“It is far better to invest in a wonderful company at a fair price, than a fair company at a wonderful price”. So said investment sage Warren Buffett.
Hot on the heels of Royal Mail‘s float, Merlin Entertainments’ IPO has sharply divided opinion. I believe Merlin is a wonderful company: at least, one with great growth prospects. But whether it’s being sold at a fair price — well, that’s another story.
A wonderful company
Merlin is a diversified play on discretionary family leisure expenditure, operating 99 attractions in 22 countries. It’s Europe’s largest operator of tourist attractions and the second-largest worldwide. It has three divisions: Midway, which encompasses indoor visitor attractions such as Madame Tussauds, the London Eye, and SEA LIFE marine centres; LEGOLAND parks pitched at families with young children; and leisure parks such as Alton Towers, Thorpe Park and Warwick Castle.
40% of revenues come from the UK, with international sales split across Europe (26%), North America (20%) and Asia Pacific (14%). The current owners, LEGO-owner KIRKBI and private equity firms, are selling down 25-30% with KIRKBI retaining a near 30% strategic stake. £200m of new shares will help reduce a big debt pile.
Attractions
The business is as filled with attractions for investors as Thorpe Park is for teenagers. Highlights include:
- Iconic brands with global cachet;
- Great growth prospects in Asia Pacific;
- Scale and corporate expertise to roll the formula out at low cost and risk;
- Synergies from ‘clustering’ compatible attractions;
- Good management: executives who built the business from the ground up anchored by top-notch non-execs.
Those business strengths, together with acquisitions, have delivered rapid growth in bottom-line results, turning an £80m loss in 2008 to a £76m profit in 2012 against a difficult economic backdrop. But the business consumes vast quantities of maintenance and growth capex, and debt has built to £1.4bn against £800m of net assets.
A fair price?
The valuation is the catch. The £3bn capitalisation implies, on paper, a historic P/E of around 40. The City has steered valuations on an EV/EBITDA basis, which overlooks Merlin’s big debts. Struggling to find the investment case, I’ve concluded that anticipated improvement in EBITDA from £346m in 2012 to £380m and reduced interest charges could get to a prospective P/E of 20, and dividend yield of around 1%.
Gearing — operational and financial — can generate big leaps in earnings. But it cuts both ways. Merlin’s high debt, cash-hungry capex and economically-sensitive revenues don’t leave much margin of safety at this valuation. There are better growth companies.