Diamond Resorts International Inc (DRII) And Its Perpetual Mortgage Machine by Roddy Boyd, SIRF
Since 2007 the website of Diamond Resorts International has made people think their personal six-night stay in heaven is only a few clicks away.
Online the company’s resorts, full of beaches and golf courses, still beckon. But Diamond is a 21st-century time-share operation and investors ought to be wary of any company using the controversial vacation concept that has provided decades of fodder for comedy writers while troubling state and federal regulators.
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Indeed what Las Vegas-based Diamond is selling is a sleeker, more expensive iteration called a vacation-ownership interest or VOI. And it seems to have proved successful for Diamond, at least thus far.
As is the case with buying a time-share, customers purchase from Diamond Resorts the right to an annual one-week vacation at a resort. There are some important differences, though: Customers aren’t receiving a deeded right to a week’s stay at a specific resort. Rather, they gain the right to stay at a collection of company-owned properties in the United States, South America, Europe or Asia.
They can also buy a membership in a “trust” that allows for stays at other venues: When buying the vacation-ownership interest, they receive “points” that can be redeemed for a week’s stay — even at resorts and on cruises with which Diamond is affiliated but doesn’t own.
The concept of points is key. Think of them as a virtual currency, albeit one for which Diamond Resorts is both the dealer and the Federal Reserve. Purchasing more points means that a member has greater latitude to book a vacation, especially during peak seasons. It also means that the customer has spent a good deal of money.
In contrast, having a lower point total may require a member to reserve certain properties as much as 13 months in advance. Determining the price of points is part of the VOI negotiation process when a new member signs up. Thus, a point does not have a fixed dollar value: A chart, with data culled from member lawsuits against Diamond, seems to indicate that over the past three years the dollar value of a point has been trending lower.
Customers can expect to pay about $26,000 for a VOI for one week a year and about $1,460 in annual maintenance fees.
And a VOI is a so-called perpetual use product with a lifetime contract that’s difficult for a member to be extricated from — and there’s no resale market that he or she could tap for cash. The mandatory five- to 10-day cooling off period after a member first signs up is the only chance a customer has for canceling the contract before entering a lasting financial commitment to Diamond. (The company has said it may make some modifications to this policy in the future.)
Diamond Resorts faces considerable challenges in selling its main product — the VOI — given the current economics of the travel industry. Travel websites and apps like Expedia.com, Hotels.com and Airbnb frequently let would-be vacationers procure the equivalent of a Diamond resort stay for less than the company’s annual VOI maintenance fees. Many Diamond resorts even allow nonmembers to reserve rooms through consumer travel sites. But when a member relies on Diamond’s financing (banks don’t do VOI financing), this can push the combined annual maintenance fee and loan-payment expense to more than $6,000, a mighty price tag for a week’s stay.
Diamond disagreed with this assessment, arguing at length that focusing solely on cost sacrifices the value of convenience and flexibility.
One fact that Diamond’s management might not dispute is the warm reception investors and brokerage analysts have bestowed thus far. Rare indeed is the brokerage analyst who has not been impressed by Diamond Resorts has sustained growth trajectory: The company booked more than $954 million in sales last year, a spike from 2012’s $391 million.
And Diamond’s share price has steadily ticked northward, from $14 during its July 2013 initial public offering to $35 a year ago. This resulted in a $2 billion market capitalization when the company’s shares reached their peak value in February 2015. For the founding management and investment group that still owns more than 35 percent of the shares outstanding, this translated into over a $600 million stake at that time.
Yet in late January, a New York Times investigation showed that some of Diamond’s rapid growth might be due to overly aggressive sales practices. The Times article roundly spooked investors and almost $300 million of market capitalization was lost for more than three weeks before Diamond’s share price recovered. In response, the company issued a press release emphasizing its “zero tolerance” policy toward misleading sales tactics.
The Southern Investigative Reporting Foundation spent two months investigating Diamond’s murky soup of public accounting and disclosures to explore the financial mechanics of the company’s success. This investigation found that the financial statements have a very large red flag.
Simply put, there are a lot of close parallels to how subprime mortgage finance companies rapidly expanded in the last decade. The most obvious similarity lies in the drive to ensure a steady stream of borrowers whose down-payment cash will keep a company operating.
