Merlin Entertainments PLC (LON:MERL) is not a bad business but it is overvalued, HSBC said as it downgraded its rating for the shares to ‘reduce’ from ‘buy’ and cut its target price to 315p from 450p.
HSBC said the theme park owner’s long-term underlying performance has been “sluggish” and returns on capital expenditure have not been “especially strong”.
In the short-term, the outlook is “ok”, HSBC said, adding that it expects 2019 to be a year of recovery for the business after being hit by headwinds from terrorism, foreign exchange and an accident at its Alton Towers theme park.
“Even though costs pressures are building, we believe that it can grow like-for-like revenues by enough to keep earnings (EBITDA) flat this year,” HSBC said.
“And even though weather comparatives are tough, and it faces a challenge on a Sea Life site in China, tailwinds from a new Lego film should help.”
In the medium-term, HSBC thinks the opening of new Legoland and Midway sites should push profits up.
Concerns about the long-term
However, the bank has concerns about the long-term.
“Returns on capital are above weighted average cost of capital, but at circa 8-9% not especially compelling, especially when set against a share price that commands a multiple of 18.6x pre-earnings, 15.7x enterprise value/EBIT,” it said.
The bank added that newer developments look set to have a different returns profile to old ones, taking longer to mature.
While the developments could end up being more profitable in the future, they add a greater degree of risk to the group and perhaps less transparency, HSBC said.
Merlin could make shareholder returns at the expense of growth
HSBC said its analysis suggests profits at the business have been broadly flat over time, while returns from new builds have been towards the lower end of the targeted 15-20% EBITDA range.
“Return on invested capital could rise over time as the business model evolves to become more asset light, but the downside is that this could be at the expense of growth: A new Legoland development on a management contract could only add c.1-2% to group profits vs. the more chunky increments when the group puts its own capital at risk,” it said.
“Unless it embarks on M&A, or finds a new format that it can roll out aggressively, that might mean that the group goes from a growth stock to one that returns excess cash to shareholders. This is not a bad thing but, again, the group is priced for more.”
Ultimately, HSBC does not see an obvious reason for Merlin to trade at a premium to UK-listed leisure groups such as Carnival PLC (LON:CCL)or Cineworld PLC (LON:CINE), which have a strong growth story and make similar returns.
Merlin shares fell 5.8% to 353p in morning trading.