating Silverleaf Resorts (SVLF)

As value investors, many of us know what its like to be caught in the veritable value trap, when a name looks cheap and enticing, but theres more under the hood then we bargained for. Most of us have been caught here a time or two (being generous in my case), and hopefully experience brings with it the benefit of knowledge. Perhaps we can avoid making the same mistake thrice.

As deep-value microcap investors, we probably see an even proportionately larger share of traps. They are especially prevalent in the land of net/nets (companies trading below net current asset value) where we expend a great deal of research effort.

Recently we stumbled on an excellent example of a potential value trap. While we are not making a judgement on this company at this point, we thought it was an excellent example of when to dig deeper.

Dallas based Silverleaf is a small timeshare company with a market cap just shy of $83 million. Trading at just 3 times earnings, the company currently trades below its net current asset value. At first glance, it appears too good to pass up. It may ultimately be a steal at $2. Or, it might be a trap.

We covered this company a few years back (search the archives), and at the time it was also trading below its NCAV. Silverleaf subsequently ran to $7 (a five bagger), and has since given back a lot of that ground.

In evaluating a company such as Silverleaf, we first look at the companys enterprise value. Equity market cap is a poor indicator of the value the markets are placing on a company, because it does not reflect the entire capital structure. We find that Silverleafs enterprise value is $425 milliona far cry from its $83 million market cap. As it turns out, Silverleaf is highly leveraged, to the tune of $352 million in short and long-term debt. Couple this with the fact that its in the timeshare industry, not a great place to be given the housing bust and current state of the economy, and you can start to see the uncertainty surrounding this company, as well as reasons it trades so cheap.

Next we examine the balance sheet. Here we find that current assets ($546 million) are comprised primarily of inventories ($183 million) and receivables ($304 million). The receivables are potentially more troublesome. Referring to the notes, we find that the receivables are used to finance the purchase of timeshares by consumers.

From the 3/31/08 10Q:

Note 4 Notes Receivable

We provide financing to the purchasers of Vacation Intervals in the form of notes receivable, which are collateralized by their interest in such Vacation Intervals. Such notes receivable generally have initial terms of seven to ten years. The average yield on outstanding notes receivable at March 31, 2008 and 2007 was 16.4% and 15.9%, respectively, with individual rates ranging from 0% to 17.9%. Notes receivable with an interest rate of 0%, originated primarily between 1997 and 2003, have an outstanding balance at March 31, 2008 of $89,000. In connection with the sampler program, we routinely enter into notes receivable with terms of 10 months. Notes receivable from sampler sales were $3.4 million and $2.9 million at March 31, 2008 and 2007, respectively, and are non-interest bearing.

We consider accounts over 60 days past due to be delinquent. As of March 31, 2008, $4.2 million of notes receivable, net of accounts charged off, were considered delinquent. An additional $26.0 million of notes receivable, of which $22.9 million is pledged to senior lenders, would have been considered to be delinquent had we not granted payment concessions to the customers, which brings a delinquent note current and extends the maturity date if two consecutive payments are made.

Furthermore, we find that the companys debt load is financing the receivables. Silverleaf makes money on the spread between the interest charged on customer timeshare loans, and the interest the company pays its lenders. This amounted to more than $14.5 million in the first quarter, nearly double net income. Clearly the net interest margin is wide. But what happens if Silverleafs customers cant pay? For more on that, we turn to the 2007 10K and find this note:

We may be vulnerable to the change in the credit markets which could adversely impact our results of operations, liquidity, and financial position.

Because we use various mass marketing techniques, a certain percentage of our sales are to customers who may be considered to have marginal credit quality. During 2007 and 2006, approximately 21.6% and 19.6%, respectively, of our sales were made to customers with FICO scores below 600. In addition, we have experienced an increase in defaults in our loan portfolio as compared to historical rates. Due to deteriorating conditions in the sub-prime mortgage industry there can be no assurance that defaults have stabilized or that they will not worsen. These and other recent adverse changes in the credit markets and related uncertain economic conditions may eliminate or reduce the availability or increase the cost of significant sources of funding for us in the future. Specifically, if default rates for our borrowers were to rise, it may require an increase in our estimated uncollectible revenue.

This tells us that a relatively large amount of the customer base may be at risk of default. Given the current credit and housing market conditions, this is another risk factor for the company, and further explanation of the depressed stock price.

Finally, the Q1 income statement gives us more evidence: Of $65 million in sales for the quarter, $14.3 million was deemed uncollectible. This was up sharply from the same quarter last year ($8.5 million on sales of $53.4 million). Clearly, conditions are deteriorating. All of this adds up to uncertainty at best. But if you look at the bottom line alone (earnings of $.19 per share, net profit margin of 11.4%),SVLF looks like a steal. It’s rarely ever that easy.

In Part II of this piece, well explore the companys assets.

*The author does not have a position in Silverleaf Resorts (SVLF). This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.