Diamond faces four interconnected problems: The company cannot survive on the amount of cash sales it makes, so it needs to finance sales. Diamond has to securitize those loans to bring cash in the door or run the risk of losing money on every sale. To retain favorable terms for monetizing its debt, the company has to use its own cash to make up shortfalls in the securitization pools. Since the realized value on customers’ loans is less than the amount Diamond Resorts has borrowed against them, it needs to monetize new loans faster and faster.
Recent history suggests that the fate of a company like this is not pretty.
(In an effort to provide readers a clearer view of Diamond’s responses, the company’s replies in full to specific questions have been embedded throughout this story. Of special interest are the replies supplied on Feb. 11, Feb. 12, Feb. 16, Feb. 17 and March 4.)
Since 2011 Diamond has experienced a decline in its VOI sales to new members as a percentage of the company’s entire VOI sales (although the percentage did modestly increase last year from 2014). According to the just-filed 10-K annual report for 2015, 21 percent of last year’s VOI unit revenue came from new members. In 2011, that figure was 34 percent. What’s the reason for the broad decline? It’s not immediately clear.
Diamond dismissed a reporter’s recent question about the possibility of a decline in VOI sales to new members, citing the dollar growth of their purchases. (The estimated dollar value of new member sales did increase to about $148.1 million last year from $135 million in 2014.)
By contrast, new members at Diamond’s two biggest rivals, Marriott Vacations Worldwide and Wyndham Worldwide, accounted for 36 percent and 32 percent, respectively, of their companies’ VOI revenues last year.
Common sense would suggest that absent large blocks of new members arriving organically or through a purchase of a rival company, Diamond’s continually pushing current members to upgrade their VOIs will eventually result in diminishing returns.
In addition, the number of “owner families” has decreased in three of the past four years. As owner families drop away from Diamond, the prospect of enticing existing members to upgrade their vacation owner interest becomes threatened. Diamond Resorts stopped reporting the number of owner families in the third quarter of 2014 without notice. An archived investor-relations Web page from June 2, 2015, tallied the number of owner families at 490,000, which is a decline to the level in early 2013.
When asked why the company abruptly stopped disclosing the number of “owner families” in its public documents, Diamond replied that it has stopped providing the number because a large amount of its paying customers are hotel guests or use a so-called time-share exchange network like RCI or Interval.
CEO David Palmer’s remarks about industry consolidation made during the company’s third-quarter conference call this past fall seemed to indicate that Diamond might be seeking additional acquisitions. When Diamond Resorts released its annual earnings report in late February, however, the company disclosed it had retained Centerview Partners to “explore strategic alternatives” — Wall Street shorthand for seeking a buyer.
Selling a company when its revenue grew at almost 12 percent last year and net income more than doubled is an unusual approach for a board of directors to take, especially since the shares nearly 50 percent off their highs. Managers with conviction about company prospects would ordinarily be seeking to add capital and expand the business or to borrow money to take the firm private.
Instead Diamond’s leaders seem to want an exit. What follows below is probably the reason why.
The 2015 10-K shows 82.8 percent of VOI sales had what the company calls “a financing component,” which can be compared with 38.6 percent in 2011.
The trend over the second half of last year is even more pronounced: In the third quarter, customers relied on company financing for 84.3 percent of VOI purchases. And in the fourth quarter, 83.4 percent of VOI purchases were financed this way.
What should shareholders be concerned that almost 83 percent of Diamond’s customers last year borrowed money for their week in the sun? The credit crisis of 2008 is evidence that consumers with high fixed-cost debt can, in the aggregate, do grave damage to a company whose sales are reliant on financing.
When one checks numbers culled from Diamond’s November securitization, it takes little imagination to see how a VOI membership can quickly turn into a dangerous burden for a consumer. Consider this: The average loan in this securitization pool is for $24,878. When that amount is coupled with an 14.31 percent interest rate for a 10-year term, this locks a member into a $391 monthly payment. That’s $4,692 annually for the member — with at least another $1,000 in annual maintenance fees. (The 2015 10-K said the average VOI transaction size in last year was $26,007 and the average down payment was 20 percent, or $5,201.)
