ClubCorp: A Focus On Deleveraging Is A Good Thing

| About: ClubCorp Holdings, (MYCC)


ClubCorp continues to be beset by concerns about its model and prospects, with bears pointing to potentially excessive leverage, macro weakness in Texas, and declining golf participation.

I think those concerns are overwrought - though that doesn't mean they should be ignored.

Still, ClubCorp's decision to focus on deleveraging makes some sense, and I'm surprised the market sold off shares in response.

Management open to change is supposed to be what investors want - ClubCorp's change in focus (if indeed that's what occurred) isn't a sign of weakness.

All told, I still see fair value in the mid-teens, potentially significant upside from current levels below $12.

What has struck me as somewhat funny about the market's reaction to ClubCorp's (NYSE:MYCC) Q3 report is that there consistently are complaints from investors about inattentive and/or stubborn managers that don't listen to shareholders. (I certainly have made my share of those complaints.) If only executives would listen to the analyst/blogger/investor, the complaint goes, and if only they would focus on shareholder value instead of enriching their pockets/chasing silly growth opportunities, the stock almost certainly would rise, probably substantially.

A month ago, FrontFour Capital, which owns 3.4% of MYCC shares, sent a letter to ClubCorp management which the fund said "explained its belief that the Company's valuation is largely self-inflicted," and in which the fund detailed several potential avenues to shareholder value. After citing MYCC's depressed valuation on a peer basis, FrontFour cited a series of examples of ClubCorp's "botched investor meeting." Number one on the list was "management's public messaging that it is comfortable taking leverage back up to 5.0 Debt/EBITDA to fund acquisitions":

We believe that management's current public messaging that it is comfortable with leverage up to 5.0x debt/EBITDA has significantly penalized the performance of the stock as investors are pricing in a "levering event". Additionally, over the past year, the equity markets' comfort level with increased leverage levels has changed significantly...ClubCorp management has allowed the "story" to be cast as that of an over-levered operating company, as opposed to a high recurring membership revenue model with a strong real estate value underpinning. As a result, we believe that it would be most beneficial for ClubCorp to toggle from the position of providing a "leverage cap" of 5.0x to an actual reduced leverage target of 3.0-3.5x in conjunction with a plan/bridge to achieve this target.

Less than a month later, ClubCorp added leverage reduction to the headline of its Q3 report, and targeted a sub-4x ratio within 12-18 months on its Q3 call. CEO Eric Affeldt said in the Q&A of the Q2 call that "we obviously have received quite a bit of feedback from the investor universe suggesting...[that markets are] looking for less leverage," directly echoing a point made by FrontFour in its missive.

This seems to be the type of move that investors should want: A company adjusting its long-term strategy in direct response to investor concerns and a weak share price. (MYCC shares were stuck around $14 heading into the Q2 report, modestly above its IPO price. A solid dividend has provided some level of shareholder returns, however.) And yet I admit that my first reaction was, "Wait, they're giving up that quickly? What's going on with the business?" It appears I wasn't the only one:

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MYCC fell 15% in the two sessions after Thursday morning's release and is off 28% from mid-September highs above $16. To be sure, there's probably some fundamental reason for a decline: ClubCorp pulled down full-year revenue guidance nearly 1%, a not-insignificant amount given the low inherent growth rate here (the company targets 3-5% increases annually).

But Affeldt said on the Q2 call that the reduction mostly was due to a relatively weak Q3, with the aftereffects of flooding in Houston a particular driver: The company expressed confidence in Q4 and maintained full-year and out-year EBITDA targets. Bears, obviously, may not share that confidence, but from a fundamental standpoint, the Q3 report doesn't seem to change the story, or the bull/bear argument, all that much.

The other issue is that ClubCorp management admittedly muddled its message on the Q3 call (supporting FrontFour's claims in the process). Affeldt said at one point in the Q&A that it "shouldn't come as any surprise" that so-called "reinvention capital" spend was slowing down, and elsewhere implied that the new leverage target wasn't much, if anything, in the way of a change in strategy.

That was after he had mentioned investor concerns in framing the decision, which struck me as confusing. The impression I got was that ClubCorp was trying to emphasize that the lowered leverage target - which obviously precludes any additional major acquisitions - wasn't an admission that the previous roll-up strategy wasn't working, if not outright failing. But it certainly seems as if at least some investors took it that way.

Again, I don't think that's the right way to see the quarter. I see the new leverage target as a good thing; while I've leaned bullish on MYCC over the past few quarters, the macro and industry-specific risks here are real. The market indeed has turned on roll-up stories (the experience with Valeant Pharmaceuticals (NYSE:VRX) certainly didn't help) and assuming rates will go up at some point, a smaller debt load ahead of a refinancing seems wise.

Management's ROIC numbers on reinvention spend aside, I've still wondered why EBITDA margins haven't shown more improvement over the past few years (though there has been progress in FY16), and I'd be happy to see that cash flow redirected toward debt reduction and shareholder returns. And broadly, I think MYCC management should get some credit for listening to shareholders when so many other teams are criticized for doing the opposite.

So, from my perspective, Q3 looks like somewhat of a wash: I'm not sure I entirely buy the argument that lower revenue purely was flooding-related, and declines in golf rounds played are a long-term concern. But a more flexible outlook on capital allocation (or asset sales) seems like something that should be seen as a positive, not necessarily the first step in the implosion of the model here. Given that I already thought the price was reasonable at $14, that makes a sub-$12 handle more attractive.

The bull/bear argument for MYCC is one of the more interesting in the market, in my opinion. There's a legitimate range of opinions on how to calculate normalized free cash flow, for instance, based on the argument as to whether that reinvention spend should be considered maintenance capex (something management strongly disputes). While ClubCorp has pointed to its recession-era performance as proof of its stickiness, the company then had a significant base in Texas, where the oil boom mitigated macro impacts. There's legitimate reason for concern about retention in that still-key market in 2017 and beyond.

But the core bear arguments have never quite resonated with me. The knee-jerk case of "golf participation is down, and ClubCorp is a leveraged golf course operator, ergo the model is doomed to failure" strikes me as far too simplistic. (I'd also point out that Callaway Golf (NYSE:ELY) is at a near-decade high, though the stories admittedly are very different.) And there's also a static nature to the bear case: The argument seems to assume that ClubCorp itself is blissfully unaware of golf participation rates or the demographics of its base. It also ignores that ClubCorp continues to diversify its clubs, focusing on non-golf amenities in a direct response to those trends.

So the fact that ClubCorp at least is willing to consider changing strategy strikes me as a long-term positive. This is a company that, all else equal, owns 30,000 acres of land which have been appraised at $1.5 billion. (That's about $8 per share in asset value, net of debt.) It's still generating substantial free cash flow at the moment; its debt doesn't mature until 2022. That doesn't guarantee upside from $12; but neither does it imply that ClubCorp has a 100% correlation to a declining golf industry that will lead to its inevitable collapse.

I give the bears some credit, but still I see $12 as a potential buying opportunity. This looks more like a case where the bearish narrative has taken hold rather than a case where the bearish narrative is playing out. The bearish narrative interprets management's commentary on the Q3 call as a negative, as further evidence that the roll-up strategy here is inherently flawed. But there's nothing in the results to support that case - and I'd prefer management that listens to shareholders (and the market as a whole) to one that doesn't. If anything, I saw ClubCorp's Q3 as a modest positive; obviously, the market disagreed. But, if that's indeed the case, then I'm not sure what MYCC management is supposed to do.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MYCC over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.