Activist Track: Sunterra Blistered

This column was originally published on RealMoney on July 6 at 10:09 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Robert Chapman of Chap-Cap Partners has struck again with a 13D filing on Sunterra ( SNRR). Sunterra and its subsidiaries develop and operate ownership resorts and Club Sunterra, a point-based vacation-ownership club. The Las Vegas-based company operates 97 owned and affiliated properties operations in Hawaii, the Caribbean, Europe and North America that cater to more than 314,000 families.

Chap-Cap and CD Capital Management are making important demands to enhance value for shareholders. With two activists involved in the company and the possibility of cuts to general and administrative expenses, this stock is a very interesting potential investment.

Chap-Cap's 13D is full of harsh criticism of the board of directors, executive management and the compensation committee.

"Chapman Capital believes that Sunterra's Board of Directors has treated their fiduciary duty of due care worse than they would a time share in a construction site Porta Potty," it says.

To enhance shareholder value, Chap-Cap proposes that Sunterra sell its European division and explore a full-scale auction of the company. Chap-Cap is down on Sunterra Europe due to its negative 3% EBITDA margins, which are driven by an estimated 75% marketing expense ratio and general and administrative expenses (G&A), which it says are nearly twice as high as other stand-alone time share companies.

The filing holds out the possibility that former Sunterra Europe Managing Director Richard Harrington may be interested in paying at least $80 million in partnership with Club La Costa for Sunterra Europe, which logged $80 million to $85 million in calendar-2005 sales. A price tag of $80 million would equate to roughly $4 a Sunterra share.

Chapman believes the company as a whole could fetch in excess of $14 a share. However, Chapman alleges that CEO Nicholas Benson is biased against any sale for less than $15.25 a share: "Due to the out-of-the-money $15.25/share strike price on his half a million stock options, any acquisition of Sunterra below such strike price would render those particular options worthless."

Last week, Sunterra announced that Benson would be placed on paid administrative leave while the company investigated allegations of improper accounting.

Chapman's 13D gets nastier: "We may seek to obtain intimate knowledge of all aspects of your life that may indicate an adverse effect or risk to our investment. In essence, you should live and breathe under the cloud that your past failures to regulate Mr. Benson have subjugated the Board and executive management into a state of perpetual audit."

And how about this: "We recommend that you pick up a copy of insomnia-killer The Modern Corporation and Private Property by Adolph Berle and Gardiner Means."

While CD Capital Management's letters to management aren't quite as nasty, they tackle a number of important points, such as the company's disproportionately high G&A expenses, which accounted for 20.6% of revenue in 2005, double the time share-industry average, according to CD.

If the company could achieve a quick reduction of 15% in G&A, its shares would be worth an additional $4.70 ($13.2 million in additional EBITDA, times 7), according to CD's research. CD proposes that the company should reinvest the money saved by cutting G&A into a share-repurchase program. In a more recent letter, it suggests that the company borrow money to start a share-repurchase program, then dedicate proceeds from the sale of the European operation to it. Also, CD believes it needs to correct a lack of travel-industry and strategic-consulting experience on the board and its disclosure policies.

What's Sunterra Worth?

Here is my own valuation on the company using comparables in the time-share industry.

Company EV/EBITDA EV/Revenue
Sunterra 7.5x 1.3x
Bluegreen 5.7x .8x
Intrawest 9.2x 1.4x
ILX Resorts 11.6x 1.2x
Silverleaf Resorts 6.1x 1.7x
Average: 8.02x 1.3x
Source: James Altucher

Sunterra seems like it deserves to trade at peer-average valuation. When considering several other factors, especially Sunterra's room to cut G&A, the upside becomes apparent. For example, Sunterra has increased its EBITDA margins from 7.5% to 17% in just five years. But I believe there is still tremendous upside in EBITDA that could result, primarily from decreasing G&A as a percentage of sales. In 2007, I expect $430 million to $460 million in revenues.

Here are the EBITDA gains I expect would result from G&A reductions:

Sales EBITDA gained when cutting G&A 15% (17.5% vs. 20.6%) EBITDA gained when cutting G&A 20% (16.5% vs. 20.6%)
$430 million $13.3 million $17.6 million
$440 million $13.6 million $18 million
$450 million $13.9 million $18.5 million
$460 million $14.3 million $18.7 million
Source: James Altucher

G&A reductions should account for roughly $13 million to $19 million in EBITDA additions from 2005 levels to 2007 levels.

In addition, let's assume the company can maintain EBITDA margins, less G&A reduction-based improvements, of 15% to 17%.

EBITDA margin: 15% 17%
Sales EBITDA ex-G&A-based improvements EBITDA ex-G&A-based improvements
$430 million $64.5 million $73.1 million
$440 million $66 million $74.8 million
$450 million $67.5 million $76.5 million
$460 million $69 million $78.2 million
Source: James Altucher

Now let's combine ...

EBITDA Margin 15% 17%
G&A Improvement 15% 20%
Sales Total EBITDA Total EBITDA
$430 million $77.8 million $90.7 million
$440 million $79.6 million $92.8 million
$450 million $81.4 million $95 million
$460 million $83.3 million $96.9 million
Source: James Altucher

Let's assume that in 2007 the company will trade for 6.75 times EV/EBITDA, assuming multiple contraction, creating a multiple 10% lower than today's.

Now, let's attempt to value the company by assuming no change in debt or shares outstanding (assuming if share repurchases occur, the debt taken to fund them will be replaced by a decrease in the number of shares outstanding).

EBITDA Margin 15% 17%
G&A Improvement 15% 20%
Sales (assumptions) Total EBITDA Value per share Total EBITDA Value per share
$430 million $77.8 million $8.16 $90.7 million $12.59
$440 million $79.6 million $8.78 $92.8 million $13.30
$450 million $81.4 million $9.40 $95 million $14.06
$460 million $83.3 million $10.05 $96.9 million $14.71
Source: James Altucher

As you can see, values ranging from $8 to $15 a share can be assumed. I believe my assumptions are rather conservative when considering that I didn't price in gains in the underlying EBITDA margins ex-G&A improvements, which have improved by nearly 10 percentage points during the last five years. In addition, I use a multiple of 6.75 times EV/EBITDA, below the company's current multiple and the time share-industry average. Lastly, I price in G&A/sales at 17.5% and 16.65%, still well above the time-share average of 11%.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Sunterra to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to TheStreet.com's RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.

James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of Trade Like a Hedge Fund and Trade Like Warren Buffett. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback; click here to send him an email.

Interested in more writings from James Altucher? Check out his newsletter, TheStreet.com Internet Review. For more information, click here.

TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.

More from Markets

Dow Gets Swept Into Nasty Reversal Even as Nasdaq Posts New Record

Dow Gets Swept Into Nasty Reversal Even as Nasdaq Posts New Record

Zoom CEO Eric Yuan Leads Glassdoor's List of Top 100 CEOs

Zoom CEO Eric Yuan Leads Glassdoor's List of Top 100 CEOs

REPLAY: Jim Cramer on Fed Rate Hikes, Oil Prices and Starbucks Worries

REPLAY: Jim Cramer on Fed Rate Hikes, Oil Prices and Starbucks Worries

3 Must Reads on the Market From TheStreet's Top Columnists

3 Must Reads on the Market From TheStreet's Top Columnists

Purdue Pharma Unloads Sales Staff, Transitioning From Painkiller Focus

Purdue Pharma Unloads Sales Staff, Transitioning From Painkiller Focus