Diamond Resorts told the Southern Investigative Reporting Foundation that these are not regulated loans like mortgages but rather so-called right-to-use contracts it described as a prepaid subscription product without a real estate component.
(It’s worth noting that several paragraphs disclosing potential risks for investors were added to Diamond’s new 10-K about the potential for expanded Consumer Financial Protection Bureau regulation of VOI sales.)
Diamond Resorts argued in its filings that other members of the VOI industry offer their customers financing. But unlike Marriott Worldwide Vacation and Wyndham Worldwide, which financed 49 percent and 61 percent of their VOI sales last year, respectively, Diamond’s customer base appears to be dependent on it.
Make no mistake: Offering customers financing of as much as 90 percent of the price of a VOI has enabled Diamond’s rapid sales growth. With the amount of cash sales a paltry 16 percent to 17 percent in the second half of last year, this kind of financing keeps a stream of money from down payments flowing.
So to ensure working capital and manage risk, Diamond set up a securitization program. Chief Financial Officer Alan Bentley explained why securitization is crucial to the company’s needs during a presentation in March 2015, shown on page 21 of the official transcript:
“If I use an example that the customer did a $20,000 transaction with us, they’ve made a 20% down payment, which means we did a $16,000 loan. … Well, that 50% is on the $20,000 transaction, right. So you look that and say, ‘Okay, you got — you did $20,000 deal,’ you’ve got $10,000 out of pocket because you’re paying for your marketing costs, you’re paying for your sales commissions, et cetera. So that part’s out-of-pocket. So effectively, you’re upside down. Remember, so you got $4,000 down got $10,000 out-of-pocket. So how do we monetize that and get the cash? During the quarters, what we will do is remonetize that by placing those receivables into a conduit facility. Now that conduit, of course, is we have a $200 million facility and that $200 million conduit facility is we will quarterly place those receivables into that conduit, for which we receive an 88% advance rate, right. So we get that cash back at that 88% level on that — on the conduit.”
Whatever Diamond Resorts borrows from the conduit facilities is repaid when it securitizes its receivables.
When one looks from a distance, the program seems to have put Diamond in a virtuous cycle — of issuing high-interest, high-fee loans bringing in interest income and freeing up cash for its sales force to secure additional sales.
Moreover, the bonds that emerge from these securitizations have performed well to date. Then again, they should: Diamond typically has the option to repurchase or substitute in a new loan when a loan defaults (and use its own cash to make up a shortfall). According to the Kroll Bond Rating Agency, “Diamond has historically utilized these options resulting in no defaults on their securitizations.”
These VOI loans do have one truly unusual characteristic, though: Diamond’s members are paying off the loans much faster than their rivals’ customers. Wyndham’s VOI loans are paid off on average in about four years; Diamond Resorts members are paying off their loans in about 1.4 years. (In 2011 Diamond’s members retained a loan for about 2.4 years on average.)
But the problem with virtuous cycles is that they can spin the other way, too. If there are broad economic problems, borrowers might start wrestling with job losses or wage pressures and then the speed of prepayment might sharply decline. When that happens, typically the number of loans in arrears increase. If the prepayment speeds stay lower for long enough, Diamond — which has used its own cash and fresh loans in the past to help the loans in the securitization pools avoid defaults — might have to come up with a serious cash injection.
Diamond said its asset-backed bonds are prepaid so quickly because its customers tend to make VOI purchases while on vacation and, upon returning home, quickly pay off the loans.
SIRF’s reporting, laid out in detail below, suggests an entirely different answer.
After weeks of investigation, the Southern Investigative Reporting Foundation came across an obscure accounting rule called Accounting Standards Codification Topic 978, which went into effect in December 2004, that allows Diamond Resorts — or any time-share company — to recognize revenue from upgraded sales even if the member doesn’t put any money down. New-member sales, in contrast, are accounted for only when at least 10 percent of the VOI’s value has been received.
If ASC 978’s logic is counterintuitive to outsiders, for Diamond’s management it is surely heaven sent. On the view that a time-share purchase is a real estate transaction, an upgrade to a vacation ownership interest is considered a “modification and continuation” of the existing sales contract.
