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Why Merlin Entertainments Plc Isn’t For Me

“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.

Unlike Merlin, the company that The Motley Fool has picked as its Top Growth Stock has a long track record of making profits. It's not highly geared and it doesn't spend vast amounts of capex. But it too should benefit from people having more money in their pockets.  If you're looking for growth stocks for your portfolio, I recommend you take a look at this report, which tells you all about it.  Just click here -- it's free.

> Tony does not own any shares mentioned in this article.