ValueAct Capital Issues Letter to the Board of Merlin Entertainments PLC

SAN FRANCISCO, May 23, 2019 /PRNewswire/ -- ValueAct Capital, a shareholder of Merlin Entertainments PLC ("The Company") since October 2017 and current holder of shares representing 9.3% of the common shares outstanding, has today sent a letter to the Board of Directors recommending that the company evaluates a public to private transaction.

The full text of the letter is included in the release below.

Sir John Sunderland
Chairman, Board of Directors
Merlin Entertainments PLC
Link House
25 West Street
Poole
Dorset BH15 1LD

Dear Sir John:

As you know, ValueAct Capital ("ValueAct") has been a shareholder of Merlin Entertainments PLC ("Merlin" or "Company") since October 2017 and currently owns 95.2 million shares, representing 9.3% of the common shares outstanding. We are writing this letter to reiterate our recommendation that Merlin should evaluate a public to private transaction. We know the contents of this letter will be familiar to you given our prior private conversations. However, due to the urgency for change and actionability of a potential transaction at the current share price, we feel that now is the right time to share our views publicly to allow you to discuss the matter openly with your other shareholders. For the benefit of other shareholders, we will summarize the point of view we have discussed with you in recent months. 

We invested in Merlin because of the Company's global leadership in attraction-based entertainment and demonstrated ability to earn high returns converting family parks into resort destinations. More specifically, we believe the runway for building hotels, second gates, and LEGOLAND parks is robust, and the Company is uniquely positioned as a global partner for intellectual property owners. We are impressed by Merlin's highly symbiotic relationship with LEGO and the future potential of other partnerships with intellectual property owners like Entertainment One. We are also confident that management is very talented and has had the right long-term focus on delivering great customer experiences and a vibrant workplace – key requirements for sustainable shareholder returns. 

However, we have been concerned that Merlin's share price does not reflect the underlying value of the Company and may not in the foreseeable future. The Company's share price is down 2.7% since the 2013 IPO^[1] despite a 35.5% increase in earnings per share.^[2] Simply put: Merlin has struggled as a public company. 

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. 

Merlin's ultimate success depends on alignment between management, the board of directors and shareholders that value and reward the Company's growth capital deployment. Unfortunately, the share price performance, current valuation and excessive focus by analysts on near term EPS rather than future free cash flow^[3] all indicate this alignment is impaired. As the Company deploys an increasing amount of capital that takes time to generate earnings, we fear it will take several years for Merlin to be appropriately valued by public shareholders. Three recent downgrades by analysts citing fears of lower capital returns and like-for-like growth underscore this challenge; together the reports sent the stock down 17%.^[4]

Years of continued share price underperformance can be demoralizing and destabilizing for employees.  While Merlin appears to have both a great culture and long-tenured management, this cannot be taken for granted. We note both the recent departure of the former Midway Managing Director, and the lower resetting of long-term incentive targets for management^[5] as a reminder that however pleasant it may be to work at Merlin, it must also be remuneratively rewarding for talented leaders. 

Given the challenge for public market investors to appropriately value Merlin's business, as well as the need to sustain a vibrant workplace, we believe the Company should evaluate a public to private transaction. While Merlin obviously thrived as a private company, it may have come public too quickly, with too many investments left to make for a yield-focused market.

We can imagine a day in the future when the new investment super-cycle is past, and the Company delivers more easily valued current return. Until then, Merlin would better maximize its enterprise value with private ownership and we believe there is significant private capital interest in partnering with the Company. Based on our analysis of the Company's current business and investment pipeline, as well as our knowledge of financial markets and private capital, 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.^[6] Despite our confidence in management and Merlin's long-term prospects, we would vote to support such a transaction as delivering favorable value for all shareholders while also being the right opportunity for the Company in its current form. Private ownership is simply better placed than current public shareholders to underwrite the investments Merlin must make, and to align employee incentives appropriately. We also note that Merlin's primary European peer, Parques Reunidos, has recently received a takeover offer.^[7]     

We appreciate that public to private transactions can be difficult to consummate in the UK market, especially with a large inside shareholder who would potentially continue to be an owner. However, we believe it is achievable if approached proactively and need not be distracting to the Company's operations. 

For nearly 20 years, ValueAct has focused on long-term ownership and constructive private engagement with our investments. Only in extraordinary circumstances do we feel it is productive to communicate publicly about specific investments. In this case, we believe a true long-term orientation requires ensuring a capital base that will help the Company succeed for all stakeholders: employees, guests and owners. 

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. We value our relationship with Merlin to date and welcome the opportunity to discuss our views further. We are prepared to assist if we can be helpful in any way.         

Respectfully,

G. Mason Morfit
President, Chief Investment Officer

Jake Welch
Partner, ValueAct Capital

CC: Nick Varney, CEO of Merlin Entertainments PLC                

[1] Share price change from 11/8/13 (£3.47) to 5/21/19 (£3.38).  Converted to USD at historical foreign exchange rates (Merlin has a sizeable USD business), the share price has decreased by 22% ($5.51 to $4.31).  Source: Capital IQ

[2] EPS change from 2013 (£0.169) to 2018 (£0.229).  Source: 2013 Full Year Results, 2018 Annual Report

[3] For example, several analysts value the business by applying peer-level multiples to near-term EPS or EBITDA.  This valuation approach does not credit Merlin's unique growth capital pipeline that will drive higher long-term growth relative to peers.  We also note significant research focused on near-term EPS dilution from the sale of ski resorts or application of IFRS16.  Source: Wall Street Research

[4] UBS report released on 1/10/19 sent the stock down 5.0% on 1/10/19. Berenberg report released on 3/21/19 sent the stock down 5.5% on 3/21/19. HSBC report released on 5/20/19 sent the stock down 6.7% on 5/20/19.

[5] Threshold 3-year EPS growth of 7% per annum in the 2015/2016/2017 remuneration schemes; threshold 3-year EPS growth of 3% per annum in the 2018 remuneration scheme.  Source: 2017/2016/2015 Annual Reports

[6] Illustratively, valuation at ~£4.50 implies enterprise value of approximately ~11.5x 2018 underlying EBITDA of £494mm with fully diluted share count and net debt / finance leases.  120-day VWAP as of 5/21/19 is £3.48.  Average analyst target price as of 5/21/19 is £3.93.  Source: 2018 Annual Report, Capital IQ

[7] On 4/26/19, Piolin Bidco (a vehicle comprised of the private equity firm EQT and 2 large existing shareholders) made a takeover offer for Parques Reunidos representing 10.0x EV / NTM EBITDA. Prior to the offer Merlin has traded at a 2.3x average EV / NTM EBITDA premium to Parques Reunidos reflecting a significantly better growth track record and asset quality. Source: Capital IQ as of 4/26/19

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