How does this work in real life? Say a new member purchases his or her VOI for $20,000 and puts $4,000 down, a 20 percent equity stake. If six months later that member seeks to upgrade to an expanded membership level that costs $20,000 and signs a sales contract to that effect, Diamond Resorts could account for this as a sale even if no money is put down.
That 20 percent equity stake, which is really now 10 percent given the $20,000 additional financed, is all the legal cover the Diamond accountants need since the upgrade is considered a modification and continuation of the initial time-share purchases contract. Diamond’s computers can now record a new $36,000 loan to pay off the initial $16,000 loan and book $20,000 in new revenue. This appears to be why Diamond has such high prepayment of its loans.
If the whole things seems circular, that’s because it is. A lending facility that Diamond Resorts controls loans an existing member $20,000 and it goes on the books as revenue but not a penny of cash has gone into the coffers — yet. Plus, that initial $20,000 loan is now accounted for as fully repaid even if it is not: The member still owes $36,000 plus the hefty interest rate. And it’s completely legal.
So who is responsible for this accounting stroke of genius? None other than the senior accounting staff from the time-share industry’s leading companies who proposed this new rule in 2003.
At the very minimum, ASC 978 should give investors pause about Diamond’s quality of earnings.
When asked if the new accounting rule had spurred the high prepayment speeds of its loans, Diamond pointed to its customers’ creditworthiness as the cause.
Evidence is beginning to mount that some of Diamond’s borrowers are struggling with their obligations. Less than two weeks ago, Diamond Resorts disclosed a 45 percent increase in the amount of its provisions for uncollectible sales revenue in the fourth quarter of 2015 to $24.8 million from $17.1 million a year prior. In the company’s release, the jump was attributed to a change of certain portfolio statistics during the quarter,” suggesting some degree of credit performance woes.
The Southern Investigative Reporting Foundation asked the company to elaborate on the “certain portfolio statistics” that proved nettlesome and in a lengthy answer, it ignored the request to discuss the specific statistics behind the spike in uncollectible sales reserves but merely referenced issues that might have informed its decision.
Nor is that the only data point that suggests looming headaches. The default rate on Diamond’s loan portfolio last year was 7.7 percent, the highest the company ever reported.
Analyzing the health of Diamond’s loan portfolio is not a cut-and-dried exercise: Its rivals, Marriott Vacation and Wyndham Worldwide, wait 150 days and 90 days, respectively, before they charge off their bad loans; Diamond Resorts uses 180 days, a full two months longer.
Asked about why the company waits 180 days, Diamond said it’s a matter of internal policy and that there is no rule governing time frames for charging off bad loans.
The more Diamond’s securitization program has expanded, the deeper underwater the company has become. In 2011 it reported $250.9 million in securitized notes and funding capacity against $270.2 million in receivables. This means that if the company had to pay off its bonds, it had a nearly $20 million surplus of money owed it to draw upon.
As the securitization program doubled in size, however, that surplus evaporated. Last year Diamond Resorts borrowed $642.8 million against a net receivables balance of $604.5 million, amounting to a $38 million deficit. In other words, Diamond would have to come up with cash rather than substituting loans to make its bondholders whole. (The Southern Investigative Reporting Foundation excluded adjustments because they were noncash accruals and assumed that receivables that weren’t securitized have a zero net realizable value, otherwise the $38 million deficit would be greater.)
During the same five-year period, the average seasoning of loans (the amount of time that the loans are kept on Diamond’s books before they are placed in a securitization pool) dropped to three months last July from 25 months in an April 2011 offering.
Disclosure: When the Southern Investigative Reporting Foundation first approached Diamond Resorts for a comment for this story by phone and email on Feb. 5., Sitrick & Co.’s Michael Sitrick responded as the company’s outside public relations adviser on Feb. 13. While his firm has a diverse and high-profile practice, Sitrick is traditionally associated with crisis communications. He also he served as the outside spokesman for Brookfield Asset Management when it threatened to sue the Southern Investigative Reporting Foundation in February 2013. Two SIRF board members (while working for previous employers) have written about high-profile Sitrick & Co. clients like Biovail, Fairfax Financial Holdings and Allied Capital.