Hedge fund wizards are beyond our comprehension #MERL

Hedge fund wizards are beyond our comprehension #MERL

I had the unexpected ‘pleasure’ last week of commuting to London on a daily basis (it has been a while) which meant that I benefited from being exposed, courtesy of the Evening Standard, to some stories that may otherwise have passed me by.

One was that the “hedge fund” ValueAct Capital had written an open letter to the Board of Merlin Entertainments PLC (MERL) which seemed to commend the Board for their management of the business but bemoan the fact that the public markets grossly undervalue the business (latest share price 376p, market cap £3.8 billion).

Hedge-Fund is not a swear word

Before I go on, I think I should just reflect that the term “hedge fund” is in my view grossly misunderstood and misused. Some managers prefer the term “total return fund” which reflects the fact that they seek to provide consistent annual returns whether the market is going up or down; by its nature this involves balancing “long” positions with some “shorts” – it is NOT an inherently evil approach and in fact it mirrors my own approach to the markets these days, so I do feel a bit of a need to stand up for these misunderstood members of our community.

Nevertheless, I suspect that the common perception of “hedge funds” is thoroughly disreputable individuals who make it their mission to tell scurrilous lies about your favourite investment in order to bring them low. So against this backdrop it may seem unusual to find them arguing that “the market” grossly undervalues a company and this was what initially attracted my attention.

But could they be right?

Well the publicly quoted markets certainly have form in grossly undervaluing companies; every one of the FAANGs in the past traded at prices that make grown men weep at the thought that they missed out on the subsequent rise (I would have said grown men and women, but we have to accept that the fairer sex have a greater pain tolerance and girls don’t cry).

And in fact ValueAct make a good case when they point out that since the 2013 IPO, the company has increased EPS by 35.5% but the share-price is down by 2.7%. Compelling.

Well, it might be compelling were it not for the fact that Merlin trades on a P/E ratio of 17x (forecast reduced earnings mean a forward PE of 19), a price to tangible book value of 5.5x and P/FCF of 32x.

Fairly valued as I see it

There are, as far as I can see, no signs whatsoever of a share that is materially undervalued by the market currently, so the only answer to the under-performance since IPO would seem to be that perhaps the IPO was significantly overvalued (as frankly is often the case).

But is there more to the ValueAct case than the raw numbers?

To be honest, not that I can see, but they do make the case :

“We believe the Company’s declining valuation is directly linked to the decline in reported return on invested capital. While it is our firm view that the decline is mostly explained by the same exogenous impacts that have pressured like-for-like growth (tragic events such as UK terrorism and the Smiler accident), it is challenging to deploy increasing amounts of growth capital while reported returns are declining. And yet, the Company is right to pursue most of these investments for the long-term value of the business.”

Maybe the company themselves has also used these justifications ( I do not know) but to be honest it all sounds pretty weak to me. There is no obvious slump in revenues associated with “the Smiler incident” and “UK terrorism” has been background noise for my entire lifetime.

Don’t love the share, it will not love you back

I am sure it will chime with many readers if I say that I have on many occasions in the past constructed similar arguments as to why “the market” wrongly undervalues my favourite share on the basis of illogical short term factors

I can probably count on the fingers of no hands the number of times I have been proven right.

ValueAct though make another interesting claim :

We believe Merlin could deliver value in the mid- £4GBP/share for shareholders in a public to private transaction, a premium of roughly 30% to the current and recent average share price.

And then go on to say :

We encourage the board to engage with any interested parties as well as existing stakeholders to determine if our recommended path can be beneficial to all.

That is vapid nonsense surely?

I am sure that most shareholders would accept a bid at a 30% premium (surely true for any listed company?) but where is even the tiniest shred of evidence that such a bid may be in the offing? [Hint – there is no such evidence as far as I can see]

This for me is one of the puzzles: from time to time, listed companies will announce that they are “putting themselves up for sale” or will be exhorted to do so by major shareholders – but listed companies are always up for sale. Any potential suitor knows that they can hoover up shares at the current price, reducing the potential premium they would have to pay and there are no barriers whatsoever to them making a premium bid at the time of their choosing.

Certainly there have been a few premium bids over the last few months, but I cannot recall any of them being triggered by existing shareholders suggesting that they are kindly waiting for an appropriate bid.

Bloomberg carry the full “open letter” here  and because I have no axe to grind with ValueAct Capital, I will also be inviting them to comment here, in case I have misstated their views.

In the meantime, as ever, I would be grateful for any observations – feedback is always great and I am aware that many readers don’t respond because they don’t consider themselves “experienced enough”, but I would reiterate that ALL views are valuable.

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  • comment-avatar

    good article. Thanks for writing. I’m not close to MERL so am not qualified to comment. However, I do own stock in their landlords (SIR) which I’ve found an easier way to make money in this space. I luv ‘picks and shovels’ companies. Hope my thoughts help the debate.

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    Thanks for the article Tony. Is it not just that they are trying pure activism and trying to highlight the value that they believe the market is undervaluing? To some extent they have had some success with the SP reacting favourably. However, with something like $2t of PE funds looking for ideas there is no downside for them putting out their thoughts. They almost certainly won’t expect a bid to magically materialise, but what if it prompts a PE fund to take a renewed look. No downside at all.

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    ValueAct must have been reading Cube.Investments last October:

    https://cube.investments/merlin-entertainments-merl-rollercoaster-for-shareholders-may-have-opened-a-value-opportunity/

    Thanks for the interesting article, Tony!

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  • comment-avatar

    Thank you for the article. Very interesting (as is the previous article identified by Graham).

    A company with very ordinary ROCE & 5 year profit CAGR of only 6.2%, with a flat forecast for the next 2 years is at first glance quite fully valued on a forward PE of 17.8 (data from Stockopedia).

    I am slightly more interested after looking at the Lego hotels. In Nagoya, a room for 2 adults comes up at £299 on Booking.com. Out of 188 hotels that came up in my search, only one is more expensive & in comparison, an ordinary well reviewed hotel is about £50. Profit margins here may be interesting, but this kind of tat is much more marketable in Japan than certain other countries & I guess it may not need that many hotels to saturate the market.
    Then follows the difficult decision: Do I invest time investigating further or move on to the next company ?

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    Some interesting responses here, thank you for those.
    Especially though thanks to Graham for pointing out the previous article (I feel a little red faced not to have noticed it!) which does give more background for those that haven’t looked in more depth at what Merlin do. In a sense though, I think it both supports ValueAct’s view and mine.
    For a high quality business like Merlin perhaps a PE ratio of 15x (as was or 17x now) is not TOO demanding, but on the other hand as Graham suggests, there are no obvious reasons to expect stellar returns. As I noted above, I think you need to assume that current trading remains “suppressed” and that this will reverse, which is something I personally would not bet on any time soon. However, perhaps ValueAct are right that “we” the publicly quoted market, cannot think long term enough and maybe, just maybe, and there is private equity capital out there waiting to take advantage of our short termism.
    (It would be a nice outcome for shareholders to receive a bid in the mid £4 range but I personally would not take a position expecting that outcome.)

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